MSC Industrial Direct Co., Inc. (MSM) Q4 2017 Earnings Report, Transcript and Summary

Good day and welcome to the MSC Industrial Q4 and full year-end 2017 earnings 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]. And please note, this event is being recorded. I would now like to turn the conference over to Mr. John Chironna, Vice President of Investor Relations and Treasurer. Please go ahead.

Thank you Alison and good morning everyone. I would like to welcome you to our fiscal 2017 fourth quarter and full year conference call. In the room with me are Erik Gershwind, our Chief Executive Officer and Rustom Jilla, our Chief Financial Officer. During today's call, we will refer to various financial and management data in the presentation slides that accompany our comments as well as our operational statistics, both of which can be found on the Investor Relations section of our website. Let me reference our Safe Harbor statement under the Private Securities Litigation Reform Act of 1995. Our comments on this call as well as the supplemental information we are providing on the website contain forward-looking statements within the meaning of the U.S. securities laws, including guidance about expected future results, expectations regarding our ability to gain market share and expected benefits from our investment and strategic plans. 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. Before I turn the call over to Erik, I wanted to note that we are no longer going to report customer count in our operating statistics. Last year, we explained that as our business has grown and evolved from a direct mail model to a full service distributor, this statistic has lost its usefulness engaging our performance. While the underlying customer count trend has actually ticked up in recent quarters, it has not changed materially over the last couple of years despite significant changes in our business. So after further reflection and discussions with many of you, we have decided to eliminate customer count altogether. I will now turn the call over to Erik.

Thanks John. Good morning and thank you for joining us today on this Halloween morning. I will begin today's discussion by covering the environment which continues to show improvement. I will then discuss our business development in the fiscal fourth quarter, which were highlighted by continued improvements in revenue growth as the environment strengthened, solid gross margins with stable underlying trends, earnings per share well above the top-end of our guidance range and our acquisition of DECO. Ruston will provide additional detail on our financial results, share our fiscal first quarter 2018 guidance and discuss our full-year framework. And I will then conclude with some broader perspective. We will then open things up for questions. I will now begin with the market environment. Conditions steadily improved through the quarter as manufacturing continued to firm. The most recent MBI readings reflect an expanding manufacturing environment. July and August readings were 55 and 54.7 respectively. September's reading came in at 56.2 and the rolling 12 month average for the MBI is now at 54. This is important, because an average above 50 points on a rolling 12 month basis correlates to growth in metalworking end markets. Historically, on a four-month lag basis, our rolling 12 month sales trends have also had a high correlation to the MBI rolling 12 month average. So all of this points to continued strength in our sales. Feedback from customers is consistent with the theme of steady improvement. This is reflected in order volumes, backlogs and general customer sentiment. The hurricanes did have a small negative impact, although most of that is in our first quarter and we estimate it to be less than 50 basis points of growth. From an end market perspective, virtually all improved during the quarter. Aerospace, fabricated metals and oil and gas continued to show strength while other end markets like heavy truck and agriculture which had bottomed out several quarters earlier are improving. In general, as customer sentiment remains positive and the industries hold the current levels, we should continue to see solid sales trends. Our own recent growth trends reflect the stronger environment. Quarter-to-date, our total growth rate is roughly 12% and excluding DECO it's roughly 8%. Taking a look at our various customer types, my comments will exclude any impact from the DECO acquisition and growth rates increased pretty much across the board. We are particularly pleased to see improvement in growth from our CCSG and our core customers. CCSG in fact reached high single digits growth in August and as well as into the double digits quarter-to-date in Q1. Initiatives to bring the CCSG vendor managed inventory offering to our base MSC customers are showing nice traction. National accounts also strengthened reaching the low double digit range. Government and core customer growth lifted into the mid single digits. Turning to e-commerce and vending, now including DECO, e-commerce was 60.4% of sales for the fiscal fourth quarter, up from last quarter and up from one year ago's 59.1%. As I said before, it's important to note that our e-commerce sales include all forms of automated selling. Product sales that go through our vendor managed inventory solutions or on vending machines account in fact for slightly less than half of e-commerce sales. Sales to vending customers contributed roughly 430 basis points to growth in the quarter. We added approximately 20,000 net SKUs in the fiscal fourth quarter, bringing our total additions for fiscal 2017 to 65,000 and we expect add a similar number of SKUs in fiscal 2018. Our total active salable SKU count remains over 1.5 million. We ended the fiscal fourth quarter with 2,370 field sales and service associates versus 2,309 last quarter. And while this is slightly, as reported, it is in line with our expectations for a slight decline excluding the additions from DECO. We expect this underlying trend to continue in the near term as our sales effectiveness programs continue. Turning to gross margin. I am particularly encouraged by our results. During the fourth quarter, we achieved improvements through increased price discipline, solid realization of the modest summer price increase we took of just over 1%, an improved growth contribution from CCSG and core. Our fiscal first quarter guidance reflects continued stability. In fact, gross margin has been roughly flat sequentially for the past several quarters. And this is despite a soft pricing environment, which may be changing as we look to the future. While competitive intensity remains high, several suppliers began taking prices up or signaling that price increases are likely in the coming months. Most of these were not included in our summer price increase due to timing. So as momentum continues building, it would bode well for a mid-year increase which typically occurs early in the calendar year. Before I turn things over to Rustom, I want to talk a bit more about DECO. While we are always looking at opportunities to strengthen our leadership in metalworking, we have remained quite selective in evaluating acquisitions. In DECO, we found a business to meet our criteria with flying colors. DECO is a roughly $100 million metalworking distributor with an excellent reputation among its customers, suppliers and the industry in general for exceptional service, high levels of technical expertise and a great team of nearly 200 associates. It has a culture that mirrors MSC's in many ways, including a strong customer focus and adherence to its values. All of this is a testament to the company's longtime CEO Dennis Quinn and the entire DECO team. Additionally DECO brings us market share and customer relationships in an area of the country where MSC is under-penetrated, making this a great fit. The strategy for DECO is similar to that of other branch-based acquisitions that we have done. We plan to build around the strong team in place and bring incremental value to DECO's customers such as a broad and deep offering in metalworking, a wide assortment of MRO products that are also consumed at their customer's plants, an industry-leading website and our next day delivery model. DECO's gross margins are in the low 20s,, in line with industry average and similar to many of our past branch-based metalworking acquisitions. We will enhance that number over time by capitalizing on MSC's buying scale and by blending in sales of other higher margin MSC products. I will now turn things over to Rustom.

