MSC Industrial Direct Co Inc (MSM) 2017 Q3 法說會逐字稿

Good day, and welcome to the MSC Industrial Supply Third Quarter Fiscal 2017 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, Nicole, and good morning, everyone.

I'd like to welcome you to our Fiscal 2017 Third Quarter Conference Call.

In the room with me are Chief Executive Officer, Erik Gershwind, and our Chief Financial Officer, Rustom Jilla.

During today's call, we will refer to various financial and management data in the presentation slides that accompany our comments as well as our operational statistics, both of which can be found on the Investor Relations section of our website.

Let me reference our safe harbor statement under the Private Securities Litigation Reform Act of 1995.

Our comments on this call, as well as the supplemental information we are providing on the website, contain forward-looking statements within the meaning of the U.S. securities laws, including guidance about expected future results, expectations regarding our ability to gain market share and expected benefits from our investment in strategic plans.

These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those anticipated by these statements.

Information about these risks is noted in our earnings press release and the risk factors in the MD&A sections of our latest annual report on Form 10-K filed with the SEC as well as in our other SEC filings.

These forward-looking statements are based on our current expectations, and the company assumes no obligation to update these statements.

Investors are cautioned not to place undue reliance on these forward-looking statements.

In addition, during the course of this call, we may refer to certain adjusted financial results, which are non-GAAP measures.

Please refer to the GAAP versus non-GAAP reconciliations in our presentation, which contain the reconciliation of the adjusted financial measures to the most directly comparable GAAP measures.

I'll now turn the call over to Erik.

Thank you, John, and good morning, everybody.

Thanks for joining us today.

I'll begin this morning's discussion by covering the environment, which continues to show improvement.

I'll then discuss third quarter business developments, which were highlighted by sales growth slightly above the midpoint of our guidance range, operating margins above our expectations and earnings per share at the top end of our guidance range.

Rustom will provide additional detail on our financial results and share our fourth quarter 2017 guidance.

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

I'll now start with the market environment.

Conditions steadily improved through the quarter as manufacturing continued to firm up.

This was reflected in the most recent MBI readings, with May reaching 57.1%, the highest reading in more than 5 years.

June's reading came in last week at 56.2%.

Feedback from customers is consistent with the theme of continued and steady improvement, and this is reflected in their order volumes, backlogs and general sentiment.

The rolling 12-month average for the MBI is 52.1%.

This is important because an average above 50% correlates to growth in the metalworking end markets.

Given our typical historical 4-month lag to the rolling 12-month average, this points to continued improvement in our sales growth.

From an end market perspective, aerospace, fabricated metals and machine shops continued to improve, as does the oil-and-gas-related business.

While automotive was still strong, it was a bit spottier than it has been over the recent past.

Other end markets, like heavy truck and agriculture, have appeared to bottom and show some improvement.

If customer sentiment continues to be positive and the industries hold at their current levels, we should continue to see improving sales trends.

Over the course of the quarter, our monthly sales growth reflected the improving environment.

We grew 4.5% in March, slightly ahead of our expectations at the time last quarter.

April came in at 1.5%, as expected, given the timing of the Easter holiday.

May rebounded to 5.5%, and our June estimate continued the upward trend at 6.4%.

Keep in mind that our fiscal June ended on July 8, and therefore, includes the July 4th holiday.

Last year's July 4th holiday fell in our fiscal month of July.

Taking a look at our various customer types, the improvement in growth rates during the quarter was pretty much across the board, with particularly strong growth in National Accounts, which increased in the mid-single-digit range, with building momentum through the quarter.

In fact, June's growth was double digits, which is encouraging because, historically, National Accounts has led the way in an upturn or downturn.

Government growth in the fiscal third quarter was in the low single-digit range.

Our core customer and CCSG growth rates were also low single digits, not as fast as our larger customers, but better than the second quarter, with improvement through the third quarter as well.

Again, this is important because our core growth rates tend to follow those of our larger customers and are most highly correlated with the rolling 12-month average MBI.

So what we're seeing now bodes well as we look out to the future.

Turning to e-commerce and Vending.

E-commerce was 60.5% of sales for the third quarter, up from last quarter and up from 58.6% a year ago.

It's important to note that our e-commerce sales include all forms of automated selling.

In fact, product sales that go through our vendor managed inventory solutions or vending machines account for slightly less than half of our total e-commerce sales.

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

We added approximately 5,000 net SKUs in the fiscal third quarter, and our total active salable SKU count is over 1.5 million.

We ended the fiscal third quarter at 2,309 field sales and service associates versus 2,352 last quarter.

This was in line with our expectations.

As we had said, we expected a slight decline over the following few months, and we expect this trend to continue as our sales effectiveness programs gain traction.

I'll now turn to gross margin, which, at 44.3%, was slightly below our guidance range.

The primary driver for the variance from our range was mix.

As we have returned to growth, the portions of our business seeing the fastest acceleration are those where we focus strategically.

They're also the areas with lower gross margins, but positive contribution margins.

National Accounts, Vending customers and some of the new product introductions are 3 examples.

I also want to note that despite the headlines on competitive activity over the past several months, our rate of price decline was actually slightly better than it's been in the past few quarters, and you can see this on the growth decomposition on our website.

Turning to the pricing environment.

While we've seen some select supplier movement, it continues to be very spotty and not broad-based.

Looking ahead, we would expect to implement an increase, as we usually do, and will provide more color on the next call.

For now, however, the pricing environment remains difficult as competitive intensity remains high.

Moving forward, there are a few signs of life, with a few large manufacturers signaling to us that price increases are likely in the coming months.

If this were to become more broad-based, it would bode well for future price increases.

I'll now turn things over to Rustom.

Thank you, Erik.

Before I go on to talk about the results -- and good morning, everyone.

Before I talk about the results, I'd like to actually mention our SAP new financial systems, which we rolled out in April on schedule and on budget.

We've been managing our receivables, paying our bills since then.

And then at 2 months, we closed those using SAP.

So it's really great to have this behind us.

And my thanks to all our team members who worked very hard for the last year to get us here.

