MSC Industrial Direct Co., Inc. (MSM) Q3 2017 Earnings Report, Transcript and Summary

Good day and welcome to the MSC Industrial Supply Third Quarter Fiscal 2017 Results Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to John Chironna, Vice President of Investor Relations and Treasurer. Please go ahead.

Thank you, Nicole and good morning everyone. I would like to welcome you to our fiscal 2017 third quarter conference call. In the room with me are Chief Executive Officer, Erik Gershwind and our Chief Financial Officer, Rustom Jilla. 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. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those anticipated by these statements. Information about these risks is noted in our earnings press release and the risk factors in the MD&A 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 may refer to certain adjusted financial results which are non-GAAP measures. Please refer to the GAAP versus non-GAAP reconciliations in our presentation, which contain the reconciliation of the adjusted financial measures to the most directly comparable GAAP measures. I will now turn the call over to Erik.

Thank you, John and good morning everybody. Thanks for joining us today. I will begin this morning with discussion by covering the environment, which continued to show improvement. I will then discuss third quarter business developments which were highlighted by sales growth slightly above the midpoint of our guidance range, operating margins above our expectations and earnings per share at the top end of our guidance range. Rustom will provide additional detail on our financial results and share our fourth quarter 2017 guidance. I will conclude with some additional perspective on our performance and then we will open up the call for questions. I will now start with the market environment. Conditions steadily improved through the quarter as manufacturing continued to firm up. This was reflected in the most recent MBI readings with May reaching 57.1, the highest reading in more than 5 years. June’s reading came in last week at 56.2. Feedback from customers is consistent with the theme of continued and steady improvement and this is reflected in their order volumes, backlogs and general sentiment. The rolling 12-month average for the MBI is 52.1. This is important, because average above 50 correlates to growth in the metalworking end markets. Given our typical historical 4-month lag to the rolling 12-month average, this points to continued improvement in our sales growth. From an end market perspective, aerospace, fabricated metals and machine jobs continued to improve as did oil and gas related business. While automotive was still strong, it wouldn’t have been spottier than it has been over the recent past. Other end markets like heavy truck and agriculture have appeared to bottom and showed some improvement. As customer sentiment continues to be positive and the industries hold at their current levels, we should continue to see improving sales trends. Over the course of the quarter, our monthly sales growth reflected the improving environment. We grew 4.5% in March slightly ahead of our expectations at the time last quarter. April came in at 1.5% as expected given the timing of the Easter holiday. May rebounded to 5.5% and our June estimate continued the upward trend at 6.4%. Keep in mind that our fiscal June ended on July 8 and therefore includes the July 4 holiday. Last year’s July 4 holiday fell in our fiscal month of July. Taking a look at our various customer types, the improvement in growth rates during the quarter was pretty much across the board, with particularly strong growth in national accounts which increased in the mid single-digit range with building momentum through the quarter. In fact June’s growth was double-digits, which is encouraging, because historically national accounts has led the way in an upturn or downturn. Government growth in the fiscal third quarter was in the low single-digit range. Our core customer and CCSG growth range were also low single-digits not as fast as our larger customers, but better than the second quarter with improvement through the third quarter as well. Again, this is important, because our core growth rates tend to follow those of our larger customers and are most highly correlated with the rolling 12-month average MBI. So what we are seeing now bodes well as we look out to the future. Turning to e-commerce and vending, e-commerce was 60.5% of sales for the third quarter, up from last quarter and up from 58.6% a year ago. It’s important to note that our e-commerce sales include all forms of automated selling. In fact, product sales that go through our vendor managed inventory solutions or vending machines account for slightly less than half of our total e-commerce sales. Sales to vending customers contributed roughly 300 basis points to growth in the quarter. We added approximately 5,000 net SKUs in the fiscal third quarter and our total active salable SKU count is over 1.5 million. We ended the fiscal third quarter at 2,309 field sales and service associates versus 2,352 last quarter. This was in line with our expectations. As we have said, we expected a slight decline over the following few months. And we expect this trend to continue as our sales effectiveness programs gain traction. I will now turn to gross margin which at 44.3% was slightly below our guidance range. The primary driver for the variance from our range was mix. As we have returned to growth, the fortunes of our business seeing the fastest acceleration are those where we focused strategically. They are also the areas with lower gross margins, but positive contribution margins. National accounts, vending customers and some of the new product introductions are three examples. I also want to note that despite the headlines on competitive activity over the past several months, our rate of price decline was actually slightly better than it’s been in the past few quarters and you can see this on the growth decomposition on our website. Turning to the pricing environment, while we have seen some select supplier movement, it continues to be very spotty and not broad-based. Looking ahead, we would expect to implement and increase as we usually do and will provide more color on the next call. For now, however, the pricing environment remains difficult as competitive intensity remains high. Moving forward, there are a few signs of life with a few large manufacturers signaling to us that price increases are likely in the coming months. If this were to become more broad-based, it would bode well for future price increases. I will now turn things over to Rustom.

