MSC Industrial Direct Co Inc (MSM) 2017 Q1 法說會逐字稿

Good morning and welcome to the MSC Industrial Supply reports FY17 first-quarter results conference call.

(Operator Instructions)

Please note, this event 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.

Thank you, Drew, and good morning, everyone.

Happy New Year.

I'd like to welcome you to our FY17 first-quarter conference call.

In the room with me are our 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 and 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 GAAP versus non-GAAP reconciliations in our presentation, which contain the reconciliation of the adjusted financial measures to the most directly comparable GAAP measures.

Now you may have noticed that we are now reporting average daily sales in our operational statistics on our website.

Also, given that customer count and average transaction size have not changed much at all in more than eight quarters, we will be reporting these metrics on an annual basis going forward.

I'll now turn the call over to Erik.

Thank you, John, and good morning, everybody.

Thanks for joining us today.

I want to start by wishing everybody a happy 2017.

I'll begin this morning's discussion by covering the environment, which is showing potential signs of stabilizing.

We've also seen increased optimism from our customers over the past couple of months.

I'll then discuss recent business developments, which were highlighted by the following: solid share gains and sales above the midpoint of our guidance for our first quarter; stable gross margins in line with expectations; strong execution, resulting in operating expenses that came in slightly below our guidance; and as a result of all of this, earnings per share above the top end of our fiscal first quarter guidance range.

Rustom will then provide additional detail on our first quarter financial results and will also share our second quarter FY17 guidance.

I'll then conclude with some additional perspective on our performance, and we'll then open up the line for questions.

So let me begin with market conditions and our first quarter.

While conditions remained difficult throughout the quarter, we did see a better than expected November, as well as a return to growth in December, the start of our second quarter.

The improvement in growth rate was across all of our customer types.

MDI readings, that had risen above 48 back in August, continued above the 48 level through October and then kicked up to 49.7 in November and 49.8 in December, bringing the rolling 12-month average to 47.2.

The most current readings imply essentially stable metalworking end markets and are a significant improvement over the trends of the past year.

Remember that December of last year was at a reading of 44.

If the current levels hold, this bodes well for our prospects, given our historical four-month lag to the rolling 12-month average of the MDI readings.

It's an interesting time right now in the industrial economy.

On the one hand, at the present, most customers continue to experience pretty low order volumes; however, there's also a marked improvement in optimism about what the future may bring.

This optimism is being driven by a couple of things.

First, there's an expectation that increases in infrastructure spending, lower corporate tax rates, and a more business friendly regulatory environment will provide a stimulus to the industrial economy.

And second, there does appear to be a leveling in manufacturing that's occurring, as evidenced by the MDI readings I just mentioned.

Among other things, oil prices have improved over the course of the year and there's greater confidence that energy-related end markets are in better shape as a result.

Our most recent December sales trends, which Rustom will talk about in more detail, provide further evidence of increasing optimism among our customers.

Part of the improvement in our growth rate came from a higher mix of capital-related sales, such as machinery, machine tool accessories, tool holders, and tooling package orders.

All of these tend to increase when customers are more optimistic about investing in their businesses.

The lift in these categories, which have lower gross margins, as they're larger ticket purchases, are pulling down the overall Company gross margin in our second quarter.

Even so, the increase in spending on these categories is an encouraging sign, and is generally followed by an increase in higher margin consumables in future quarters.

All of that said, we caution that these are not yet sustained trends and increased optimism will need to translate into sustained increases in demand and order activity before we declare that the environment has turned.

We are certainly more optimistic than even just a couple of months ago, but we're not yet drawing firm conclusions.

I'll now turn to the pricing environment, where it remained soft in the fiscal first quarter and continues to be so.

Commodity prices are still fairly low relative to historical levels, despite improving over the past year.

While we have seen some supplier price increase activity, we characterize it as selective and not broad based.

That said, any activity at all is more than we've seen over the past couple of years.

If we continue to see increases, we anticipate taking a very modest price increase some time in the next month or two.

Turning to our share gains, we remain pleased.

Our growth rate against the markets within which we operate reflects that.

Average daily sales growth came in at minus 2.9% on a year-over-year basis, more than 0.5 point better than the midpoint of our guidance range.

These numbers remain better than the movement in metalworking manufacturing indices and the growth rates of local metalworking distributors, based on our discussions with suppliers and other industry trade partners.

Should recent optimism translate into future increased demand, we would expect to continue to outperform the end markets that we serve and hence, see improvements to our growth rates.

I'll now look at our various customer types.

I'll start with our government business, which was basically flat year over year in the fiscal first quarter; and this result was achieved in what was a very difficult spending environment within those customers.

National accounts had a low single-digit decline and was below the Company average.

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 we should benefit as conditions turn.

Overall, our national accounts new business funnel remains quite strong.

Turning to our core customers.

They declined roughly in line with the Company average for the quarter.

Now this is an improvement from where the core had been trending, which was below Company average, and it's consistent with the notion that metalworking is experiencing some stabilization.

CCSG sales, on the other hand, slightly lagged the Company average, due to high end market exposure to natural resources and transportation, which have not yet shown improvement.

Now turning to e-commerce and vending.

E-commerce reached 59.6% of sales for the first quarter, up from 59.1% last quarter and 57% a year ago.

Sales to vending customers contributed roughly 60 basis points of growth in the first quarter.

We also added approximately 10,000 net SKUs in the first quarter.

This brings our total active saleable SKU count to just over 1.5 million.

By the end of FY17, we expect to add roughly 75,000 to 85,000 net SKUs, and increase, therefore, our total active saleable SKU count to about 1.6 million.

With respect to our field sales and service teams, we remain focused on expanding salesforce capacity, meaning selling hours in front of customers, and we're doing so by executing on our various salesforce effectiveness initiatives.

