Fastenal Company (FAST) Q4 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Fastenal Company Q4 and Fiscal Year 2017 Earnings Results Conference Call. At this time, all participants are in a listen-only mode. Following management’s prepared remarks, we will host a question-and-answer session and instructions will be given at that time. [Operator Instructions] As a reminder, this conference call may be recorded. It is now my pleasure to hand the conference over to Ms. Ellen Trester of Investor Relations. Ma’am, you may begin.

Welcome to the Fastenal Company 2017 annual and fourth quarter earnings conference call. This call will be hosted by Dan Florness, our President and Chief Executive Officer; and Holden Lewis, our Chief Financial Officer. The call will last for up to 45 minutes, and we’ll start with a general overview of our quarterly results and operations, with the remainder of the time being opened for questions and answers. Today’s conference call is a proprietary Fastenal presentation and is being recorded by Fastenal. No recording, reproduction, transmission or distribution of today’s call is permitted without Fastenal’s consent. This call is being audio simulcast on the internet via the Fastenal Investor Relations homepage, investor.fastenal.com. A replay of the webcast will be available on the website until March 1, 2018, at midnight Central Time. As a reminder, today’s conference call may include statements regarding the Company’s future plans and prospects. These statements are based on our current expectations, and we undertake no duty to update them. It is important to note that the Company’s actual results may differ materially from those anticipated. Factors that could cause actual results to differ from anticipated results are contained in the Company’s latest earnings release and periodic filings with the Securities and Exchange Commission, and we encourage you to review those factors carefully. I would now like to turn the call over to Mr. Dan Florness.

