MSC Industrial Direct Co Inc (MSM) 2019 Q1 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the MSC Industrial Supply Company Fiscal 2019 First Quarter Results Conference Call.

(Operator Instructions) Please note, this event is being recorded.

At this time, I would like to turn the conference over to John Chironna, Vice President of Investor Relations and Treasurer.

Please go ahead, sir.

Thank you, Denise, and good morning, everyone.

Welcome to our fiscal 2019 first quarter conference call.

With me today 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 and strategic plan, including expected benefits from recent acquisitions.

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.

Good morning, everybody, and happy new year, and thank you for joining us this morning.

To kick off this morning's call, I'll provide a brief overview of our fiscal first quarter results.

I'll then offer specifics about the environment and our recent performance before turning it over to Rustom to review the details of the first quarter and to provide our second quarter guidance.

I'll then wrap it up before we open up the line for questions.

Our fiscal 2019 started with a slightly better-than-expected first quarter performance, which included sales growth above the midpoint of our guidance range, gross margins in line with our guidance range and earnings per share $0.02 above the midpoint of guidance.

Turning to the environment.

Despite some of the recent headlines and choppiness in the financial markets, the U.S. industrial economy remains strong.

Sentiment indices, like the MBI, remained in positive territory, although down in recent months, with readings of 57.7 in October and 54.7 in November.

Adding the December reading of 53.4 brings the rolling 12-month average for the MBI to 57.7, which points to continued growth in metalworking end markets.

And we continue to see this in customer order volumes and general and industry sentiment.

Although there is more uncertainty than there was 6 months ago, tariffs and lower oil prices are 2 overhangs with the potential to create macro headwinds.

Another area of uncertainty is the government, as we're now well into a shutdown with no apparent end in sight.

Historically, a shutdown initially softens demand, although it does create some pent-up spending.

Once a budget is approved, then the shutdown ends.

With respect to tariffs, on our last call, we framed our own exposure as roughly 5% of our cost of goods sold, reflecting those goods that are directly and indirectly sourced from China and that have exposure to the tariffs.

Since that time, things have played out pretty much as expected.

We've seen the increases that we anticipated, and we've generally been successful, in passing those tariff increases along as they arise.

As a result, tariffs have not had a material impact on gross margins to date.

Of course, we will, along with everybody else, watch and see what happens come March with respect to the potential step-up to 25%.

And that's a good segue to the pricing environment.

Since our last call, as expected, we've seen significant activity from our suppliers in raising their list prices and expect more to come this month in January based on recent discussions.

As a result, we anticipate implementing a meaningful price increase later this quarter, and more specifically, in the month of February.

We decided to wait an extra month, as compared to last year's midyear increase, in order to capture as many supplier moves as possible and so that we can begin notifying customers well in advance.

Turning now to our revenue performance in the first fiscal quarter.

Sales growth came in above the midpoint of our guidance range.

Similar to last quarter's trends, core account growth continued to lift and was in the high single digits, as was National Accounts.

As anticipated, government saw a near double-digit decline.

As we mentioned on the last call, this is the result of a couple of contract losses.

We expect government to remain a headwind to sales growth for the next couple of quarters with our third quarter being the peak of that headwind.

Sales to vending customers contributed roughly 280 basis points to growth.

More encouraging is that we've accelerated our vending signings and implementations, which bodes well for future growth prospects.

In fact, Q1 signings were up double digit sequentially and more considerably over prior year.

In support of this growing funnel, and as part of our high-touch strategy, we've stepped up our vending service organization and have now brought the entirety of the service function in-house.

We are now at headcount levels that are needed for the remainder of the fiscal year to support the growth.

Finally, our net total active salable SKU count was approximately 1.7 million, up from last quarter by roughly 20,000 SKUs.

Moving now to our recent sales force transformation, it is now behind us.

We continue to see improvement in our underlying growth rates, particularly in core where most of the changes were aimed.

Our recruiting efforts continued to deliver strong results at a tight labor market for the second consecutive quarter.

We added a net 34 field sales and service personnel in the quarter.

We now expect to add roughly another 40 or so through the remainder of fiscal 2019.

This, of course, could move up or down based upon the environment and based upon the performance that we're seeing.

The new additions will take a few quarters before they fully ramp to speed -- up to speed and start contributing meaningfully to our growth rate.

Finally, AIS continues to progress according to plan, delivering solid top line growth, in line with our expectations, and beginning to make headway on cross-selling with MSC.

We're encouraged by the nice start.

I'll now turn things over to Rustom.

Thank you, Erik, and good morning, everyone.

Before getting into details, let me remind you that we had provided Q1 guidance for both our total company results and our base business, that's total company excluding the impact of the AIS acquisition, so I'll talk to both sets of numbers.

Our first quarter total average daily sales were $13.4 million, an increase of 8.2% versus the same quarter last year and above the 7.8% midpoint of our guidance.

AIS contributed 230 basis points of growth, while base business growth was 5.9%, also above the 5.5% midpoint of our guidance.

Our report -- our reported gross margin was 43% for the quarter, in line with the midpoint of our guidance range.

This was down roughly 60 basis points from last year with about half of the decline coming from AIS.

In our base business, price contribution remained positive.

However, as expected, purchase cost continued to increase, and mix remained a headwind.

Our next price increase will help mitigate this, but given the February timing, we will see very little benefit in our fiscal 2019 second quarter.

We continue to drive productivity in Q1.

And even with higher growth investments, OpEx to sales at 30.7% was flat versus last year's Q1.

Total OpEx was $255 million, up $19 million from last year's Q1 with about $5 million of this coming from AIS and roughly $5 million attributable to volume-related variable costs, such as big pack, ship, freight and commissions.

