MSC Industrial Direct Co., Inc. (MSM) Q2 2019 Earnings Report, Transcript and Summary

Good day, and welcome to the MSC Industrial Supply Company Fiscal 2019 Second Quarter Results Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask question. [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'd like to welcome you to our fiscal 2019 second quarter conference call. With me today 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, including expected benefits from recent acquisitions. 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 and 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'll now turn the call over to Erik.

Thanks, John. Good morning, everybody and thank you for joining us today. To kick off this morning's call, I'll provide a brief overview of our fiscal second quarter results. I'll then offer specifics about the environment and our recent performance before turning it over to Rustom who'll review the details of our second quarter and provide third quarter guidance. I'll then wrap up before we open up the line for questions. Our fiscal second quarter earnings per share came in slightly below our midpoint due to a lighter-than-expected top line, particularly in February. Gross margins were as guided, and in fact, slightly ahead for the base business, and operating expenses were also in line. Included in our total company results this quarter was our expansion into Mexico. While it was not material to our overall results, it did mute our gross margins by roughly 10 basis points, and more coming on these subjects in just a bit. Turning to the environment. Conditions generally remained solid in the industrial economy, although the last couple of months were softer than we've seen in recent quarters. Sentiment indices like the MBI remain in positive territory, but have come down from previous levels. The last two months’ readings for February and March were identical at 53.6. The rolling 12-month average for the MBI is now 56.2, which is still very healthy. However, a combination of some weather, destocking, softness in automotive and oil and gas, and some ripple effects from the prior government shutdown were factors. To be clear, nothing we see indicates a dramatic step down, but demand moderated at least for those two months. Customer sentiment generally confirms this picture. Things have gotten off to a slower start than expected in the beginning of calendar 2019, but the outlook remains generally positive. With regard to the pricing environment, things have remained stable providing a solid backdrop as we implemented our midyear price increase. The tariff landscape also remained stable with no indications that we're headed towards the 25% level. As a reminder, our own tariff exposure is relatively small at roughly 5% of cost of goods sold. I'll now turn to our performance within this environment. While our overall growth rate came in below our expectation, it's important to understand what's happening under the surface. Our core customers maintained growth rates in the high-single digits. This is particularly important because core is where most of our sales transformation efforts have been aimed and demonstrates ongoing traction of our changes. National Accounts also remained in the high-single digits, and as expected Government was negative in the quarter weighing down our overall growth rate. As you'll hear from Rustom in greater detail shortly, we're projecting our third quarter growth rate to tick down and this is primarily a function of two things. First, the slower growth rates from February continued into March when factoring out the Easter holiday benefit. To be clear, we're not seeing acute weakness in specific accounts. If we were, it could point to competitive movement or change in share. However, neither one has changed meaningfully. Instead, we saw lower growth across the board, particularly towards the end of the calendar quarter. A good example of this was in our highly penetrated National Accounts, where our relationships are strong. Many of these accounts saw lower spending levels in March even as compared to December. This is consistent with softening demand or inventory destocking. I should note that the last week of our fiscal March, which was the first week of calendar April or the calendar second quarter rebounded and was much stronger. Should that sustain, it would suggest the February and March softness was just temporary. Our fiscal third quarter guidance does not anticipate that this strength continues for the rest of the quarter. If it does, it would mean upside to our guidance. The second factor impacting the third quarter revenue guide is