We continue to optimize our field sales and service teams, and total headcount ended the first fiscal quarter at 2,352 associates, down slightly and in line with our expectations.

As I mentioned earlier, we maintained our focus on gross margin stabilization.

Our gross margin was 45% for the first quarter, in line with the midpoint of our guidance.

And finally, operating expenses were $218 million, or about $10 million below last year and slightly better than our guidance.

I'll now turn things over to Rustom to go through it in more detail.

Thank you, Erik.

Good morning, everyone.

So let's turn to our fiscal first quarter in greater detail.

Our average daily sales in the first quarter declined by 2.9% versus last year, with our sales to manufacturers being down 4.2%; however, Q1 ABS was better than our guidance midpoint of minus 3.5% and also better sequentially, as last year's fourth quarter ABS was minus 3.6%.

Our gross margin was 45% for the quarter, in line with the midpoint of our guidance and down very slightly from the 45.1% delivered in FY16's first quarter.

As Erik noted, the pricing environment remained soft, but we've continued to offset this headwind with gross margin countermeasures.

We have also continued to tightly manage our operating expenses.

Fiscal first quarter sales were approximately $4.4 million above the midpoint of guidance; nevertheless, even after allowing for the increase in variable costs associated with this, OpEx still came in below the guidance midpoint.

OpEx was also around $10 million lower versus the fiscal first quarter of last year.

Now, keep in mind that last year's Q1 included about $5 million of unusually high medical expenses, as we transitioned to a new medical plan at the end of calendar 2015.

So after adjusting for this, and for lower variable costs due to lower Q1 sales, our year-on-year OpEx reduction on an apples-to-apples basis was around $3 million.

Of course, there are other puts and takes.

Lower amortization related to the J&L acquisition and higher bonus accruals were the two largest, and they roughly offset each other.

I'd like to reiterate an important point also made on our last earnings call.

In FY16 on a comparable 52-week basis, our sales declined by around $103 million and our gross margin declined by around 20 basis points.

We nevertheless took out enough OpEx to maintain our OpEx-to-sales ratio and deliver a flat year-over-year operating margin of 13% for last year.

So this focus on tightly managing costs will continue.

Our various productivity initiatives are allowing us to offset key investments, merit increases and other cost increases; however, in FY17, as we discussed on our last call, we expect a roughly 40 basis point, or $12 million, step-up in market-driven incentive compensation versus FY16.

Our OpEx, and consequently, operating margin comparisons grew more challenging in Q3 and Q4.

And although we have started FY17 ahead in terms of operating margin performance, our annual framework still holds.

Now, back to Q1.

Operating margin was 13.2%, better than the guidance midpoint of 12.8% due to higher sales, gross margin in line with expectations, and tightly controlled OpEx coming in slightly below the midpoint, despite, as noted, those variable expenses associated with higher sales.

Now compared to last year's fiscal first quarter margin of 12.8%, you also see a similar dynamic.

So even with lower sales and the slightly lower gross margin this quarter, we delivered a higher operating margin due to lower expenses, which resulted in improved OpEx-to-sales ratio.

So this quarter's results do illustrate the potential for significant leverage in our business model, as the environment improves and the industrial economy returns to growth.

Of course, this leverage translates to our EPS, as well.

Our fiscal first quarter EPS was $0.95.

That's $0.03 above the midpoint and just above the high end of our guidance range.

Taxes, at 38.2%, were in line with our guidance.

And so roughly $0.02 of the upside in EPS, that's versus the midpoint, came from higher sales, and roughly $0.01 came from lower OpEx.

Last year's Q1 EPS was $0.89.

Therefore, even after adjusting for a roughly $0.055 benefit from the share buyback completed in August, our EPS was up slightly year over year, despite lower sales.

Turning to the balance sheet.

Our DSOs were 52.5 days, up roughly 1.5 days from last year's fiscal first quarter.

Our inventory turns at 3.3 were essentially flat with the prior quarter, and our inventories increased by roughly $10 million over the quarter.

As you may recollect, we flagged an inventory increase as being the likely case on our last call.

In Q2, inventories will likely be flat to slightly up, so we remain well positioned for a possible upturn in sales.

We had another excellent quarter in terms of cash conversion, turning 139% of our net income into cash flow from operations.

Net cash provided by operating activities was $75 million in the fiscal first quarter, versus $122 million last year.

The difference was mostly due to inventories and accounts receivables, which were an $11 million use of cash in Q1 versus a $26 million source of cash in the prior year's Q1.

Our capital expenditures were $12 million in the first quarter, down $3 million from FY16's Q1.

So our free cash flow, i.e., net cash from operating activities less CapEx, was $63 million versus $107 million in the prior year Q1.

Our total FY17 CapEx is expected to be around $60 million and we continue to expect FY17's cash conversion to be about 100%.

We do not provide quarterly cash guidance, so I'd like to take this opportunity to remind everyone that Q2 is the quarter we typically make two cash -- we make two tax payments versus none in Q1.

This is simply a consequence of how the quarters fall in our September to August fiscal year.

At the end of the first quarter, we had roughly $544 million in debt, mainly comprised of $166 million balance on our revolving credit facility, $175 million on our term loan, and $175 million of private placement debt.

We closed the quarter with $32 million in cash and cash equivalents; and therefore, this resulted in a leverage ratio of approximately 1.1 times.

Now to our guidance for the second quarter of FY17, which you can see on slide 4 of our presentation.

First, please note the usual caveat that our visibility is limited.

So we expect ADS growth to range from 0.5% to 2.5% positive.

At the midpoint of that range, average daily sales would be $11 million.

This implies average daily sales of $11.4 million for the remainder of Q2, or basically flat with last year.

Let me explain our estimated December sales growth of around 4.1%.