Thank you Erik. Good morning everyone. Let's turn to our fiscal fourth quarter in greater detail. In Q4, we made our first acquisition in four years. So on slide three in the presentation, we have therefore shown our Q4 results both excluding DECO and with DECO included. Our first notes are reported results which include DECO then since our Q4 guidance and prior year do not include DECO, I will discuss our Q4 results excluding DECO. Let me start with an overview of our reported results for the quarter. MSC's average daily sales growth was 9.2%, gross margin was 44.2%, operating margin was 13.3% and EPS was $1.07 per share. Included in these results are roughly five weeks of contributions from DECO, which was acquired on July 31. Excluding DECO, ADS growth was 7.7%, better than the 7% midpoint of our guidance and sequentially up nicely on the third quarter's 3.8%. Again excluding DECO, our gross margin was 44.6%. That's well above our guidance midpoint of 43.8% versus guidance, higher supplier rebates and lower inventory provisions contributed about half of the outperformance. The remainder, as Erik noted, came from increased pricing discipline and the modest summer price increase versus last year's 44.8% higher supplier rebates and lower inventory provisions partially offset the negative gross margin impact of mix and pricing. Higher supplier rebates are mostly a function of our recent sales growth and the lower inventory provisions are simply the outcome of an improved inventory profile where we are holding less of our slower moving stock. Our focus on operating expense management continued. Our OpEx to sales ratio of 31.1% excluding DECO was right in line with Q4 guidance and lower than last Q4's reported 31.5%. There was of course an extra week last year. So a more relevant comparison would be with fiscal 2016's 13 week Q4 OpEx to sales ratio which we estimate was roughly 120 basis points higher than this year's ratio. Our fiscal fourth quarter 2017 operating margin was 13.5%, again excluding DECO. This was an improvement over the 13.3% reported in the same quarter a year ago as 40 basis points of OpEx leverage more than offset the 20 basis points of lower gross margin. And compared to last year's more relevant 13 week fourth quarter estimated operating margin, we improved by about 90 basis points. OpEx expense in Q4 came in at 38%, higher than our guidance of 37.3% with an unfavorable impact from share based compensation accounting being the largest contributor. Before I turn to the balance sheet and cash flow, I would like to briefly review our full year P&L performance and the incremental or read-through margins which we have talked about often. As we have shown on slide four, we had fiscal 2017 sales of $2.9 billion, up about $70 million excluding DECO and after adjusting for our estimate of the impact of fiscal 2016's extra week. We continue to focus on productivity and reducing our cost to serve and delivered approximately 60 basis points of operating expense leverage this fiscal year, which more than offset roughly 40 basis points of lower gross margin. Our operating profit rose by approximately $16 million from last year's estimated 52-week results, a roughly 22% read-through and our operating margin improved by roughly 20 basis points to 13.2%. Excluding the roughly $8 million bonus increase, our read-through was 33%, consistent with our expectations and 30% commitment on the first $100 million of sales growth. Now turning to balance sheet. Our DSO was 54 days, in line with the fiscal third quarter and up three days year-over-year. We had expected to recover some lost ground in Q3's DSO by the end of Q4. So this remains an area of sales and finance cross-functional focus and we expect modest improvement during fiscal 2018. Inventory, on the other hand, was better than expected with turns improving slightly to 3.5 times as inventories declined despite higher sales. In the fiscal fourth quarter, we turned about 144% of our net income into cash flow from operations. For the full year, our cash conversion ratio stood at 107%, in line with the 100% or better that we expected. Net cash provided by operating activities was $88 million in the fourth quarter versus $115 million in the fourth quarter last year. Basically, this was due to working capital. In fiscal 2016's fourth quarter as sales declined, working capital was roughly $18 million source of funds. In fiscal 2017's fourth quarter, as sales grew, working capital used approximately $10 million of cash. Our capital expenditures were $9 million in the fourth quarter and $47 million for the year. This was lower than expected as some projects were deferred into fiscal 2018. After subtracting capital expenditures from net cash provided by operating activities, our free cash flow was $79 million and $200 million in our fourth quarter and fiscal 2017, respectively. In addition to paying out a higher ordinary dividend during fiscal 2017, we bought back nearly 642,000 shares on the open market at an average price of $71.29 and acquired DECO in the fourth quarter and we still ended the year with a $37 million reduction in our net debt. We ended Q4 with $533 million in debt, mainly comprised of $332 million balance on our revolving credit facility and $175 million of private placement debt. We ended the year with $16 million in cash and cash equivalents and a leverage ratio of 1.1 times. This compares