DXP Enterprises, Inc. (DXPE) Q3 2017 Earnings Report, Transcript and Summary

Good morning. My name is Chris, and I will be your conference operator today. At this time, I would like to welcome everyone to the DXP Enterprises Third Quarter Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question-and-answer session. [Operator Instructions] Mac McConnell, Senior Vice President and Chief Accounting Officer, you may begin your conference.

Thank you. This is Mac McConnell, good morning and thank you for joining us. Welcome to DXP's third quarter results conference call. David Little, CEO; Kent Yee, CFO, will also speak to you and answer your questions. Before we begin, I want to remind you that today's discussion will include forward-looking statements. We want to caution you that such statements are predictions and actual events or results can differ materially. A detailed discussion of the many factors that we believe may have a material effect on our business on an ongoing basis is contained in our SEC filings, but DXP assumes no obligation to update that information. Now I will turn the call over to Kent.

Thanks, Mac, and good morning to everyone on our call today. We will begin with a summary of our key financial information and then Mac will go into more detail regarding our year-over-year sequential and year-to-date performance. David will conclude with comments about DXP and shares his thoughts on our financial results. So starting with our third quarter fiscal 2017 income statement. The Q3 financial results reflect continued sales growth since Q4 of last year and consistent improvement year-over-year in EBITDA. The third quarter performance was broadly line with all of our key financial metrics and our expectations at this point in the cycle. Total sales for the third quarter were $251.9 million. Total DXP sales grew 9.5% year-over-year and 0.5% sequentially. Average daily sales for the quarter were up 0.5% over Q2 over $4 million per day in Q3 versus $3.8 million per day in Q2. The sequential growth was predominantly driven by our Innovative Pumping Solutions segment, which experienced 14.8% sequential growth or an average of $810,000 per day in Q3. Additional drivers of this growth include our Rotating Equipment and metalworking product division sales performance. We also experienced strength in both of our industrial and oil and gas driven regions, specifically the Ohio River Valley, South-central, Texas Gulf Coast and net – North Texas regions. The overall growth year-to-date is great to see and reflects what we see in some of our key end market indicators. In terms of our business segments, all 3 business segments sales are up year-over-year with IPS showing the greatest improvement increasing 28%, Service Centers increasing 5.8%, followed by Supply Chain Services increasing 4.9%. Turning to our gross margins. Gross margins declined 92 basis points from 27.5% in Q2 to 26.6% in the third quarter. This was disappointing given the positive gross margin results to the second quarter. That said, our gross margin were flat a mixture of anticipated and unanticipated softness. First, DXP's Canadian Safety Services business experienced 122 basis point decline sequentially in gross margins driven by wage inflation and pressures that outpaced our ability to pass price increases through to our customers. This came as a surprise given we were encouraged by the pickup in sales year-to-date and the historical margin performance of Safety Services. If you recall, through Q2, we had experienced 3 quarters of sequential growth within Canadian Safety Services. Longer-term, we're excited about the 33% sales growth year-over-year and we feel we can address the margin pressure as we move closer to the upcoming busy season. The second factor contributed to the decline in gross margins was our performance within Integrated Flow Solutions or what we call IFS. While IFS's performance was disappointing, we did anticipate softness given the backlog and order intake through the second quarter. However, at that point in time, we expected other pieces of DXP to counterbalance the anticipated softness. Integrated Flow Solutions within IPS is working through a reduced level of large complex orders. Moving forward, IFS will not only focus on large complex orders, but also less complex, higher volume package orders that tend to go into the midstream market, but will also come at a lower gross margin. This strategy will balance to make the IFS business more consistent in its performance going