MSC Industrial Direct Co Inc

NYSE:MSM

Earnings Call Transcript 2018-Q3

[Operator]

Good morning and welcome to the MSC Industrial Supply 2018 Third Quarter Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [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, Mr. Chironna, go ahead.

[John Chironna, VP, IR and Treasurer]

Thank you, Anita, and good morning to everyone. I’d like to welcome you to our fiscal 2018 third quarter conference call. In the room with me are Erik Gershwind, our Chief Executive Officer; and Rustom Jilla, our Chief Financial Officer. During today’s call, we will refer to various financial and management data in the presentation slides that accompany our comments, as well as our operational statistics, both of which can be found on the Investor Relations section of our website.

Let me reference our Safe Harbor statement under the Private Securities Litigation Reform Act of 1995. Our comments on this call as well as the supplemental information we are providing on the website contain forward-looking statements within the meaning of the U.S. securities laws, including guidance about expected future results, expectations regarding our ability to gain market share and expected benefits from our investment 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 section 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.

[Erik Gershwind, CEO]

Thanks, John, and good morning, everybody. Thank you for joining us today. I will begin this call with an overall assessment of our third quarter performance, which is consistent with my assessment of last quarter. First, our strategy to position the Company in highly defensible niches, as well as our execution on the buy and the sell side continued to deliver gross margin stability. Second, our ongoing productivity efforts throughout the Company resulted in strong incremental margins and operating margin expansion. Third, our focus on working capital delivered strong free cash flow generation. And finally, I am pleased with the performance of our two recent acquisitions, DECO, which has begun producing earnings accretion ahead of schedule; and AIS, which is off to a nice start.

All that said, like last quarter, our organic growth rate continues to fall short of my expectations. Given the current environment, as I said last quarter, I believe that we should be growing well into the high single digits, and at present time, we are not. We know that this is mainly due to the impact of our sales effectiveness initiatives and the related lower sales headcount. And we fully expect MSC to return to our more typical organic growth levels after a couple of quarters.

My assessment is reflected through our third quarter numbers. Sales growth slightly above the lower end of our guidance range, gross margins at the midpoint of guidance, incremental margins of 28% on the base business, and earnings per share $0.01 above the midpoint of guidance, when factoring in the AIS dilution, which we had anticipated.

Turning to the environment. Manufacturing conditions generally remained solid. MBI readings while moderating from earlier highs, continued to reflect expansion with March and April at 59.5 and May of 58.6, adding June reading of 57.8, and that brings the rolling 12-month average for the MBI to 57.6, pointing to continued growth in metalworking end markets. All of this is reflected in our customers’ order volumes and the backlogs.

Like many others, we are watching the tariff developments closely. We have not yet seen tariffs impacting customer demand, although they are now top of mind for both customers and suppliers, and are beginning to impact manufacturing input costs. We are just beginning to see cost pass-throughs from some suppliers. But as of now, it’s still way too early to predict any longer term implications.

The pricing environment remains solid. We implemented a moderate price increase in late January and saw nice realization. Price contribution, which had turned positive in our fiscal second quarter, stayed in positive territory in the third quarter as expected. Commodities, freight and wages are all rising. Today, however, the number of our suppliers who have raised their list prices, since our last increase in January, is more limited than the inflationary pressures might suggest. This will of course impact the size of our pending price increase. That said, should these inflation pressures continue, we expect to see considerably more price increases from our suppliers to come and that would be reflected in our fiscal 2019 midyear pricing actions.

Turning to our performance in the quarter. Sales growth was slightly above the bottom end of our guidance range. March comparatives were negatively impacted by the timing of the Easter holidays this year, while April then benefitted. Through most of April, we were on track to achieve the midpoint of our sales guidance range. However, we then saw some softening in May.

For the quarter, our government business grew low single digits, but it dropped sequentially through the quarter. National accounts grew in the high single digits, while growth for core and CCSG were both in the mid single digit range. Finally, DECO maintained its strong double digit growth pace, and continues to exceed our expectations. I spent some time in Iowa two weeks ago with the DECO team and came away very excited about our continued prospects for growth. Finally, AIS had a small but positive impact on growth given the timing of the acquisition.

And before going further, let me talk a bit more about AIS now. We have three primary filters when evaluating acquisition candidates: strategy, culture, and financial performance. AIS has passed each of those filters.

First on strategy, AIS competes in the OEM fastener market which is a technical and high-touch niche. AIS’ sales team interacts directly with customers’ engineers to design fasteners that go into the final product. And they then deliver those fasteners through a hands-on vendor managed inventory service. It’s closely related on the plant floor to metalworking and our Class C parts. So, it’s a good complement to our existing business. In fact, many of our existing manufacturing customers have a need for these production fasteners, which creates an exciting cross-sell opportunity. Second, much like DECO, AIS has a strong culture whose values line up closely to ours. And that’s a testament to CEO, Jim Ruetz and his team. Third, we look for acquisitions to be accretive by their second full year with us and to achieve a return on invested capital above our weighted average cost of capital in the third full year, and we expect AIS to meet both of those financial hurdles.

Turning to e-commerce. It was 60.6% of sales in the quarter, up slightly from the same quarter last year and from last quarter. The overall trend remains positive and consistent with e-commerce increasing moderately as a percentage of overall sales. As I’ve said before, it is important to note that our e-commerce sales include all forms of automated selling. For instance, product sales that go through our vendor managed inventory solutions and our vending machines account for a slightly less than half of our total e-commerce sales.

Speaking of vending, in the third quarter, sales to vending customers contributed roughly 300 basis points to growth. Rounding out the results of the third quarter, our total net active saleable SKU count was just over 1.6 million, flat with last quarter. Given the success of our SKU expansion program, we are accelerating it during our fourth quarter, and this will positively impact sales growth in fiscal 2019.

As I mentioned earlier, our recent performance has been tracking below the levels that I would expect due to the impact of our sales effectiveness initiatives and the related lower sales headcount. For many years, we’ve operated with what could be described as one-size-fits-all sales model. And this worked for a long time, and we grew our top line nicely. However, as the market changed and the sales process became more technical and complex, we recognized the need to evolve our sales model.

