MSC Industrial Direct Co Inc (MSM) 2016 Q3 法說會逐字稿

Hello, and welcome to the MSC Industrial Direct reports FY16 third-quarter results conference call.

(Operator Instructions)

Please note: This conference is being recorded.

I would now like to turn the conference over to John Chironna, Vice President of Investor Relations and Treasurer. Please go ahead, sir.

Thank you, Keith, and good morning, everyone. I'd like to welcome you to our FY16 third-quarter conference call. Erik Gershwind, our Chief Executive Officer, and Rustom Jilla, our Chief Financial Officer, are here with me. During today's call, we will refer to various financial and management data in the presentation slides that accompany our comments, as well as our operational statistics, both of which can be found on the Investor Relations section of our website.

Let me reference our Safe Harbor statement under the Private Securities Litigation Reform Act of 1995. Our comments on this call, as well as the supplemental information we are providing on the website, contain forward-looking statements within the meaning of the US Securities laws, including guidance about expected future results, expectations regarding our ability to gain market share, expected benefits from our investment and strategic plans, including the balance sheet recapitalization plans announced today.

These forward-looking statements involve risks and uncertainties that could cause the actual results to differ materially from those anticipated by these statements. Information about these risks is noted in our earnings press release and the risks factors in the MD&A sections of our latest annual report on Form 10-K filed with the SEC, as well as in our other SEC filings.

These forward-looking statements are based on our current expectations, and the Company assumes no obligation to update these statements. Investors are cautioned not to place undue reliance on these forward-looking statements.

In addition, during the course of this call, we may refer to certain adjusted financial results that are non-GAAP measures. Please refer to the tables attached to the press release which contain the reconciliation of the adjusted financial measures to the most directly comparable GAAP measures.

I'll now turn the call over to our CEO, Erik Gershwind.

Thank you, John, and good morning, everybody, and thanks for joining us today. We have a lot to cover with you this morning: the results of our fiscal third quarter, the capital allocation actions that we announced earlier today, and our guidance for the fiscal fourth quarter.

I'll get started with current market conditions and our fiscal third-quarter performance against the backdrop of what continues to be a very challenging environment. Conditions remain quite difficult, and in fact, grew even more challenging as we progressed through our fiscal third quarter and into June.

On our last call, we described the tough environment, and in talking to our customers and looking at the macro indices, commented that we saw the potential for some stabilization on the horizon. Unfortunately, that did not materialize, and in fact, things weakened.

After a meaningful improvement in the March MBI reading to 49.7%, April and May readings dropped significantly to about the 45% level. On a rolling 12-month average, the MBI currently sits at 45.3%, which implies the continued and significant contraction in metalworking manufacturing activity levels.

This is consistent with what we're hearing right now from customers, who are describing short backlogs, soft incoming orders, and low visibility. It's also consistent with what we're hearing from suppliers, who are seeing very much the same thing.

The root causes for this prolonged downturn remain the same: the ongoing effects of low oil prices and the strong US dollar. The uncertainty around the impact of Brexit could serve to create further headwinds on US manufacturing exports, given a stronger dollar, as well as the potential slowing of underlying European demand.

Overall, the sense that the industrial economy may have been stabilizing has given way to more belt tightening and less optimism among our customers. We're hearing more talk about furloughs, time off, and even some layoffs. And while our visibility remains very limited, we're beginning to hear about distributors laying off sales people, which we had not heard much of until very recently. That said, we caution that our visibility is very low.

At this point, it's hard for us to say how much of this is a material step-down in conditions, as opposed to customers taking advantage of seasonal summer slowdowns with more extensive shutdowns. If things continue to deteriorate, it would provide an opportunity for MSC to accelerate share gains, as local distributors would come under even greater pressure. This would present opportunities, including the hiring of industry salespeople, and capturing new customer and supplier relationships.

Turing to the pricing environment, it remains extremely soft. While there's been some upward movement in many commodities during the calendar year, it has not yet translated into the manufacturer list price increases that are needed to trigger distributor pricing moves. Should the higher commodities level sustain, that could bode well for pricing in the future. Weak demand is compounding the soft pricing conditions, as local distributors, desperate to hang on to what they have, are being extremely aggressive in their pricing decisions.

In the face of this very difficult environment, our performance continues to be strong, highlighted by three things: first, our continued share gain, as evidenced by growth rates in excess of the markets we serve; second, sustained gross margin stabilization from solid execution on the buy side and the sell side; and three, strong expense controls and realization of the benefits from our productivity initiatives. These all reflect our intense focus on managing what we can control.

Let me start with our revenues. On an average daily sales basis, our net sales were minus 3.9% from prior year, and were at the lower end of our guidance range, reflecting the increasingly difficult conditions as the quarter progressed.

Within our large account business, government grew at a mid-single-digit pace. National accounts growth, while better than Company average, slowed and actually went just slightly negative. Our core customers lagged the Company average, reflecting continued softness in the metalworking end markets.

CCSG growth rates were roughly in line with the Company average in the third quarter, and were impacted by ongoing headwinds in manufacturing and natural resources. For the month of June, CCSG's growth rate, while just slightly negative, was ahead of the Company average. With respect to our three growth levers in that business, service improvement and cross-selling remain strong, while sales force transformation efforts continue to gain steam.

eCommerce reached 58.6% of sales for the fiscal third quarter, up from 57.8% last quarter, and 56% a year ago. Sales to vending customers were roughly flat in the quarter. We also enhanced our web offering during the quarter by adding approximately 65,000 SKUs, net of removals.