Thank you, Ellen, and good morning, everybody and thank you for joining us on our fourth quarter earnings call. First off, Happy New Year and welcome to 2018. Before I touch on the quarter, I’d just like to share a couple of stories. One is the conversation I had with Bob Kierlin, our Founder of Fastenal, about a week ago. Being in just finishing my second year in this role it’s nice to having Bob around to share thoughts with periodically, and I shared with him my President’s letter for the annual report we will be filing here in early February. And he stopped back and after reading through and he said, yes, I liked your letter. I do have a question for you though on the right hand column of the first page, I really think you should change it. And I am like okay and he said it feels like you are on an apology tour because you are frustrated with Q4. And he said, you know, what are you doing right now? Your -- Fastenal is working to evolve the business. Where we’ve been ramping up our business activity, we’ve been ramping up our development activity, that’s relates to our district manager and our branch managers. We’ve been ramping up the business to support vending at a higher level and you are ramping up to turn on Onsites and all these things require people and energy and a lot of it. And we are doing it quickly and he said you know we’ve tripled the number of Onsites we have in a couple of years and we have a whole bunch to turn on, and again that takes energy to do, explain that, don’t apologize for it, explain that. And that was helpful. I did modify my President’s letter as a result and hopefully explaining it better. One thing you will notice when you read the President’s letter, I touched a lot on the what we are trying to accomplish as well as I explained a lot about the year from the standpoint of the pretax because if you get into after tax, it starts to get little noisy, we’ll touch on that later in the comments. The other aspect of the story is a conversation is with our RVPs this morning, our Regional Vice Presidents. In that call, 7 O’clock Central this morning I thanked them for 2017, wished them all very good luck in 2018, shared with them my thoughts on the health and capabilities of our business and how much that’s improved in the current year. And the excitement there is when we have financial success, career success, our customers have a good year. But I challenged them on a few points and the first one centered on gross margin. And in the last call I really felt our gross margin in fourth quarter would come in at 49 and we are about 20 basis points below where I thought we would be and if you think about our gross margin it was really - we talk about end customer mix and end market mix. I oftentimes think about it in the simple context of there is really three components, if you ignore customer mix for a second, as fasteners, non-fasteners and freight. When you move in relatively inexpensive product per pound around a large continent, freight is a big deal as well. In the case of non-fasteners, our largest group of products, it’s about two thirds of business, a lot of noise in the summer and fall about what was going in that marketplace, lot of ecommerce change really impacting that marketplace, a lot of noise in the market, some competitors lowering - adjusting their prices and what that might mean for Fastenal. Right now non-fasteners and our non-fasteners about 25% of that goes through vending platform. So we go to market in a very different channel than our competitors. Our non-fastener business is growing as strong as it’s ever grown, Holden would touch on that later in the call. Our gross margin in non-fastener was 10 basis points higher in the fourth quarter than it was in the third and it dead on even where it was a year ago and I feel really good about that. All the noise that’s going on, all the stuff that’s going on in the marketplace our team is reacting very well. And I shared that with our team this morning. In the case of fasteners, we’ve seen our gross margin slip from the both year ago and from the third quarter. And really two things that’s driving it. One, a disproportionate amount of growth is coming from large customers, lot of OEM fasteners, that’s -- and it’s going to hurt margin and I get that but part of the slippage is occurring because the fasteners are seeing inflation right now and we are little rusty on addressing that, perhaps I am not pushing the group fast enough, perhaps group isn’t a moving fast enough, or maybe it’s a little bit of both. We are little rusty on that. We lost some gross margin in the quarter but that’s not what was frustrating me because I believe and I believe that’s fixable. And I believe the things we have in motion will fix that. What frustrates me was on the freight side. And in uncustomary fashion we were sloppy on the freight in the fourth quarter. And it’s a not a revenue problem, it’s an expense problem. And we were careless and sloppy and it involved our distribution centers, it involved our branch network and it involved everybody that supports those two. So it involved 20,000 people and we were careless in the fourth quarter. And that’s where our 20 basis points were lost. We’ve always deleveraged little bit in the fourth quarter because our sales are dropping off but we did more than normal and that was frustrating me. And Bob also pointed out, yes, and some of that is because you are adding capacity to handle the volume you see in the near New Year and to support those Onsites that are turning on never lose sight of that. And but if you are being sloppy, just fix it, don’t apologize for it, just fix it, so that was my conversation with our RVPs that’s related to gross margin. Our second conversation talked about, we spoke about rent and I am talking about dollar spent on rent throughout our network. A year ago I really challenged the group and said, we need to look at dollars we spend on our buildings. And from Q1, 2017 to Q4, 2017 it can’t grow, in our 50 year history that’s never happened. But this year it can’t because as we are migrating to the Onsite platform, as we are continuing to leverage and lean-up our income statement to be more nimble in the marketplace, that can’t grow. I am pleased to say between the first quarter of 2017 and the fourth quarter of 2017, the rent dollar we spent dropped $360,000. Now on the context of $4.5 billion Company that might be not mean a lot, it was huge in our business because we’ve