MSC Industrial Direct Co Inc (MSM) 2019 Q3 法說會逐字稿

Good morning, and welcome to the MSC Industrial Supply Co.'s Fiscal 2019 Third Quarter Earnings Results Conference Call.

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

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

Mr. Chironna, please go ahead.

Thank you, Anita, and good morning, everyone.

Today, I'd like to welcome you to our fiscal 2019 third quarter conference call.

With me in the room 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 plans, 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 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, and thanks, everybody, for joining us today.

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

I'll then offer specifics about the environment and our recent performance, and I'll discuss our plan moving forward before turning it over to Rustom to review the details of the third quarter and provide our fourth quarter guidance.

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

Our fiscal third quarter results were disappointing.

Sales were below our expectations for the quarter while gross margin was at the low end of our guidance range.

Although operating expenses were below anticipated levels, our earnings per share were below the low end of our guidance range.

We'll dissect the reasons in detail this morning, and I'll share with you the actions that we are taking to address them.

First, I'll start with the environment.

We've seen a step-down in industrial demand since our fiscal April.

On the last call with you, we described the softer-than-expected March, with the rebound during the first week of calendar April, which was the last week of our fiscal March.

As we said at the time, we weren't sure what to make of it.

As it turns out, the softness from March not only continued, but it has worsened since we last spoke.

And we've seen this softness evidenced in discussions with customers and suppliers along with data points coming from many sources, including manufacturing output numbers, distributor growth surveys and the sentiment indices.

In April and May, the last 2 months of our third quarter, readings for the MBI were 53.6 and 51.6, respectively, and June was at 51.8.

The rolling 12-month average for the MBI is now 54.7.

While still reflective of growth, there's a continued deceleration.

With regards to the pricing environment, there continues to be an overhang of uncertainty mostly due to tariffs and trade.

In the fiscal third quarter, realization of our midyear price increase continued to be positive.

As we look forward, our plan is to take our late-summer increase, as we usually do, although it will likely be slightly later than last year to give ourselves more time to understand how the tariff situation is shaking out.

In terms of our performance within this environment, our core customers had growth rates in the low single digits, while National Account growth was mid-single digits.

Both were slightly lower than expected, impacted by the softness that I just mentioned.

As expected, government sales growth declined mid-teens this quarter, weighing down our overall growth rate.

You'll remember that our fiscal third quarter was expected to be the peak of the government headwind.

And while the headwind continues for another couple of quarters, it does begin to abate in this coming quarter.

Let me now step back and share my assessment of our performance along with an overview of our action plan moving forward.

Clearly, the biggest difference between our actual results and our previous guidance has been a change in industrial conditions.

And because of that softening environment, we've implemented a 3-part action plan designed to achieve improvement in the following: one, field sales execution, particularly around new account implementation; two, profitability of our supplier programs; and three, expense control and productivity.

Part one, improve field sales execution and new account implementation.

We are winning new accounts at a fast clip.

However, revenue growth from our new account wins is taking too long to materialize, as these new account wins have outpaced our expectations and hence, our resource planning.

I would have liked to have seen more contribution from these wins heading into our fiscal fourth quarter.

In response, we've focused one of our top sales leaders on new account implementation and have allocated additional resources to keep up with the rate of new account signings.

This is one of the key actions that we're taking to improve field sales execution.

Overall, I continue to have strong conviction in our plan.

I should also note that Eddie Martin, who we recently announced as our Senior Vice President of Sales, has hit the ground running and is playing a significant role in field sales execution improvements.

Action plan part two, improve the profitability of our supplier programs.

We are working to deepen our relationships with our suppliers in a win-win fashion.

Those that improve their programs and invest in MSC and our customers will be rewarded with focus and investment on our part.

Suppliers that do not step up will see moves away from them and towards their competitors who choose to invest in our partnership.

Related to this, the softening demand conditions and reductions in commodities prices have led us to reassess product cost increases.

Whether it's tariff-related or otherwise, we are pushing back when we don't think an increase is justified for our customer.

And when it comes to our own tariff exposure on direct imports, we're also pushing back on our Chinese suppliers to offset tariff-related increases.

Action plan part three, increase operating expense controls and improve productivity.

And we're taking 3 steps to do so.

First, curve hiring and clamp down on discretionary spending; second, ratchet up performance management and review resourcing needs department by department; and third, reengineer inefficient processes to drive productivity.

It's a bit too early to quantify additional details right now, but we will do so as part of our fiscal 2020 framework on our next call.

I'll now turn things over to Rustom before I come back with some concluding remarks.

Thank you, Erik.

Good morning, everyone.

Before getting into the details, let me remind you that we provided Q3 guidance for both our total company and our base business, which is our total company excluding the impact of the AIS acquisition and the Mexico business.

Our third quarter average daily sales were $13.6 million, an increase of 4.6% versus the same quarter last year and below the low end of our guidance range.

AIS and MSC Mexico contributed 260 basis points of growth between them, slightly ahead of guidance.

The entire shortfall therefore was in our base business, which had ADS growth of 2%.

Erik has already covered the reasons, so I'll move on to gross margin.

Our Q3 reported gross margin was 42.5%, 20 basis points below our guidance midpoint.

The majority of this gap was due to base business customer mix and slightly-higher-than-expected purchase cost escalation.