Regarding our field sales and service personnel, net headcount for the quarter was up slightly. We saw an increase in the base MSC field sales and service team, offset by a slight decrease in CCSG field sales and service headcount due to the sales force efforts I just mentioned. This was all in line with what we expected. Looking to the fiscal fourth quarter, we would expect total sales and service headcount to be roughly flat with the third quarter.

We continue to execute well on our gross margin stabilization countermeasures, and as a result, gross margin came in at the mid-point of our guidance. This continued the trend of sequential stabilization seen over the past several quarters.

Finally, our team maintained its focus on expense control. Operating expenses for the quarter were well below the prior year, and that reduction is beyond volume-related declines, despite ongoing incremental spending on growth initiatives.

I will now turn the discussion over to Rustom.

Thanks, Erik, and good morning, everyone. As usual, I will cover our fiscal third-quarter results, and specifically gross margins and operating expenses, in a bit more detail.

Before doing so, let me speak about this morning's share repurchase announcement. Our Board of Directors has authorized and we have announced our intent to repurchase up to $300 million in class A common stock through a modified Dutch auction tender process. The Company was offered to repurchase shares at a price per share of not less than $66 and not greater than $72.50. The tender offer will commence tomorrow, on July 7, and will remain open for at least 20 business days.

In addition, we have entered into a stock purchase agreement with the holders of our class B common stock to repurchase a pro rata number of shares at the same price per share gave to class A holders who choose to participate in the tender offer, such that the percentage ownership of class B owners/shareholders remain substantially unchanged. Our total outlay should, therefore, be around $390 million, taking leverage to about 1.4 times.

We expect to finance the repurchase using proceeds from the sale of $175 million in new unsecured senior notes, and by drawing down on our existing revolver, where we today have $400 million of capacity. In the coming months, we plan to take out an additional term loan, replenish our revolver capacity, and lock in a portion of our interest expenses.

This tender offer will be contingent upon other customary items on successful closing of the sale of notes. And as we move forward, there will be additional disclosures.

After completing these purchases, and finalizing the new debt facilities, we'll provide an update as to the EPS impacts. However, we currently expect that FY17 EPS will be approximately $0.23 to $0.24 higher, assuming the tender offer is fully subscribed. Erik will share more on the rationale behind our decision to repurchase shares via this two-step Dutch auction mechanism later.

Now, I will turn to our fiscal third quarter. Sales came in at the lower end of our guidance range, with average daily sales, ADS, declining 3.9% for the quarter to $11.2 million. This is discernibly lower than the $11.4 million run rate of the first half.

While sales disappointed, gross margin was another story. We posted 45% for the quarter, right in line with the mid-point of our guidance, and down just 40 basis points from the third quarter last year. Gross margins have now held at 45% for the last four quarters. And considering the increasingly challenging price environment, as well as the headwinds from customer mix, our gross margin countermeasures have been quite successful.

As expected, we're now seeing the benefits from our supplier cost initiatives. But as we've said before, we will need all of these countermeasures just to keep gross margins stable.

Our team also delivered another quarter of solid operating expense reduction. Fiscal third-quarter OpEx came in roughly $13 million lower than in the same period last year, and $8 million below guidance. Volume-related operating expenses were lower, of course, but we also controlled costs pretty tightly across the board.

Our headcount at the end of the third quarter was 6,510, down by 184 from last year's third quarter through attrition as we continue to drive productivity. Roughly $9 million of the year-on-year reduction came from payroll and payroll-related costs, with a reversal of incentive compensation expenses accounting for $3 million of this. This is because lower third-quarter sales and sharply reduced sales expectations for the fourth quarter negatively impact our FY16 bonus expectations. Given the US manufacturing environment, our focus on productivity and controlling all our discretionary expenses will continue, and indeed intensify, over the months ahead.

The third quarter's tax provision came in at 38.2%, as expected. Our diluted EPS for the quarter was $1.05 versus $1.03 in the prior year's third quarter. So, after setting aside the incentive accrual reversal noted above, we were broadly in line with the high end of our third-quarter EPS guidance range.

Turning to balance sheet, our DSO was 50 days, a slight improvement from last year's third quarter. Our rolling 12-month inventory turns were 3.18, slightly up from the prior quarter's level of 3.13. Turns should be slightly higher at the end of the fiscal fourth quarter, but we believe that the value of holding ample inventories to meet our customers' needs exceeds the carrying costs.

Our free cash flow, ie, cash flow from operations ex capital expenditures, was $95 million in the third quarter. This compares to last year's $102 million. But our year-to-date free cash flow now stands at $251 million, double last year's $125 million. This was mainly due to the working down of excess inventories built up in 2015 for the new Columbus CFC, and also in anticipation of higher sales. Capital expenditures were $8 million for the quarter, versus $13 million in last year's fiscal third quarter, and are now $35 million year to date.

Last quarter, I mentioned our intention to purchase our Atlanta distribution center, and on July 1, we entered into an agreement to do so for $33.7 million. As noted in our last earnings call, we consider distribution facilities as core strategic assets, and this was the only major CFC not owned outright by MSC. The purchase is expected to close in August, and we now expect -- as a result, we now expect FY16 CapEx to be in the range of $80 million to $90 million.