Today, a heavy premium is placed on the solutions and documented cost savings for the customer, which is a positive development for us given our metalworking expertise. But it requires making our sales model more effective, and we’re doing so by differentiating between our customers and clustering our sales people who serve those customers. As a result of these changes, we’ll be sufficient to better meet our customers’ needs and should be able to grow top line without the same percentage increases in headcount as were needed historically that of course means leverage and productivity.

We’ve been implementing these changes over the past year. As we did so, it did not make sense to hire sales people. So, sales headcount has come down by design. We did not want to bring in a lot of new sales talent only to change their position within the first few months of joining us. There’s no question that there’s a connection between sales headcount and top-line growth over time. Of course, there also was and is some level of distraction for the current sales organization as we put these changes in place.

As I mentioned on our last call, we’re through the bulk of the changes and assigning reps and accounts, and we are now beginning to recruit sales talent. Excluding AIS, our sales headcount was down very slightly by handful of people from the second quarter to the third quarter. But as I also mentioned on the last call, we do expect that number to grow moderately in this coming fourth quarter and then into the start of fiscal 2019.

I’m encouraged by several early indicators that our new model will produce the results we expect. First, our pilot market is showing strong performance with growth rates that are in line with our high single digit expectation. Second, while mid single digit organic growth is not to our standards in this environment, when coupled with mid single digit declines in organic sales headcount we’re seeing growth for sales person in the double digits. Third, our leadership spends a lot of time in the fields with our sales team. Feedback on the ground is positive. But these changes, while not easy in the near-term, are absolutely the right thing for our business and will lead to a more effective sales model. Of course, it takes time for our new associates to become productive. So, we do not anticipate an immediate lift in sales. But as I look past the next couple of quarters, I’m very confident that these are the right changes and will deliver stronger growth, levels more in line with our historic expectations.

Now, over to Rustom.

[Rustom Jilla, CFO]

Thank you, Erik. Good morning, everyone. Before getting in the details, let me remind you that we had provided Q3 guidance for both the base business, which excluded DECO and AIS, and also for our total Company which included DECO. AIS was acquired on April 30th and so was not in our Q3 guidance.

We owned AIS for just over a month in our Q3 and it generated sales of $6.7 million and $400,000 operating profit before $1.8 million of transaction expenses and purchase accounting requirements put into the red. So, rather than talk to three sets of numbers, on slide four, we have provided you with our reported results as well as the impact of AIS, so that you can see clearly how we performed versus guidance, which again was provided before AIS was acquired. Of course, we’ll still discuss our reported Q3 results. So, let’s do that now.

Total average daily sales for the third quarter were $13 million, an increase of 11.4% versus the same quarter last year. DECO continued to generate double digit growth, high teens in fact, and AIS’s ADS growth was in the high single digits. Base business organic growth of 6.1% was just above the low end of our guidance range. Erik has already covered the key drivers. So, I will simply reinforce his comments by noting that our sales performance gap is isolated to the base U.S. business where the sales effectiveness changes randomly.

Our reported gross margin was 43.6% for the quarter, in line with our guidance, after taking into account the 20 basis-point negative impact of AIS. The 70 basis-point year-on-year reduction came entirely from our two acquisitions. That negative mix effect that was exacerbated by $1.1 million AIS purchase accounting charge required to amortize the stepped up value of acquired inventory. Excluding the acquisitions, our gross margin was 40 basis points higher than last year’s Q3, which as you may recall came in below our expectations at the time. Pricing and mix along with higher supplier rebates were the major drivers, more than offsetting product cost inflation.

We continue to drive productivity with OpEx to sales declining 90 basis points from last year to 29.7%. Total OpEx was $246 million versus last year’s $228 million with about $7.5 million of the increase coming from the acquired businesses, and this included $0.7 million of one-time AIS transaction costs.

Our base business OpEx to sales was 30.2%, 40 basis points better than last year’s Q3. After $10 million year-on-year increase, roughly $5 million can be attributed to volume related variable costs such as pick, pack, ship, freight and commissions and $3 million of higher incentive accruals. Productivity and cost controls offset much higher investment spending and a general inflation increases including fringe and merit.

So, our third quarter operating margin was 13.9%. It’s worth noting that we absorbed $1.8 million of AIS acquisition costs and purchase accounting charges in this, and this pulled our operating margin down by roughly 20 basis points. Our base business operating margin was 14.5%. This was 80 basis points improvement on comparable 13.7% reported in the same quarter a year ago, as we achieved the higher gross margin and also leveraged our OpEx to deliver incremental margins at the high end of our long-term incremental margin range.

As you know, we aim to deliver 20% to 30% incremental margins on an annual basis. The drivers of incremental margins are sales growth, gross margin movements and OpEx leverage. Year-to-date, our base business gross margin is 44.6%, unchanged from fiscal 2017, while we have leveraged our OpEx with the 70 basis points improvement. So, after three quarters, we have delivered a 24% incremental margin on 6% organic growth.

Inclusive of the recent Tax Cuts and Jobs Act impact, our total tax expense for the fiscal third quarter was 29.3%, slightly better than our guidance of 29.5%, and this was mainly attributable to our higher benefits from share-based compensation. So, all of this resulted in reported earnings of $1.39 per share, a strong third quarter EPS performance from DECO, more than offset the $0.02 of dilution from AIS, which was comprised of acquisition cost and purchase accounting charges.

After allowing for AIS’s dilution, our actual EPS came in $0.01 higher than the midpoint of our guidance range. Last year’s Q3 reported EPS was $1.09. A fairer comparison will be to exclude both the negative impacts of AIS’s acquisition cost and purchase accounting charges as well as the benefits of the Tax Cuts and Jobs Act. And this would yield EPS growth of 14% versus the prior year period.