forward. However, the execution will take some time. That said, we will see increases in sales and order intake, but we'll also experienced lower margins within IFS than we have historically seen. In terms of operating income, combined all 3 business segments showed a 26 basis point improvement year-over-year with service center showing the greatest uptick improving 89 basis points. Turning to EBITDA. Third quarter EBITDA was $13.5 million, up 5.7% from the third quarter of 2016. Our EBITDA margin decline 19 basis points from the third quarter of 2016 and 140 basis points from the second quarter of 2017. This primarily reflects the decline in our gross margins in our Canadian Safety Service business and the IFS business that I discussed earlier. Turning to the balance sheet. In terms of working capital, we were comfortable with where the numbers came out. Working capital, as a percentage of the last 12 months, sales was 16.9%. This is above our historical average of 15.4%, but remains within our targeted range. The main driver was payables, which decreased 8.4% or $7.4 million to $81.5 million. This reflects the accounting treatment of outstanding checks at the end of the quarter given our gross cash position of $35.8 million, net of $12.7 million announced and in checks. This left us a cash balance of $23.1 million at the end of the quarter. Receivables were up 3.0% to $165.2 million in the third quarter versus Q2 and inventory was down 3.3% to $87.7 million. We continue to believe there's improvement still to come in terms of working capital as a percentage of sales, but we are investing in the business at this point in cycle and we are comfortable with where we're at. In terms of CapEx. CapEx in the third quarter was $1 million, up $522,000 sequentially and up $1 million year-over-year. The increase reflects investment in software to enhance our sales efforts, facilities and improvements to future supercenters. Year-to-date, CapEx of $2.2 million or 0.3% of year-to-date sales continues to reflect a minimal maintenance CapEx that our business needs in our ability to manage investments. In terms of free cash flow. Free cash flow for the third quarter was a negative $365,000. This was a result of 2 primary uses of cash: The increase in cost and profits in excess of billings by $5 million; and the previously mentioned $7.4 million reduction in accounts payable. Adjusting for the $12.7 million reclassification of outstanding checks that created the reduction, adjusted free cash flow would have been a positive $12.3 million. Return on invested capital or ROIC, remains stable and strong at 19% and continues to be above our cost of capital. During the quarter, on August 29, we closed on a new debt structure. We announced a new $85 million ABL credit facility and $250 million term loan B. Putting in place our new debt structure was a significant step of many that occurred prior to the transaction, which included raising equity and selling the noncore piece of DXP in the fall of last year. The new ABL revolver and term loan B provide us with a competitively price and flexible debt capital structure that forms a foundation for our balance sheet going forward. We believe the new structure positions us well to support our disciplined growth strategy. The new ABL revolver provides DXP with lower costs compared to our prior recent revolver costs. However, the term loan B increases our cost 50 basis points, but provides us with extended maturities, minimal amortization, increased borrowing capacity and flexibility for continued execution against our strategic priorities, including acquisitions. The borrowing spread under the ABL revolver is based on total availability and ranges from LIBOR plus 125 to LIBOR plus 175. The term loan B is priced at LIBOR plus 550. We have 2 major financial covenants under the ABL and term loan B, our traditional fixed charge coverage ratio and a secured leverage ratio, which gives us the benefit of cash. December 31 is our first test under the secured leverage ratio, which needs to be less than 5.75x to 1. At the end of Q3, our fixed charge coverage ratio was 4.3:1 and our secured leverage ratio was 3.4:1. In summary, the financial takeaways include a strong sales growth year-over-year with year-to-date earnings meaningfully ahead of this time last year, a refreshed executing flexible capital structure and improving end market dynamics that will allow us to continue to take distinct actions to further strengthen DXP. With that, I'll turn the call over to Mac.