to a leverage ratio of 1.3 times at the end of fiscal 2016. In fiscal 2018, we expect revenue growth, some expansion in working capital and capital expenditure of $60 million to $65 million We are hopeful for, but not building in, lower taxes, although it is good to see corporate tax reduction on the legislative agenda. Therefore in fiscal 2018, we continue to expect cash conversion of roughly 100%. Now let's move to our guidance for the first quarter of fiscal 2018 which you can see on slide five of our presentation, which shows our guidance both including and excluding DECO. I will comment first on our Q1 guidance for the base MSC business without DECO and then discuss guidance with DECO included. And continuing in the spirit of the complete transparency, we will keep breaking out the impact of DECO as we report fiscal 2018's operating results. Excluding DECO, we expect fiscal first quarter revenues to increase our on an ADS basis by 7% to 9% versus the prior year period. Through last Friday, our quarter-to-date ADS is up approximately 8%. Excluding DECO, we expect fiscal 2018's first quarter gross margin to be 44.4% plus or minus 20 basis points. This is down sequentially 20 basis points from the fourth quarter's 44.6% and down roughly 60 basis points from last Q1's 455%. Adjusting for Q4's additional supplier rebates and lower inventor provisions, Q1's gross margin is sequentially slightly higher. We expect Q1 operating expenses to be around $229 million, excluding DECO, up $11 million from last year's first quarter. Roughly half of the year-on-year increase is due to variable expenses using our estimate of 10% of sales growth. The rest is mostly due to investment spending and salary bonus and medical cost inflation. Note that we still expect our Q1 OpEx to sales ratio to register another solid year-on-year improvement of about 80 basis points. So after excluding DECO, operating margin would be approximately 13.4% at the midpoint of guidance, up slightly on last year's 13.2%. Essentially, we expect operating expense leverage to more than offset the negative gross margin impact. Finally, our EPS guidance for Q1 is $1.03 to $1.07, up 9% at the midpoint over last year's $0.96. This is due to the tax rate of about 38.2% versus 38% in 2017's Q1. No share based compensation impact or tax credits are built into this guidance. We expect DECO to contribute about 400 basis points of growth to ADS in the quarter, thus taking the guidance range to 11% to 13%. And I am pleased to say, the business is off to a strong start in terms of sales growth. We anticipate that DECO will reduce our reported gross margin by roughly 80 basis points. So Q1's gross margin range with DECO included is 43.6, plus or minus 20 basis points. We also expect DECO to add about $6 million Q1 OpEx. This includes $500,000, roughly, of intangibles amortization, a number that will be approximately a third lower in the second year and onwards. As such, we expect an operating margin of about 13% at the midpoint of guidance with DECO having a roughly 40 basis points negative impact in the first quarter. Turning now to our full year fiscal 2018 framework. We continue to base the operating margin scenarios on two factors, growth levels and the pricing environment. The two sale scenarios are moderate growth and strong growth and the two pricing scenarios are slightly negative and slightly positive. Again, we lay these out with DECO excluded and with DECO included to facilitate comparison. With DECO excluded, as you see on slide seven, our moderate growth scenario is for 4% to 8% ADS growth and our strong growth scenario has an ADS range of 8% to 12%. With DECO included and expected to add 400 basis points to our ADS growth, our moderate growth scenario is 8% to 12% and our strong growth scenario is 12% to 16%. With regards to pricing, the slightly positive scenario envisages zero to positive 1% of net pricing and the slightly negative scenario assumes minus 1% to zero net pricing. In the fourth quarter, we had roughly flat pricing. So moving to the slightly positive scenario assumes a moderate mid-year price increase which would make pricing positive for the back half of the year, absent other negative movements. A robust mid-year price increase, while a possibility, is not compensated in this framework. The slightly negative net pricing scenario would likely if no mid-year price increase materializes. And these pricing scenarios are the same regardless of whether is DECO is excluded or included. With DECO excluded, operating margins under these scenarios range from 13.2% to 14.3% with an average of 13.7%. We expect 2018 incremental margins excluding DECO of 20% or better in all of the quadrants expect the bottom left. Including DECO, as you can see on slide six of the presentation, reduces operating margins by roughly 40 basis points in each quadrant. So they range from 12.8% to 13.9% with an average of 13.3%. Our 2018 fiscal first quarter guidance is being provided in the context of a borderline high growth sales environment and a roughly flat pricing environment which is where we are today. Q4 saw a much smaller negative mix impact from mix and pricing than we have seen in the last several quarters. And as Erik noted earlier, we have finally seen some supplier price increases. However, our Q1 guidance assumes a similarly mix/pricing contribution as Q4. I will now turn it back to Erik.