Another $5 million was growth investments, including additional field, sales and service personnel, stepped-up marketing, the vending service initiative that Erik referred to earlier and roughly $3 million of inflation net of productivity.

Our base business OpEx to sales was also 30.7%, roughly flat with last year's Q1 and in line with our guidance, as the higher investments offset the benefits of sales leverage.

With sales coming in above our guidance and gross margins and OpEx to sales in line with guidance, the benefits of a stronger top line flowed through to our operating profit and our operating margin.

Our reported fiscal first quarter operating margin was 12.4%, down roughly 50 basis points from the prior year with approximately half of the decrease due to AIS.

Our base business operating margin was 12.6%, but down about 30 basis points from the same quarter a year ago, and this was entirely due to lower gross margin as noted earlier.

And both of these were slightly better than guidance.

Our total tax expense on a percentage basis for the first quarter was 25.1%, slightly favorable as compared to guidance of 25.2%.

All of this resulted in reported earnings of $1.33 per share, $0.02 above the midpoint of our guidance.

AIS had no impact on reported EPS.

Last year's reported EPS was $1.05.

However, if we applied the lower tax rate of 25.1% to last year's Q1, the net tax benefit would have amounted to $12 million and added $0.21 to last year's Q1 EPS.

So therefore, excluding this benefit, our Q1 EPS was up roughly 5% to the prior year's first quarter.

Now turning to the balance sheet.

Our DSO was 58 days, up 3 days from our fiscal fourth quarter of 2018 and broadly in line with our typical seasonal pattern of collection slowing towards the end of the calendar year.

Our inventory also increased during the quarter to $528 million, up $9 million from Q4, as we continue to buy ahead of likely supplier price increases and also to take advantage of calendar year-end rebate opportunities.

Total company inventory turns decreased slightly to 3.6 times.

Looking ahead the second quarter, we expect inventory to again increase as we protect against possible supply chain disruption and continue to buy ahead of further price increases.

Should we see disruptions, our strong inventory position creates a competitive advantage for us, particularly versus the local distributors that make up the vast majority of the market.

And in addition, the increases are coming almost entirely from our fast and moving item classes, so we do not envisage any difficulties burning them off when we decide to slow down our rate of purchasing.

Net cash provided by operating activities in the first quarter was $77 million versus $82 million last year.

Our capital expenditures in the first quarter were $10 million.

And after subtracting capital expenditures from net cash provided by operating activities, our free cash flow was $67 million as compared to $73 million in last year's Q1.

We paid out $35 million in ordinary dividends during the quarter and bought back 778,000 shares to $64 million at an average price of $81.71 per share during the quarter.

Our total debt as of the end of the first quarter was $523 million, comprised mainly of a $210 million balance on our uncommitted revolving credit facility and $285 million of long-term fixed-rate borrowing.

Our leverage remained at 1x, unchanged both sequentially and versus last Q1.

Now let's move to our guidance for the second quarter of fiscal 2019, which you can see on Slide 4 and is shown with and without acquisitions.

Please remember that DECO is now in the base in F '19.

And it is only the AIS business that is included in acquisitions.

Our fiscal second quarter, particularly December, includes a larger-than-typical negative holiday impact on total sales and operating profits.

We see this when Christmas Eve and New Year's Eve fall on Mondays.

But this year, we closed on Christmas Eve, and New Year's Eve played out as expected with minimal sales.

Through the first 3 weeks of December, growth was is in the high single digits before turning negative for the last 2 weeks during the holidays.

Overall, for Q2, we expect total company ADS to increase by 8% to 10% versus the prior year period.

This includes a 5.5% to 7.5% of organic growth range and another 250 basis points from AIS.

You can see on the website offset that December's total average daily sales growth came in at 10.6%.

That was boosted by 1 fewer selling day this year due to our closure on December 24.

Our guidance forecast assumes January and February ADS growth at about 8%, similar to where we've been running.

When evaluating our Q2 ADS growth rate guidance in its entirety, it is fair to say that a higher ADS from 1 fewer selling day outweighs the -- slightly outweighs the drag for holiday timings.

Our Q2 reported gross margin is expected to be 42.8%, plus or minus 20 basis points, and that's down 20 basis points sequentially and down 110 basis points year-over-year.

Roughly 20 basis points of the year-over-year decline is due to AIS.

On our last call, I noted that supplier cost increases would be a headwind until we put through a midyear price increase.

As Erik noted, we'll be taking our increase in February, so as to include as many of the January increases as possible.

Therefore, we do not expect a significant incremental price contribution, while the supplier cost headwind worsens in our fiscal second quarter.

So while we expect our midyear price increase to be meaningful, it will have much more of an impact on our fiscal third quarter gross margin than on our second quarter.

A sequential decline in Q2 is fairly typical in years where we don't have a midyear price increase early in the quarter.

Operating expenses are expected to be around $256 million, up $17 million over last year's second quarter with AIS accounting for roughly $5 million [of this].

Variable expenses associated with higher base business sales account for another roughly $4 million.

Growth investments, including the higher field sales and service headcount, should be another roughly $6 million.

Recall that we added 35 sales and service associates in our fiscal fourth quarter as well as another 34 in our fiscal first quarter and -- that we've added to our vendor serv -- vending service team to support accelerated vending signings.

The remainder comes from inflation net of productivity.

After absorbing these costs, our expected OpEx to sales ratio in Q2 is 31.1%, flat with the prior year's Q2.

And sequentially, our OpEx is expected to be up around $1 million after allowing for volume movement and, again, primarily attributable to growth investment strategy.

We expect the second quarter's total company operating margin to be approximately 11.7%, at the midpoint of guidance, 110 basis points decline over last year's 12.8%.

The largest driver is, of course, the gross margin decline.

