MSC Industrial Direct Co., Inc. (MSM) Q3 2015 Earnings Report, Transcript and Summary

Good morning, and welcome to the MSC Industrial Supply Company Third Quarter 2015 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 and Investor Relations and Treasurer. Please go ahead.

Thank you, Emily, and good morning, everyone. I'd like to welcome you to our fiscal 2015 third quarter conference call. 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, and expectations regarding future revenue and margin growth. 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 the earnings press release and the risk factors in the MD&A sections of our latest Annual Report on Form 10-K filed with the SEC, as well as in our other SEC filings. These forward-looking statements are based on our current expectations and the company assumes no obligation to update these statements. Investors are cautioned not to place undue reliance on these forward-looking statements. In addition, during the course of this call, we will refer to certain adjusted financial results, which are non-GAAP measures. Please refer to the table attached to the press release and 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 our Chief Executive Officer, Erik Gershwind.

Thank you, John. Good morning, everyone, and thank you for joining us today. Also with us is Jeff Kaczka, our Chief Financial Officer. Before I cover our usual subjects, I'll start with yesterday's announcement. I imagine that most of you saw our press release introducing Jeff's replacement. I'm very excited that Rustom Jilla has agreed to join us, and start as our new Executive Vice President and Chief Financial Officer on July 20th. Rustom comes to us with extensive experience as a CFO at companies such as Dematic Group, a global provider of warehouse logistics and inventory management solutions, and Ansell Limited, a global leader in protective solutions, and also happens to be a supplier to MSC. We look forward to having Rustom join us in Melville in a couple of weeks. I'd also like to take this opportunity to thank Jeff for his partnership over the last four plus years, and for remaining such an active part of our management team since he announced his retirement. I'll now turn to our normal agenda, and start by covering the operating environment. I'll then turn to business developments, which contain three headlines. First, that sales growth rates were in line with guidance, reflecting the challenging demand environment. Second, that gross margin stabilization continued, despite the extremely soft pricing conditions. And third, that strong expense management led to earnings exceeding expectations. From there, I'll discuss our key initiatives where I continue to be pleased with execution. Jeff will then provide additional detail on our third quarter financial results, and discuss our fourth quarter guidance. I'll then conclude with an update on our expectations for the remainder of the fiscal year, and a broader perspective on the opportunity in front of us. We'll then open things up to Q&A. I'll now turn to the environment. On our last call in April, I described a significant and swift change in demand conditions since the start of the calendar year, and I shared that I believed the weakness was more than just a temporary disruption. Root causes for the slowdown included the impact of the rapid drop in oil prices, softening export demand, and foreign exchange headwinds all of which were impacting broader manufacturing activity. At the time, I said that it was unclear as to whether we had moved out of a moderate demand environment and into a low one. With another few months under our belts and with the same headwinds persisting, it's now clear that we are in a low demand environment. In speaking with customers, while things have not continued to deteriorate, they have essentially remained at low levels in what is a sluggish environment. The root causes are once again primarily related to the oil and gas dislocation and a slowdown in export demand more generally. Visibility remains limited, so it's difficult to look out too far. However, most customers are suggesting that their activity has at least leveled, meaning they've not seen further significant declines. The macro indices we track confirm what we're hearing from customers. The ISM has generally trended downward over the past six months, despite a slight improvement in May and June. It remains well below October's peak, as well as below the 12 month average. As for the MBI, after an up-tick in March, the index fell below 50 in April, and continued to tick down below 48 in both May and June, suggesting a considerable slowdown in metalworking activity. With respect to the pricing environment, conditions remain extremely soft, due primarily to the lack of commodities inflation. Supplier pricing activity, which is the primary driver of distribution pricing movement, remains well below historical levels. Within the context of this environment, our organic growth was 3.5% for the third quarter, consistent with our expectations. Breaking out our growth rate, the base business, which excludes CCSG, performed above company average. Government continued to grow at a strong double-digit pace. National accounts grew at high single digit growth rates, which is down a bit from prior quarters as a result of the macro slowdown. Our core customers on the other hand, lagged the company average, and were slightly positive for the quarter. This is reflective of the particularly soft metalworking market as evidenced by recent MBI ratings. The combination of these factors means that customer mix remains a gross margin headwind. As for CCSG, the macro demand softening and the foreign currency effect on the Canadian business continued to serve as headwinds. Including our cross-selling program and excluding the impact of foreign currency exchange, revenues were flat year-over-year. Although this is in line with overall industry, the headwinds that I just mentioned continued to slow the momentum that we have been experiencing in the business. Cross-selling is now adding roughly 300 to 400 basis points to the CCSG organic growth rates. This is important, because our sales force transformation and cross-selling initiatives are important growth levers, and we're starting to see the results of our efforts. At this point, those benefits are being offset by the macro slowdown. Despite the overall slowing growth rate in the third quarter, we continue to feel good about our share gain performance. Both vending and e-commerce remain strong, as our customers continue to leverage our technology platforms. E-commerce reached 55.9% of sales for the third quarter, as compared to 53.4% a year ago, and 55.4% last quarter, while sales to vending customers added roughly 2 points to our growth rate. We also added approximately 70,000 SKUs net of removals to our web offering, and we now have approximately 970,000 available online. Continued growth in these areas bodes well for future share gains. With respect to sales force expansion, we continued moderating as we had started to do last quarter. This is in response to the softening demand environment, as sales force paybacks lengthen when growth rates slow. We now anticipate sales force expansion to be roughly 2% for the fiscal year. Sales force expansion remains one of our important growth levers, and one that we can easily throttle up as soon as market conditions improve. I continue to be pleased with the sequential stabilization of gross margin. Our third quarter gross margin came in above the midpoint of our guidance range, and flat with the second quarter. This stabilization continues to be largely a function of the counter measures on both the buy side and the sell side of our business that we've discussed on prior calls. Looking at sales since the third quarter ended, we posted average daily sales growth of roughly 2.2% in our fiscal month of June in the face of a challenging environment. June trends by customer type remain consistent with what we saw in the third quarter. With that, I'll now turn it over to Jeff to cover our financial results in greater detail.

