MSC Industrial Direct Co Inc (MSM) 2017 Q2 法說會逐字稿

Good morning, and welcome to the MSC Industrial Supply 2017 Second Quarter 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, sir.

Thank you, Denise, and good morning to everyone.

I'd like to welcome you to our fiscal 2017 second 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 U.S. 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 adjusted financial measures to the most directly comparable GAAP measures.

I'll now turn the call over to Erik.

Thanks, John, and good morning, everybody.

Thank you for joining us today.

I'll begin this morning's discussion by covering the environment, which continues to show improvement as the momentum that began a quarter ago sustained.

I'll then discuss second quarter business developments, which were highlighted by sales growth above the high end of guidance, gross margins in line with our expectations and earnings per share above the top end of our guidance range.

Rustom will provide additional detail on our financial results, and I'll share our third quarter 2017 guidance.

I'll conclude with some additional perspective on our performance, and then we'll open up the call for Q&A.

So I'll begin with market conditions, our second quarter and an early look at our third quarter.

Conditions remained positive during our fiscal second quarter with January building upon December's return to growth.

While February reflected difficult comparisons to the same period last year, March's growth rate picked back up to start the third quarter.

We estimate March growth to be around 4%, which is inclusive of the benefit of Easter timing.

Keep in mind that our fiscal March does not close until April 8. And as a result, our final monthly sales result could have greater variability than in prior quarters.

MBI readings that were at 49.8 back in December surpassed 50 for the first time in 2 years in the month of January, reaching 53.8.

February lifted further to 56 and March's reading came in at 56.4, which brings the rolling 12-month average to 49.3.

Given our historical 4-month lag to the rolling 12-month average, that data point points to higher growth in our metalworking end markets and consequently higher sales growth in the quarters to come.

Customer sentiment generally matches what we're seeing from the macro indices across a broad range of manufacturing sectors.

The growing optimism in the industrial economy has continued as the outlook has turned noticeably more positive over the past 2 quarters.

While order volumes are not yet as robust as sentiment, they have begun to turn the corner for most of our customers.

And this is true despite the lack of further clarity on policy topics, such as infrastructure spending, lower corporate tax rates and a more business-friendly regulatory environment.

Last quarter, we were cautious not to call December's improvement a sustained trend.

Today, we would.

If the indices hold at current levels, we should continue to see improving sales trends for our business.

Turning now to the pricing environment.

As we mentioned on our last call, we had seen some supplier price increase activity, but it was very select and not broad-based.

As such, we did implement a very modest midyear increase in February.

Given how small it was, it is not material to our overall results nor do we expect it to be so for our fiscal third quarter.

We are, however, hearing more and more conversation about potential future, more meaningful price increases from suppliers.

And this bodes well as we look ahead.

Moving on to our revenues.

Our growth rate against the markets in which we operate reflects continued share gains.

Our average daily sales growth for the quarter is consistent with the rise in the MBI.

And given the correlation of our sales trends on a 4-month lag to the MBI's rolling 12-month average, this also bodes well for continued growth.

Taking a look at our various customer types.

The improvement in growth rates has been fairly widespread across our customers.

Government business was up slightly year-over-year in the second fiscal quarter, which was a small improvement over the first quarter.

National Accounts grew nicely in the mid-single-digit range and above the company average.

We had mentioned on our last call that our funnel for large customers remained strong.

Some of this National Accounts growth was new business, but our existing customers also lifted their buying levels.

Our core customers grew in the low single digits for the quarter.

This is a significant improvement and is reflective of the improving manufacturing environment.

CCSG's sales growth also turned positive for the first time in more than 2 years.

E-commerce was 59.8% of sales for the second quarter, basically flat from last quarter and up from 57.8% a year ago.

Sales to vending customers contributed roughly 300 basis points of growth in the quarter.

And we added approximately 25,000 net SKUs in the second quarter.

Our total active salable SKU count remains over 1.5 million and our SKU expansion program remains an important contributor to growth.

With respect to our field sales and service teams, we continue to focus on increasing selling hours by improving sales force effectiveness.

As such, we ended the second fiscal quarter at 2,352 associates, flat with last quarter.

Looking forward, we expect that number to decline slightly over the next few months as our sales effectiveness programs gain traction.

We also continue to focus on gross margin stabilization.

And our result for the fiscal second quarter was 44.7%, just slightly above the midpoint of our guidance.

I'll now turn things over to Rustom.

Thank you, Erik.

Good morning, everyone.

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

Our average daily sales in the second quarter increased by 2.9% versus last year with sales to manufacturers up 2.6% and to non-manufacturers, 4.5%.

So overall, ADS growth came in slightly above the high end of our guidance range of 2.5%.

And this was a very nice turnaround after 5 quarters of ADS declines.

As Erik mentioned, our Q2 gross margin at 44.7% was slightly better than the midpoint of our guidance and down roughly 40 basis points from last year.

