MSC Industrial Direct Co Inc (MSM) 2016 Q4 法說會逐字稿

Good morning and welcome to the MSC Industrial Supply Q4 and full-year 2016 conference call.

(Operator Instructions)

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

Thank you and good morning, everyone. I'd like to welcome you to our FY16 fourth-quarter and full-year conference call. In the room with me are Chief Executive Officer Erik Gershwind and our Chief Financial Officer Rustom Jilla. 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, and expected benefits from our investment and strategic plans.

These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those anticipated by these statements. Information about these risks is noted in our earnings press release and the risk 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, which are non-GAAP measures. Please refer to the tables attached to the press release and the GAAP versus non-GAAP reconciliations in our presentation, which contain the reconciliation of the adjusted financial measures to the most directly comparable GAAP measures. I'll now turn the call over to Erik.

Thank you, John. Good morning, everyone, and thanks for joining us today.

I'll begin by covering what continues to be a very difficult environment. I will then discuss our recent business developments, which are highlighted by solid share gains, stable gross margins, the ongoing benefits of strong expense control, and earnings per share above the top end of our fourth-quarter guidance range. Rustom will provide the details on our financial results, share our first quarter 2017 guidance, and then discuss our FY17 annual operating margin framework. I will conclude with some additional comments on our expectations for the coming year, and then reinforce the opportunity that we see moving forward. We will then open up the line for questions.

So let me begin with market conditions and our performance against the challenging backdrop. Conditions remained very difficult throughout the quarter, much as they have for the past few quarters. Low oil prices and the strong US dollar continued to weigh on manufacturing activity. While we did not see the more extensive summer planned shutdowns that some of our customers were talking about back in late June, demand levels remained depressed, particularly in metalworking and heavy manufacturing.

As you may have noticed, MBI readings have ticked up over the past two months, posting over 48 for both August and September. While these levels still denote contraction in metalworking end markets, the readings are nonetheless a significant improvement over the trends of the past year. If they sustain it would bode well for our future prospects and indicate a potential leveling in the metalworking industry.

That said, for now we remain cautious. Keep in mind that the rolling 12-month average, which on a four-month lag is most highly correlated with our sales, is only reading 45.7. That reading is indicative of significant contraction for metalworking end markets as things remain quite soft despite the potential for leveling on the horizon. With some exceptions like aerospace, customers continue to see low volumes, backlogs, and quoting activity. Visibility remains extremely low, with some customers taking a wait-and-see approach as is typically the case in a presidential election year.

With respect to the pricing environment, conditions continue to be extremely soft. While many commodity prices have increased during calendar 2016, they still remain low relative to historical levels. As a result, we have not seen a significant increase in supplier pricing activity as of yet. As such, and as expected, our annual catalog increase was modest at under 1%.

While this backdrop is challenging, it does afford MSC significant opportunities for share gains. The more protracted the downturn, the more pressure is exerted on local distributors, which creates all sorts of opportunities to improve our competitive position in the market. Cutbacks in distributor inventory and clampdowns on receivables create disruptions in customer relationships. Manufacturer and distributor sales force cuts create hiring opportunities. New supplier programs get created. And the list goes on.

Our share gain performance versus the market within which we operate reflect these dynamics. Our average daily sales growth came in at minus 3.6% for the fourth quarter on a year-over-year basis, more than a point better than the midpoint of our expectations. These numbers remain ahead of the metalworking related macro indices as well as the growth rates of local metalworking distributors based on our discussions with suppliers and other industry trade partners.

So how are we achieving this better than market growth? I will give you a simple real-life example. For a number of years we were doing a modest level of business with a metalworking company in the Southeast. This manufacturer had a strong relationship with a local distributor that was providing good service and high levels of technical expertise. So the company did not see a reason to change.

However, as conditions softened and its business started coming under pressure, this company became more receptive to hearing about our inventory management program in order to reduce cutting tool inventories, our high service levels that shrink lead times, and our metalworking experts who produced documented cost savings on the production floor. Fast forward two years and we have now more than quadrupled our business with this customer.

I will now turn to our various customer types. Our government business grew at a low single digit pace in a difficult spend environment, the result of a number of contract wins. National accounts had a low single digit decline. This is the result of the ongoing drag from clamp downs in spending at many of our largest customers. We continue to feel quite good about our position within these accounts, and should benefit when conditions eventually turn. Overall, our national accounts new business funnel remained strong, and that's a good leading indicator of future performance.

Turning to our core customers, they lagged the Company average for the quarter, reflecting the acute softness in metalworking. TCSG sales, on the other hand, declined less than the Company average. In spite of difficult economic conditions, we continue to make progress with the growth initiatives in that business. The combination of all of these factors across our customer types meant that customer mix remained a gross margin headwind for the quarter.

I will now turn to e-commerce and vending. E-commerce reached 59.1% of sales for the fourth quarter, up from 58.6% the previous quarter and 56.7% a year ago. Sales to vending customers were roughly flat in the quarter. We also added approximately 10,000 SKUs during the quarter, bringing our total additions net of removals to 150,000 SKUs for the year. This brings MSC's total active sellable SKU count to approximately 1.5 million, and continued growth in all of these areas bodes well for future growth.

