MSC Industrial Direct Co Inc (MSM) 2017 Q4 法說會逐字稿

Good day, and welcome to the MSC Industrial Q4 and Full Year end 2017 Earnings Conference Call.

(Operator Instructions) And please note this event is being recorded.

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

Please go ahead.

Thank you, Allison, and good morning, everyone.

I'd like to welcome you to our fiscal 2017 fourth quarter and full year conference call.

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

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 on our presentation, which contain the reconciliation of the adjusted financial measures to the most directly comparable GAAP measures.

Before I turn the call over to Erik, I wanted to note that we are no longer going to report customer count in our operating statistics.

Last year, we explained that as our business has grown and evolved from a direct mail model to a full service distributor, this statistic has lost its usefulness in gauging our performance.

While the underlying customer count trend has actually ticked up in recent quarters, it has not changed materially over the last couple of years despite significant changes in our business.

So after further reflection and discussions with many of you, we have decided to eliminate customer count altogether.

I'll now turn the call over to Erik.

Thanks, John.

Good morning, and thank you for joining us today on this Halloween morning.

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

I'll then discuss our business development in the fiscal fourth quarter, which were highlighted by continued improvements in revenue growth as the environment strengthened, solid gross margins with stable underlying trends, earnings per share well above the top end of our guidance range, and our acquisition of DECO.

Rustom will provide additional detail on our financial results, share our fiscal first quarter 2018 guidance and discuss our full year framework.

And I'll then conclude with some broader perspective.

We'll then open things up for questions.

I'll now begin with the market environment.

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

The most recent MBI readings reflect an expanding manufacturing environment.

July and August readings were 55 and 54.7, respectively.

September's reading came in at 56.2, and the rolling 12-month average for the MBI is now at 54.

This is important because an average above 50 points on a rolling 12-month basis correlates to growth in metalworking end markets.

Historically, on a 4-month lag basis, our rolling 12-month sales trends have also had a high correlation to the MBI rolling 12-month average.

So all of this points to continued strength in our sales.

Feedback from customers is consistent with the theme of steady improvement.

This is reflected in order volumes, backlogs and general customer sentiment.

The hurricanes did have a small negative impact, although most of that is in our first quarter, and we estimate it to be less than 50 basis points of growth.

From an end market perspective, virtually all improved during the quarter.

Aerospace, fabricated metals and oil and gas continued to show strength, while other end markets, like heavy truck and agriculture, which had bottomed out several quarters earlier, are improving.

In general, if customer sentiment remains positive and the industries hold at current levels, we should continue to see solid sales trends.

Our own recent growth trends reflect the stronger environment.

Quarter-to-date, our total growth rate is roughly 12%, and excluding DECO, it's roughly 8%.

Taking a look at our various customer types, my comments will exclude any impact from the DECO acquisition, and growth rates increased pretty much across the board.

We're particularly pleased to see improvement in growth from our CCSG and our core customers.

CCSG, in fact, reached high single-digits growth in August and is well into the double digits quarter to date in Q1.

Initiatives to bring the CCSG vendor-managed inventory offering to our base MSC customers are showing nice traction.

National Accounts also strengthened, reaching a low double-digit range.

Government and core customer growth lifted into the mid-single digits.

Turning to e-commerce and vending.

Now including DECO, e-commerce was 60.4% of sales for the fiscal fourth quarter, up from last quarter and up from one year ago's 59.1%.

As I've said before, it's important to note that our e-commerce sales include all forms of automated selling.

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

Sales to vending customers contributed roughly 430 basis points to growth in the quarter.

We added approximately 20,000 net SKUs in the fiscal fourth quarter, bringing our total additions for fiscal 2017 to 65,000, and we expect to add a similar number of SKUs in fiscal 2018.

Our total active salable SKU count remains over 1.5 million.

We ended the fiscal fourth quarter with 2,370 field sales and service associates versus 2,309 last quarter.

And while this is up slightly, as reported, it is in line with our expectations for a slight decline, excluding the additions from DECO.

We expect this underlying trend to continue in the near term as our sales effectiveness programs continue.

Turning to gross margin, I'm particularly encouraged by our results.

During the fourth quarter, we achieved improvements through increased price discipline, solid realization of the modest summer price increase we took of just over 1% and improved growth contributions from CCSG and core.

Our fiscal first quarter guidance reflects continued stability.

In fact, gross margin has been roughly flat sequentially for the past several quarters, and this is despite a soft pricing environment, which may be changing as we look to the future.

While competitive intensity remains high, several suppliers began taking prices up or signaling that price increases are likely in the coming months.

Most of these were not included in our summer price increase due to timing.

So if momentum continues building, it would bode well for our midyear increase, which typically occurs early in the calendar year.

Before I turn things over to Rustom, I want to talk a bit more about DECO.

While we're always looking at opportunities to strengthen our leadership in metalworking, we've remained quite selective in evaluating acquisitions.

In DECO, we found a business that meets our criteria with flying colors.

DECO is a roughly $100 million metalworking distributor with an excellent reputation among its customers, suppliers and the industry in general for exceptional service, high levels of technical expertise and a great team of nearly 200 associates.

It has a culture that mirrors MSC's in many ways, including a strong customer focus and adherence to its values.

All of this is a testament to the company's longtime CEO, Dennis Quinn, and the entire DECO team.

Additionally, DECO brings us market share and customer relationships in an area of the country where MSC is underpenetrated, making this a great fit.