never done it before. And I challenged them to do it again in the next 12 months between Q4, 2017 and Q4, 2018, let’s repeat that feat. Some of it’s occurring because we are consolidating some of the businesses as we are moving some of our business in the Onsite as our growth is driving in Onsite. We are rationalizing everything we do and we are consolidating some branches. But everything we are doing we are doing to grow faster. It isn’t about saving expense dollars but I did want to see if could harvest some of that because I’d rather deploy those dollars elsewhere, which brings us to the quarter. The -- our pretax earnings for the fourth quarter of 2017 and for 2017 grew double digits. I can’t think about a better way to celebrate 50 years in business. Our earnings per share for the year came in at just over $2.01, that’s a bit noisy of a number given that we had some tax legislation passed late in the year and that impacted our income statement. As you all know, most of our revenue and most of our profits are generated in United States of America. And I think it’s still just over 85%, 88% to be exact. And we’ve historically paid a tremendous penalty for being a US based business in our global market place and our tax rate has been dropping over years as our internationals got to be bigger. So it creates some noise but if you look at ignoring that tax change, our earnings -- our pretax earnings -- earnings would have grown about 12 -- just over 12% in the quarter and just over 11% in year. Again, an excellent way to finish the year. Daily sales growth is strong in the fourth quarter, we grew almost 15%. That was lifted little bit our Mansco acquisition early in the year, without it, it would have been just over 13%. And for the year, our daily sales grew 11%. As mentioned, we are aggressively investing to spurt our Onsite initiative, our vending initiative, and our ecommerce initiatives. But we obtained good operating leveraging in the fourth quarter and for the year. I believe we can stay in this momentum as we go into 2018. There was a little window dressing going with some customers late in the year and our cash payments just abruptly halted between Christmas and New Year and cash came in like crazy the first week of January. So a little window dressing to hurt our cash flow late in the year. I am pleased with the fact that after making a sizable investment in what we call CSP16 our inventory in 2016, we were able to lower our days on hand of inventory nominally in the 2017 and we work to do that again in 2018. That was the third item I covered with the -- our VP group this morning. Our share price has had a nice run in recent months, really in 2017 in general, little choppy along the way but had nice run and because of that and our desire to maintain a meaningful dividend for our shareholders, we raised our dividend as we announced last night. I am going to page 2 of the flip book if you are following along but our Onsite initiative used to be a regional thing. It was something we were doing aggressively -- we were doing aggressively in some of our older regions especially in the upper Midwest. We were doing it aggressively in Mexico and seeking incredible growth in recent years because of it. What I am really proud of is we’ve turned Onsite a regional thing into company thing. Two years ago when we really started to move the Onsites signing up, we moved the needle because instead of signing a handful 8, 10, 12 Onsites in the year, we signed just over 75 because 25% of district managers went out and signed an Onsite. Our business is -- our success stems a lot from that group about 240 some people scattered around the planet mostly North America. In 2016, we dramatically increased our Onsite signings add about 100 to it because 52% of our district managers signed an Onsite that year. Comes into this year we have a big goal to expand that another 100. We came in at 270 Onsites because 73% of our district managers signed an Onsite this year. It’s not a regional thing anymore, it’s a company thing and it’s moving the needle on our business, its moving needle on our growth. We have a big goal for next year. Let say another 100. Don’t know who had that goal, but our stated goal right now is 360 to 385, even in some of internal meetings you might even hear us say, hey, let’s go for 400 but our stated goal is 360 to 385. We have the expansion of our Onsite; we have almost 3,000 in market locations across the planet today again most in North America versus just over 2,900 a year ago. We signed 19,355 vending devices in 2017, up nicely from last year. The one positive as we rapidly expanded our footprint, we’ve grown in a basically a decade from literally no vending machine to just over 70,000. When you do some very quickly you make some mistakes, you get along the way, and you are aggressive along the way. And we removed a number of licenses, we didn’t install 10, we need really -- we installed 5 where really need 4 that kind of stuffs. Thanks we’ve installed one; maybe we shouldn’t install that one. And so one thing that’s very uplifting when I look at 2017 is the percentage of devices what we are removing every year it started to improve. And we saw that in the final three quarters of 2017. So said another way, you can feel and think a lot faster if you turn on the faucet and you plug the drain. And we plugged up drain a bit. Our goal is to sign 21,000 to 23,000 devices this year. National Accounts, the group is executing at an unbelievable level. They are busy. They are creating a lot of work at branch network and they are creating the need for us to invest heavily. Our National Accounts grew 14.5% for the year, 18.5% in the fourth quarter. My compliments to the group and to everybody else in the company who supports that business. Finally, and it’s not a bullet on the chart, our construction has gained momentum as we’ve gone through 2017 and that’s a really pleasing thing because in the last decade, we became an ever better company in the industrial market, we doubled in size. But our construction business in that same decade grew about 35%, that’s cumulative number, not an annual number, cumulative number. We really struggled to gain footing in growth. We started to get taste as year went on. Our goal was to grow 5% I think for the year we grew around 6%, but we exit the year growing double digit. So I feel really good about what that means for 2018. With that, I’ve overstayed my welcome. I’ll let Holden talk.