And now let me turn to our fiscal third quarter performance in greater detail.

Our average daily sales, or ADS, in the third quarter were $11.6 million, an increase of 3.8% versus last year and slightly above the 3.5% midpoint of our guidance range.

ADS was up 2.8% to manufacturers and 6.5% to nonmanufacturers.

Our fiscal third quarter gross margin of 44.3% was down 70 basis points from last year and 30 basis points below the midpoint of our guidance.

Erik already discussed the factors that drove this result, so let me just note that it was basically the outcome of our sales growth coming from lower margin customer types and channels, such as National Accounts and Vending, as well as increased penetration of new products, which changes product mix within these types.

As you know, these are strategic growth areas for us, and we were happy to take higher growth in these areas as an average to make a positive contribution to operating margins.

Now moving to operating expenses.

They were about $6 million higher year-on-year, and higher bonus accruals accounted for roughly $3 million of this difference.

Volume-related expenses, which we assume as 10% of higher sales, accounted for approximately $1.5 million.

And so the remainder included higher medical costs and spending on key initiatives, such as SAP and telephony, partly offset by lower depreciation, amortization and other savings.

Compared to guidance, we accrued less for bonuses in Q3 than we had originally expected.

This, of course, is based on our current payout projections, which we update quarterly.

There were no other major variances, and as such, operating expenses were about $3 million lower than guidance.

So our third quarter operating margin was 13.7%, 20 basis points better than the midpoint of our guidance.

The benefits of higher sales volume and lower bonus accruals more than offset the impact of a slightly lower gross margin.

Versus the same quarter a year ago, our operating margin was lower, and that was mostly due to lower gross margins, which we've talked about, and last year's bonus accrual reversal, which we've communicated often.

Our effective tax rate was 36.3% for the third quarter, in line with guidance.

We had noted in April that it was difficult to predict how many stock options would be exercised in the fiscal third quarter and had estimated there would be a $0.01 EPS benefit.

In addition, we had expected a $0.02 benefit from an R&D tax credit, mostly associated with our investment in our SAP financial implementation.

As it turns out, we had very few options exercised, and therefore, no EPS benefit from share count, but we did benefit by $0.03 from the R&D credit.

So our fiscal third quarter EPS was $1.09, at the high-end of our guidance range.

Now turning to the balance sheet.

Our DSO was 54 days, up 2 days sequentially.

This was due to a temporary increase in receivables arising from the implementation of our core financial system in April.

However, we've recently seen collections increase, and we do expect DSO to improve over the next 2 to 3 months.

Inventory turns of 3.4 were in line with last quarter, with a small sequential inventory increase of roughly $2 million.

We expect inventories will be slightly higher in the fiscal fourth quarter as well as we continue to position ourselves for higher sales growth.

Free cash flow, or cash flow from operations less capital expenditures, was $50 million in the quarter.

This compared to $95 million for the same quarter last year and is mostly due to higher working capital.

Our capital expenditures, which were $0.4 million in the third quarter and are roughly $38 million year-to-date.

We now expect our fiscal 2017 capital expenditures to be around $55 million to $60 million.

Our operating cash flow conversion ratio, and that's net cash from operating activities divided by net income, was around 99% in the quarter, and we expect to end the fiscal year at roughly the same level.

As of the end of the fiscal third quarter, we had roughly $515 million in debt, mainly comprised of a $314 million revolving credit facility balance and $175 million of private placement debt unchanged from the last quarter.

We had $28 million in cash and cash equivalents, and our bank leverage ratio remained at 1.1x.

Now to our guidance for the fourth -- fiscal fourth quarter, on Slide 4 of our presentation.

But first, please note that our fiscal 2016 fourth quarter had 5 extra selling days worth roughly $55 million of sales with low operating expenses, so it's essentially just volume-related expenses and an extra week of payroll.

So now to the quarter.

We expect sales to be between $732 million and $746 million.

Our guidance assumes average daily sales of $11.7 million and ADS growth of roughly 7%, at the midpoint of guidance.

We expect our fiscal fourth quarter gross margins to be 43.8% plus or minus 20 basis points, and that's down 50 basis points sequentially from the third quarter and roughly 100 basis points from the prior year period as reported.

Let me emphasize that a fourth quarter sequential decline is typical.

In fact, if you look back over the last decade, 50 basis points is the average seasonal drop that we typically see from Q3 to Q4.

Last year was an outlier as we saw only a 20-basis-point drop, and that was mostly due to reduced sales mix headwinds and a negative growth environment last year combined with the results of gross margin countermeasures.

We expect midpoint operating expenses to be about $230 million, or roughly $5 million lower than what we reported in last year's fiscal fourth quarter.

However, on a comparable basis and after adjusting for the additional operating expenses associated with those 5 extra selling days last year, we estimate OpEx will be about $8 million higher.

The composition of this is using a 10% variable OpEx estimated higher sales; about $5 million comes with the $50 million of incremental sales at the midpoint, and another $2 million or so is attributable to higher incentive compensation accruals expected this quarter -- this year.

OpEx as a percentage of sales will be down roughly 120 basis points in comparison to the same 13-week period a year ago, demonstrating our leverage.

This marks our second year of strong OpEx productivity.

Assuming fourth quarter OpEx is in line with our expectations, for the full year and on a 52-week comparison, OpEx will be up roughly $3 million on a sales increase of about $66 million.

This means that we will have more than covered our cost inflation and investments as well as the higher -- the expected higher bonus payouts in 2017.

Turning to operating margin for the fiscal fourth quarter.

We expect it to be around 12.6%, at the midpoint of guidance.

This would be flat to the fiscal fourth quarter of 2016 on a comparable 13-week basis.

Last Q4, operating margin as reported was 13.3%, and that's with the extra week.

If the fourth quarter comes in at the midpoint of guidance, we would expect fiscal 2017's operating margin to be around 13%, flat with last year's 52-week number.

This would also be in line with the annual operating guidance framework that we provided at the start of the year, where the applicable quadrant of a slightly negative price environment and slightly positive volume had an operating margin of 12.7% plus or minus 50 basis points.