Product and customer mix, including capital-related sales, were basically in line with our expectations.

In mid-February, we did take a small midyear price increase in some select product categories.

However, it was too late to have an impact on Q2 gross margin and too small to have much of an impact on gross margin for the rest of fiscal 2017.

As always, we continue to tightly manage our operating expenses.

And despite approximately $20 million in higher sales year-over-year, our OpEx declined slightly.

Of course, there are number of pluses and minuses.

Last year's Q2 had high medical expenses as we transitioned to a new medical plan and amortization related to J&L acquisition.

This year, we had volume-related variable costs, SAP finance project expenses, a higher bonus accrual and higher salaries due to merit increases, all partially offset by productivity savings.

So this resulted in roughly 100 basis points of leverage as operating expenses as a percentage of sales declined.

Now versus our guidance midpoint, Q2 OpEx was about $3 million higher.

Roughly $1 million was due to higher sales volumes and the remainder was a combination of payroll and payroll-related expenses, primarily additional sales commissions and bonus accruals.

Our second quarter operating margin was 12.3%, slightly better than the guidance midpoint of 12.2% but up a solid 50 basis points on last year's Q2.

Our operating margin improvement versus guidance came from higher sales volumes and gross margin performance while the improvement versus last year came from expense leverage.

Operating income itself grew 8% on 3% growth, illustrating the potential for leverage in our business model as the industrial economy returns to greater growth.

Our fiscal second quarter EPS was $0.93, $0.03 above the high end of our guidance range.

$0.03 of EPS was attributable to a lower effective tax rate.

Our effective tax rate came in at 36.1%, well below our guidance of 38.2%.

And this was due to the early adoption of the new accounting standard on stock compensation, which requires excess tax benefits and deficiencies resulted from vested or exercised stock-based compensation to be recognized in the income statement.

Our early adoption resulted in net excess tax benefits, which were previously being recognized through additional paid-in capital on the balance sheet but are now recognized as a reduction of income tax expense during Q2.

So Q2's EPS was up 16% from last year's Q2 of $0.80.

Broadly, operating income growth contributed $0.05; the income tax benefit, about $0.03; and a lower number of shares outstanding, another $0.05.

Turning to the balance sheet.

Our DSO was 51.5 days, up over the prior year and slightly down from the last quarter.

Our inventory turns at 3.4 were up from last year and also up slightly from last quarter's 3.3.

And this was despite inventories increasing sequentially by roughly $10 million.

You may recollect that we signaled Q2 inventory growth on our last call.

Likewise, in Q3, we expect inventories to be slightly higher as we want to remain well positioned for an upturn in sales.

Our free cash flow, which is cash flow from operations less capital expenditures, was $8 million in the second quarter.

This compared to roughly $50 million for the same quarter last year.

So the major drivers of this change were higher inventories and accounts receivable, which can be expected in a growth environment, offset partially by higher accrued liabilities.

Our capital expenditures were $13.2 million in the second quarter, up $2 million from last year's Q2.

Note that our fiscal 2017 CapEx is now expected to be around $55 million to $60 million.

And we continue to expect fiscal '17's operating cash flow conversion, which is net cash from operating activities divided by net income, to be above 100%.

At the end of the second quarter, we had roughly $549 million in debt, mainly comprised of $184 million revolving credit facility balance, $163 million on our term loan and $175 million of private placement debt.

We have $36 million in cash and cash equivalents.

And so our leverage ratio remained at 1.1x.

Now to our guidance for the third quarter of fiscal 2017, which you can see on Slide 4 of our presentation.

We expect Q3 sales to be between $734 million to $748 million, up from the prior quarter's $727 million despite 1 less workday this quarter.

So our guidance, therefore, assumes average daily sales of $11.6 million in Q3 and ADS growth of roughly 3.5% at the midpoint.

We expect gross margin to be 44.6%, plus or minus 20 basis points in Q3.

And that's down 40 basis points from the prior Q3's 45% and virtually flat sequentially.

And this is consistent with what we anticipated on our last call.

We expect Q3's operating expenses to be about $230 million or roughly $9 million higher than the prior year.

3 buckets here broadly.

Variable expenses related to higher sales should amount to $1 million.

The second bucket is spending on our key initiatives and other items net of productivity and J&L amortization account for another $2 million.

And I should point out here that both of our 2 large projects, SAP finance and telephony, peak in Q3 as they're currently being implemented and expenses will begin to subside in Q4.

The single largest driver of Q3's increase in OpEx is the roughly $6 million of bonus accruals versus last year's third quarter, which we have been talking about since last year's third quarter.

If the bonus accruals and last year's extra day were normalized between the 2 years, Q3's OpEx as a percentage of sales would be below last year's.

This is obviously at midpoint of guidance.