Thank you, Dan. Good morning. I am going to begin with a quick recap for our 2017 results. Before moving on to discuss on the quarterly performance. In 2017, Fastenal generated $4.4 billion in sales, which is up 10.8% from 2016. We had one fewer selling day in the year so on day’s basis we are up 11.3%. We did get the economic tailwind that began in late first quarter, strengthens throughout the year, however, we also believe our growth drivers have allowed us to outgrow the marketplace and I want to provide a little bit more color on those. For vending, excluding units in all these locker program, we finished 2017 with over 71,000 in installed machines, up 8,600 units or 14% over 2016. Signings were below our full year goal but up 7%, but at the highest level since 2013. We also saw higher revenue per machine of 2% to 3% and removables were down 4% and because of that revenue through our machines rose more than 15% in 2017. In 2018, we are targeting signings of 21,000 to 23,000. We signed 270 new Onsite agreements in 2017, shy of our goal of 275 to 300 but well above last year’s 176 signings. Growth of sales through Onsite excluding branch transfers accelerated through 2018 and was up 22% for the year. We are targeting 360 to 385 signings in 2018. Lastly, National Accounts pace the overall business with daily sales growth of 14.5% in 2017. Sales for our largest customers accelerated through the year with December up 19.7% to a greater extent than last year this is achieved both through a combination of new accounts and by penetrating existing accounts. Margins in 2017 stabilized. Our gross margin finished at 49.3 which were down 30 basis points. This was largely due to products margin which was mostly impacted by a combination of product and customer mix and the inclusion of Mansco since acquiring it on March 31. Operating margin finished 2017 at 20.1%, flat with last year. Operating expense leverage offset the gross margin decline which was most significantly attributable to occupancy as we shut 120 net public branches in 2017. This was probably offset by the absence of vendor freight credits received in 2016 related to CSP16, increased amortization and higher legal settlement activity. At the gross margin line, mix will likely remain headwind in 2018. We’ve recently taken actions to offset product inflation and the degree to which this variable affects gross margin 2018 will depend on the effectiveness of these actions. At the operating expense line, we think there is room to leverage occupancy further. Everybody expects some leverage over employee related expenses as growth and incentive compensations moderates. Our interest expense was up 40% in 2017 owing to higher rates of debt assumed in the Mansco acquisition. Our tax rate fell for 36.8% in 2016 to 33.7% in 2017 due largely to the discrete items related to the recently passed tax reform which I’ll discuss in the quarterly recap. Excluding this, our tax rate would have been 36.5% in 2017, it all blended to a full year 2017 EPS figure of $2.01, up 16.2% from 2016. If I exclude the discrete tax items, our EPS would have been $1.92, up 11.3% from 2016. Now shifting to the fourth quarter and looking Slide 5 of the deck. As Dan stated, total and daily sales were up 14.8% in the fourth quarter which represents acceleration from 13.6% daily sales growth in the third quarter. Mansco contributed 140 basis points to this growth. The fourth quarter finished well with December daily sales growth coming in at up 14.7% or up 13.3% excluding Mansco. In terms of market tone, conditions remain healthy. Macro data remain favorable with a PMI averaging 58.9 in the fourth quarter. Industrial production growth accelerated is now rising at a low to mid single digit rate. Manufacturing end markets continue to lead with strength in heavy and general manufacturing, transportation and energy. The positive inflection in the quarter was in construction as Dan mentioned which was up 9.6% in the fourth quarter and was 11.9% in December. Feedback from the field, our construction began to improve late in the first quarter. The uptick in November and December seems to reflect activity levels catching up with that sentiment. From our product standpoint, we experienced acceleration in both fastener and non-fastener lines. From a customer standpoint, National Accounts accelerated again growing 18.4% in the quarter with our 72% of top 100 accounts growing. Growths to smaller customers are steady and nearly 65% of our branches grew into the fourth quarter, up from 64% in the third quarter or 62% in the second. We have no reason to believe that the demand we experienced in the fourth quarter has to continue into the first quarter. That said, beware that storms in the Eastern and Southern regions of the US have had a significant impact on business activity in the first half of January. Now on the Slide 6. Year-over-year, our gross margin was 48.8% in the fourth quarter, down 100 basis points from the fourth quarter of 2016. We had a particular