With respect to our field sales and service teams, we continued to optimize total headcount and we ended virtually flat for the year as expected. We remain focused on expanding sales force capacity, meaning selling hours, and are doing so by executing on our sales force initiatives.

As I mentioned earlier, we maintained our focus on gross margin stabilization. On our last call we shared that we expected a slight sequential decline in the fourth quarter due to normal seasonality that would be mitigated by our various gross margin initiatives. Fourth-quarter gross margin came in within guidance, and I'm pleased with this result in light of the current environment.

Finally, the organization once again responded to our call to action on productivity, bringing operating expenses down to levels well below last year on a comparable basis and in line with guidance. This was despite continued spending on ongoing growth initiatives. I will now turn things over to Rustom.

Thank you, Erik. Good morning, everyone. Let's turn to our fiscal fourth quarter in greater detail. Our sales growth for the quarter was 2.4% over last year, however there were four extra sales days in this year's fourth quarter. So the relevant comparison is really average daily sales. These, though better than guidance, declined 3.6% versus last year's Q4. So we return to the usual 52-week year for FY17, and I'll cover that when discussing our guidance and annual operating margin framework.

With regards to gross margin, we posted 44.8% for the quarter, just 10 basis points below the midpoint of our guidance and 20 basis points lower than the fourth quarter last year. The year-over-year reduction reflects the impact of ongoing headwinds from customer mix, as well as a soft pricing environment offset to quite an extent by our gross margin countermeasures.

We continued to fight to manage operating expenses. Q4 sales were approximately $9 million above the midpoint of guidance, and after allowing for the increase in variable costs associated with this, our OpEx too came in slightly below the guidance midpoint. Year upon year, OpEx as reported appears higher, but that's only due to the extra week of payroll costs, et cetera. On a comparable basis our OpEx was significant lower versus FY15's fourth quarter. Part of our year-over-year OpEx decline is due to lower variable expenses, credited to lower average daily sales. But even without this, we continued our pattern of expense reductions versus prior year with associate compensation, advertising, auto, T&E the main drivers.

Note that our initiatives are not just about cost reduction. For example, we've given our associates more technology at their fingertips, not only making them more efficient but also more effective by allowing them to bring the most value-adding solutions to our customers. These and other productivity initiatives have continued as we go into FY17.

It's worth noting again that FY16 was a 53-week year rather than the usual 52. To help you understand our results better, we're sharing our best estimates of P&L impact off the 53rd week, and you can see this on slide 4 of the presentation. Based on Management estimates, the extra week contributed an additional $56 million to sales, approximately $12 million to operating profit. That's about 17 basis points operating margin and $0.12 to EPS.

Our FY16 operating margin was 13.1% as reported, or 13% on an estimated 52-week basis. This compares to FY15's 13.2% adjusted or 13% as reported. This means that our operating margin was roughly in line year on year despite lower sales.

Earlier this year, we had said that we could hold operating margin flat at zero sales growth and grow it any level of sales growth. So clearly we did well with operating margin given that sales declined by an estimated $103 million on a 52-week basis, or $47 million on a 53-week basis. This result was achieved by keeping our gross margin stable and by taking out significant operating costs such that our OpEx-to-sales ratio slightly improved.

So moving on, Q4's tax provision came in at 36.7%, essentially in line with our guidance of 36.8%. Our Q4 EPS was $1.02; that is $0.04 above the midpoint of our guidance range.

So we've often talked about our lack of sales visibility and our ability to leverage higher sales; well, Q4 was a clear demonstration of both. Sales were $9 million above our guidance midpoint, and this accounted for $0.03 of EPS variance. The other $0.01 of EPS was due to the share buybacks under the Dutch auction tender offer which was completed in August.

Turning to balance sheet, our DSOs were 51 days, up roughly a day from both Q3 and from last year's fourth quarter, and attributable primarily to higher national accounts DSO. Inventory turns at 3.2 were flat with the prior quarter. However, with lower sales, inventories declined by roughly $18 million over the quarter, and this continued to drive our cash flow. In fact, throughout the fiscal year we improved inventory turns slightly despite the higher sales.

So we had an excellent quarter and fiscal year in terms of cash flow generation. In Q4 we turned 186% of our net income into cash flow from operations. This compared to 147% for the same quarter last year. For the full year of FY16 our cash conversion ratio stood at 173% versus 108% for FY15. In FY17 we'd expect our cash conversion to also be above 100%.

Net cash provided by operating activities was $115 million in Q4 and $401 million for FY16. In FY15 it was $87 million in Q4 and $250 million for the whole year. So FY16's big improvement came from working capital, which was a $63 million source of cash versus last year when it was an $83 million use.

Our capital expenditures were $53 million in Q4. This includes $34 million for the purchase of the Atlanta CFC and $88 million for the year, which also included $7 million as we commenced upgrading our core financial and accounting system. After subtracting CapEx from our net cash provided by operating activities, our free cash flow was $62 million and $313 million in the fourth quarter and FY16, respectively. In FY17 we expect our total CapEx to range from $60 million to $70 million, including $11 million to $13 million required to complete the financial system upgrade.