We paid out approximately $26 million in dividends, and we repaid $65 million of debt, net of borrowings, in the third quarter. We ended the third quarter with $32 million in cash and cash equivalents, and $263 million in debt, mostly comprised of $194 million on our term loan and the $40 million balance on our revolving credit facility for a leverage ratio of 0.5 times.

Now, to our guidance for the fiscal fourth quarter of 2016. First, because our fourth quarter this year has an additional week, I'll spend more time bridging the movements, and try to do so both versus the third quarter of FY16, and also versus the fourth quarter of FY15.

The deterioration in daily sales that we saw in May continued into June, with ADS declining by 4.6% to $11.1 million. Thus, while we expect a slight increase in sales both sequentially against the third quarter and also against the prior-year period, this is only due to the extra week.

In ADS terms, we expect the fourth quarter to decline by roughly 4% to 6% versus the prior-year period. The mid-point of our guidance reflects an average ADS figure for the fourth quarter of about $10.8 million, compared to $11.2 million in our fiscal third quarter and $11.4 million in our fiscal fourth quarter of 2015. So, our guidance assumes a drop in ADS in July, due partly to slowdowns, and an increase in August.

In the fourth quarter, we expect gross margins of 44.9%, plus or minus 20 basis points. That is down just 10 basis points from our fiscal third quarter. This is despite the seasonal headwinds that historically have resulted in a 40- to 60-basis-point decline, sequentially.

We expect operating expenses in our fourth quarter to be roughly $13 million higher than in our third quarter. This comes from the additional expenses of one extra week.

You might expect OpEx to be down, given the lower sequential ADS, which it would have been if not for the third quarter's incentive accrual reversal. In the fourth quarter, there will also be a $2 million non-cash, one-time charge arising from the Atlanta CFC purchase, which is offset by no longer having J&L-related amortization.

Looking at OpEx year over year, you can see the impact of our team's expense controls and productivity actions. After factoring out the extra week, our expenses are down around $10 million. Some of this, of course, is a result of lower volumes, but the majority is due to our productivity efforts. So, apples to apples, our fourth-quarter operating expenses are expected to be flat sequentially and down year on year.

Despite the challenging economic environment, we expect that our gross margin countermeasures and tight control in operating expenses will result in operating margin of about 13.1% at the mid-point of guidance. For the year, we will then be at the high end of the lower-left quadrant in our FY16 operating margin framework, or about 13.1%. This would be approximately the same as last year, despite a roughly 4% decline in ADS and flat pricing.

Once again, this is a testament to strong execution of both our gross margin countermeasures, as well as our productivity improvements and cost savings initiatives. All of this will result in a fourth-quarter EPS range of $0.96 to $1, and note that this assumes a tax rate of about 36.8%.

I will now turn it back to Erik.

Thank you, Rustom.

Let me start by sharing with you the rationale behind the repurchase program that Rustom discussed earlier on. For over a year now, we have conveyed our willingness to operate with somewhat higher leverage, in order to create a more efficient balance sheet and enhance shareholder returns. We've said that we are comfortable operating with at least 1 times leverage on a steady-state basis and that we would flex up further for the right opportunities.

As we look out, we see an extremely strong balance sheet and very strong free cash flow generation. Additionally, several large infrastructure projects are now behind us. And so, over the next few years, our CapEx should be below the elevated levels that we saw a couple of years back.

As we have done periodically throughout our history, we see now as a good time to return capital to our shareholders, particularly given the extremely low interest rate environment. At a size of roughly $390 million, this repurchase will put our leverage ratio at about 1.4 times, giving us plenty of flexibility for future opportunities, including acquisitions or additional share repurchase.

It was important to us to maintain that flexibility, as the current environment could create compelling opportunities, particularly if things were to erode further. If they do, our Business offers a nice built-in hedge, as cash flow generation only gets stronger when sales decline, as has been evidenced this fiscal year.

I will now explain why we chose to do so through this particular mechanism, a modified Dutch auction tender. It returns a significant amount of excess capital to our shareholders, and it does so in an equitable and transparent way. Given that we have two classes of shareholders, the two-step approach allows all shareholders to participate as they desire, while maintaining proportionate ownership between the classes.

It also allows us to tap the capital markets to take advantage of the current rate environment and to take on some additional longer-term debt. Optimizing our balance sheet this way also lowers our overall cost of capital. In summary, this is an appropriate decision at the right time for the Business and for our shareholders.

Before I close, let me offer some perspective on our performance and our outlook. We continue to operate in an extremely challenging demand and pricing environment.

Against this backdrop, we have focused on controlling what we can: taking share by outgrowing the markets we serve, stabilizing gross margins by working with our suppliers and maintaining price discipline, and bringing down operating expenses by strengthening our productivity mindset throughout the Company and taking costs out of the Business. I am very pleased with how we have performed on all three dimensions through the first three quarters of our fiscal year.

Looking to the future, we are well positioned regardless of which way the environment turns. Should things improve, we have a powerful embedded earnings leverage story built in. Between the infrastructure investments already made, and the progress that we have made on productivity and our cost base, we're poised for strong operating margin read-through on our top-line growth when it returns. On the other hand, should the environment remain poor or even deteriorate further, distributor layoffs may accelerate, creating even more opportunities for MSC, such as new customer relationships, the hiring of industry salespeople, and stronger supplier relationships.

As I wrap, I would like to thank all of our associates for their dedication and hard work. Our success in the face of a tough environment is a testament to their commitment and their continued effort.

And we'll now open up the lines for questions.