Thank you, Erik. Before I go to – I will talk about the results – good morning everyone. Before I talk about the results, I would like to actually mention our SAP new financial system which we rolled out in April on schedule and on budget. We will be managing our receivables, paying our bills and spend and two monthly closes using SAP. So it’s really great to have this behind us. And my thanks to all our team members who worked very hard for the last year to get us here. And now let me turn to our fiscal third quarter performance in greater detail. Our average daily sales or ADS in the third quarter were $11.6 million, an increase of 3.8% versus last year and slightly above the 3.5% midpoint of our guidance range, ADS was up 2.8% to manufacturers and 6.5% to non-manufacturers. Our fiscal third quarter gross margin of 44.3% was down 70 basis points from last year and 30 basis points below the midpoint of our guidance. Erik already discussed the factors that drove this result, so let me just note that it will basically be outcome of our sales growth coming from lower margin customer types and channels such as national accounts and vending as well as increased penetration of new products which changes product mix within these types. As you know these are strategic growth areas for us and we would happily take higher growth in these areas as an average to make a positive contribution to operating margins. Now, moving to operating expenses they were about $6 million higher year-on-year and higher bonus accruals accounted for roughly $3 million of this difference. Volume related expenses which we assume as 10% higher sales accounted for approximately $1.5 million and so the remainder included higher medical costs and spending on key initiatives such SAP and telephony, partly offset by lower depreciation, amortization and other savings. Compared to guidance we accrued less to bonuses in Q3 than we had originally expected. This of course is based on our current payout projections which we update quarterly. There were no other major variances and as such operating expenses were about $3 million lower than guidance. So our third quarter operating margin was 13.7%, 20 basis points better than the midpoint of our guidance. The benefits of higher sales volume and lower bonus accruals more than offset the impact of a slightly lower gross margin. Versus the same quarter a year ago, our operating margin was lower and that was mostly due to the lower gross margins which we talked about and last year’s bonus accrual reversal which we have communicated often. Our effective tax rate was 36.3% for the third quarter, in line with guidance. We had noted in April that it was difficult to predict how many stock options would be exercised in the fiscal third quarter and that estimated there would be $0.01 EPS benefit. In addition, we had expected the $0.02 benefit from an R&D tax credit mostly associated with our investments in our SAP financial implementation. As it turned out, we had very few options exercised and therefore low EPS benefit from share front [ph], but we did benefit by $0.03 from the R&D credit. So our fiscal third quarter EPS was $1.09 at the high end of our guidance range. Now turning to the balance sheet, our DSO was 54 days, up two days sequentially. This was due to a temporary increase in receivables arising from the implementation of our core financial system in April. However, we have recently seen collections increase and we do expect DSO to improve over the next two months to three months. Inventory turns of 3.4 were in line with last quarter with a small sequential inventory increase of roughly $2 million. We expect inventories will be slightly higher in the fiscal fourth quarter as well as we continue to position ourselves for higher sales growth. Free cash flow or cash flow from operations less capital expenditure was $50 million in the quarter. This compared to $95 million for the same quarter last year and is mostly due to higher working capital. Our capital expenditures were $12.4 million in the third quarter and are roughly $38 million year-to-date. We now expect our fiscal 2017 capital expenditures to be around $55 million to $60 million. Our operating cash flow conversion ratio and that’s net cash from operating activities divided by net income was around 99% in the quarter and we expect to end the fiscal year at roughly the same level. As of the end of the fiscal third quarter we had roughly $515 million in debt, mainly comprised of $314 million revolving credit facility balance and $175 million of private placement debt, unchanged from the last quarter. We had $28 million in cash and cash equivalents and our bank leverage ratio remained at 1.1x. Now to our guidance for the fourth – fiscal fourth quarter on Slide 4 of our presentation. But first, please note that our fiscal 2016 fourth quarter had five extra selling days, worth roughly $55 million of sales with low operating expenses, so it’s essentially just volume related expenses and extra week of payroll. So now to the quarter, we expect sales to be between $732 million and $746 million. Our guidance assumes average daily sales of $11.7 million and ADS growth of roughly 7% at the midpoint of the guidance. We expect our fiscal fourth quarter gross margins to be 43.8%, plus or minus 20 basis points and that’s down 50 basis points sequentially from the third quarter and roughly 100 basis points from the prior year period as reported. Let me emphasize that the fourth quarter sequential decline is typical. In fact if you look back over the last decade 50 basis points is the average seasonal drop that we typically see from Q3 to Q4. Last year was an outlier as we saw only a 20 basis point drop and that was mostly due to reduced sales mix headwinds and a negative growth environment last year combined with the results of gross margin counter measures. We expect midpoint operating expenses to be about $230 million or roughly $5 million lower than what we reported in last year’s fiscal fourth quarter. However, on a comparable basis and also adjusting for the additional operating expenses associated with those five extra selling days last year, we estimate OpEx will be about $8 million higher. Composition of this is using a 10% variable OpEx estimate and higher sales about $5 million comes with the $50 million of incremental sales of the midpoint and another $2 million or so is attributable to higher incentive compensation accruals expected this quarter – this year. OpEx as a percentage of sales would be down roughly 120 basis points in comparison to the same 13 week period a year ago demonstrating our leverage. This marks our second year of strong OpEx productivity. Assuming fourth quarter of OpEx was in line with our expectations, for the full year and on a 52 week comparison, OpEx will be up roughly $3 million on a sales increase of about $66 million. This means that we will have more than covered our cost inflation and investments as well as the higher - expected higher bonus payouts in 2017. Turing to operating margin for the fiscal fourth quarter, we expected to be around 12.6% at the midpoint of guidance. This will be flat with the fiscal fourth quarter of 2016 on a comparable 13 week basis. Last Q4 operating margin as reported was 13.3% and that’s with the extra week. If the fourth quarter comes in at the midpoint of guidance, we would expect fiscal 2017’s operating margin to be around 13% flat with last year’s 52 week number. This would also be in line with the annual operating guidance framework that we provided at the start of the year where the applicable quadrant of the slightly negative price environment and slightly positive volume had an operating margin of 12.7% plus or minus 50 basis points. So back to the fiscal fourth quarter guidance, we are assuming an effective tax rate of 37.3% for the fiscal fourth quarter with no material R&D tax credits or share based compensation benefits envisage. The fiscal fourth quarter’s tax rate is higher than last year due to expected lower state tax reserve releases. Finally, our EPS guidance for the fiscal fourth quarter is the range of $0.97 to $1.01. At the midpoint this would represent a 10% increase versus last year’s 13 week EPS and includes the benefits of last year’s buyback. I will now turn it back to Erik.