So back to the fiscal fourth quarter guidance.

We're assuming an effective tax rate of 37.3% for the fiscal fourth quarter, with no material R&D tax credits or share-based compensation benefits envisaged.

The fiscal fourth quarter's tax rate is higher than last year due to expected lower state tax reserve releases.

Finally, our EPS guidance for the fiscal fourth quarter is a range of $0.97 to $1.01.

At the midpoint, this would represent a 10% increase versus last year's 13-week EPS and includes the benefits of last year's buyback.

I'll now turn it back to Erik.

Thank you, Rustom.

I remain pleased with the company's performance, particularly the acceleration in growth in many areas that are of strategic focus to us: National Accounts, Vending and SKU expansion, to name a few.

Overall, as revenue growth rates continue to improve, the expense leverage latent in the business is beginning to demonstrate itself.

Our fourth quarter guidance implies over -- or roughly a 120 basis point improvement in operating expense leverage on roughly 7% ADS growth.

Looking to the future, we would expect revenue growth rates to continue rising should the MBI at least remain at current levels.

If we see any meaningful price inflation, or if the recent accelerated mix headwinds abate just a bit, we are poised for strong earnings growth and nice operating margin expansion.

Even if pricing does not return, and even if the recent accelerated mix headwinds do not abate, we are still positioned to grow earnings nicely.

And as we move to high single-digit revenue growth, once again expand operating margins.

I'd like to thank our entire team for their hard work, their commitment and their dedication to our plan and most importantly, to our customers.

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

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

So look, obviously, I think everyone's going to want to know a little bit more about what's going on with gross margin.

I appreciate all the color that you guys gave us.

It sounds like it's just sort of seasonal products and that sort of thing sort of returning to normal.

I'm really more curious on the year-over-year comparison as we move forward.

At what point do you guys think we could see gross margin bottom as you look out into the future?

Was there a level of revenue growth that is necessary for that to happen?

Or what should we be thinking about and looking at?

Yes, Matt, so let me -- I'll put a little more color on gross margin.

And then as you're talking about bottoming out and out to the future, I'll talk a bit more, and Rustom will chime in on the incrementals.

So yes, look, gross margin, what you saw, our typical pattern in a year is for gross margin generally starts out highest in Q1, and absent any price movement, you'd see it tick down gradually through the course of the year, the fiscal year.

And that's essentially what's happened here, although it's been, particularly the last couple of quarters, the erosion has been a bit more severe than it would be on an average year.

And really, what I tried to do in the prepared remarks is parse out what's going on.

So point one is, there's no price inflation right now.

So you don't have any meaningful price to offset the headwinds in the business.

Point two would be what we saw and particularly what we've seen here in the back half of the year as we've started increasing our growth rate, as we've returned to growth, where we're growing fastest and where growth is really accelerated is in some areas where gross margins are lower.

So we have taken what was a normal headwind, and the headwind has essentially gotten larger.

So in essence, that's the story right now.

What I did want to hit, especially given all the headlines recently, is what it's not is a change in what we were seeing on the pricing front.

And so that's where if you go to our decomposition, you can see prices is always laid out separately, and that's, if anything, slightly better than it's been in the past couple of quarters.

So that's the story of what's happening right now.

Look, we're pleased, and we'll take all day long seeing those strategic areas of growth take off.

The big thing, what we'd like to see, and what would certainly, looking out, make the gross margin picture better is to see some of the areas of the business that are higher gross margin pick up and grow further.

And so there's 2 I'll call out, one being our core bread-and-butter business.

And I think what's encouraging there is that's been certainly steadily improving for the last few quarters, but lagging the larger customers.

That's a fairly typical pattern for us coming out of cycles.

And so if history repeats itself and the MBI correlation holds true, we should see core growth rates lifting, which will help buffer the headwinds, and that will create somewhat of a tailwind.

And then the other one is CCSG, where, certainly, momentum in the business -- we want to see that growth rate outpace the company growth rate, and then that becomes another buffer from what has been the headwinds.

So I think that's the story, and I'll just give you sort of one more piece looking out on gross margin.

So if you wanted to look out, and obviously, way too early for us to give you any perspective on 2018 given the number of moving parts, but of those variables I've described, look, if pricing inflation returned to any meaningful degree, that would be a big change.

And we could see a picture where gross margins would be flat, maybe even up, depending upon the size of the increase we could take.

If there were no price inflation, so the price environment stays as is, the other case for gross margin improvement from where we are is a change in the mix headwind.

So this recent acceleration in the mix headwind moderating a bit.

And again, the big linchpin there is the core growth rate, which should happen, given history and the CCSG growth rate.

So that's a bit of color on how we view gross margin looking out and how it would improve from here.

That's very helpful.

And then my second question, sort of sticking a little bit on topic here, is on price.

Do you have any thoughts at this point as to what type of price increase you guys think you might be able to get in the catalog?

I appreciate that it's early.

I think, typically, it's like August or sometime in the fall when you might put that through.

So either size of increase that you might think you could get based on what you're hearing from the suppliers and timing of when you guys might do it this year, any thoughts on that?

Yes, Matt.

So a little early.

Look, timing-wise, generally, as you know, we tend to sync this up with the launch of our catalog plus or minus a month.

I don't think this will be radically different, so sometime during the summer.

In terms of size, I'm going to wait until next quarter.

I'll give -- we'll give, obviously, the full color on the size of the increase.

What I would tell you is, for now, the size of the increase, you can imagine, is going to be correlated to how we view the pricing environment, which we're still describing as quite spotty.

So if -- what I'd say there -- so that's not a particularly large increase.

That said, what I would tell you is that if some of the recent rumblings that we've heard were to play out and become more broad-based, what you'd likely see us do, even if it weren't a larger increase, is we could move soon thereafter if we saw the market justified it.

Our next question comes from Hamzah Mazari of Macquarie Capital.

Just the first question is on pricing as well.

Maybe Erik, could you give us any color on how competitive your pricing is in your portfolio versus the market?

And also, maybe what kind of premium is justified for distributors for service?