Our total company gross margin was down roughly 110 basis points from last year, with about 40 basis points of this coming from AIS and MSC Mexico.

Sequentially, our base business gross margin of 43.1% was flat with Q2, as the February price increase offset both mix headwinds and purchase cost escalation.

Total operating expenses.

In Q3, there were $258 million or approximately $4 million lower than the guidance midpoint, mainly due to actions taken to reduce discretionary spending and avoid planned cost increases as well as lower volume-related variable costs and a lower incentive accrual.

We slowed our rate of hiring in Q3 tempering our headcount growth, which, when combined with performance-driven attrition, resulted in field sales and service headcount reduction of 22 and an overall reduction of 31 heads from Q2.

But note that we do not expect -- that we do expect to end Q4 with close to the Q2 level of field sales and service associates.

Operating expenses were up $13 million from last year's Q3.

About $5 million of this year-on-year increase came from the acquisitions, another roughly $2 million was attributable to volume-related variable costs such as pick, pack, ship and freight, and roughly $4 million came from higher field sales and service payroll costs, where headcount is up 63 versus a year ago.

OpEx to sales of 29.8% was up 10 basis points from last year's Q3 and 10 basis points above the midpoint of guidance, as our cost control actions helped but did not fully offset the impact of lower-than-expected sales.

Our fiscal third quarter reported operating margin was 12.8%, within but at the low end of our guidance range.

This was down roughly 110 basis points from the prior year with roughly 10 basis points due to AIS and MSC Mexico.

Our base business operating margin was 13.2%, at the low end of our guidance range and down about 100 basis points from the same quarter a year ago.

Lower gross margin and the ongoing impact of people and project investments made earlier in fiscal 2019 both contributed to the year-on-year decline.

Our total tax rate for the third quarter was 25.0%, slightly below guidance and lower than our fiscal 2018 Q3 effective tax rate of 29.3%.

The year-on-year decrease was primarily due to the lower corporate tax rate resulting from the Tax Cuts and Jobs Act.

So all of these resulted in reported earnings of $1.44 per share, $0.05 below our guidance midpoint.

AIS and MSC Mexico combined had a $0.01 negative impact on reported EPS.

Last year's reported EPS was $1.39.

Turning to the balance sheet.

Our DSO was 59 days, up 3 days from fiscal 2018's Q3, with National Accounts continuing to be the main driver.

Our inventory decreased during the quarter to $561 million, down $12 million from Q2.

Total company inventory turns were down slightly to 3.5x from Q2.

We have slowed purchasing and expect inventory levels to decline again in our fiscal fourth quarter, but by a lower amount.

Net cash provided by operating activities in the third quarter was $89 million versus $112 million last year.

Our capital expenditures in Q3 were $13 million versus last year's $14 million.

And after subtracting CapEx from net cash provided by operating activities, our free cash flow was $76 million as compared to a strong $99 million in last year's Q3.

Note that we currently expect annual CapEx of $50 million to $55 million in fiscal 2019.

We paid out $35 million in ordinary dividends during the quarter and did not buy back any shares on the outside market.

In last year's Q3, we paid out $33 million in dividends and bought back $4 million in shares.

As you saw this morning, we increased our quarterly dividend to $0.75 per share, a 19% increase.

Based on fiscal 2019's expected EPS, this will result in a payout ratio of about 57%.

Our strong balance sheet and high levels of free cash flow generation comfortably support this level.

Erik will elaborate more on this in his closing.

Our total debt as of the end of the third quarter was $531 million, comprised of a $246 million balance on our credit facility and $285 million of long-term fixed-rate borrowing.

Cash and cash equivalents were 20 -- $39 million, and net debt was $492 million.

So our leverage decreased to 1.0x as compared to 1.2x at the end of Q2 and was flat with last year's Q3.

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

Please remember that DECO is in the base, whereas both AIS and MSC Mexico are included in the total company views.

And note that when we get to fiscal 2020 guidance, we will move AIS into the base, but leave Mexico in the total company view.

Overall, for Q4, we expect total company ADS to increase by approximately 1.2% to 3.2% versus the prior year period.

This includes the range of 0% to 2% of organic growth and around 120 basis points from acquisitions.

As you see on the op stats in our website, June's total average daily sales growth is estimated at 3.7%.

Note that this year's June had 1 fewer selling day as we closed in the Friday following the July 4 holiday.

Our Q4 total company gross margin is expected to be 41.8%, plus or minus 20 basis points.

This is down 110 basis points year-over-year.

Our base business gross margin is expected to be 42.3%, down 120 basis points from last year.

While price realization has continued at expected levels, we anticipate higher purchase costs and sales mix to also continue as gross margin headwinds in the fourth quarter.

Also, the higher sales growth coming from vending and direct ships comes in at gross margins below the company average.

Gross margins for the base business are expected to be down 80 basis points sequentially from the third quarter.

This is due to the normal seasonal Q4 decline, exacerbated by escalating product costs and a slightly later annual price increase.

Let me provide some additional context on gross margin.

Our gross margin formula is made up of 3 elements, price, costs and mix.

In recent years, we averaged a gross margin decline of 30 to 50 basis points.

And if price and costs are neutral, we would still expect year-over-year gross margin deterioration from sales mix.