In Q4 we bought back 8% of our outstanding shares through a Dutch auction tender at a total cost of $362 million. We funded this with $175 million in private placement debt and by drawing on our existing revolver. During the quarter, we also paid out $26 million in dividends. Note, we remain committed to consistent and steady increases in our ordinary dividend, and in fact our Board of Directors increased the quarterly dividend 4.7% to $0.45 per share last week.

As of the end of the fourth quarter, we had roughly $607 million in debt, mainly comprised of a $217 million balance on our revolving credit facility, $188 million on our term loan, and $175 million of the private placement debt I mentioned before. We also closed the quarter with $53 million in cash and cash equivalents, which resulted in a leverage ratio of approximately 1.3 times. Our cash flow generation remained strong, and we expect our leverage ratio to decline further in the first quarter.

Now, to our guidance for FY17, which you can see on slide 5 of our presentation. Please note the usual caveat that our visibility is extremely limited. We expect first-quarter revenues to decline on an average daily sales basis by 2.5% to 4.5% versus the prior-year period. Through last Friday our quarter-to-date sales decline was approximately 3.7%.

We expect a Q1 gross margin of 45% plus or minus 20 basis points. This is slightly up sequentially versus our fiscal Q4 of 44.8% and slightly down versus FY16's first quarter of 45.1%. As Erik noted earlier, the pricing environment remains very difficult, and we expect continued headwinds from our customer mix, but we'll look to offset much of this through our ongoing gross margin countermeasures.

We expect first-quarter operating expenses to be about $9 million lower than in the prior year, mostly attributable to continued cost management, lower depreciation and amortization, and the spike in medical expenses in last year's first quarter. And of course, there will be lower variable expenses associated with lower sales this quarter. As such, we expect an operating margin of about 12.8% at the midpoint of guidance for Q1, and that's in line with last year's Q1.

Finally, our EPS guidance for the quarter is for a range of $0.90 to $0.94, and this includes a roughly $0.05 benefit from Q4's share repurchase. This also assumes a tax rate of about 38.2% and for comparison last year's Q1 EPS was $0.89 and also had a 38.2% tax rate.

Turning to our full-year FY17, the framework on what we expect our operating margin to be under various scenarios is summarized on slide 6 of the presentation. We continue to base our operating margin scenarios on two factors: MSC's growth level and the pricing environment. So the framework continues to show two scenarios for sales growth for the Company, slightly negative and slightly positive. The slightly negative scenario correlates with sales trends of minus 4% to zero, and that is where we are today. The slightly positive scenario encompasses a growth range from zero to positive 4%. After the last 12 months it would rather nice to be in that quadrant.

Like last year, we will also have two pricing scenarios also slightly positive and slightly negative. The first scenario of slightly positive anticipates 0% to positive 1% of pricing, and the slightly negative scenario assumes roughly minus 1% coming up to zero pricing. We do not expect any further price increases in calendar 2016, and the longer the soft demand environment continues the more discounting we will expect to see from the local and regional distributors. This dynamic would continue to serve as a gross margin headwind for the year as it did in FY16. On the other hand, should suppliers take any meaningful price increases for 2017, we would follow up with a midyear price increase and that would create a gross margin tailwind.

It's important to note that in FY16 we paid out incentive-based compensation at levels below 50% of target, as lower sales more than offset our strong gross margin and OpEx execution. In FY17, based on performance goals being met, we have assumed that incentive compensation will be paid at 100%. This will impact full-year operating margins by roughly 40 basis points. As a result, only in the top right quadrant do we envisage a higher operating margin midpoint than what was achieved in FY16.

Let me make a very important point here. We will continue taking cost down in FY17. In fact, our various productivity initiatives are allowing us to offset other costs such as key investments, merit increases, and other inflation. However, after a year of solid cost reductions we do not expect the additional savings to be enough to offset all of these expenses plus the step up in market-driven incentive compensation versus FY16.

Our Q1 operating guidance at a 12.8% midpoint is being provided in the context of slightly negative sales growth and an essentially flat gross margin environment, which is where we are today. This of course looks slightly better than where the operating margin would be in the full-year framework. Last year's incentive compensation accruals were higher in the first half, making for more difficult comparisons in the back half.

And as we're currently targeting incentive compensation repaid at 100%, our FY17 accruals are expected to be evenly spread through the year. Of course normal seasonality is also a factor, as Q2 for example tends to have a significantly lower operating margin than Q1. Also keep in mind that the annual framework is not intended to apply precisely to any individual quarter.

Finally, please remember that we have a cost base that better allows us to leverage our sales growth than we have enjoyed at any time in our recent history. Even with the additional costs in FY17, we only need sales growth of 1% to 2% to expand operating margin, and at any level of sales growth EPS will expand faster than sales. I will now turn back to Erik.