So I realize your pricing may be higher than the mom-and-pops due to service, but maybe just give us a flavor of how competitive you guys are relative to competition or the market, however you guys think about it.

Yes, Hamzah, a really good question.

And obviously, timing given some -- timely given some of the recent headlines.

I mean, the answer is our pricing is quite competitive.

And I think one thing that's important to understand here, a very important nuance is how distributor pricing and our pricing and many in the industry's works is there's a list price and then there's a post-negotiated discount price.

And so if you were to go on our website and look at our list price, which is effectively servicing pure spot-buy, random purchases, that price is not going to look particularly competitive, particularly to a larger customer.

That's a very different price than the price that our customers who have relationships with us, who are looking to -- for solutions and a person-to-person relationship, which by the way, is where our business and our focus is, they're seeing a much different price and a very competitive price.

So just to put some more context on that for you.

So roughly somewhere around 90% of our business, in terms of revenues, is attached to a salesperson relationship, okay?

In those cases, there is going to be a price that is much different from what's available publicly.

The other data point I'll give you to help put some context on this is that for that pure spot buy, come to the website and just see the visible web price, well under 5% of our revenues come from that sort of business, from a list price.

So where our business is, where our focus is and where we're going, the customers are seeing a very different price.

And then one other point and I'll stop is that if you were to ask our salespeople, for decades now, our salespeople have been competing with a price that is deeper than a web price and that's street price.

That's the street price that a local distributor that makes up 70% of the market is selling at every day.

You're correct, we do tend to command a premium over that price.

But look, there's a limit to how far we can take that premium.

But that's something we've been dealing with, as I said, for decades.

Great.

And just a follow-up question, I'll turn it over.

On the CCSG business, could you give us a sense of how you're performing versus the market?

And you mentioned that, that business lags.

Has that lag gotten larger versus historical cycles?

I know you haven't owned that business for decades, but just any sense of how you're thinking about that particular segment versus internal expectations?

Yes, Hamzah, so what I would say is that business has fared, I would say, similarly to many of our other types of business inside the company, which is it's seeing significant improvement.

So from Q1 to Q3 to what we're expecting in Q4, radically better growth rate.

But as I've said, still coming in somewhere around company average.

My expectations for that business and where I think it should be is well above company average.

And what I was pointing to earlier in Matt's question is that would then create, obviously, a buffer to some of the headwinds we're seeing.

And certainly what I see under the covers, I like what I'm seeing.

I like some of the progress we're making internally, but the proof will be in the pudding, and that will come when growth rates outpace the company.

Actually, there's one thing just to add there is that as we've recently integrated the sales forces between the 2 businesses, we're also seeing a little bit of a benefit coming from that with the little bit more -- just more integration.

And we're also moving to get the 2 systems, in terms of our ability to supply MSC customers with CCSG products but from an MSC warehouse, we're working on getting some of that stuff.

And that's coming to fruition in a few months.

It's not ready quite yet, but that too will benefit, just to add.

Our next question comes from David Manthey of Baird.

So looking at the gross margin in light of the operational statistics, your mix of large accounts and nonmanufacturing customers has been drifting up over many quarters, and you've seen more moderate gross margin declines than we saw this quarter or what you're guiding for in the fourth quarter.

I'm just wondering, is there anything you see in the business beyond mix that's causing you a higher level of gross margin degradation?

And Erik, I know you mentioned that you would expect it to be flat, I guess, at worst, next year.

And I'm just wondering what changes in the complexion of the business to get you there.

So David, 2 parts to the question.

One is what's changed other than sort of, I think where you're going, the normal culprits, if you will, of National Accounts.

So certainly what we're seeing is some of the usual suspects where we've been putting greater focus have accelerated.

So I mentioned National Accounts in June getting to double digits.

Vending continues to accelerate.

Those would be normal.

I think that one other one I'd call out, and I mentioned this briefly, David, that would be different is we've had some really nice product expansion and some lines in particular that have really taken off over the past -- we've been on a build of SKUs and an expansion of suppliers and lines for a while.

I would tell you that this year, we saw a pretty dramatic acceleration in growth rate coming from them.

A couple of those happened to be lower gross margin than the company average.

Look, as Rustom said, they are wonderful pieces of business.

Their share capture and they -- from a contribution margin standpoint, they're good.

They are lower gross margins.

Now look, those are the types of things, David.

So it is a headwind to gross margin percentage.

I would say, over time, I would expect what is typical when you enter sort of a new relationship is that, over time, the terms of the relationship improve and the margin percentages would improve.

But for now, that would be the one thing I'd call out that's different from the past.

And then, of course, the lack of price to buffer kind of the sequential downdrift.

I'd like to add one thing to that.

And it's moving beyond gross margins a little bit too, and it's something we've talked about before.

Cost to serve is really important here.

And as something we have -- a point we've made in the past, but worth reiterating, that with some of these National Accounts, as we -- as yes, they come with lower gross margins, but if we can make sure that our cost to serve is less correspondingly, then from an operating margin perspective, it's not necessarily a negative.

I mean, so that's an important point to make here, and it applies not just to National Accounts but to all the areas of our business -- the efficiency with which we serve Vending, other different areas like that.

Okay.

And just as a follow-up to that then.

Your contribution margin has been highly volatile over the past several quarters.

Is there a target that you're thinking of in light of this gross margin situation, and as you just outlined, that the cost side is an important variable as well, is there a contribution margin we should be thinking about, let's say, for the next 12, 18 months, steady-state, assuming that would be the case?

Well, you know we're loathe to provide any guidance on the next 12 to 18 months, but yes, we are.

Look, I mean, I think one way to look at it, and perhaps just to talk about it in terms of our incremental margin commitment, which we have talked about before.

So we've talked about delivering 30% incremental margins on the first $100 million of our growth, right, and part of that is occurring right now.

So interestingly, of course, our commitment didn't include the bonus step-up.

We've clarified that previously.

And if you look at the midpoint, assuming we get to the midpoint of our Q4 guidance on sales and op margin and if you add back the bonus step-up, I mean that's an incremental margin of about 27% in -- on $66 million of sales growth, again, making an apples-to-apples comparison for the year, right?