Thanks, Erik. And good morning, everyone. In our fiscal third quarter, the soft environment continued and sales growth came in as expected. I'm particularly pleased that we were able to take effective action in areas of the business that we can control. Consequently, we saw significantly lower operating expenses than forecasted, and that coupled with continued gross margin stabilization resulted in adjusted earnings per share coming in well above our guidance range. So let's get into the third quarter results in more detail. I'll continue to speak in terms of our reported results and our adjusted results, which reflect the exclusion of non-recurring costs that were minimal for the quarter. Our sales growth for the quarter on an average daily sales basis was 3.5% compared to last year. Although we continued to see the impact from the overall demand conditions that Erik mentioned, we are pleased that our growth rate is well above industry average, and that we are maintaining our share gains. With regards to gross margin, we posted 45.4% for the quarter, the same as the previous quarter and just above the midpoint of our guidance. We're pleased that our counter measures have continued to have a positive and sustained impact, offsetting the soft pricing environment. Our reported and adjusted EPS was $1.03, well above the high end of our guidance range of $0.95 to $0.99. The primary reason we were able to exceed the top end of our EPS guidance was our tight management of operating expenses. In fact, our operating expenses came in roughly $5 million lower than our guidance. In response to the change in the macro conditions, we implemented several additional cost-down measures in the last two months of the quarter, including clamping down on discretionary spend, moderating hiring, optimizing freight programs and implementing other productivity initiatives. The team mobilized quickly, delivering excellent results faster than expected. As a percent of sales, adjusted operating expenses were 31.4%. That's the same as last year's third quarter, even though we only had low single digit sales growth, and we had increased investment spending. We will continue to tightly manage operating expenses as the soft environment is expected to continue in the fourth quarter. And finally, the tax provision came in at 38.3%, slightly below our guidance of 38.4%. Turning to the balance sheet, our DSOs were 51 days, up from last year's fiscal third quarter, reflecting continued high growth in our national accounts. Inventory turns were down to 3.29 from the prior quarter level of 3.42. As I mentioned on our previous call, over the longer term, we expect inventory turns to improve. However, turns should continue declining through the balance of fiscal 2015 before they begin improving again in fiscal 2016. This reflects the previous inventory build related to expected future sales growth, improving service levels, and the stocking of the Columbus CFC, working itself through the 13 point average turn calculation. As expected, we had a high cash conversion ratio turning 182% of our net income into cash flow from operations for the quarter. This compared to 116% for the same quarter last year, and our conversion ratio now stands at 95% for the first nine months year-to-date. In terms of other uses of cash, we paid out approximately $25 million in dividends within the quarter. Total capital expenditures and infrastructure investments were $13 million in line with our plan, and our expectation for CapEx for the fiscal year is now about $70 million. As of the end of the third quarter, we had $460 million in debt, mostly comprised of $219 million on our term loan, and a $213 million balance on our revolving credit facility. We closed the quarter with $25 million in cash and cash equivalents, and this resulted in a leverage ratio of about 0.93 times. Now let me turn to our guidance for the fiscal fourth quarter of 2015, and let me emphasize that visibility continues to be somewhat limited in this environment. We expect revenues to be between $735 million and $747 million, which translates to ADS growth of about 2% at the midpoint. The midpoint of our guidance range assumes that July and August continue with similar sales growth rates seen in June. We expect gross margin to be in the range of 44.7% plus or minus 20 basis points, which is down 70 basis points sequentially. This decline, inclusive of the expected significant step down in supplier rebates, also reflects the sustained impact of our gross margin initiatives that are helping to offset the typical Q4 seasonality, soft pricing environment, and customer mix. We expect adjusted operating expenses to increase at the midpoint of guidance by only about $1 million versus the fiscal third quarter. This reflects an up-tick in several one-time growth initiatives, as well as the sustained benefits of our recent cost down actions. At the midpoint of our guidance range, adjusted operating expenses as a percent of sales for the fourth quarter is 31.7%. Once again, flat with prior year. While we certainly expect to gain operating expense leverage at higher revenue growth levels, we are pleased that even with low single digit top line growth and continued growth spending, OpEx as a percent of sales is flat. So at the midpoint of our guidance implies adjusted operating margin of approximately 13%. Finally, our EPS guidance is $0.93 to $0.97, and this assumes a tax rate of about 37.4%. In summary, the soft market conditions continued, but we were able to exceed our Q3 earnings per share guidance through effective management of expenses. We will continue to work on gross margin counter measures, and operating expense management as a soft environment is expected to continue through our fiscal fourth quarter. Since this will be my last earnings call before retirement, let me just say that I'm very grateful for having the opportunity to serve. MSC is a special company, and I'm excited about our direction. I also want to especially thank my finance team. I'm proud of what they have accomplished, and how they always operate with the highest integrity. With Rustom coming on board as CFO, we'll be in good hands. And I look forward to working with him in the coming weeks. Thanks, and I'll turn it back to Erik.