Government, which as we anticipated will hit its peak headwind in the third quarter with a low-double-digit decline projected. This is a function of year-over-year comparability as both of our previously communicated contract losses is hardest this quarter. As I've shared with you in the past, we've been making significant changes in Government, and . And as a result our pipeline of new opportunities has improved considerably. Keep in mind that moving past this comparability issue will reduce a headwind of at least one point of growth and this is before the changes that we've made bear fruit. Despite the lower projected third quarter growth rate, my conviction in our sales transformation remains high. I base this on several data points. First, our core customer growth rate remains solid and given that core is where the bulk of our sales changes were aimed, this is important. Second, the sales changes have freed up our sellers to engage in more growth activities, and we're seeing the positive impact of this in inventory management signings and, in particular, vending. Vending signings are up over 50% for the year. And while it takes time for signings to turn into revenues, they are a good indicator of future growth prospects and share capture. As a point of reference, vending did contribute 280 points of growth in our second quarter. Third, we have stepped up our focus on new business generation considerably. Most of our sales force hiring has been aimed at business development. Our hunters have gone from just a handful a few years back to about 100 associates today as part of our sales transformation efforts and this number has nearly doubled just over the past year. These hunters are beginning to hit their stride and we are seeing a robust new account funnel that continues to build each month. They are not yet moving the needle on our growth rate, but they will as they move to implementation. We believe that our business generation efforts, including what we're seeing in vending will add one point or more of growth over the next couple of quarters, and it will build from there. As you can see from our operating statistics, we added another 16 net sales and service additions this past quarter, and we'll continue on our moderate hiring pace given the success of the program. A fourth proof point, we continue generating considerable cost savings for our customers through our technical expertise on the plant floor. These cost savings are an indication of the value that we're bringing to customers and they help build loyalty. Finally, feedback from our sales team, from customers, and from suppliers is consistent with the quantitative data and is telling us that we're on the right path with our plan. I'll now turn from the top line to our pricing actions. Since our last call as expected, we implemented a meaningful price increase of 2% to 3% in February. We are pleased with the high realization rates that we're seeing, which are due to the solid efforts of our sales and marketing teams. It's also a testament to our strong value proposition as we're delivering the type of cost savings and productivity to our customers that justify the increase. A moment on AIS, which has generally performed in line with expectations over the course of the past three quarters, since our acquisition of this OEM fastener business. This past quarter however, we did see some softness coming primarily in the automotive sector in the Midwest. As AIS supplies OEM fasteners, they will feel changes in automotive production rates acutely and that is the case now with just a handful of customers driving the bulk of the softness. The team continues making early inroads with cross-selling and we expect that to build over time. Before wrapping up, I'll talk about Mexico, which is an exciting development for the company. We've established a majority owned business, MSC Mexico working with an existing Mexican distributor, T-A-C or TAC. We view Mexico as a strategic foothold for us and a critical component of presenting ourselves to National Accounts as a North American supplier. A direct presence there allows us to not only support current U.S. customers with Mexican plants, but also opens up the Mexican market for us, which is a meaningful long-term growth opportunity. We've been looking for the right expansion opportunity for quite a while and we were excited to find an excellent partner in TAC whose cofounder is now MSC Mexico's CEO. They built a strong value proposition as a BMI provider of MRO supplies into various industries within Mexico, and we're very much looking forward to a bright future ahead. I'll now turn things over to Rustom.