So you look at that, I mean, it's pretty -- it is something that we focus on and something that we attempt to -- we obviously try to maximize our gross margins, obviously, right, wherever we can through pricing and through gross margin stabilization and all the rest of that.

But then we also, and this is something we've been doing over the last 2 years, is really focusing a lot on -- we have an initiative in place focusing on optimizing our cost to serve as well so that we can deliver op margin growth.

Our next question comes from Ryan Merkel of William Blair.

So the first question I had, I thought the lack of acceleration with manufacturing customers this quarter was a little surprising just given what some of the peers are seeing and, obviously, the strong MBI.

So why have we not seen more lift there?

And then I know the core customer lags, but it just seems to me that the growth should be a little bit better.

I think it's up low single digits.

So has anything changed there?

Well, Ryan, I would say no, look, I think if we looked at manufacturing, and what you're referring to is the quarter, and the Q3 number of 2.8.

Certainly, as you can imagine, May was better than that number.

We expect June will be better than that.

And it was coming from a pretty negative place a quarter -- a couple of quarters ago.

So I would say just pulling back, zooming out from manufacturing for a second, looking at total company growth rate, Ryan, I would say it's doing, particularly, as I look to Q4 with June, what we're guiding to for Q4, more or less, the company is doing what it should be doing.

Given the improving environment, the growth rate is lifting as it should.

You're right, look, there's been a lag in the core customer, but that's not atypical.

So I don't make too much of it.

To me, as I look sort of big picture, the growth is moving up as it should given the improvement in the indices.

Okay.

And then secondly, Erik, do you think distributors still have pricing power such that if suppliers raise prices, you're going to be able to pass that along?

Or could web price transparency impact this?

Ryan, I do.

I mean, I do.

I do think that distributors have the ability to pass along pricing when suppliers move.

I think distributors do not have the ability to pass along pricing if suppliers don't move, to be honest.

But I don't see here anything -- look, if the pricing environment comes back, Ryan, and just some manufacturers move on list pricing and distributors are not able to capture that, I think then it's a different discussion.

I don't see any signs of that.

And I guess the evidence and data points I have are just that very select over -- if I look back over the last couple of years, there's very select times where suppliers have moved.

We generally have been able to pass them along.

And what I would say, in some ways, look, there's no question, web transparency is real, it's there.

But in some ways, it helps a bit with the passing along of supplier price increase.

And what I mean by that is as web transparency has grown, customers are actually more aware of -- supplier list price becomes very visible.

So it becomes easier to justify a movement of the supplier -- a movement of your pricing if the manufacturer moves if more people know about the list pricing.

So I do.

That's the answer.

Okay.

And then just lastly, when a customer orders online, what percent of the time is he talking to an MSC salesperson or inside salesperson?

And then secondly, have you seen call center volume going down if you look at it over the last couple quarters because people can now solve what they're looking for online, they don't necessarily need to call somebody?

So Ryan, 2 questions.

The first thing I'll say is -- and I don't have a number to quote you in front of me, okay, so this is going to be more anecdotal.

But the overwhelming majority of our web business is coming from assigned accounts.

Look, I've shared the number before that somewhere around 90% of our business is tied to a sales rep relationship.

So you can imagine the -- if you looked at our web business, the percentages are not going to look that much different.

So when a customer goes online with us, look, for that transaction, it may be a seamless transaction where they're not talking to anybody at the given moment, but the relationship is way deeper.

So they're generally going to be talking to a branch.

They're generally going to be talking to technical people.

They're going to be seeing a salesperson.

They're going to be getting visited from an inventory management specialist, their service rep, if they have a VMI or vending.

So that is the overwhelming majority of the cases in terms of where the revenues are coming from.

Your second point, I apologize, Ryan, it was a good one, and I missed it.

Can you remind me?

Yes.

Just have you seen call center volume going down as people can solve more of their needs online?

You know what's happened?

The answer is no, they have not.

So first of all, what I'd say is our productivity in the call center, we have seen some improvement.

In general, though, what's more or less happened is if I look at the calls coming in, it's not that the calls are going down, it's that the complexion of the calls are changing, Ryan.

So what's happened -- and this is not a new dynamic, by the way.

This has been happening over several years.

A lot of the easy stuff will go through the web.

So if it's just a straightforward transaction, that will move to the web.

And what's happened is and where we're trying to really beef up is in our technical support, because the questions coming in, the calls are much more about asking for advice, getting help, maybe doing sourcing for things that we or another distributor don't carry or maybe for a special item.

So I would say it's more that the nature of the calls have changed.

And look, to some degree, they're more time-consuming calls, but they are -- create part of the stickiness that we talked about, because that's the kind of stuff that's very difficult -- the experience is very difficult to get online.

And one quick comment there.

I mean, the productivity that Erik -- that he just -- that Erik just referred to is more associated with, I mean, telephony.

I mean, we upgraded a very -- replaced a very old phone system with something that is much more easier to transfer calls, have records and just basically enhances productivity fundamentally.

So that's the driver, Ryan, of that one.

Our next question comes from Andrew Buscaglia of Credit Suisse.

Not to belabor the point on gross margin, but just one last question there.

One of your competitors this morning reported, and seeing similar mix issues but can sort of execute their way out of it.

What are like 2 or 3 things that are controllable for you guys going forward, whether it's maybe potentially more sourcing initiatives or maybe it's private-label sales?

Are -- is there anything controllable that you see going forward that you think could lead to some upside there in gross margin?

Yes.

Andrew, great question, and you're entitled to belabor whatever you like because it's your time.

So yes, and look, I think it's a good point, and the answer is yes.

So one of those things I highlighted.

The first and foremost that I would say is the growth in the core business and the growth in CCSG, which will take what is -- really, what's happened to us in the last few months is there's a headwind that has always existed in this business and we've talked about it with National Accounts and Vending on the gross margin line, has gotten accelerated based on the acceleration in the growth.

So one thing that is in our control that could change that is improvement in the growth rates in core and improvement in the growth rates in CCSG.