Thank you, Rustom. I remain pleased with the company’s performance, particularly the acceleration in growth in many areas that are of strategic focus to us, national accounts, vending and SKU expansion to name a few. Overall, as revenue growth rates continued to improve, the expense leverage leads in the business is beginning to demonstrate itself. Our fourth quarter guidance implies over roughly a 120 basis point improvement in operating expense leverage on roughly 7% ADS growth. Looking to the future, we would expect revenue growth rates to continue rising should the MDI at least remain at current levels. If we see any meaningful price inflation or if the recent accelerated mix headwinds abate just a bit, we are poised for strong earnings growth and nice operating margin expansion. Even if pricing does not return and even if the recent accelerated mix headwinds do not abate, we are still positioned to grow earnings nicely and as we move through high single-digit revenue growth once again expand operating margins. I would like to thank our entire team for their hard work, their commitment and their dedication to our plan and most importantly to our customers. And we will now open up the line for questions.

Thank you. [Operator Instructions] Our first question comes from Matt Duncan of Stephens. Please go ahead.

Okay. Good morning, guys.

Hi, Matt.

So, look obviously I think everyone is going to want to know a little bit more about what’s going on with gross margin. I appreciate all the color that you guys gave as it sounds like it’s just sort of seasonal products and that sort of thing sort of returning to normal. I am really more curious on the year-over-year comparison as we move forward. At what point do you guys think we could see gross margin bottom as you look out into the future. Is there a level of revenue growth that is necessary for that to happen or what should we be thinking about looking at?

Yes. Matt, so let me give – I will put a little more color on gross margin. And then as you are talking about bottoming out and out to the future, I will talk a bit more and Rustom will chime in on the incrementals. So, yes, look gross margin what you saw, our typical pattern in a year is where gross margin generally starts out highest in Q1 and absent any price movement you see it tick down gradually through the course of the year, the fiscal year and that essentially what’s happened here although it’s been particularly the last couple of quarters, the erosion has been a bit more severe than it would be on an average year. And really what I tried to do in the prepared remarks is parsed out what’s going on. So point one is, there is no price inflation right now. So, you don’t have any meaningful price to offset the headwinds in the business. Point two would be what we saw and particularly what we have seen here in the back half of the year as we have started increasing our growth rate as we have returned to growth where we are growing fastest and where growth is really accelerated is in some areas where gross margins are lower. So, we have taken what was a normal headwind and the headwind has essentially gotten larger. So, in essence that’s the story right now. What I did want to hear especially given all the headlines recently is what it’s not is a change in what we were seeing on the pricing front. And so that’s where if you go to our decomposition, you could see prices is always laid out separately and that’s if anything slightly better than it’s been the past couple of quarters. So, that’s the story of what’s happening right now. Look, we are pleased and we will take all day long seeing those strategic areas of growth take off. The big thing what we would like to see and what we are certainly looking out made the gross margin picture better is to see some of the areas of the business that are higher gross margin take off and grow further. And so there is two I will call out, one being our core bread and better business. And I think what’s encouraging there is that’s been certainly steadily improving through the last few quarters, but lagging the larger customers, that’s a fairly typical pattern for us coming out of cycles. And so if history repeats itself and the MDI correlation holds through, we should see core growth rates lifted, which will help buffer the headwinds and that will create somewhat of a tailwind and then the other one is CCSG where certainly momentum in the business we want to see that growth rate outpace the company growth rate and then that becomes another buffer from what have been the headwinds. So I think that’s the story and I will just give you sort of one more piece looking out on gross margin. So if you wanted to look out and obviously way too early for us to give you any perspective on 2018 given the number of moving parts plus all of those variables I described. Look, if pricing inflation returned to any meaningful degree that would be a big change and we can see a picture where gross margin would be flat maybe even up depending upon the size of the increase we could take. If there were no price inflations, so the price environments stays as is, the other case for gross margin improvements from where we are is a change in the mix headwind. So, this recent acceleration in the mix headwind moderating a bit and again the big lynch pin there is the core growth rate which should happen given history and the CCSG growth rate. So, that’s a bit of color on how we view gross margin looking out and how it would improve from here.

Thank you. Very helpful. And then my second question sort of sticking a little bit on topic here is on price. Do you have any thoughts at this point as to what type of price increase you guys think you might be able to get in the catalog. I appreciate, but it’s early I think typically is what August or sometime in the fall when you might put that through. So either size of increase that you might think you could get based on what you are hearing from suppliers and timing of when you guys might do it this year, any thoughts on that?

Yes. Matt, so little early, look, timing wise generally as you know we tend to shake this up with the launch of our catalog plus or minus a month. I don’t think this will be radically different, so sometime during the summer. In terms of size, I am going to wait till next quarter we will give obviously the full color on the size of the increase. What I would tell you is for now the size of the increase you can imagine is going to be correlated to how we view the pricing advantage which we are still describing as quite spotty. So what I’d say there, so that thing not particularly large increase. That said, what I will tell you is that if some of the recent rumblings that we have heard were to play out to become more broad based what you would likely see us do even if it weren’t a larger increase is we could move soon thereafter if we felt the market justified it.

Okay. All right. I appreciate it. Thank you.

Our next question comes from Hamzah Mazari of Macquarie Capital. Please go ahead.

Good morning. Thank you. Just the first question is on pricing as well, maybe Erik could you give us any color on how competitive your pricing is in your portfolio versus the market? And also maybe what kind of premium is justified for distributors for service. So I realize your pricing may be higher than the mom and pops due to service, but maybe just give us a flavor of how competitive you guys are relative to competition of the market, however, you guys think about it?