The past 2 years have produced quite a different picture, primarily due to the timing of price/costs.

In fiscal 2018, we benefited from our price increases before the cost increases flowed through our P&L.

As a result, the price/cost spread was positive, and our base business gross margins were flat.

This year, fiscal 2019, we are later in the price/cost cycle.

While price realization has been positive, the gap between price and costs has turned negative, as we are now bearing the full impact of escalating product costs from fiscal 2018.

As such, at our Q4 guidance midpoint, fiscal 2019's base business gross margin would be down 80 basis points versus last fiscal year.

On top of the price/cost timing issue, the demand environment, though still positive, discernibly softened in Q3.

We don't see this changing in the fourth quarter and are addressing the purchase cost side of the equation.

Moving now to operating expenses.

They are expected to be around $258 million, up $6 million from last year's fourth quarter, with the base business accounting for about $4 million of this.

As you know, we added sales and service headcount over the course of the year, and total payroll and payroll-related costs account for about $3 million of the year-over-year increase.

We might expect a sequential decrease in operating expenses in Q4 rather than sequentially flat operating expenses.

There are 3 reasons why OpEx was flat sequentially.

First, most of the actions taken in the last 2 to 3 months were to avoid planned headcount and cost increases rather than to reduce costs.

To be clear, we will take cost-reduction actions in the coming months, and the savings will kick in more meaningfully in fiscal 2020.

Second, we had a roughly $1 million incentive compensation accrual reversal in Q3.

And third, we are expecting depreciation costs to rise sequentially, driven primarily by the strong growth in vending signings this year.

We expect the fourth quarter's total company operating margin to be approximately 11.2% at the midpoint of guidance, a 170 basis point decline over last year's 12.9%.

The year-on-year drivers are the roughly 110 basis point gross margin decline and a roughly 50 basis point operating expense expansion due to our growth investments and the acquisitions.

Assuming the midpoint of our total company Q4 operating margin guidance, we would fall below the lower left quadrant of our 2019 annual operating margin framework for the full year.

Before turning to taxes, I'll say a word on base business incremental margins.

While we delivered a solid fiscal 2018, we will have taken a significant step-back in fiscal 2019.

Assuming the midpoints of our fourth quarter guidance, we expect operating profits to decline roughly $20 million on approximately $90 million of additional sales.

This is, of course, unacceptable, and we are taking actions to improve our performance.

Turning to our estimated tax rates for the fourth quarter.

It is 24.1%, slightly lower than our year-to-date tax rate of 25.1%.

This was due to the typical release of state tax reserves that occurs in our fiscal Q4.

Finally, our Q4 EPS guidance range is $1.21 to $1.27, with a midpoint of $1.24.

This includes AIS and MSC Mexico, which together should be EPS-neutral in Q4.

Our guidance also assumes a weighted average diluted share count of roughly 55.3 million shares.

I'll now turn it back to Erik.

Thank you, Rustom.

As I shared earlier, we're taking actions aimed at improving sales and gross margin and lowering expenses.

You heard some of the details today.

But in summary, we are focused internally on improving execution.

And this also means that any M&A activity that we may consider over the near term will have higher hurdles rates, particularly as valuations remain historically high.

You also saw that we are adjusting our capital allocation philosophy to return more capital to our shareholders via the quarterly dividend.

As Rustom said, we have a strong balance sheet and generate high levels of free cash flow.

This dividend leaves us with a comfortable payout ratio, and this would be true even if things soften further.

Reflecting on the fiscal year thus far, we're disappointed with our performance.

And more importantly, we are taking action to address this.

That said, I don't want the progress that we're making in some critical areas lost on all of this.

We're winning new accounts, and doing so at a very strong pace.

Our vending implementations are growing more rapidly than they have in a long time.

We are deepening our commitment to our valued supplier partners at a time when our shared goals are more important than ever.

And our team of associates is working to deliver on our action plan.

I thank each of them for taking it on with urgency and commitment as we continue our journey from a spot buy distributor to a mission-critical partner on the plant floor.

We'll now open up the lines for questions.

(Operator Instructions) The first question today comes from Robert Barry with Buckingham Research.

Actually, before my question, I just wanted a housekeeping item, clarification on the ADS results estimate for how much you think Easter impacted April.

And how much does having one less selling day benefit June ADS?

So the April impact washed out, I mean, so we didn't -- in the quarter, as we looked at it, the ADS impact of the one less selling day in June, if you do it purely mathematically, right, would not be quite the way to do it, Robert.

Because, effectively, the last -- if I just disclose what the number was in Friday, I mean, we had like just a little bit over $1 million in sales.

So when you -- if we didn't have that $1 million and didn't have that day, we'll have really a negligible impact on the overall number.

I see.

So it's pretty minimal?

Erik, do you want to add anything?

No, you got it.

Sorry...

No problem.

Feel free to keep going if there's other...

Yes, okay.

I'll follow up afterwards.

So on the price/cost impact to gross margin, what was that impact in 3Q, in the quarter?

So the price impact -- the price/mix impact, we haven't disclosed the price/cost impact specifically like that, but the price/mix impact that we had was roughly around 60 basis points.

Right.

I guess you said that it went negative.

The price/cost equation turned negative, so I was curious how much of it was -- yes.

Yes.

Rob, so a little bit on gross margin.

