MSC Industrial Direct Co Inc (MSM) 2019 Q4 法說會逐字稿

Good morning, and welcome to MSC Industrial Supply 2019 Fourth Quarter and Full Year Conference Call.

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

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

Please go ahead.

Thank you, Brandon, and good morning to everyone.

Today I'd like to welcome you to our fiscal 2019 fourth quarter earnings 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 results from acquisitions.

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

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

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

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

In addition, during 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.

Thanks, John, and good morning, everybody.

Thank you for joining us today.

To kick off this morning's call, I'll provide an overview of our fiscal 2019 fourth quarter results.

I'll then discuss the environment and our recent performance before turning it over to Rustom, who will review the details of the fourth quarter and provide our fiscal first quarter guidance for 2020 as well as our fiscal 2020 annual operating margin framework.

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

Our fiscal fourth quarter performance represents solid execution in the decelerating demand environment.

Sales were roughly in line with the midpoint of our guidance, and gross margin was at the top end of the guidance range.

And although reported operating expenses were above anticipated levels, they included costs related to the productivity improvement actions that we took during the quarter.

Excluding these costs, our operating expenses were lower than guidance.

As a result, our adjusted operating margin and adjusted earnings per share came in well ahead of guidance.

Rustom will share more details on all of this in just a couple minutes.

Turning to the environment.

Industrial demand deteriorated as the quarter progressed.

The softness was evidenced in the data points coming from manufacturing output, distributor growth surveys and sentiment indices.

In June and July, readings for the MBI were 51.8 and 47.9, and then August was 48.3.

The September MBI reading came in at 48.6, which takes the rolling 12-month average to 52.5.

And while the rolling 12-month average is still positive, it has been declining steadily, which is indicative of weakening manufacturing and metalworking markets.

We are seeing some customers and suppliers eliminate shifts, and in some pockets restructure, including layoffs.

We are also hearing a shrinking order of backlogs.

In terms of end markets, the weakness in industrial demand is broad-based, with some acute pockets of softness in areas like automotive, heavy truck, oil and gas and agriculture.

Aerospace is one of the few end markets that remains strong.

With regards to the pricing environment, the overhang of uncertainty due to tariffs and decelerating global macroeconomic growth, combined with the price scrutiny that typically comes when customers' businesses slow down, did result in softening.

We implemented our annual summer price increase, and it came in at about 1.5%.

Realization so far has been about as expected and in line with recent history.

Now taking a look at our performance.

Core customers and National Accounts grew in the low single digits, and both slowed through the quarter.

Government sales growth levels improved slightly from the third quarter as anticipated, but still declined in the low double digits, weighing down our overall growth rate.

The continuing government headwind peaked in our fiscal third quarter and should continue to abate during the first half of our fiscal 2020 as we fully lap the previously discussed 2 contract losses by our fiscal third quarter.

As you'll hear from Rustom when he discusses his -- the first quarter fiscal guidance, we saw continued deceleration in September and October, with our overall growth rate turning negative.

National Accounts remains in positive growth territory, while government is essentially unchanged from the negative growth levels seen in the fourth quarter.

The biggest change has, not surprisingly, been in our core customers, which are most heavily geared towards the metalworking markets that are acutely soft.

You'll recall from our last call that we implemented an action plan designed to improve performance in 3 areas: one, field sales execution, particularly around new business implementation; two, profitability of our supplier programs; and three, expense reduction and productivity.

I'll now provide some color on each of the 3. As I shared with you last quarter, we were not executing well enough in implementing new business wins and translating those wins into revenues.

We have successfully addressed the bottlenecks, and the sales from new business wins should ramp over the coming quarters.

Meanwhile, our funnel and new business wins continue to build momentum.

Given the early success we are seeing, this will be an area of investment in fiscal 2020 as we expand the size of the business development team.

Beyond new business, our new Head of Sales, Eddie Martin, has rounded out his leadership team with new leaders for government, National Accounts and sales operations.

He is ramping up the intensity and focus on performance management through all levels of the sales team, and he's making necessary cuts in certain areas and investing in others, such as business development, CCSG and inventory management, meaning vending and VMI.

The second part of our action plan was to improve the profitability of our supplier programs.

We've seen a good response from our supplier community in the form of increased investment into MSC.

We expect to realize roughly $20 million in profit improvement on an annualized basis.

The resulting gross margin improvements will come in the back half of fiscal 2020 and in fiscal 2021.

This is due to a combination of our average inventory costing method and the timing of our rebate programs.

Our focus now turns to delivering market share growth for the supplier partners that have invested in the program.

The third part of our action plan was to reduce operating expenses and improve productivity.

You'll notice in the operating statistics on the website a drop in headcount over the last quarter.

This was the result of 3 actions that we took during the month of August.

First, we ran a voluntary program in our distribution centers, giving associates with significant tenure an opportunity to retire.

Second, we ratcheted up performance management intensity considerably.

And third, we selectively eliminated positions where our focus is changing.

While most of these actions were completed during the first quarter -- the fourth quarter, excuse me, we are continuing the program into the first quarter as well.

Moving forward, we expect headcount to come down again in our fiscal first quarter.