Thank you, Jeff. Before I close the call, I want to confirm our fiscal 2015 operating margin framework, and then I'll pull back and look at the bigger picture. With respect to our annual framework, our expected operating margin remains in the lower left quadrant, or 13.4% plus or minus 50 basis points. We continue to hover on the lower side of that range, meaning somewhere between 12.9% and 13.4%. This is despite the fact that the demand environment has moved outside of our expectations at the start of the fiscal year, and we now characterize it as soft. Regardless of the demand and pricing environments, we remain focused on achieving share gains, and hence, growth rates well above market, executing the gross margin counter measures that are producing stabilization, managing expenses carefully, and executing on our growth initiatives. These are all things within our control. As I look ahead, longer term dynamics remain favorable for an exciting growth story. First, the MRO marketplace is very large and highly fragmented, with clear signs that we've entered the early stages of a consolidation story. This is starting to play itself out in the large accounts arena, and I expect the trend to build momentum over time. If the recent softness continues, local and regional distributors will be hit disproportionately hard, and that will mean even more opportunity for MSC to execute our growth plan. Second, despite the recent dislocation that we've seen, U.S. manufacturing will only benefit over time from lower energy prices over the long run, and this will be a tailwind to MSC. Third, we are strategically growing in value-add, high retention businesses, such as metalworking, inventory management, Class C, and more. Fourth, the infrastructure investments that we've made over the past few years including Davidson, Columbus and CCSG, position the company to benefit from earnings leverage, as the environment returns to more normalized growth rates. Fifth, we are assembling a strong and deep management team to lead us through our next growth phase. Rustom, our new CFO, will be in place in two weeks, and our CCO search is making good progress. I'm pleased to announce that Jim Drohan has assumed leadership for CCSG. Jim has served as our Vice President of Business Development for the past two years, and brings with him a wealth of management and operating experience with several large industrial companies. He replaces Ray Rutledge, who has decided to leave MSC for personal reasons. I'm also pleased to report that we're promoting four internal leaders to Senior Vice President roles. These are four individuals who have continued to deliver strong results, and demonstrate company leadership over many years. They are Steve Baruch, who leads Strategy and Marketing, Chris Davanzo, who's our Controller and a key leader within Finance, Greg Polli, who runs Product Management, and Dave Wright, who leads our field sales force. As you can see, it's an exciting time within our company. I would like to thank our entire team of associates for their hard work and dedication to executing our plan, and to helping our customers improve their business. We'll now open up the line for questions.

Thank you. We will now begin the question and answer session. [Operator Instructions] Our first question is from Flavio Campos of Credit Suisse. Please go ahead.

Good morning. Thank you for taking my questions. Great results, guys. I'm very excited about the operating expense control. I just wanted to dig a little deeper on the impact of sales force here. I saw that your total headcount has gone down for the first time in a while. And I was wondering if that had an impact on operating expenses this quarter, and if that has happened through natural friction, or if there was some conscious decision about doing that?

Yes, Flavio. It's Erik, and thank you for the comments. So I'll talk specifically, and I'll address your question on sales force expansion. And let me start by saying, it remains a very important growth driver for the company. And what we talked about is for year end, basically what we've done is continue to temper our growth target for sales force expansion, based on and in response to the environment. It's one that can easily throttle up or down. If you're looking specifically at the sequential tick down from Q2 to Q3, I would not make much of that. That's timing. It's never a perfect science when targeting a certain head count growth number. As you can imagine, there's new hires coming in. There is some degree of attrition. So I wouldn't make much of that. I think the bigger point would be that we have tempered the growth investment in response to the environment. Realizing that paybacks expand, and that we're confident we've got a whole portfolio of growth investments that are producing results for the company. And then I think the bigger story is around the expense management, which is where you - when you saw pretty dramatic, I'd call it dramatic clamp down on expenses through some of the efforts that Jeff described. The tempering of the sales force was a relatively minor piece to the OpEx story.