While we have seen a pick up in sales, this comparison has benefited from the timing of the Christmas and New Year holidays, which this year fell on Sundays versus last year, when they fell on Fridays.

While it's difficult to exactly pinpoint the benefit, we estimate that this generated approximately 250 basis points of growth.

In addition to this holiday benefit, we believe that most of December's remaining sales growth was due to our customers' capital-related purchases in anticipation of a lift in business activity.

It could well be that we are being cautious when providing Q2 guidance, but given that we've had five successive quarters of ADS declines through Q1, averaging around 3.5%, we'd rather err on the side of caution.

Turning to gross margin, we expect it to be 44.6%, plus or minus 20 basis points, in Q2.

And that's down from the prior Q2's 45.1% and down about 40 basis points sequentially.

The primary driver is product mix, including the capital-related purchases Erik described earlier.

Now, we do not provide guidance beyond the current quarter, but it's worth noting that we currently expect Q3 gross margin to be relatively stable, unless capital-related sales increase.

And obviously, if that happens, this would be a positive and would bode well for the manufacturing, for a manufacturing recovery.

We expect Q2 operating expenses to be about $4 million lower than in the prior year, despite the increase in average daily sales, and our OpEx-to-sales ratio for the quarter should improve by around 100 basis points year-over-year.

As in Q1, this would be due to higher medical costs in the comparable period, lower amortization and payroll expenses, offset partly by higher spending on the upgrade of our SAP core financial system and other key investments.

Sequentially, we expect an OpEx increase from Q1 to Q2 of roughly $6 million.

Around $1 million each is due to higher sales volume and key investments and around another $3 million comes from fringe expenses, which are mostly the payroll tax reset that occurs every January, as well as higher medical costs as a new plan year commences.

Now you may wonder why you didn't see a similar sequential lift last year, and this was mostly because last year's Q1 had unusually large medical expenses, as mentioned earlier, and also sales declined from Q1 to Q2.

So as such, we expect a second quarter operating margin of around 12.2% at the midpoint of guidance, as we leverage positive sales growth to improve on last year's Q2 operating margin's 11.8%.

Finally, our EPS guidance for the fiscal second quarter is a range of $0.86 to $0.90, and this assumes a tax rate of 38.2%.

I'll now turn it back to Erik.

Thank you, Rustom.

For the past two years, we've operated in the midst of a prolonged industrial recession, one that was particularly acute in our primary end markets of metalworking manufacturing.

We executed well during this time, outperforming the markets that we serve; but we also used this time to retool and refocus the Company, making MSC a better performing business.

We stayed focused on providing our existing customers with exceptional service, as well as creating new customer relationships.

Many of our customers' businesses have been depressed by the difficult environment, and this has created the potential for a spring loaded effect when the industrial economy returns to stronger footing.

We've enhanced our value proposition by investing in improved technical capabilities, inventory management solutions, and technology, including e-commerce, digital capabilities, and analytics.

We forged new supplier relationships and enhanced existing ones to further our efforts to capture market share from the local and regional distributors that make up roughly 70% of the market that we serve.

We worked hard with our suppliers to bring purchase costs down and stabilize gross margin in a historically challenging pricing environment.

We leaned out the Company, with a heavy grassroots focus on productivity throughout the organization; and that's a testament to the hard work of all of our associates.

We've built on our already strong culture to become leaner, sharper and more nimble.

We generated significant cash flow by carefully managing working capital, and then we deployed that capital in ways that enhanced shareholder returns, such as the buyback that was done in August of last year.

We did all of this in preparation for an eventual industrial recovery, and we are now seeing signs that a potential recovery could be coming.

If, in fact, it becomes a reality, we will benefit from a tremendous earnings leverage story.

If it does not, we will stay focused on continuing to execute the play-book that I've outlined, knowing that it will make that earnings leverage story even more compelling when the recovery eventually does arrive.

I'd once again like to thank our entire team for their hard work and their dedication, and we'll now open up the line for questions.

(Operator Instructions)

The first question comes from Hamzah Mazari of Macquarie.

Good morning.

Happy New Year.

Just a question on your margin framework: You guys did pretty strong margins, 13.3%, despite sales declining.

Is the margin framework too conservative around your operating leverage?

I know you mentioned incentive comp potentially being a headwind.

Just trying to think of how to think about the operating leverage, which seems to be coming in stronger relative to the go-forward margin framework.

Hamzah, hi, it's Rustom.

Good morning and Happy New Year to you, as well.

So the short answer is, no, we don't think it's too conservative.

Look, quite simply, our framework is for the year and not for any one quarter.

We have seasonal swings in our quarterly operating margins.

In Q2, for example, the operating margin is typically much lower, due to the holidays, as well as the payroll tax resets for a new calendar year.

Now, last year we also reversed, remember, some of our H1 bonus accruals in the third quarter, and that was based on updated forecasts and deteriorating market conditions.

And last year's Q1 also had unusually high medical expenses.

So, look, I could give you more detail on that, and I could also talk about the incentive compensation step-up, which will impact more in the second half than the first half because of the reversals last year, and we flagged that.

But really, the real answer is that our operating margin framework is appropriate for a full year, but quarter by quarter it will bounce around.

So hence, we are out of the gates with a very strong start, but the full-year framework holds.

Hamzah, it's Erik.

I would highlight one thing that Rustom said there, and we mentioned it on the last call, which is the incentive comp.

So for the year, on the last call we said we had what we saw as a one-time, meaning this year a step up in incentive comp that would be 40 basis points of headwind.

That was for the year.

As Rustom mentioned, the dynamic is such that virtually all of that 40-basis-points headwind is going to happen in the second half of the year.

So we have not yet seen that headwind.

So to Rustom's point, we think, net-net, still on track.

That's very helpful.

And then some of your suppliers have talked about potentially using more of a distribution channel versus a direct channel.