About 20 basis points is due to AIS with another 20 basis points coming from them roughly, coming from the more pronounced holiday timing in December.

Finally, the additional sales and service headcount added in fiscal Q4 2018 and fiscal Q1 2019 produced operating margin by roughly another 20 basis points.

Assuming the midpoints of our Q2 operating margin guidance, we would be at roughly 12% for the first half of fiscal 2019.

This is below the bottom end of the range at the lower left quadrant of our 2019 annual operating margin framework.

However, our second half operating margins, on average, have been about 100 basis points higher versus our first halves due to seasonality.

We expect to do better in the second half this year and we aim to be within the framework for the full year.

This is for a few reasons, including the lift from the meaningful -- for a meaningful midyear price increase, continued traction on our sales program, front-end loaded investments and the fact that we lapped the AIS acquisition in May.

Keep in mind that AIS is contributing sales in the first half of fiscal '19 with minimal operating profits.

Turning to our estimated tax rate for the second quarter, it is 25.1%, in line with the first quarter.

Our guidance also assumes our weighted average diluted share count declines to roughly 55.3 million shares.

And our fiscal 2019 second quarter EPS guidance range is $1.22 to $1.28.

Note that this includes AIS with a roughly breakeven impact on EPS.

Last year's Q2 reported EPS was $2.06, but this included a onetime tax benefit of $0.72 per share relating to the revaluation of the net deferred tax liabilities and an additional $0.30 impact related to applying the lower year-to-date tax rate in Q2 of last year, the period of adoption.

As only part of the $0.30 applies to Q2 of last year to facilitate an apples-to-apples comparison, we simply applied this year's Q2 expected tax rate of 25.1% to last year's Q2 pretax income.

And as a result, at the midpoint of our guidance, our Q2 fiscal year -- fiscal 2019 EPS would then be flat year-on-year.

I'll now turn back to Erik.

Thank you, Rustom.

As I've said before, technical expertise is an important element of our competitive advantage.

One way that this manifests itself is in documented cost savings for our customers, which are particularly important now as we enter price increase discussions.

A key reason that we've been able to sustain gross margins over the past few years in the face of a fiercely competitive environment is our ability to save our customers money by engineering productivity on the plant floor.

I'll share a recent example that demonstrates this.

Our metalworking specialists regularly conduct reviews of customer plant floors.

During one such review for a customer on the West Coast, our specialist identified a drill that he felt was not the right choice.

It was not strong enough to efficiently cut the raw material being used.

And as a result, the customer was running its machines too slowly in order to avoid breaking the tools.

And different shifts were actually running their machines at different speeds.

This resulted in extra costs tied up in machine time, labor and even excess material.

Our specialist recommended a different version of the cutting tool, one that had a special coating on it.

It was a much higher piece price, in fact, 10x higher than the drill that the customer was currently using.

Fortunately, for the customer, our specialist convinced them to run a test with the coated tooling and that has produced compelling results.

While the cost of cutting tools is generally somewhere between 3% and 5% of the total manufactured part, this one change drove annualized cost savings of over $200,000.

For example, cycle times were reduced by about 3x, tool life more than quadrupled and the number of parts produced per tool increased 4x.

Additionally, the customer was now able to standardize its speeds and speeds across shifts and increased machine availability by almost a full shift per day.

All of this, by the way, is based on the customer's calculation.

Based on this success, we're now working with this customer to replace the same tool in other sizes as well as other applications.

These kinds of examples are routine among our metalworking group.

Our team's expertise, combined with the broadest metalworking brand offering in the industry, allow us to bring a strong value proposition such as this to our customers each and every day.

And all of this is only possible due to our team's dedication to our customers and to our mission.

I thank you, and we'll now open up the lines for questions.

(Operator Instructions) Your first question will be from John Inch of Gordon Haskett.

Erik, are there product categories where you're expecting it to be, say, easier to raise prices versus others or the corollary, are there categories where the channel because of, say, competition or whatever dynamic, it's just going to be more difficult to raise prices?

And if so, could you maybe give us some examples?

John, so what I would say, and, I guess, you're referring to the upcoming price increase, generally, what happens is, so the size of the increase and then our success in realization, look it's a function of a number of factors.

So one factor is what's happening with the key suppliers in that product line.

Another is what's happening with the raw materials that drive the cost.

Third is, of course, our competitive position and the relative importance for the customer.

So all those factor into the mix and drive -- helping (technical difficulty) the increase would be and how successful we are in realizing it.

I mean, just -- I'm going to be careful not to give too many specifics about the one upcoming since it hasn't hit the market yet.

But just as an example, looking back over the past couple of years, one of the things we've called out is we've had larger increases in our cutting tool business, primarily because the commodities, tungsten, steel, metals, have been up there more than they have in other categories, and that's driven more suppliers to raise prices and, hence, more of an increase for us.

That makes sense.

I mean, it kind of looks like Grainger is raising prices by maybe 3%.

And I think your traditional midyear is around 1% and change.

Is that just based because we're obviously in a different dynamic given the cost increases and supplier price increases?

Is that kind of the magnitude of the overall increase we should be expecting?

Or how would you frame it?

Yes.

So yes, right, So John, the words we used in the prepared remarks were meaningful.

The color I gave are meaningful would be larger than the last few increases that we've taken.

So if you go back and look over the last several we announced, we would expect this to be a bit bigger.

And that is based on the macro.

And then maybe one just -- understood.

And maybe just one more.

Erik, what's your recession playbook?

I realize things are good debatably today, but we could be in a peaking time.

It's not really clear.

But I'm just curious, what is your recession playbook?

You must have talked about this as a management team.

I mean, do you stop the sales hiring?

Do you look for other costs to cut?

Like, how do you -- how does this all have been maybe even dovetail with sales effectiveness?