Perfect. Perfect, that’s very helpful. And just on the same vein, e-commerce has continued to climb up, right, even as organic growth has slightly moderated. Has that been helping as well the operating expense line? I'm thinking, are we growing faster in online and those channels that are higher margin, or is that not been a major contributor?

Yes, another good question. E-commerce has been – I mean, it continues to be a headline for us as a great part of the growth story. It is very sticky. It's typically where we're growing our e-commerce. It's integrated in with the sales relationship. We're tightly connected with customers. So, very pleased. Yes, certainly, there is an OpEx benefit to e-commerce, but what I would tell you is that growth in e-commerce has been a trend that's pretty steady over time. So if what you're pointing to is the specific change in trend that you're seeing in OpEx this quarter, again, the headline is not e-commerce. The headline is not really around the growth investments. It's really around the pretty significant moves we made to the rest of the operating expense in the business.

Great. Great. Good color. Thank you for taking my questions.

Thanks, Flavio.

Our next question is from Robert McCarthy of Stifel. Please go ahead.

Good morning, everyone. Erik, congratulations on the quarter. I guess the first question I have is, I'm intrigued by the hire of the new CFO. Do you think this will augur for kind of a really - a re-look at kind of core operating expenses and productivity investments, because I know from his background, he probably has done a lot of work thinking about the substitution of capital for labor over time?

Rob, let me start by saying, very excited by the hiring of Rustom. I mean, there is a few things that I'd highlight that I think he brings to the table. One is going to be a very strong track record of business leadership, partnership with the operations. He's got good operating experience in addition to financial experience. And a good track record of partnering with CEO and with management to drive improved performance. The second thing that I really like about Rustom, is that he's got a terrific track record of developing people, developing teams and developing organizations. And then the third thing that we really like is a shared sense of values. And on past calls I've talked about the importance of fit with culture, the importance of somebody that shares a common sense of values, and Rustom has that. So I think he brings a lot to the table. Look, what I would tell you is, like any new person coming in, they are going to bring new ideas to the table, and hopefully some new perspectives that can help take things to the next level. Some of what you are describing in terms of looking at our costs are things that are already under way, and I think that Rustom will only be additive to the process.

One follow up, if you'll indulge me. In terms of thinking about this environment, clearly it looks like kind of a sluggish environment. But it's not giving you tell that it's getting incrementally worse, so that it would be an opportunity for incremental investments and probably take share versus kind of your smaller competitors. Although, you did cite on the call that that's definitely an opportunity. I guess will we see it from your level of investment that if the environment deteriorates further and we start seeing declines in the back half of next year. That we could see just a ramp of investment of perhaps sales force or in other areas that will be a sign that you're poised to kind of take share?

Yes, Rob, that's a really good point. Let me give a sense. From where we sit right now, look our goal is to increase operating margins from where they are now over time. But we're also going to take a very consistent approach from that which we've taken in the past. Which is that, if there is a real severe dislocation that tends to be a time of opportunity and an opportunity to accelerate investments. You hit on one of them in sales force expansion. The times where we've done this in the past, we've seen a really compelling opportunity. We've invested, and then that investment has resulted in enhanced profitability in the periods that follow it. And I think you could expect us to apply the same thought process again. I think what we would describe right now is, you hit it on the head. It's a very sluggish environment, it’s soft demand. What we did want to get across in the prepared remarks is it's not - we haven't seen a continued dramatic deterioration within the last couple of months that things have sort of stabilized, but stabilized at a very soft level. Were we to see a more significant dislocation, yes, I think you could expect us to apply the same thought process as we have historically.

Congratulations, Erik, on the hire.

Thank you, Rob.

Our next question is from Matt Duncan of Stephens. Please go ahead.

Good morning, guys. Good job this quarter.

Hey, Matt, thank you.

Erik, the first thing I've got is just on M&A. Can you talk a little about what the M&A environment is like right now, and sort of where your head is at on how aggressive you want to be on that path right now?

Yes. Matt, so I would say with respect to M&A, very consistent with our overall perspective, which is, we see it as an important part of the growth story over time. You've seen us do it strategically. I think you could expect in the future us to do it strategically again as part of the growth story. But I will say that we've always said at our hearts, in our core, we are organic growers. And what I would say is I think for right now, our primary focus is on organic growths and share gain.

Okay. And then the second question I've got is just on the sales force growth. You've dialed that back again. Just curious, sort of - if there is an opportunity to take share, at what level of sort of underlying growth in the business do you get more aggressive growing that sales force again? You're now saying it's only going to be up a couple percent this year. I think when the year started, you were thinking closer to 10%. So what kind of underlying revenue growth would you want to see before you would be comfortable spending that money to grow the sales force again?