Yes, Hamzah, really good question and obviously timing given – the time we have given some of the recent headlines. I mean, the answer is our pricing is quite competitive. And I think one thing that’s important to understand to you, the very important nuance is how distributor pricing and our pricing and many in the industries works is there is a list price and then there is a post negotiated discount price. And so if you were to go on our website and look at our list price, which is effectively servicing pure spot buy random purchases that price is not going to look particularly competitive particularly to a larger customer. That’s a very different price than the price that our customers who have the relationships with us, who are looking for solutions and a person-to-person relationship which by the way is where our business and our focus is. They are seeing a much different price and a very competitive price. So just to put some more context on that for you so roughly somewhere around 90% of our business in terms of revenues is attached to a sales person relationship, okay. In those cases, there is going to be a price that is much different from what’s available publicly. The other data point I will give you to help put some context on this is that for that pure spot buy come to the website and just see the visible web price, [Indiscernible] 5% of our revenues come from that sort of business from our list price. So where our business is, where our focus is and where we are going, the customers are seeing a very different price and then one other point and I will stop is that if you would ask our sales people, for decades now our sales people have been competing with a price that is deeper than our web price and that’s street priced. That’s the street price that a local distributor that makes up 70% of the market is selling at everyday. You are correct. We do tend to command a premium over that price. But look there is a limit to how far we can take that premium and that’s something we have been dealing with as I have said for decades.

Great. And just a follow-up question, I will turn it over. On the CCSG business, could you give us a sense of how you are performing versus the market and you mentioned that that business lags, has that lag gotten larger versus historical cycles, I know you haven’t owned that business for a decades, but just any sense of how you are thinking about that particular segment versus internal expectations?

Yes. So what I would say is that business has faired, I would say similarly to many of our other types of business inside the company which it seems significant improvement, so from Q1 to Q3 to what we are expecting in Q4, radically better growth rate. But as I have said still coming in somewhere around company average, my expectations for that business and where I think it should be is well above company average. And what I was pointing to earlier in that question is that would then create obviously above for some of the headwinds we are seeing. And certainly what I see under the cover is I like what I am seeing, I like some of the progress we are making internally, but the proof will be in the putting and that will come when growth rate outpaced the company.

Actually as one thing just to add, as we have recently integrated the sales forces between the two businesses, we are also seeing a little bit of a benefit coming from that would be with more – with just more integration. And we are also moving to get the two systems in terms of our ability to supply MSC customers with CCSG products, but from an MSC warehouse. We are looking on getting some of that stuff and that’s coming to fruition in a few months, it’s not really quite yet, but that too will benefit, just to add.

Great. Thank you.

Our next question comes from David Manthey of Baird. Please go ahead.

Hi guys. Good morning.

Hi David.

So looking at the gross margin in light of the operational statistics, your mix of large accounts and non-manufacturing customers have been drifting up over many quarters and you have seen more moderate gross margin declines than we saw this quarter which you are guiding for in the fourth quarter, I am just wondering is there anything you see in the business beyond mix that’s causing you a higher level of gross margin degradation and Erik I know you have mentioned that you would expect it to be flat, I guess at worst next year and I am just wondering what changes in the complexion of the business to get you there?

So David, two parts to the question, one is what’s changed other than sort of I think where you are going the normal corporates if you will of national accounts. So certainly what we are seeing is some of the usual suspects where we have been putting greater focus have accelerated, so I mentioned national accounts in June getting to double digits, vending continues to accelerate, those would be normal. I think one other one I would call out and I mentioned this briefly David that wouldn’t be different is we had some really nice product expansion and some lines in particular that have really taken off over the past. We have been on the build of SKUs and expansion of suppliers in line for a while. I would tell you that this year we saw a pretty dramatic acceleration in growth rate coming from them. A couple of those happen to be lower gross margins than the company average. Look, as Rustom said they are wonderful pieces of business. Their share capture and from a contribution margin standpoint they are good. They are lower gross margins. Look, those are the types of things David, so it is a headwind to gross margin percentage. I would say over time I would expect what is typical when you enter sort of a new relationship over time that turns of the relationship improve and the margins – the margin percentages would improve. But for now, that would be the one thing I would call out is different from the past and then of course the lack of price to buffer kind of being sequential down drift.

I would like to add one thing to that it’s moving beyond gross margin a little bit too. And it’s something we have talked about before, cost to serve is really important here and something, a point we have made in the past, but worth reiterating that with some of these national accounts as we – as yes they come with lower gross margins, but if we can make sure that our cost to serve is less correspondingly then from an operating margin perspective it’s not necessarily a negative. I mean that’s an important point to make here and it applies not just to national accounts, but to all of the areas of our business the efficiency with which we serve, vending, other different areas like that.

Okay. Thanks Rustom. And just as a follow-up to that then your contribution margin has been highly volatile over the past several quarters, is there a target that you are thinking of in light of this gross margin situation and as you just outlined that the cost side important variable as well, is there a contribution margins you are thinking about let’s say for the next 12, 18 months steady state assuming that would be the case?