Now, turning to the balance sheet. Our DSO was 56 days. Consistent with historical trends, this increased 2 days from the second quarter. DSO usually drops in our fiscal second quarter, then goes back up in the third. But DSO has also trended higher in recent years due to national account growth. We will continue to focus on receivables with an aim to offset this customer mix headwind as much as possible. Excluding roughly about $20 million of inventory from the AIS acquisition, our inventory declined slightly during the quarter. Base business turns remained sequentially flat at 3.5 times. So, looking ahead to the fourth quarter, we expect inventory to increase as we protect against some longer lead times and also buy ahead of expected price increases.

Net cash provided by operating activities in the third quarter was $112 million versus $62 million last year. The main drivers of working capital which had an $11 million inflow this year versus the $22 million outflow last Q3; cash income taxes paid were $7 million lower and net income was $16 million higher. Our capital expenditures in the third quarter were $14 million, and after subtracting, capital expenditures from the net cash provided by operating activities, our free cash flow was $99 million as compared to $50 million in last year’s fiscal third quarter.

Our free cash flow generation has been solid all year with $199 million generated year-to-date, versus $121 million last year. We ended the third quarter with $536 million in debt, comprised mainly of the $284 million balance on our revolving credit facility and $225 million of long-term fixed rate debt. We also ended the quarter with $40 million in cash and cash equivalents and our leverage ratio remained at one times.

Now, let’s move to our guidance for the fourth quarter of fiscal 2018, which you can see on slide five, and is shown with and without acquisitions. We expect total Company ADS to increase by 8.2% to 10.2% versus the prior year period. This includes 3% to 5% of organic growth and around 500 basis points from acquisitions. Our preliminary base business ADS growth rate in June was 3.1%, and this was impacted by two primary factors. First, we had an extra selling day this June, which negatively impacted ADS. Absent the extra day, the June growth rate will be more comparables July and August projections of roughly 5% ADS growth. The second year-over-year factor affecting June was down in spending. In June, our government spend -- our government growth rate turned significantly negative as we did not see the typical uplift in daily sales. So, at this point, we’re assuming some government spending pick up as we enter the last quarter of the government’s fiscal year, but not as much as in prior years.

Our fourth quarter total gross margin is expected to be 42.7%, plus or minus 20 basis points with 100 of the 150 basis-point year-over-year decline due to the acquisitions. In Q4, we will complete the purchase accounting amortization of AIS’s inventory setup, and this alone accounts for non-recurring 40 of the 100 basis-point headwind.

Sequentially, Q4 total Company gross margin is expected to be 90 points lower than in Q3, roughly half is from AIS and the remainder from our base businesses, which is following the typical seasonal pattern in which gross margin drops, largely due to product mix and the sale of more heavily discounted items.

We often point out that there are quarterly swings in many line items and try to look at numbers on a full-year basis. Gross margin is no exception. And if Q4 comes in at the midpoint of guidance, our full-year base business gross margin will be 10 to 20 points lower than the prior year.

Fourth quarter operating expenses are expected to be around $250 million, up $17 million from last year’s fourth quarter. Acquisitions account for roughly $9 million of this. And year-over-year, total OpEx-to-sales is expected to improve 110 basis points to 29.9%. Variable expenses associated with our higher sales account for $4 million and the bonus accrual is expected to be $2 million higher than last year’s Q4. The remainder comes mostly from investment spending, medical cost inflation and salary inflation, partly offset by productivity. Excluding acquisitions, we expect OpEx -- our OpEx to sales ratio to improve in Q4 by roughly 70 basis points. Again, taking a full-year perspective, if actual OpEx to sales ends up in line with our Q4 guidance, this ratio will have improved by approximately 70 basis points versus fiscal 2017’s full-year.

We expect the fourth quarter’s operating margin to be approximately 12.8% to the midpoint of guidance, a 50 basis points decline over last year’s Q3 and due entirely to the impact of acquisitions. Base business operating margin is expected to be 13.7%, up 20 basis points from the prior Q4. At the midpoint of our Q4, operating margin guidance excluding acquisitions, we expect to achieve an operating margin for the full-year well within our operating margin framework for fiscal 2018, which you see on slide six. It would also mean that our annual incremental margin would be around 22% in fiscal 2018.

Our estimated tax rate for the fourth quarter is 29.6%, consistent with what we said in January and our guidance also assumes no significant change in our weighted average diluted share count from Q3. Our fiscal 2018 fourth quarter EPS guidance range is $1.24 to $1.30. Note that this is after absorbing $0.03 uplift dilution from AIS, which includes a $0.04 negative impact from the purchase accounting amortization of the AIS’s inventory step-up.

I’ll now turn it back to Erik.

[Erik Gershwind, CEO]

Thank you, Rustom. I’ll conclude with some brief additional remarks and then we’ll move to Q&A.

While I am not pleased with the organic growth that we are delivering right now considering the environment, I fully expect us to return to our more typical organic growth levels after a couple of quarters, and our team is intensively focused on this. As we do so, we will benefit from the leverage inherent in this business and continue to achieve our long-term annual incremental margin target range. We will also maintain our focus on growing areas that are technical and high-touch, creating a deeper moat around the business. All of these are critical to our long-term success, and I am confident in our ability to deliver.

Let’s now open up the call for questions.

[Operator]

[Operator Instructions] The first question today comes from Evelyn Chow with Goldman Sachs. Please go ahead.

[Evelyn Chow, Goldman Sachs]

Hi. Good morning, Erik, Rustom, John. Maybe just starting out on the sales force effectiveness initiative. Helpful to understand your expectation that that will resolve in a couple of quarters, but it would be helpful to understand, is it about reacquiring lapsed customers, is it about expanding share of wallet at those customers, is it more about driving new business? How do you kind of think about the drivers of the headwind you are seeing in organic sales today, and to that point, how -- what kind of metrics are you looking at to understand the path to recovery?