Thank you Rustom. For the past several years, our company has been heads down executing our strategic plan in the face of challenging market conditions. We have enhanced our value proposition and the competitive moat around our business. We have captured market share in our targeted customer segments and we kept gross margin stable in the face of severe pricing conditions. We have streamlined expenses by improving productivity throughout the company. And we have invested in our foundation to create more scale and leverage as we grow. We have deployed capital carefully in a balanced approach that includes organic reinvestment, select acquisitions and returning cash to shareholders. As market conditions have turned, we are now beginning to realize the fruits of the dedication and hard work of our entire team of associates. Earnings per share grew 11% in fiscal 2017 as compared to fiscal 2016's comparable 52 week number. And we are off to a strong start in the first quarter of fiscal 2018. We are very much looking forward to the upcoming year. I thank you for joining us this morning and Happy Halloween. We wish you more treats than tricks and we will now open up the line for questions.

[Operator Instructions]. Our first question will come from Hamzah Mazari with Macquarie. Please go ahead with your question.

Yes. Good morning. Thank you. The first question was just on the national account business. Could you give us a sense if this business has become more competitive over the years? And what I mean by that is, do you have national accounts sitting in with consultants? Are they requiring more cost savings documentation? I know it grew better than expected this quarter. But just any sense, has that business changed? And has there been more focus on MRO in direct spend versus past years?

It's a great question. This is Erik. I will take it. So yes, the short answer is, absolutely. I think that's been a trend that's been occurring, really I would say, since I entered the business 20 years ago. And if I look over the past five years, 10 years, that's been escalating. No question, smarter customers, more sophisticated customers in the way that you are describing, an interesting dynamic though. So yes, in some ways it makes it more competitive, particularly as it relates to gross margin pressures and it's why we refer to national accounts as a gross margin headwind. On the other hand, I would also tell you that those dynamics create for a really compelling share capture opportunity. And I think it's one of the reasons why you are seeing our national accounts program perform so well, because the business, remember how fragmented our marketplace is with 70% of the market made up of local and regional distributors that when you get a smarter customer and they are evaluating their total spend, it becomes less and less easy to justify having the small local players around and easier for companies like MSC to capture market share. So I think it's two sides of the coin, but I do think that dynamic is real and one of the elements driving the growth we are seeing.

Great. And just a follow-up question on gross margin. Just trying to understand how conservative the fiscal Q1 guide is? It seems like margins increase sequentially historically Q4 to Q1, maybe 50 bips or somewhere in that range. And then if we exclude DECO, that still puts us at maybe 44.2 or something in that range. So it feels like the Q1 guide maybe has you more negative on mix? Or maybe it's just pricing? Any sense of what you are backing in, in terms of the Q1 guide in terms of conservatism? Or what is upside that you are backing in?

Hamzah, this is Erik. So if you are looking sequentially, Q4 to Q1, one thing to keep in mind, if you go back and you look over past cycles and past years, look, the big difference between Q4 and Q1 is the implementation of pricing. This year, we shared with you that the big book increase, if you will, is rather small. It's just over 1%. So the biggest reason why and by way, as Rustom described, when you account for the outsized adjustments and rebate and inventory provisions that we had in Q4, there is a sequential lift Q4 to Q1. But you would be correct in saying that it would be below something like 50 bips. The biggest driver there is just the size of the big book increase that was taken which was pretty small.

Great. And just last question, I will turn it over. On your inventory levels, they appear pretty flat the last three quarters. Should we expect a step up in inventory given the inflection you are seeing in terms of demand?

Hamzah, let me take that. Actually what we are seeing is continued optimization of our supply chain. And that helped us also with those lower inventory provisions in Q4. SKU management, product launch process improvements, procurement process improvements, demand planning process enhancements and a lot of good things like that. So no, I think there probably will be some slight inventory increase as our sales go up. But hopefully we will continue to be having turns of at least as good or slightly better than where we are today.

Great. Thank you.

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

Hi. Good morning guys. A nice quarter.

Thank you Matt. How are you?

Thank you.

Doing great, Erik. thanks. So I want to start with focus on margin, both in the shorter term and longer term. First of all, on the operating margin framework you gave us for FY 2018, what is the year-over-year change in gross margin contemplated in that framework?

Yes. Good question Matt. So I will try to say it as simply as I can. And realize, that framework has two dimensions, demand environment or the growth trajectory and the pricing environment. And what I would tell you is that as you could imagine as the pricing environment moves, so does the gross margin assumption that are baked into that framework, okay. So if you went right to the middle of the frame, so take that, the vertical axis, I think that's the Y-axis, which is the pricing axis, right. So it moves from plus one to minus one, go right into the middle at zero. If pricing were zero, were flat, we would anticipate some modest gross margin decline. And as we have talked about in the past, that would be primarily due to mix effect. But all of less than 50 basis points, but gross margins would be down slightly in a flat pricing environment. Should, as Rustom talked earlier and I mentioned a little bit, look, we are seeing more discreet signs of pricing firming in the marketplace and should we get a mid-year price increase, some sort of moderate mid-year price increase, we would expect we would move up on that axis. If we move up on that axis, then we are getting something close towards the high end of that range there or 1%, we would expect gross margins to be roughly flat.

Okay.

On the other hand --

Is that including pressure from DECO or no?

So I am giving it to you ex-DECO and then DECO, Rustom, is, what did we say? 80 basis points just by virtue of the math of that business.