The strategy for DECO is similar to that of other branch-based acquisitions that we've done.

We plan to build around a strong team in place and bring incremental value to DECO's customers, such as a broad and deep offering in metalworking, a wide assortment of MRO products that are also consumed at their customers' plants, under this industry-leading website and our next-day delivery model.

DECO's gross margins are in the low 20s, in line with industry average and similar to many of our past branch-based metalworking acquisitions.

We will enhance that number over time by capitalizing on MSC's buying scale and by blending in sales of other higher-margin MSC products.

I'll now turn things over to Rustom.

Thank you, Erik.

Good morning, everyone.

Let's turn to our fiscal fourth quarter in greater detail.

In Q4, we made our first acquisition in 4 years.

So on Slide 3 in the presentation, we have, therefore, shown our Q4 results, both excluding DECO and with DECO included.

Our first notes are reported results, which include DECO, then, since our Q4 guidance and our prior year do not include DECO, I will discuss our Q4 results, excluding DECO.

Let me start with an overview of our reported results for the quarter.

MSC's average daily sales growth was 9.2%, gross margin was 44.2%, operating margin was 13.3% and EPS was 1.07 per share.

Included in these results are roughly 5 weeks of contributions from DECO, which was acquired on July 31.

Excluding DECO, ABS growth was 7.7%, better than the mid -- than the 7% midpoint of our guidance and sequentially up nicely on the third quarter's 3.8%.

Again, excluding DECO, our gross margin was 44.6%, that's well above our guidance midpoint of 43.8%.

Versus guidance, higher supplier rebates and lower inventory provisions contributed about half of the outperformance.

The remainder, as Erik noted, came from increased pricing discipline and the modest summer price increase.

Versus last year's 44.8%, higher supplier rebates and lower inventory provisions partially offset the negative gross margin impact of mix and pricing.

Higher supplier rebates are mostly a function of our recent sales group, and the lower inventory provisions are simply the outcome of an improved inventory profile where we're holding less of our slower-moving stock.

Our focus on operating expense management continued.

Our OpEx to sales ratio of 31.1%, excluding DECO, was right in line with Q4 guidance and lower than last Q4's reported 31.5%.

There was, of course, an extra week last year, so a more relevant comparison would be with fiscal 2016's 13-week Q4 OpEx to sales ratio, which we estimate was roughly 120 basis points higher than this year's ratio.

Our fiscal fourth quarter 2017 operating margin was 13.5%, again excluding DECO.

This was an improvement of the 13.3% reported in the same quarter a year ago, as 40 basis points of OpEx leverage more than offset the 20 basis points of lower gross margin.

And compared to last year's more relevant 13-week fourth quarter estimated operating margin, we improved by about 90 basis points.

Our tax expense in Q4 came in at 38%, higher than our guidance of 37.3%, with an unfavorable impact from share-based compensation accounting being the largest contributor.

Before I turn to the balance sheet and cash flow, I'd like to briefly review our full year P&L performance and our incremental or read-through margins, which we have talked about often.

As we've shown on Slide 4, we had fiscal 2017 sales of $2.9 billion, up about $70 million, excluding DECO and after adjusting for our estimate of the impact of fiscal 2016's extra week.

We continue to focus on productivity and reducing our cost to serve and delivered approximately 60 basis points of operating expense leverage this fiscal year, which more than offset roughly 40 basis points of lower gross margin.

Our operating profit rose by approximately $16 million from last year's estimated 52-week result, a roughly 22% read through.

And our operating margin improved by roughly 20 basis points to 13.2%.

Excluding the roughly $8 million bonus increase, our read through was 33%, consistent with our expectations and 30% commitment on the first $100 million of sales growth.

Now turning to our balance sheet.

Our DSO was 54 days, in line with the fiscal third quarter and up 3 days year-over-year.

We had expected to recover some lost ground on Q3's DSO by the end of Q4, so this remains an area of sales and finance cross-functional focus, and we expect modest improvement during fiscal 2018.

Inventory, on the other hand, was better than expected with turns improving slightly to 3.5x as inventories declined despite higher sales.

In the fiscal fourth quarter, we turned about 144% of our net income into cash flow from operations.

For the full year, our cash conversion ratio stood at 107%, in line with the 100% or better that we expected.

Net cash provided by operating activities was $88 million in the fourth quarter versus $115 million in the fourth quarter last year.

Basically, this was due to working capital.

In fiscal 2016's fourth quarter, as sales declined, working capital was a roughly $18 million source of funds.

In fiscal 2017's fourth quarter as sales grew, working capital used approximately $10 million of cash.

Our capital expenditures were $9 million in the fourth quarter and $47 million for the year.

This was lower than expected, as some projects were deferred into fiscal 2018.

After subtracting capital expenditures from net cash provided by operating activities, our free cash flow was $79 million and $200 million in our fourth quarter and fiscal 2017, respectively.

In addition to paying out a higher ordinary dividend during fiscal 2017, we bought back nearly 642,000 shares on the open market at an average price of $71.29 and acquired DECO in the fourth quarter.

And we still ended the year with a $37 million reduction in our net debt.

We ended Q4 with $533 million in debt, mainly comprised of a $332 million balance on our revolving credit facility and $175 million of private placement debt.

We ended the year with $16 million in cash and cash equivalents and a leverage ratio of 1.1x.

This compares to a leverage ratio of 1.3x at the end of fiscal 2016.