Thank you, Rustom. As we look ahead to 2017, I want to briefly pull back and offer some perspective on our performance against the Company's strategic plan. We have several priorities, and I am encouraged by the progress on each of them.

First, we continue to outgrow the markets we serve and [maintain] market share from the local and regional distributors that make up roughly 70% of the industrial distribution marketplace. Second, we are advancing our leadership position in our core market metalworking and are cultivating a second one in the Class C consumable VMI market through CCSG.

Third, we are leaning out our Company's cost structure. We are doing so by aggressively partnering with our suppliers to reduce purchase costs and by mobilizing a bottom up grassroots effort to attack operating expenses. Both of these initiatives are translating into results. The former in the form of stable gross margins in the midst of a historically bad pricing environment, and the latter in the form of operating at cost take out.

Fourth, we have assembled and fortified a very strong industry-leading team across our organization, one that is building upon our heritage and making our culture even better. As you know, our performance-based compensation this past year reflected the impact of the ongoing very difficult environment on our results as it should. At the same time, it has not reflected the intense and ongoing efforts of the entire team to deliver above industry growth rates and reshape our business at the same time. As a result, and as Rustom mentioned earlier, we're targeting FY17 performance-based bonus compensation payouts at 100% of target.

Fifth, we're increasing the value we bring to our customers. Our inventory management solutions are reducing inventory levels and increasing customer control. Our technical experts are working on customers' plant floors to engineer production cost savings. Our e-commerce solutions are streamlining our customers' procurement process, our digital analytics are bringing new insights regarding customers' purchasing patterns and their plant operations.

We're elevating the role that MSC plays and helping our customers improve their business. And we've captured this spirit in our new brand platform that we introduced at the recent IMTS show, Built to Make You Better.

Sixth, we have accomplished all of this in the midst of an extremely difficult and prolonged industrial downturn. We have capitalized on the opportunities that come with soft conditions, including cementing new customers, forging new supply relationships, and bringing great talent onto our team. As we look ahead to FY17, the Company is well positioned regardless of what happens in the industrial economy.

Should conditions improve or even just stabilize, the Company is poised for a tremendous growth and leverage story. On the other hand, should the difficult conditions persist for another year, we will continue to capitalize on all of these opportunities and even more so, making our future growth and leverage story even more compelling when conditions eventually improve.

As we now move into a new fiscal year, I would like to thank all of our stakeholders; our customers to whom we remain committed to driving greater productivity, profitability, and growth. To our suppliers for playing such a vital role in our business. To our owners for continued confidence in our future. And, of course, to our associates who are continuously rethinking, retooling, and optimizing our Company for a better tomorrow. I thank you, and will now open up the line for questions.

Thank you, sir. We will now begin the question-and-answer session.

(Operator Instructions)

Matt Duncan from Stephens, Inc.

Nice job in a tough environment here. I want to start with the operating margin framework. Which quadrant do you think we are in right now, or are we in the middle of all four of them? Where should we be thinking, based on the current environment, that you would come in for the year?

Matt, it's Rustom. I will start on that. We're clearly in the slightly negative on the sales, because we're guiding 3.5% and the sales quadrants are 0% to 4%. From a pricing perspective, I mean, while we were minus 1% or so, as Erik said, in the more recent period, we're pretty much close to that mid-line, if you would, and that's what we think in the first quarter. So, close to the middle of those two quadrants over there in Q1.

But remember, for the whole year, going on the second part of your question, remember that our framework is for the whole year, so we have those seasonal swings. For example, in Q2 we had payroll, tax resets for the new calendar year, stuff like that. So it's hard to really take a line from Q1 to the entire year. Does that answer? Is there anything else?

I guess what I'm getting at is, if the environment does not change, which quadrant in this table should we think you're going to be in?

Matt, it's Erik. I think Rustom pretty much summarized it. The one thing I would add is, the reason we came out with this framework two years back was the reality that we are in such a short-cycle business, visibility is so limited that for us to go out and project the year in terms of environment on either demand or pricing, to be honest with you, we would be kidding ourselves.

What we like to do is let you -- and you guys are smarter than we are in terms of figuring out what will happen in the world to -- based on your assumption about what happens in the world, here is how the Business performs. I think Rustom's comments were right on.

Look, just to offer you one perspective, if you took our current average daily sales levels and said, if you wanted to believe nothing changed and average daily sales held through the year, allowing for the holiday effects and such, that would put us somewhere minus 1%, minus 2% top line on an average daily sales basis, moving closer towards the center. As Rustom said, if you ask us right now on pricing, somewhere between those. It's a bit gray given the environment, but hopefully that gives you some perspective.

It does, Erik. Thank you. Another thing I wanted to ask about the operating margin framework, if I remember two or three years ago you told us at $3.5 billion in revenue you would have a high-teens operating margin. I'm curious if anything has changed in the environment or with the Business that would change that, or is that still applicable assuming at some point the industrial economy has to grow again.

That sounds like a nice number. So, essentially what you're looking at there is $700 million in growth. What we've talked about, as we look at the next tranche of growth for the Company, what we've talked about is that the op margin, the incremental margins at that next tranche of growth should certainly be in the 20%s over an extended period of time.