[Erik Gershwind, CEO]

Yes. Evelyn, so, it’s an excellent question, and I think what it helps tee up is a very important distinction what’s happening in the business right now because it’s really sort of like a tale of two cities. When we look at our existing base of business, meaning business with existing customers, I give us strong grades. We’re growing nicely. Where the largest delta is from our historic growth rate is new business generation. And I guess, it shouldn’t be surprising given the sales force declines and that’s where the biggest hole [ph] is. So, the biggest part of the plan right now as we move through these changes is getting the sales headcount back and it’s directed specifically at new business generation, which is where we see the gap relative to historic performance.

[Evelyn Chow, Goldman Sachs]

Thanks, Erik. And then, and maybe a more granular question just thinking about the gross margin line, I think if you look at gross margins ex the acquisitions, in 3Q, they actually expanded year-over-year. In 4Q, it looks like the guidance on a core basis implies a decline year-over-year. I would just be interested in understanding the dynamic there.

[Rustom Jilla, CFO]

Sure. Let me take that Evelyn. So, the primary driver of the Q4 sequential drop is a normal seasonal pattern that we see due to sales of lower margin summer products. And so, no, we don’t expect the erosion to continue, particularly given our planned summer 2018 price increase, and also, if you’re looking year-on-year, another reason why we don’t think Q4 is a start of a trend or anything we said last year, there was an unusual pattern with Q3 dropping and Q4 rising, and of course finally taking the longer-term view which we always say, we focus on more than a quarter.

[Operator]

The next question comes from Ryan Merkel with William Blair. Please go ahead.

[Ryan Merkel, William Blair]

So, first question I had, if I adjust June organic growth for the days and maybe a little bit for the government, that would get you to 5%, 6% organic. So, this implies that the lack of hiring and the distractions are impacting results by about 300 basis points to get you back to high-single digits. Is that the right way, Erik?

[Erik Gershwind, CEO]

Yes. I think you got it right. I mean, as we look at, obviously the print on the organic growth rate in the Q4 guide, it is down from Q3. I mean, as I assess the performance, it’s very similar assessment, so Rustom outlined that book in reality when you account for the extra day, last year just to be clear, July 4th fell on a Tuesday; we were closed that Monday. So, just that the day differential, the one day differential paced the 3.1 back to roughly 5, which is where we the July-August implicit is. And then the second change, you’re exactly right is government where historically what happens and just to be clear, it’s not so much that ADS is falling off as it is that we’re not getting the lift that we normally get due to year-end spend. We’ve got a lot of intelligence on the ground in government. From everything we’re reading, this is not share lost, this is a lack of year-end spending to-date. And so, normalizing for those two things, yes, correct. Q4 looks a lot like Q3, which looked a lot like Q2. And to be clear, those are still under our expectations. And I think you’re right in terms of the kind of gap to historical expectation of somewhere in the 200, 300 basis points is right up.

[Ryan Merkel, William Blair]

Okay. So, 200, 300 basis points is what we need to make up. And you said it was a couple of quarters, and I think you need to hire the sales folks and then it takes two quarters or so for them to get productive. So, should we be thinking about sales recovery back to normal in the second half of fiscal ‘19?

[Erik Gershwind, CEO]

I think, look, absent any other changes, I would say that that’s a reasonable assumption. The reason I said a couple of quarters is you’re correct Ryan that it takes a few quarters for a new hire to get fully up to speed. Look, we are mindful that we’ve moved through a lot of changes. There is some distraction that should be behind us. So, we should get some benefit from that sooner with the sales benefit of the incremental heads being a little further out. So, net-net, yes, about right.

[Ryan Merkel, William Blair]

Okay. And then, just lastly, I want to clarify the comments about historical incremental margins even while you hire these sales folks. So, I think that means 20% to 30% incremental margins. And I want to clarify, so you think that you can do that in 2019 even while you’re adding these heads? And then, once the heads become productive, would you expect that that would help the incremental margins, so again in the back half maybe sized [ph] up?

[Rustom Jilla, CFO]

Hi, Ryan. Let me take that. So, yes, we do expect regardless of this investment long-term annual incremental target range of 20%, 30%, we expect to be able to deliver that. And the second part of your question, as the sales people become more productive and all the rest of it, we get the contribution from it. I think that will still keep us in that 20% to 30% range. We’re not saying we’re going out of it either.

[Erik Gershwind, CEO]

But, I do think, Ryan, I think the point is right that if we looked first half of the year, back half of the year, yes, I mean if you ask me right now, look we’re not giving – we’ve got another quarter before we give an annual framework that one would think the performance should get better as the year goes on. If you look out past the couple of quarters, the biggest driver there Ryan being the growth rate. Obviously, to the extent the growth rate is higher that’s going to move us further up the market in the incremental margin range.

[Ryan Merkel, William Blair]

Right. That’s kind of what I was thinking. All right, thanks a lot. I appreciate it. I’ll pass it on.

[Erik Gershwind, CEO]

You got it.

[Operator]

The next question comes from Scott Graham with BMO Capital Markets. Please go ahead.

[Scott Graham, BMO Capital Markets]

I have two questions. The first one is simply, I know that we’re trying to improve effectiveness of sales and trying to tune them into a more market specific focus, solutions, end markets, the whole thing. I guess what I’m wondering is, sales were kind of going along okay. And why are we maybe kind of doubling down or however you would want to put it Erik, right now at the height of where sales growth in short cycle is? It just seems like you kind of want to let it ride for a while before we do anything that could potentially be disruptive. So, why the timing?

[Erik Gershwind, CEO]

Got you, Scott. So, really sort of two questions embedded there. One, why do it and then two is why do it now. In terms of the why do it. Look, I think you’re right. Historically, the model produced pretty good rates of top -- organic, top-line growth. But if you look back over a number of years, we were getting commensurate leverage on that. The model was losing productivity and effectiveness for a lot of the reasons I mentioned, changes that happened outside of the Company, changes in the market. We are very confident that these changes are the right changes, and this is the right model for the future to deliver the top-line and get more leverage out of it. So that we don’t have to add at the same rate we added historically. That’s the why.