Okay. That helps. And then looking out longer term, look, obviously there is a lot of focus on gross margin for you and your peers right now, but I want to have a conversation about more than gross margin and focus on what really counts as operating margin. As you look at your business over the next, call it, five to 10 years, given what's happening with price transparency, the mix in your business, all these different factors, what do you expect to see happen with both your gross margin? And then more importantly, what are you guys doing to manage operating margin over that time frame? And what do you expect to see happen there?

So Matt, I tell you what, I am going take, we are going to chunk this out. I am talk a little bit about long-term trajectory for the business, gross margin. I want Rustom to touch on some of what we are doing in terms of productivity and op margin. But look, I think if you go on over time, look, in the near term, one of the scenarios that I didn't talk about was pricing could get more and more robust than perhaps was even contemplated in the framework. And if that were to happen, obviously incrementals move up. But if I look out over multiple years, look, holding gross margin flat would be a very good result. Seeing modest pressure on gross margin due primarily to mix as we have seen over the last couple of years wouldn't be shocking. But look, in that scenario, what we are seeing into the last couple of quarters and guide it like little microcosm of that due to leverage that we are getting on the bottomline at mid single digit, high single digit organic growth really nice earnings growth and some margin expansion. So I will let Rustom touch on that other one.

Yes, absolutely. And look, you know we have been focusing a lot on our cost to serve and on productivity in terms of our operating expenses. So that would continue. And if you are looking at 2018's assumption, I know your questions is longer term, but 2018's assumptions on operating expenses, we basically have the usual sort of increase in variable OpEx, call it 10% to sales growth. And unlike the last couple of years, we don't expect productivity to fully offset our cost inflation and investments. And if you looked at the go-forward, heading into future, we still see a decent amount of leverage, because if we can continue with our strong productivity, offsetting a bunch and have the variable come through at 10%, you would see the leverage. So that would have a positive impact on operating margins.

And Matt, I will take this last one and then I will turn it back. But just take Q1 as a little microcosm, right. So Rustom touched on that. So this is ex-DECO again to try to isolate the base business here at a guide of, call it, 8% revenue growth, we are talking about 80 basis points of leverage on OpEx. So that's a little microcosm that would certainly be more than offset what we would anticipate over the long run if there were any gross margin dilution.

Sure. All right. I appreciate the insight, guys. Thanks.

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

Good morning. This is Katja for Scott. On pricing, can you tell us roughly what percent of your suppliers have raised prices?

So Katja, I will start with the increase that we took over the summer. I mentioned, it was just over 1% which was modest. What I would tell you is that, since that point in time we have had, I would say, several, is the word I would use, meaningful suppliers either announce increases into the market or tell us that increases are coming. Timing wise, it was done after our increase but that bodes pretty well. I would tell you that we will be in a better position to give you more specifics on the next call. Generally what happens, most of our suppliers will move early in the calendar year. It would generally be January of 2018 and we will have entertained more serious discussions about those in November and December. So I expect that to materialize soon. But what we are telegraphing here is a big bit firmer and more defined activity than what we have seen in past years at this point in time.

Okay. So you are seeing the suppliers are indicating that higher prices are going to come. What else do you have to see to be more confident that you will be able to raise prices at mid-year?

I think we are seeing the right signs for now. And I think the answer is, we just need a little more time. As I said, November and December are important months because it's when the pricing discussions with suppliers move from conceptual to they get very real. But I would tell you that between discussions with suppliers, a couple of supplier announcements and what we are seeing from the indices in terms of the pricing metrics increasing, we are seeing the right signs. I think it's just a matter of time in seeing it play out. If the next couple of months plays out as we expect based on the cards, I would expect to be able to get a mid-year increase.

Okay. One more. Which groups of customers are driving the highest sales in first Q, if you can discuss that a little bit?

So what we described, the nice thing is, we have seen the movement, the positive momentum pretty much across the board. I think if there were a couple of areas to call out as our relative shining stars, the CCSG business would be one, as I described, particularly into the first quarter as growing healthy double digits. National accounts would be another growing double digits. So I call those two out. But we have seen a lift in pretty much most segments.

Okay. Thank you very much for taking my question.

Sure.

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

Good morning, guys. Congratulations on a solid quarter. Some of my questions may have been answered in the context of this and I do apologize. I have been multitasking here a little bit. But in any event, I guess the first question I would have, just on DECO, you did talk a little bit about the opportunities there. But could you just give us a sense of squaring the circle in terms of where we are in terms of gross margin and operating margin on excluding transitory cause at each, I picked out the intangible amortization as an example? And what's the vision going forward for gross margin expansion and margin conversion there? Because I think some investors are scratching their heads about the existing profitability.

So Robert, hi, it's Rustom. Let me take the first part and Erik can chip in as well, if he wants to. We have been expensing on the P&L, so the entire intangibles amortization, so you hold in on that and then any investments that we might feel we need to make in the business to enhance their systems or anything like that. I mean, whatever it is, we will expense that. But gross margin is probably thing that's worth talking about most. So we expect to improve the gross margins on DECO's existing business a few hundred basis points through purchase cost synergies. Then the incremental value however is by selling MSP's MRO products to DECO's customer base in addition to their current production metalworking portfolio, right. So this will occur over the coming years. It doesn't happen immediately, but at MSC like margins. And Rob, past acquisitions have shown that we can improve margins, that's gross margins I am talking about, over time close to a typical MSC branch. And this acquisition is very much about that, about getting the people and doing it. We are not baking in cost synergies of any type or anything like that in terms of OpEx cost synergies. We have got, as Erik made the point, I will just reiterate it, we feel that we have been fortunate enough to acquire a business with a great culture and a great team and we just want to slop that alongside our operating teams out there and build on it. Erik?