And for the balance of the year, we anticipate select hiring in certain growth areas and to replace a portion of the Q4 reductions.

We will, however, maintain our intense focus on performance management.

We will also continue to reshape and rightsize the business, particularly if the environment deteriorates further.

I'll now turn things over to Rustom, who'll provide further financial details, and then I'll come back with some concluding remarks.

Thank you, Erik.

Good morning, everyone.

Before getting into the financial details, let me remind you that we provided Q4 guidance for both total company and our base business, that is our total company, excluding the AIS acquisition and our new Mexican business.

Additionally, in our fiscal fourth quarter, we incurred $6.7 million of severance and separation expenses related to our OpEx reduction and performance improvement initiatives.

As such, I'll speak first in terms of our reported results and then in terms of our adjusted results, which reflect the exclusion of these costs only.

Our fourth quarter average -- total average daily sales was $13.4 million, an increase of 2.1% versus the same quarter last year and a roughly in line with the 2.2% midpoint of our guidance range.

MSC Mexico contributed just over half of that growth.

Our Q4 reported gross margin was 42%, at the high end of our guidance range and down roughly 90 basis points from last year.

Versus last year, Mexico accounted for roughly 25 basis points of the decline and the remaining 65, roughly 65 basis points came from mix and negative price cost.

Total reported operating expenses in Q4 were $263.1 million, which resulted in a reported operating margin of 10.7%.

Our tax rate for the fourth quarter was 23.1%, approximately 100 basis points below guidance, due mostly to favorable resolutions of state tax audits.

Our effective tax rate was also lower than last year primarily due to the Tax Cuts and Jobs Act.

All of this resulted in reported earnings per share of $1.20.

Now let me move to the adjusted results.

Excluding the $6.7 million of severance and separation charges incurred in Q4, adjusted operating expenses were $256.4 million, approximately $1.4 million or 20 basis points as a percentage of sales lower than the midpoint of our guidance.

This was due mostly to a lower incentive accrual and to ongoing controls on discretionary spending.

Total headcount declined by 135 in Q4, with the bulk of this due to our cost reduction and performance improvement actions.

Now they occurred mostly in mid- to late August, so there were minimal Q4 savings.

All of the headcount reduction occurred in the distribution and support functions.

Field sales and service headcount was sequentially flat during the quarter.

Versus last year, our adjusted OpEx was up $4 million, with half of this coming -- half of this increase coming from the addition of the Mexican business and the remainder due to annual salary increases and slightly higher year-over-year headcount.

Our fiscal fourth quarter adjusted operating margin was 11.5%, 30 basis points above the midpoint of guidance.

Gross margin, higher than the midpoint of guidance and adjusted OpEx, lower than the midpoint, both contributed roughly equally.

Adjusted operating margin was down roughly 140 basis points from the prior year with lower gross margin as the main driver.

On an adjusted basis, EPS for our fiscal fourth quarter was $1.30, $0.06 above the midpoint of guidance, with the lower tax rate accounting for about $0.02.

Last year's reported EPS was $1.29, with an effective tax rate of 29.6%.

Turning to the balance sheet.

It remains very healthy.

Our DSO was 57 days, up 1 day from fiscal 2018's Q4 with higher relative growth in National Accounts continuing to be the main driver.

Our inventory decreased slightly by $2 million during the quarter to $559 million.

Total company inventory turns remained at 3.5x, that's unchanged from Q3 but slightly lower than last year's 3.7x.

Net cash provided by operating activities in Q4 was $141 million versus $109 million last year.

Our capital expenditures in the fourth quarter were $16 million versus last year's $14 million.

And after subtracting capital expenditures from net cash provided by operating activities, our free cash flow was $125 million as compared to $95 million in last year's Q4.

This brings our total free cash flow for the year to $277 million.

We paid out $41 million in ordinary dividends during the quarter, reflecting our increased dividend of $0.75 per share.

In last year's Q4, we paid out $33 million in dividends and bought back 57 million in shares.

During fiscal 2019, we increased our dividends paid out by $20 million to $146 million, spent a net $64 million buying back shares and reduced our leverage slightly.

If the economy remains weak or deteriorates further, our fiscal 2020 free cash flow is likely to rise, as we historically produce stronger free cash flow during periods of weak industrial demand as net working capital typically declines.

Our total debt at the end of the fourth quarter was $442 million, comprising of $175 million balance on our credit facilities and other short-term notes, and $265 million of long-term fixed rate borrowing.

Our cash balance was $32 million, so net debt was $410 million at the end of the quarter.

Our leverage ratio decreased to 0.9x as compared to 1.0x at the end of Q3 and last year's Q4.

Now let's move to guidance for the first quarter of fiscal '20, which you can see on Slide 5. This includes the Mexican business.

We do, however, provide guidance with and without approximately $2.3 million of expected severance and separation expenses.

Our total OpEx is expected to be approximately $256 million, including these expenses, with operating margins of 10.7% and EPS of $1.15 at the midpoint.

My following remarks will focus on our guidance, excluding severance and separation expenses.

We expect Q1 ADS to come within the range of minus 2.5% to minus 0.5% versus the prior year period.