Why now. Look, the answer is -- and obviously with hindsight, you never know when you go into something. But I will tell you, we take a long-term perspective on the business. And so, the answer is, if we felt and we did feel that this was the right thing to do. It sort of didn’t matter whether it was high in cycle, low in the cycle, we’re taking a long term perspective. And from our standpoint, if it’s the right thing, the sooner we get it in, the sooner we’ll get the benefit and we come out the other side and the better for the shareholder over the long run. So that’s really the answer on why now.

[Scott Graham, BMO Capital Markets]

Understand. Thank you. That I kind of fashioned as one question but I see how you look at it as two. So my other question was what…

[Erik Gershwind, CEO]

Scott, I wasn’t trying to...

[Scott Graham, BMO Capital Markets]

What percentage of your supplier costs, let’s say just say, your input -- inventory input is sourced out of China? Could you tell us that?

[Erik Gershwind, CEO]

So, look, the direct -- we shared that the direct percentage of sales that are coming directly from Asia, meaning not from a lot of -- a lot of our -- a lot of the products we sell are branded manufacturers, who may produce around the world. Those branded manufacturers represent the vast majority of our purchases. So, for our direct -- what we source directly in relatively small, call it under 20% in that range in terms of total impact. And I guess, where it is going is with respect to tariff, the other thing I’d say, we have a lot -- that would be global. We have a lot of sourcing flexibility within that where our sources will come from various parts around the world.

[Scott Graham, BMO Capital Markets]

Right. But would that -- because you’re kind of tuned to the way you are right now, would that lead to higher input costs for you?

[Erik Gershwind, CEO]

Look, I think certainly no question that the discussion of looming tariffs has the potential to raise input costs. I think, to the -- and as I mentioned we are beginning and just beginning to see that now. So, two things, one is, that should lead the pricing opportunity. And historically, when costs go up, we are able to at least recover those costs in the way of pricing. And the second thing I would say is that Scott we’re pretty well-positioned. One of the ways we market our product offering is a good, better, best. So, if you go to most of our categories, you’ll see branded manufacturers; you may see something that’s sourced overseas. You’d likely also see an alternative, particularly in our bread and butter metalworking that would be a made in USA product. That gives us a lot of flexibility. So to the extent we see over time real cost pressure, we have the ability to move both from a sourcing and a marketing standpoint for our customers to domestic product.

[Rustom Jilla, CFO]

Scott, just want to add, so just one tiny add to that. Just like we have opportunities to adjust sourcing, our suppliers for the most part have facilities all over the world and they will also be moving around their sourcing and then looking at the implications of the tariffs when these things finalize.

[Operator]

The next question comes from Robert McCarthy with Stifel. Please go ahead.

[Robert McCarthy, Stifel]

So, a couple of questions there, not meant to be bracing. So, just prepare yourself. I guess, the first question is, kind of to Scott’s point, and I think Ryan’s, there is -- you can’t go through the sales reorg and come out the other side and capture share but you are a short cycle business. So, the question becomes is, is there a risk here and you could miss kind of the fad of the upcycle here, right? And then, as we go into next year that you just structurally lost 300 basis points of sales going forward, right? And what can you do to combat that? And kind of part and parcel of that, do you think you have to train the sales force or do you think you’ve trained or do you have the initiatives in place that you’re going to train the sales force to get price in this environment and exploit price in this environment? Because that’s a key part of maintaining organic growth.

[Erik Gershwind, CEO]

Yes, Rob. So, like with Scott’s answer, I’ll parse that into two. Let me get price first. The answer is yes. I mean, we have been spending a lot of time and effort over the last couple of years to build up our capability around pricing. And I think the first sort of proof point that we have some that work coming to fruition with the midyear price increase where we saw what I would consider to be pretty much realization on a midyear increase. And you could see that. The metric you can see is price contribution turning positive in Q2, getting a little more positive in Q3. I would fully expect that when it comes time to the next increase, I would expect strong realization rates, particularly given the environment right now and the headlines around inflation. So, I do think that is a real opportunity and I fully expect that we capture good realization -- go ahead. Sorry.

[Robert McCarthy, Stifel]

Was that me or is Rustom going to…

[Erik Gershwind, CEO]

Okay. I thought you were trying to get in Rob. I’ll hit the second, your point on sales. And I think your question was around the timing of these initiatives doing it at the peak cycle and missing out on some of the upside. Look, as I mentioned to Scott, we take a long-term view on this, Rob. And we fully believe this is the right plan. And so, we are going to do it and get in as fast as possible. And I guess, the answer is yes, I mean one of the downsides here is we probably are missing out on some of the upside of the up market. Here is the flip side is the sooner we get it in place, should the market come back, we are going to be better positioned to outperform. And if the market continues to be strong, we should be better positioned to outperform. So, from our standpoint, the sooner it gets in and the sooner we outperform, the sooner we recapture.

I also just -- one of the things, I want to circle back to the point I made to Evelyn’s question which is around what’s happening in the business. Very different picture right now when you look at existing base of business where the performance has been good. Where we’re missing out is on new business generation, no question. And look, the nice thing about that Rob, new business can be generated in virtually any month.

[Robert McCarthy, Stifel]

And to that point, just the problem is, right, investors shoot first and ask questions later, and you’re going to see that today, right? And kind of what you -- the messaging is basically, listen, we have a gestation period of the sales force. But the cycle remains strong, pricing remains strong, kind of full speed ahead and will catch-up here. But the bear case would suggest couple of things. Number one, could the cycle be decelerating? I mean -- and you can comment as to that, maybe it isn’t an all of your thought. Maybe we are starting to see a relative deceleration. Number two, on new business opportunities specifically, that does come down to the fact that, is your offering really competitive, right? And is there a pricing dynamic that perhaps has to be taken into account to get new business? And that gets to the core of kind of the Amazon Google transparency argument. So, how would you respond to kind of those two critiques of how you’re operating in this environment?