Thank you, Erik. Good morning, everyone. Before getting into the details, let me remind you that we had provided Q2 guidance for both our total company results and our base business or total company excluding the impact of the AIS acquisition. In addition, on February 1st, MSC Mexico commenced operations, which Erik just spoke about. Our guidance did not include this business, in which we have a 75% controlling interest, but one month of actuals are included in our total company results. We will exclude MSC Mexico along with AIS when discussing our base business. Our second quarter total average daily sales were $13.3 million, an increase of 8.8% versus the same quarter last year, just below the 9% midpoint of our guidance. AIS contributed 230 basis points of growth and MSC Mexico contributed 40 basis points of growth. Our base business growth was 6.1% versus the 6.5% midpoint of our guidance. Our reported gross margin was 42.7% for the quarter. This was in line with guidance as the 10 basis point difference from the midpoint of guidance was entirely due to our MSC Mexico business, which of course was established post guidance. Our total company gross margin was down roughly 120 basis points from last year with about 30 basis points coming from AIS and another 10 basis points from MSC Mexico. Our base business price contribution remained positive and in fact improved due to the price increase. Although as expected, purchase cost continued to increase and mix remained a headwind. Our OpEx to sales at 31.1% was flat versus last year's Q2 and in line with guidance. Total OpEx was $256 million, up $17 million from last Q2 with about $5 million of this coming from the acquisitions. Just under $4 million of the increase was attributable to volume related variable costs such as pick, pack, ship, freight and commissions. Another $6 million related to growth investments, including additional field, sales and service personnel and stepped up marketing. Cost inflation and all other expenses net of productivity added nearly another $2 million. Our fiscal second quarter operating margin was 11.7%. That's down roughly 110 basis points from the prior year with roughly 20 basis points of this due to AIS. Our base business operating margin was 11.9%, down almost 90 basis points from the same quarter a year ago and due to lower gross margins as noted earlier. Total company and base business operating margins were both in line with guidance. Our total tax expense on a percentage basis for the second quarter was 25.1% also in line with guidance. So all of this resulted in reported earnings of $1.24 per share $0.01 below the midpoint of our guidance. AIS and MSC Mexico had no impact on reported EPS after rounding. Last year's reported EPS was $2.06, which included a one-time tax benefit related to Tax Cuts and Jobs Act of roughly $0.72. Also included in last year's Q2 was the catch up of the lower tax rate on our year-to-date income. As noted in January, perhaps the simplest way to normalize EPS for tax benefits is to apply the current quarter's tax rate of 25.1% to fiscal 2018's Q2. And if we did this, Q2's EPS was $0.01 below last year. Turning to the balance sheet. So our DSO was 54 days flat with fiscal 2018's Q2 and down roughly four days from our fiscal first quarter of 2019, which is broadly in line with our typical seasonal pattern. Our inventory increased during the quarter to $573 million, up $45 million from Q1 as we continued to take advantage of calendar year-end rebate opportunities, build safety stocks ahead of possible tariff related disruption and also to get ahead of impending supplier price increases. Total company inventory turns remained at 3.6 times. With tariffs looking less likely, we have slowed purchasing and expect inventory levels to decline in our third fiscal -- in our fiscal third quarter. Net cash provided by operating activities in Q2 was $22 million versus $36 million last year. Our capital expenditures in the second quarter were $13 million versus last year's unusually low $8 million. And after subtracting capital expenditures from net cash provided by operating activities, our free cash flow was $9 million as compared to $28 million in last year's Q2. We paid out $35 million in ordinary dividends during the quarter and bought back 275,000 shares for $21 million at an average price of $76.02. In last year's second quarter, we paid out $33 million in dividends and spent $18 million on buybacks. Our total debt at the end of the second quarter was $593 million, comprised mainly of $281 million balance on our credit facility and $285 million of long-term fixed-rate borrowing. Our leverage increased slightly to 1.2 times as compared to one times at both Q1 and last year's Q2. So now let's move to our guidance for the third quarter of fiscal 2019, which you can see on slide 4 and is shown with and without acquisition. Please remember that DECO is in the base while AIS and MSC Mexico are included in the total company deals. Please also note that Easter is later this year and this artificially inflates our March growth, but then suppresses our April growth rate. For the fiscal third quarter, of course, the anticipated impact is a wash. So overall, for Q3, we expect total company ADS to increase by approximately 5.5% to 7.5% versus the prior year period. This includes 3% to 5% of organic growth and around 250 basis points from acquisitions. Note that AIS was acquired on April 30 last year, so one month of sales was included in last year's Q3. And MSC Mexico is now