(Operator Instructions)

First question comes from Matt Duncan with Stephens Inc.

Hello. Good morning, guys.

Hello, Matt. How are you?

Good Erik, thanks. Just talk a little bit more, if you would, about the monthly sales trend that you're seeing and what end markets do you think are most responsible for things starting to weaken a little bit again here? It seemed like things were going to get better. They didn't. They're actually weakening. What is causing that?

Matt, I think what you're seeing, if you take a look at our monthly sales trends, they are reflective of what we are feeling, seeing, hearing in the environment. That is as measured by customer discussion, supplier discussions, looking at the macro indices. What I would say in terms of root cause is it really point you back to, amazingly, the same drivers that it's been throughout this prolonged downturn. And that's the lagging and ongoing effect of low oil prices and the effects of the strong dollar.

The weakness is pretty widespread within manufacturing. I would say it is acute within our sphere of the world, within metal cutting manufacturing. Many of the segments that we have pointed to before, heavy machinery, metal fabrication such as job shops and machine shops, et cetera. So, really not much of a change.

I think you're right, from our perspective a quarter ago, our sense was that there was a chance of stabilization. I would not have called it an uptick, but stabilization. That has certainly not materialized and so, I would say that our sales trends are reflective of the environment.

I think what you heard from us, as I look at it, the Company regardless of which way this thing goes is very well-positioned. In some ways, the worse it gets, the more opportunity there is for the Company in capitalizing on local distributor weakness. No question, what we saw a quarter ago as the potential for stabilization did not materialize.

Okay. The outlook for a 5% ADS decline at the midpoint of guide, the comps are going to get easier and actually, you're going to start comping against negative months from one year ago going forward. So that would imply further weakening. Is that really just the impact of the dollar strengthening in the wake of Brexit, the impact that would have on your manufacturing customers' exports? What makes you think things continue to get worse here?

I will give you the big picture and certainly, Rustom, if he wants to chime in on specifics with our average daily sales implied for the quarter. Yes, you are correct, that a worsening growth rate in the face of lower comps is the result of projection of lower average daily sales. I think it's just tracked right back to what I said to you about what we are sensing in the environment, which is weakening demand among our customers.

I can anecdotally tell you that for the month of June, what we heard from customers, and particularly what I heard from some of our key supplier partners, that June was a really bad month. So what you see -- now, the one caution I will give you is it's always tough for us to sort out this time of year, how much of this, as I said, is a material step down that is ongoing versus softening as we get into the summer and customers taking advantage of summer slowdowns in a more serious way. But what is implied in our guidance is lower average daily sales.

That's right, Matt. All I would add is visibility is particularly bad right now, as Erik pointed out. But we're assuming that July will come in probably around $10.5 million on average daily sales, and August will bounce back to around the $10.9 million type level. Hence, you see how we come up with our $10.8 million guidance. Looking at absolute average daily sales is probably the easiest way to see how the business is performing.

Sure, Rustom. And then last thing just real quickly on the buy back, it's really just as it pertains to capital allocation in general. Should we take this as a sign that maybe you are not seeing M&A at the right price of any meaningful size out there right now? Or am I reading a little too much into that?

Yes, Matt, I would say the perspective on M&A, really I would not take much from this either way. If you look at -- Rustom took you through the math on where this, it fully subscribes where this brings us to a leverage ratio of 1.4 times. We feel that's a very comfortable range. Gives us the ability to flex up for the right opportunity. Our posture over the past several quarters on M&A has been we are open, we're looking, but we are also very selective. And I would say our posture is no different than it has been.

Okay. Very helpful. Thanks, guys.

Next question comes from Sam Darkatsh with Raymond James.

Good morning, Erik, Rustom. How are you? Three questions if I might. First off, regarding the Dutch. I applaud the method and the scale. I frankly wish we would see more of these broadly speaking. I am curious as to how the price and timing were determined? The last couple of quarters you were buying stock at a much smaller scale than this, obviously, at lower prices. If you could help as to the thinking behind why now as opposed to perhaps a couple quarters ago?

Sure, Sam. Let me take that. As Erik said earlier, we have a history of returning excess capital, but we don't try to time the market per se. We have excess capital now and we have an opportunity to create a more efficient balance sheet with the outcomes being a lower [WAC] and doing all this in a pretty low interest rate environment.

Looking at spending roughly $390 million, if we were to continue with open market buybacks, that would take many months to execute or you accelerate and probably drive the price up. It is not as transparent. That is pretty fundamental and a Dutch auction tender, and thanks for those supportive words, a Dutch auction tender offers all shareholders the same opportunity to participate within a communicated range. Then, it is also very critical from our perspective because the family, then only sales that, they've committed to sell the same number of shares that's required to keep their proportion to ownership unchanged and they get the same clearing price that everybody else gets.

So the tender price itself, the other part of your question, it was basically a tender price to achieve our objective, which is to accretively return capital. So the $66 lower end is actually the approximate midpoint of our 52-week high and low. The $72.5 upper end, represents a 7.5% premium to our one-year VWAP, the volume weighted at average price. That is pretty much how the range is. And of course, in keeping with our governance standards, the actual range is set by an independent committee of the Board after input from advisors.

That is very clear. Thank you for that. The second question, the OpEx in the quarter, I think you mentioned Rustom, that it was $9 million lower year-on-year because of payroll. But I think it was roughly $8 million or so below your original plan, or at least the plan that you vocalized to us. Where were those savings achieved specifically? And if you do intensify your productivity measures going forward, what specific areas within OpEx would get the most amount of attention?