You can see this on -- you can on the op stats on our website that September's total ADS growth was minus 0.6%, and October is estimated at minus 1.2%.

So implicit in the midpoint of the guidance is the assumption that November will take a further step down to around negative 3%.

Our Q1 gross margin is expected to be flat sequentially with Q4 at 42.0%, plus or minus 20 basis points.

This is down 100 basis points year-over-year due to purchase cost escalation, mix headwind and a 20 basis point impact from Mexico.

Q1 operating expenses, excluding severance and separation costs, are expected to be around $254 million.

That's down approximately $1 million from last year's first quarter and down about $2 million sequentially from Q4's adjusted OpEx.

Based on our expected sales levels, we would expect OpEx to be down roughly $2 million in Q1 from lower volume variable expenses.

We anticipate that a higher bonus accrual, wage inflation and investments will be offset by our Q4 cost reduction actions, stepped-up indirect procurement savings and continued cost discipline.

We expect the first quarter's operating margin, excluding additional severance and separation costs, to be approximately 11% at the midpoint of guidance, 140 basis point year-over-year decline.

The drivers of this decline are the roughly 100 basis points of lower gross margin, and the remainder is due to the impact of lower sales on our OpEx leverage.

Turning to the estimated tax rate for the first quarter, it's expected to be 25.1%, in line with Q1 2019.

So our Q1 EPS guidance range, excluding additional severance and separation costs, is $1.15 to $1.21 with a midpoint of $1.18.

Our guidance assumes a weighted average diluted share count of roughly 55.4 million shares.

Now let us move into our fiscal 2020 annual operating margin framework.

As a reminder, this annual framework is intended to help you understand how our business is likely to perform over the course of the fiscal year under various scenarios and not for individual quarters.

Like last year, we are providing potential annual growth rate scenarios on a horizontal axis and annual gross margin scenarios on the vertical axis.

This is the 2 by 2 metrics that you see on Slide 6. With respect to revenue growth, we have 2 scenarios: slightly positive and slightly negative.

The contraction scenario is minus 4% to 0% ADS growth, and the slightly positive scenario has an ADS range of 0% to 4%.

Moving on to gross margin.

42.0% is the midpoint, which reflects our Q4 actual run rate.

The gross margin contraction scenario has a 41.2% to 42.0% range, while the top half gross margin expansion scenario has a 42.0% to 42.8% range.

Note that the top half of the metrics could still imply year-over-year gross margin contraction as fiscal 2019's full year gross margin was 42.6%.

Let me offer a bit more perspective on gross margin.

Right now, we're experiencing sizable year-over-year gross margin compression.

This is because we are price cost negative as we typically are in the late stages of the inflation cycle and because we are experiencing a roughly 40 to 50 basis points mix headwind.

However, as the fiscal year moves along, we expect purchase cost escalation to abate, and gross margin should also benefit from our supply initiatives, which will be -- which should also be back-end loaded.

As a result, absent any meaningful change to the environment, the gross margin gap year-over-year should improve in the back half of our fiscal year.

Returning to the framework.

In 3 of the 4 quadrants, operating margins contract over fiscal 2019's adjusted operating margin.

Operating margin is close to or equal -- or close or equal to fiscal 2019's adjusted operating margin of 12.1%, only in the upper right-hand quadrant.

That scenario would occur if gross margins are above Q4's 42.0% level and sales grow low to mid-single digits.

At the middle of our framework, with the flat revenues, we will anticipate operating margins being about 11.3%.

Given the 42.0% gross margin, this implies an OpEx increase of 0% to 1% versus the prior year.

We expected our productivity measures, which include roughly $6 million of net savings from our Q4 headcount reduction and a similar amount in direct cost savings, would largely offset salary and wage inflation, higher depreciation, amortization and our growth investments.

And all of this reflects actions taken or in process as of today and does not include any additional actions we may take going forward.

I'll now turn back to Erik.

Thank you, Rustom.

Against the backdrop of deteriorating conditions in the industrial demand environment, we have taken initial actions to reshape and resize the organization.

You're now seeing early results.

Moving forward, we will continue to focus on streamlining our cost structure and transforming our operating model to be leaner, more agile and more effective.

We've also made good progress in addressing the issues related to the conversion of new business into revenue.

Work remains to be done, including making investments into programs such as business development.

This should also improve our market share gains moving forward.

In times when industrial demand deteriorates, the local and regional distributors that make up the majority of our market pull back on inventory, credit, people and more.

This creates an opportunity for us to capture market share, while forging new relationships and implementing new supplier programs such as the ones that we initiated recently.

Should industrial demand conditions remain at the levels that we're seeing right now or even deteriorate further, I expect MSC to be well positioned to benefit just as we have in the past.

The recent progress on our sales initiative as well as the actions that you've seen in terms of productivity are the beginning and not the end of our journey towards fulfilling our mission to be the best industrial distributor in the world.

We'll now open up the line for questions.

(Operator Instructions) Our first question comes from Adam Uhlman with Cleveland Research.

I was wondering if we could start with the supplier savings that you're targeting with the program, the $20 million.

I'm wondering what you have to deliver on to be able to earn those funds.

I'm sure there's top line growth, and new account wins are associated with that.