Thank you, Kent. Again, sales for the third quarter of 2017 increased 9.5% to $251.9 million from $230 million for the third quarter of 2016. After excluding third quarter 2016 sales of $7.1 million for Vertex, which was sold on October 1, 2016, sales for the third quarter increased $29 million or 13% on a same-store sales basis. Sales by our Service Centers segment in the third quarter of 2017 increased $8.8 million or 5.8% to $160.9 million compared to $152 million of sales for the third quarter of 2016. After excluding 2016 Service Centers segment sales of $7.1 million for Vertex, Service Centers segment sales for the third quarter of 2017 increased $15.9 million or 11% from the third quarter of 2016 on same-store sales basis. The sales increase is primarily the result of increased sales of rotating equipment, metalworking products and bearings to the oil and gas and industrial customers. Sales at the Innovative Pumping Solutions products increased $11.2 million or 28.1% to $51 million compared to $39.8 million for the 2016 third quarter. This increase was primarily the result of the 1P nature of IPS sales combined with increased capital spending by our oil and gas customers in 2017 compared to 2016. In connection with the increased capital spending in 2017 by our oil and gas customers, our IPS backlog has increased sequentially each month since December 2016. Sales for the Supply Chain Services segment increased $1.9 million or 4.9% to $40 million compared to $38.2 million for the 2016 third quarter. The increase in sales is primarily related to increased sales to customers and the oilfield services and oilfield equipment manufacturing industries. When compared to the second quarter of 2017, consolidated sales for the third quarter of 2017 increased $1.2 million or 0.5 of 1%. Third quarter 2017 sales by our Service Centers segment decreased $3.9 million or 2.4% compared to the second quarter of 2017. Third quarter 2017 sales for Supply Chain Services decreased $1.4 million or 3.5% compared to the second quarter of 2017. Third quarter 2017 sales of Innovative Pumping Solutions products increased $6.1 million or 14.7% compared to the second quarter of 2017. The decrease sales for the third quarter compared to the second quarter for our Service Centers segment primarily resulted from the effects of Hurricane Harvey. The decline in sales by the Supply Chain Services segment primarily resulted from the closing of 2 customer plants. The increase in sales of Innovative Pumping Solutions products was primarily due to the lumpy nature of IPS sales combined with improving oil and gas market's conditions. Gross profit for the third quarter of 2017 increased 4.9% from the third quarter of 2016 compared to the 9.5% increase in sales. Gross profit, as a percentage of sales, decreased to 26.2% in the third quarter of 2017 compared to 27.7% for the third quarter of 2016. On the same-store sales basis, gross profit, as a percentage of sales, decreased 69 basis points. This decrease is primarily the result of a 61 basis point decrease in the gross profit percentage in our Supply Chain Services segment and approximate 186 basis points decrease in the gross profit percentage in our IPS segment and a 16 basis point decrease in the gross profit percentage in our Service Centers segment. The gross profit percentage for the supply chain segment decreased as a result of increased sales of lower margin products to oilfield service and related customers. The decrease in gross profit percentage for the IPS segment is primarily the result of competitive pricing pressures and our reduced level of orders for large, complex higher-margin fabricated packages in the most recent period. The decrease in the gross profit percentage for the Service Centers segment is primarily a result of the decline in the gross profit percentage for our Safety Services provided in Canada. Gross profit, as a percentage of sales for the third quarter of 2017, decreased to 26.6% from 27.5% for the second quarter of 2017. This decrease is primarily the result of a 110 basis point decrease in the gross profit percentage in our Service Centers segment and approximate 79 basis point decrease in the gross profit percentage in our IPS segment, partially offset by an approximate 81 basis point increase in the gross profit percentage in our supply chain segment. The gross profit percentage for the supply chain segment increased because the sales loss due to the closing of 2 customer's plants were at below average margins. The decrease in gross profit percentage for the IPS segment is primarily the result of competitive pricing pressures and a reduced level of orders for large, complex, higher-margin fabricated packages. The decrease in the gross profit percentage for the Service Centers segment is primarily the result of decreased margins on sales of Safety Services and bearings compared to the second quarter. SG&A for the third quarter of 2017 increased $1.6 million or 2.7% from the third quarter of 2016. As a percentage of sales, SG&A decreased to 24.0% for the third quarter of 2017 from 25.6% for the third quarter of 2016, as a result of SG&A increasing only 2.7% while sales increased by 9.5%. SG&A for the third quarter of 2017 increased $1.8 million or 3% from the second quarter of 2017. The increase primarily resulted from increased compensation-related expenses. As a percentage of sales, SG&A increased to 24% from 23.4% for the second quarter of 2017 as a result of sales increasing by 0.5 of 1% while SG&A increased by 3%. Corporate SG&A for the third quarter of 2017 increased $1.1 million or 11.3% from the third quarter of 2016 and increased $1.2 million or 12.7% from the second quarter of 2017. The increases for both periods where primarily the result of increased compensation-related cost. Interest expense for the third quarter of 2017 increased $600,000 or 13.6% from the third quarter of 2016 and increased $900,000 or 23.5% from the second quarter of 2017. The increases are primarily the result of the $600,000 write-off of debt issuance cost in connection with the termination of the previously existing credit facility during the third quarter of 2017. The tax benefit recorded for the third quarter is primarily the result of the reversal of a valuation allowance previously recorded against deferred tax assets. The valuation allowance was reversed because we receive a refund from Canadian revenue related to a very old NOL carry forward. The tax rate for the fourth quarter of 2017 is expected to be in the range of the tax rates recorded for the first and second quarters of 2017. Capital expenditures were $1,039,000 for the quarter. Cash on the balance sheet at September 30, 2017 was $19,473,000. Restricted cash was an additional $3,614,000. Excluding $12,689,000 of checks outstanding from our Wells Fargo bank account and including the restricted cash at September 30, 2017, our bank account cash balances totaled $35.8 million. The accounts receivable balance was $165,235,000 and the inventory balance was $87,720,000 at September 30, 2017. Now I would like to turn the call over to David Little.