That is a good multifaceted question there, Sam. $3 million off those savings come unfortunately from the fact that we -- as we looked at the sharp, at the decline in Q3's performance on sales and at the sharp decline that we envision in Q4, versus what we were expecting just a few months ago. That basically means that we do not require our bonuses to be as high as they would have been otherwise. The payroll savings have come from a focus on efficiency and really looking at every head as we have people at 3,000. Most of the headcount reduction, almost all of it has come through attrition. Yes, there's been a little bit of performance management, but in those cases, there have been replacements and it's fundamentally through attrition.

So what we have done is, we've across the Company mobilized our team. And that is why I keep using the -- bringing this back to our team and giving our team the credit for this performance. Because really what you are seeing is people everywhere looking to say okay, as a person drops out, voluntarily drops out, how could we achieve what we are doing better? That is the core of it. That is why the bulk of the savings come from there. Of course we're cutting back on discretionary stuff like travel and we're using videos and we're cutting back on the use of consultants and hitting every other lever that we possibly could do without jeopardizing the long-term health of the business. That's really very important to us.

Sam, just to chime in for a second and add on top of what Rustom said, I can not underscore enough what Rustom, the finance team and our executive team have really I think energized and mobilized the organization around a productivity mindset. So as he pointed out, headcount's dropping just because of attrition and it's really a testament to our team getting more creative, scrappier in terms of thinking about new and different ways of doing things.

As Rustom said, we are targeting some areas for productivity, whether they be freight or travel or things like that. But, it has really been an across the board mindset ramping up the productivity mindset that I think still has legs to it. I think we're still relatively early on in this process through the Company.

That is a good point. Sam, if you look at our year-to-date, if you look at the reduction in our OpEx. And even if you take out 10% on sales, even as a rough approximation for variable and impact of volume, that is still a $21 million reduction over the first nine months of this year. So, it has been a very sustained, completely team driven process.

Last question, if I could. I know this is a small part of your business, but it is obviously particularly topical now. What are you seeing of late in J&L in the UK?

Good question. So, UK, I would say -- so, very topical and very raw and fresh. In fact, I know we had some folks from here, from the Melville area, who were just spending time with our UK team. I would say, as you would imagine, they are still sorting out what this means. I would say nothing really to report other than a lot of uncertainty, a lot of angst, a lot of questions, not a lot of answers.

Thank you, gentlemen. I appreciate it.

Next question comes from Robert McCarthy with Stifel.

Good morning, Rustom. Good morning, John. Good morning, Erik. How are you doing today?

Good morning.

I guess going back to the share repurchase, I think you highlighted $0.23 to $0.24 in terms of your assumption. In terms of the assumption for the guide for the fourth quarter, is there anything material? And obviously, it's happening midway through the fourth quarter, so it's going to be a fairly muted impact, but is there going to be any positive impact to share count for the fourth quarter?

No, Robert. It's Rustom. I'll take this. No, because by the time the process actually works its way through, the buyback occurs in two steps. First, the [remedial] in the middle of August and then the family 10 working days later. So, it will have no impact. So there is no EPS benefit in the guidance, and any interest expenses that we have will be fairly small as well. What we thought is that subsequently after we, given after we finalize everything, we provided updates on what impact it has had.

Okay. Shifting gears not to 2017 explicitly, but just so we understand for modeling purposes. Do you expect 253 days in 2017? In other words, consistent with your long-term pattern, not the five extra days you had in 2016?

We do not expect the extra week for sure. That is a one-off in this year's number.

So 253 is for modeling purposes is how we should be thinking about it, days?

Rob, I think you are right, but let's talk later in the day and confirm that.

Okay. So, at least I'm thinking about it right. Away from the mist and perhaps a little more high level. In terms of you had -- you said a very bad June and obviously, you have different tendrils to different parts of the economy, maybe you could talk about where you're seeing pricing pressure specifically? And how do you reconcile your comments overall to what was at least optically a strong ISM for the month?

I'll hit your last one. I'll go in reverse order, Rob. The ISM, I would tell you that it's been -- to be honest, we scratched our head at the latest reading, but I think we and the rest of the industry have been scratching our head at the readings over the last several years. So really not surprising and if you ran regression analysis against our average daily sales levels in the ISM, you would find over an extended period of time and you'd find virtually no correlation. Very different from if you ran the regression analysis against the MBI on the rolling 12-month average. So not much do I make of that.

I think more relevant with respect to June, as you point out, is we certainly look at the MBI, we will look at other indices and most relevant to us is talking to customers and talking to suppliers. Boy, I'll tell you as it relates to June in particular, overall, we made the comment like as amazing as it sounds, we do feel good about the share gain performance as measured by what is happening with our growth rate relative to what is happening to the end markets that we serve. And if June was any indication, it certainly would support the data point. Because what we heard from suppliers -- and we will get pretty specific saying what is happening in your business ex MSC? And the numbers were really bad.

And what is interesting is I cannot really point to anything new, Rob. It has been the same sustained pressure from oil and the dollar. It's been widespread in manufacturing, acute in metal cutting manufacturing. And again, the one caution is we are not sure what to make of it yet. How much of this is kind of a new level and a new step down versus is this entering summer, people are just going to get clamped down over the summer. We do not know.