In fiscal 2018, we expect revenue growth, some expansion in working capital and capital expenditure of $60 million to $65 million.

We are hopeful for, but not building in, lower taxes, although it is good to see corporate tax reduction on the legislative agenda.

Therefore, in fiscal 2018, we continue to expect cash conversion of roughly 100%.

Now let's move to our guidance for the first quarter of fiscal 2018, which you can see on Slide 5 of our presentation, which shows our guidance both including and excluding DECO.

I will comment first on our Q1 guidance for the base MSC business without DECO, and then discuss guidance with DECO included.

And continuing in the spirit of complete transparency, we will keep breaking out the impact of DECO as we report fiscal 2018's operating results.

Excluding DECO, we expect fiscal first quarter revenues to increase on an ADS basis by 7% to 9% versus the prior year period.

Through last Friday, our quarter to date ADS is up approximately 8%.

Excluding DECO, we expect fiscal 2018's first quarter gross margin to be 44.4%, plus or minus 20 basis points.

This is down sequentially 20 basis points from the fourth quarter's 44.6% and down roughly 60 basis points from last Q1's 45%.

Adjusting for Q4's additional supplier rebates and lower inventory provisions, Q4's gross margin -- Q1's gross margin is sequentially slightly higher.

We expect Q1 operating expenses to be around $229 million, excluding DECO, up $11 million from last year's first quarter.

Roughly half of the year-on-year increase is due to variable expenses, using our estimate of 10% of sales growth.

The rest is mostly due to investment spending and salary, bonus and medical cost inflation.

Note that we still expect our Q1 OpEx to sales ratio to register another solid year-on-year improvement of about 80 basis points.

So after excluding DECO, operating margin will be approximately 13.4% at the midpoint of guidance, up slightly on last year's 13.2%.

Essentially, we expect operating expense leverage to more than offset the negative gross margin impact.

Finally, our EPS guidance for Q1 is $1.03 to $1.07, up 9% at the midpoint over last year's $0.96.

This assumes a tax rate of about 38.2% versus 38% in 2017's Q1.

No share-based compensation impact or tax credits are built into this guidance.

We expect DECO to contribute about 400 basis points of growth to ADS in the quarter, thus taking the guidance range to 11% to 13%.

And I'm pleased to say the business is off to a strong start in terms of sales growth.

We anticipate that DECO will reduce our reported gross margin by roughly 80 basis points, so Q1's gross margin range with DECO included is 43.6, plus or minus 20 basis points.

We also expect DECO to add about $6 million to Q1 OpEx.

This includes $500,000 roughly of intangibles amortization, a number that will be approximately 1/3 lower in the second year and onwards.

As such, we expect an operating margin of about 13% at the midpoint of guidance, with DECO having a roughly 40 basis point negative impact in the first quarter.

Turning now to our full year fiscal 2018 framework.

We continue to base the operating margin scenarios on 2 factors, growth levels and the pricing environment.

The 2 sale scenarios are moderate growth and strong growth and the 2 pricing scenarios are slightly negative and slightly positive.

Again, we lay these out with DECO excluded and with DECO included to facilitate comparison.

With DECO excluded, as you see on Slide 7, our moderate growth scenario is for 4% to 8% ADS growth, and our strong growth scenario has an ADS range of 8% to 12%.

With DECO included, and expected to add 400 basis points to our ADS growth, our moderate growth scenario is 8% to 12% and our strong growth scenario is 12% to 16%.

With regard to pricing, the slightly positive scenario envisages 0 to positive 1% of net pricing and the slightly negative scenario assumes minus 1% to 0 net pricing.

In the fourth quarter, we had roughly flat pricing.

So moving to the slightly positive scenario assumes a moderate midyear price increase, which would make pricing positive for the back half of the year, absent other negative movements.

A robust midyear price increase, while a possibility, is not contemplated in this framework.

A slightly negative net pricing scenario would likely occur if no midyear price increase materializes.

And these pricing scenarios are the same, regardless of whether DECO is excluded or included.

With DECO excluded, operating margins under these scenarios range from 13.2% to 14.3%, with an average of 13.7%.

We expect 2018 incremental margins, excluding DECO, of 20% or better in all of the quadrants, except the bottom left.

Including DECO, as you can see on Slide 6 in the presentation, reduces operating margins by roughly 40 basis points in each quadrant.

So they range from 12.8% to 13.9%, with an average of 13.3%.

Our fiscal -- our 2018 fiscal first quarter guidance is being provided in the context of a borderline high-growth sales environment and a roughly flat pricing environment, which is where we are today.

Q4 saw a much smaller negative mix impact from mix and pricing than we've seen in the last several quarters.

And as Erik noted earlier, we are finally seeing some supplier price increases.

However, our Q1 guidance assumes a similar mix/pricing contribution as Q4.

I'll now turn back to Erik.

Thank you, Rustom.

For the past several years, our company has been head down, executing our strategic plan in the face of challenging market conditions.

We've enhanced our value proposition and the competitive moat around our business.

We have captured market share in our targeted customer segments, and we've kept gross margin stable in the face of severe pricing conditions.

We've streamlined expenses by improving productivity throughout the company, and we've invested in our foundation to create more scale and leverage as we grow.

We've deployed capital carefully in a balanced approach that includes organic reinvestment, select acquisitions and return of cash to shareholders.