But I was wondering if you could maybe put some more meat on the bone.

And does that expand, it obviously does, beyond the framework that you've provided this year?

Kind of what kind of commitments have you laid out?

Yes, so Adam, I'll take it.

Regarding the supplier initiatives, what I would emphasize is that, and as you can imagine, the characteristics of the programs span a wide range of scenarios depending upon the supplier, the product line and the circumstance.

The spirit behind them, and I think the common theme was around win-win, meaning that if there's investment coming from the supplier, it's in exchange for a return of focus, share capture investment from MSC.

Now the number that we're giving you is a number -- look, that that's a number we feel comfortable we're going to deliver on.

So certainly some of that profit improvement would be in the form of guarantees, some would be contingent on certain actions.

But that's a number that we feel confident in.

In terms of the framework, and I think this is an important thing to emphasize that Rustom and I hit on briefly, is timing.

So that number is factored into the framework.

But the reality is that the majority of that savings due to timing are going to be achieved toward the end of fiscal '20 into fiscal '21.

So that is a number that is an annualized number that we reach full run rate in '21, not in '20.

And the reason is really twofold.

One is timing of our average costing system as changes to our deal work their way through our P&L; and the second is the timing of our rebate programs.

Many of these programs are done on a calendar year, a calendar year '20 rebate, and so it doesn't quite sync up with our fiscal.

So you'll see benefit towards late -- the latter quarters of fiscal '20 and then into 2021.

Okay.

Got you.

And then somewhat related to that, I was wondering if you could just share an update on your new customer win progress and anything that you could share along the lines of active customer count or national account wins, or any feeling of how the traction is building there?

Yes, Adam.

So look, this was a key focus of last time, obviously.

And then just to refresh everyone, what we talked about is part of the sales transformation that had been done was a built-out focus on new business wins with a hunter or business development function.

And what we've been seeing is good traction from that group in terms of not only a funnel building but conversion to wins.

And what we called out in the last quarter is that the wins have come in at or above expectation, we were too slow to turn those wins, move them through the implementation cycle and start getting revenue.

So as I described in the last call, we put a full court press on it.

I think there's been progress.

And really, the way we manage this process, we use a CRM, and we can track essentially each account at every single stage all the way from opportunity through revenue realization.

What we saw last quarter was too many accounts stuck in the same stage for too long.

We relieved those bottlenecks and what we're now seeing is the accounts appropriately moving through the stages of implementation to revenue conversion.

Now what I'll say, Adam, is it takes time.

So we have targets on full annualized run rate per account.

It takes time to ramp to that, even when we get through implementation.

So we are starting to see revenue traction on those.

Obviously, masked by what's going on in the macro, but that will continue to build over the next quarters.

We have not come close to full revenue realization.

Our next question comes from John Inch with Gordon Haskett.

It's Karen Lau dialing in for John.

So I guess first on the cost savings actions, apologize if I missed it, but did you quantify how much savings you're going to generate for this year?

And I'm looking at you guys spending maybe $9 million to $10 million of charges between these quarters.

Are you expecting sort of a 1 year payback on those costs?

So Karen, let me answer that.

I'll clarify the numbers.

So yes, the $6.7 million is in Q4, and the savings of all of that are what are baked into Q1 and into the framework right now, right.

So what we have is we expect net savings in Q1 to be up from the Q4 actions to be roughly around $2 million and roughly around $6 million for the full year, and the net savings.

So absolutely, it's a payback within the 1 year.

And note that our gross savings are significantly higher, but we'll also be replacing roughly half of the reductions over the course of the year.

So...

Okay.

It doesn't -- I mean I'm just looking at the operating framework.

It doesn't appear that the -- it doesn't appear from the operating framework that a lot of the -- you're seeing much uplift from -- in the operating margins from these savings.

I guess to your point in the first quarter, a lot of that savings get offset by just regular cost increase in other areas.

Is that sort of the expectation for the year that most of these savings will get offset by hiring back people and just ongoing -- just higher sales count year-over-year, things like that?

Yes.

We are continuing to invest appropriately, right.

Erik mentioned business development when he was talking earlier.

I mean we also have some selective field sales and service headcount in the increases planned as we expect to get more benefits coming out of this.

But look, in Q1, I went through the Q1 numbers, right.

So in Q1, what we've got is we've got these savings coming through, which we should have lower volume-related expenses, and that we also have higher bonuses coming because we are accruing more in line with budgets, obviously, as you kick off the year.

We've got higher bonuses.

We've got the wage inflation from before.

We've got some additional depreciation, amortization costs.

All that's baked into our numbers.

But let me come to your -- to the framework, and I'll take that answer to framework for a second.

If you think about the midpoint of our framework of what we've got out there, that's basically about 11.3%, if you look at the sizes that's out there and just go into midpoint, 11.3%.

And if you take our 12.1% number that we end up this year at, take out about 10 basis points for Mexico, right, coming out of the number, and about 60 basis points of gross margin.

I mean that takes us very close to where we are.

And then the 3 -- and slightly higher, that's slightly higher, but very close to where we are in OpEx.

Does that help?

Yes.

Yes.

Appreciate the color.