Yes. Matt, so you're correct. At the start of the year, we had given a range of about 8% to 10%. Of course, our perspective on the demand environment was quite different. So not a coincidence that what you've seen is the targeted growth in sales force headcount coming down, along with the organic growth rates, and the environment coming down. I think in terms of how we view, so to give you a perspective on how we view sales force growth going forward. I think you could expect that if things improve, even modestly, you'd expect to see a modest tick-up commensurately in the sales force headcount target. The other thing I'd say, and I hit on in Rob's call, is I could also take it the other way that should there be a more severe dislocation and we see a compelling opportunity, we would also use that as a chance to step up headcount. So as things improve, were they to improve, I think you could expect to see a commensurate pick up in headcount, and at the same time, should things get significantly worse, we would also be inclined to take advantage of the opportunities like we've done historically being mindful that any step-up in investment in a period of dislocation, we'd have to be real confident would result in future profitability returns.

Okay. Thanks, Erik.

Our next question is from Ryan Merkel of William Blair. Please go ahead.

Thanks. Good morning, everyone.

Hey, Ryan.

Hey, Ryan.

So first, I was impressed with sales and share gains in the quarter, given metalworking demand is clearly soft. So I guess sort of two questions. What is your sense of what the industry is growing? And then secondly, you're clearly doing well with the large accounts. But are some of the investments you've made in the share gain programs helping you take share with the core accounts as well?

Ryan, so yes. There is a few questions in there, kind of all getting at share gain. Look, I would say we continue to feel good about our share gain story, as measured by MSC growth rates relative to market growth rates. And in a market this big and this fragmented, there is no one single metric that we use. What we do is we triangulate a number of things. We look at the macro sentiment indices like ISM, like MBI. We look at some of the distribution surveys that are produced by your community. We talk to suppliers, which is a great source for us to get at point of sales growth for distribution, and then we triangulate. I think as we triangulate, the story continues to be that we're growing well above market. I think you are right to call out the fact that our core business, metalworking, cutting tools, have been particularly hard hit. You could see that evidenced in a number of places, but most notably the MBI has been under 50, indicating contraction for three months in a row. In terms of share gains, yes, we've been highlighting large accounts. I'll also tell you that we feel while our core business was slightly positive for the quarter, we do feel like that is growth above market. And yes, I think what you're seeing is it continues to be an impact from the growth investments that we're making. Be that sales force, SKU expansion, some significant investments that we've made into marketing and e-commerce programs, of course vending and inventory management, et cetera. So I think that's the story.

Okay. And then second question, I was a little worried gross margin guidance could have been a little worse. But down 70 basis points sequentially is sort of normal seasonality. But I was thinking that rebates were a bigger headwind this year. So am I correct in this thinking? And then sort of what are the one or two gross margin counter measures that are working the best?

Yes, Ryan, you are correct. We're pleased. I mean, so interestingly, I know 70 basis points sequential tick down. If you didn't know our story, you'd look at it and say, what do you mean gross margin stabilization, we feel really good about the story. You're right to point out. This is typically a quarter, the Q4 quarter, in which we see a sizable sequential drop in gross margin. So the fact that we have what is pretty much in line sequential drop due to cyclicality when factoring in a big rebate step down, that's roughly close to half of that 70 basis point drop is due to a reset on the rebate line. So when you - and I'll talk about that in a second to explain what we mean. But when you strip out the reset on the rebate line, the underlying gross margin is definitely - we're seeing stabilization. In terms of what counter measures, it's really the portfolio of things that we've talked about on the last couple of calls. Which are some counter measures that we're implementing on the sell side, taking a hard look at our - make sure that we're keeping our discounting disciplines high in the face of a soft demand environment. And then also on the buy side, working with our suppliers, we have been pleased with the response from a good portion of our supplier community where we put a request out there, and it's been really win-win in nature. The suppliers that are investing in us, I think if you ask them, would say they are seeing investment back from us in the form of mind [ph] share and disproportionate growth. Quickly, I'm going to touch on the rebate, the rebate story there, because we mentioned it's clear nearly half of that 70 basis point step down. That headwind will remain in the numbers, but it's a one-time step down. So it won't be a continued sequential step down, provided that growth trending doesn't change dramatically. And that's simply a result of the fact that revenue growth has come down, which impacts the rebate forecast.

All right, makes sense. Well that's a pretty good story there on gross margins. I guess just lastly, Jeff, since this is your last call, it's been great working with you and wish you all the best.

Same to you, Ryan. Appreciate it.

Our next question is from David Manthey of Robert W. Baird. Please go ahead.

Hi. Good morning, everyone.

Hey, David.

First off, Erik, I'm struggling to understand this barbell investment structure you have. Where you're saying if sales accelerate, you're going to accelerate your growth investments. If there's a dramatic drop off in sales, you're also going to accelerate your growth investment. But here in the middle, at 2% growth, you're aggressively cutting costs. Can you help me understand why you're looking at the world that way?