Well, thanks, Kent and Mac, and thanks to everyone on our third quarter conference call today. Before I review our results, I would like to address the recent hurricanes. Our thoughts and prayers continue to be with all those that have been devastated and damaged by what was left behind in a bad weather – as the bad weather subsided. These events were especially close to DXP with our headquarters in Houston and a direct impacts of our DXP family. Of our 600 plus employees within the Gulf Coast region, 54 were directly impacted on some level, including flooded homes, vehicles or other similar damage. As we work through the long road to recovery, we have focused our efforts on supporting and helping them to rebuild their homes and lives. Let me thank all of our DXPeople for their support of our fellow employees and the countless calls, e-mails and texts that we received during that time. I look forward to all of us individually and as a company finishing the year strong and building a path to an even better 2018. That said, go Astros. Can we believe that we beat 3 awesome powerhouses, Boston, Yankees and LA? Pretty fantastic. Like I say, go Astros. Moving to our results. This is DXP's third quarter of sequential increases in total sales. Year-to-date through 9 months, DXP sales are up 3.4% over the same period in 2016, adjusting for the sale of Vertex. As such, we are encouraged by the improvement of sequential and year-over-year financial performance and remain focused on growing our business and finishing fiscal year 2017 with strong sales and operating results. The ISM PMI manufacturing index, which uses an indication of how DXP's broad industrial markets will perform, expanded from July 5 – 56.3% reading through September, a 60.8% reading. September is a year-to-date high and represents 13 consecutive months of growth in the broad manufacturing sector. This is also the highest reading since May of 2004. This trend continues to be above the average of the last 12 months of 56.2%. This supports the strength we have seen within our Service Centers as we experienced growth in some of our broad industrial regions, including the Ohio River Valley, South Central, South Atlantic and Western Region. We remain excited to see this momentum on the industrial side of DXP, and we look forward to the momentum continuing through the year. That said, oil continues to fluctuate between $45 and $53 per barrel during the third quarter. And as it did in the first and second quarters, has averaged year-to-date at $49 per barrel through the third quarter. As the year has progressed, we have seen continued improvement in our oil and gas weighted regions. Specifically, we have seen sequential and year-over-year increases in sales in Texas Gulf Coast, Southwest and North Texas regions. Total DXP revenues of $251.9 million for the third quarter 2017 was a 9.5% increase year-over-year and a 0.5% increase sequentially. Service Centers increased 5.8% year-over-year to 160.9. Supply Chain Services sales increased 4.9% year-over-year to $40 million. Innovative Pumping Solutions increased 28.1% year-over-year to $51 million and increased 14.8% sequentially. The year-over-year increases were primarily driven by increases in our Rotating Equipment and metalworking product divisions. DXP Rotating Equipment's strength was driven by increases in all our pump manufacturers we represent, plus our aftermarket services. Year-over-year, Service Centers sales increase were driven by increases in Rotating Equipment, metal working and Bearing and Power Transmission. Innovative Pumping Solution increases were driven by our modular package equipment, a large manufacturer pump sold both domestically and international, engineering services and aftermarket services. Sequentially, IPS experienced 14.8% increase or $6.6 million sales uptick. We continue to remain encouraged by the improvements in our backlog, which have continued to grow throughout the year. Trends in our backlog show IPS quarterly average backlog increased 15-plus percent for the second quarter to the third quarter. DXP's overall gross margins for the third quarter were 26.6% or 90 basis point decline from the second quarter and a 110% point decline year-over-year. 2 major factors drive the weakness in our gross profit margins. DXP's Integrated Flow Solutions business and Canada Safety Services. DXP continues to work through pricing pressure on jobs and unabsorbed factor overhead within the IPS segment in total. But specifically, Integrated Flow Solutions within the IPS is working through a reduced level of complex large, high-margin where we are providing a single source solution of engineered services, plus fabrication of modular equipment to do the job. Just so you understand. As an example, instead of the customer using an engineering firm to design the desired process and then get a second fabricator to build the desired equipment to finish of the job, IFS does both. And the customer benefits in 2 ways. One is less expensive. Two, one company is responsible for quality, delivery and results. This is a great business. IFS is working on several large jobs. The problem is the business is inconsistent. Moving forward, we are addressing the