Just a follow-up on the pricing question, I think in the quarter -- and this math may be wrong, probably because it's coming from me. I think you had a negative price headwind of I think 0.7%, a little less than 1%. Any specific areas or verticals that you would call out in terms of the pricing pressure?

And Rob, it's a good point. I think if you pull back -- I didn't hit pricing, apologies. If you pull back and look at the performance, my assessment is I think the team has done a really good job about maintaining price discipline. And over the course of the fiscal year, the last few quarters, roughly flat pricing and what has really been a deflationary environment. You are right to note that our third quarter, there was a little tick up in the negative price realization. I think your numbers are right, a little less than 1%.

What I would say is the longer this thing drags on and particularly, the longer the demand environment stays weak the way it is, the more intense the pricing environment gets. Because what happens is, and you may have noted my comment about local distributors, just now for the first time we are starting to hear the first signs of distributors laying off salespeople that we have not heard to date. I think what it is indicative of is the longer this goes on, the more difficult it gets for a local distributor to hang on and they get more and more aggressive with respect to pricing. I think the downside here, certainly, is that pricing gets tougher and tougher as time goes on.

Obviously the flip side to that is that if things really continue to stay this bad or if they even get worse, from our standpoint, our opportunities actually grow. Because it's really -- for the last two years, in a sense we have been in no man's land in that things have been lousy. But the step downs have been gradual and gradual enough that most local distributors have been able to avoid laying off salespeople.

The longer this goes on, the more pressure they are under to lay off people, cut back inventories, cut back on service and I think the share gain opportunities will grow. If you believe things will eventually turn, as we do, what that should do if things get worse in the near-term, is widen our gap to market on the way back up. And of course, with the built-in leverage we've got, create an even better earnings story. So, that's how we're viewing it.

Your cost actions have been admirable. I think just to press my luck with one little more question, on the operating margin framework, any thoughts on where we are in terms of the quadrants right now given the superior execution on the cost initiatives?

You mean in the coming quarter?

Page 5 for the full-year. Just any further commentary around that or you think it's just consistent with where we are now as consistent with your prior statements?

Rob, I think what we have said, we are firmly in that lower left quadrant in environment, but on the high-end of the range within that. I think it was 12.6% is the midpoint plus or minus 50 basis points that we said we're at the high-end of that lower left quadrant based on the cost actions.

Understood. Thank you for your time.

Rob, I will also confirm that 253 days in real time. That's a good number.

Thank you very much.

Next question comes from Ryan Merkel with William Blair.

Good morning, everyone. First, I want to ask about the shutdowns in July. Did you say that it's going to be worse or more extended this year versus last year? And then, can you comment is it widespread or is there particular end markets where it's going to be more robust?

Ryan, so, yes. To answer your first question, if you see the ADS that Rustom mentioned, the ADS going from June of about $11.1 million to July, $10.5 million, is a pretty significant step down. That is mostly attributable to summer slowdown and shutdowns. I would say yes to the first question. More extensive than prior years.

If you look back over the past, and this by the way is never a perfect science trying to get at this, but if you look back, every time there has been any sort of holiday in the last several months, it has been an excuse for customers to take time off and there's been slowdown. We do not see any reason why this is going to be any different and we think we're probably in the midst of it right now, this week, next week, till first half of July is where it would be most acute.

Then to your second question, I think there is a correlation between how extensive are the shutdowns and how soft is the end market. So again, I think the softness is fairly widespread, but of course we're coming from a world, Ryan where our front porch is metalworking end market. So, it's pretty acute in the metalworking end markets.

Got it. Okay.

And Ryan, if you do the math on that, which you will on those numbers, we were minus 4.6% using the midpoints in June. August is back to that minus 4.6% and July, was actually [in messaging] maybe down about 5.2%, 5.3%. You can see that we thought that July would be a little bit worse but broadly in proportion.

Okay. That is helpful. Back to Sam's question on intensifying the productivity. I am just wondering, number one, can you give us an estimate of how much you think cost cutting is going to help over the next couple of quarters? And then my second question is you have been talking about it flat sales, you could hold margins, maybe maintain them. You did a little better than that this year, obviously, but as you look out the next couple of quarters, is that still a fair framework to think about how you are going to manage the business? Flat sales, you could think about holding, maybe even expanding, margins?

Let's both take a crack at that. Maybe I will go first. So, you take June's run rate of $11.1 million per day and you run that out for the whole year, next year, and you just assume that we are [end of year]. What that would translate to, that is about 1% below our FY16 full-year projection. Again, at midpoint. We are not talking a massive degradation, but what we have said is that we would need sales to be at least flat to hold operating margin.

We've taken out a lot of costs and we have continued taking out costs, but we need sales to be at least flat. Then, yes, we'd expect to generate margin expansion even on very low sales growth levels, but it is too early to provide specifics going forward more than just the quarter ahead.

Ryan, I think that says it well. Obviously, we will come back, it will be next quarter when we will give you a full perspective on 2017. I think Rustom said it well. Directionally, not much changing. So we would expect to expand out margins when we get into the growth levels. Obviously, with where the business is right now, with the kind of growth rates for the fourth quarter, we'd have a tough time doing that. We would need to see an improvement in growth rates. So that could be the stabilization of average daily sales at the June levels or a tick up different story. But obviously, if things continue at the current growth rate, different story. Directionally, yes, I think that is in the ballpark where we have been, but we'll refine the picture as we get to 2017.