So essentially, what happened was, as Rustom described, we came in on the bottom end of our gross margin range.

So effectively, 20 basis points off the midpoint.

And what he highlighted is that 2 drivers behind that in the base business, one being purchase cost, slightly higher than expected, the escalation, and then two being customer mix.

He also put some context on price/cost in terms of essentially what happens in our business when we take price, we get it right away.

When we take a cost increase, it bleeds into our P&L slowly.

And what we were describing in the prepared remarks was how this fiscal year price/cost has turned negative as we're bearing the full brunt of the cost increases taken over this year and last year.

Got it.

And I guess just lastly, curious about what the outlook is there for that price/cost equation getting back to at least neutral.

I mean is there a line of sight to that happening?

Because it seems actually like maybe the inflation, at least from tariffs, might continue to rise, especially if you're seeing more coming through from third-party vendors.

Yes, Rob, really good question is, where does it go from here as it relates to gross margin and price cost?

Here's what I would say.

On the pricing side, so right now, absent -- if we did nothing else and just trended things out, price/cost would likely stay negative in '20.

However, an important however, 2 things could change.

One is pricing.

And as I mentioned, we're going to be taking a summer increase.

We would expect to see solid levels of realization as we did in the midyear.

And you raised a fair point that should -- still for us too early to say what's going to happen with tariffs.

But should that stimulate inflation, there could be more coming on price.

I think the second important thing that we talked about this morning was the fact that we're taking aggressive actions on the buy side with our supplier community in a number of different forms, still a little early to quantify exactly how much of the cost -- the embedded costs that eats into, and we'll certainly follow up on the next call with the 2020 outlook.

The next question comes from Ryan Merkel with William Blair.

So first off, can you provide a little bit more context around the organic slowdown, daily sales?

Was it broad-based?

Or did certain end markets drive the bulk of the weakness?

Ryan, so what I would say is 2 comments.

One is we saw some real pockets of weakness.

A few that I would call out.

Automotive -- it's probably not going to be a surprise to you.

Automotive, oil and gas and then the Midwest was hit pretty hard with agriculture certainly.

Pockets of strength.

Aerospace continues to remain strong.

That said, what I would say, outside of the pockets of weakness, we did, through most of our customer base, see a change through the quarter.

And I would characterize the change as more uncertainty and shorter backlogs, along with some softening in export demand and concerns about more softening in export demand.

So that's how I'd characterize it.

Okay.

Yes, that's kind of what I expected.

And then as a follow-up, the 1% organic ADS guide for 4Q, it looks like this assumes a little bit of further market slowdown, but not that much, right?

Because you're going from basically a 2% run rate to a 1% in 4Q.

Is that the right way to think about it?

Yes, I think that's right.

I mean if you look at the June number that Rustom mentioned, so the 3.7% is inclusive of a bit of acquisitive growth.

I think without that, we're somewhere in the 2.5% range, slightly benefited by the 1 fewer selling day.

And then you're right.

Ryan, if you do the math and you did the forecast for July and August, it would be less than that.

So yes, what we have assumed is a modestly softer July and August than what we saw in June.

Okay.

And then just lastly, and I'll turn it over.

You mentioned that the price environment is more uncertain.

Can you just expand upon what you mean by this?

And are there any implications for the P&L that we should think about based on that comment?

In terms of what I mean, it's really, Ryan, what we were referring to is the tariff and trade situation.

Unlike the last round of tariff increases in 2018, which were smaller in size and more telegraphed, people saw them coming, this was larger in size and was not telegraphed and was a bit more of a surprise.

So the uncertainty, Ryan, is really about what happens with our supplier community and how much of that attempts to get passed through, and I think as more importantly, what happens with the customer base, the end markets and how much of that makes its way through and gets accepted.

So I think it's just the overhang of tariff and trade is what I would describe.

I mean I think in terms of the impact on the numbers, Ryan, look, you're seeing it acutely in our fourth quarter, our fiscal fourth quarter guide with gross margin, and what you are also hearing is we're taking action.

So I would highlight, we did choose to push back the price increase a little bit, which obviously cost us a little bit of gross margin in Q4.

We did that, so we get a little more line of sight into the tariff situation with customers and suppliers.

And then as we mentioned a couple of times here, we're moving aggressively with suppliers.

The next question comes from David Manthey with Baird.

So thinking about the action plan here.

Step one, Erik, you said you're gaining customers but not ramping them quickly enough.

It's been years since you've given us any insight on active customer data.

I'm wondering if -- just in the spirit of that part of the action plan, can you give us a spot update on the number of active customers today and sort of what that is year-over-year?

Dave, I actually do not have the number handy, to be perfectly honest with you, so we'll have to follow up.

John, I'm just -- John is making a note for a follow-up.

What I will -- the color I'll add there, Dave, is that relative to my time in the business, the new account wins we're seeing now, and this is based on the changes that we've made in the sales force to put more focus on the hunter population, we are definitely seeing a greater rate of new wins than I've seen in a long time, maybe ever in the business.

What we called out is, quite frankly, the rate and pace of the new account wins was a bit faster than we projected.

And as a result, we need to play some catch-up on implementation.

And that's what we called out as action plan part one, is we're investing, we're reallocating resources as needed to get the wins in because what you heard from me is I'd like to see the new wins translate into revenue faster.