Does that have to get modified in some manner?

Or does it actually still, do you think let you return 200 to 300 basis points above the market even in a -- an economic downturn?

Yes, John.

So look, we clearly -- and one of the benefits of growing up in this business is I've seen the business perform, and I've been part of several cycles up and down.

We certainly do have a playbook for a recession.

What I'd tell you one thing, out of the gate, as a management team, we've not spent much time talking about it because right now, no sign of a -- from our standpoint, no sign of a recession.

Things, if we look -- and what we wanted to get across is looking at the industrial market today, things are robust, things are very solid.

What we did want to flag is a couple of yellow flags that are out there that are certainly caution signs that it's -- something could change.

But at this point, we don't see recession.

Should that occur, yes, we would certainly move into a different operating mode.

We'd certainly look to clamp down on expenses and discretionary spending as we've done before.

What I would say is our goal would be, as it always is, John, to try to out -- our gauge and our success measure on the growth side would be how are we performing relative to market.

And our goal would be to outgrow the market.

We would clamp down on discretionary spending.

And then what we would do is take a very careful look at investment spending.

There'd probably be somewhere we feel it would be responsible to modify and to reduce it.

There'd be other things where we'd say if they were really important to our future that we continue to plow through.

So broad strokes, that's how I'd describe it.

The next question will be from Robert Barry of Buckingham Research.

Just wanted to start actually by clarifying the comments on the December ADS, the 10.6.

How much was that number boosted by having 1 less selling day, that 10.6?

So if you -- this is an estimate obviously, I mean coming to that.

But it would be -- it would have been north of 4% if you look at that number.

So the 10.6 number would have dropped down to --

Sorry, something just north of 4%?

Yes, north of 4% in the month of December.

In the quarter, the ADS boost from 1 day would be about 1.5%.

So Rob, just to be clear, by the way, because you have a couple of moving parts with respect to what we refer to as holiday timing and a day.

So there's the math on simply closing Christmas -- closing Christmas Eve day, which we did because, with it was falling on a Monday, there's virtually no activity going on in the business community, okay?

So there's the math of if you simply add back the extra day, what happens?

The second effect -- so that would be -- that would bring the growth down.

The second effect moves the other direction, which is that with Christmas and New Year's falling on Tuesdays, we see a more pronounced holiday drag, so that actually takes the numbers down, which is why in the prepared remarks, Rustom tried to give some description of December in sort of a tale of 2 months.

If you look at the first 3 weeks, which was a true picture of pre-holidays, business was up high single digits.

It then turns negative the last 2 weeks.

That turning negative is a result of the holiday timing.

Right.

On the days you weren't closed, you had some weaker open days.

Yes.

So specifically, we had several weak days, but the one that was really dragged us down was -- so we were closed Christmas Eve day.

New Year's Eve day was really, really slow and was a full day of -- counted as a full day in the numbers and really, really slow.

Got it, got it.

So just looking at the revenue for 2Q, excluding the M&A, it looks like the growth is going to be down about 1.5 points versus 1Q.

So is that all on the loss selling day or was something else going on (inaudible) ?

No, no.

And that's why -- I mean, that's why Erik stepped in to explain the second half with -- I just explained the mechanical answer to it, right?

Now if you looked at the -- if you adjusted for the actual lost sales by having the 2 holidays coming on Tuesdays and the Christmas Eve coming on the Mondays, right, the actual lost sales and you pull that out, I mean, we felt that our number would be -- I mean, if you just looked at our base business number, I mean, we were talking about closer to 5.9%, 6%, pretty much the number that we had in Q1.

Now the other factor -- and that's the number, just the math on how it comes up.

But the other things here to take account of it is that the comparatives in last year were a little stronger in January too because we had post tax -- all the changes with taxes and everything we thought we had -- we thought we had at the time and talked about a stronger January last year.

So that's, of course, incorporated into our number.

And that's why it makes it seem kind of flat growth if you adjust it around the 6% number.

Got it.

Just to close the loop, I guess, and some of the data has been, I guess, a little less robust, the MBI, the ISM, et cetera, it sounds like you're still forecasting that the, call it, organic growth ex the selling days and the M&A is similar in 2Q versus 1Q.

Yes.

I think Rustom has described it exactly right, Rob.

That basically, when you net out the extra day, the timing effect of the holidays, the growth rate in Q2 for the base business looks pretty darn similar to Q1.

I think that's a very fair description.

And sort of the one point he's adding there, is what we do this quarter, in particular, is always a tricky guide, because we have 1 quarter under our belt, it's December and then we go into January and February, so we modeled January and February.

We'll normally look at to provide you with a guidance forecast -- we look at our sequential historical patterns, so how do November and the first part of December compare to January and February.

And what we've modeled implicit in our guidance this year is slightly less of a sequential lift from November, first part of December into Jan-Feb this year.

And the thinking there was we got an outside lift last year.

We think, because of the tax change, we saw a bigger-than-normal lift.

So what we've modeled in is something closer to a normal lift this year.

The next question will be from Hamzah Mazari of Macquarie Capital.

My first question is just on pricing.

It feels like some commodities have come off.

Oil, maybe some others -- maybe if you could talk about how quickly do commodity changes roll through in your price discussions?

And is there anything different in your customer base that just makes price cost a lot more competitive to get this cycle than prior cycles?

Hamzah, so what I would say regarding pricing is, look, you're right to call out that there are certain commodities that have come off of what was -- there was some really aggressive growth in commodities for a period of time, and there are some that have come off.

But I think, overall, I would characterize the pricing environment as robust and as a good time for a pricing discussion.

When you look at sort of the broad landscape of business and you look -- so that would include tariffs, that would include freight, that would include wages, pressures that nearly every business is feeling now.