margin and the order intake issue by not only focusing on engineered complex large orders, but also nonengineered solutions that require just a quality fabricator, which is the core business IPS is in. And IPS now needs more fab space. If you remember, we close our Denver location a couple of years ago because we had more capacity than orders. And now today, we have the reverse. So IPS needs more fabrication space, which IFS can provide. This is a win-win for all of IPS and IFS specifically. This new strategy will take some time to fully implement, but we are encouraged and look for improvements in Q4. Additionally, DXP's Canadian Safety Service business also experienced 122 basis point decline sequentially in gross margins. DXP's Canadian Safety Services business sales are up 29% year-to-date versus the same period in 2016. However, gross profit margins are down 343 basis points over the same time in 2016. This is driven by wage inflation and people pressures that have outpaced our ability to pass on price increases through our customer at this point in the cycle. However, safety technicians have become hard to find. So I believe the cycle has turned and a 4% to 6% price increase will fix this issue. SG&A for the third quarter was $60.5 million or 24% of sales, a decline of $1.6 million from the third quarter of 2016 and a $1.8 million increase or 3% rise from the second quarter. At the end of the third quarter, DXP had approximately 2,250 full-time employees. Even as we continue to invest in people for the future, I would note that our Q3 expenses are usually higher than our Q4 expenses. SG&A, as a percent of sales, will come down as we leverage sales growth. DXP's overall operating income margin was 2.6% or $6.5 million, which includes corporate expenses and amortization. This reflects a 44 basis point improvement margins over the third quarter 2016. But also includes the impact of sequentially lower gross profit margins and a slightly higher SG&A expense as a percent of sales by 59 basis points. While the hurricane did impact – did not impact DXP's facilities, we were fortunate, they did dampen our results and impact our customers in varying degrees. From 5 to 14 days, our employees could not get to work. Our customers had the same problem. Of course, we paid everyone, plus helped people and customers that had lost homes and other damages. So sales, unabsorbed overhead, gross profit margins, expenses were all impacted. Service Center's operating income was 9.7% or increased 90 basis points year-over-year driven by lower SG&A percentage of sales versus the same period in 2006, plus overcoming the Safety Services in Canada, as discussed. While IPS and Supply Chain Services operating income margins were 3.6% and 9.9%, respectively, IPS operating income margins were impacted by overall price pressures, fixed cost absorption and utilization rates at IFS, as mentioned earlier. Overall, DXP produced EBITDA of $13.5 million versus $12.8 million in the third quarter of '16, a year-over-year increase of 28.5%. EBITDA was, as a percent of sales, was 5.4% versus 5.6% for the third quarter in 2016. Earnings per diluted share for the third quarter was $0.16 compared to $0.02 per share in the third quarter of '16, a year-over-year increase of 800%. Sequentially, DXP experienced a decline of 0.07 from the second quarter. In summary, DXP delivered 9% sales growth, 6% EBITDA growth. And in the third quarter, we were negatively impacted by gross margins but do not see this as a long-term trend. In addition to delivering profitable growth, at the end of August, as Kent mentioned, we completed the refinancing of our debt, and we now have a capital structure in place to execute our strategy and position DXP for the future. Moving forward, we will pursue both organic and inorganic growth. We are actively engaged in discussions around acquisitions and expect both organic and acquisition opportunities in the future to maximize our growth. DXP and all our stakeholders are barred up, excited about winning and growing as we continue to be customer driven, partner with great suppliers and take market share by being fast and convenient with technical people and products to solve our customer's most demanding problems. Before I turn it over to our analysts for questions, I would like to thank our entire team again for their hard work, commitment, dedication to our plan, our customers, but also to each other during the third quarter. DXP's facilities endure the floodwaters from the hurricanes. Unfortunately, many of DXP's employees and customers were not so lucky. Our thoughts and prayers will remain with those employees and customers and their families who experienced significant damage and are in the process of putting their lives back together. We are proud of our DXPeople who pitched in to help their coworkers, families and friends, neighbors and our customers. There are many stories of DXP people rescuing those trapped from high waters, serving meals, volunteering in shelters and pulling wet carpet and sheet rock. Everyone worked hard to take care of both our coworkers as well as our customers. Thanks again, and we are all proud to be part of DXP. With that, we will now take questions.