Yes. So Rob, if you look, I think Rustom explained the financial elements well. Just to comment on your point about investors scratching their heads. Look, so we are pretty selective, as you could tell. Look, we haven't done an acquisition in a few years and we are currently looking. Our bar is high and I would tell you that there are a handful of metalworking distributors out there that are really blue-chip companies and DECO is one of them. And so as I said, it met our criteria with flying colors. If the scratching of the head is the margins, what I would tell you is look, if you go out in the marketplace and look at the 70% of the market that's competing against companies such as MSC, this is typical. This is what the average typically looks like. It's a great business. And as Rustom said, there is a path here. When we look at our past acquisitions that now from a decade ago, that are now MSC branches, they don't look dissimilar to an MSC branch. It happens over time. But we feel great about this business. Hopefully we answered your questions.

Yes. Two other brief ones, hopefully. One is, I just want to make sure as a point of clarification, I think you contemplate in 2018 incremental margins of 20% or better. And I don't want to parse that too much, but wasn't there an expectation previously that it would be closer to 30%? Or am I thinking about it wrong? What is the state of play there for what incremental margin conversion is? And has there been any change there in terms of the guide for 2018?

Yes. Rob, I would say, what you are seeing this year is pretty much in line with what we feel our long range targets have been. So what you have heard us talk about is our long range target is between 20% and 30% incrementals. And what we have said is that, where we fall in that range is going to be a function of two things. One is how strong is the revenue trajectory and two is how firm is the pricing environment. So what you are seeing is, in three of the four quadrants here, we are 20% or north and the one quadrant where we are not is where we had negative price. By the way, even with negative to slightly negative pricing, we can still get to 20% if we were in that stronger revenue environment. So look, I think from our perspective, we are right where we should be in that range. I think the one other point I note is also realize that and we mentioned earlier, the framework contemplates a slightly positive pricing environment. It does not contemplate a robust pricing environment. And I think if you go back to our historical ranges where we talked about pushing towards the top end of that range, it would be in a robust pricing environment. Look, if that happens and there is a chance it happens, we could push north of what you see on the quadrant.

And then finally, because as you know, inquiring minds want to know, any anecdotes or any sense of competitive environment with respect to the pricing actions with respect to Grainger and then the announcement by Amazon Business? Anything that you could talk about the current environment in terms of affecting your business and not affecting your business? And then just thinking about longer term, do you explicitly refute stagflation argument that you can get in a bind where you see rising costs, but you can't pass it on because of the increased transparency in the marketplace. Anything you can speak to that issue? Obviously it's at the heart of the debate right now.

So you got a three-for-one there. So we have got regular pricing actions. So on Grainger, what I will tell you is, we are really not seeing much. Remember, Rob, it's still fragmented. You know the industry well. So a very fragmented market. We are competing against so many players, a lot of locals, each company, even of the large companies has their own pricing nuances. So what I would tell you, very little there. Your second point was around, I am sorry?

Amazon Business launch in terms of any comment there?

Yes. It's similar. You can see in terms of our numbers, we are not really seeing or hearing, not much to speak of there, I think. So no news, at least on the ground in the field, not much to make up there. And then your third point was around pricing.

Which I think is contemplated in your framework, the fact that you don't have a robust pricing scenario on the table. So you are hedging your bet that that probably won't happen. But I guess the question for investors is, could we see a scenario where you could just even have some level of volume growth, but at a much tougher pricing than you have historically witnessed, given the transparency in the aggregate and the environment.

Yes. Rob, just on your point, one point about not putting the robust, you are right. The reason we didn't put it in the framework, you mentioned hedging our best. The reality is, we have been, just given our experience of the last few years, we are hesitant to put anything until we actually see it happen. Look, I think for now, everything that we see would suggest that should manufacturers move on their list prices that we would pass those along and see strong realization. I would tell you, it's a small sample and data point, but so far the 1% plus price increase that we just implemented is seeing very solid realization levels. So a little bit of data to support it there. But until I see otherwise, no reason to believe that wouldn't be the case if we do a mid-year.

I will see you next month. Thanks again.

Thanks Rob.

Our next question will come from Robert Barry of Susquehanna. Please go ahead.

Hi guys. Good morning.

Hi Robert.

Hi Rob. Welcome back, Rob.

Thank you. It's good to be back. Just wanted to clarify a couple of things. So you talked about the impact of the rebates being half the outperformance. Was that the 44.2% versus the 43..8% guide, so about 20 basis points?

Rob, it's Rustom. That was rebates and the inventory provisions together being roughly half of the outperformance.

The outperformance being 43.8% versus 44.2%. So that implies the 20 -- yes?

No. The outperformance being the 80 basis points or so that we were higher than the midpoint.

Got you. Okay. That's what I want to clarify. So half of the 80 is the inventory and the rebates?