And I'm just curious if that's something that you've seen already as a benefit to you guys or is that something yet to come?

And is it at all material and how we should think about that?

Yes, Hamzah, it's a good observation.

I would say we are seeing a trend among some of our suppliers.

Look, many already do all, or virtually all, of their sales through distribution.

I would say there is more of a trend of late towards putting more sales through distribution.

And I think the reason that's the case is because distribution is winning as a channel in the marketplace.

So I think it's a response to what's happening with customers making choices about where they want to buy, and that's through well-performing distributors.

What I would say is I think that it's still very early.

There are certain suppliers, some very important suppliers to us, that we're in discussions with about how we can help them in their efforts.

But I would say still very early and you're not really seeing much of that in our numbers to date.

Last question and I'll turn it over, maybe for Rustom.

Could you maybe outline what the corporate tax reform benefit would be to you guys and what you plan to do with the cash?

It seems like the cash tax rate is very similar to book tax, and you have obviously 97% US exposure.

Just curious if you could outline what you think the benefit is and what you guys plan to do with the potential cash savings.

Thanks.

Sure, Hamzah.

Look, yes, our federal tax rate is pretty much, we pay our full federal tax.

So any reduction, whether it's to 20% to 25% to 15%, any reduction will be a positive for us.

The ultimate EPS benefit to us, and [that's what they] expected, will depend on what the offsets are and whether there are any offsets.

And that could be with foreign tariff, cross-border taxes, interest, a whole bunch of different factors which might or might not come into play.

So it's hard to quantify.

Since you did ask the question, even though it's foreign tax-related, but I will make the point on our cost of goods sold, as well, in there.

And that is that remember that about 12% to 15% of our cost of goods sold comes directly from outside the US.

And we believe, we don't have the exact number, that with US purchases that are actually foreign sourced, it's roughly about 40%.

So remember, our many suppliers have multiple countries of origin and alternatives, as we do also.

And in any case, inflation is historically good for distributors.

But there's a bunch of different factors here that mean it's hard to quantify exactly how much of the benefit will flow through, but we clearly are expecting a benefit.

Now, part B of your question is what will we do with that?

So, look, in general, we believe in steadily increasing our ongoing ordinary dividends.

Erik and I have been very consistent in terms of communicating that.

There's no reason to think that will change.

And we have also demonstrated over the years that if we do have excess cash over and above our requirements, we're balanced and opportunistic in terms of capital management.

And if we do have excess cash at the end of the day that we can't deploy in the Business, that we can't deploy for ordinary dividend increases, and if we don't have attractive M&A, we are absolutely not averse to returning it by way of open-market buybacks or even tender type things.

So that's a long answer, but it's hopefully a comprehensive answer.

No, very helpful.

I appreciate it.

Thank you.

The next question comes from Matt Duncan of Stephens.

Good morning, guys.

Happy New Year.

Nice job this quarter.

Thanks, Matt.

Happy New Year to you.

Thanks.

So, Erik, I wanted to start on the average daily sales trends.

So, November, you said, was a little bit better than expected.

You moved to December and the growth got 6 points better against a 4-point more difficult comparison.

And, Rustom, you talked a little bit about what drove that higher December number.

Could you maybe talk about, was there any improvement in that growth rate through the month of December?

Did you see maybe fewer plant shutdowns in 2016 than in 2015?

Just trying to get a sense for how much conservatism there could be in the expectation for flat the next couple of months, if some of this stuff does carry forward.

Yes, Matt.

So, look, no question, when you pull back, we are seeing an improvement in the growth rate in the Business, plain and simple.

Because you're right, you point to it started in November being better than expectations, December certainly better.

What we wanted to do, though, was give you a realistic picture.

What I'd say in terms of December, it was a pretty strong month across the board.

Obviously, so, Rustom mentioned the 250-ish basis points, so I'd say rough, we estimate from the holiday effect.

So obviously, we did get a lift in the end of the month.

But in general, look, we're seeing some firming up in the underlying business.

So even if you back out the 250 basis points or so from the growth rate, you're still at about 1.5 points for December.

Now, our belief there, Matt, is we did see a spike in what we call capital-related purchases.

So these are, it could be a machine, it could be a tool holder, it could be a tooling package, which think of that as like a start-up kit of cutting tools when a customer purchases a machine.

All of those things tend to imply optimism about the future, obviously, if they're investing in the business.

Our assumption right now, and again, Rustom mentioned limited visibility, we're sitting here very early in the month of January, is that a lot of what we saw was end-of-year buying because customers are more optimistic and that won't continue in January and February, which hence gets us to what's more or less flat for January, February.

As Rustom said, look, if we're wrong, our guidance will, the mid-point anyway, would prove to be conservative.

But we just don't know.

We're giving you our best view of what we see right now.

(Multiple speakers) Erik, does that imply that the capital purchases did not carry over into the first 10 days of this month or is it just too early to know?

Well, I would say a little early, Matt.

Too early to tell.

Also, realize our December went through Friday, so that would include early calendar January.

So we do have the numbers.

Matt, I was just going to add that it's because we have such difficulties and then because December is a little bit of an unusual month, right?

That's why we are being so -- to the best of our ability, we are trying to provide you with the breakout of what it is between the holiday effect and the capital goods.

Implicit in our guidance, if we were, if ADS did happen to come in and it's 1% higher, that movement, that's worth about $0.02 on the share.

You can see that in our numbers.

We are just trying to be very transparent as to how -- as to what the basis is for the guidance.

Okay.

That's all very, very helpful.

And, Rustom, you made a comment about gross margin potentially stable into the third quarter.

Are you saying stable year over year or stable with the 44.6% for the 2Q?

The latter.

The latter.

Okay.