Well, as you know, we are lose [ph] to provide any guidance on the next 12 months to 18 months, but yes we are. Look, I mean I think one way to look at it and perhaps is to talk about it in terms of our incremental margin commitment, which we have – which we have talked about before. So we have talked about delivering 30% incremental margins on the first $100 million of our growth, right and part of that’s occurring right now. So interestingly of course our commitment didn’t include the bonus step up, we have clarified that previously. And if you look at the midpoint assuming we get the midpoint of our Q4 guidance on sales of Op margin and if you add back to bonus step up, I mean that’s an incremental margin of about 27% on $66 million of sales growth, again making apples-to-apples comparison for the year, right. I mean so you look at that I mean it’s pretty – it is something that we focus on and something that we attempt to, we obviously try to maximize our gross margins, obviously right wherever we can through pricing and through gross margin stabilization and all the rest of that. But then we also and this is something we have been doing over the last 2 years as we are focusing a lot on we have an initiative in place focusing on optimizing our cost to serve as well so that we can deliver Op margin growth.

Right, very helpful. Thank you.

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

Thanks. Good morning everyone.

Hey Ryan.

Hi Ryan.

So the first question I had, I thought the lack of acceleration with manufacturing customers this quarter was a little surprising just given what some of the peers are seeing and obviously the strong MBI, so why have we have not seen more left there and then I know the core customer lags, but it just seems to me that the growth should be a little bit better, I think it’s up low single-digits, so anything changed there?

Ryan, I would say no look I think if we look at manufacturing and what you are referring to is the quarter and Q3 number at 2.8. Certainly if you can imagine May was better than that number, we expect June will be better than that. And it was coming from a pretty negative place a quarter, couple of quarters, so I would say just pulling back, zooming out for manufacturing for a second looking at total company growth rate Ryan, I would say it’s doing particularly as I look to Q4 with June what we are guiding to for Q4 more or less the company is doing what it should be doing. Given the improving environment, the growth rate is lifting as it should. You are right look, there has been a lag in the core customer, but that’s not atypical, so I don’t make too much of it. To me, as I look through a big picture, the growth is moving up as it should given the improvement in the indices.

Okay. And then secondly Erik do you think distributors still have pricing power such that if suppliers raised prices you are going to be able to pass that along or could web price transparency impact this?

Ryan, I do. I mean I do think that distributors have the ability to pass along pricing when suppliers move. I think distributors do not have the ability to pass along pricing, if suppliers don’t move to be honest. But I don’t see here anything – look if the pricing environment comes back Ryan and manufacturers move on list pricing and distributors are not able to capture that I think that is the different discussion I don’t see any signs of that. And I guess the evidence – the data points that averages very select, if I look back over the last couple of years the very select times where suppliers moved, we generally have been able to pass them along. And what I would say in some ways, look there is no question web transparency is real is there, but in some ways it helps a bit with the passing along the supplier price increase. And what I mean by that is as web transparency has grown, customers are actually more aware, supplier list price becomes very visible. So, it becomes easier to justify a movement of the supplier, movement of your pricing if the manufacturer moves if more people know about their list pricing. So, I do. That’s the answer.

Okay. And then just lastly, when a customer orders online, what percent of the time if you are talking to an MSC salesperson or inside salesperson? And then secondly, have you seen call center volume going down if you look at it over the last couple of quarters, because people can now solve what they are looking for online. They don’t necessarily need to call somebody.

So, Ryan, two questions. The first thing I will say is and I don’t have a number to quote you in front of me, okay. So, this is going to be more anecdotal, but the overwhelming majority of our web business is coming from signed accounts. Look, I shared the number before that somewhere around 90% of our business is tied to a sales rep relationship. So you could imagine, if you looked at our web business, the percentages are not going to look that much different. So, when a customer goes online with us, so for that transaction it maybe a seamless transaction where they are not talking to anybody at the given moment, but the relationship is way deeper. So, they are generally going to be talking to a branch. They are generally going to be talking to technical people. They are going to be seeing a sales person. They are going to be getting visited from an inventory management specialist, their service rep if they have VMI or vending. So, that is the overwhelming majority of the case in terms of where the revenues are coming from. Your second point, I apologize, Ryan, it was a good one and I missed it, can you remind me?

Yes. Just have you seen call center volume going down as people can solve more of their needs online?

You know what’s happened – the answer is no, so, first of all, what I’d say is our productivity in the call center, we have seen some improvement. In general though what’s more or less happened is if I look at the calls coming in, it’s not that the calls are going down except the complexion of the calls are changing, Ryan. So what’s happened and this is not a new dynamic by the way this has been happening over several years. A lot of the easy stuff will go to the web. So, if it’s just a straight forward transaction that will move to the web. And what’s happened is where we are trying to really beef up is in our technical support, because the questions coming in, the calls are much more about asking for advice, getting help, maybe doing sourcing for things that we or another distributor don’t carry or maybe for a special item. So what I would say it’s more that the nature of the calls have changed and look to some degree, they are more time consuming calls, but they create part of the stickiness that we talked about, because that’s the kind of stuff that’s very difficult to experience – very difficult to get online.

And one quick comment there, I mean, the productivity that Erik just referred to is more associated with, I mean, telephony. I mean, we upgraded a very replaced, a very old phone system with something that is much more easier to transfer calls, have records and just basically enhance this productivity fundamentally. So, that’s the driver, Ryan, of that one.

Got it. Okay, very helpful. Thank you.

Our next question comes from Andrew Buscaglia of Credit Suisse. Please go ahead.

Hey, guys. Not to belabor the point on gross margin, but just one last question there, one of your competitors this morning reported and I think similar makes issues, but can you sort of execute their way out of it? What are like two or three things that are controllable for you guys going forward whether it makes potentially more sourcing initiatives or maybe it’s private label sales or is there anything controllable that you see going forward that you think could lead to some upside there on gross margins?