included for the full quarter. You can see on the website op stats that March's total average daily sales growth is estimated at 9.5%. We estimate that this includes about 350 basis points from the acquisitions with Mexico contributing about 100 basis points of that. We also estimate that the month was boosted by about 200 basis points from Easter falling into April this year. As Erik mentioned, our fiscal March was softer than expected for most of the month with a nice rebound in our final week, which is the first week of calendar April. Our guidance forecast assumes daily sales rates above the first few softer weeks in March, but not at the levels we saw in the last weeks' rebounds. Our Q3 operate -- our Q3 reported gross margin is expected to be 42.7% plus or minus 20 basis points. This is inclusive of a roughly 60 basis point negative impact from the acquisition and roughly 30 of this comes from the new Mexican business. Our base business gross margin is expected to be 43.3%, up 20 points sequentially from the second quarter and bucking the trend of a seasonal decline. Year-on-year, our total company Q3 gross margin is expected to be down almost 90 points with roughly 40 basis points due to acquisitions. On our last call, we flagged price realization as the key gross margin driver for the second half of the fiscal year. So far price realization has been strong. However, higher purchase cost and mix are continuing gross margin headwinds as higher sales growth coming from vending and direct ships comes at gross margin below the company average, but they do contributes to our operating profit. Operating expenses are expected to be around $262 million, up $17 million over last year's third quarter with AIS and MSC Mexico accounting for roughly $5 million of this. Variable expenses associated with higher base sales are expected to account for another roughly $3 million. And an additional roughly $2 million comes from inflation net of productivity. And finally, our growth investments including the higher field sales and service headcount are expected to be up roughly $7 million on the prior period. Recall that we added 35 sales and service associates in our fiscal fourth quarter, 34 in our fiscal third quarter and 16 more in our fiscal second quarter. We also added to our inventory management implementation team to support accelerated vending signings. Sequentially, our base business OpEx is expected to be flat after allowing for the roughly $5 million of higher volume-related variable expenses. So year-on-year in percentage terms, we expect our total company third quarter OpEx to sales ratio to be unchanged at 29.7%, despite the higher growth investment spending. We expect the third quarter's total company operating margin to be approximately 13% at the midpoint of guidance, a 90 basis point decline over last year's 13.9%. The driver is a roughly 90 basis points gross margin decline with roughly 40 of this coming from acquisitions. The additional sales and service headcount added since fiscal Q4 2018 also contributes, but the impact is minor. Assuming the midpoint of our total company Q3 operating margin guidance, we would remain in the lower-left quadrant of our 2019 annual op margin framework through the first three quarters. You might have noticed that we modified slide 6 in our deck and that's the operating margin framework. And this is including acquisitions. This is strictly to reflect the Mexican acquisition which dropped the GM ranges and the operating margins in each quadrant by 10 basis points. Before turning to taxes, I would like to briefly cover incremental margins. In fiscal 2018, we delivered base incremental margins of over 22%. In fiscal 2019, we have taken a step back. Our first half base business operating profit only grew slightly as the decline in gross margins cost us around $2 million or 50 basis points of operating margin and we invested around -- about $11 million for growth mostly in field, sales and service personnel. Q3 is expected to show a similar picture. Our gross margins will be sequentially higher, because of the February price increase, but down year-on-year. And as Erik noted before where OpEx is concerned, we intend to continue investing in field, sales and service personnel through this fiscal year. Our full year 2019 incremental margin picture implied by our annual operating margin framework was already slightly below 20%. Assuming the midpoint of our fiscal Q3 guidance for the total company, our nine-month year-to-date incremental margins will be only marginally positive. The primary driver of this is revenue growth. Sales have been softer than anticipated over the past couple of months and our guidance assumes that this will continue in our fiscal Q3. At the same time, our higher growth investments, namely sales and service both operating expenses as a percentage of sales also slightly above what we had anticipated at this point in the year. As we look ahead, we remain confident that our investments will continue to yield payback and that we will achieve leverage on the step-up in investment spending. Now turning to our estimated tax rate for the third quarter, it is 25.1% in line with the first half of the year. Our guidance also assumes a weighted average diluted share count of roughly 55.4 million shares. So our fiscal third quarter EPS guidance range is $1.46 to $1.52 per share with a midpoint of $1.49. This includes AIS and MSC Mexico which together are expected to have a roughly breakeven impact on EPS. I'll now turn back to Erik.