And then that, assuming that you do see a continued -- I guess that's assuming a continued pickup in capital goods spend, which would then be followed by the higher margin stuff, so we would see a gross margin improvement down the line, I guess is the way for us to think about that.

Yes.

And if we do see more of the consumables going through, you'd begin to see the benefits over there.

And you know we really can't provide Q3 guidance.

We were just trying to provide some color that we're not suddenly seeing something that we'd call a trend, a sequential drop.

That's all we're trying to provide color on.

Matt, I think the one thing I'd add about the capital-related purchases, look, it is an encouraging data point for sure.

So even if we're right about Q2, meaning January and February, it tends to imply -- we haven't seen this dynamic in several years, where historically we would.

In a normalized growth environment, we tend to see a dip in gross margin in the underlying business in the second quarter, and certainly in December because of end-of-year buying and capital purchases.

We haven't recently, because there's not been optimism.

So it is, January and February notwithstanding, we do view it as an encouraging data point.

Okay.

And then last thing, just real quick, on pricing, Erik, can you talk a little bit more about what's going on there?

I think everyone's expecting that we might see some inflation show up.

It sounds like you haven't really seen the supplier price increases key up here, but the comment that you might be doing a price increase in a month or two implies to me that you think that may happen.

So what are you hearing and seeing out there on that front?

Yes, good question.

Matt, I would say right now, we are seeing some activity.

But the words I used were selective and not broad based.

So we have seen some suppliers come forth with increases at the calendar year, not a ton.

Now, that may change as time goes on here.

Certainly, if things firm up, I would expect more to come down the road.

So my comment on a price increase, and what I called a very modest price increase, is more reflective of what we've seen to date, which would be sporadic.

So it's some activity, which is better -- the last two years were pretty tough and virtually nothing -- but not what I would consider to be broad based.

So you could expect whatever we do in pricing, at this point anyway, would be pretty modest.

Okay.

Thanks, guys.

Appreciate the answers.

The next question comes from Robert McCarthy of Stifel.

Good morning, everyone.

Happy New Year.

Happy New Year, Rob.

I guess the first question would be, maybe you could just talk about, your average daily sales rate is hovering in the $11 million range or thereabouts, If you saw pricing and the beginnings of what you talked about here for an industrial short cycle recovery fueled by this optimism, what do you think could be the outside bound of what that daily sales rate could be over the next 12 to 18 months?

Rob, I wish I knew.

We can hardly give you the outer bounds of the quarter for two months out.

Here's what I would tell you, is that you can generally track some of -- what I can tell you is what we measure and what I feel like we can control and feel pretty certain about is how are we doing relative to the environment that we're in.

And what we're seeing now is an environment that appears to be, certainly has signs of stabilizing.

Now, what we look to do is outperform the market in any given level.

If you believe in a strong recovery and you believe that the manufacturing markets and, in particular, the metalworking manufacturing markets were to grow at a meaningful rate, you could see growth rates for the Company in double digits, based on our gap.

But of course, that would require that the economy really firm up.

On the other hand, if things are really continue to muddle along and December was just a bit of a one-time spike, over time, based on all the indices we're looking at, we'd expect to grow, but not nearly at those rates.

So for us, what we can control is how fast do we outpace the market.

Certainly, if the market comes back -- you look at our historical numbers, Rob, nothing from our standpoint has changed that would lead us to believe normalized growth environment, the Company historically has grown mid- to high-single digits, and in a stronger recovery case, the Company's grown double digits.

No reason to think that couldn't be the case, but we just have such limited visibility.

And in terms of the border adjustability tax and other issues, do you think you're going to have to revisit your 10-Q in terms of highlighting the risks?

Because there is, you can talk about that it's in showed, at this point, in terms of what the risks are, but you do have the Republican tax plan out there, you do have some detail around how these offsets could play out.

So do you think you have to address in a forthright manner what it would mean if we saw a border adjustability tax world?

So, Robert, here's our challenge: It's really early.

What's going to be the new tax law?

There's different reports, slightly different proposals out there between, as far as we can tell, the incoming administration, Congress, all the rest of it.

It's just too early.

But, yes, your broader philosophical point, as soon as these things firm up, absolutely.

We would, once they firm up, we can then figure out what the impact is.

And once we figure out what the impact is and what the implications are, of course, we'll communicate them.

And then I'll take it down from the 30,000-foot level to something a little more ticky-tacky.

It looks like your depreciation expense year over year came down modestly, but a couple million in the context of that.

And I think it was -- you did have some asset sales and the bolus of CapEx last year.

But could you talk about what drove the lower D&A in the quarter versus last year?

Sure.

That's mostly the A part of that.

That's the J&L amortization I was talking about, which we also mentioned back last year and that's what it's mostly about.

Our full-year depreciation is in the ballpark of around $65 million.

$65 million?

Yes, including the D&A.

I will leave it there.

Thank you.

Thanks, Rob.

The next question comes from Ryan Merkel of William Blair.

Hi.

Good morning, everyone.

Hi, Ryan.

So first of all, just want to put a little more context around the cap goods lift.

How much was this category up year over year, if you have a number?

And then when was the last time you saw the cap goods perking up at all?

My guess is it's been maybe two years, but maybe that would be helpful to put some context to it.

Yes, Ryan, to answer the last question first, it's actually been more than two years, at least three years, because the last two years there's been really low confidence among our customer base.

It's been at least three years since we've seen anything resembling this.

That's the first thing I would say.

The second point, I don't have the numbers offhand, but I can tell you it's something that it was a noticeable and unexpected uptick across really all of those categories that I mentioned, so the machinery, the machine tool accessories, so think of like the tool holders, and then also the tooling packages, pretty evenly disbursed across all of those.

It was a pretty healthy unexpected lift that drove a good part of the sequential downdraft in gross margin.

But obviously, very encouraging about what that could mean.

Right.

About 1.5% of December is ADS growth.