With respect to core, we do see it starting to happen.

We fully expect it to happen, but that's one.

With respect to CCSG, the growth rates have improved.

They're not yet outpacing the company.

As Rustom said, look, inside the company, we see lots of good markers for progress, but the ultimate measure will be when it starts outpacing the company.

Outside of that, yes, I mean, you raised a couple of good points.

And if you look back over the company's track record over the last year or two, we've talked about gross margin countermeasures, and basically 2 of them, one on the buy side and one on the sell side, our purchasing activities and our selling -- optimizing our discount levels.

Both of those are active programs, and both of those have been getting a heck of a lot of attention.

So realize that all the benefits we got from our supplier activities over the last year have not gone away.

It's just that they're in a run rate, whereas last year, they weren't yet in a run rate, and they were buffering some of the seasonal -- for instance, Rustom talked about last year a more gradual Q4 step-down.

One of the reasons was we were just gaining the traction and seeing results on the Supplier Summit.

All of that is in the numbers.

So what we're doing internally now is absolutely saying, okay, where are we going from here?

How are we going to ratchet things up further?

So both purchasing activities and discount optimization are areas that are in our control and are getting a lot of attention.

And if we see improvements, would have a significant impact on gross margin in 2018.

Okay.

All right, that's helpful.

And just one last one on you mentioned that stat of 90% of your sales, on Ryan's question, going through online related to customers with existing accounts.

But I guess going forward, what's the -- what's your expectation that, that -- or gives some confidence that, that doesn't go to 85% or 80% in coming years?

Maybe where was that last year or the year before that?

I guess that's a concern is will that change.

Yes, Andrew, so let me just clarify.

So that number of around 90% was the percentage of our revenues that are connected to a selling relationship, to a salesperson, okay?

Actually, no concern at all there.

In fact, what's been happening over the years and will continue to happen is that percentage climbs.

So more and more of our business, just based on where we've been focusing the company, between metalworking, between Class C, National Accounts, Vending, all of these things are pushing towards that number goes up.

That is a number that's gone up over the years.

I don't have the numbers in front of me in terms of giving you a historical look back, but I don't have a concern that it goes down.

Our next question comes from Scott Graham of BMO Capital Markets.

I'm going to kind of ask some previous questions in maybe a little bit of a different way for my own purposes.

The fourth quarter gross margin guidance, is there an impact on the difference in sales days at all on that guidance, Rustom?

Well, what do you mean the difference in -- we have 5 less sales days compared to the -- for the full year number, right?

Right.

Compared to last year, is that what you're referring -- so I mean, that doesn't really impact the gross margin per se.

And, again...

Yes, that's kind of what I thought.

So I guess kind of what -- is it just that you're facing a different type of comparison on a year-over-year basis?

I know you went through the individual points there, but I guess the fourth quarter gross margin is kind of a bit of a point of the questioning in this call.

So I'm just trying to understand a little bit as to, again, you mentioned the points, but is there anything that you would maybe more specifically call out as a little larger, particularly since -- and I know the price increases that you're thinking about are small and are sort of later in the quarter, that kind of thing.

But what would be maybe the largest factor impacting the fourth quarter gross margin?

Whether you want to say that sequentially, year-over-year, anything would be helpful.

Scott, it's Erik.

Let me chime in for a second because I'll just give some historical context.

So if you look back, take a look at our last decade, what you'll find, it is very typical for us that Q4 seasonally drops from Q3.

The range of the drop has varied, okay?

So I think if you go back and look, and you can do it on your time, the only year you would find where there wasn't a drop Q3 to Q4 was 2013.

The reason for that was we acquired the CCSG business in that fourth quarter, which was at higher gross margin.

So it just -- it masked the seasonal trend.

Otherwise, pretty much every year, there's a decline.

Now that decline has varied from 10 or 20 basis points, like last year, all the way to this year, where it's been 100, 120.

What Rustom gave you in the prepared remarks was the historical average of 50.

The biggest -- so we're actually amazingly right on kind of historical average.

The biggest driver behind that is nothing deeper than seasonal mix of products that tends to -- what tends to happen in Q4, summer months are hot.

We see a spike in -- I mean, to be -- to put all the cards on the table, a big spike in HVAC, in fans and air conditioners, which are capital-type purchases, tend to come in at lower gross margins.

Just the way we generally, in the month of December, we -- the cycles to our business see a spike in machinery, gross margin temporarily goes down.

That's the biggest driver.

So what we've been calling out on this call was more sort of looking beyond it.

The Q4 sequential drop is really not surprising to us.

It's looking from Q1 to Q4, it was a bigger erosion this year than on average.

And that's where I talked about the accelerated mix headwinds.

But that 50 basis points specifically Q3 to Q4 is not really much different from the past.

No, and I guess I do understand that.

At the same time, the last, call it, 6 or maybe even 8 quarters, you've been able to apply these countermeasures that have really kind of limited the weakness in the gross margin.

And then, really, this quarter and next quarter, not the case.

So I guess kind of that's what I was getting at.

But let me move on to the next question, if you don't mind.

The pricing increase that you're looking for, admittedly, you talked about it, modest, the whole thing.

Is the timing of that kind of your decision to wait to see if we get a little bit more commodities inflation, then you can go out with something larger?

And if so -- I know you've consistently characterized the pricing environment in terms of what your suppliers are doing.

But maybe is there a way to recharacterize that into certain materials?

Because obviously, pricing is impacted by demand and, very importantly, by materials.

Are there certain materials that you guys are looking at that you kind of need to see a certain threshold, whether it's HRC or cold rolled or ethylene prices, is there anything you guys are looking at where you think that there's more -- would be more of a green light on the ability to increase prices?

Yes, Scott, what I'd say there, so we track a number of commodities, okay, a bunch.

You could imagine, given our exposure to metalworking, we'll look at the materials in particular that make up cutting tools, whether that's steel or carbide and tungsten and such.

What I'd say, though, is the vast majority of our sales as a percentage are connected to branded manufacturers.

And so unless the manufacturer moves -- I mean, generally, what we're going to do is mirror where their list prices are and not get out ahead of their list price.