[Operator Instructions] Your first question comes from Matt Duncan of Stephens. Your line is open.

Hey good morning guys.

Hey Matt.

So first thing, I may have missed it, did you quantify the revenue impacts from the hurricanes?

Yes, Matt, this is Kent. As everyone knows, kind of, our business tends to surge at the end of any month. And so when we looked at that surge and the impact on August really tearing into September, that impact roughly was about $5.2 million. The surge was not a strong at the end of August, and that's when the hurricane started to hit back as early as that Thursday, if you will. And so it was about a $5.2 million impact.

Okay. But Kent, if I'm doing my quick math right here, the write-off of debt issuance costs was about $0.02. And then the hurricane impact seems like at a corporate average, gross margin maybe that was about a $0.05 impact had you not had the hurricanes. Is that sound reasonable?

That sounds reasonable. In terms of gross margin, one thing you got to keep mindful of is we did – it guarantee certain pay even though we were down for individuals during that 5-day period, if you will. So our margins for the quarter at 26.6% reflects some, call it, inflated cost on a gross margin level. But yes, and so if you look at gross margin excluding the noise we discussed, you can really look at gross margins at 26.75% or so, call it and put that against the 5.2%.

Okay. So – and that sort of leads to my next question. If 26.75% is what it would have been without the impact from the hurricanes. You talked a lot about the 2 items, the weight on your gross margins sequentially. Obviously, I think, everyone is trying to figure out how much we need to extrapolate that forward? How quickly can your gross margin recover? It sounds like you've got a pretty clear plan to get both items fixed, 4% to 6% price increase is something you can do or at least attempt to do pretty quickly on the Safety Service business side in Canada. Obviously, at IFS, that may take a little bit longer to push through. So 27.5% is where you were from a gross margin perspective back in the second quarter of this year. How quickly can we see you get back to that rate? Is that something you can start to 27 plus in the 4Q and then by first quarter next year, we can maybe be back to that level, especially given that they'll be on the Canadian Safety Services business as entering a strong part of a year here. So how do we think about the recovery in the gross margin because I think that's really going to be really important to helping us solve forecast profitability going forward?

So Matt, I think you stated the obvious very well. But to be specific. So yes, the price increases for Canadian Services can happen pretty quick. I think one thing missing in the equation is on IFS. This new strategy was sort of implemented, really, let's say, as long as 6 months ago. And so we have built a backlog of nonengineered type fabricate modular systems already. And so those are – it looks kind of like the third quarter was the pinnacle of the low point. And we should see things improving pretty quickly going forward because we have booked I don't know, it's something like $7 million for those types of business. So we should see a little quicker improvement than you might think. And then lastly – no, you go ahead.

I was thinking given that, can you get back to the second quarter level in the fourth quarter, especially since the Canadian Safety Services business is entering the strong part of its year?

I think we – yes and no. I think that was likewise missing part of the equation is that IFS, when they do an engineered, one source engineering fabricating job, of which they haven't had one of those to longer period of time, those margins are 50%, okay? So we – we're not walking away from that business. We're still working on that type of business in, et cetera. But we don't have one of those. We're just – it's not in our backlog right now. We're working on lots of quotes and they will come, and let's say when they come, we normally are relying on 2 or 3 jobs a year. This year, we've kind of had the tailwind of the one. And now, we had don't have any. But they're significant. So this business is, at IFS is still going to kind of be lumpy to the extent we can – that we get those kinds of jobs because they're great and we make a lot of money at them. So the business it's coming. It's going to be better, much, much better than not having any business because they will be more in the 25% type range, 20% to 25% type range of fabrication work. And so we'll get some improvement, but if the weather goes all the way back to 27.5%, I don't know. The other piece I was going to comment on is that, as we continue to certainly, pay people that were along the Gulf Coast, when we take all the people that were in fabrication, I really want to make this clear, we still pay these people in fabrication, but we didn't charge them to the job. So they become unobserved overhead. And so that hurt – that directly hurt our margins, not when we close the job. But today, we – a guy works an 8 hour day, we charge 8 hours to the job and it's recorded in absorbed overhead. So we had all this unobserved overhead that will go away. And so will have an immediate pickup on that in the fourth quarter. Now I think we've calculated that out to be $400,000 or $500,000. So it's not like a tremendous picks, but everything helps.

Okay. Yes, all that color helps a lot. So we probably don't get back to that level in the 4Q, if I'm hearing you correctly. But we're well on our way to fixing gross margin. And if we're not there in the 4Q, we probably should be in the 1Q is the way to think about it.