Roughly.

Got you. And should we, is it fair to assume that will rise from here just given the sales continue to accelerate?

Well, supplier rebates as sales accelerate, yes, we should get more supplier rebates. Yes, they go together. But the inventory? No, not necessarily. There was a lot of -- its an evaluation that occurs every quarter and it just depends on the quality of the inventory and everything we have. Do we continue to expect to manage our inventory? Yes, absolutely. Would we expect as much in a particular quarter? Not necessarily. But I couldn't call it in or call it out honestly, because it depends on the profile of our inventory as we get to the end of the quarter.

Sure. And then just lastly, I think in the past you have talk about HVAC sales typically weighing on mix in 4Q. I think it was a weak quarter for HVAC sales. I don't know if that had a material impact versus what's typical this quarter or not? Any color there?

Yes. Rob, what you are referring to is, you are correct that we will generally see seasonally things tick down absent any pricing acts or anything. Things generally tick down Q3 to Q4. By the way going back a quarter ago, it was part of the logic behind our fourth quarter guide being below the third quarter very consistent. What I would tell you is, yes, this year we did buck that trend but less to do with any sort of a track mix, more to do with the factors that we called out. So beyond what Rustom mention with rebate and inventory, what we did see stronger pricing discipline in the quarter. So we think we made some improvements there and strong realization from the summer increase. So that was a bigger factor than any change in mix effect.

Got it. Thank you.

Thanks Rob.

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

Yes. Thank you. Good morning everyone.

Hi John.

Hi John.

Could you remind us, what was the price increase a year ago? So you did around 1% or just over 1%. What was it a year ago?

I don't have the right page. Do you?

Our realized price increase a year ago?

Do you mean the catalog increase, John?

Yes. I am sorry, Erik. You are right, the catalog increase.

John, it's the same between 1% and 2%. We don't remember offhand exactly, John.

Okay. Yes, that's fine. So it's fair to say, it's a little bit lower, but it's probably better than you had hoped for kind of earlier in the year or something like that?

I would say, a little lower than last year based on what John is saying.

Erik, how does this pricing work? Like in other words, I had thought, so you put through the price increase and then you have to give that back over the course of the year. Would you be expecting, I see your price was flat this quarter, sequentially in your guide, Rustom, what is price and do you expect price to drift lower? Or do you think you can kind of hold it at this flat realized level?

Well, in Q1, basically the assumption is, as I said, that we will stay at roughly the sort of levels that we are, which is pretty flat.

Okay. So your margin guide is assuming flat pricing, not sort of the drag that we have seen historically, right?

In Q1.

Yes. John, you certainly know the drill of the business. So generally what happens is, there is competitive pressures in the marketplace during the course of the year, so you get realization and then it will drift down during the year. What I would say and what we are contemplating in the framework is, a mid-year pricing, should there be a mid-year pricing which we are getting encouraging signs on, that could change that trend.

I think if I recall, we were hoping for mid-year pricing this past year. Was there something that stymied that in some way? Like, if you were to go back in time, what makes you more optimistic other than the fact that economy is obviously strong? So we know that, right. Is that really kind of the secret sauce that why we hope for a better pricing environment this year versus last year? Or how should we think about it?

Yes. John, so I would say, two data points here, because you are right. Look, we did get a small one last year, but you know we would be hoping for more this year. So what was different this year to last year, I think there is two things. So one is, yes, the demand environment is firmer and related to the demand environment, if you look at MBI, for instance and you look at the pricing indicator, it's definitely firmer than it's been. So that would be one. And two would be suppliers. As I mentioned, there are some specific suppliers who have announced or signaled towards that an increase is coming in a way that's more definitive than I would say we were sitting here a year ago. So those would be the two.

Rustom, going back to --

Sorry, it's Rustom. I mean last year's business environment was actually negative. Demand was declining over much of last year. And so what you have seen is not just the demand environment, you are also seeing inflation expectations broadly being a lot more robust compared to last year. And we are probably talking deflation more than anything else.

No. I agree. I guess the issue is, if product cost through commodities and other things are actually rising, are you going to able to pass those along, right? That's going to be the $64,000 question. But it seems like we are off to a reasonable start. Rustom, what as exactly were the gross and Op margins for DECO in the quarter?

Sorry, in Q1. In Q4, it was almost nothing. And we picked it up for five weeks.

Yes.

And also with the way that --

I can imagine. Right, so I kind of meant pro forma. So I am sorry. If you just looked at their financials for your fiscal fourth quarter, what would their fourth quarter gross and op margins have looked like?

They run in the low 20s. If you did the math from what's in our details out there, it looks ever so slightly lower than that and that's simply because when you acquire you get the inventories. You have to write up the value and then you have got to amortize that over the first six months or so. So proportionately, it's the impact. But if we were doing some sort of pro forma, it would be very much right there at the 20% and just north of 20% kind of range.

So John, if you think about the model for the business, the year one model is basically in the neighborhood of $100 million in revenues, low 20s gross margin, accretion breakeven year one and improves from there.

Yes. And the business is a profitable business. I mean that's realized. We are not cutting it out and saying exceptional pro forma or anything like that. We are absorbing all the amortization, any cost post-integration, post-acquisition, any integration cost, whatever we are doing. We are just absorbing them in our numbers. So we are being more conservative there.