And so unless the manufacturer moves, it's -- even if the commodities have moved, and to be honest, that's something that surprised me a bit over the last, call it, 6 to 12 months, is commodities, certainly for a while, had firmed up, and there wasn't as much manufacturer movement.

Now that could change.

We're hearing bits and pieces that, that could change as capacity starts to get filled out by the manufacturers.

But really, for us, the trigger is seeing a manufacturer move their list price.

Yes.

Scott, I want to come -- just I want to come back to your first question.

Erik answered the sequential stuff comprehensively, but the one more factor to note is in our fourth quarter, if you look at what we're expecting internally, we're expecting much stronger growth from the National Accounts part of our business, which is at the lower gross margin.

So going back to your -- when you're looking at the sequential drop between Q3 and Q4 and stuff like that, that's the only other addition to what Erik said.

That's very helpful, Rustom.

That's exactly what I was looking for.

And Erik, in the -- embedded within all of the verbiage that I used just now to ask some questions was the one question of are you looking to maybe delay -- are you pushing out your thinking on the price increase to see if you can do something more meaningful?

Scott, I'm -- a little early to say, but my first answer would be no, we wouldn't delay it.

I think what we would sooner do is if pricing firmed up -- because we're really in a rhythm with our sales team and our customers when there's a certain time when they expect an increase from us.

I don't see deviating from that.

I think what we would do is if we really saw things firm up, we would go, again, with a price increase.

Particularly to the extent that those increases come from kind of big, high-profile manufacturers, that becomes very easy to explain to the customer.

Our next question comes from John Inch of Deutsche Bank.

Rustom, just out of curiosity, what, again, is accounting for the $3 million lower bonus accrual?

Like real -- I guess you thought the bonuses were going to be $6 million incrementally or something, and they're $3 million.

What's the $3 million delta from the beginning of the quarter to the end?

Was it lower volume?

Or was there something else?

No.

As we looked at our expectations for the year -- you look at this -- the accounting rules, right, are pretty firm.

You look at your actual performance for the period to date, and then you look at your expectations for the period coming forward.

So compared to what we had -- and look, we've been talking about our gross margins and stuff, so you're seeing that.

Compared to what we had expected before, we expect slightly less internally than what we had.

And so we adjusted downwards.

Right, okay.

I was just thinking, but your sales came in slightly above your midpoint of guide.

Was that -- that's all consistent, I guess, in terms of what you're saying.

Is that correct?

Yes.

I mean, the bonuses being accrued are not simply for the quarter ahead.

They're the expectation of the entire year.

So you run with -- if you exploit -- so in quarter 1, you've got 3 months of actuals and 9 months of expectations.

And based on how you've tracked and how you expect to track if -- and versus our plan, our internal plan, which is obviously something different to what the -- often what we talk about on these calls.

There's different aspects to the bonuses and stuff like that.

So yes, it's a combination of all those factors, nothing that's not utterly routine in the process.

Okay.

So the -- right.

So the sales were better, and you actually expect sales to get better, the 7%.

But then the gross margins were weaker, and then you expect gross margins to get weaker.

But I think you're accruing for bonuses to be higher again in the fourth quarter.

Is that not the way to think about it?

Or is there some other input to the equation?

It is because you're seeing a true-up or something like that?

No, no.

You're good on that.

We're accruing for -- in one part, we're accruing for -- we're expecting to accrue for bonuses more than we did last year.

But last year, remember, we cut our bonuses in half, basically, in the second half, right?

However, compared to our original full year guidance, we're not expecting -- our full year bonus expectations, we're no longer quite at that total level, but we're definitely expecting to be well north of last year, based on what we have.

So you got the first part.

Okay.

So then I want to -- I do want to go back to gross margins for a second.

If the gross margins are lower, could that also not somewhat reflect the fact that customers are trying to chase cheaper product?

I'm just -- I realize what you're saying in terms of mix, but I'm just wondering like maybe it's reflecting the fact the market is actually looking for a cheaper product, and somehow, there's some structural element to kind of the new norm of future gross margins because of that.

Maybe not.

I'm just curious what you're thinking.

John, interestingly, I actually see a different dynamic happening.

Particularly, look, we realize our sweet spot, call it a medium-sized manufacturer.

And what we find with most of our customers right now, they're facing competitive threats, they need more productivity, they need to get product to market faster, et cetera, et cetera.

They are starving for productivity.

And in a lot of cases, the productivity -- if they can move the needle on their productivity of their manufacturing process, it dwarfs the savings they can get on the product itself.

And so what's actually -- what's interesting and what's happening, like if you take our cutting tool portfolio, it's actually migrating up in quality of product, because in a lot of cases, they're going to spend more for the product, but they're going to get a much better length of cut or the length of the tool life and the productivity coming out of the tool.

And it's actually moving the other way towards high performance.

So I think, for our core customers, anyway, the big lever for them is productivity and getting more output for less dollars.

So that actually bodes kind of favorably for future gross margins.

I did want to ask about your...

That's correct.

Yes.

I wanted to ask you about your sales force, though.

You clearly expect -- as evidenced by the economy, so that's all consistent, you expect business to pick up, but you're cutting the sales force.

And I accept the fact that there's maybe productivity tools.

I think the -- I think companies cutting sales, their front office in this kind of a dynamic is somewhat unprecedented.

So could you give us a little more color on how you're actually accomplishing this?

Like how do you -- do you give each sales guy more accounts to cover?

Or do they have a lot more -- I mean, I'm just curious how this is actually working, considering it's somewhat new territory.

Yes.

John, so there's actually -- there's a few things going on here.

So there's -- and this has actually been a program that we're encouraged by, and it's why we keep going here.

So one thing we're not going to do is reduce customer touches.

What we've found and what this program is all about is the idea of saying we want to get more customer touches.

And in the past, what we've done is associated -- you add a head and you get more customer touches, which, while obviously is true, is a crude way of doing it and is a costly of way of doing it.

So what we've done is introduced -- really, there's a few elements to the program.

Just competitive sensitivity, I won't go too far, but certainly, one is leveraging technology.