Absolutely. And really, I would like to think in terms of margins being higher. I mean, we really need to get, as business improves, our people have to go from a mindset of trying to win every order to now, let's win orders in that we can make money on. Our IPS is working double shifts right now. Our manufacturing people are working double shifts. So we've got to turn our attention from – we've got to win every order to keep busy to no, no, no. Now, we have enough orders. We just need – we need to make sure we make some money on them. And so as we shift to that kind of a seller's market and not being such a buyer's market, we should see margins improve.

Okay. Well, and that's kind of where I was going with my next question. You said that your backlog in IPS was up 15% on an average run rate from 2Q to 3Q. What is the margin profile look? Is your backlog is changing? Have you already gotten your people to start thinking profitable growth as opposed to take all volume? Or is there still a little bit of margin squeeze in the backlog?

We're very slowly improving margins, very slowly.

Okay, all right. And then last thing and I'll hop back in the queue. On your Service Centers business, it sounds like a lot of the hit from the hurricane is probably there. But you also had the sale of Vertex that layed on year-over-year growth in that segment. And I think you may have had one less selling day this quarter too, correct me if I'm wrong. But what was the average daily – organic daily sales growth rate if you normalize for Vertex, let's not worry about the hurricane piece, but the one less selling day, if I'm right about that, what was your average daily sales growth for the Service Centers business this quarter?

I think it was – we calculate it's 14.8%.

That's obviously really helpful, guys. I mean, is that more energy driven at this point? More industrial driven? Is it – you're seeing good benefit from the both? And then again, clearly, the Americans, if not for the hurricanes, it would be even better.

It's both.

It's both. It's both, Matt. Obviously, the indicators we look to PMI, the metalworking business index, they support the industrial piece of our business in the region. Some of the regions we mentioned are kind of more heavily industrial driven versus oil and gas, higher River Valley, North Central, frankly, year-to-date, if you look at year-to-date and year-over-year. And so in the industrial pieces definitely beginning to show strength. And then, obviously, oil and gas is, call it, in the aggregate in 2017 has been in recovery mode. And so we're getting a positive feedback when we go through our planning as well as in the results. So...

Okay. Alright, I appreciate it guys.

Thanks Matt.

Your next question comes from Joe Mondillo of Sidoti & Company. Your line is open.

Hey Joe.

Joe.

Your line maybe unmute sir.

Good luck to talk to you.

Your next question comes from Steve Barger of KeyBanc Capital. Your line is open.

This is Ryan on for Steve.

Hey Ryan.

Hey Ryan.

My first question is, can you kind of talked about the trend you're seeing during the quarter on a month-to-month basis and so far what you're seeing from preliminary October results. Sorry if you already brought this up. I kind of got on the call a little bit late.

I guess you're asking sales per day?

Yes.

Sales per day for July were $3,785,000; August, $3,643,000; September, $4,622,000, for an average for the quarter of $3,999,000 a day. Our October, which includes some estimates of sales for the month comes out at $4,005,000. So essentially, definitely better than in the July and August sales per day, below the September, but perfectly flat with the average for Q3. Do you want to know about the first 2 days of November? Is that what you're asking?

No, no. I wasn't asking that. And then looking at a incremental margins during the quarter came in at about 7% or 9% roughly 9% growth. I think, I was expecting a little bit of a higher number. And looking at IPS and supply chain services, I mean, you put up a 2% incremental on all those 30% growth in IPS. I assume a lot of that was from the gross margin pressures. But was there anything else in that kind of drove that low incremental during the quarter?

No, that's it, Ryan. It's the gross margin pressure we discuss in IFS within IPS. And so, ideally, at this point in the cycle, even though we're still working through the pricing pressures, if you will, in the market becoming more favorable to us, the operating income margin is probably frankly, should be up 100, 200 plus basis points at least at IPS at this point.

I really would like to say it, that's all correct technically. But really, what's intriguing and important and just kind of, I guess, the people have faith that the things are going to improve is that IFS simply only sold engineered product and modular systems. And they only did that type of business. We have simply added all of our other products that DXP does, other types of modular systems, other types of large pumps, et cetera, to their product offering, which is already made great dividends and the increased sales. And yes, they make a little. We make less than that. Margins go from 50% to 25%, let's say. But it's going to make their business so much more dynamic and so much more profitable going forward. This feast or famine thing is ridiculous, and so we fixed that. We fixed that a while back. And so it'll start paying dividends going forward here. And the other is that I kind of get that they oilfield companies want to hold your margin, they want to hold pricing down as much as they can so they make money at $50 a barrel. But the truth of the matter is they are making money at $50 a barrel. And so us holding our prices firm on safety services where we basically rent people, and those people, though, have said, "Look, we haven't had an increase in 2 years." Well, I don't blame them. I think the people deserve an increase after 2 years. But we have got to pass that on to the customer. We can't – we're not a non-profit organization here. They can't pass that on to the customer. So that simply has to be done. The fact it wasn't done is pretty – I didn't like that. So let's just say that there's some things that are very logical here and very simple fixes and they're in the process of happening, and we'll get this thing. We're just simply not hitting on all cylinders and we're going through pretty quickly. So...