difficult comparison with the fourth quarter of 2016 gross margin having been unseasonably strong on the back of vendor credit received as a result of CSP16. We experienced a downtick in our products margin as a result of mix, inclusion of Mansco and to a lesser degree product inflation in fasteners. Freight was a significant drag in the period owing to higher payments of third party shippers, and incremental investments in drivers and equipments. On a sequential basis, our gross margin was down 30 basis points. While it’s not unusual for our gross margin decline sequentially, we did expect slightly better. And I think two things are notable. First, the freight variables cited in the annual comparison fell heavily into the fourth quarter relative to the third. Second, the fourth quarter did see price cost pressure on our fastener line. This is modest in the period; however, given continued inflationary condition in the marketplace, we did initiate actions in the fourth quarter including pricing to defend our profitability. We would expect these actions to provide stability to our margins in 2018. Our operating margin was 18.7% in the fourth quarter, down 60 basis points year-over-year. The 100 basis points decline in gross margin was partially offset by 40 basis points of operating expense leverage. Looking at the components to that, occupancy related expenses were down 1%, the largest element being the continued deduction of public branches in the quarter and to the year. Selling transportation related expenses were up 7.4%, the most significant element of that was a 17% rise in fuel primarily from higher prices for unleaded. This leverage was partly offset by the cumulative effect of small items such as lower vendor credits given the absence of a major CSP initiative in 2017, higher legal cost and higher amortization. Employee related cost were up 15.5%, 120 basis points of which relate to Mansco’s headcount and incremental expenses related to implementation of last year’s DOL rules. The latter of which will fully anniversary in the first quarter of 2018. The remaining increase is a function of the reset of incentive comp throughout the organization given our return to strong growth in 2017 and an increase in overall staffing. Total headcount growth was up 4.8%, or up 7.7% on an FTE basis. It all blended to fourth quarter EPS figure of $0.53, up 33.5% from fourth quarter of 2016. The quarter included two discrete tax items, a gain related to deferred taxes on fixed assets and a charge related to transition tax on foreign cash and earnings. This added up to one time tax benefit of $24.4 million excluding the discrete items, our tax rate would have been 36.2 and our EPS would have $0.45, up 12.2%. We are still refining our understanding of various elements of tax reforms but expect our full year rate to settle at a range of 24% to 26% excluding any additional discrete item that may arise during the year. Turning to Slide 7, we generated $129 million in operating cash in the fourth quarter which was 85% of net income. We believe this is a function of the timing of receivable which I’ll cover in a moment. For the full year of 2017, we generated a record $585 million which represent 101% of net income. These improvements are primarily a function of better earnings. Net capital spending in 2017 was $113 million, down 39% largely from the absence of spending on vending machines related to lease lockers. This is below our target for 2017 of 127 which cannot be attributed to a single item but just slightly lower capital spending in a number of places in the company. For 2018, we are anticipating capital spending of $149 million with the increased being largely attributable to spending and upgrading hub capacity and property purchases for potential future expansion. We finished the year with debt comprising 16.5% of total capital consistent with last year and a level that provides ample liquidity to invest in our business and pay our dividend. Given our expectation for earnings and cash flow in 2018 and our desire to maintain an attractive dividend yield, we have increased our quarterly dividend from $0.32 to $0.37 in the first quarter. In terms of working capital, we are pleased with inventories excluding Mansco; our inventories were up 8%, trailing sales growth due to the ability to leverage the heavy investment branch inventory in 2016 and more energy enterprise wide on this line. Overall, days on hand fell by 7. Receivable growth excluding Mansco was up 20% in the fourth quarter 2017. Accelerating growth generally and relative growth from national accounts played a role as has all year. In the fourth quarter however this was compounded by the end-of-week timing of holidays in December which caused a significant volume of receivables to fall into 2018. Payables excluding Mansco were up 34%. Last year’s fourth quarter was unusually low in the wake of high CSP16 related purchases. That’s all for our formal presentation. So with that, operator, we’ll turn it over for questions.