Yes, Andrew, great question and you are entitled to belabor whatever you like, it was your time. So, yes, look I think it’s a good point and the answer is yes. So, one of those things that highlighted, the first and foremost that I would say is the growth in the core business and the growth in CCSG which will take what is – really what happened to us in the last few months is due to the headwind that has always existed in the business when we have talked about, it was national accounts and vending on the gross margin line is gotten accelerated based on the acceleration in the growth. So, one thing that is in our control that could change that is improvement in the growth rates in core and improvement in the growth rates in CCSG. With respect to core, we do see it starting to happen. We fully expect it to happen, but that’s one. With respect to CCSG, the growth rates have improved. They are not yet outpacing the company. As Rustom said, look inside the company we see lots of good markets for progress, but the ultimate measure will be when it starts outpacing the company. Outside of that, yes, I mean you raised a couple of good points and if you look back over the company’s track record over the last year or two we have talked about gross margin countermeasures and basically two of them, one on the buy side and one on the sell side. Our purchasing activities and our selling – optimizing our discount levels both of those are active programs and both of those has been getting a heck of a lot of attention. So, we realized that. All the benefits we got from our supplier activities over the last year has not gone way. It’s just that they are in the run-rate whereas last year they weren’t yet in our run-rate and they were buffering some of the – for instance, Rustom talked about last year a more gradual Q4 step down. One of the reasons was we were just gaining the attraction and seeing the results on the supplier summit. All of that is in the numbers. So, what we are doing internally now is absolutely saying okay, where are we going from here, how are we going to ratchet things up further. So both purchasing activities and discount optimization are areas that are in our control and are getting a lot of attentions and if we see improvements would have a significant impact on gross margin in 2018.

Okay. Alright, that’s helpful. And just one last one on – you mentioned that 90% of your sales on Ryan’s question going through online related to customers with the existing accounts. But I guess going forward, what’s the – what’s your expectation of that or give us some confidence that, that doesn’t go to 85% or 80% in coming years? Maybe where was that last year or the year before that – I guess that’s the concern is, will that change?

Andrew, so let me just clarify. So that number of around 90% was the percentage of our revenues that are connected to a selling relationship to sales person. Okay. Actually, no concern at all there, in fact what’s been happening over the years and will continue to happen is that percentage climbs. So, more and more of our business just based on where we have been focusing the company between metalworking between Class C national accounts vending, all of these things are pushing towards that number goes up that either the number that’s gone up over the year. I don’t have the numbers in front of me in terms of giving you a historical look back, but I don’t have a concern that it goes down.

Okay, alright. Thanks for the help guys.

Our next question comes from Scott Graham of BMO Capital Markets. Please go ahead.

Hey, good morning.

Hey, Scott.

I am going to kind of ask some previous questions and maybe a little of a different way from my own purposes. The fourth quarter gross margin guidance, is there an impact on the difference in sales days at all on that guidance, Rustom?

Well, what do you mean the difference – that we have five best sales days compared to the – to the full year number right?

Right.

Compared last year is everything, so I mean that doesn’t really impact the gross margin per se.

Yes, that’s kind of what I have thought. So, I guess kind of what – is it just that you are facing a different type of comparison on a year-over-year basis? I know you went through the individual points there, but I guess that the fourth quarter gross margin is kind of a bit of a point of the questioning in this call. So I am just trying to understand a little bit as to again you mentioned the points, but is there anything that you would maybe more specifically call that as a little larger? Particularly since and I know the price increases that you are thinking about are small and are sort of later in the quarter that kind of thing, but what would be maybe the largest factor impacting the fourth quarter gross margin whether you want to say that sequentially year-over-year anything would be helpful?

Scott, let me chime in for a second, because I will just give some historical context. So, if you look back take a look at our last decade. What you will it is very typical for us that Q4 season of the drops from Q3. The range of the drops has varied. Okay, so I think if you go back and look and you can do it on your time. The only year you would find where there wasn’t a drop Q3 to Q4 was 2013 and the reason for that was we had acquired the CCSG business in that fourth quarter, which was entire higher gross margin. So it just – it mapped the seasonal trend, otherwise pretty much every year there is a decline. Now, that decline is varied from 10 basis points or 20 basis points like last year, all the way to this year’s where it’s been 100 to 120. What Rustom gave you in the prepared remarks was the historical average of 50. The biggest – so we are actually – amazingly right on historical average. The biggest driver behind that is nothing deeper than seasonal mix of products that tend to – what tends to happen in Q4, summer months are hot. We see a spike in I mean we put all the cards on the table. A big spike in HVAC, in fans and air conditioners which are capital type purchases tend to come in the lower gross margins. Just the way we generally in the month of December, cycles to our business see a spike in machinery gross margin temporarily goes down. That’s the biggest driver. So what we have been calling out on this call was more sort of looking beyond the Q4 sequential drop is really not surprising to us, it’s looking from Q1 to Q4 it was a bigger erosion in this year than an average. And that’s where I talked about the accelerated mix headwinds, but that 50 basis points specifically Q3, Q4 is not really much different from the past.

I guess I do understand that it’s the same time, the last, call it six quarters or maybe even eight quarters you have been able to apply these countermeasures that are really kind of limited the weakness in the gross margin and then really this quarter and next quarter not the case, so I guess kind of that’s what I was getting at, but as I move on to the next question if you don’t mind the pricing increase that you are looking for immediately you talked about it modest the whole thing, is the timing of that kind of your decision to wait to see if we get a little bit more commodities inflection then you would go out with something larger and if so I know you consistently characterize the pricing environment in terms what your suppliers are doing, but maybe is there a way to re-characterize that into certain materials, because obviously pricing is impacted by demand and very importantly by materials, so there are certain materials that you guys are looking at that you kind of need to see a certain threshold whether its HRC or cold rolled or ethylene prices, is there anything you guys are looking out where you think that there is more – it would be more from green light on the ability to increase prices?