Okay. Then just lastly, price is a little bit tougher now. I just wonder, are your manufacturers starting to offer deeper discounts? It sounds like they are struggling a bit as well. In the past, has that led to worse pricing down the road if all of your competitors are getting lower prices? Just talk about that, if you would?

Ryan, sure. Let me talk -- so, two things. One is on the pricing environment and then two, is on the supplier perspective on this. Pricing environment remains quite weak. If there were one little point of light to point to that I mentioned in the prepared remarks, certainly if you look at many commodities, most commodities, are the ones that are relevant to our business -- and this is on the price side, not the cost side -- they are well up over, since the start of the calendar year. So if you looked on a three-month, six-month basis, most of those commodities are up. That bodes well. If you looked on a 12-month rolling basis year-over-year, they are still down.

But, if the current push, tick up I should say in commodities were to sustain, we would potentially see what we have yet to see to date, and that is movement in distributor -- manufacturer list pricing. That would allow us and other distributors to pass along pricing to end users. So, it has not happened yet. Should commodities hold, we are hopeful that that could be maybe in the latter half of our fiscal year. Who knows?

As it relates to the cost side, we've been talking as it relates to MSC, Ryan, about the aggressive actions we have been taking with our suppliers as best we can. This is on the purchase cost side, doing it in a win-win way. One thing I will say that part of doing it in a win-win way means not just taking any concessions or improvements in our deal, if we have a supplier that is willing to do it, not just taking that and passing that through because really that does not help anybody. It is certainly not good for manufacturers to see their sale prices go down. So who knows, it is hard to say what others are doing. But I know from our discussions with suppliers, they would be very reluctant at most to pass along discounts just to see them bring pricing down in the market.

Ryan, let me just jump in there. What we have been doing on working with our suppliers, the supply initiative is not totally about cost or anything like that too, it's very much about working together to try and see what we can do. And that could be in terms of training, that could be in terms of additional support, ways in which we can grow sales for them and for us. It is very much as Erik said, aligned more on the win-win in there. I would not bring it down straight to just price and cost. It is a strong win-win relationship.

Okay, thank you very much.

Thank you, Ryan.

Next question comes from David Manthey with Robert W. Baird.

Thank you. Good morning, guys. First off, Rustom, I'm hoping you can shed some light on this. When you look quarter to quarter, second quarter to third quarter, revenues were up $43 million and GP was up $18 million. That is about a 6% quarter to quarter increase. If you look at, even excluding these accrual reversals, your SG&A was down $4 million or about 2%. I'm wondering if you could just bridge the sequential change in what areas, what costs were reduced, just in the last 90 days from second quarter to third quarter? And particularly, it is a big number relative to history, particularly given your outlook last quarter was a little more positive. Could you help us bridge the second quarter to third quarter cost situation?

Sure. And Dave, I think you are honing in on those numbers really. If you look at what we had in the second quarter, it was $228.2 million, and the third quarter was $221.2 million. Then if you also looked at the differences on our sales, $727 million coming through in the third quarter versus $684 million. So you will see that what we did was achieve that improvement despite the actual sales number being significantly higher.

It was a combination of those things. It was very much the bonus accruals reversing, which is the $3 million that you saw there. And actually quarter-on-quarter, it would probably be excess [of basis] because we probably have accrued for that in the second quarter as we were looking much stronger in performance. You will see that is a good part of the swing.

Then, the rest of it is, just the good old-fashioned blocking and tackling. Just a whole bunch of initiatives, freight initiatives, working with suppliers, discretionary professional fees, IT data cost savings, virtual meetings. We are just very focused on keeping costs down. Headcount of course, which we mentioned earlier. I hope that helps.

Yes. It is just truly remarkable because the last time you saw a sequential decline second quarter to third quarter was 2009, when sales were down year-over-year like 20%, 23% to be exact. It is a remarkable decline in cost and I was just hoping to get a little more clarity in terms of what specifically was reduced from second quarter to third quarter.

Sorry, let me just comment again. As I think about it, the bonus was obviously the biggest one because A, we approved for it in the second quarter and B, unfortunately it turned out we did not need it in the third as we ran it through our numbers. So that is part of the swing. It's the others. I'm looking at professional fees, there was salaries, fringe expenses, because as you know, we have moved to a different healthcare plan nine months ago or so, advertising, there is just a bunch of costs where we did better.

Then, second, on the tax rate, was the 36.8% guided tax rate for the fourth quarter versus 38.2% in the third quarter and year-to-date? Is that because of the DC purchase?

No. That is actually because our fiscal fourth quarter typically benefits from the release of various state tax reserves and that is just due to the timing of the [statue of limitations]. And it seems to occur every year in the fourth quarter. That's all this is.

Okay.

Dave, just to circle back to your OpEx question. If you do the math, and this is the math that you did, you are looking at sales, as Rustom says, so sales plus $40 million. You would generally expect given our variable expenses OpEx on that sales base to be plus $4 million and then you are looking at a minus $7 million on expenses. So the $7 million and the $4 million together, effectively minus $11 million.

Rustom pointed out, you do have to take out of that -- the first thing I'll say, the big driver there is the productivity that is going on. But that minus $11 million is bigger than what is sustainable. I think that was the point Rustom made largely because we had a bonus accrual in the second quarter and then unfortunately, because of the results in the outlook, a reversal in the third quarter. That is artificially inflating the $7 million. The majority of that $11 million is the productivity and it is really coming from the areas that Rustom just rattled off.

Okay. Final question, on the guidance share count, could you tell us what you are using to get to your EPS range?