I think the environment is actually quite good for pricing.

What I would say is that with respect to commodities specifically, reductions in prices typically, like the same way it works on the way up, you'd have to see that for a sustained period of time before that would, I think, really impact our suppliers' view, in particular, who are the ones passing us the list price increases on a change in strategy.

Got it.

And then just on the government side, you had mentioned contract losses, I think, previously.

I believe, most of your exposure is federal versus state.

But anything in government that's going on in that segment?

Are you pulling back on purpose?

Aside from the shutdown, is there any competitive dynamic change in the government business, which is causing you to lose share ex the shutdown?

No.

Hamzah, no change in direction and really no change in the program or our focus on it.

I mean, really, what you're seeing from us in government is a function of the 2 contracts I mentioned on the last call.

At this point, it's just a matter of those working their way through the numbers and through our comps.

Outside of that, though, it's an important area for us.

We're focused on it.

And I can tell you, inside the team, there's a lot of work going on to try to recapture some of that lost share from those 2 contracts with other contract wins and opportunities.

So no change in approach.

Okay.

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

Maybe if you can frame for us how investors should think about sales force execution risk.

What I mean by that is we integrated bonds, there were some issues around sales force transformation, realignment.

I think you just had a recent leadership change in sales as well.

Now you're beginning to add headcount potentially late in the cycle.

It's not a ton of headcount, but just any thoughts on sales force strategy for MSM and execution risks going forward.

Hamzah, very fair challenge and very fair point.

What I'd tell you on the sales force front is I actually feel quite good about where we're at, at the moment and encouraged by what I'm seeing.

So what I would say is execution risk was probably highest a year ago as we were going through the changes.

We're really on the other side of the changes now.

Dave leaving, the timing -- with the way the time worked out, really, is not a concern.

We have the plan.

It's in place.

The changes have been made.

We have a playbook.

We have a strong team.

And yes, look, we may be adding late in the cycle, but I like what I'm seeing.

And just some proof points there, Hamzah, would be: number one, is we had a pilot market that sort of predicted when we should start seeing improvements in some of the underlying pieces of the business, particularly in core.

And the improvements to our growth rate happened just as predicted from the pilot, that's point one; point two is the core, which is really where the changes were aimed is growing high single digits.

It's been a while since they're growing -- that was growing high single digits.

I didn't touch on it this time in the prepared remarks.

We did last time.

Our small accounts, our marketing program which is connected to these changes.

The small accounts growing double digits, the strength there continues.

The last proof point I'll call out is to why I'm encouraged, and I think the prospects are good on the sales force side is, we mentioned that the vending pipeline is growing, and that's really a result of getting through the sales changes with our sales force back and focused, more time in front customers is leading to an increased demand for vending.

So net-net, I'm encouraged.

Obviously, it's still early.

And I want to see us perform.

And I'm, by no means, declaring victory here.

But I think, in terms of risk-reward, I like the balance.

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

I was hoping if we can maybe go a little bit down the rabbit hole here on the end markets, and I know that you called the industrial environment robust Erik.

But obviously, you've got a view on a lot of different end markets.

Is there -- are there any out there that have either seen pretty meaningful slowdowns in growth in the last 6 months, perhaps even flipping to negative other than government that you would cite?

Right.

So obviously, government, we hit on.

I would say, Scott, generally strong.

So again, there are yellow flags out there, right?

So there's some caution signs that things could change.

But right now, strong.

I think if I were to call out a couple: one, no surprise, oil and gas.

So I'm sure you'll remember from our last go around with oil prices that our direct exposure to oil is low -- is low single digits.

The indirect exposure, obviously, way bigger with all the -- the trickle down.

Certainly, we've seen our oil and gas-related customers soften, no question, but that has not extended beyond direct oil and gas.

So in areas -- in Texas where last go around when prices really came down where the softness really extended, we've not seen that at this point.

But oil and gas would be one.

And the other I'd call out, automotive.

more is leveling, I think, than acute softness, but those would be the 2.

Got you.

I guess, my follow-up question would be, again, on the pricing and not to beat this horse dead.

But are you getting any pushback from customers?

We've kind of heard in the channels a little bit that customers would prefer to see, on certain commodity-related price increases, surcharges as opposed to list price increases?

Are you getting pushed back in that way?

And if so, in what pockets of your business?

Scott, no.

We are not getting -- so to answer your question specifically, we are not getting pushback in that regard.

And the proof point there is that when there was an increase that was a direct tariff-related increase, those have been passed along.

And our success has actually been quite good.

Customers have understood.

They obviously -- we give them specifics, we give them documentation, and they've understood.

So our success there has been good.

More broadly, I'll let you know next quarter how we do.

But look, I would expect that for most of our customers -- look, no one ever likes to talk about a price increase, but it's important.

And if we're doing our job as -- we were in this case with this West Coast customer where we're delivering value and we're bringing documented cost savings, it becomes a much easier discussion.

And so I guess, I'll let you know next quarter though how we do.

Yes, Erik, if I just make this tuck-in sort of a question 2A here along those same lines.

Are your price increases in February going to contemplate the List 3 at 25% tariff?

And to that end, are your discussions with customers going to allow that to sort of stay?

I know that's a hard question to ask, that second one, but I mean, are you contemplating 25% tariff increase in your February price increases?

No, we're not.

We're not.

So I think we're -- should that happen come March, that would then be sort of a new data point and we'd have to assess from there, but not.

Even the tariff increases we have passed through to date, and we have passed them through very successfully, Scott, they have been different, specific and identified.

So the idea there with the customers, too, is, look, this is a tariff increase and customers understand it.

And if the tariff is rolled back, we'd roll that back as well.

So that is kind of more the surcharge that you were referring to that approach.