So if you do the math, it's in the $3 million to $4 million range.

And again, with these numbers and with the holidays, they're estimates, Ryan, because it's always hard to exactly quantify.

Okay.

It is encouraging.

It's just one month.

I think we should all be cognizant of that.

But it's definitely encouraging.

So then, your peers had a soft November and you beat my model.

I'm just wondering, this may be hard to answer, but do you think this is more about your metalworking exposure and coming off a deep trough, or do you think share gains are picking up steam?

Ryan, look, I would say we've been pretty consistent in a couple of things.

One is, we have felt over time pretty good about our share gain performance, and I think that continues.

I feel like we're executing well.

And I think we've also been pretty consistent in that we don't make too much of one month, even two months.

The same way if we have one or two bad months, I would tell you we don't get too alarmed -- one or two good months.

And look, I think you're right.

I think on a relative basis, November and December appear to be pretty good months.

We don't make too much and we don't celebrate.

So what I would say is talk to me in a quarter, if we continue outperforming indices and outperforming peer sets, et cetera, by more than we would have expected, I think then there could be something there.

And I think you're right.

I think the two candidates would be improved share gains and/or improved metalworking stabilization, rebound, recovery, whatever you call it.

But I think too early for us to form a judgment.

Okay.

And lastly, going back to gross margin and Matt's question, I recall last quarter you were talking about or thinking about a flat gross margin for this year and now, just based on the 2Q guide and the early 3Q thoughts, it looks like gross margins could be down 20 bps, call it.

Now, I think, just to be clear, is the change here primarily just the increase in cap goods mix?

Yes, actually.

So, Ryan, hi.

First of all, our framework for the year did contemplate modest gross margin deterioration throughout the year.

And that's consistent with our usual seasonal patterns, and absent a meaningful price increase, which, as we said, we weren't really counting on as we started the year.

So, absolutely.

Our current Q2 mid-point guidance of 44.6% is slightly lower than we had anticipated at that time, and that is due to December's product mix, including the capital-related sales.

So that's what you're seeing.

And at this point, we don't think it's a significant departure from our annual framework.

Okay.

And just for fun, if core customers came back and they're higher margin, I recall, and if you get some price increase, that would obviously maybe push you back towards flattish, maybe a little better, is that fair?

Absolutely, they'd be positives.

Right.

Okay.

Very good.

Thank you.

Thank you.

The next question comes from Adam Uhlman of Cleveland Research.

Hi, guys.

Good morning.

Good morning, Adam.

How are you?

Good.

Congrats on getting back to growth.

Thank you.

I was wondering if we could start maybe -- earlier in the prepared remarks you had talked a little bit about oil and gas, but could you talk about what you're seeing in those, that geography of the country and in the oil patch and maybe what you're hearing from those customers?

Has that led this rebound in the capital equipment-related sales, or could you dig into that, please?

Yes, sure, Adam.

And I'll start even more broadly, just with an end-markets view and then I'll hit your point on oil and gas.

And one thing I would say is I wouldn't yet call this, and December looks like a rebound, but I think in general we're calling this, we see this to date as more of a stabilization.

And look, if the December trends really continued, and we're wrong about January and February, and things continue at this rate, you'll probably hear us talking differently on the next call.

But for now, I think what we're seeing is more stabilization.

The stabilization has been pretty broad based, Adam, so across most of our core customer types that we refer to as our typical core customer types of the machine and equipment folks, primary metals, metal fabrication, all of those are seeing an improvement over the last couple of months.

I think some of that is driven by oil and gas, no question, Adam.

Because we've said the indirect effect on all these job shops, and again, what we're hearing is more stabilization than it is a strong rebound, even with oil and gas.

Things have stabilized a bit, based on oil prices.

Maybe the potential to improve, but the word I'd use is more stable.

Okay.

Got you.

Thank you.

And then just regarding more of the medium term, maybe the longer term, could you talk through scenarios where you would start to add more aggressively to sales headcount?

Would you need to see mid- to high-single-digit growth to add people, rather than trying to get additional selling hours out of your existing force?

And then maybe somewhat along those lines, if you could just talk about the SKU growth that you had mentioned earlier, is that geared more towards new categories this year or is it further penetration of existing ones?

Thanks.

Yes, two really good questions.

So on salesforce, what you've picked up on for a while now, headcount has been more or less stable, and in fact, now slightly down.

And look, a lot of this, Adam, is in response to the environment.

So clearly, big picture, if I look long term here, or medium term, as you call it long term, salesforce expansion remains an important component of the Company's plan.

What we found though is, number one, in response to the environment, we're taking a hard look at productivity before we spend money.

And number two is, the real driver of growth of share gain, of customer satisfaction is how many hours do our salespeople get in front of their customers.

And so what you're seeing from us now is really in response to seeing some of our salesforce effectiveness programs gain traction that are allowing us to get more selling time without adding to headcount.

So those are things such as better using technology, and that's using technology to help our salespeople be more effective and help them grow customer relationships.

It's using technology to help free up their time from more back office administrative tasks.

Salesforce effectiveness includes much better work and cross-selling between MSC and CCSG, which is improving seller productivity.

So there's a number of levers that we're looking at and we like what we are seeing.

So, yes, certainly if the economy improves, or I should say when the economy improves, over time, do I envision adding sales headcount?

I do.

What I would also tell you, though, is some of that will be a function -- how fast that grows will be a function of how good we feel about some of these productivity measures.

So to the extent we think we can continue generating increased selling hours without rapidly adding to headcount, we'll do it.

And at the point of which we think we need to add headcount to generate more selling hours, we'll do that, as well.

So big picture, the punch line is, salesforce expansion is still important.

But in the meantime, we think we have a number of things to increase selling capacity without adding headcount.

Your other question was about SKU growth.