Sure, Dave. So let me just be clear. I think what I would say is in general, our approach to sales force expansion and investment is one that it's going to continue to be a growth investment. Realize we're still up year-over-year. It's not as if we're cutting. There's growth. But that you know, as we look at it, the degree in which we grow the sales force is going to be somewhat correlated to what we see in terms of the environment. Okay. So that's the general framework. I think what we talked about and the question came in around if there were a dislocation which would be kind of a more extreme circumstance. Would we deviate from that approach? And the answer is, yes we would, if we saw really compelling opportunity. So I think there's one general framework, which is to say, sales force investment is an important growth driver, and it will throttle up or down based on conditions. And then, we would consider deviating from that if the opportunity were really compelling.

Okay. And then as it relates to this quarter specifically, the reduction in SG&A of $5 million or it looks like about 2% of your cost stack, seems very aggressive in one quarter. And, Erik, you mentioned that moderating hiring was not that impactful. So Jeff, I'm just wondering, can you help us with what components of discretionary spend added up to $5 million here? Or if you could itemize or just prioritize them so we understand what got cut? And then are these things that are semi-permanent, they just won't come back, or are they being delayed into future quarters, or how should we think about those costs?

Yes, David, it's Erik. Let me clarify. Because there was a portfolio of actions that were taken. Look, it was a pretty dramatic cutback in expense. You are correct. There was a portfolio of actions taken. So discretionary spend was certainly one of them, but not the only one. So things like T&E and certain projects. When we – when I mentioned the moderating of hiring, that was specifically around sales force hiring that had a modest impact. I will tell you that for non customer-facing, we had a dramatic scale back in hiring as it relates to non-customer-facing activities that serve to pretty sizably moderate headcount levels. So that was another big driver. A third, Jeff mentioned some freight programs. We - and this had been in the works, and then some more came in following the call. We looked to optimize our freight programs. We also had a few other productivity initiatives that had been in the works that kicked in. So what I would tell you is, is it was a portfolio of actions. The other thing I'd say, I think the reason for the positive surprise was, and I'll tell you, I'm really proud of our team. We mobilized fast, and so what you're seeing is, the run rate of those actions got into the numbers quickly, faster than we expected, and I think it's a testament to the work of the team. We do expect those to stay in the run rate, and it's essentially why you're seeing Q4 OpEx despite ongoing growth investments that would tend to raise OpEx, you're basically seeing it stable. The only reason it's up a smidge, and it's up $1 million, is some one-time growth related investments that we're making in the quarter. But otherwise, yes, those are in the numbers.

Okay. Thanks, Erik. That's helpful. And Jeff, congratulations and best of luck.

Thank you very much.

Our next question is from Adam Uhlman of Cleveland Research. Please go ahead.

Yes. Hi, guys. Good morning.

Hey, Adam.

Hey, Adam.

Hey, I guess, somewhat related to that, Jeff, you had mentioned earlier that you cut the CapEx guidance for the year. How much of this is deferral into next year, and maybe could you help frame your CapEx expectations for next year? And then how much of that has just been cancelled outright, and just decided not to proceed with various programs?

Yes, Adam, we - just like in OpEx, we tightened our belt in terms of CapEx spending. And CapEx is really comprised primarily of IT, infrastructure, supply chain spending, and some vending. And I would say there were small cuts across all of these. We're not prepared to provide guidance yet for FY 2016. But I think it's fair to say that we're in a normalized range of that $70 million to $80 million. And then depending on what projects we decide to take on next year, it may vary above or below that.

Okay. But somewhere around $70 million to $80 million range?

Yes.

Got you. Okay. And then when you think about the pricing environment for 2016, I guess MSC is unusual in that the catalog is going to print now. And I'm wondering what level of price increase is going into the catalog, and how your expectations for pricing next year are unfolding? Or is there – with the decline in tungsten prices and a lot of other commodities that we've seen, is there the – should we be bracing maybe for price reductions for the out year?

Adam, so what I'll tell you is we will certainly give you the full color on the next call for the big book increase. But look, suffice it to say, I think two things I'd say. One is, we would expect there to be some modest increase overall. And two is that you could expect the increase to be in line with what we're seeing in the environment. And you know how we've characterized the environment, which is soft as it relates to pricing.

Okay. Got you. Thank you. And, Jeff, congrats on the retirement.

Thanks a lot, Adam.

Our next question is from Chris Dankert of Longbow Research. Please go ahead.

Good morning, everyone. Congrats again on the quarter. Just a quick question. Pull forward, in the third quarter do you guys see any pull forward demand from the fourth quarter? Or was it just a matter of strong execution and the share gains that you've already highlighted?

Chris, you're talking on the top line?

Yes.

No, I would say the story on the top line I think continues to be in terms of the environment. It's sluggish. I don't think there was pull forward. No more or less than there would normally be in a quarter. So I think the results kind of speak for themselves. And yes, I mean, I think we feel like we continue to grow above market, and that's the story.

All right. Fair enough. And then I guess kind of building on some of the earlier questions, on the OpEx line. You mentioned freight optimization. I guess, is there - what's the runway like there? I mean, can we see further cuts? Or was it kind of a one-off thing where you just saw some minor opportunities?