As market conditions have turned, we are now beginning to realize the fruits of the dedication and the hard work of our entire team of associates.

Earnings per share grew 11% in fiscal 2017 as compared to fiscal 2016's comparable 52-week number.

And we're off to a strong start in the first quarter of fiscal 2018.

We're very much looking forward to the upcoming year.

I thank you for joining us this morning, and happy Halloween.

We wish you more treats than tricks, and we'll now open up the line for questions.

(Operator Instructions) Our first question will come from Hamzah Mazari with Macquarie.

The first question was just on the National Accounts business.

Could you give us a sense if this business has become more competitive over the years?

And what I mean by that is do you have National Accounts sitting in with consultants?

Are they requiring more cost savings documentation?

I know it grew better than expected this quarter, but just any sense -- has that business changed?

And has there been more focus on MRO indirect spend versus past years?

That's a great question.

It's Erik.

I'll take it.

So yes, the short answer is, absolutely.

I think that's been a trend that's been occurring really, I would say, since I entered the business 20 years ago.

And if I look over the past 5 years, 10 years, that's been escalating.

No question, smarter customers, more sophisticated customers in the ways you're describing.

An interesting dynamic, though, in some ways -- so yes, in some ways it makes it more competitive, particularly as it relates to gross margin pressures, and it's why we refer to National Accounts as a gross margin headwind.

On the other hand, I'd also tell you that those dynamics create for a really compelling share capture opportunity.

And I think it's one of the reasons why you're seeing our National Accounts program perform so well, because the business, remember how fragmented our marketplace is, with 70% of the market made up of local and regional distributors.

That when you get a smarter customer and they are evaluating their total spend, it becomes less and less easy to justify having the small local players around, and easier for companies like MSC to capture market share.

So I think it's 2 sides of the coin, but I do think that dynamic is real and one of the elements driving the growth we're seeing.

Great.

And just a follow-up question on gross margin.

Just trying to understand how conservative the fiscal Q1 guide is.

It feels like margins increased sequentially historically, Q4 to Q1, maybe by 50 bps or somewhere in that range.

And then if we exclude DECO, that still puts us as -- at maybe 44.2 or something in that range.

So it feels like the Q1 guide maybe has you more negative on mix?

Or maybe it's just pricing?

Any sense of what you're baking in in terms of the Q1 guide in terms of conservatives?

Or what is upside that you're not baking in?

This is Erik.

So if you're looking sequentially Q4 to Q1.

One thing to keep in mind, if you go back and you look over past cycles and past years, look, the biggest difference between Q4 and Q1 is the implementation of pricing.

This year, we shared with you that the big book increase, if you will, is rather small.

It's just over 1%.

So the biggest reason why -- and by the way, as Rustom described, when you account for the outsized adjustments in rebate and inventory provisions that we had in Q4, there is a sequential lift, Q4 to Q1, but you would be correct in saying that it would be low -- be below something like 50 bps.

The biggest driver there is just the size of the big book increase that was taken, which was pretty small.

Great.

And just last question, I'll turn it over.

On your inventory levels, they appear pretty flat the last 3 quarters.

Should we expect a step up in inventory, given the inflection you're seeing in terms of demand?

Hamzah, let me take that.

Actually, what we're seeing is continued optimization of our supply chain.

I mean -- and that's helped us also with those low inventory provisions in Q4: SKU management, product launch process improvements, procurement process improvements, demand planning process enhancements, and a lot of good things like that.

So no, I think we'll -- there probably will be some slight inventory increase as our sales go up, but hopefully we'll continue to be -- have returns of at least as good or slightly better than where we are today.

Our next question will come from Matt Duncan of Stephens.

I want to start with a focus on margin, both in the shorter term and longer term.

First of all, on the operating margin framework you gave us for FY '18, what is the year-over-year change in gross margin contemplated in that framework?

Yes, good question, Matt.

So I'll try to state it as simply as I can.

Realize that framework has 2 dimensions, demand environment or the growth trajectory and the pricing environment.

And what I would tell you is that, as you could imagine, as the pricing environment moves, so does the gross margin assumptions that are baked into that framework, okay?

So if you went right to the middle of the frame, so take that -- the y-axis -- the vertical axis, I think that's the y-axis, which is the pricing axis, right?

So it moves from plus 1 to minus 1, go right into the middle at 0. If pricing were 0, were flat, we would anticipate some modest gross margin declines.

And as we've talked about in the past, that would be primarily due to mix effect.

But call it less than 50 basis points, but gross margins would be down slightly in a flat pricing environment.

Should, as Rustom talked earlier and I mentioned a little bit, look, we are seeing more discrete signs of pricing firming in the marketplace.

And should we get a midyear price increase, some sort of moderate midyear price increase, we would expect we would move up on that axis.

If we move up on that axis, and we're getting something close towards the high end of that range there or 1%, we would expect gross margins to be roughly flat.

On the other hand, I'll just...

Is that including pressure from DECO or no?

That is -- so I'm giving it to you ex-DECO.

And then DECO, Rustom is, what did we say, 80?

Yes.

80 basis points just by virtue of the math of that business.

Okay, that helps.

And then looking out longer term, obviously, there's a lot of focus on gross margin for you and your peers right now.

But I want to have a conversation about more than gross margin and focus on what really counts, that's operating margin.

As you look at your business over the next, call it, 5 to 10 years, given what's happening with price transparency, the mix in your business, all these different factors, what do you expect to see happen with both your gross margin?