And where that falls in the 20%s is going to be a function of a couple things. Number one, how fast the recovery would be. The faster the recovery, the more it moves up. And number two would be what happens with pricing.

So, if it's a demand environment recovery with any modest amount of pricing, we're going to inch up in that range because we'll get some margin expansion in an early-stage inflation cycle. So it really does depend.

The one other thing that I would add in would be, look, for the near term that incremental margin perspective in the 20%s would be over an extended period of time. I think for the early rebound, we would probably see it a bit higher, meaning the first bit of growth. Rustom?

Let me try and make it concrete. Let's say we were at [zero for tight] revenues and might be at $100 million of additional revenue. When you take into account the average margins and then our variable costs -- freight, commissions, all that stuff -- you take the packing and shipping, take that out and then even allowing for a little bit of additional investment in the Business, I mean, we should be able to, from that $100 million, migrate the first -- from that first $100 million, take $30 million down to the bottom line.

And that doesn't mean that we'd continue doing that because I think that's important also to reinforce credit and reestablish credibility on our leverage. But there's still $100 million after that, the next $100 million we'd probably invest a bit more. So you couldn't model out into infinity at 30%.

Okay. Last thing just real quickly, the quarterly interest expense and share count that we should be using post the share buyback, I just want to make sure we know what you are assuming in this $0.90 to $0.94 guidance range?

At this current leverage that we are, interest costs would be less than $3 million in Q1, is our assumption.

And then share count somewhere around 56.5 million? Is that right?

Yes it is. 56.6 million, I think.

Okay. Thank you, appreciate it.

Hamzah Mazari from Macquarie.

This is Kayvan; I'm stepping in for Hamzah. I had a question about your balance sheet and capital allocation in relation to your M&A strategy. Can you give us any color on that, what you are thinking right now?

Sure. I mean, at 1.3 times leverage and dropping, we still have plenty of financial capacity if the right opportunities present themselves. We're being selective.

There's no change in our M&A outlook. We remain quite active in building our funnel. We're looking for opportunities, but the bar is high and the opportunities must be the right fit strategically, culturally, and financially.

All right. Appreciate that. Thanks.

Ryan Merkel from William Blair.

First question I want to start with the environment. At the mid-point of the sales guidance, I think November average daily sales would be down about 3.5%, which is a little worse than October, down 2.4%. So my question is: Should we be reading that the environment is getting a little worse, or would you say nothing has really changed and you took the average of September and October and just extrapolated it?

The latter. The punch line is the latter. The reality is, and I'll just discuss, when we look we tend to not make too much of any one month's movement.

So if you look back over the last few months, you'd say August looks like things are getting better, September ticked down, October back up, and the reality is it's moving around. We don't see at this moment material changes. What we did for November was took the average of the two.

I figured, I just wanted to be clear. Okay. The second question, on the full-year guidance, the mid-point is roughly 0% average daily sales growth. Am I right that you are assuming the market is down, what, 2 to 3 to 4 points and that you're taking 2 to 3 points a share to get there? Is that how we should be thinking about it?

Ryan, so that would be -- so what I'd say, we really haven't made much of an assumption. We have painted the scenarios; I guess what you're talking about is somewhere in the middle there would be 0%. That would be correct.

The way we look at it is, if we are at 0%, based on -- I can only tell you based on what we see today, and what we have seen over the past several quarters when we benchmark the MSC level of growth against some of the indices, particularly the indices that will reflect what's going on in metalworking, and then when we benchmark that against what we're seeing from competitor growth rates, particularly closest to the markets we serve in metalworking, we're seeing a spread of a few hundred basis points.

And so our assumption is that not much changes with respect to share gain when we project out. So the answer is, yes, that at flat growth we would anticipate the metalworking market to be down, a few points would translate into roughly a flat growth for MSC.

Got it. If the market were to grow slightly next year, you would be growing 4%, 5%, 6%?

Ryan, that's right. I think that's really where -- the answer is, yes, we would. If you make the assumption that the market stabilizes, and we pointed to the MBI sentiment reading as ticking up for two months at 48, that's negative but starting to approach neutral.

Based on our historical model, there's roughly a four-month lag on the average. If that gets close to neutral for a period of time and implies a leveling in the market, you are exactly right, we would expect our growth rate to be plus a few hundred basis points.

And at that point, you'd be on the outer edge of the margin framework, maybe even beyond it. Obviously that's where, when I was referencing in my comments the leverage story that's getting built up here is really exciting. Because what we see happening right now is a lot of the share gains that we're getting are in customers that are way down. So we're getting the -- capturing the spend, but there's not much spend at the time. Should things level and the spend come back, we really see the potential for a big story here.

And that's really what I'm getting at and trying to clarify. You mentioned in the press release the tremendous leverage, so let's put some numbers on that. If you were to get up to 5%, 6% sales, I know the MBI would have to go above 50 and stay there because of the lag. But could you do high 20%s, low 30%s incremental margin? I think that's what you're saying.