So CRM, among other things, are making our salespeople a heck of a lot more productive than they were 5 years ago.

They have more time than they had 5 years ago.

They've get more information right at their fingertips.

That's one.

Two is we're doing some more on segmentation.

So in the past, and again, this is where I won't go too deep, but in the past, we would have each salesperson assigned to a set number of accounts, and it would be somewhat of just a sort of a peanut butter spread on the type of accounts and the rest.

We're getting much more targeted, and that's producing productivity where we're getting more touch per person.

And then the third thing I'd call out, John, is just as we now, Rustom alluded to bringing CCSG and MSC together, there's opportunities, there's synergies there.

Look, a lot of that's being just captured just through attrition.

It's not like any big program, but we're just finding ways where we bring the teams together to be able to cover more ground with the same or fewer people.

Yes.

And kind of not replace heads as they attrit.

So that's great.

Just last, what was the magnitude -- can you just remind everyone, what was the magnitude of the price increase you took in the summer of 2016?

And what ultimately was realized kind of on a net basis over the course of the ensuing 12 months or up -- say, up until now or whatever?

In the summer of 20...

Just to put your future price increase into a context.

Yes.

Last year's price increase, I want to say, John -- well, to get back to you, but I -- below 2 -- somewhere between 1 and 2.

But the realized was...

Yes, somewhere between 1 and 2. We'll get back to you with the number.

Realized would have been less, obviously.

Realized is -- look, realized is certainly less than 100% because you don't get all of it.

But I would say the realized number, and I'll also get back to you on that, too, but not out of line with what we would have seen in a normal year over the past few years in terms of realization.

So in other words, the spread between kind of your gross price increase versus realized hasn't been narrowing because of what other -- whatever factor could be going on?

Well, what -- no, no.

So the answer is no.

What has -- I mean, I will say what has been there and one of the things we've called out, John, is look, the market, for the last couple of years, it remains competitively fierce.

And so what we do see, absent the price increases, is that there's areas where discounting or, well, local distributors are getting ultra competitive.

So there's competitive intensity, but in terms of isolating the price realization from the increase, it's solid.

In fact, if you look at -- slightly different answer, but if you look at our price decomposition, which you have, over the last several quarters, you'll see that there's been no major trend that sticks out there if you look back over the last year or so.

Our last question comes from Robert McCarthy of Stifel.

Obviously, a lot of questions have been asked across the board, and I'm not going to ask too much on the fourth quarter guide as I think we'll discuss that off-line.

Some mismodeling, perhaps, on my part.

I think the question I do have, though, is -- I don't want to put words in your mouth, but are you backing off anything with respect to your contribution margin communication?

And I'm not going to put words in your mouth around the heuristic around $100 million of sales and what the contribution margin could be.

But is there a change in tone there?

Or is there a specific change in messaging there?

No, no.

So Robert, let me take this, actually.

I mean, we talked about this incremental margin commitment, and I talked about the 30% of the first $100 million, and then we talked about north of 26%, or 28%, 30% sort of range as we go forward, right?

And no, frankly, I mean, we're not.

I mean, if we -- we didn't, by the way -- when we made that commitment, we had flat gross margins at that point in time.

And if gross margins -- in a flat gross margin environment, we can still deliver that with any level of sales growth.

And that, of course, depends on our continuing to offset OpEx inflation and investments through productivity every year, as we've done for the last couple of years, right?

And then going forward, no.

I mean, in the numbers, I mean, it just means that the incremental contribution margins coming out of that whole, but if you're having degradation in the base on the gross margin, right, on the average, it just means that you need a certain amount of sales to offset that.

So if you have the probably a -- let's say, if the average the last 2 years was minus 50 basis points or something like that, you'd need mid- to high single-digit sales growth to fully offset that.

And that's really how you look at it.

Rob, this is John.

I would just add that just to keep in mind, that commitment never included the bonus step-up in fiscal '17.

And so actually, if you take the numbers and you look at our -- if we hit our guide for the Q4, and we do $66 million in growth for the -- for fiscal '17, we should deliver 27% incrementals.

So then we'd have next year to finish the $100 million of growth.

Understood.

Two other quick ones, and I'll keep it quick.

In terms of management, any more announcements around a Sales or Chief Commercial Officer, anything along those lines that we should be expecting in the coming months?

No.

Rob, I've got to tell you, I'm very pleased with what I'm seeing from the team inside the company in terms of the progress being made on the sales and marketing front.

So I don't think you should expect, certainly, any sort of outside hiring for that role, I don't think you should expect that.

And then the final question for Rustom is, do you -- given your previous experience in working for companies and entities that have dealt with the warehouse automation, and looking at your cost structure, do you think down the road, given the volumes you're seeing or how the channels are shifting, do you think we could see more incremental automation investment coming out of you through your DCs in the coming years?

So Rob, I mean, first, I actually think that we have a very sharp sort of operations group, supply chain group in there, and they do optimize very nicely with what we have.

But yes, I mean, as volumes grow, as volumes going through our CFCs, as they increase over time, most definitely, we'll use automation.

And we are actually in a nice scenario from a growth perspective.

If we get more volume through our CFCs, we have the ability to go up to about $4 billion in sales without needing any significant additional investments, yes.

So you'd keep tuning the software, you'd do other stuff in automation, all the rest of it, but you almost wouldn't even need to do too much of that until our sales were a lot higher, the sales going through the CFCs.

It's a nice situation to be in.

And then if you go to our CFCs, we also then, if we don't need another one or something like that, we have plenty of physical space between buildings and land for expansion on those sites.

So really, what -- so our scenario, and it's nice to see growth coming back to -- our estimate of 7% for this quarter, I mean, that's great from our perspective.

And if we continue to grow and have this growth coming through our CFCs as we get into the future, we're in a pretty good position.

This concludes our question-and-answer session.

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

Thank you, Nicole.

We -- I want to thank everyone for joining us today and remind you that our next earnings date is set for October 31, Halloween, 2017.

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

We'll be on the road and look forward to speaking with you then.

Take care.

The conference has now concluded.

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