And then more importantly, what are you guys doing to manage operating margin over that timeframe?

And what do you expect to see happen there?

So Matt, I'll tell you what, I'm going to take, we're going to chunk this out.

I'll talk a little bit about for the long-term trajectory for the business, gross margin.

I want Rustom to touch on some of what we are doing in terms of productivity and op margin.

But look, I think, if you go on over time, look, in the near term, one of the scenarios that I didn't talk about was pricing could get more and more robust, and perhaps was even contemplated in the framework.

And if that were to happen, obviously, incrementals move up.

But if I look out over multiple years, look, holding gross margin flat would be a very good result.

Seeing modest pressure on gross margin due primarily to mix as we've seen over the last couple of years wouldn't be shocking.

But look, in that scenario, what we're seeing in sort of the last couple of quarters and guide, is like a little microcosm of that due to leverage that we are getting on the bottom line at mid-single-digit, high-single-digit organic growth, really nice earnings growth and some margin expansion.

So I'll let Rustom touch on...

Yes.

Absolutely.

And look, you know we've been focusing a lot on our cost to serve and on productivity in terms of our operating expenses, so that would continue.

And really, I mean, you're talking -- if you're looking at 2018's assumption -- I know your question is longer term, but 2018's assumptions on operating expenses, we basically have the usual sort of increase in variable OpEx, call that 10% of sales growth.

And we do not -- unlike the last couple of years, we don't expect productivity to fully offset our cost inflation and investments.

And if you looked at the go-forward, heading in the future, we still see a decent amount of leverage.

Because if we can have -- continue with our strong productivity, offsetting a bunch and have the variable come through at 10%, you'd see the leverage.

So that would have a positive impact on operating margins in, say...

Matt, just take this last point, and then we'll turn it back.

But just take Q1 as a little microcosm, right?

So Rustom touched on that at -- so this is ex-DECO again to try to isolate the base business here at a guide of, call it, 8% revenue growth.

At 8% revenue growth, we're talking about 80 basis points of leverage on OpEx.

So that's a little microcosm that would certainly be more than offset, what we would anticipate over the long run if there were any gross margin dilutions.

Our next question will come from Scott Graham of BMO Capital Markets.

This is Katja for Scott.

On pricing, can you tell us roughly what percent of your suppliers have raised prices?

So Katja, our -- I'll start with the increase that we took over the summer.

I mentioned, was just over 1%, which was modest.

What I would tell you is that since that point in time, we have had -- I would say, several is the word I'd use, meaningful suppliers either announced increases into the market or tell us that increases are coming.

Timing-wise it was done after our increase, but that bodes pretty well.

I would tell you that we will be in a better position to give you more specifics on the next call.

Generally what happens, most of our suppliers will move early in the calendar year, will generally be January of 2018, and we will have entertained more serious discussions about those in November and December.

So I expect that to materialize soon.

But what we are telegraphing here is a bit firmer and more defined activity than what we've seen in past years at this point in time.

Okay.

So you're seeing the suppliers are kind of indicating that higher prices are going to come.

What else do you have to see to be more confident that you will be able to raise prices at midyear?

I think the -- we are seeing the right signs for now and I think the answer is we just need a little more time.

As I said, November and December are important months because it's when the pricing discussions with suppliers move from conceptual to -- they get very real.

But I would tell you that between discussions with suppliers, a couple of supplier announcements and what we're seeing from the indices in terms of the pricing metrics increasing, we're seeing the right signs.

I think it's just a matter of time in seeing it play out.

If the next couple of months plays out as we expect, based on the current, I would expect to be able to get a midyear increase.

Okay, one more.

Which groups of customers are driving the higher sales in first Q?

If you can discuss that a little bit.

So we -- what we described -- the nice thing is we're seeing it.

We've seen the movement, the positive momentum pretty much across the board.

I think if there were a couple of areas to call out as sort of our relative shining stars, the CCSG business would be 1, as I described, particularly into the first quarter is growing healthy double digits, National Accounts would be another growing double digits.

So I'd call those 2 out, but we have seen a lift in pretty much most segments.

Our next question will come from Robert McCarthy of Stifel.

Some of my questions may have been answered in the context of this, and I do apologize, I've been multitasking here a little bit.

But in any event, I guess the first question I would have, just on DECO.

You did talk a little bit about the opportunities there.

But could you just give us a sense of squaring the circle in terms of where we are in terms of gross margin and operating margin on kind of excluding kind of transitory cost as each picked out the intangible amortization as an example?

And what's kind of the vision going forward for kind of gross margin expansion and margin conversion there?

Because I think some investors are kind of scratching their heads about the existing profitability.

So Robert, hi, it's Rustom.

Let me take the first part, and then Erik can chip in as well if he wants to.

The -- we've -- we are expensing on the P&L, so the entire intangibles amortization, so you homed in on that, and then any investments that we might feel we need to make in the business to enhance their systems or anything like that.

I mean, whatever it is, we'll expense that, but gross margin is probably the thing that is worth talking about most.

So we expect to improve the gross margins on DECO's existing business a few hundred basis points through purchase cost synergies.

Then, the incremental value, however, is by selling MSC's MRO products to DECO's customer base in addition to their current production metalworking portfolio, right?

So this would occur over the coming years.

It doesn't happen immediately, but at MSC like margins.

And Rob, past acquisitions have shown that we can improve margins, that gross margins I'm talking about over time, close to a typical MSC branch.