Okay.

And the number two part of the plan here is the better realization from supplier programs.

I'm wondering, are these conversations you've already had?

Are those yet to happen?

And what about this is going to be different?

Vendor management is sort of a key ongoing function of any distributor.

I'm wondering, what are you planning to do differently than you've been doing over the past several years there?

Yes, Dave, really good question.

So what I would tell you is the bulk of the conversations have already occurred.

So it's a bit early to provide results and outcomes because as you could imagine, it's not a onetime conversation.

There's ongoing dialogue, and we're still sort of sorting through it.

But most of the conversations have occurred.

I would say that what's different is a heavier emphasis this time around on providing growth investment, sort of 2-way growth investment, and sales and marketing programs that we would commit to, to those suppliers that step forward to give them heavy degrees of focus inside of MSC in a way that would be stepped up from what we've done in the past.

Okay.

And then finally, Erik, more of a strategic question here.

As you make this drive to become a mission-critical partner on the shop floor, do you feel that today you have the people, tools, technology and products and services in order to do that?

And if so, I'm wondering, why hasn't the update been faster?

If not, what do you need to get there?

Yes, really good question.

I would say -- Dave, so let me start out by saying my conviction in the plan is high.

My conviction in the team, our management team in particular, is high.

So look, that said, there have been considerable changes in the sales organization in particular.

We mentioned Eddie coming onboard.

And beyond Eddie, really largely a new sales leadership team around Eddie with several other members of the team.

But my conviction in the team and the plan is high.

So to your question about why the traction being slower, and I think it's fair to say, look, I want to be clear.

On the one hand, I'm excited and encouraged about the new account wins.

On the other hand, I want to be clear, I'm disappointed with the results we're producing, and I'm disappointed in how fast the new accounts are materializing into revenues.

You heard us making some adjustments.

We'll continue to make adjustments as needed until we get it right.

But for me, the headline is conviction in plan and the team are high.

The next question comes from John Inch with Gordon Haskett.

Erik, is part of the issue that suppliers have been raising their List 3 prices, that the market, in terms of your peers, are lagging?

Is that part of what's going on here?

I'm just wondering if you could comment a little bit in terms of what suppliers are doing with respect to List 3 and what you're seeing kind of competitively in the market with respect to List 3.

With respect to List 3 on the tariff situation, John?

Yes, correct.

Yes, the 25%.

Yes.

I mean to be honest, with respect to the latest round of tariffs, still very early, still very early.

So I would say too early to comment.

And that's sort of part of what we described as the overhang and uncertainty.

What I would say is the last round of tariffs, John, late 2018, most certainly triggered a greater incidence of list price increases from suppliers.

So far, and again, I think that's part of the reason why we're waiting and seeing, there has not been significant amount of movement I think in part because this was a surprise to many.

Do you think it has anything, Erik, to do with maybe there is a threshold of greater sensitivity, given the uncertainty in the economy that, all of a sudden, there's just not to going to be quite the ability or perhaps greater resistance to push through some of these increases?

And I'm just curious how you think that maybe kind of ultimately nets up for MSC.

Are you comfortable that the costs will ultimately be offset?

Or is there -- I mean you're obviously taking the supplier adjustments.

I'm just curious how you're thinking.

Are we reaching a bit of a threshold here in terms of how much customers are willing to accept?

John, I would say -- yes, it's a good point.

I would say anytime -- this is largely cyclical, and what we're seeing is no question a change in the demand environment.

And many times, there's a correlation between how the demand environment goes and how the pricing environment goes.

So softer conditions on the demand side will lead customers to be scrutinous of price and certainly will lead local distributors that make up the bulk of the market to get more aggressive.

I think that's real, and I think that's why you're seeing us pull out our playbook on the buy side, absolutely.

Yes.

No, it makes sense.

But you also -- sorry, John, just to add.

You also are seeing, as Erik alluded to, with the demand weakening and everything too, you're also seeing inflation in general and in commodities and -- also beginning to come down, so it could very well have peaked.

Just one thing...

By the way, guys, how is metalworking in general responding to the demand?

It's obviously a huge metalworking data point, right?

How is metalworking in general -- ex the MBI, how is the channel for suppliers, customers, competitors, how are they responding to these fluctuating tariff price changes and demand softening?

What are you seeing there?

I would say, in general, John, what we're hearing from -- look, the bulk of our customers are going to be broad-based metalworking, is we're seeing uncertainty.

There's more uncertainty.

There's less confidence as there was.

As I mentioned, the backlogs are shorter and impact on the export demand.

It makes sense.

I guess, lastly, Erik, you guys at MSC have been on a multiyear ramp with respect to SKUs and expanding the big book and the product offering.

I'm kind of assuming that these supplier initiatives are going to result in some actual supplier rationalization.

Where would you anticipate -- like what would you anticipate coming out of this in terms of maybe your supplier count?

Could you give a thought process in terms of how much it may decline?

And in turn, what would you anticipate for sort of an SKU product offering kind of in totality going forward?

Yes, John, another good question.

The SKU effort has been successful.

And actually, it's been an important part of the strategy to make sure that when a customer comes to us, they can get anything that they need that's industrial-related.

So I don't see that changing, and I don't see the SKU count changing dramatically.