Chris, I would say like other areas of the business, taking a hard look at OpEx, just doing some smart things on the buy side and on the sell side is what was accomplished. I feel very good about what the team did. In terms of go forward, and I think I'd pull back from freight specifically, and then say, right now, the actions that we took are fully baked into the run rate. You saw the benefit in Q3. You're seeing it in the Q4 guide. And yes, look depending upon how things progress, freight otherwise, I mean, there's certainly other things that we – other actions that we could take to bring costs down further. But that will largely be a judgment based on how we see things play out in the environment over the coming months. And certainly by the time we reach the next call, you'll have our full perspective on 2016.

All right. Great. Thanks for taking my question, and congrats again.

Thank you.

Thank you.

Our next question is from Joshua Wilson of Raymond James. Please go ahead.

Hi. Thanks for taking my questions. And, Jeff, let me extend congratulations from both myself and Sam on your retirement as well.

Thank you very much.

I'd like to drill into pricing a little more. In your operational statistics, you cited a $0.9 million benefit from net pricing, but clearly the customer mix component of that's negative. Is that all product mix or is there some like-for-like pricing that's actually positive too?

Josh, look, I would say the headline on price continues to be that it's a really soft pricing environment, and therefore, we're not getting much out – that price mix combination there, we're not getting much. So you were right to point out that it's slightly better in Q3 than it was in Q1 or Q2. But as we look at it kind of big picture, all three quarters are hovering kind of around the zero range. And to me, that's the bigger story on price. That we're not getting any benefit, and it's the result of what's happening on the commodity side and the lack of manufacturer movement.

And on the regions, could you remind us how you define the Southeast region, and explain why it slowed down so much in the third quarter?

Offhand, we will have to take a look at specifically there's a set of states. The slowdown, I mean, offhand, Josh, I mean, the only thing I could tell you is that the two big effects that we're seeing in terms of a slowdown are oil and gas related, one, and two being export demand. Those are the two drivers, so nothing to point to specifically.

If I might sneak in just one more. You cited the SKU expansion you've been doing. Are there - given the tough pricing environment, are you making any changes to your plans around inventory management?

Yes, I would say what you've seen on the inventory front from us, I think inventory has basically – the answer is yes. Our playbook certainly changes in a slow demand environment. What you've seen and what you saw through the first part of the year, is you saw inventory build. And it was - a piece of that was Columbus, which is now the headwind is behind us. And a piece of that, quite frankly, was building for what we were seeing on the demand side and had a pretty positive outlook for calendar 2015. You have since seen that inventory number stabilize. That is the result of certainly changing our approach. As a result, correlating you are seeing free cash flow generation really improve. I'll tell you that we are mindful, though, that our next day delivery really, really is a differentiator. And particularly against local distributors who come under duress in these times. So we change our playbook, but we're going to be highly sensitive to making sure that while we modify inventory, we're keeping service levels very high.

Thanks. Good luck with the next quarter.

Our next question is from John Inch of Deutsche Bank. Please go ahead.

Thank you. Good morning, everyone. Is there a way to - I know, Erik, you said that the extra cost saves attributable to sales force wasn't that big versus, say, freight. But is there any way to quantify how much of the $5 million of cost saves or lack of spending was attributable to slower sales force? Is it really just not that material?

John, what I'd tell you is, as you can imagine it's a sensitive one. So I'm not going to share for competitive reasons the breakout. What I would tell you though, is that one is a very small piece of the $5 million.

Yes. I understand. Okay. Just curious, are you able to accrue for lower expected sales or other comp kind of to help with expense management at this juncture just because the demand environment is so sluggish? I mean, is there some sort of a – it's almost like an accrual expense matching that you are able to transcend to kind of help preserve your cost basis? Or do you think all of this is really just extra in terms of the benefit that you're seeing in terms of ability to manage your cost?

I'm not sure I understand.

Not sure of the accrual. What I would tell you is, I think the punch line on the $5 million is – I mean, we track it back to the cost actions.

Okay. Yes, that's more my question. My question is how much of the $5 million might have happened naturally because the demand environment is sluggish? In other words, companies that have slower demand ultimately are not going to pay as much variable compensation, and therefore, they can accrue that as part of the framework of what they report out as quarterly expenses?

Yes. I got you. Yes, look there is a piece to our cost certainly, and we've referred to it the variable costs that are - we track as a percentage of sales that will move up or down. So a little piece of this, correct. But just remember also this came in sales, while 3.5% is not where we want to be over time, it was right at guidance. So relative to expectation that cost – those costs - the variable costs would have been in line. So these were really driven by action. And I can tell you, just to give you some color. Internally here and as I said, I was really pleased with the way the team mobilized. But there is a score card that we had of specific cost actions with the name of a person and a targeted range of savings and week-by-week status reports that were shared by management. So we can track this back to actions that we took.

Could you give any more color, Erik, on how you can get these freight saves? How does that work? Like why for instance weren't – I mean, you guys are so good on costs, why weren't you getting the freight saves beforehand? I mean, do you get - is this sort of a temporary thing, or are you actually truly sort of realigning the way you procure freight or sort of organize by regions or something like that?