And I guess on gross margins, you make the point that the savings from this moderating inventory inflation and also the supplier initiative, that is more back-end loaded.

I mean historically, I guess in an inflationary environment, your gross margin typically goes down sequentially throughout the year.

Given that dynamic this year, do you expect that you'll be able to hold gross margin steady throughout the year or even maybe improve it a little in the back half even the rebates and so forth?

Or do you -- given the weak environment, you have to give back some of these savings to -- in terms of more attractive pricing to customers to kind of boost volume?

How are you thinking about that?

So complex questions.

So I'll handle a little part of it, and then Erik can even chip in and do more.

The -- so yes, first of all, yes, I mean the Supplier Summit initiatives that we are talking about to benefit later, because here, most supplier rebate programs are calendar year programs.

Given the -- given our inventory terms, the benefits of these new deals will mostly materialize in our P&L, I mean from Q4 really, as it comes in and continue well into '21, right, I mean that's what you see there.

The only other factor to remember, and I think mentioned it, but the only other factor to remember is that we also have the price cost escalation that's flowing through.

It's beginning to abate, and it will be abating more as you get into the second half of the year.

Karen, just the way -- and I think Rustom answered it perfectly.

The only thing I'd say is you are right you point out that if you looked at our historic pattern without significant inflation, you are correct.

And generally Q4, by the time you get to Q4, it drifts down versus Q1.

And look, hard to give guidance out that far, right, I mean hard to know exactly what happens.

But absent the change, Rustom describes it well.

There's 2 dynamics this year that are a bit different from a typical year; one being the fact that purchase costs abate and then add onto that the back-end loaded supplier benefits that we see coming.

So I think he answered it well.

Okay.

So it's fair to say that the gross margin trend could be more stable versus what you -- what we had witnessed maybe in the past 2 years?

Well, we provided a range.

I mean the framework's a range.

We use 42% as the midpoint, and then we've got the range going in there.

Our next question comes from Stephen Volkmann with Jefferies.

So anyway, can we pull on the string just a little bit more specifically on price cost?

What are you thinking for that in 2020?

So look, Stephen, what I would say is let me start -- and I'll answer your question.

Let me start high level and drill.

And I think what we would see is over a cycle, okay, over an inflation cycle, what we've seen, if you take the last few years, price cost has been roughly flat.

We are now late stage, and we have been for the last couple of quarters, and we've been pointing out price cost turned negative.

We are price cost negative now.

If you look over time, and I'll sort of lay out a gross margin formula for you, with price cost about a wash, what we have been seeing is somewhere in the neighborhood of 40 to 50 basis points of gross margin erosion due to mix, a mix headwind, okay.

So right there, 40 to 50 basis points.

If price costs were equal, we would therefore obviously be looking at a 40 to 50 basis point year-on-year gross margin erosion.

When price cost is positive, that gets better.

Reference FY '18, when price cost is negative, that gets worse.

Look at the tail end of FY '19 and look at right now.

So net-net, as Rustom said, we can't give you a precise number for 2020.

But if you take the middle of our framework at 42.0%, what that says is for the year, price cost would be slightly negative.

But with the bud that Rustom talked about earlier, it's going to be much more heavily negative in the first half, and it's going to look a lot better towards the end of the fiscal year for the reasons we described.

Okay.

Great.

That's helpful.

And then just as we think about the top line, you sort of have the 0% midpoint on your framework.

But I guess I would assume that based on some of the new contract wins, et cetera, you'd outperform the market.

So is it accurate to say that the midpoint of your guidance sort of looks at market growth being negative?

And kind of how much outgrowth do you think you could get a relative to end markets?

Yes, Stephen.

So look, what I would say, as we look at our performance right now, what I would tell you in terms of outperformance relative to market, what we've been saying for the last couple of quarters is we're around in line with market.

And that's due to a bunch of the factors that we've talked about, including some of the disruption from the changes we've made, from the couple of government contract losses that you referenced, roughly in line.

I don't think much has changed this quarter.

Certainly, what you're seeing is the deterioration in the growth rate that is reflective of what's happening in heavy manufacturing and metalworking.

Those have definitely turned sharply down, and I think we're feeling the effects.

What we're seeing in terms of the framework for now, it's basically assuming business as usual.

Now you are right.

As we look out, I certainly expect us over time here to reestablish our share gain gap to market, our growth gap to market, which historically, we've talked about as being the 300 to 400 basis point range.

And yes, you're hitting on one of the levers or you hit on a couple of the levers that we're focused on.

And really there's 3, one is business development.

We like what we see.

We like the wins.

And we are not only going to continue focusing on implementation of existing wins, we're ramping up the team to accelerate the wins.

Two, with government and turning that program around and hopefully once again making that a tailwind.

I think we're making some nice changes to the program which should materialize.

And then the third is, just some of the refinements that I described that Eddie and team are making to the plan.

It was a sound plan, but it's being refined.

Over time, we expect that gap to grow.

Now what I can't determine is what happens to the environment, certainly.

But as we move forward, I absolutely would expect the growth gap to restore over time.

Great.

Great.

That's helpful.

And then maybe just a real quick one for Rustom.

If we do have sort of a flattish year in 2020, what does that do, do you think, to working capital?