To be honest, the supplier count may or may not change dramatically, John.

Really, what we're talking about here is where we put focus, effort and investment.

So it may not necessarily mean that it could.

It will really depend.

It will be circumstance and product line specific.

In some cases, it may mean some pruning or rationalization of suppliers, but in other cases, it may just be about where we put focus, sales focus and marketing focus in particular.

And when do you think this is finished?

Or are most of the bulk of this work on supplier over?

Is it going to be 6 months?

Is it a bit of a longer process?

Or how should we think about it?

I would expect by our next call, we'll have a pretty good feel for what we can expect to see in terms of results and what moves we'll be making.

The next question comes from Adam Uhlman of Cleveland Research.

I was wondering if we could go back to the cost control effort, and in particular what you're looking to do with headcount.

It sounds like most of the efforts here are focused on attrition and your hiring rates and not layoffs or the likes.

But I'm trying to understand beyond that what other levers you're pulling.

Here, in the medium term, you mentioned that there's more underway here in the fourth quarter.

But assuming that flat demand environment persists for next 6 months or a year or whatever, what do you think your underlying rate of expense growth shakes out at?

Adam, I'll take at least the first part of the question and touch a little bit about what we're doing and what you're seeing from us here and what Rustom and I described.

What you can expect to see is, number one, more aggressive performance management.

You can expect to see, number two, a greater focus on productivity than we've had in the past.

Look, I'll mention that over the past few years, we have made moves at times to align specific departments and make changes with the needs of the business.

You're going to see us step up those efforts.

As a result of those things, certainly, with the picture that we see now for the demand environment, you'll likely see headcount levels come down during fiscal 2020.

Yes.

And Adam, I mean, yes, just to elaborate on that, I mean it's more than simply attrition.

I mean, we are looking at -- yes, we're looking at curbing hiring and clamping down on discretionary spending, but the ratcheting up on performance management and reviewing resourcing needs department-by-department is something that we will be doing more intensively than we've done.

I mean we have taken our OpEx down a couple of hundred basis points.

I mean this is now going up to another level, but also reengineering inefficient processes to drive productivity.

That's something else that we will be taking up to another level.

And then we'll provide some further details as part of our fiscal '20 framework when we come back and talk next quarter.

Okay.

And then just a clarification on vending.

It sounds like the signings have been ramping for some time.

I missed what the sales growth contribution was this quarter.

If you could repeat that for me.

But I guess I'm just wondering how that looks now for maybe the second half of the year.

Should we be expecting an acceleration in the sales contribution?

Or is the weak manufacturing environment going to mute that?

No.

Vending is still contributing, I mean, quite solidly in terms of the numbers.

It probably contributed about 1.4% or something to -- of our sales growth in this quarter.

I expect vending to continue to contribute, I mean, in terms of revenue.

There's -- it's an area of focus.

It's something that we're doing.

It's something that we've invested in.

And along with vending, I mean, just one thing to remind you of is that, yes, it comes at lower gross margins.

The contribution margins do vary greatly by account, but I mean one of the things is over the years, I mean, all the insights we've gained through our net profitability analysis have led to reductions in cost to serve.

And so we continue working on that.

And vending's profitability also typically improves as the account matures.

I mean that's the past trend.

Does that help?

The next question comes from Chris Dankert of Longbow Research.

I guess if we could kind of circle back to government, we're looking for that headwind to kind of peak this quarter mid-teens.

You said that it does kind of trickle as we get into the fourth quarter and fiscal '20.

Just can you kind of help us size what that headwind is moving forward?

Just it's lower than mid-teens.

That's a pretty wide range, I guess.

Yes.

So look, I mean, the headwind, we talked about mid-teens.

So you think about the third quarter has peaked, mid-teens and government is 7%-ish of our business, 7% to 8% of our business.

So you do the math there, Chris, and that is a point headwind to the growth rate right now.

Looking ahead to Q4, we still have government negative, but less negative.

And it will be certainly, I believe, by the back half, so Q1, we'll still be slightly negative.

As we move Q2 back half of the year, the headwind completely dissipates, which means that it's no longer negative.

And if the work that's being done now in the program, and I should add, by the way, I think there is some very good work going on in the government program right now, I expect that piece of our business to restore to growth.

But that gives you a feel for the headwind and how long it'll last.

That's very helpful.

And then we talked a lot about kind of the hunters and their impact.

I guess is the goal near term still to kind of get them to add about 100 basis points?

I mean I believe they're kind of hitting that maturation rate.

Just any color on what your expectation is for the actual kind of sales growth contribution from the near term.

Yes.

So Chris, you'll remember from the last call I had talked about what I saw from then in the next quarter or 2. I think I described that, at least 100 basis points in growth contribution.

Absolutely nothing has changed in terms of what I see as the size of the contribution from hunters.

Our confidence is growing.

The payback looks strong.

What has happened is, quite frankly, we've -- I mean, so this is good news, bad news.

The good news is it does appear that the value proposition is working because the new wins coming in are greater than expected.

The bad news is it's more than we planned for.

And as a result, the revenues are slower to materialize.

But in terms of size of the price, absolutely nothing has changed.

Got it.

Just the last thing for me.

Thinking about pricing, obviously, you had waited a little bit longer than usual on the midyear increase.