Yes. I - John, so as you can imagine, this is a bit of a sensitive one that I'm not going to go too far on. But I will tell you that for the most part, what we saw in the quarter is sustaining. It's not temporary. Which is why - so it’s factored into our Q4 run rate. And as we look at 2016, that would be part of our run rate.

One last one. Erik, what are you seeing with respect to competition? You have – kind of have a bifurcated comp set, right? You have the national players, like Bassinall [ph] and Grainger, then you have the mom and pops. Is there any color you can provide in terms of how they are behaving in this you know, sort of challenged price environment, slow price – slow growth environment, what are you seeing?

Yes, John, that's a really good question, because there is a headline to it. And we may not have spelled it out as clearly, which is times like this, what we're seeing is very typical with what we've seen in past cycles, where guys like us, the national players, get hit certainly. We get affected when there's a slowdown. The local distributors that make up the 70% of the market get disproportionately hit. And what we see in times of slowdown is competition. They will get very - the local distributors will get very competitive. So I would say price competition is very high right now. And a lot of that, I mean, that's really being driven off the local distributors doing what they do when things get slow, which is fight for survival. So that's the biggest headline.

Yes. Got it. Thank you. Appreciate it.

Thanks, John.

Thanks.

Our next question is from Barry Haimes of Sage Asset Management. Please go ahead.

Thanks very much. Good quarter.

Thank you.

Had a question just on end markets. As you went through the quarter, you talked about overall how you are kind of stabilizing. But as you went through the quarter sequentially, were there any end markets you'd point that either were getting better as you went through quarter or were still getting worse as you went through the quarter? Thanks.

I think the biggest thing I would call out with respect to end markets is the distinction that we drew in the prepared remarks. Specifically around metalworking related, which is our core business, and you're seeing it. We talked about the fact that our core growth rates, while we're confident are above market, are actually below company average. That's really being driven off of what we're seeing in metalworking related end markets that have been particularly hard hit. And I think the best proof point there would be the MBI, which is a sentiment index specifically geared towards metalworking shops which has gone negative now for three straight months. So that's probably the single biggest highlight that would also be influencing our results.

Thanks very much.

Sure.

Our next question is from [indiscernible] of Jefferies. Please go ahead.

Good morning, Erik and Jeff.

Good morning.

Morning.

Again a question on CCSG. Erik, you mentioned about the cross-selling program, which benefited I believe top line by 300 to 400 bps. Can we get some more color on that and how that program is going to progress going into fiscal 2016 on the cross-selling side? And especially when you're ramping down your sales force growth rate here? Thanks.

Yes. So we're actually really pleased with despite the overall top line being influenced by the macro environment and being lower than where we'd like to see it in a normalized environment, we are pleased with the cross-selling traction. So we mentioned 300 to 400 basis points in growth. I think that's important because what we've been highlighting is three big growth initiatives for CCSG. Sales force transformation and expansion being one. Service improvements to the business being two, and then cross-selling being the big one. And I think we've shared that out of the gate, cross-selling has taken more time than we had initially anticipated to gain traction. That we saw the ultimate opportunity as being as large as we had sized out from the start, but it was taking a little more time. That was in fact the case. There was a significant ramp this past quarter. We're pleased with progress, and I think that was the result of a lot of actions that the team has been taking over the past number of months to increase the traction. Going forward, look, I certainly would like to think that we're building momentum here. I don't see a reason why that traction shouldn't continue. And the exciting part about that growth program is we're leveraging the entire base of the hundreds and hundreds of salespeople that we have. So there's a lot of leverage in that program.

Okay. Thanks a lot.

Thank you.

Our next question is from Charles Redding of BB&T Capital Markets. Please go ahead.

Hello, good morning, gentlemen. This is Payton Porter on for Charles Redding. How are you?

Hey, Payton, how are you?

Doing very well. Thanks for taking my call. I just had a quick question on some of the customer mix headwinds that you kind of saw last quarter. You spoke to a trend concerning some of your larger customers, putting work in-house that had previously subcontracted out. Is that a trend that you've continued to see during Q3? Has that impacted you at all, or do you think that that's more of a reaction to the precipitous decline in demand conditions earlier this year? Thanks a lot.

Sure, Payton. I would say in general, we are seeing a continuation of what we pointed to last quarter, which is that the larger businesses are faring better than the small guys, and we are seeing that play out in a continued differentiation in the growth rates between the large accounts and the core or the smaller accounts. So really, no surprise there, no dramatic change from the last quarter. I think what we wanted to point out though is that, that growth delta is producing at an ongoing - in an ongoing way a gross margin headwind. That fortunately we - I'm pleased with how we're making up for that headwind with some of the counter measures that we've implemented.

Sure. Sure. Thanks a lot, guys. And congratulations again, Jeff.

Thank you, Payton.

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

Thanks again, everyone, for your continued interest. Our next earnings date is set for October 27th where we'll cover our fiscal fourth quarter results. So we look forward to speaking to you over the coming months. And thanks again for joining us today.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.