Yes. Scott, what I would say there so we track a number of commodities, okay, a bunch. You could imagine given our exposure to metal working, we will look at the materials in particular that make up cutting tools whether that’s steel or carbide and tungsten and such. What I would say though is the vast majority of our sales as a percentage are connected to branded manufacturers. And so unless manufacturer moves I mean generally what we are going do is mirror where their list prices are and not get out ahead of their list price. And so unless the manufacturer moves it’s – even if the commodities have moved and to be honest that’s something that surprised a bit over the last call it 6 months to 12 months these commodities certainly for a while have firmed up and there wasn’t as much manufacturer movement. Now, that could change. We are hearing bits and pieces that that could change as capacity starts to get fueled out by the manufacturers. But really for us the trigger is seeing a manufacturer move their list prices.

Scott I want to come – just I want to come back to your first question. Erik on to the sequential stuff comprehensively, but one more factor to note is in our fourth quarter if you look at what we are expecting internally, we are expecting much stronger growth from the national accounts part of our business which is at the lower gross margin. So going back to your – when you are looking at the sequential drop between Q3 and Q4 and something like that that’s the only other – other addition to what Erik said.

That’s very helpful Rustom. That’s exactly what I was looking for. And Erik in the – embedded within [indiscernible] that I used, just now to ask some questions was the one question of are you looking to maybe delay, are you pushing out your thinking on the price increase to see if you can do something more meaningful?

Scott, I will – a little early to say, but my first answer would be no, we wouldn’t delay it. I think what we would sooner do is if pricing firmed up, because we are in a rhythm with our sales team and our customers when there is a certain time when they expect an increase from us. I don’t see deviating from that. I think what we would do is if we really saw things firm up, we would go again with the price increase, particularly to the extent that those increases come from kind of big high profile manufacturers that becomes very easy to explain to the customer.

Thank you both very much.

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

Thank you. Good morning everyone.

Hi John.

Hi John.

Thank you, guys. Rustom just out of curiosity what again is accounting for the $3 million lower bonus accrual like real – I guess you thought the bonuses were going to be $6 million incrementally or something and they are $3 million, what’s the $3 million delta from the beginning of the quarter to the end what – was it lower volume or was there something else?

Now as we look to the expectations for the year – you look at the accounting rules, right. You look at actual performance for the period to-date and then you look at your expectations for the period coming forward. So compared to what we had and look we have been talking about our gross margins and stuff so you are seeing that compared to what we had expected before. We expect slightly less internally than what we had and so we adjusted downwards.

Okay. I was just saying your sales came in slightly above your midpoint of guide, would that – that’s all consistent I guess in terms of what you are saying, is that correct?

Yes. I mean the bonus has been accrued, not simply for the quarter ahead, the expectation of the entire year, so you run with – so in quarter one, you have got three months of actuals and nine months of expectations and based on how you track and how you expect the track versus our plan – our internal plan which is obviously something different to what we talk about on these calls different aspects to the bonuses and something like that. So it’s a combination of all these factors, nothing that’s not utterly routine in the process.

Okay, right. So the sales were better and you actually expect sales to get better the 7%, but then the gross margins were weaker and then you expect gross margins to get weaker, but I think you are accruing for bonuses to be higher again in the fourth quarter, is that not the way to think about it or is there some other input to the equation is because you are in true up or something like that?

No, you are good in that. We are accruing for bonus – in one part, we are accruing – expecting to accrue for bonuses more than we did last year. But last year, remember we cut our bonuses in half basically in the second half, right. However, compared to our original full year guidance, we are not expecting – our full year bonus expectations we are no longer quite at that total level, but we are definitely expecting to be well north of last year based on what we have.

Okay. So then I want to – I do want to go back to gross margins for a second, if the gross margins are lower, could that also not somehow reflect the fact that customers are trying to chase cheaper product, I am just – I realize what you are saying in terms of mix, but I am just wondering, maybe it’s reflecting the fact that market is actually looking for cheaper product and somehow there is some structural element to kind of a new norm of future gross margins because of that, may be no I am just curious what you are thinking?

John, interesting, I actually see different dynamic happening, particularly look, we realized our sweet spot called a medium size manufacturer and what we find with most of our customers right now they are facing competitive threats, they need more productivity, they need to get product to markets faster, etcetera, etcetera. They are starving for productivity. And in a lot of cases the productivity – if they can move the needle on their productivity, their manufacturing process, it dwarfs the savings they can get on the product itself. And so what’s actually – what’s interesting and what’s happening like if you take our cutting tool portfolio, it’s actually migrating up in quality of products, because in a lot of cases they are going to spend more for the product if they are going to get a much better length of cutter, the length of the tool life and the productivity coming out of the tool. And it’s actually moving the other way towards high performance. So I think our core customers anyway the big lever for them is productivity and getting more output for less dollars.

So that actually bodes kind favorably for future gross margins. I just want to ask about – I want to ask you about sales force, you clearly expect as evidenced by the economy so I thought consistent, you expect business to pick up, but you are cutting the sales force and I accept the fact that there is maybe productivity tools, I think company is cutting sales, their front office in this kind of a dynamic somewhat unprecedented, so could you give us a little more color on how you are actually accomplishing this like how do you need to give each sales guy more accounts to cover or do they have lot, I am just curious how this is actually working considering its somewhat new territory?