So we've been -- so our number for 2017, by the way, was around 75,000 to 85,000 for the year, slightly down from the last couple of years, but still pretty healthy clip.

For the most part, Adam, I would say the strategy is a little bit of both.

So we have some product line extension, we have some product line fill-in, we have some new supplier additions.

And that makes up the bulk of where we're adding the SKUs.

I think if you look back last year, we had a particularly large year in terms of SKU additions.

The primary driver there was we had a couple of really large supplier additions that had a lot of SKUs that drove that; whereas this year, it's not as much high profile new suppliers as it is fill-ins and extensions.

Great.

Thank you very much for the color.

Thanks, Adam.

The next question comes from David Manthey of Baird.

Hi.

Thank you.

Happy New Year, guys.

You, too, David.

So as it relates to the operating margin framework, I believe you said you contemplated 20 or 30 basis points of gross margin degradation in the framework at the beginning of the year.

Did your framework also assume a mid-year price increase or would that be over and above what's in the assumption?

Hi.

There was a very small price increase contemplated in there, really not particularly material.

Okay.

So, David, I think I know where you're going.

Is what we're outlining now about consistent with the framework, less than the framework, more than the framework?

And I would say, you heard it will happen over the next month or two.

The reason being, the supplier price increase activity, as I said, has not been that broad based.

We want to get a little more feel for how much is coming in before we quantify it.

We refer to it as very modest.

What I would say is there's probably, from a pricing standpoint, not downside to what's in the framework.

At this point, what we would contemplate is either consistent with the framework, and depending upon how the next month or two goes, maybe a little more.

But I would caution that it's still too early to say.

And it stays, David, if you think about our framework, it was a minus 1% to 0% on the slightly negative side and a 0% to plus 1% on the slightly positive, in terms of the guidance that we provided.

So everything we're talking about is very much within those.

Okay.

And as it relates to your ability to get price in the coming year, you've got one big competitor out there that's lowering prices on a large swath of their customers and you've got just general secular pressure and relatively slow growth.

Even if growth picks up a bit here, how are you navigating the environment?

Are you seeing any price declines generally from competitors out there, or you feel you could navigate this effectively?

David, I would say, look, I would say pricing, and I referred to in the pricing environment remains fiercely competitive, as competitive as it's been.

But look, I would say the primary driver here is consistent with what we've seen, which is the distributors that make up the bulk of the market, the roughly 70%, the local distributors are really, really under pressure right now, David.

And when they get under pressure, price becomes one of their primary levers.

So that is front and center.

We're seeing it.

Of course, there's other competitive movement going on.

I would still tell you that the primary driver of the pricing environment is the local distributors.

Look, that said, what I would tell you is that if we implemented a mid-year price increase, first of all, it would be in response to visible manufacturers moving their list prices.

And second of all, we would only do it if we felt that we could get realization from it and that it would be well justified with our customers.

And then look, the last thing I'd say is we feel like, in a lot of cases with our good customers, we're bringing a heck of a lot of value to them.

We're helping them take cost out of their manufacturing operation through technical capability, inventory management, et cetera.

And we think it's justified, and in many cases we think our customers will feel it's justified, based on the costs we're taking out of their business.

Got it.

Okay.

Last question: I think when you're near the end of the call, it's required to ask the acquisition question.

So what does your pipeline look like.

What is your appetite to do deals today?

So I'll take that.

There's no change in our M&A outlook.

We remain active in building our pipeline, and we do have a pipeline, and we're keeping on building and assessing.

We're at different stages talking to different things, but we are actively looking for opportunities.

But they have to be the right fit.

And we are talking there about strategic fit, most of all, cultural, ease of integration, and last, but absolutely not least, not overpaying.

And the good news is that with 1.1% leverage, we have plenty of financial capability.

Got it.

All right.

Thanks very much, guys.

Thank you, David.

The next question comes from John Inch of Deutsche Bank.

Yes, thank you.

Good morning, everyone.

Hi, John.

Rustom, your comment around the 40% of product that you sell that has an imported content, do you think that's -- I'm sorry, was it 40% and then there's 12% to 15%, or does the 40% include the 12% to 15% directly imported?

It's the latter, John.

It's roughly 40% to start with, and that would include the 12% to 15% of direct imports that we've talked about in the past.

It hasn't been as relevant to talk about it, is why we haven't done it in the past.

But remember that many of these suppliers that we buy from have multiple countries of origin and multiple sources from which they supply to us.

So now we're trying to quantify more.

But that's what it is, 40%.

The 40% makes more sense than 40% plus 12% to 15%.

So I think I'm on board.

I just wanted to make sure I heard that right.

The rolling J&L amortization, so this is going to be a $12 million benefit for the year, I'm assuming, right?

I think it was closer to about $8 million, right?

I'll come back to the exact number, but I think it was $8 million plus.

Okay.

I guess my question is, if it's -- I want to go back to the framework that you presented last quarter.

So we think that the op margins are going to decline 40 to 60 basis points.

But if we're starting and we've got lowered J&L amortization, so call that maybe 30 basis points plus, and then I think, Erik, you implied that the headcount was going to remain at these levels, if you see more of a pickup, then you're going to pick it up, what's accounting for it, which is kind of bullish because I would have thought that your headcount might have actually been rising, so, bullish for your cost structure.

So what's accounting for the difference again in terms of the down, call it, 50 basis points at the mid-point and you seem to have these tailwinds in not having to hire people and then you've got this J&L?

Again, just remind me what's the bridging, just at a very high level.

So, John, we talked about the J&L amortization last time when we did the 4Q call, because we started to see the benefits coming in then.

And there's tons of puts and takes in here.

Forget the obvious one is the variable costs and that is the picking, packing, and shipping labor that does come in as volume increases or that we take out as volume decreases.

There's commissions, there's freight, but there's the key investments.