Looking forward to Q4, at these levels of sales growth and after backing out the extra 4 days in last year's Q4, we expect further leverage, meaning that OpEx as a percentage of sales will be below prior year.

So all of this results in a Q3 operating margin of about 13.5% at the midpoint of guidance.

Last year's Q3 was 14.5%.

But if the bonus accruals and the 1 extra working day are normalized -- last year are normalized out, then Q3's operating margin is slightly up on last year with the mix-driven lower gross margin offset by OpEx leverage.

Furthermore, if Q3 ends per our guidance, then year-to-date with virtually flat sales, we'd be at an operating margin of 13%.

This would be slightly ahead of the expectations contemplated in our framework, which is on Slide 5 in the presentation.

We're assuming an effective tax rate of 36.3% for Q3.

While it's difficult to predict how these stock options will be exercised in Q3, and our share price, we have estimated in our guidance that under the newly adopted accounting standard for share-based compensation, there will be a $0.01 EPS benefit.

In addition, we've assumed a $0.02 EPS benefit to EPS from an R&D tax credit, mostly associated with the investment in our SAP finance implementation.

So finally, our EPS guidance for our fiscal third quarter of 2017 is a range of $1.05 to $1.09.

I'll now turn back to Erik.

Thank you, Rustom.

For the past 2 years, we've been operating in a deep and prolonged industrial recession.

We've used that time to capitalize on opportunities that present themselves only during downturns, to focus on the fundamentals of the business and to improve this company.

Along the way, we've delivered solid financial results, given the environment.

We are now seeing things start to turn positive as momentum in manufacturing is building.

Our business is performing in fiscal 2017 as we would expect.

Revenue growth rates are improving and we are generating leverage in the form of earnings growth, particularly when considering the roughly 40 basis points of bonus expense headwind that we described at the start of the year.

More exciting to me, however, is the story that is building with each passing week.

As I look out a couple of quarters, here is what I see.

I see revenue growth rates that should continue to improve as we've not yet fully benefited from the recent spike in MBI readings based on our historic 4-month lag.

I see gross margins that will likely benefit from the early rumblings of inflation that has yet to make its way to market.

I see operating expenses that will certainly include ongoing investments but will no longer be weighed down by a bonus step-up the size we're experiencing in fiscal 2017.

I see a strong balance sheet that can be used to enhance returns by effectively deploying capital, be that through acquisition, share repurchase or other cash returns.

When I put all that together, I see an exciting growth story right in front of us, one that we've been preparing the company for over the past few years.

I'd like to thank our entire team of associates for their dedication and commitment to our plan, to our customers, our stakeholders and to our mission.

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

(Operator Instructions) Our first question will come from Matt Duncan of Stephens.

So wanted to just talk about sort of what you're hearing from your customers.

Are you seeing a building of optimism here?

Are we still in maybe more of a cautiously optimistic environment, where you're not quite seeing them ready to ramp yet?

And I know the health care decision is not that far in the rearview mirror at this point.

But do you feel like that has changed sentiment in any way?

Matt, so I would say, in general, we are seeing a building optimism in our customers.

So I would describe it more as building optimism than I would cautious optimism.

Look, certainly like everybody else in the country, there is somewhat of a wait-and-see approach with respect to the various policy reforms.

No question about it.

But in general, more and more strengthening, more and more confidence.

And I think there are a couple of proof points I'd point to.

One would be at the turn of the calendar year, we talked about capital-related purchases that generally happens when customers are feeling more optimistic in their business.

This quarter, this past quarter, Q2, I'd point to, you may have noticed, our vending growth contribution spiked up.

A lot of our vending is metalworking, production-related metalworking items.

That started to ramp up.

So those are indications to me, sort of proof points to support the anecdotal evidence we're hearing from customers that there is building optimism, yes.

Okay, very helpful.

And then the other question I've got, you talk about a return to more meaningful growth a couple of quarters out.

And so conceptually, if we do see some inflation return, let's say, it's 1 point or 2 that you're getting in growth from inflation, what level of revenue growth do you think maybe the current MBI reading would translate to for you guys?

Matt, good question.

So look, you could do the math and the current reading -- so by the way, the current lag -- the way we look at it, again, is on rolling 12-month average because what we find with the sentiment indices is they can move around a lot.

The rolling average tends to smooth that out.

So right now, that rolling average is still at a 49.

However, if you believe the leading indicators here are at 56, hypothetically, let's say that 56 were to continue for a period of time and that rolling 12-month inches up higher and higher.

Look, if you look back over history, at minimum, that would support growth that looks much more like the historical average organic CAGR that you're used to seeing out of the company.

And then look, if you put -- you're getting on sort of another element of what gets me excited, which is if inflation does come to be, which we're not seeing yet but are seeing some leading indicators, if that comes to be, it certainly enhances the leverage story and the growth story.