And the next question will be from Stephen Volkmann of Jefferies.

Maybe just a couple of quick follow-ups from me, if I could.

I want to understand sort of the cadence of the investments in operating expenses, and, I guess, that's mostly sort of sales force additions.

It sounds like it will be similar in the second quarter than it was in the first quarter.

And then does it basically go away in the second half?

Well, when you talk investments -- we've built up, so we've added heads in sales and service.

We've added in the vending service, which includes in-sourcing over there.

We've added some people in the CFCs, so that's -- the demand, that shows up it in pick, pack and ship.

Now the headcount cost increases that we put in are layered in.

So I mean, obviously -- and some of them would have occurred partly through the quarter, I mean, clearly, on average, when you hire through the quarter.

And so you'll see a higher amount of cost coming into Q2, right?

That is layered in.

For the most part, except for the additional sort of small field -- moderate, really, for a company of our size, sales and service hiring that Erik flagged, for the most part, there wouldn't be any other big sort of surge after that, that we are talking about.

And so -- and that's kind of reflected -- so a little bit of that will occur in Q2 and some over Q3 and Q4.

In the second half, you'd get much more of a positive impact coming through because by that point, a lot of the people -- the sales transformation has weighed in history, the additional adds have been occurring and people had time to build up and in fact, as we've talked a little while, we didn't expect to see the benefits from the sales headcount really showing up until the second half, right?

So now we'll see that beginning to flow through.

It's all for all the vending implementations and stuff as we brought in people and there's implementations and their roles.

Is that kind of cover what you're looking for?

Yes, right.

That's exactly it.

Next one, just switching to the government business.

I know you had a couple of contracts that you lost.

But are you also seeing any significant impact of the shutdown?

Or are the customer-specific sort of sites that you serve still open and working?

So far, Steve, shutdown impact would be -- and early to tell.

Hard to tell discreetly because most of it occurred during the holidays when it's hard to tell what the number is anyway.

They're so funky during those holiday weeks.

But so far, from what we can see and our intelligence on the ground, impact is very minimal because of where the shutdown is directed and versus where a lot of our spend is.

Impact appears to be minimal so far.

Okay.

Understood.

And then just my final quick one.

Rustom, you mentioned in your comments some additional inventory build around potential supply chain disruptions and I wonder if you can just give us a little more color on what you think might happen in terms of supply chain disruptions.

Just being cautious.

If the 25% tariff increases go through in March, we'd like to have more of those products on the right side of U.S. customs before that occurs.

And that's why we -- and this is deliberate.

And that's all there is to it.

It's not that we are being told of any supply chain disruptions or anything like that, but we do have a strong balance sheet.

And we're willing to leverage it when need be.

The point, I may not repeat it again, I talked about it earlier, with the stuff that we are buying is inventory in the categories that moves very fast.

So if, for instance, these tariff increases don't occur, okay, then there's resolution.

Then yes, we will tune down our buying and burn it off fairly quickly.

The next question will be from David Manthey of Baird.

First off, looking at contribution margins here, clearly, they've been below your expectation.

And I think the second quarter implies a negative result.

But thinking about the second half of your fiscal year, when you look at the operating framework, it would imply clearly an improvement there, even as much as 20% with pull-through margins closer to 50-plus.

And Rustom, in your comments, you mentioned price, sales force effectiveness, front-end loaded investments and acquisition contribution as factors that you hope to get leveraged on in the back half.

Is there any way that you can quantify those factors to give us some clarity or comfort on the outlook?

Yes.

I mean, look, we -- it's just a normal sort of sequence.

On average, if you look at the last 4 years, I mean, just a normal average, there's like 100 basis point difference between the operating margin in H1 and in H2, right?

So no reason why we shouldn't, at a minimum, see that.

But then you add to that all these others, the size and timing of the price increase, the AIS 4 months of -- only 2 months of AIS that -- compared to 6, the full effects in there, the holiday impact, I mean, don't forget that, I mean, that's probably about 20 basis points.

I mean, just the -- and by that, I mean, again, I'm getting away from the ADS that we talked about earlier, it's just the absolute loss of sales that we would have by having those 2 Monday, Christmas Eve and New Year's Eve.

So absolutely -- and then the others, you talked about it.

And that's why -- that gives us -- that's what gives us confidence that we'll be in the framework between the...

But Dave, I think a little tricky to try to -- like, so Rustom mentioned the holiday impact was about 20 basis points in Q2 -- of a drag in Q2.

Some of these others are hard.

Particularly with pricing, we're going to wait and see how we do roll it out.

Growth will be a function of how strong the growth is in the back half of the year, how much leverage.

It's tough to quantify other than to say if we looked at the 4-year average of 100 basis point lift, H2 to H1, there are several tailwinds here that say to us, if we execute properly and nothing major changes in the environment, to push it considerably higher.

Okay.

And then second, when you think about the sales force effectiveness efforts, how would you expect them to most manifest themselves in the second half results?

I mean, what financial metrics are you watching that you think will reflect the benefits the most?

Yes, that's a good question, Dave.

Look, over time, there's going to be metrics, like sales force productivity.

What I would tell you is given that we've just started -- we're -- we hadn't added sales heads in a while.

Because of all the changes we were making.

We just started in the fourth quarter, that takes a little bit of time.

Obviously, internally, you could imagine, we measure the new people 10 ways until Sunday.

But in terms of seeing that evidence itself for you, it's going to take a little time.

Look, I think the biggest proof points that I'm going to be looking for that I think are tangible for you are going to be core growth rate, are going to be National Accounts growth rate because part of what we've done here is also free up some of the National Accounts sellers and should translate into improved signings, more signings that layer into growth there over time.