Thank you, Rustom. Before closing, I'll provide some perspective on our performance and our path forward. Over the past few years, we've repositioned MSC from a spot buy supplier to a mission-critical partner on manufacturing plant floors. This journey has included several important initiatives, migrating our product portfolio, the technical and high-touch product lines, expanding our inventory management footprint through vending and VMI, creating a new value proposition anchored in producing cost savings and productivity improvements for our customers and reengineering our sales force to support the new value proposition. As we entered this fiscal year, our plan called for improving revenue growth relative to the market, particularly in our core customers, moderating gross margin pressures through price realization and achieving operating expense leverage on our growth despite a step-up in sales investments. Halfway through the fiscal year, the biggest difference in financial results compared to our expectations comes from revenue growth. While starting out in the right direction, topline growth has not maintained momentum at least not over the last two months. Whether the moderation that we've seen continues or it proves to be just a blip is still unclear. In either case, we like what we're seeing from our growth investments. We therefore remain focused on our growth plan and we are confident that it will deliver the anticipated benefits as we move forward. We'll now open up the line for questions.

Thank you. We will now begin the question and answer session. [Operator Instructions] Our first question comes from Evelyn Chow of Goldman Sachs. Please go ahead.

Good morning, Erik, Rustom, and John.

Hi Evelyn, how are you.

Very well, thanks. I just want to start on your fiscal 3Q growth guidance and the deceleration you embed. Helpful to hear a few of the things you posited, inventory destock in the National Accounts, maybe some potential share shifts, your government contract headwinds peaking next quarter. It seems like April is a step in the right direction, but from what I gather a lot of the headwinds you cite don't really seem like things that resolve in the short term. So maybe Erik or Rustom, could you elaborate a bit on what you're seeing here? And also what factors could actually get better as you go through the fiscal year?

Yes. Sure Evelyn. So, I would say with respect to the deceleration in the growth rate, and we're referring to of course the base business, really two things to talk about. One is that look we did see softer conditions in February that continued into March, and what we've done with our guidance is assume that basically those conditions hold. In terms of color on that, I would say it was no one thing, a combination of a whole bunch of things. I mean, some weather, particularly in February, I would say weather. Destocking, which what I'd say on destocking hard to quantify, but a lot more anecdotal evidence than we've heard about in the past. We saw some pockets of softness in automotive and oil and gas, and a little bit of ripple effect from the government shutdown that occurred on some of our core customers who did government work. So that was the macro. I would say hard to say for sure, but a good chance that – there's a case to be made that some of that lingers on, and there's a case to be made that says some of that is temporary and doesn't, reasonably encouraged to see the start of the calendar quarter second quarter or the first week in April bounce back. So, I think that's what we'll see. The second thing that, I want to hit on is essentially what we're seeing. What you're hearing for me is despite the tick-down in growth, a lot of confidence in what I'm seeing from our growth initiatives. And essentially what's happening is there is a lag between what we're seeing on the ground in terms of progress on initiatives, and how that progress is translating into numbers. So during the prepared remarks, I commented on two of those, one being vending; and the other being business development or as I referred to as hunting in other words new account generation. So just to put some color on new account generation, we're seeing – I talked about the growth in the size of the team, but that is translating. So new account signings had doubled in recent months, and these are signings per month, and we're seeing a pipeline that continues to grow. And most of that progress is being driven by the core team of hunters that have been in place for a while, nearly half the team is new – meaning they've only been hired in the last year and haven't hit their stride yet. So we expect that pipeline to keep growing. Again, still early, but we're seeing a lot of positive indicators there. So as we look out, let's put the macro to the side and who knows what happens there. We do see a couple of things in our control that should positively impact growth rate. So one is just the math of Government lapping Government over the next couple of quarters, which the headwind abates and that's worth roughly a point. And then between vending and new business generation, as we talked about we see – again, you can never pinpoint timing precisely, but over the next couple of quarters at least a point there. So we do like what we're seeing on the ground and what's in our control.

Thanks, Erik. That's all really helpful. And then maybe just touching upon something you raised just now. As you've been folding new salespeople into your organization, have you gotten a better sense of when they become productive and when you feel like they get past that ramp phrase – phase and start to produce?

Yeah, Evelyn, that's a really – oh you want to go ahead Rustom? Go ahead.

Sure. I mean, it was the – yes, Evelyn. Well, first of all, they're different, right? There’s some of the hunters all the way from teddy [ph] sales hunters to the large enterprise hunters. But the early economics of these hunters, I mean, that we're seeing that they're producing as Erik said significantly more revenue per head, and that gross margin's lower than company average, but better than National Accounts. And most importantly, it's still early, but the initiative is already breaking even from a P&L perspective overall.

Great. And then maybe just –

One thing, I'll highlight just to underscore Rustom's point about early signs being positive and just – I have the benefit of being here since the "old days". Relative to – and it is early as Rustom said. But relative to the "older model" the one size fits all model before all these changes, we are seeing for the base of sellers that have been here for a bit now considerably higher revenue per head than what we saw under the old model. So very early, but encouraging.

Thanks, guys. And if may just sneaking in one more in here on the fiscal 3Q margin, Rustom, I know you said, it will probably stay in that lower left quadrant of the guide, i.e. around 12.8%. Just thinking about typical seasonality I think your fiscal 3Q margins tend to be up quarter-over-quarter 100 to 200 bps. Pricing should improve. So, are you – do you just think that particular quadrant looks especially good to you or are there other headwinds to margins that I'm not really thinking about?