Yes. John so there is actually – there is a few things going on here. And this has actually been a program that we are encouraged by it’s why we keep going. So, one thing we are not going to do is reduce customer touches. What we found and what this program is all about is the idea of saying we want to get more customer touches and in the past what we have done is associated you add ahead and you get more customer touches, which look obviously is true. It’s a good way of doing it and it’s a costly way of doing it. So, what we have done is introduce really there is a few elements to the program, just competitive sense I won’t go too far, but certainly one is leveraging technology. So, CRM among other things are making our sales people a heck of a lot more productive than they were 5 years ago. They have more time than they had 5 years ago. They got more information right in the fingertips. That’s one. Two is we are doing some more on segmentation. So, in the past and again, this is where I won’t go too deep, but in the past, we would have each sales person a sign to a said number of accounts and it will be somewhat of just sort of a peanut butter spread on the type of account to the ret. We are getting much more target. That’s producing productivity where we are getting more touch per person. And then third thing I would call out, John is as we now alluded to bringing CCSG and MSC together, there is opportunities. There are synergies there. Look, a lot of that is being just captured just through attrition. It’s not like any big program, but we are just finding ways when we bring the teams together to be able to cover more ground with the same or fewer people.

So, that’s great. Just the last – what was the magnitude, can you just remind everyone, what was the magnitude of the price increase you took in the summer of 2016 and what ultimately was realized kind of on a net basis over the course of the ensuing 12 months or say up until now or whatever?

Yes, last year, it’s price increased. I want to say, John, we will get back to you, but somewhere between 1 and 2.

Okay.

Yes, somewhere between 1 and 2, we get back to with the number.

Realized would have been last August.

Realized, look, realized it certainly led to 90%, because you are growing as you don’t all of it, but I would say the realized number and I wanted to get back to you on that too, but not out of line with what we would have seen in a normal year over the past 2 years in terms of realization.

Okay. So, in other words, the spread between kind of your gross price increase versus realized hasn’t been narrowing because of whatever factor could be building off?

No. So, the answer is no. What has – I mean, I will say what has been there and one of the things we have called out, John, look the market for the last couple of years, it remains competitively fierce. And so what we do see absent the price increase is the areas where we are discounting where local distributors are getting ultra competitive. So there is competitive intensity. But in terms of isolating the price realization from the increase, so in fact if you look at slightly different answer, if you look at our price decomposition which you have over the last several quarters, you see that there is no major trend that sticks out there, because it was back over the last year or so.

Yes, that’s helpful. Thank you. Appreciate it.

Our last question comes from Robert McCarthy of Stifel. Please go ahead.

Good morning, everyone. Obviously lot of questions have been asked across the board. And I am not going to ask too much in the fourth quarter guide, I think we will discuss that offline some mismodeling perhaps on my part. I think the question I do have though is I don’t want to put words in your mouth, but are you backing off anything with respect to your contribution margin communication? And I am not going to put words in your mouth around the heuristic around $100 billion of sales and what the contribution margin could be, but is there a change in tone there or is there specific change in messaging there?

No. So, Robert, let me take this actually. I mean, we talked about this incremental margin commitment and I talked about the 30% in the first $100 million and then we have talked to north of 20%. So, it’s a 20, 30 sort of range as you go forward, right. And no, frankly, I mean we are not. I mean, if we did it by the way when we made that commitment, we have flat gross margins at that point in time. And if gross margins, in a flat gross margin environment, we can still, if you go back with any level of sales growth and that of course depends on our continuing to offset our mix inflation and investments through productivity every year as we have done through the last couple of years, right. And then going forward, no, I mean, in the numbers, I mean it just means that the incremental contribution margins coming out of that hold, but if you are having degradation in the base on the gross margin, right, it just means that you need a certain demand of sales to offset that. So, if you have probably a let’s say if the average of the last 2 years of minus 50 basis points or something that you need mid to high single-digit sales growth to fully offset that and that’s really how you look at it.

Rob, this is John. I would just add that just keep in mind that commitment never included the bonus step up in fiscal ‘17. And so actually if you take the numbers and you look at our – if we hit our guide for the Q4 and we do $66 million in growth for the fiscal ‘17 we should deliver 27% incrementals so then we have next year to finish the $100 million of growth.

Understood. Three other quick ones and I will keep it quick, in terms of management anymore announcements around sales or Chief Commercial Officer, anything along those lines that we should be expecting in the coming months?

No. Rob, I got to tell you, I’m very pleased with what I am seeing from the team inside the company in terms of the progress being made on the sales and marketing front. So, I don’t think you could expect certainly any sort of outside hiring to that role. I don’t think you should expect that.

And then the final question for Rustom is given your previous experience and working for companies and these are dealt with the warehouse automation and looking at your cost structure, do you think down the road given the volumes you are seeing or how the channels are shifting, do you think we could see more incremental automation investment coming out of through your DCs in the coming years?

So, Rob, first, I actually think that we have a very sharp sort of operations group, supply chain group and then they do optimize very nicely with what we have. But yes, I mean, as volumes grow – as volumes growing through our CFCs as they increase over time, most definitely we’ll use automation. And we are actually in the nice scenario from a growth perspective, if we get more volume through our CFCs, we have the ability to go up to about $4 billion sales without needing any significant additional investments. Yes, so you keep building the software. You do other stuff in automation or the rest, but you almost wouldn’t even need to do too much of that, until our sales were a lot higher, the sales going through the CFCs. It’s a nice situation to be in. And then if you go to our CFCs, we also then – we don’t need another one or something like that. We have plenty of physical space between buildings and land for expansion on those sites. So, really – so, our scenario and it’s nice to see growth coming back to our estimate of 7% for this quarter. I mean, that’s great from our perspective. And if we continue to grow and have this growth coming through our CFCs as we head into the future, we are in a pretty good position.

I appreciate you guys taking my questions. Thank you.

Thanks, Rob.

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

Thank you, Nicole. I want to thank everyone for joining us today and remind you that our next earnings date is set for October 31, Halloween 2017 and we certainly look forward to speaking with you over the coming months. We will be on the road and look forward to speaking with you then. Take care.

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