But I think punchline is you should start to see -- if these levels sustain the most recent readings, organic growth that looks more like what you're used to out of our historical CAGR.

So you would say that's high single digits, perhaps better?

I would.

I would.

The next question will come from Ryan Merkel of William Blair.

So first, on forward guidance, the midpoint implies average daily sales in April and May remaining at March's $11.6 million level.

And you mentioned the building customer optimism.

So it seems to me that would imply a little bit more of a lift.

So I'm just wondering if is this typical conservatism?

Or is there anything to call out?

So Ryan, let me try that.

And it's actually -- it's averaging $11.6 million for the 2 months.

But April with Easter would be a little bit lower, the Easter impact in there, and then the May number.

So you kind of look at it that way.

Ryan, by the way, just a little more color.

Typically, what we -- as you know, what we do is we'll always say, "Our window into the future is pretty short, no matter what the environment, we will take a look at what we're seeing in the business." And with March, there was a portion -- beginning of March and the end of March have been particularly strong, a little softer in the middle.

And what we do is average it out and to the best of our ability, apply that average going forward, unless we saw some radical change.

And at this point, we didn't see enough radical change to model it in as part of the forecast.

Yes, that makes sense.

Okay.

And then secondly, one of your big peers is reducing list prices to be more in line with the market.

And I'm wondering, is this something that your customers even notice?

And could there be any impact to your pricing?

Yes, Ryan.

So what I would say, let me start by saying, look, pricing environment, to be clear, even as things pick up, competition remains fierce and the pricing environment remains challenging.

That said, Ryan, the vast majority of what we're hearing, when I described a tough pricing environment, that is really coming from the local distributors.

We are not hearing a whole lot and certainly not seeing a whole lot from our customers in regards to any other movement.

What we hear more about is local distributors getting aggressive.

And then look, as it relates to pricing, the other thing I'll point out and as I look to the future, if conditions continue to get better and if -- you've got 2 factors there that I think could abate some of the pricing pressure if they work according to plan.

So one being, as demand picks up, generally, look, when our customers are busy, they have less time to price shop and what they really value is getting product in their door fast, which we can do.

And it's why Rustom pointed out we're building up inventory to keep our value proposition really strong.

So pricing pressure tends to abate when customers are really busy and they really value the next-day delivery.

And then the second thing would be inflation would also help soften pricing pressure.

But look, as of now, it remains pretty intense but really coming from the locals more than anything.

Got it.

And that, well, your answer is consistent with history, so nothing's really changed.

All right.

And lastly, CCSG turning positive is nice to hear and nice to see.

I'm curious if you can give us an update on the EBIT margin performance and the progress you've made in that business.

Because I recall when you bought it, I think it was high single-digit margins.

Yes.

So Ryan, we really can't give you -- we've essentially integrated that business, particularly the back end of that business, such that I can't give you an EBIT answer because we don't have a view into EBIT because the back ends have been integrated.

What I can tell you is, look, on the top line, encouraging, like the rest of the business, some encouraging signs of progress and some signs of life.

We are really focused on the 2-way cross-selling opportunities that are continuing to gain traction and a part of our sales force effectiveness initiatives.

But that's really the degree to which we manage that business, given the back ends are now together.

The next question will be from Scott Graham of BMO Capital.

So help me square something here.

So we have a really good amount of large account growth, yet you still have manufacturing, which improved obviously markedly.

But for the nonmanufacturing -- to have been up more than the nonmanufacturing.

Can you -- my understanding was that most of your large accounts were sort of in your core metalworking business.

And so could you help square that and what that means for mix going forward?

Yes, sure.

Scott, it's actually a really good observation.

So what's happened is, interestingly, so you're right to note that the nonmanufacturing is pretty high.

Normally, when that happens, what you see is a really strong performance in Government, which we've shared makes up a healthy chunk.

This quarter, we happen to note that Government was just up slightly.

What we saw in nonmanufacturing was a couple of pockets of end markets that are connected to our National Account wins that are outside of core manufacturing, but where we've had some real success.

And you can imagine, for competitive reasons, I'm going to be a little sensitive about pointing out where those are.

But there were 1 or 2 in particular that had big growth that were tied to new National Account wins that makes up...

Because intuitively that doesn't normally happen that way, right?

Normally, when nonmanufacturing grows faster, the biggest driver there is Government.

So this was a little bit different, I would agree.

And I would say, mix-wise, I wouldn't read too much into it.

The bigger mix element that you point out is the large accounts growth is a customer mix headwind to gross margin, as Rustom mentioned, but not so much the manufacturing.

No, I wouldn't read into the manufacturing, nonmanufacturing.

So if -- let's even pull out these couple of isolated situations.

It still looks like the large accounts, I'm guessing, were still a nice pop.

I mean, that was a big number, right, on the increase.

So is that maybe a little bit more of a headwind that you were thinking within your framework or in line?