[Operator Instructions] And our first question will come from the line of David Manthey with Baird. Your line is now open.

Thank you. Good morning, guys. Happy New Year. Just quick two part question here. One mechanical and one soft side. First, could you level set everyone on your FIFO accounting and how the price increases flow through P&L? I am just interested in this price increase that you recently put through if you can talk about maybe magnitude and timing of the effect on both the top line and the gross margin as it flows through, that’s one. And then second, what is the main message that you as a leadership team are sending out to the field this year? And I know you mentioned a few things. I am wondering about aggression on new business and focus on value and Onsite and price increases but Dan when you had that conversation with your RVPs what is the number one most important message you would have those guys and gals take out to their team and their customers today?

I am going to start with the second part then I’ll go to the first. And Cheryl [ph] or Holden feel free to chime in if you feel my answer is somewhat lacking. As far as the main message, last year talked about growing - a simple message, grow sales and grow earnings. We’ve struggled for few years. Obviously amplified by the oil and gas slowdown and how it hit our business. The message this year just had one more thing to it. Grow sales and grow earnings, let’s grow it double digit and then the concept of think big. And think big is about one thing we did in 2017 as we worked with all of our district leaders, all of our district managers came in for two day workshop, a day and half workshop. And it was about developing a business plan, a five year business plan for their business. And think big that’s basically this, have a plan. Incorporate our growth drivers Onsite, vending, construction, CSP16, national accounts, international, incorporate that into your plan and vet your plan. Share with your peers, share with a regional -- whether it’s your region or not, share with somebody else and then share with every member of your team because if you get great people pursuing a common goal, you can accomplish great things. And you can get the most out of great people and be more successful move faster. So our biggest message is have a plan and grow your business and think big about it. In regards to -- we are on FIFO accounting, and so our part of inventory increase for the year is inflation. I am not going to get too deep into the magnitude because I just don’t want to get ahead of ourselves Dave but it’s really a third of our business is fasteners and we are getting some squeezing there. And in some cases we have mechanisms in place that’s tethered to indices as far as on a six months basis, there is ability to raise prices in an inflationary period and lower prices in a deflationary period. But we just need to be really crystal with that and I think part of the issue, so I am getting a little beyond your question, part of the issue has been we have been -- we are so wired to grow, grow, grow. And even Holden and I have conversation this morning. We are so wired to grow, grow, grow that sometimes when you are having a conversation with a customer about turning on five or seven additional facilities, you want to balance that with the pricing aspect, but our customers do value the service and what we bring, whether that’s in our traditional branch model or Onsite model and/or our vending model. And it’s really impressing upon the way for us to provide that service as we need to price the product fairly. And we are doing a great job with that on our vending business and our non-fastener business in general. We are just not moving fast enough on our fastener business. So I am going to shy away from quantifying the impact but Holden, you want to talk about it.

Yes. I might just chip in Dave as well. If you recall we actually had a modest increase in prices we put in the second quarter in response to what we are seeing inflation in the channel. That really was intended to go after a sliver of the business. And at the end of the day, the amount of which price moved our revenue line this year was fairly immaterial. And we felt that it achieved a goal but it was fairly immaterial overall. This iteration now the demand has gotten stronger and cost inflation has gotten stronger, is intended to address a large slice than we had done in the past. And it’s really intended to do address the same thing is to address the inflation that we see in what’s relatively long supply chain in the fastener business. So we would expect that the -- without giving the details of our quantity, we expect it would be more significant this time around than it was certainly with the smaller on in the second quarter.

And Holden we could see some of that impact as early as first quarter, correct.

Yes. We would expect that we would be able to speak about in concrete terms by that point.

Thank you. And our next question will come from the line of Ryan Cieslak with Northcoast Research. Your line is now open.

Hi, good morning, guys. And my first question is really quick follow up on the gross margin and/or pricing side of things. Holden or Dan, the way I think about the pricing implementation, is it give you the opportunity to once again get ahead of the COGS inflation on the fastener side or should we be thinking about this more as a catch up to what maybe you saw in the fourth quarter with regard to that headwind?

Yes. I would characterize it as a bit of a catch up in this regard. I mean as Dan had indicated and I talked about in the script was, we did see the fastener gross margin in the fourth quarter tick down as a result of product inflation. So the group has done a great job staying ahead of it in the non-fastener side, we’ve gone little bit behind on the fastener side and so this is intended as much anything else to begin to cover up some of that lag.