[Erik Gershwind, CEO]

Yes. Rob, I think on the new business side, really, it’s a direct correlation to not having the people in place to be able to do the new business. And really where most of our hiring is directed right now to be even more transparent is new business that development, i.e. hunters. So that is imperative right now. It’s just getting the people in place to do the new business development.

Your other question, I’m sorry, was around?

[Robert McCarthy, Stifel]

Just around the fact that you don’t think -- you’re basically saying the cycle remains strong, trends remains strong, MBI remains strong. It’s more a question of your execution. You’re not concerned about a second related to deceleration in the cycle at this point?

[Erik Gershwind, CEO]

Look, and Rob, I count it with our view is always very near term. Given our lead cycle is 24 hours, we’re shortly time business. From what we see today and our discussions with customers, things remain pretty good. Look, there is -- we mentioned, there is a little bit of a sector kind of a looming question around the impact of tariffs that at this point I would say is more psychological and related to input costs than it would be to demand. But, look, to be fair, that’s out there. I mean, I think that’s a risk. But right at this moment, I think demand still remains quite solid.

[Robert McCarthy, Stifel]

And so just one last one. The price increases, we would expect to see really the realization is really going to a fiscal ‘19 event at this point, right, in terms of the pricing. Can you talk about fiscal 4Q in terms of realization of price increases?

[Erik Gershwind, CEO]

Yes. So, our -- the pricing, our typical Big Book pricing will be later this summer. So, you are correct. Look, it will be driven off of market increases of what we are seeing from suppliers. It will be later in the summer. So, you are correct, a greater impact in Q1 than in Q4. That’s correct.

[Operator]

The next question comes from Hamzah Mazari with Macquarie. Please go ahead.

[Hamzah Mazari, Macquarie]

Good morning. Thank you. The first question was just on pricing. Erik, you mentioned that the number of suppliers raising list price since January is more limited relative to sort of inflationary pressures. Is there anything structural in the space whereby suppliers are raising price, demand is guard, we’re seeing inflation, but distributors can knock out price? Is there anything we should read into that or any color around pricing, just longer term structural? I know you talked about for fiscal Q1 versus fiscal Q4, but just for deeper question on pricing.

[Erik Gershwind, CEO]

Yes. Hamzah, at this point, I would say, no. What we’re seeing is not structural. And my answer would be different, I believe. If the dynamic we saw was that our manufacturers were passing along a lot of increases, lift increases and distributors could not get them through, I think we have a different situation on our hands. But today, the proof at least for us has been pretty good. As I mentioned, when we did the mid-year price increase, realization was good, pricing turned positive. The issue has been more one that the manufacturing communities, so our suppliers have not moved at the rate and pace one would expect given the inflation headline, which I think is a different story than the structural one you’re describing.

In discussions with most of our suppliers, the biggest thing that comes back is capacity utilization that at this point they don’t want to do anything to risk getting capacity utilization up. I will tell you that our discussions with most, also we want to conclude that if the cost pressures we’re seeing now sustain and not just tariffs but we’re talking commodities and wages and freight, that there’s going to come a point where there is more increases coming for manufacturers. That would trigger more increases coming from distributors, certainly coming from us. And today, my expectation will be that realization is good, particularly in this environment. So, I think structural question is -- would be a different story, if we weren’t getting price.

[Rustom Jilla, CFO]

Hamzah, I’ll just throw out one factor on that again, just to repeat. I mean, look our three quarters of year-to-date gross margin performance were actually in line with last year. That is a better nine months than certainly mostly anything I can think over the last few years. So, just something to think about when you’re questioning on the structural issues.

[Hamzah Mazari, Macquarie]

Right. That makes sense. And then, I guess the second question is aside from sort of DECO and AIS, the last time you guys did a deal was Barnes five years ago. Could you maybe touch on -- and a lot of questions on sales force effectiveness. How much of the M&A strategy is sort of levered to just buying headcount whereby some of these sales people are already pretty productive? So, can you accelerate some of the sales force effectiveness issues by just doing more deals?

[Erik Gershwind, CEO]

Hamzah, the answer is that the acquisition strategy is really motivated by -- look, the three criteria that we laid out in the prepared remarks. Specifically first and foremost, the strategy is about bolstering technical and high-touch niches. So that’s metalworking, that’s the Class C parts. In this case with AIS, we found kind of a third, a third growth leg in the OEM fasteners. But that’s the real motivation more so than headcount. Now, I will tell you that what comes along with both of those businesses is an exceptionally strong, technical, and capable sales force. But the driver has been about the technical high-touch niche and that of course obviously culture and financial performance are on the same level of importance.

[Hamzah Mazari, Macquarie]

Just a clarification, I will turn it over. Just on the tariff question, how much of your -- I guess, you mentioned, it’s not material impact to you directly, how much of your COGS is sort of sourced from China? Is it just -- you said less than 20% I guess or just clarifying that?

[Rustom Jilla, CFO]

The direct is well under the 20% number. But just remember that a lot of our major suppliers, right, have facilities all over the world, and they change around their countries of origin. So, if you run the report for Q1 and the report for Q2, you might find similar products having changes in country of origin anyway.

[Operator]

The next question comes from Adam Uhlman with Cleveland Research. Please go ahead.

[Adam Uhlman, Cleveland Research]

I was wondering, Erik, if we could move back to Hamzah’s question and on the number of suppliers raising prices here. I guess, I am curious what your view is as to how much inflation we should start to expect to see over the next year. And what would be your starting point of the catalog list price increase as we all start to think about your fiscal ‘19 pricing framework and that discussion? And then also, how much you might have to put in for that midyear increase to catch up to what you think might be the new run rate? Just any kind of color you can give us on that?

[Erik Gershwind, CEO]

Yes. Sure, Adam. So, a couple of points on pricing that I’ll make. So, one is, we are going to take -- just to be clear, we are going to do an increase. We will do it later in the summer. It will be our normal Big Book cycle. So, just to be clear, it’s not like we’re not taking an increase. It will be market based, meaning we will take all suppliers that have moved since the January midyear, we will pass those along. Nothing here should indicate that we are lagging behind that there’s more cost coming through that we are passing along in price.