The answer is yes. What I can certainly tell you is that, I'll look to Rustom, but we would be at 4% or 5% top line, well into the double digits on earnings growth.

In fact, Ryan, the same point, the $100 million I was alluding to earlier, it's like a 3% revenue growth number in absolute dollars. That would be a very nice migration at the very start, and then hopefully as growth continues then you would start to invest more.

You don't just have everything flow through to the bottom line, because we have been tight on our costs. As we go forward, there'd be some investment going after establishing firmly the credibility of our leverage story.

Got it. Thank you. I will pass it on.

David Manthey from Baird.

Within your margin framework you widened the price axis; last year it was flat to up, this year it's slightly negative to slightly positive. First question: Is there any information content there?

And then second, even if you look at that slightly positive pricing grow, with sales ranging from slightly negative to slightly positive, those quadrants are consistent with last year. You reduced that range I think by 40 to 60 basis points, which is just a little bit more than that 40 basis points you were talking about on the compensation accruals. That is in light of the fact that you've got gross margins up about 10 basis points at the mid-point. I'm just wondering there, is the delta because of negative expense leverage only, or is there something else happening?

David, it's Rustom. The downside is mostly because of the negative expense leverage. If you basically compare those mid-points year on year, and apart from the slight tweaking, if you would, on the price ranges, basically what you're seeing is about 40 basis points coming out of them is fundamentally from the higher incentive compensation envisaged.

Thank you (multiple speakers).

If you're trying to get at what's under the covers, gross margin, so to give you our outlook on gross margin, not up. I'm not sure, the 10 basis points over prior year is not what we would -- if you look at our guide, we're actually 10 basis points under for Q1.

So basically we are starting the year at 45%, which would be flat with prior year. And you know our Business long enough to know that absent any pricing move whatsoever through the course of the year there would be a deterioration from Q1.

This year, given all the purchase cost actions, we'd expect that deterioration to be mild, in line with what we saw last year. But then certainly to the extent there were any mid-year pricing actions, and we'll have a better feel for that, by the way, most likely next quarter, we should have a better feel on what manufacturers are doing around the calendar year. That could push gross margins up. Hopefully that helps give you a little color.

It does. I guess I misread that. That gross margin guidance that you gave was relative to the first quarter.

Along those lines, you started talking about the gross margin countermeasures almost two years ago now, and as those efforts have played out and as you said, Erik, if pricing is negligible and volumes are flattish with this negative mix continuing I guess, as you said, we could almost expect a slight degradation there this year.

Yes. David, I would say slight degradation -- if there were no further pricing at all, I would say, similar to the picture in 2016 would be our outlook in 2017, which would be, I would term as pretty mild degradation. In terms of the countermeasures, we've talked about them for a while and it's remarkably simple when we talk about what they are, which is just smarter buying and smarter selling. It sounds simple and it's just a lot of continued ongoing execution. And I would not make the assumption that they are done.

Certainly part of what is going to happen in 2017 is we're going to enjoy the benefits, particularly on the buying side of the actions taken in 2016. But there is also further actions that will occur. We're continuing to work with suppliers that want to invest in us. They're going to see an investment in return, and we are continuing to look at refining pricing activities, discounting activities, and discipline. So it's remarkably simple, basic stuff, and just a whole lot of continued execution.

Okay. Thanks.

Adam Uhlman from Cleveland Research.

To start with a clarification, I think you had mentioned that metalworking mix was the gross margin headwind. Is there any way to dimension for this past year how big that was? Would the gross margin have been up excluding that mix headwind over the past year?

I think the mix headwinds we are talking about, it wasn't specific to metalworking; it's more of national accounts, more of government sales proportionately. I mean that's what we're talking about more, the customer mix.

Okay, got you. And then, over the past year the Company has been adding a lot of new SKUs. Any sense of the incremental sales benefit that you might have gotten this past year, what you might get in FY17? And then, can you talk about what you're planning on adding over the next year, and how I should think about inventory levels associated with that?

Adam, sure. This has been a good program for us. It has been a few years now of continued SKU addition.

What I would say is, you are pretty much seeing now -- what tends to happen is there is a cumulative benefit that we get, whereby we're still getting benefit from classes of SKUs that were two, three years ago that were added to our mix. There is a compounding effect. You are pretty much -- I would say at this point for the most part, other than a really exciting new supplier addition or something, you are more or less seeing in our numbers now the benefit of the program. And what I would say is at this point you could expect that to continue.

I would say the same thing from the inventory side, Adam. You're seeing in our inventory numbers now the impact of this program. So I wouldn't think necessarily about a tremendous change in pattern either way on revenues or inventory [because] this is now in the mix.

Adam, just the quarter, not the whole year. Inventory is probably going to be up about $10 million or so in Q1, just as we look at how far they went in Q4 and what becomes true within what we see. So you actually see a slight uptick just in the quarter. Doesn't fully answer your question, but gives you some color.

Okay. Thank you.

Sam Darkatsh from Raymond James.

I've got a few quick questions and one of them is a follow-up on the last point. With respect to your inventories all in, if sales are flat this year, do you expect inventories to continue to be a source of cash?