And just lastly, their Op margin was like what, 2% to 3%? Is that roughly in the zone? If you have got a 20% gross margin, was the Op margin about 2% to 3%?

Yes. I would say it's actually slightly more than that before you take into account all the things that we are doing, yes.

Okay. Got it. Thanks guys. Appreciate it.

Thanks John.

Welcome.

Our next question will come from Luke Junk of Baird. Please go ahead.

Hi Erik. First question, just wondering if there is any additional color you can share on CCSG, I guess relative to your efforts to better integrate their sales force and the VMI offerings with legacy MSC and relative to the uptick in growth that you are seeing, how sustainable do you think that is?

Luke, we are pretty encouraged by it. Well, look, we have been talking about the efforts we have been making in the business. They do seem to be paying off. So our feeling, it is quite sustainable, the growth in the business.

And then second question, I was just curious what's going on within the core customer base today? I know you mentioned in your prepared remarks turning out mid single-digits. As the industrial economy is getting better in general, are you seeing that translate to the kind of growth that you would be expecting with those customers?

Yes. Luke, look, the core is growing. It's definitely, at this point, lagging national accounts which is not shocking to us, given the pattern. As things continue to grow as the MBI improves, we would expect to see those growth rates increasing as the bigger companies farmout work. So no big surprises to us there. It's doing what we would expect it to do as the MBI improves.

Okay. Thank you.

And our last question will come from Ryan Merkel of William Blair. Please go ahead.

Hi guys. Last but not least.

Hi Ryan.

So a lot of ground covered. Just wanted to go back to an Amazon question. As you guys saw, Amazon announced Prime for business and stocks were down that day for the group. But can you just comment, will this have any impact on your ability to charge freight?

Yes. So Ryan, here is the reality that the trend of free freight or freight promotions in our business or our industry is nothing new. It's something that's been there for years. It's been escalating for years. So you have been seeing, as you look at and evaluate the MSC financials, you have been seeing and it may been the indirect Amazon effect from when they got into retail, but this practice has been part of B2B for some time, particularly for volume purchasing. So look, down the road, could there be any impact? Hard to say. It wouldn't be as significant, nearly as significant as what you would think by reading the headlines, right. And I think the one other point that I would make is, realize that there is a difference in the quality of shipping and for a B2B customer, they really do value the MSC, it's not just about the next day delivery, it's about how many boxes does the shipment come in? How easy is it to receive? How consistent? Are the standards, the packaging, et cetera? With MSC, you are getting complete consistency. There is a value for that.

Yes, absolutely. And I think it's also true that most of your customers or many of your customers already get free shipping, correct?

Yes. Look, we have over the years and I want to be sensitive, just competitively sensitive but you can imagine, we have been responding, if this trend has been growing for the last decade, it's one that haven't been immune to and we have been responding to it. So you are seeing it in the numbers that we produced over the past.

Right. Okay. And then secondly, another high level question. You said, about 90% of the cost of buying MRO is overhead and this is a big reason why service matters in distribution. Can you just bring this to life with an example? And then, is this the big reason why e-commerce hasn't had more success in this industry? Just comment on that, if you would.

So Ryan, yes. You raised something that's the right at the heart of our value proposition. We are calling on industrial plants. And when you look at an industrial plant, a manufacturing business and say, what percentage of their total cost of operations is made up the cost of price of indirect supplies. You are right. It is under 10%. And so while the pricing has gotten a lot of focus, pricing on products, the reality is that the MSC value proposition has really been geared around focusing on the 90% and not the 10%. And that's the biggest lever that our customers are starving for productivity, they are starving to get their products into market faster because that's how they make money. And they make money by getting products into market and getting productivity on the plant floor. So an example would be, what we do with metalworking. So we have got and I have shared this before, but hundreds of folks in the field who are metalworking specialists and these folks are in there, not just talking about price and availability of products, but they are walking plant floors and they are helping our customers take cost out of their operations. They are reducing excess raw material. They are saving labor rates by coming up with new and improved ideas on how to actually improve the manufacturing process. That's where we live and breathe. That's where we spend our time. And I think you are right to draw it out. The last part of your question, Ryan, I forget.

Just why e-commerce hasn't had more success in this industry? Everyone is worried about it, but the reality is the impact has been pretty minimal, as far as I can tell.

Look, I think e-commerce has had a remarkable amount of success, just not in the way -- I mean just look at our numbers. Our website is a very important part of the value proposition, just not in the way that I think you are describing that some of the fear is that it just drives pricing down. But e-commerce for a business-to-business customer, if you can find ways to help them speed up the procurement process and move things through their plants after, that's going to be value adding. It's why you are seeing MSC Direct as an important driver behind our e-commerce sales. I think, you are right. What hasn't been quite a big a force is just the pure transparency to, say, let me take pricing down because for a business customer that's a small percentage of their total cost.

Right. Okay. Very good. Thank you.

Ladies and gentlemen, this will conclude our question-and-answer session. I would like to turn the conference back over to John Chironna for any closing remarks.

Thanks again everyone for joining us today. Our next earnings date is set for January 10, 2018. And we will see you on the road. We will be at several conferences coming up over the next month or so as well as doing some roadshows. So we certainly look forward to speaking with you over the coming months.

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