And then I think things like vending, which, to be honest, was a -- sort of an offshoot that we didn't necessarily anticipate coming out of the sales force changes, seeing the acceleration in vending.

So what you'll see there over time if we execute properly is you'll see the growth contribution from vending.

As these signings and implementations layer in, we should see improved growth contribution there over time.

So those are the metrics for now.

And I think, over time, as the sales headcount -- as people settle in, we'll be looking at productivity measures.

And internally, we look -- because we don't do a one-size-fits-all approach to our sales anymore, right, that was the whole sales transformation, so internally, we look at the different categories of salespeople that we're hiring and all the way from inside sales to hunters and things and we look at whether they are achieving their plans in terms of revenue growth and new account signings.

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

Could we go back to the timing of the February increase?

Could you maybe just expand a little bit more on why the price increase was delayed from January into February?

Was it a function of the absolute number of price increases that you were seeing from suppliers?

Or did the magnitude catch you off-guard relative to maybe what you were hearing several months ago?

I guess, I'm just trying to better understand -- are there -- was there an issue of just updating your price file in a timely manner to -- that led to the delay of the price increase versus what you did last year?

Adam, absolutely, I'll hit this.

Yes, it's pretty simple, which is when we go out with price increases, we try as best we can to minimize the number of times that we hit our customers with increases, okay?

So look, there are times, in a real inflationary period, where we could be taking pricing up 3, 4 times a year.

But usually, let's put tariffs to a side because Rustom described -- that's a very specific instance.

But usually, our cycle is 2 times a year, around summer and around early in the calendar year.

What we were seeing was late in the calendar year into January, meaning into this month, a significant number of list increases from our suppliers.

Look, that's what we've been hoping for, for a while.

I think it came to fruition as we expected.

But for us, the trade was to -- by waiting an extra month, what it allowed us to do was capture more increases coming in January and go to our customers one time as opposed to missing out on that opportunity.

That's pretty much it.

Okay.

Got you.

That's helpful.

And then back to the gross margin on the quarter.

I guess, mix was mentioned as being a negative.

But at the same time, the discussion was that core customer growth was up high single digits and small customers were up double digits.

Was this a product mix headwind that we experienced?

And how do you think about that through the rest of the year?

It's also mix within categories.

So for example, National Accounts, I mean, we've had some of our lower gross margin accounts in National Accounts that we have either won or renewed have either have been -- had lower gross margins relatively have been growing faster.

So that's a negative mix in National Accounts.

Then look at vending, I mean, Erik made the point about vending, and vending is one of our sort of strong positives in terms of revenue growth.

But vending does come through at a lower gross margin.

So Adam, you -- sorry, look, you're right to call it out.

We saw the same thing.

Look, in the numbers, mix is a pretty broad umbrella.

Underneath our mix bucket, there's like 10 or 12 moving parts that we're looking at.

You are calling out 2 that within the mix bucket would be tailwinds.

Core growing faster, government growing slower.

What Rustom called out is a couple of others that offset that, being the National Accounts mix and vending being 2, in particular.

Now if I -- having gone into little bit details, I take it the very top level is with our -- this segregation, our stats.

I mean, in the price/mix in this quarter was about 80 basis points.

It was about 50 in last -- in Q4.

So the price/mix from that perspective has actually been a positive too.

So there are different ways to look at the business with as many products and customers as we have.

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

So I want to start with gross margin for the year.

Erik, how likely would you say that we're going to be in that gross margin expansion part of the framework?

So look, Ryan, a lot of this is going to hinge on our price realization -- I mean, obviously, sort of stating the obvious, it's a little early.

We put that framework out there.

And as you know, what we did kind of the middle of that line this year was basically the Q1 jump-off point, right?

So the sort of the plus or minus range was around 43.0, 43.1.

So let's take a look at the first half.

If we hit the midpoint of guidance in Q2, it's 42.8.

We hit 43.

That averages to roughly around 42.9.

We're sort of right underneath the line.

Close, but underneath the line.

So obviously, I'm going to state the obvious one more time.

To get above the middle of the line, we have to be north of 43 and north of where we were Q1, Q2.

On the one hand, costs are going to keep going up.

But on the other hand, look, we have a meaningful price increase that's coming late in Q2.

And a lot of it is going to hinge on how we do in realization.

So I hate to punt on you, Ryan, but I think we'll have a better feel of the quarter under our belts to see how realization goes.

Yes.

I get it.

Understood.

All right.

And then on price cost, I may have missed it, but what was the headwind there for the current quarter and then for the 2Q guide?

The -- in price/mix, it's actually a tailwind.

If you look at the numbers, we had about -- this segregation, we have about an 80-basis-point improvement.

So I was making the point that it was actually better compared to last -- to the last -- sequentially the quarter before that Q4, right?

The point on cost was that because of our average costing system and the way things work and the lag effect of cost leading into our system, we have steady increase in cost going on each month, right, where as price increases occur, as you know, every 6 months.

So after the price increase that we put through last year in the summer, right, I mean, the next point in time at which our prices go up is February once we -- once it goes through...

So Ryan, take it real simple.

From Q1 to Q2, the price -- so if you look at the decomposition of growth and the price -- that price/mix thing, which is our best proxy on prices, plus 70 basis points, our models would assume that given pricing, our next increase comes late in Q2, not much changes on the price front in Q2 and yet costs go up.

And those 2 things, the net of those are resulting in what you see, which is a 20 basis point sequential decline.

Yes.

I'm really asking about price cost just to quantify sort of see the progression because my understanding was in the current quarter it was going to be about a 10 basis point headwind.

Seems to me, it's actually going to be a little bit bigger in 2Q because you push back the price increase.

But then presumably, it could be positive in the second half.

So that -- is that correct?

Okay.

Yes.

You got it right.