Okay, okay, fair enough. And then Dan when you think about the opportunity here in 2018, obviously 2017 was a really good year for you guys in terms of top line. I am not looking for specific guidance but what maybe are some of puts and takes on the top line in the context that comps do get more difficult and what are maybe some of the incremental drivers and how do we sort of maybe frame up what the opportunity could be? Can you actually grow again double digits or should we be maybe tempering our expectations just given the comps gets more difficult? Thanks.

As far as the opportunity drivers for 2018, here are the things that come to mind for me, we have great momentum in our business. As I mentioned earlier, our National Accounts team is executing about as well as I think we’ve ever executed in our history. We have built in lift from the – if you think about the vending machines that we’ve signed that we’ve been deploying late in the year or throughout the year but they have been strong throughout the year. The fact that we are removing fewer and I feel better about installed base and how we are going to grow that in the next 12 months. Our Onsites, we have record number of Onsites that we signed. I feel we have great momentum come into the year because again Onsite now is a company thing. It’s not touching a small chunk of our business, it’s touching the business. So I feel very good about our growth right and the couple of years momentum we have built into them and we are finishing the year strong. And I feel really good about the tax bill signed late in the year. And it’s ability to list -- to lift the industrial marketplace in the United States. Industrial marketplace and I don’t want to get too deep into the discussion here but let’s be honest. The industrial marketplace in United States has been the highest taxed population on the planet. And we are unleashing some of that potential with the tax change. I mean I look at our business for example, I believe the S&P 500 has an effective rate of about 27% before the tax act. Our effective tax rate in recent years has been about 10 points higher than that, 36.5%-37%. And we are indicative of that example. And I believe for a lot of our customers it unleashes their potential to think bigger about their business and to grow faster and we are going to participate in that growth because we are going to help support their business. And I feel really good about that coming in 2018. And I think it has some legs to it.

And Ryan just wants to chip in one thing from the earlier question just to make sure everyone understands it. Although product inflation was a factor in fourth quarter, it was well behind product mix, the impact of Mansco and the issues around freight in the quarter in terms of an impact. So when we say that we are sort of catching up, if you will, I don’t want to leave the impression that we fall in particularly far behind. It was a fairly minor factor in the fourth quarter. We are acting because we needed to make sure that it doesn’t expand as an issue in 2018.

Fourth quarter was above guidance.

Got it. Just really quick on freight, Dan. Just really quick if I can. Is the freight component more of an internal or company specific element or are you actually seeing some pressure from the marketplace as well as it relates to maybe drivers? You mentioned few, how much of it is more company specific and execution versus maybe some market headwinds that you guys are seeing right now? Thanks.

It’s us. It’s company specific. A piece of it is seasonal but that was true last year too. But when I look at the impact of fourth quarter versus third quarter a year ago, and the impact of fourth quarter versus third quarter in 2017, it’s us. Because what were -- the relativeness of what we are charging for freight, relativeness of how much we are doing internal versus external, we moved most of the freight on our own trucks which is a huge competitive advantage. We still manage it well. And I am going to cut you off with that question. And we will go on for the next one. We are running a little tight on time.

Thank you, sir. Our next question will come from the line of Christ Dankert from Longbow Research. Your line is now open.

Hi, good morning, guys. Thanks for taking my question. I guess just trying to take a bigger picture here. How would we think about the pathway to profit kind of in the context of Onsite being such a key driver now? And kind of how that looks versus traditional stores?

Okay. I’ll take that one. Pathway to profit historically was about growing our average branch size and as that would happen the operating expenses drop dramatically. A branch doing $50,000 to $80,000 a month has operating expenses well into 30s. A branch doing $150,000 to $250,000 a month has operating expenses that are well down into the mid if not low 20s but mid 20s anyway and so that’s really what the pathway to profit was about, was letting the inherent profitability shine through. Onsite creates challenge for pathway to profit in that your revenue growth is coming from our growth drivers, vending help our branch revenue grow. CSP helps our branch revenue grew. Onsite actually help, cause the brands revenue to either trade or maybe go back slightly. So if I have $20,000 month account in a $150,000 branch and I move that to an Onsite to turn into $100,000 customer, the branch close on $150,000 to $130,000 and so we have negative leverage going on there which hurts the pathway to profit concept. Our job is can all those other things get us back to 150. The more thing we’ve been talking about in our business where we’ve been closing some branches, so if we move out enough customers and a handful of branches maybe we go from 10 branches in that market to 9 which lets us claw back a little bit to pathway to profit because you got a 9 have a higher average. And so it’s really about on the branch side, the pathway to profit is as healthy as ever. The Onsite creates real challenge for it but I’ll take that challenge because it allows us to grow an Onsite in attractiveness business from the standpoint of our ability to grow with it, and our ability to generate return.