You mentioned potentially some opportunity there.

Yes.

We'll -- so typically, when this -- in this business, when the economy is weak, I mean working capital reduces, and you'll see some cash coming back.

So our free cash flow will go up.

Our next question comes from David Manthey with Baird.

So just mathematically, the $20 million in incentives on the gross margin line, it's about 50 to 60 basis points annually.

And I guess you're saying you should get some fraction of that, maybe half in fiscal 2020.

So just if I'm reading this right, at the 42.0% midpoint, are you assuming that the core sort of declines 25 to 30 basis points, and then you make up that difference with these supplier incentives?

So Dave, yes.

I mean look, we have a secular -- the usual secular mix headwind that comes as we grow more from parts of the business that have lower gross margins.

I mean we expect that to continue.

So this should help when you look to the number.

But also remember, I mean the 42.0% is going off the fourth quarter, the fourth quarter of fiscal '19.

And Dave, if you wanted to do some math, I mean I think where you're going is right, which is take a look at the last quarter or 2 and the Q1 guide.

We're looking at something like 100 basis points year-on-year gross margin change.

The midpoint of the framework would imply 60 basis points.

So obviously, what that would mean is towards the end of the year, it gets better.

And you are correct.

It's actually a little bit less than half of the total 20 million would be seen in this fiscal.

And we would reach the full run rate and the basis point impact you described in 2021.

Got it.

Okay.

And second, as far as your e-commerce disclosure, it seems that you mix in there both traditional direct marketing business along with elements of your high-touch model like VMI and vending.

Is there any way you can tell us in the quarter what percentage of sales were just mscdirect.com so we can kind of parse out the percentage that's resulting from your efforts as a mission-critical partner on the shop floor?

Dave, it's a good point.

What I would tell you is -- and I don't have the numbers handy.

We -- of that number, it's a little over 50% has been from mscdirect.com.

And that's not radically different than if you look back over the last year or so.

And that would be the traditional web business.

If where you're going is -- you're correct.

So that number has that mscdirect.com, it also has vending and e-procurement type business.

I don't have the number handy.

What I would point, just one data point that we didn't mention in the prepared remarks is vending.

So I don't have the percentage of business flowing through vending.

We are seeing good traction on vending.

And we've talked about this year's signings being up.

Signings for the quarter, year-on-year, so for Q4, were up, I want to say it was over 80% year-on-year.

So in terms of where you're going of movement to the new strategy, with some of these changes we made, we are seeing traction with vending inventory management getting closer to the plant floor.

Our next question comes from Robert Barry with Buckingham Research.

Just to connect the dots on the gross margin.

I'm not sure if you said how much Mexico is, I think that's maybe 5 or 10.

But it sounds like if price cost is, say, 20 or 30; and sources of growth 50, offset by about 25 of benefit from the supplier incentives, I think that adds up to about 55 or 60.

Are those kind of the main moving pieces?

Rob, are you talking Q1 or the year?

For the year, I'm sorry.

They're down 60.

I'm trying to get to the components of the down 60.

Yes.

So, I mean...

I think they filtered out through the call.

I was just kind of lifting them, Mexico, price cost, sources of growth and the supplier incentives.

Right.

So you've got Mexico is about 20 basis points coming from there, right.

You got -- over time, you've got the supply incentives which you talked about, which are -- remember that we talked about the 60 basis points or so.

And even if you consider that half-half, okay, it's roughly in that ballpark.

Today you've got about 30 basis points or so positive coming in that direction.

You have the secular sort of headwind as well that I talked about, 40 -- and that Erik about, actually, 40 basis points that come through from that.

And the rest is price cost.

I mean it's (inaudible).

Yes, that would be about 25.

Great.

Okay, perfect.

And then just to clarify from an earlier question, I think.

Is the delta between the down 4% and the up 4% on the growth all about just what the end markets do?

It sounded like you assumed no outgrowth.

There could be some, but it sounds like you didn't assume any in the framework.

Is that correct?

Yes.

Rob, look, I mean really what we did here, what we try to do with -- you're right.

So from minus 4% to plus 4% is a pretty wide swing.

But essentially, what we're trying to get at is those are reflective of economic scenarios environments.

And we refer to them as a slightly positive scenario and a slightly negative scenario.

Obviously, at the moment, given our Q1 guide, we'd be sitting in the slightly negative scenario for the quarter, who knows what happens for the year.

Yes.

Look, I think should we really start to outperform and reestablish a gap?

Yes, that would certainly move us up regardless of environment.

But what we were reflecting there was more about environment.

Got it.

And just based on the historic correlation with the MBI, would you expect that the business would probably continue to decelerate into 2Q?

So tough to tell.

It'll -- this is going to sound kind of silly, Rob, but a lot of it'll depend on what -- look, there's so much uncertainty right now, Rob.

Certainly, what I'll do is speak to what we have in Q1.

You could see that our guide of -- at the midpoint of our guide was minus 1.5%.

If you look at September and October, Rustom did the math for you.

We are expecting a little more of a step-down in November, and that's based on what we're seeing in the business, what we're seeing in the environment.

To go beyond that is so tricky because, look, there's so much swirling now.

There's so much uncertainty over trade and tariff.