And this acquisition is very much about that, getting the people and doing it.

We don't have -- we're not baking in cost synergies of any type or anything like that in terms of OpEx costs synergies.

I mean, we've got, as Erik made the point I'll just reiterate it, we feel that we've been fortunate enough to acquire a business with great culture and a great team, and we just want to slop that alongside our operating teams out there and build on it.

Erik?

Yes, Rob, I think Rustom explained the financial elements well.

Just to comment on your point about investors scratching their head.

Look, we're pretty selective, as you could tell.

Look, we haven't done an acquisition in a few years, and we are constantly looking.

Our bar is high, and I would tell you that there are a handful of metalworking distributors out there that are really blue chip companies, and DECO is one of them.

And so as I said, it met our criteria with flying colors.

If the scratching of the head is the margins, what I would tell you is look, if you go out in the market place and look at -- the 70% of the market that's competing against companies such as MSC, this is typical.

This is what the average typically looks like.

It's a great business.

And as Rustom said, there's a path here.

When we look at our past acquisitions, that now, from a decade ago, that are now MSC branches, they don't look dissimilar to an MSC branch.

It happens over time, but we feel great about this business.

Hopefully, we answered the question?

Great, but -- yes.

Two other brief ones, hopefully.

One is, I just want to make sure, as a point of clarification, I think you contemplate in 2018 incremental margins of 20% or better.

And I don't want to parse that too much, but wasn't there an expectation previously that it would be closer to 30%?

Or am I thinking about it wrong?

What is the state of play there for what incremental margin conversion is?

And has there been any change there in terms of the guide for '18?

Yes, Rob, I would say what you're seeing this year is pretty much in line with what we feel our long-range targets have been.

So what you've heard us talk about is our long-range target is between 20% and 30% incrementals.

And what we've said is that where we fall in that range is going to be a function of 2 things: one is how strong is the revenue trajectory; and two is, how firm is the pricing environment.

So what you're seeing is in 3 of the 4 quadrants here, we are 20% or north.

And the one quadrant where we are not is where we had negative price.

By the way, even with negative -- slightly negative pricing we can still get to 20%, if we are in that stronger revenue environment.

So look, I think from our perspective, we are right where we should be in that range.

I think the one other point I note, is also realize that, we mentioned earlier, the framework contemplates a slightly positive pricing environment.

It does not contemplate a robust pricing environment.

And I think if you go back to our historical range and where we've talked about pushing towards the top end of that range, it would be in a robust pricing environment.

Look, if that happens and there is a chance it happens, we could push north of what you see on the quadrants.

And then finally, because as you know, inquiring minds want to know, any anecdotes or any sense of the competitive environment with respect to the pricing actions with respect to Grainger and then the announcement by Amazon business?

Anything that you could talk about in the current environment in terms of affecting your business, not affecting your business?

And then just thinking about longer term, I mean, do you explicitly refute kind of a stagflation argument that you could get in a bind where you see rising costs but you can't pass it on because of increased transparency in the market place?

Anything you can speak to that issue, obviously it is the heart of the debate right now.

So you got a three for one there.

So with regular pricing actions, so, I mean, Grainger, what I would tell you is really not seeing much.

I mean, remember, such, Rob, so fragment -- you know the industry well.

So a very fragmented market.

We are competing against so many players, a lot of locals, each one -- each company, even of the large companies has their own sort of pricing nuances.

So what I would tell you, very little there.

Your second point was around, I'm sorry...

Amazon business, I mean, Amazon business launch in terms of any comment there.

Yes, similar.

I mean, very -- you can see in terms of our numbers, we're not really seeing or hearing -- not much to speak of there.

I think sort of no news, at least on the ground in the field, not much to make of there.

And then your third point was around pricing and whether...

Which I think is contemplated in your framework, the fact that you don't have a robust pricing scenario on the table so you're kind of hedging your bet that that probably won't happen.

But I guess the question for investors is could we see a scenario where you could even -- just even have some level of volume growth, but at a much tougher pricing than you've historically witnessed given the transparency in the aggregate and the environment?

Yes, Rob, just on your point.

One point about not putting the robust, you're right.

We did -- the reason we didn't put it in the framework, you mentioned hedging our bets, I mean, the reality is -- we've been -- just given our experience the last few years, we are hesitant to put anything in until we actually see it happen.

Look, I think for now, everything that we see would suggest that, should manufacturers move on their list prices, that we would pass those along and see strong realization.

I would tell you, it's a small sample and data point, but so far, the 1% plus price increase that we just implemented is seeing very solid realization levels.

So a little bit of data to support it there, but until I see otherwise, no reason to believe that wouldn't be the case if we do it midyear.

Our next question will come from Robert Barry of Susquehanna.

Just wanted to clarify a couple things.

So you talked about the impact of the rebates being half the outperformance, was that the 44.2% versus the 43.8% guide, so about 20 basis points?

No.

That was the -- Robert, this is Rustom -- that was the rebates and the inventory provisions together, being roughly half of the outperformance.

The outperformance being 43.8% versus 44.2% so that implies like 20...

No.

The outperformance being the 80 basis points or so that we were higher than the midpoint.

Got you.

Okay.

That's what I wanted to clarify.

So half of the 80 is the inventory and the rebates?

Roughly.

Got you -- and should we -- is it fair to assume that will rise from here just given the sales continue to accelerate?