And one thing I’ll contribute to that is if you do look at the Onsite that predate this becoming a growth driver; the operating margins are above where the newer Onsites are. And so there is a pathway to profit element that’s getting lost only because we are opening so many. The intermediate term measure of success is the degree to which we use the pathway to profit to expand maturing Onsite base and to begin to refill what we took out of the branch and then they sort of go down that pathway to profit, second time if you will.

And I guess if I could just flip through the timing a bit more I guess. Is there a way to breakout the Onsites by age then? Maybe we can back into year where you started the year where you finished the year but as far as trying to think about profitability and size, the net impact for 2018 and beyond. I mean is there any way that we kind of look at profitability by our size and then sub divisions at all?

So we do. We have not necessarily gone down the path of sharing that year by year with investment community but we do track that internally. I mean what I would tell you is that from the point that you start an Onsite probably between call it six quarters later you are sort of where the Onsite should be in sort of steady state and then from there you begin doing the things you need to do to improve the margin you go down that pathway to profit, looking for product substitution opportunity, looking for additional volume opportunities. So that path down the pathway is probably begin in earnest between four and eight quarters after sort of the signing and that progress begins and then ultimately you get there but with these new ones since it’s becoming growth driver, I am not sure we necessarily figure out the exact date that you get to a corporate margin on the Onsite business from the time you start.

We are going to take more one call. I see we are at 43 minutes past the hour, one more question I should say.

Absolutely. Our last question will come from the line of Robert Barry with Susquehanna. Your line is now open.

Hey, guys. Thanks for taking the question. Good morning and Happy New Year. I did actually one who follow-up on a comment holding during the prepared remarks about stability, expecting stability in gross margin in 2018. But that’s just a price cost comment and then maybe we should layer on what has become this kind of normal 20 to 30 bp hit from next from the growth drivers. So like to [Multiple Speakers]

So thank you for clarifying. That’s right. It was intended to be comment about what we were doing at pricing and it was really twofold. One to just let you know that we are taking sort of part and places seriously and taking steps to do it. But the second is we are not necessarily looking at this is an opportunity to boost our margin, if you will, right. We are trying to defend our margin from product inflation that everybody in the marketplace knows that’s there. And so I think that you are right to think about in terms of -- it’s intended to offset product inflation and then the other variables that are always there on gross margin are still there.

Right. So thinking about just kind of level setting a base case for 2018 it seems like prices offsetting cost inflation and then you’ve got 20 to 30 basis points impact from the growth driver and so maybe that’s kind of what we see. Would that be kind of good expectations?

Yes. I think it’s a good place to start and then we’ll try to do everything we can freight and other element but I think a good place to start is what we said before, which is every year we kind of start off in the whole 20 to 30 basis points on gross margin because of product and customer mix and when you see how faster our National Accounts are growing, international growing, the Onsites are growing, there is no reason to think that that’s any different 2018 than it was 2017.

Got it. And if that happens do you think operating leverage [Multiple Speakers]

We try to religiously keep this till 45 minutes because we realized its earnings season and everybody business and have other call to hop on. Thank you everybody for participating on our call today. As our last question touched on, it forces us to focus very, very intently on the operating expenses within our business. Invest wisely to support growth, invest wisely to grow faster and but manage our expenses prudently. Thanks everybody. Have a good day.

Ladies and gentlemen, thank you for participation on today’s conference. This does conclude our program. And we may all disconnect. Everybody have a wonderful day.