Framework, you're talking a headwind to operating margin, right?

That's correct, yes.

Right.

So Scott, the way -- with large accounts, I mean, quite clearly, the National Accounts, quite clearly they adversely impact our gross margin.

But when you take into account cost to serve and all the rest of that, they wouldn't necessarily have that effect on operating margin.

But yes, I mean, part of what you saw, and it comes back to a lot of the large accounts and a lot of those vending sales that Erik referred to earlier, also actually have a negative impact on our gross margin.

Yes, I'm with you.

I got that.

Last question is within manufacturing, again that was a really nice pivot there, could you talk about, to the extent that you know, which specific verticals -- obviously, there are a lot of verticals that do metalworking, which one specifically within manufacturing are the ones that you would maybe call out as the reason for why it's now up after however many quarters down?

Yes, Scott.

So the good news here is that the improvements we're seeing in the numbers and in customer sentiment is pretty broad-based.

So we're finding it across most of our customer types and most of our end markets, things are improving.

Look, so within that, some of our -- if you wanted to call out what are MSC's core metalworking-related segments, metal fabrication is a big one, which is essentially job shops and fab shops.

Heavy equipment and machinery would be another one that's a big -- and primary metals would be a third that are a big metalworking end markets for us, all of which are showing improvement.

And then look, I think another influence here that I wouldn't underestimate is oil and gas stabilizing, not growing but stabilizing.

So relative where this economy has been the last 2 years, the fact that it's stabilized and showing signs of life now is a big change.

The next question will be from Hamzah Mazari of Macquarie.

The first question is if you could just give us a sense of the potential for increased online competition to your business and any changes you may be seeing there.

I know you have a higher metalworking component, so there's more technical support requirements.

But any color you can sort of frame as to how you're thinking about higher online competition to your business model?

Yes, Hamzah, I think that's been an ongoing trend of some of the digital models.

I would say sequentially here quarter-to-quarter, not much new to report.

Look, it remains a presence.

The whole digital competition remains a presence.

It remains a threat.

And I think what you're seeing from MSC, what you have seen and what you can expect to continue to see is a move of our business towards technical, high-touch product line services such that the MSC value proposition becomes way deeper than just price and transact.

So you brought up metalworking, you're absolutely right.

We have metalworking experts that are in there with our salespeople, helping the customer improve their production process.

That's pretty sticky.

And that's something that's hard to sub out, just because you could find a product cheaper online.

We talk about our Class C business and the high service element to the small consumable nuisance items that we essentially take over a headache for customer.

So you're going to continue to see MSC migrate our business towards those type of categories and services.

And look, I think the proof has been in the pudding that, for the most part, to date it's been working.

Great.

And just a follow-up, you mentioned broad-based improvement in manufacturing.

Could you maybe outline your exposure to the auto market?

The SAAR has been weak lately and just curious to see what your exposure to that end market is.

Yes, Hamzah, oil, it's funny, it's become -- like if you remember a couple of years back, we were getting questions about oil and gas exposure.

And on first glance, it was small.

And the same would be true with auto.

It's small as a direct.

The challenge is where it becomes difficult to say with oil and gas is the indirect exposure is much difficult -- much bigger than the direct and it's much more difficult to quantify.

So specifically, if you went and you visited a lot of our core customers, particularly those in the Midwest and maybe the Southeast, they're job shops.

And so they have customers from all different end markets, one of which would likely be automotive, so very difficult to quantify.

But look, in general, Hamzah, to me, the general takeaway here is most segments are moving in the right direction in terms of outlook.

Your next question will be from Adam Uhlman of Cleveland Research.

I guess I'm wondering what magnitude of price increases that the company would need to see that would really start to turn the gross margin story around, work through some of the mix headwinds that we're seeing over the next 9, 12, 18 months.

Is this something where we need to see 3%, 4% type price increases or -- to really move the needle on gross margin and revenue?

Or is it small enough that just a couple points would really change the outlook for MSC?

Adam, what I would say there is that if you look ahead, that getting back to what we'd want to see to really move the needle is something in line with historical averages for our increase.

And I say that we haven't had any "historical average increase" in the last few years here.

But you mentioned something, the 2%, 3% range.

That would be more in line with historical average, certainly.

And we haven't been there in the last couple of years.

So if you asked me if, hypothetically, there were a 2.5%, 3% increase, would that -- should that move the needle for the company, I think the answer would be yes.

Maybe, Adam, maybe another way to think about this is if you look at the last couple quarters, mix and price combined, mix and price variances have run at about 1.3% each, right, and in -- negative.

And in those quarters, I mean, we were basically coming in with -- we talked about vending and all the rest of it, but like 40 basis points off compared to prior years.

So if you look at that, that gives you another way of perhaps triangulating back to that answer.

Okay.