Price cost actually worsens a bit in Q2 for that reason.

Now we don't get a lot more in price, and we have costs going up.

And then again, cost will go up again in Q3, Ryan, right, so we had no pricing -- price cost would turn more negative.

If we get good realization on the price increase, I'd expect a much better result.

Right.

Okay, just lastly, and this is a question I get from investors, but you have these National Accounts contracts where, typically, there's a 6-month price window for you to pass along price.

So how are you navigating that?

Is that a headwind?

And is there any offsets?

Look, so it depends.

And without, Ryan, getting too sensitive information with a lot of our commercial contracts, but there's different ways that -- each contract and each customer, there's different terms, so it's not a one-size-fits-all on the National Accounts is what I would say to start.

And look, historically, what we've seen for midyears is that there are cases where timing prevents us from getting all of the price day 1. But in virtually all of our contracts, there are set periods for pricing discussions.

And look, we expect -- given what's gone on when those times arise, we expect to get pricing through based on what's happening to cost, all the documentation we have.

And then the -- what we're doing for customers in terms of cost savings, our expectation is that we get the pricing through when allowed for by contract, and that varies.

And the final question this morning will be from Ryan Cieslak of Northcoast Research.

So I just -- I don't want to go back -- hate to go back and continue to focus on pricing, but I just want to make sure I understand what you're saying, Erik.

Obviously, demand seems like there's a potential for it to slow here in the market going forward.

Your commodity costs have rolled over a little bit.

What gives you the confidence that the realization -- because ultimately, that seems like that's the linchpin here.

You see the type of realization that you want to see.

That's going to benefit, obviously, the margins going forward.

But what gives you the confidence that you can sustain at least the type of realization you saw this past year versus actually seeing maybe less realization just because the environment is starting to slow a little bit?

Ryan, yes.

No, good question.

Look, I'd point to a couple of things.

One is the backdrop.

While commodities have softened again, go back to a lot of -- for many businesses, what are the large inputs?

The tariffs have been significant.

Wage inflation, significant, Freight inflation has been significant.

So there is a backdrop of cost going up, one.

Two, when we bring a price increase to our customers, it's supported with a lot of detail and backup, meaning that we're not just taking pricing up for the sake of taking pricing up.

It's where we can point to our suppliers having passed along list price increases.

So I think it's justified, and we show documentation.

And then three, going back to value proposition, look, we invest a ton of time and money and effort into helping engineer savings for the customer.

And generally, with most of our customers, in most cases, there's a win-win relationship and an understanding that we're entitled to get paid if we're, in fact, bringing the value and documenting the value.

If we're not, shame on us.

But I think, in most cases, we are.

And with most customer relationships, it's win-win.

So those are the things that would give me confidence.

And again, Ryan, to be determined, we'll see how we do with the pricing under our belt.

But those are the reasons I would have confidence in seeing solid realization levels.

Okay.

And then just to go back to the comment made -- being made about the back half of the year, margin trends beings significantly higher, are you -- it seemed like there's a lot of pieces that can drive that.

If you assume that the market and demand stay stable, doesn't get better, doesn't get worse from here, are you saying that you can actually get towards the higher end of your incremental margin outlook that you've typically given?

Which I think has been like 20 to -- low 20s to high 20% type of range?

Is that what you're trying to say?

Or are you saying actually even better than that is based on all the different moving dynamics?

No.

We're saying -- we're really saying that in the second half of the year -- well, most of the conversation that occurred earlier was all around operating margin.

And the difference in the operating margin between the expected H1 and the likely H2, I wouldn't use the term expected because it's too early to call for it, right, so that was more of the -- the discussion was about in terms of that.

I mean, in terms of the Incremental margins, I mean, we -- incremental margin is a factor of many things.

I mean, gross margins, one of them operating expenses, the other revenue growth, I mean, all the rest of it.

But I mean, we're not saying that we would be coming in at the high end of our 2018...

Yes, right.

Ryan, a couple of points to make just to ground us.

So one, if you take that annual framework and you look at the midpoint of that annual framework, it implies incremental margins actually slightly below our long-term 20% range at the midpoint.

As you got high up in the high quadrants, you get north of 20%.

But the midpoint was to begin with -- the second thing is, look, just to be grounded in reality, let's assume we hit the midpoint of Q2, I think Dave Manthey mentioned it early, incremental from the second quarter were negative.

If you look at the average, we're like low single digits incremental margins for the first half of the year.

That makes getting to 20%, which is the long-term range and absolutely, still, I believe, longer-term where we could be.

But for this year, I mean, that would mean we'd have to do something like close to 40% incrementals in the back half.

That's -- realistically, that's unlikely.

What we were trying to get across though is that the back half of the year, as Rustom said, should be considerably better.

That was the point.

But looking past F '19, there's no reason we shouldn't be back in the 20% to 30% range for incremental margin.

Okay.

And then just last one, and I'll get off the line here.

Any update on the timing of hiring a new sales lead?

I know it's still early, but I just wanted to see if you have just initial thought directionally of when a decision might be made?

Yes.

Ryan, what I would say there is search is underway.

We have a strong interim -- very strong interim leader in the place -- search -- in place in the interim, and search is underway.

One of those things that's tough to give you an exact time frame, but obviously a top priority for me.

And we're going to move quickly.

But we're going to make darn sure it's the right person and not let that get in the way of finding the -- a timeline get in the way of finding the right person.

So in process.

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

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

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

Our next earnings date is set for April 10, 2019.

We'll be attending a number of conferences and field trips over the coming quarter, so I look forward to seeing you and speaking with you over the coming months.

Take care.

Thank you.

Ladies and gentlemen, the conference has concluded.

Thank you for attending today's presentation.

At this time, you may disconnect your lines.