Tough to kind of get the full realization maybe kind of waiting a little bit longer on the late summer increase.

I guess is there an opportunity to kind of revisit some of these price negotiations on a more quarterly basis rather than the biannual, given kind of how tariffs have changed the landscape a bit?

So Chris, one of -- it's interesting.

I hadn't thought about it.

You're right.

That's sort of 2 increases in a row.

One of the things that we've done, and I think we've put a strong pricing discipline in place in the company, and one of our findings is that we'd rather wait a little bit and be really well prepared when we go and when we sit in front of a customer and talk about pricing and why the increase is justified.

And so what we found, if it's buying ourselves a little extra time, the results have been really good in terms of the kind of realization rates that we're seeing, particularly if I look back at this last midyear.

And so I think as much as anything else, that's part of our improved pricing discipline and practice.

In terms of the frequency and cadence, look, what we try to do, Chris, as much as we can, is we know price is a sensitive subject for our customers and keep the cadence to some sort of regular time intervals and where it's not too often that we're introducing price changes.

We would rather go once or twice and have a meaningful discussion than go all the time and continually sort of opening up that wound.

Yes, makes sense.

Always tough to kind of have that discussion, but makes sense.

The next question comes from Justin Bergner with G. Research.

I was curious as to what parts of, I guess, the sales disappointment in Q3 and in the Q4 guide you would attribute to company-specific challenges versus end markets.

Because it seems like what you're seeing on the company-specific side is that you're getting more account wins and you're expecting the slower conversion to revenue, which would sort of be an offset.

Or is there anything else that you would sort of attribute to company-specific factors versus end market factors?

Justin, so 2 points I'd make.

One is the biggest change.

If you look at the third quarter, our actual sales number to the guidance, the biggest delta there was change in environment that we didn't see.

Where I was disappointed is not -- obviously, we can't control the environment.

What I would have liked to have seen was the new account wins begin to materialize into revenues faster, therefore buffering some of that market downturn.

But really, you hit on the 2 key factors that are the headlines of the story.

Okay.

That's good.

And then on the margin side, is there anything that's happening outside of sort of List 3 and the surprise impact of that on price cost?

Is there anything else that is material that's affecting sort of the gross margin trajectory versus your expectations, be it sort of increasing mix headwinds or other factors?

No.

I would say no other major change in terms of either inside or outside of the company in terms of environment.

I think we hit on -- you hit on sort of the key overhang in the environment with the tariffs and trade.

I think there's nothing else I'd call out.

The next question comes from Patrick Baumann with JPMorgan.

I just had a couple of questions.

Maybe just to start, could you provide an update on the competitive intensity that you're seeing in the current environment, and maybe just broadly from this perspective how you see this, if it is a barrier to pricing versus historical inflationary cycles?

Patrick, I would say competitive intensity is high, and it would be typical of what I've seen in past cycles certainly, that as demand conditions soften -- I think important to remember, 70% of the market is made up of local and regional distributors.

And those distributors, when things get tight, will hang on to business and will certainly use price as a weapon and a lever to retain accounts.

So we're seeing competitive intensity as high, and I would specifically call out the local distributors as to where the ratcheting up has come from primarily.

Got it.

And then on the tariffs, can you just remind us once again of the exposure as a percent of your COGS for List 3 and then List 4, just the direct exposure?

Yes.

I mean the original exposure -- I mean remember, what we buy from China is about 5%.

I mean that was fairly small -- a fairly small number coming through.

And we are, by the way, going back to our suppliers in China as well and specifically going to them as they go on to List 3 and the higher 25% and going back and looking for alternative sources and working with them to be more efficient and not just pass through those numbers.

That's part of what Erik talked about as well.

And so it's just 5% of COGS?

And the recent increase to 25%, that has yet to hit your P&L, correct?

Yes, that's -- yes, I mean, the recent increases are coming into P&L as well as tariffs.

And it would basically double it, isn't it, when you look at the further exposure if all of it came through again.

And that's why I made the point that we're not really necessarily seeing all of it come through yet.

So the 5% will become 10% you're saying?

Yes.

So just to -- Patrick, just to explain.

I think what we have described as 10% is the total universe of what comes from China, what our direct impact -- our direct sourcing is.

The 5% is roughly what was covered by the first few lists that we had.

What Rustom is describing is if everything else were covered by List 3 and 4, there is a remaining 5% of potential exposure.

Potentially taking us up to 10%, yes.

Got it.

Got it.

And the move in List 3 from 10% to 25%, that will start to be felt in your P&L in the fourth quarter or next year.

That's not yet in the numbers, correct?

Right.

Right.

Also depending on if those 25% come through, right?

That's the point I'm trying to make.

Yes, yes.

You're assuming it does come through in your guidance, correct?

We -- minimal in Q4.

Because of the way we buy and the time -- the lag -- the time lag for overseas sourcing, it wouldn't be in our numbers right now.

I think Rustom's hitting an important point.

If we were to take a tariff-related increase, one would see that -- would not see that in our numbers now, it would be next fiscal year.

As I talked about, we are pushing back rather hard on the -- anything that's tariff-related.

Understood.

Understood.

And then maybe just kind of a different question.

The top line environment is slowing, obviously, but we're not yet declining.