No. If sales are flat, we are probably a slight source of cash, but not much. If sales are completely flat, we will probably run at around this 3.2 level.

And, Sam, the reason for that is we actually see our strong balance sheet and our strong cash basically as being a competitive tailwind. So we'd rather hold plenty of inventory and then be able to make those extra sales.

Got you, okay. Next couple of questions, Erik, I'm going to try and word delicately because I respect that there are some sensitivities around it. First, with respect to the variable comp payout, the assumption that there's going to be a full payout in FY17, if we end up being at the lower-left quadrant, does that still assume that there is going to be a full payout? And is that a realistic assumption?

So, Sam, to answer your specific question, the framework contemplates a full payout. What you're seeing in the framework has a full bonus in all scenarios there.

Your second question, is that realistic? On your second question, let me step back for a second, I want to give you a little context here and then I will answer you.

What we've been looking at, really for the past couple of years, is the Business has been operating in a very, very difficult environment. And in the midst of a difficult environment, producing solid results and solid execution. And that's -- we're looking at the whole picture here on share gains, holding margin, stabilizing gross margins, holding operating margins, the job that has been done on cash, the job that has been done on execution of strategic programs, the job that has been done on customer service, Rustom noted inventory. So, inventory is way down year over year, with service levels at all-time highs and a competitive weapon.

I look across the board, and in spite of a difficult environment for the last couple years, I see strong execution from the Company. And then I look at bonus payouts and they have not been reflective of the team's performance in this environment.

Look, the reality is we have a real -- I mentioned it in the remarks -- I feel like we have a really top-notch team and I want to make sure that that top-notch team is rewarded and incented to continue with this good work. So that is the reason for the assertion that we're making on the bonus and the incentive comp at the 100% payout.

To your specific question is -- okay, so we've modeled it in at 100%, is that going to happen in all scenarios? I would say at this point, early to tell. And early to tell only because to some extent it will be based on the environment, and the performance will be relative to the environment in which we operate. So what I would say is, if we were in that lower-left quadrant, it certainly would not be a guarantee that we'd be at 100% of target, but there would also be a chance if, based on the measures we put in place for our plan, our performance is strong relative to that environment.

Final question, if I could, and to the extent you feel comfortable answering this, of course, Erik. After the sale of the Atlanta and DC, and after the Dutch auction, is the family done, at least for the time being, in terms of raising cash?

Sam, let me start by saying this: Look, I think that the -- take both of those. Both of those were done really, and I can let Rustom talk about the process we followed, as Company decisions. So if we take Atlanta, the decision on Atlanta was based on what's the right decision for the Company, not what is the right thing for the family.

The same thing with the tender offer. If you look at the tender offer, look, the family's overall holdings in this Business remained absolutely constant and consistent pre- and post-tender. So the stake in the Business is just as high as it was. I can tell you -- share a little bit that, for me personally, the family as a whole remained constant, for me personally. My stake as a percentage went up post tender. So, commitment in the Business is extremely high, and these decisions are being made by what's the right thing for the Company, for all four stakeholders.

Let me just add a couple of things on the tender offer there because it might be helpful. MSC has a history of returning excess cash. Usually that's been done via a special dividend. And this time all we did is we gave, in sort of a special dividend, we gave all our owners the opportunity to sell some of their shares, same cash outflow from the Company's perspective, but we have the future benefit of the lower share count, the 56.6 million that we talked about a moment ago.

And as a practical matter, I mean, the way we did it through a two-step Dutch auction tender, it made absolutely sure that at the end of the day everybody had tender, that's the strike price, the Company -- the family sold enough shares to remain proportionately with the same, but very importantly they got the exact same price, but then the clearing price. So hopefully that helps there, too.

Thank you for the clarification. That's terrific to hear. Thank you, both.

Ryan Cieslak from KeyBanc Capital Markets.

Good morning, thanks for taking my question. I just wanted to go back really quick. First, Erik, on the comments about the SKU count growth, I just want to clarify, are you expecting then to continue to expand the SKU count into FY17? I know it has been growing in the double digits. How do we think about that directionally?

Ryan, I would say overall don't expect major changes in the program. We will continue adding SKU count. Look, it probably is not going to be at the level. We added a net 150,000 SKUs in FY16.

I would not expect a number quite that big in FY17, but what I would tell you is that the revenue contribution has as much to do with what is being added, what lines, as it is how many SKUs. So the key takeaway there is I would not view it moving forward as an additional tailwind or as creating a headwind. The program is in flight, and steady as she goes, and it is in the results. But we will continue adding, yes.

Okay. And then this quarter, or actually the last couple quarters, some nice trends with your overall eCommerce sales. Curious to know what's some of the one or two drivers you're seeing there and how to think about that as you go into this FY17 year?

I think you're right, I think you're hitting on one of the high points. The eCommerce percentage keeps growing and I think a couple of things going on.