What I would tell you in terms of sizing is, the point I wanted to get across was that the size of that increase isn’t commensurate to what you -- when you’re reading the headlines now around tariffs and freight and wages, you would think that we would be back in the glory days of like 3%, 4% price increases across the board from manufacturers. That’s not the case right now. Now, you are asking me to kind of hypothesize about looking out past the summer. It’s hard to imagine that the current cost pressures could sustain a whole lot longer before manufacturers have to move much more significantly. If that’s the case, we would plan to be ahead of it as we normally are, meaning we’ll pass along market price increases. We should have a timing lag -- benefit, a price cost benefit. When that happens and look -- generally our rhythm is to do that for us, our midyear is somewhere early -- would be early calendar 2019, all subject to change, depending upon just how hard things got, we can always build sooner if we need to. But that’s sort of how I would look at things.

[Adam Uhlman, Cleveland Research]

Okay. And then, Rustom, could you remind us all, what the normal seasonality is for the first quarter gross margin performance relative to the fourth quarter’s, up or down and ballpark kind of a number? And then within that, is there any carryover inventory step-up expense that we need to keep in mind with AIS, or we all done with that next quarter?

[Rustom Jilla, CFO]

Sure. So, third quarter to fourth quarter, right, if heard you correctly?

[Erik Gershwind, CEO]

Q4 to Q1…

[Rustom Jilla, CFO]

I can do that. Yes, in general it is. But I mean, it almost always is looking at that from Q1 going up, right? But the AIS, there is about 40 basis points coming solely from finishing the amortization of the inventory step up, the usual thing, that’s all in Q4, which means it’s gone. And in Q1, you -- that there is a longer headwind there.

On the total business also, there is also another loss of headwind, to use that phrase, because we acquired DECO in July a year ago. So, DECO, we wash in this thing fourth quarter when you look at it. Once you go into Q1, that’s no longer a negative comp. So, when you think about the acquisitions putting us down this year, it no longer becomes effect in Q1.

[John Chironna, VP, IR and Treasurer]

Adam, this is John. The only other thing I’ll add is that if you look back historically, you need to kind of figure out, okay, when do they take the Big Book, right? So if the Big Book came at the end of the Q4, then, you’re likely to get more of a kick into Q1. If sometime it comes into Q1, so then you don’t get as much -- or it comes earlier in the Q4, then some of that price increase is in the Q4, you don’t get as much of a lift sequentially. So that’s something to consider as you look back at the historic trends over the last 10 years.

[Adam Uhlman, Cleveland Research]

But I think summary would be fair to say that the general pattern here is Q3 to Q4 goes down, Q4 to Q1 goes up.

[Erik Gershwind, CEO]

Yes.

[John Chironna, VP, IR and Treasurer]

Yes.

[Operator]

The next question comes from David Manthey with Robert W. Baird. Please go ahead.

[David Manthey, Robert W. Baird]

Thank you. Good morning, guys. First of all on the growth guidance. So, 4% for the fourth quarter, as you mentioned, Erik, below your expectations relative to a strong market, but also down from the 6% core this quarter. I’m just wondering couple of things. First, as you look forward, you’re certainly not anticipating that the market is changing, given weaker or anything like that would be my first question. And second is, would you -- are you already starting to see some of the benefits from the sales force effectiveness? And again, if so, if that’s happening, you’re seeing some benefit it would seem to be incongruous here with the growth rate moderate. Can you just help us understand that outlook?

[Erik Gershwind, CEO]

Yes, sure, Dave. So, let me just also walk you from Q3 to Q4 a little bit, because you’re right. It’s down -- the guide is down roughly 200 basis points. Again, you’ve got over the quarter, roughly a 100 basis points of that into difference in the days with the July 4th holiday last week. And the rest of the -- the other 100 basis points or so government has taken from a growth rate standpoint a sharp turn negative because of the lack of year-end surge so far. Okay? So, those are the two factors on the step-down. What I would say is not -- the difference is not market based. And I would also say on -- with respect to sales effectiveness, we are seeing success in the pilot, which is not enough of a sample size to move the needle for the Company. And I also tell you, look, there is other green shoots that we’re certainly seeing, but they’re not big enough to move the needle for the Company.

[David Manthey, Robert W. Baird]

Okay. That’s helpful. Thank you. And second, as it relates to the sequential change in your field associates. If you exclude AIS from that, what was the change from last quarter in the field sales force?

[Erik Gershwind, CEO]

We are down a handful of people, literally like a handful of people ex-AIS.

[David Manthey, Robert W. Baird]

Last quarter, I think you said expect it to be up this quarter. And I know we’re hearing from a lot of folks, it’s just a struggle to find good people and at the right price. And is there a reason why it didn’t uptick this quarter other than just some minor timing issues or are you having a harder time finding good people?

[Erik Gershwind, CEO]

Nothing to look -- nothing big to read in. Certainly, it’s a hot labor market, Dave, no question there, but nothing to read into in terms of the size and the quality of the funnel. Some of it is timing in a hot labor market. We’re not lowering our standards for the kind of people we want. So, we’re making sure we get the right people. I’d also tell you, look, inside the Company, there is a heavy focus right now on performance management as well. So, you look at the base, it dropped a little bit more to performance management. But as I look this quarter Q4, I do expect the number to be up.

[Operator]

The next question comes from Ryan Cieslak with Northcoast Research. Please go ahead.

[Ryan Cieslak, Northcoast Research]

Erik, I just -- I want to go back just really quick and peel back the onion a little bit about what’s going on with sales versus maybe your expectation at this point. And I get that the sales force is coming down, which I think there has been the expectation. But it sounds like maybe the disruption from that has been greater than what you expected. Is that the case? And if it is, ultimately what can you do to address that near term, or is this going to take, like you said, a little bit of time to get things worked out and normalized as it relates to how operationally the sales force is going to market and working under this new strategy?