I'm just curious if you could provide some perspective on how we should be thinking about decremental margins if we do, in fact, see a lower top line, I don't know, 5% or something if the environment could turn for the worse and your top line goes down mid-single digit or so.

What's a reasonable range on decrementals?

I mean I looked back in '09, and I think you guys did 30% to 40% or something like that.

Just kind of curious to see if you can provide some perspective on that.

So you're really going into fiscal '20's guidance, and we try to avoid giving that guidance.

We try to avoid giving more than a quarter's guidance ahead, but maybe I can put it -- maybe I can take it -- take another angle at it than say in fiscal '20 and just say if sales remain in low single digit, right, I mean, we can still -- our target would still be to grow earnings.

And that would depend upon price realization, the supplier actions that Erik talked about and the cost down actions which are being undertaken and others that are being contemplated.

And we'll share much more of this on our next call.

Yes.

No, obviously, just thinking hypothetically, if we had a recessionary environment, what kind of decremental margin would the company target?

So Patrick, the real -- the reason it's tricky to answer at the moment is Rustom just hit on 3 variables that are -- we'll have a better feel for quantifying next quarter than we do right now.

So one being even if things get softer, how does price realization hold up.

Does it hold up as it did in the mid-year?

Two is quantifying the benefits of the supplier actions we're taking, and three is quantifying the benefits of the cost down actions that are underway.

And right now, we don't have those quantified.

We will next quarter.

So without those, it would be an incomplete answer.

Understood, okay.

And then last one for me, just the performance on recent acquisitions.

Just curious, was there any change to the hurdle rates due to results from these deals?

Just wanted an update on -- you've done a bunch of deals over the last couple of years.

Just curious if you can give an update on performance of those.

Yes.

The -- so Patrick, let me just answer the second piece first, which is the hurdle rate is a function of 2 things.

It's a function of what we're seeing on valuations, one.

And two is, look, the company is focused on improving our performance.

And you heard we're internally focused right now.

So those are the 2 drivers behind the higher hurdle rate.

In terms of the acquisitions in flight now, really not much to report.

The only news I would report is that what drove the $0.01 in -- negative in Q3 was really around the AIS acquisition, and that is really focused on automotive.

The business is solid, but we have seen a stark change.

That business is heavily exposed to automotive in the Midwest.

And we saw a stark change in performance driven by automotive.

And that's just the environment as opposed to share loss?

Yes.

We -- I mean, we go -- and particularly, that's an OEM fastener business.

So it's pretty easy to determine share loss or not.

And we go in that business account-by-account.

So the answer is, yes, it's environment.

What is auto as a percentage of AIS?

You know what, I don't have the number handy.

I don't have the number handy.

It's -- one of their primary locations is right in Michigan, which is virtually all auto, but we could get back to you with the number.

The last question today comes from Barry Haimes with Sage Asset Management.

So I had just a quick question on the hunter situation, where you're getting more accounts, but not quite as much volume upfront as you have hoped.

So it sounds like that net is a slight negative.

And I wanted to hopefully get a little color on the extent overall sales were below expectation.

How much was from that factor versus just sales from existing customers?

That's one question.

And then secondly, I was hoping you could talk a little bit about what you see in terms of inventories out there, both your own, but more importantly customer inventories.

Are they in line?

Are they a little bit heavy still from what you hear as you speak with customers?

Yes.

So Barry, what I would say is, for the quarter, the biggest change, if you're reconciling what happened in the third quarter revenues to guidance, I've mentioned earlier, the biggest change is environment.

So the slower revenues coming from the new accounts was a factor.

And I was -- as I told you, I was disappointed it didn't buffer the downturn, but environment was the biggest factor.

And that would -- of course, when the environment softens, what happens is sales from existing customers go down.

That was the primary factor.

Secondary would be materialization of revenues from new account wins.

But I think I picked up in your question you're also checking on the economics of the program in there.

So I just want to cut in and point out that, no, I mean, actually, the initiative is already covering its costs.

The economics are strong.

I mean basically, these accounts, as they do come, they provide significantly more revenue per head than our sales model.

And using all the cost-to-serve insights we've been learning over the past 2 years, we focus on making them profitable as well.

So right now, from a P&L perspective at the bottom line, I mean, there's no net negative coming from that.

There is also the revenue end of it specifically.

And just the inventory question?

Yes.

I would say on inventory, I mean, you see our inventory is coming down a bit.

But more broadly, I think that's reflective of what's happening in the channel, yes, manufacturer, distributor and user.

And I guess not surprising given softening conditions, uncertainty, et cetera, I think what you're seeing from us is reflective of what's happening in the market.

And I think if you spoke to others, you'd find inventory levels coming down.

Any feel for -- is that another quarter, another couple of quarters to rightsize if you look into the overall?

You know what, Barry, I'm not sure.

And I'm not sure because I don't know.

You'd have to tell me what happens in the environment, whether things are kind of at a level now and they stabilize would be one answer.

Whereas if they were to pick up or if they were to fall further, I'd give you a different answer on inventories.

This concludes our question-and-answer session.

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

Thanks, Anita, and thank you, everyone, for joining us today.

Our next earnings date is now set for October 24, 2019, and we look forward to speaking with you over the coming months.

Have a good rest of the day.

This conference has now concluded.

Thank you for attending today's presentation.

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