With supplier rebates as sales accelerate, yes, they should.

We should get more supplier rebates.

Yes, they go together.

But the inventory, no, not necessarily.

I mean, there was a lot of -- it's an evaluation that occurs every quarter, and it just depends on the quality of the inventory and everything we have.

Do we continue to expect to manage our inventory?

Yes, absolutely.

Would we expect as much in a particular quarter?

Not necessarily, but I mean, I couldn't call it in or call it out, honestly, because it depends on the profile of our inventory as we get to the end of the quarter.

Sure.

Sure.

And then just lastly, I think in the past, you've talked about HVAC sales typically weighing on mix in 4Q.

I think it was a weak quarter for HVAC sales.

I don't know if that had a material impact versus what's typical this quarter or not.

Any color there?

Yes.

Rob, what you're referring to is -- you are correct that we will generally see seasonally things tick down, absent any pricing acts or anything, things generally tick down Q3 to Q4.

And by the way, going back a quarter ago, it was part of the logic behind our fourth quarter guide being below the third quarter, very consistent.

Yes, what I would tell you is, yes, this year we did buck that trend, but less to do with any sort of a track mix, more to do with the factors that we called out.

So beyond what Rustom mentioned with rebate and inventory, look, we did see stronger pricing discipline in quarter, so we think we made some improvements there and strong realization from the summer increase.

So that was a bigger factor than any changes in mix effect.

Our next question will come from John Inch with Deutsche Bank.

Can you remind us what was the price increase a year ago?

So you did around 1 or just over 1?

What was it a year ago?

I don't have it offhand.

John, do you...

Our realized price increase a year ago.

You mean the catalog increase, John?

Yes, I mean, sorry, Erik, right, the catalog increase.

Between 1 and 2.

John is saying between 1 and 2, we don't remember offhand exactly.

Ok, yes, yes, so that's fine.

So it's fair to say it is a little bit lower, but it's probably better than you would hope for kind of earlier in the year or something like that?

I would say a little lower than last year based on what John is saying is right (inaudible).

How does this, Erik -- how does this pricing work?

Like in other words, I thought -- so you put through the price increase and then you kind of have to give that back over the course of the year.

Would you be expecting -- I see your price was flat this quarter.

Sequentially in your guide, what -- Rustom, what is price, and then what do you expect price to kind of -- does it drift lower or do you think you can kind of hold it at this flat realized level?

Within Q1 -- in Q1, I mean, we are basically -- hold -- the assumption is, as I said, that we'll stay at roughly the sorts of levels that we are, which is pretty flat.

So your guide -- your margin guide and all that is assuming kind of a flat pricing not sort of the drag that we've seen historically, right?

In Q1.

Yes, John, that would be, you certainly know the drill with the business, so generally what happens is there is competitive pressures in the marketplace during the course of the year, so you get realization and then it'll drift down during the year.

What I would say and what we're contemplating in the framework is, in midyear pricing -- should there be midyear pricing which we're getting encouraging signs on, that could change that trend.

I think if I recall, we were hoping for midyear pricing this past year.

Was there something that stymied that in some way?

Like, I mean, if you were to kind of go back in time, what makes you more optimistic other than the fact -- the economy is obviously strong, so we know that, right?

Is that really kind of the secret sauce to why we hope for a better pricing environment this year versus last year?

Or how should we think about it?

Yes, John, so I would say two data points here.

Because you're right.

Look, we did get a small one last year, but we would be hoping for more this year.

So what's different this year to last year?

I think there's 2 things.

So one is, yes, look, the demand environment is firmer.

And related to the demand environment, if you look at MBI for instance, and you look at the pricing indicator it's definitely firmer than it's been.

So that would be one.

And two would be suppliers.

As I mentioned, there are some specific suppliers who have announced or signaled to us that an increase is coming in a way that's more definitive than I would say we were sitting here a year ago.

So those would be the 2.

Rustom, what exactly...

Sorry, Rustom here, I mean, last year's business environment was actually negative.

I mean, demand was declining over much of last year.

And so what you've seen is not just a demand environment, you're also seeing inflation expectations broadly being a lot more robust compared to last year, and we're probably talking deflation more than anything else.

Yes, no, I agree, I guess the issue is, can you -- if product costs through commodities and other things are actually rising, are you going to be able to pass those along, right?

That's going to be the -- like the $64,000 question.

But it sounds like we're kind of off to a reasonable start.

Rustom, what exactly were the gross and op margins for DECO in the quarter?

I mean, sorry, in Q1 or -- in Q4, it was almost nothing.

I mean, what you've got in there, and remember we picked it up for 5 weeks.

And also, with the way that, and...

I kind of meant, right, so I kind of meant pro forma.

So I am sorry, if you would've owned it for the -- if you just looked at their financials for your fiscal fourth quarter, what would their fourth quarter gross and op margins have looked like?

They run in the low 20s.

If you did the math from what's in our details out there, it looks ever so slightly lower than that.

And that's simply because when you acquire, you get the inventories, you have to write up the value and then you've got to amortize that over the first 6 months or so, so it's -- proportionately it's the impact.

But if we were doing some sort of pro forma, it will be very much at the -- right there at the 20 and just north of 20 kind of range.

I tell you, John, if you think about the model for the business, the year 1 model is basically in the neighborhood of $100 million in revenues, low 20s gross margin, accretion breakeven year 1 and improves from there.

And the business is a profitable business.