And then could you talk to what you're seeing in active account growth, new National Account wins, maybe your shift to location, traction?

Have we turned the corner on bringing in new customers and maybe any kind of magnitude you could put around that?

Yes, look, Adam, as you know, we stopped reporting on that quarterly.

So I'll certainly give you the color.

And by the way, the reason we stopped reporting on it quarterly was because it really -- we didn't find it to be a metric that was particularly meaningful, having looked back over the last couple of years and seeing it was remarkably stable.

Look, I think what we're seeing is the trends remain more or less stable.

So I don't think any major changes over the last quarter from the numbers that you've seen to talk about either direction.

Look, within that total number, realize there's a lot of new accounts coming in, new high-potential accounts.

We've called out the National Accounts area, for instance, as one where we're pretty encouraged about the funnel of new opportunities.

Your next question will be from Sam Darkatsh with Raymond James.

It's Paul on for Sam.

Just a quick question.

So you talked about the selling hours and sales associates being down in the next few months.

At what point would you have to actually increase sales associate count, based on end market conditions?

Or what would you have to see out of your end markets to really increase that number?

So Paul, let me help on this.

I mean, if it's -- it's to do, first of all, with productivity and what we are doing, all the technology and the things that we're using to try and increase the productivity of our people.

So hard to give you a call and say exactly at what point we'd expect it to pick up.

Of course, certainly we'd actually expect it to go down over the next couple of quarters, so -- a little bit.

Harder to say when it will pick up.

But clearly, Paul, at some point as we go forward and absorb productivity and as the business has grown significantly, if it does the kinds of numbers Erik is talking about, at some point, we would start to add some sales and service people because remember we add the 2 together, it's field sales and service.

And service is part of our high touch that differentiates ourselves, so a lot more volume, there will be some headcount at some point.

Paul, the only other thing I'd add is I think right now, if you talk to our sales management team, they would tell you they see -- and I think we have some good programs in pilot mode and in-flight on the sales effectiveness front.

They see a decent-sized runway to extract growth without adding headcount.

So Rustom is absolutely right, this doesn't last forever.

But I think for a little while here, there's growth to be had without adding people.

Got it.

And then are you hearing anything or seeing anything yourself or hearing anything out of your customers in regards to problems with labor constraints and tightness in the labor markets in terms of getting jobs done?

I would say I'm not hearing anything new, Paul.

What comes off the top of my -- I will tell you that, in general particularly in the manufacturing world, access to qualified talent is a hot topic.

But that's been a hot topic for a couple of years.

I haven't seen much change in the last quarter in that regard.

The next question will come from David Manthey of Baird.

Rustom, could you repeat what you said about DSOs and describe how you calculate that ratio?

Yes, I mean, it's -- I said our DSOs were up versus last year, right?

And I think when you're talking about how you calculate the ratios, I mean, that's just the standard calculation of sales divided by sales and multiplied by the number of days.

So what we are seeing, however, and what we are seeing and I guess probably what you're trying to get to is what's happening with our DSOs.

And so you're seeing 2 things.

One is the impact of National Account growth with typically longer terms.

And David, as well, we're also seeing the extension of terms that we're seeing in there.

So this has been an ongoing trend and it's likely to continue, okay, as we continue to grow this side of the business.

But the good news is that our aging remains stable and our write-offs remain low.

So perhaps that was where you're trying to get to.

Yes.

By my calculation, if you look at net instantaneous DSO, it's the highest that I've basically ever seen.

And if you look at AR, net AR just as a number, I think you exited the quarter at $430 million and that had been running $388 million to $395 million in the 5 quarters preceding it.

It just seems like a pretty big increase.

And given that February wasn't all that strong, it seems out of character.

So any additional comments on that?

No, we've seen it steadily increasing month-on-month.

I mean, obviously it's not one of the metrics that we like as we see it going up there.

It's just a fact, I mean, it's being going up pretty steadily.

But if you look at aging, which is another way of looking at it, I mean, if you compare aging, I mean, our aging is actually down on last year, the comparison of the aging.

So it's -- the quality of our debt remains decent.

It really comes down to, if you think about it, just look at the big mix increase in National Accounts.

And so you've got the big mix plus the fact that we've been sort of giving longer terms.

And the combination of those 2 is what you're seeing in there.

Now...

Dave, I would say this one, sort of similar to the gross margin discussion earlier, where as you could imagine, look, negotiating terms, much like all terms, with a large buyer who's doing a lot of business is different from a small company.

And so just like as National Accounts grow, there's a gross margin impact, you're seeing something similar here.

And I think to Rustom's point, what we are focused on is, number one, are we getting value back in return of terms or longer?

And then number two, is the quality -- how are we doing managing those terms?

How are we managing risk?

But by all measures on that front, we're managing it well.

But you're right to point it out that it's growing, much the way gross margin has been a headwind.

But let me cut in there.