We've talked about telephony, which is one of our big investments which is helping us.

We've talked about the SAP core financials.

But there's a lot of other investments that the Company has continued to make.

The bigger point over there, and, yes, the compensation increases, all the rest are in there.

But the point we made last time, and which I'll probably take this question as an opportunity to reiterate this time, is that we're targeting a culture and a discipline that looks for productivity to offset pretty much all these things.

And, yes, there will be some puts and takes, and we call them out, like J&L.

I mention that here you've got this in there and that's a benefit, a tailwind or a headwind.

But at the end of the day in FY17, in FY17 the only thing that we said we were not planning on offsetting was the increase in the bonus.

And that would -- that's what you saw flow through the numbers.

So, John, let me just try to answer it, as well.

The big headline behind the headwind for 2017 was the bonus step-up.

The bonus step-up is pretty much, as I said, pretty much exclusively back-end loaded.

So if your question is, hey, wait a second, you're getting a tailwind from J&L amortization, you're correct.

And what I would tell you is take a look at our Q1 results and take a look at our Q2 guidance, and you'll see, without the headwind from bonus, what we're producing.

So our Q2 guidance implies 100 basis points or so reduction in OpEx as a percentage of sales on 1.5% sales growth.

I think that's pretty healthy.

No, it absolutely is, Erik.

You actually said the bonus is going to be skewed to the second half.

So just conceptually, I think you said last quarter the bonus is going to account for the lion's share of the 40 to 60 headwind.

I think you just confirmed that, didn't you, Rustom, that you've got all these puts and takes, and then you've got the bonus and that's the lion's share of that.

Does that then imply that in the second half margins, because it's 40 to 60 for the year, or call it, I don't know, let's say 40 from the bonus, does that imply margins in the second half fall under a lot more pressure, maybe go down to 70, 80 type of thing because of the bonus?

Without quantifying, that's a definite headwind, John.

But remember when we say skewed towards the second half, it's not that we're accruing a different amount this year.

It's pretty even this year as we envisage our accruals, right?

It's just that last year's comparative, we spent more in the first half and we provided less in the second half.

That's why you'll see the impact being skewed more towards the H2.

Okay.

Got it.

And lastly, if we do see this recovery continuing to percolate, and let's say it's not double digit but it goes back to the mid- to high-single digits, which seems completely realistic and expected, how do you think of the initial 30% that you had talked about last quarter, the variable contribution?

Is that mid- to higher-single-digit run rate, ex compares, just if we get back to that.

Is that enough to drive the 30 or was the 30 predicated, that we talked about last quarter, on a much more substantive recovery, in the low-double digits that you alluded to before, Erik?

No, the points we were making on that, and which we will repeat again, is that our first $100 million of revenue growth, and we are looking at that and obviously where margins can move around a little bit up or down.

But broadly, off our first $100 million in revenue growth, after we have our incremental labor and commissions and freight and all the rest of that, we believe that $30 million, or 30%, is what we will take down to the bottom line, to the operating profit line.

John, I think to your point, we don't need a dramatic recovery.

Your point is, how fast that $100 million comes, does impact the incrementals?

Sure.

If the $100 million took a year to come, you're right.

Because in a very slow growth case, it would be more challenging.

And the faster the $100 million comes, the higher the incrementals.

But to answer, I think if we had the $100 million in something like what you described, a scenario you described, we would expect 30%.

And it sounds like then it's not a function so much of contribution leverage as it is maybe filling up excess capacity.

So in other words, companies historically, if your volume grows faster, you see much more rapid incrementals.

And I realize you're a distributor, not a manufacturer.

So it sounds to me like it's a function of the $100 million, which is a fairly specific number, as a function of, I'm assuming, incrementally filling up the new Columbus DC, et cetera.

Is that a reasonable assumption?

I'll say it helps.

But fundamentally, it's operating discipline and a culture that says that, look, we're not going to increase our costs just because our revenue goes up.

And that's been really impressive.

Thank you very much.

Appreciate it.

Thanks, John.

And the last question will come from Ryan Cieslak of KeyBanc Capital Markets.

Thanks for squeezing me in, guys.

Happy New Year.

You, too, Ryan.

A lot of questions asked.

I don't want to keep this long.

But, Erik, I'd be curious to know, when you think about the potential price increase you might put through here in the coming months, how does that compare to maybe what you guys have done the last several years?

Is it the first type of price increase, broadly speaking, for you guys?

Is the magnitude greater, just in the context of what the last couple years have presented, maybe talk a little bit around that?

Ryan, it would be, so specifically around the mid-year, if you're referring to it, would be more than the last couple of years, less than historical average.

Okay.

Great.

And then just a follow-up: Talking and thinking about the capital expenditures and spending that you saw here the last couple of months and then the possibility of consumables following that, Erik, historically, when would you typically see that?

Is that a couple-quarter lag when you finally start to see an inflection in the consumable purchases, or just how do we think about that going forward, as well?

Yes, Ryan, good question.

I think that's about right.

If you think about somebody, a customer that says they're going to buy a new machine to expand capacity, by the time they get the machine in and install it, and then they buy a tooling package with it, which is, think of that as like a start-up kit of the consumables that go through it.

So they've got to get the machine in, which may take some time to get in and install, get it up and running, and then burn through the tooling package.

You know, I think that's a reasonable assumption of a couple quarters.

Okay.

Great.

Thanks, guys.

I appreciate it.

Thank you, Ryan.

This concludes our question-and-answer session.

I would like to turn the conference back over to John Chironna for any closing remarks.

Thanks again, everyone, for joining us today.

Our next earnings date is set for April 13, 2017, and we certainly look forward to speaking with you over the coming weeks and months.

Thanks again.

The conference has now concluded.

Thank you for attending today's presentation.

You may now disconnect.