I mean, just realize, I mean, we are not cutting it out and saying exceptional pro forma or anything like that.

We are absorbing all the amortization, any cost post-integration, post-acquisition, any integration cost, whatever we are doing, we're just absorbing them in our numbers.

So we are being more conservative there.

And just lastly, their op margins was like what, 2 to 3, is that roughly in the zone?

If you got a 20% gross margin, was the op margin about 2 to 3?

Yes.

I would say it's actually slightly more than that before you take into account all the things that we're doing, yes.

Our next question will come from Luke Junk of Baird.

First question, just wondering if there's any additional color you can share on CCSG, I guess, relative to efforts to better integrate their sales force and VMI offerings with Legacy MSC.

And relative to the uptick in growth that you're seeing, how sustainable you think that is?

Luke, we're pretty encouraged by it.

And look, we've been talking about the efforts we've been making in the business.

They do seem to be paying off.

So I mean, our feeling is quite sustainable, the growth in the business.

And then, second question, just curious what's going on within the core customer base today?

I know you mentioned in your prepared remarks turning out mid-single digits.

As the industrial economy is getting better in general are you seeing that translate to the kind of growth that you'd be expecting with those customers?

Yes, Luke, look, I mean, the core is growing.

It's definitely at this point lagging National Accounts, which is not shocking to us kind of given the pattern.

As things continue to grow, as the MBI improves, we'd expect to see those growth rates increasing, as the bigger companies farm out work.

So no big surprises to us there, it's sort of doing what we'd expect it to do as the MBI improves.

And our last question will come from Ryan Merkel of William Blair.

Last, but not least.

So a lot of ground covered.

Just want to go back to an Amazon question.

As you guys saw, Amazon announced Prime for business and stocks were down that day for the group, but can you just comment?

Will this have any impact on your ability to charge freight?

Yes, so Ryan, here's the reality, that the trend of free freight or freight promotions in our business, our industry, is nothing new.

It's something that's been there for years.

It's been escalating for years.

So you've been seeing -- what -- as you look and evaluate the MSC financials, you've been seeing -- and it may have been the indirect Amazon effect from when they got into retail.

But this practice has been part of B2B for some time, particularly for volume purchasing.

So look, down the road, could there be any impact?

Hard to say.

It wouldn't be as significant, nearly as significant as what you would think by reading the headlines, right?

And I think -- the one other point that I'd make is realize that there's a difference in the quality of shipping.

And for a B2B customer, they really do value the MSC.

It's not just about the next day delivery, it's about how many boxes does the shipment come in.

How easy is it to receive, how consistent are the standards, the packaging, et cetera?

With MSC, you're getting complete consistency.

There's a value for that.

Yes, absolutely, and I think it's also true that most of your customers or many of your customers already get free shipping, correct?

Yes.

Look, we have, over the years, I want to be sensitive, just competitively sensitive.

But you could imagine, we've been responding.

If this trend has been growing for the last decade, it's one that we haven't been immune to and we've been responding to it.

So you're seeing it in the numbers that we produced over the past.

Right.

Okay, and then, secondly, another high-level question.

You said about 90% of the cost of buying MRO is overhead.

And this is a big reason why service matters in distribution.

Can you just bring this to life with an example?

And is this the big reason why e-commerce hasn't had more success in this industry?

Just comment on that, if you would.

So Ryan, yes, you raised something that's sort of right at the heart of our value proposition.

We are calling on industrial plants.

And when you look at industrial plant or manufacturing business and say what percentage of their total cost of operations is made up of the cost, the price of indirect supplies?

You are right, it is under 10%.

And so while the pricing has gotten a lot of focus, pricing of products, the reality is, that the MSC value proposition has really been geared around focusing on the 90% and not the 10%.

And that's the biggest lever that our customers are starving for productivity.

They're starving to get their products into market faster, because that's how they make money.

And they make money by getting products into market and getting productivity on their plant floor.

So an example would be what we do at metalworking.

So we've got, and I've shared this before, but hundreds of folks in the field who are metalworking specialists.

And these folks are in there, not just talking about price and availability of products, but they're actually walking plant floors and they're helping our customers take cost out of their operations.

They are reducing excess raw materials, they're saving labor rates by coming up with new and improved ideas on how to actually improve the manufacturing process.

That's where we live and breathe.

That's where we spend our time, and I think, you are right to draw it out.

The last part of your question, Ryan, I forget.

Just why, why e-commerce hasn't had more success in this industry?

Everyone is worried about it.

But the reality is the impact has been pretty minimal, as far as I can tell.

Look, I think e-commerce has had a remarkable amount of success, just not in the way -- I mean just look at our numbers.

Our website is a very important part of the value proposition.

Just not in a way that I think you're describing that some of the fear is that it just drives pricing down.

But e-commerce, for a business-to-business customer, if you can find ways to help them speed up their procurement process and move things through their plant faster, that's going to be of value.

I think it's why you are seeing MSC Direct as an important driver behind our e-commerce sales.

I think you're right.

What hasn't been quite as big a force is just the pure transparency to say, let me take pricing down, because for a business customer that's a small percentage of their total cost.

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

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

Thanks again, everyone, for joining us today.

Our next earnings date is set for January 10, 2018.

And we will see you on the road, we'll be at several conferences coming up over the next month or so as well as doing some roadshows.

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

The conference has now concluded.

Thank you for attending today's presentation.

You may now disconnect.