[Erik Gershwind, CEO]

Yes. Ryan, look, there is no question, there’s some distraction. I would say most of that distraction is -- most of it is behind. I mean, a lot of the heavy lifting has occurred over the last few quarters. So that is a piece of the story in addition to the headcount coming down. I think, in terms of what we can do, I can tell you that inside the Company, there is no wavering. And we are heads down and we’re executing like crazy and to move through it as fast as we can. And we are almost through it. And it’s now sort of rebuilding headcount. But from our standpoint, the mitigating actions are about getting headcount back up, which is going to be focused on new business development. And it’s just executing our plan and getting comfortable, both getting comfortable in new roles and we are heads down inside the Company.

[Ryan Cieslak, Northcoast Research]

And then you’re going back to the market commentary. I get that year-over-year things are still good and demand -- underlying demand is still positive. But are you also saying that you’re actually seeing when you strip out maybe some of the noise with what you’re doing with the sales force, are you actually seeing ongoing acceleration in demand or are we at a point where maybe things have flat lined a little bit. I just wanted to take your perspective on maybe the sequential trends and underlying demand as it relates to what you would expect this time of year?

[Erik Gershwind, CEO]

Yes. We would not characterize it as acceleration now, more there is leveling. I mean, certainly, but it’s leveled at a robust, very solid demand perspective but level, not accelerating.

[Ryan Cieslak, Northcoast Research]

Okay. And my last one is just, you talked about on the prepared remarks about SKU expansion going forward into next year and that might benefit the top-line. I know in the past you guys have talked about at least within the -- in the near-term that some of these new SKUs that come on line that could impact the mix negatively and gross margins. Should we be thinking about of that way as it relates to maybe what this new SKU expansion can do for gross margins or how do we -- how we balance that from the top-line impact versus maybe the gross margin impact? Thanks.

[Erik Gershwind, CEO]

Yes. Ryan, that’s actually a good catch. I will tell you, it’s been a very successful program. We saw opportunities to round out some lines, do some expansions and accelerate the program. You are actually seeing most of the costs of that in our Q4 numbers. So, from a productivity standpoint, we are pleased that we are offsetting some investment spending with productivity in the fourth quarter. The benefit will build during the course of the year. So just a ballpark, if by the back half of the fiscal year we could be looking at a point of contribution from our SKU program, you are correct. So, the historic profile of the SKUs, these SKUs that we have, are lower gross margin. I will tell you that net margins on that which we are heavily focused on as a company right now are very strong. So, could be -- this could be slight. And look, I call it slight because in a big picture, it’s not going to be a major needle mover, very slight headwind on the gross margin line but should be a nice top-line contributor and bottom-line contributor.

[Operator]

The last question today comes from Patrick Baumann with JP Morgan. Please go ahead.

[Patrick Baumann, JP Morgan]

Just to clarify, do you still see the Big Book prices this summer up more than the 1% to 2% that you did at midyear in January or will you have to wait until the next midyear and at this point you see some acceleration there? It sounds like the latter. I just wanted to clarify.

[Erik Gershwind, CEO]

Yes. Pat, I would actually say, look, it hasn’t come yet. But, if you are asking me, somewhere in that range would be a likely range, 1 to 2, for the increase later this summer. And again, that would be based on what we are seeing in the market. And that’s an average across all of our SKUs by the way. So, we’re going to have SKUs, certain lines and SKUs would be up well more, some don’t move. But as an average across the whole business, 1% to 2% would be reasonable. And then, look, the midyear -- again, should these inflation pressures continue, hard to imagine suppliers absorb them and that they don’t start moving more aggressively on price. The likely timing for that would be beginning of calendar 2019. But of course, depending upon how fast things get, we could always go sooner.

[Patrick Baumann, JP Morgan]

Is there lot of flexibility to do things in between? For example, if tariffs were put in place kind of in between those periods, what your flexibility to move between the midyear and the Big Book?

[Erik Gershwind, CEO]

There is a lot of flexibility.

[Patrick Baumann, JP Morgan]

Okay. And then on the sales force initiative, I mean, its impact on the top-line, just wondering if you could flash out what gives you confidence that the volume weakness is sales force related and not the pricing problem on the new business front?

[Erik Gershwind, CEO]

Well, to be honest, Pat, where we do have people going after new business we’re generally pretty successful at. So that’s what gives me the confidence. The issue is not that we can’t win new business; it’s that we don’t have enough people doing it, is the answer.

[Patrick Baumann, JP Morgan]

Got it. And then just lastly, just looking where the stock is this morning, curious if you can update us on kind of your thinking on buyback, and you had a big authorization over this year, you’ve put in place, I think and hasn’t been a ton of movement on that. I am just wondering how the management kind of thinks of the capital allocation alternatives?

[Rustom Jilla, CFO]

So, Pat, I will take that. So, I mean we always take a balanced opportunistic approach to allocating capital to enhance shareholders returns. Our first -- I’ll just repeat. I mean, it’s organic investment, steadily growing dividends, I mean that’s what we do with it. And after that, depending on where -- depending on the amount of extra cash that we have, based on what we think we’re going to be doing, it’s M&A and buybacks. And it’s returning cash to shareholders, which is -- you could do in various forms of buybacks. You could even do special dividends. I mean, there is enough avenues to do things, but remember, it also depends on whether you have acquisition opportunities that you see out there that might be interesting in the near-term, bunch of different factors. But again, as always, I mean, we’re trying to stay with the longer term view on these things, Pat.

[Patrick Baumann, JP Morgan]

Okay, great. Makes sense. Thanks a lot. And good luck, guys.

[Erik Gershwind, CEO]

Thanks, Pat.

[Operator]

This concludes our question-and-answer session. I would now like to turn the conference back over to John Chironna for any closing remarks.

[John Chironna, VP, IR and Treasurer]

Thanks, Anita. And thank you everyone for joining us today. Our next earnings date is set for October 30, 2018. And we certainly look forward to seeing and speaking with you over the coming months. Take care.

[Operator]

This conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.