For Q4?

Right.

The guidance, it would be 61.4 without taking it down to another decimal.

That's great. Thank you very much.

Next question comes from Adam Uhlman with Cleveland Research.

Hello, good morning.

Hello, Adam.

Rustom, just a clarification. You had mentioned there was going to be a $2 million charge in the fourth quarter. That's not in the EPS guidance, correct?

No, that is in the EPS guidance. That's why I was mentioning all the swings and roundabouts. And that is simply because we have to write-off the leasehold improvements and we get a write-back of deferred rent. And that's in our numbers. We are not doing any pulling out of numbers and saying adjusted numbers or anything like that. We're just noting it and yes, it is in the guidance. It's a goal in our guidance.

Great, thank you. Can you guys talk to your performance with national accounts? It sounds like their sales have slowed further there. I am wondering if you could talk to your performance in terms of the number of national accounts that you have pulled together? Are you growing year-over-year on that basis and then the average spending is just down? Could you also talk to the vending sales in a similar way? The sales are flat. Is your machine count growing and then the average revenue per machine is down or is the machine count actually flat as well?

Two good questions, Adam. Let me hit national accounts first. What we mentioned is for the third quarter, national accounts was ahead of Company average but slightly negative. I would tell you that seeing national accounts come down historically when there is -- if one were to make the case that what we're seeing now is a further step down, national accounts are generally a leading indicator.

What I would say there, performance on national accounts has been strong, account base is growing, and we get very specific on our view in terms of where the growth is coming from, where the erosion is coming from. The erosion is coming from basically the base of existing accounts that are simply -- we can generally point to, has there been share loss? Is this strictly environment? This is for the most part existing customers spending less.

I feel like execution is quite good on national accounts. It is still a share gain. If I look at that performance in our national accounts relative to what is happening in the market, it is still a driver of share gain for us particularly against the locals. That's been the story; it's the base of spending coming down in existing accounts. Your second question was around vending. Is that correct? Vending?

Yes.

The story for vending in the quarter was, basically what we gave you this quarter was that the growth rate on customers with vending machines was roughly flat. So ahead of Company average but basically flat. And the story there once again, is for us a lot of our vending installs are into metalworking accounts given the weakness, production, metalworking items such as cutting tools, consumption is down. So the number of units in place absolutely continues to grow quarter by quarter, month by month. This is a story of spend in existing accounts contracting due to the environment. Again, I'd point out, I think a flat performance relative to the environment is considerably ahead.

Could you quantify the growth that you're seeing in units?

We have not broken out the number of units.

We have not done that, Adam. If you want to get more granular, you can call me afterwards and I can try to help you. But generally, we have not disclosed the number of machines, et cetera.

It is a pretty healthy growth rate though, Adam.

It is still definitely growing for sure.

It's been a core focus of, particularly in a downturn when customers are really worried about keeping inventory. It's freeing up cash not having inventory. Inventory management solutions are pretty powerful and that could be vending. It could be vendor managed inventory like we're doing through the class C business, but that whole inventory management umbrella is a major area focus for us.

Great. Thank you very much.

By the way, I will correct what I said a second ago. The share count was 61.46, so it would round to 61.5.

Thank you. This morning's last question comes from Andrew Buscaglia with Credit Suisse.

Hello, guys. Thank you for taking my question. Could you just talk a little bit about you talked about your conversations with customers and suppliers on this call. Can you talk about if the tone has changed pre and post Brexit or some of the conversations you have had more so post Brexit, if there's any concerns there?

I think post Brexit, what I would say is, again, going back to the comments I made earlier on the UK, uncertainty. I think like everybody else, our customer suppliers are scratching their heads not sure exactly what to make of it. So, a lot of uncertainty. I think the general sense though is net-net, a negative not a positive in that it creates the headwind given both the potential for the stronger US dollar, which hurts exports. And then the potential for weakening underlying European demand that would also hurt exports. I think the sense would be net negative but uncertain as to how big of a headwind and how much to make of it.

Got it. Just a quick one. I think on the last call you guys mentioned even without price, given pricing continues to weaken here, you could still get high single-digit sales. That is going to be tough. But can you talk about what that environment in the past has been where you have gotten high single-digit sales on almost no pricing? How does that compare to today and is that still something you see potential for?

Sure. I would say if you go back in time and look at the Company's long-term CAGR over a 10-year period, a 20-year period, what you would see is organic CAGR in the high single-digits in what would average out to what we call a quote-unquote moderate demand environment. So depending upon the metric that you use, it would indicate somewhat -- it would be a moderate growth case, whether it is GDP, ISM, MBI, whatever that metric is that you'll look at. In a moderate growth environment, we produce high single-digits.

In fairness, that has been with some degree of pricing. So if you stripped out pricing and said okay, there would be a moderate demand environment at no pricing, what would the business produce? You could probably shave a couple of points off of that due to price. But, to me, the punch line is even without price, in a moderate demand environment, certainly, there is positive growth. Even in a flat environment, a no growth environment, but without contraction. So if you have flat demand and no price, we would still expect, just based on outperformance to be growing. That growth, given the leverage that we have built up, is going to produce our margin expansion.

All right. That's good color. Thank you, guys.

Thank you. At this time, I would like to return the call to Management for any closing comments.

Thank you, everyone, for joining us today. Our next earnings date is now set for November 1, and we will look forward to speaking with you over the coming months. Have a good day.

Thank you. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.