Things change quickly in this business, and we tend to be a leading indicator, not a trailing indicator.

So tough to call it beyond that.

Got it.

Got it.

Just lastly, for me, I think the growth investment in the first 3 quarters was tracking at a sum of about $15 million.

I didn't hear any in 4Q, so maybe that was like 1 or 0. But would you expect the growth investment in the 2020 P&L to be kind of a decline from that $15 million, $16 million?

Or kind of level or higher?

So look, it's a combination of factors, and hard to give full guidance this early, right.

Because we are going to look at the performance as we say the new business people coming in, the performance, the environment, all the rest of that.

But part of what we are doing as well is even the effort, the $2.3 million we mentioned in Q1, the efforts we've got underway right now as we're taking -- as we are moving away -- eliminating positions that aren't required in the business, we're also redeploying the money into areas where there's business development, field sales, service, all the rest of it, areas that we think will generate growth.

And Rob, just to put some more color.

Rustom gave you a sense, right, and I think he's right.

A lot of this is going to depend on we flex up, flex down based on 2 factors: one, the performance we're seeing out of the investments; and two, the environment.

That's what he's saying.

The -- just a little more color.

I think in terms of where the investments are going by and large similar to what we've been doing, which is focused on inventory management, i.e.

vending and VMI, business development, we like what we see there, it's going to be expanding.

We like what we see from vending.

I mentioned that the growth rates in vending are up, signings are way up.

And then with 1 or 2 new things sprinkled in, based upon a fresh look from Eddie.

I mentioned CCSG as an example of where we're seeing some nice traction, and they're going to continue building on it.

So similar program with 1 or 2 new twists based on a fresh look.

Our next question come from Michael McGinn with Wells Fargo.

I just want to go back to the free cash flow comments.

If I look historically, your free cash flow conversion has been over 150 -- averaged about 150% in a down environment.

Just the vending signings are going to be positive this year.

I just want to make sure I'm not missing anything on the CapEx side.

Or -- and then what are your priorities for that cash flow going forward?

So CapEx, $60 million to $70 million.

You're correct as you go back to math.

I mean if you look at '16, if you're going -- it's going back a few years, but that was a down environment.

Free cash flow was $313 million that year.

I'm not saying that, that's guidance by then, I'm just providing color behind what we say when there are net working capital and free cash flow in down environments.

What we do with the cash, I mean we continue to invest.

I mean priority 1a is to invest as much as we can in the business; 1b is to enhance dividends, I mean ordinary dividends.

We've had a 19% dividend per share increase this year.

So it's a steady ordinary dividend growth.

And then after that, with the money that's left behind, I mean there's lots of stuff.

We can have buybacks, we can have special dividends.

We can just keep the cash.

I mean it's -- in a tough environment like there is today, there's an advantage to having a strong balance sheet with lots of cash and lots of firepower.

Okay.

And if I could just touch -- move to the end markets real quick.

Going back a way, as you acquired a business called J&L.

I believe that business had some auto exposure.

Just wanted to check in, see if you have anything on the GM front with that strike going on?

Or any impact to your business that you could kind of break out?

Yes, Michael, look, what I would say is definitely, that move, the J&L move enhanced our Midwest presence considerably.

I mean if you look at the end -- I mean the answer is yes, we're feeling it.

Even though -- we always talk about the fact, our direct exposure to some of these big end markets like automotive is low.

What's really big and is hard to get precision on is the indirect effect.

Meaning a lot of the machine shops, job shops that we service, service that industry.

If you look in the op stats, you'll notice in Q4, while total company revenues were positive, Midwest was actually negative already in Q4.

And you got 2 things going on there that we saw acutely: one being automotive for sure; and the second being ag, which another acquisition -- our DECO acquisition, increased our ag exposure being based in Iowa.

Both of those not surprisingly contributed to what we saw in the Midwest.

Right.

Right.

And then if I could just sneak one more in here.

For the second half of this year, can you kind of -- I'm sorry if I missed this, can you bucket basically the level of upside you're expecting between the rebate initiative versus the inventory costing initiative?

What -- which is more impactful for the second half of this year?

Yes.

We did not -- we sort of lumped them together.

And Mike, as you could imagine, there's some sensitivity around -- we're talking about programs with specific suppliers.

So what we're doing is we're bucketing them for purposes of what we're conveying here.

And look, the punchline is, of the $20 million, that is an annualized number full effect in 2021.

Under half, slightly less than half in 2020.

Of that, it's made up of both.

Some will come through at average costing, and a good chunk will come in rebate, most of that coming in our Q4.

Our next question comes from Patrick Baumann with JP Morgan.

Just had a -- maybe first, just circling back on operating expenses.

I was looking at the first quarter guidance and thinking it would -- maybe implied 2020 would be down like low single-digit percent year-over-year for that $1 billion bucket of operating expenses.

But it seems like you're saying flat to up.

So I just want to clarify kind of from the low to the high end of the framework, how to think about that $1 billion bucket of operating expenses year-over-year versus 2019?

So yes, so in a flat -- and yes, you nailed it, actually.

In a flat environment, on the framework, we would be up about 0% to 1%, we're saying.