Okay. Then my last question going back to the Service Centers in the gross margin pressures you're seeing there. Are you seeing any pricing pressures from nontraditional distributors such as the Amazon business primarily within your safety products as price transparency increases? I mean, are you seeing any pricing pressures from that?

I'm well aware of Amazon, well aware of people that have a lot of headwinds against that company in the industrial sector. I'm really aware of the fact that their whole model is based on 3 things, and we'll kill them all – 2 of them, but the third one is a little concerning at times. And that's speed, convenience and price. That their whole model is based on speed, convenience and price. We're frankly faster to market with our type of products because they're technical, they're solution driven, they're not just a simple part number, and we can do it faster than anybody else can in the industry, quite frankly. Our customers are not mass marketed customers. They're specific customers where we have a relationship. We call them the account. And we do everything we can to serve that customers, like – be like Mac having somebody drive his car everyday versus Kent who drives himself. We're out there driving that guy's car. We understand his business, et cetera. So I'm not at all worried about Amazon. I'm not really worried about other mass market retailers and industrial people. I am worried a little bit at times on some of our stuff that's not as technically. If it's technical, there's no worry. But if it's not as technical, if it's just part of safety products that are hardhats and things like that, that we – we only have those things to capture more spend of each customer. We want more of each wallet of each customer we have, and our customers are specific. We got – I don't really know how many of them they are today. But 30,000 to 40,000, 50,000 customers are very specific. We're not trying to cover the world. They – we get call through on those products because we're they're already. We are delivering already. We're – We got vending machines that are on their floor, nothing is faster than a vending machine on the floor because we need somebody walks over there and gets it, he get it in 2 minutes, okay? Amazon talks about 2 hours on things they have on inventory. Nobody delivers something in 2 hours if they don't have it in inventory. So I'm not really worried about that. The problem is, get on, going to screw up with the market, we're just giving things away. The pricing policy, I mean they're just bad news. They're not making any money on giving the stuff away. So the question is, ultimately is, I don't think they're going to affect our sales or they affecting our margins. And I don't – we are not just going to play that game with them. And if we have an account, that was buying pump from us that he can't buy from Amazon, but he's buying all the other stuff from Amazon. But we'll just let him know. Hey, that's going to be unacceptable. We are going to stop calling on you, et cetera. And so I'm kind of painting – I really want to make sure I'm painting worst-case scenario, which I don't think is that bad. And best-case scenario is that the customer relies on us and he's going to continue to buy all of his technical products, technical services and his commodity stuff from us like he does today and they're not going to shift to Amazon. On convenience, we have B2B sites, we can set up a customer-to-customer relationship and do it all electronic. We can do all of that. What we don't have is – we don't just have this site and people come because they want to buy something from DXP. That didn't happen. We have a relationship with that account and we're going to treat him better than Amazon can treat him. That's a given. What's not a given is I'm just giving it away, and I don't know what to do about that.

Hey, Ryan, just to put the sequential growth.

Sorry to take you through my lecture, by the way.

So just to put in the gross margin sequential performance in the context. If actually, our gross margin in Service Centers, we don't necessarily disclose it. But from a basis point perspective, it's actually up 14 basis points from Q1. And so – and when you look at our gross margins for Q3, they're well in line with where we performed last year. So once again, we get the backdrop in the question and query around Amazon ultimately, and David gave us the global view. But from a performance perspective, we're really not seeing it impacting our Service Centers.

And to add to that, just one thing. The area that we are going to fix pretty quickly here, Amazon doesn't touch. Amazon doesn't make modular package system. They do engineering work. They don't even touch that. Amazon doesn't have Mac McConnell's train to the safety technicians. They go out and set on a drilling rig. They don't do those types of services. So the area where our margins got pulled down and we told you specifically what caused that, that's not even – Amazon is not even in that business.

[Operator Instructions] There are no further questions at this time. I return the call to our presenters.

We are done.