One is, particularly MSCdirect.com, and the way we positioned the website, which is it is pretty -- don't just think public transaction site -- it's pretty sophisticated. And a lot of our customers, particularly in a down market when customers are starving for cash, cost savings, streamlining operations, and freeing up people to focus on higher value-add stuff. Our website, a lot of the workflow and the functionality that we have on the site is really resonating with our customers because it's freeing up time.

And from our standpoint, it is a really good thing. It's obviously efficient, but it's also pretty sticky because it's a way for us to really embed ourselves with our customers. I think that's the biggest thing that you're seeing is it is resonating with customers, particularly in a tough environment.

Okay. Really quick the last one for me and I'll jump off is, you have a lot of good color about the environment, Erik. What are you hearing in the field right now today relative to maybe where we were three months ago? Is there any significant change in the way customers are talking about the environment, and their outlook and tone going into next year?

Yes, good question, Ryan. I would say for the most part more of the -- and what you heard from our comments was more of the same, with the one added dimension, generally pretty soft, low backlogs, low order flows, some pockets of activities we pointed to. Oil and gas continues to weigh, we have not seen that pick up. Heavy machinery, infrastructure continues to weigh.

I think the one added thing I would add in, as we have gotten closer to November to the election is for many of our customers we're hearing wait and see. That's pretty typical in an election year. That's the one new thing I would call out over last quarter, and it's typical that it builds as you get close to November.

I don't make much of it either way. I don't think any of our customers have a sense of what it's going to mean for after. The only thing I think it means is that we always say our visibility is low; it's probably even a bit lower just because of the cautious perspective that many of our customers have.

Thanks. Best of luck.

Andrew Buscaglia from Credit Suisse.

Hello. Just one quick question, along those lines with the customers. Can you talk a little bit about what your discussions are with suppliers, and then how it pertains to pricing? I know you don't want to give 2017 guidance, but any sense of how quickly that can move to the upside?

Yes, very good question. Discussions with suppliers, as it relates to the demand side, very consistent with what I described to you on -- we described earlier on end users. As it relates to the pricing environment, the answer is, yes, it can change in a hurry. And that's one of the reasons why we also go with this framework concept, because what today is a very difficult pricing environment, tomorrow or next quarter could quickly turn into a more positive one.

Certainly our suppliers are seeing what we're seeing, which is many commodities are up this calendar year. But if you took a six-month view of commodities prices, most are up and, of course, our suppliers take notice of that. However, on a 12-month view it is much more of a mixed bag.

So I think we're going to have a much better feel next quarter and we will share it because typically many of our suppliers, if they're going to take pricing, will do it at the turn of the calendar year, effective January 1. Those discussions will generally happen a bit later in the year as we get into late November and December. And so when we talk to you next quarter we should have a better feel as to what we see for the potential of a mid-year price move.

That's helpful. Nothing else for me. Thanks.

Justin Bergner from Gabelli & Company.

Thanks for fitting me in. You mentioned in your opening remarks that government sales decelerated a bit from the third quarter, national decelerated a bit, CCSG seemed to be flat or decelerated a bit. So what actually improved in your sales mix in the fourth quarter versus the third quarter on an average daily sales basis to hold that number flat?

Justin, if you look on an average -- so our fourth quarter average daily sales were minus, Rustom, 3.6%?

Yes.

So what we were describing was relative to that Company average, how did the various customer types perform? So what we said was government grew a bit in the single digits, low-single digits. That was in a pretty difficult environment, and we feel like that was the result of some specific wins.

What we said was that CCSG, relative to the Company average, was better; it was down but it was better than the Company average. That has been an improving trend over the past couple of quarters; that business has moved from being at or below Company average, and it's starting to tick up.

What we also said, and I think this is probably the most relevant as it relates to a mix question that Rustom was talking to earlier on gross margin, is the core customers which historically have been high gross margin customers for us have been below Company average. And you can imagine that is directly tied to the acute softness that we've seen in metalworking.

Okay. Great. That's helpful, I think I had misheard the CCSG comment. That's good clarification.

In regards to your share gains, you seem to have a more confident tone towards your share gains this quarter than you had in prior quarter calls. Is it because you think the share gains are larger, or you have just gotten more confidence on your estimate versus fairly opaque markets in terms of estimating share gains? Or how would you describe your level of confidence on share gains versus prior quarters?

Justin, I would say, as it relates to share gains, our assessment this quarter has not changed much, if at all, from the last couple of quarters. We continue to see a steady, solid performance in terms of outpacing the markets we serve.

I would say relative to, if we look to Q4 to prior quarters in the fiscal year, not much changed. I think if you're hearing -- look, if you're hearing a more positive tone, it would be forward-looking, we really like the story that is building here. Despite the very difficult challenging environment, we like the story that's building here. And as things eventually turn, we think the Business is really loaded for a nice earnings leverage story.

Great. Thanks.

This concludes our question-and-answer session. I would now like to turn the conference back over to Management for any closing remarks.

Thank you, everyone, for joining us today. We will be participating in several equity conferences in the coming weeks in both New York and Chicago, and we certainly hope to see you there. Our next earnings date is set for January 11, 2017, and we will look forward to speaking with you over the coming months. Thank you again.

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