There's one more point.

I mean, we'll take those sales any day of the week because even if we got $100 million more in sales and even if we sort of added $25 million to our working capital or something -- some number like that, net, of course, inventory, everything.

And that's a one-time sort of addition.

But then the cash flow that we get from that consistently and ongoing would be like $20 million a year, right?

So the tradeoff is pretty good.

Okay.

And just as a follow-up here, it sounds like this is -- it's been a change.

And maybe you could talk about when that happened in terms of extending terms to your customers.

The National Account thing has been sort of a secular trend.

And the trend to longer DSOs has happened over time.

But this seems like a pretty significant change just quarter-over-quarter.

And like I said, it's up 10% versus the last 5 quarters, it seems like a pretty big increase.

So first of all, no, it's not -- there's no change.

It has been steadily increasing if you look at our numbers.

And I think you made the point, too.

So no, there isn't a sea change in this quarter at all.

But there has been a steady movement on this.

I mean, I look at our numbers by month obviously, and then look back.

And you can see this pretty steadily evolving.

And actually, when we dive, when we cut into the components, it's in National Accounts piece.

And you can see that steadily -- it's been steadily increasing pretty much as long as I can remember anyway.

Okay.

Just last question, if I can get one more in here.

Your next opportunity to raise prices in a meaningful way, does that happen in the fall?

Dave, what I would say to that is so we are sitting in April, there have been cases where we've raised prices sooner if the market got really hot.

So I wouldn't rule it out.

What I would tell you is that the more weeks pass and the closer we get to the kind of historical cycle we're on of the August, September timeframe, the more we'd be likely to wait.

So at this point, it's not impossible that we could do something.

But with every passing week, more likely to wait.

The next question will be from Andrew Buscaglia of Crédit Suisse.

Just looking on that gross margin line again.

Can you talk about -- last quarter, you talked about a pickup in capital goods.

I would think that, that would help you guys going forward.

However, we're getting into Q3 and it looks like there's nothing material there, I guess.

And you didn't have a whole lot of commentary on those capital goods ramping, the spending ramping.

Can you just talk about that, what you're seeing this quarter, and then how it translates into the gross margins and at what point?

Sure, Andrew.

So we talked about capital goods in the context of December -- capital and capital-related, by the way.

We shouldn't include tooling packages, stuff like that.

And so for the entire quarter, I mean, there was nothing discernibly out of line in terms of the mix of capital.

However, we did see the vending.

And if you look at our vending sales, which went up so much, and the impact that they have on us, I mean, that's production metalworking.

So as that continues, that's nothing but a good sign.

It shows gross margins -- it shows metalworking continuing to grow.

Erik, any thoughts?

Yes, Andrew.

So I think what you're seeing here is a fairly typical cycle of what happens when things are starting to improve.

So end of year, around the December, January time at the year-end, tends to be the time when, if there's more optimism, customers will put in machine orders.

We saw that, and that was the capital-related purchases.

Once the machines get delivered, they need to get tooled up.

And then they start running.

So they get tooled up with what Rustom referred to as tooling packages, which think of that as like a starter kit of tooling, large purchase that tends to be lower gross margin; and tooling accessories, like holders and things that hold the tools.

Once that happens, then presumably these machines are going to start running and they're going to start consuming tools, consumables.

And so what you're seeing is, so in Q2, it was a spike in capital-related purchases, encouraging sign.

It means customers are investing in capital.

What you're now seeing and we're seeing it in the spike up in the vending growth contribution is tools are starting to get used to.

Now these are production tools.

Production tools tend to get a lot of scrutiny.

And we've talked about the tools that run in the vending unit tend to come in at slightly lower gross margins because they're part of the production process.

And that's definitely what you're seeing.

And Rustom said good thing.

It's because this is seeing a cycle play out that is indicative of increasing customer confidence now turning into machines starting to run.

Okay.

All right, that makes sense.

And on the pricing side, I mean, you guys were optimistic last quarter.

It sounds like you've got a price increase, but it was just wasn't all that meaningful.

But can you talk about where that price increase is, like where that was exactly?

And then if they do transpire, I mean, it sounds like your comment earlier, if you don't get some -- if you're not pushing it by August, it's probably not going to happen until the fall.

Is that correct?

Yes.

So Andrew, the increase we took was very small.

We generally don't break out midyear increases.

But it was small.

It was select, meaning that it tied primarily to some select suppliers that took their list prices up.

But the list price increases were quite moderate and they were sparse.

So it averaged out to a small increase.

What we're -- I described this being encouraging.

What we're hearing more and more from suppliers, look, they're all seeing what we're seeing, which is commodities recovering from a 2-year low period.

They're building almost all commodities now on a 12-year -- a 12-month basis or up and suppliers are also looking at it and saying demand environment is getting better.

So commodities up, demand environment is getting better, there is more talk from our suppliers that they are entertaining increases.