So I mean you call it as 0 to $10 million ballpark, right, on the number.

And that is quite simply the function of everything we did.

We have $6 million of savings coming out of net savings, coming out of the Q4 stuff.

We have that amount and roughly a little bit more coming out from the indirect procurement.

We've got a whole bunch of other initiatives, pluses and minuses there and investments going on.

So the net number with the -- also by the way, we have higher wages.

This is still a reasonably tight employment economy as well, too.

So we do have wage and salary inflation as well baked into our numbers.

So the net number coming out of all of that is exactly where you were, up slightly.

Patrick, the only thing -- not much to add, comprehensive look, and I think that's probably the right way to index it is the way Rustom did, at a flat economy because it takes out variable.

The only other thing I'd say is, look, there's some discretion here, depending upon what happens with the economy.

Rustom, I think mentioned it in his prepared remarks.

The framework was all based on actions we've taken to date.

If things were to deteriorate further, look, you'd see us adjust and adjust quickly.

So there's some room there.

And what he's doing is indexing for you, saying flat to flat is kind of the easiest way to benchmark it.

But we would take other actions if things got worse.

Got it.

And then maybe along those lines, just thinking more medium term, like, how do you guys, at this point, think about the incremental margin framework if the macro environment is kind of more normal, maybe -- assuming you guys grow low to mid-single digits organically, or wherever you guys think about it, just curious if you could update on the framework for incremental margins in your mind.

Yes.

Sure, Patrick.

So let me start, and I'll sort of walk you down.

And we put a little color already on how to think about gross margin, that over an economic cycle, price cost likely to be flat, roughly flat, call it.

And again, that means that early in a cycle, i.e.

'18 price cost is going to be positive.

Late in the cycle, like we're seeing right now, price cost is negative.

Over time, roughly flat.

And then we are left with the mix pressures that we've talked about in the business of somewhere 40 to 50 basis points.

Looking at the revenue line, we would expect to deliver -- again, over a full economic cycle here, at least mid-single digit revenue growth.

Hopefully better, but at least mid-single digit revenue growth.

At those levels, we see ourselves generating -- we should generate at least 40 to 50 basis points of operating leverage.

Potentially more, but at least 40 to 50, therefore offsetting gross margin degradation.

And then you add on top of that, I think there's 2 ways where that brings you, obviously, is op margin is flat.

How do op margins grow, and how do we get incrementals above current levels?

Really 2 ways: one is revenue growth back to historic levels of high single digit, where we would see more leverage.

And the second thing is improvements we're making to the business, to the operating model and the cost structure which have begun now certainly would then create a path to layer on top of that and create op margin expansion.

Got it.

Okay.

So base case, you hold margins in kind of a mid-single digit growth environment.

Upside case should be maybe 15% to 20% incrementals?

Is that another way to think about it?

Look, I would say in the base -- as we see it, if I look out over, call it the next 5 years, I would say in the base case are some of the improvements to cost structure and operating model that would enhance that.

So look, do we get the 20% plus?

To me, it's one step at a time, like, let's get this back on track.

But that -- I would say that the things that we're talking about would be part of the base case.

Got it.

Helpful color.

And then maybe last one for me quickly.

Just you said you're assuming a further step-down in sales in November.

Just I guess my question is what's your visibility to that?

Or are you just being conservative?

It's -- so I'll take it.

Patrick, I would say visibility as usual, low.

And if anything really low right now, given all the uncertainty, it is so hard to say.

Hard to say whether we're being conservative or not.

Basically, what we're doing is we're looking at the trending in the business.

So look, you've seen a step-down.

From Q4, we were positive; September, we were 0.5%, it was 0.6%; October got a little worse.

And then you add on top of that what we're seeing from our suppliers, what we're hearing in the channel.

Our suppliers, not only their numbers, what they're seeing in their channels, what we're seeing in the MBI and discussions that we have, yes.

As always, this is sort of best guess based upon all those factors.

And right now, that's what we see.

Hard to go out to past November, to be honest.

Our last question comes from Justin Bergner with G. Research.

I just want to review the mix headwinds.

I realized they sort of just get mentioned pretty quickly in conversations.

But could you just review what are the drivers of those mix -- of that 40 to 50 basis point mix headwind?

And what would cause that to get smaller or larger?

Very quickly, the secular mix headwind is as we do more vending, as we do direct ships and as we do more National Accounts.

All areas that have grown in the last 2 years, there's a secular sort of headwind, quite agnostic from what's happening with price costs, I mean, and that impacts GM.

Okay.

And that headwind has sort of remained at that level pretty consistently.

It hasn't fluctuated too much higher or too much lower in any given year?

One thing I'll say, Justin, it moves around.

I mean so we're -- look, we're giving you 40 to 50 depending upon -- because it's a mix headwind, it's a lot function of exactly how fast the different channels, the different customer types and product types grow at.

What we're giving you is an estimate.

Could it be more or less?

Absolutely, but that's kind of the rough range.

This concludes our question-and-answer session.

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

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

Our next earnings date is set for January 8, 2020, and we certainly look forward to speaking with you over the coming months.

The conference has now concluded.

Thank you for attending today's presentation.

You may now disconnect.