Those have not yet come to market.

But if they do, as we suspect they will, that could mean a more robust increase in the future.

And that look, hypothetically as I said on the earlier question, could be sooner than the catalog increase, the typical catalog increase, August, September, but more likely than not would be then.

And if this trend continues, it would be a healthier increase.

Your next question will be from Justin Bergner of Gabelli & Company.

First off, I wanted to just follow up on the vending topic.

I think you mentioned earlier that vending contributed 300 basis points to overall company growth.

So that would mean that it was essentially driving all of the growth in the quarter and growing perhaps double digit in isolation.

Is that a fair conclusion?

It would be fair to say that vending customers -- what we haven't done is broken out, so we gave you the growth contribution.

Yes, I mean, so the growth contribution is 300 basis points.

Factually, you are correct that vending customers accounted -- that absent vending, the growth would be flat.

I mean, I think what you're seeing is vending customers tend to represent where we put focus and where our value proposition is really coming to life.

And they also tend to be manufacturing-oriented and you're seeing that start to pick back up.

Okay, that's helpful.

And so I mean, if I look out to the third quarter, given that there might have been a boost from sort of initial vending orders in the second quarter, would you still expect vending to be as strong?

Or would you expect it to taper a bit, given sort of the transition from buying the initial machine and stocking it to buy the consumables?

Justin, I would say if the environment stays strong as the MBI indicates it would and as what we're hearing from customers supports, then no reason that should back down.

I mean, so we would think what that should translate into is stronger manufacturing activity.

Stronger manufacturing activity should translate into more tools being consumed and that should stay strong.

And that's what results are by our gross margin guidance, which is pretty much in line sequentially and indicative of what we expect from vending in the same sort of product/customer mix going forward, Justin, in Q3 anyway.

Okay.

And then finally, does that all almost fall in the National Accounts customer group?

Or is it spread across customer groups, the vending?

Spread.

It's much more widespread than National Accounts.

And final question this morning will be from Steve Barger of KeyBanc Capital Markets.

I'm curious, is there a general rule of thumb for revenue growth or gross margin contribution trends for new SKUs relative to existing products?

And is the decision to add new SKUs primarily driven by customer request or by you evaluating relative cost and margin opportunity?

Yes, a really good questions.

And we noted, look, that program remains an ongoing growth driver.

Steve, what I would tell you, and I'll describe the program a little bit, punchline is what you can't do is simply model out and say, "If SKUs are up 8% or 10%, that means revenue should be up 10%." We do find that the reason is the base business has very mature SKUs that tend to produce a higher revenue per SKU, as you could imagine, than most of the new SKUs, which take time to build up.

What we do with the program is we are leveraging a few pieces of insights.

One is our supplier intelligence, so what products they're bringing, what they're seeing selling, what's not.

Two is a whole lot of our own analytics around what customers are looking for based on -- we mine a lot of data from our website on failed searches, on what gets requested in branches.

So we've gotten smarter and smarter about the SKUs that we add, meaning that we're adding things that we're pretty certain have some built-in demand.

And that has helped improve the program to where it's really become a growth driver.

What we'll typically do is not add those -- so gross margin, I would say, not a huge difference to the company.

From an inventory standpoint, we will tend to have them earn their way in so that we don't -- it's not a ton of speculative inventory until we have a little bit of history with the item.

So hopefully, that helps give you a sense of how we run the program.

Definitely.

And one more, just in response to the digital question earlier, you talked about the move towards more technical products and Class C inventory management.

How much of that has been done with existing customers?

Or is that early in the process?

And how much of that is prospecting new customers to take share from someone else?

So the answer, Steve, is it's some above.

What's interesting is even within existing customers though, so the share gains don't only have to come from the new customer.

One of the beautiful things about this industry is it's just so darn fragmented.

So $160 billion in the U.S., the top 50 distributors have 30% share.

70% of the share sits with the locals and regionals.

And that plays out when you get on to the ground and you go into on account.

Very few accounts of ours or any distributor for that matter have all their eggs in one basket.

So typically, there's many distributors selling into a given customer.

So the interesting thing is in a lot of cases, our best share capture opportunities are in existing customers, where we may have a small percentage of their spend, we may only have one product category or be in one plant or one area of the plant.

And that tends to be a really effective way of capturing share is just share of wallet.

And then certainly, as you point out, new customer acquisition, and particularly we called out the National Accounts area as one example, also becomes a good mechanism.

And ladies and gentlemen, this will conclude our question-and-answer session.

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

Thank you, Denise, and thank you to everyone for joining us today.

Our next earnings date is set for July 12, 2017.

And we look forward to speaking with you over the coming months.

Thanks again, and have a good day.

Thank you.

Ladies and gentlemen, the conference has concluded.

Thank you for attending today's presentation.

You may now disconnect your lines.