No. I mean, the fiscal – I mean, sequentially, I mean, between Q2 to Q3, I mean, there's normally a downward drift. So, in this time, it's actually bucked it the base margins and that's due to strong price realization. It's net of the normal seasonality that with the price increases have been gone through earlier, and then going through and then reflecting, but also increased purchase cost. But also don't forget that Mexico pulls down our Q3 and this is going off the base. Mexico pulls down our Q3 gross margin by roughly 30 basis points, because remember there's a only in for one month in the first – in the second quarter. And were you talking about gross margins? Or were you focusing more on op margins?

I was looking more at the EBIT margins Rustom.

Oh, sorry.

No, not so worry.

So look I can – I can – I can give you that as well. I mean the – so the EBIT margins, I mean, we've – and maybe I'll actually take it in terms of that incrementals. I mean, we do expect incremental margins in the second half to be in the lower left quadrant of the framework and we expect slightly positive incrementals for the second half. But it's too early really to be definitive beyond Q3.

I appreciate the time today guys. Thank you.

Thank you, Evelyn.

Our next question comes from Robert Barry of Buckingham. Please go ahead.

Hey guys, good morning.

Hi Rob.

Just to maybe clarify, were you able to quantify how much these factors impacted the quarter, the weather, the government shutdown impacts?

Rob, it is so tricky. So the short answer is no. I mean what I would say though is what you saw from the base business. Rustom mentioned in the prepared remarks we were off from the midpoint. So if we go February in particular, we were off from the midpoint of our guidance by about 40 basis points on the base business on the topline. That was -- the driver behind that were these factors that I saw and it was particularly in February which quite frankly didn't surprise us all that much based on what we were seeing in terms of weather and other reports and surveys about February. What surprised us a bit is that it extended into March with the exception of that last week of our fiscal month. But tough to quantify other than to say that that gap between the midpoint of our revenue range and where we landed would be the difference.

Got it. Got it. So kind of marginal I guess is the best estimate.

It's certainly -- look nothing we saw or we point to would indicate any sort of major step down here. And certainly that drives -- what we're hearing from customers things did get off to a slower start for all of those reasons. But outlook generally remains pretty good. So nothing we're talking about here appears to be dramatic.

Got it. And sounds like you put through the price increase it went as expected. So on the base business, do you expect or does the gross margin forecast assume that you're net positive on price/cost in 3Q?

So the answer is no. I mean because we have a very strong positive contribution coming back on realization on our pricing, but we also have a long lag coming through in our cost as we've explained before. And so think about our last quarter. If you think about the last quarter of fiscal 2018, when we got pricing earlier than the cost coming through we saw the positive benefit of that. Because we have an average costing system, because we buy ahead, because we defer increases, all the rest of that, it takes a while for cost to come catching up with us. And so we are seeing that. I mean we are seeing that in our numbers. And for instance in the first half Robert, I mean most of the P&L impact was from calendar 2018 cost increases, the costs that we saw coming through.

And just to tag on to what Rustom's saying if you're looking Rob to say, where's the pricing benefit? Take a look -- the answer to that Rustom sort of hit this in his remarks that essentially we bucked what has been -- if you look over our last few years what you'd see is margin absent any action will tick down Q2 to Q3. It ticked up that's basically price.

Got it. I mean, do you think in 4Q you'll be neutral? Or is there line of sight to being at least neutral on price/cost?

Look I'd say early to say so many moving parts. The one thing I'd say just the caution there will be generally if we follow a seasonal pattern as we do most years, you'll see Q4 generally will drop from Q3 primarily due to seasonality. That would be the typical pattern. But obviously, we'll give more color next call.

Got it. I guess just lastly I wanted to follow-up on the comments about all these sales efforts adding about one point to growth. I think, a few quarters ago you talked about the kind of sales realignment causing you guys to under perform the market by maybe it was 200 or 300 basis points. And as you kind of ramp the salespeople that you could close that gap. And I don't know if that's taking longer or if I'm not remembering it correctly, but now it sounds like you're only talking about all the efforts adding one point to growth versus where we are now. So could you just clarify that please?

Yes absolutely Rob. So in terms of gauging progress, first thing I'd say is take a look. I think it's important to isolate government in the story here because we've been pretty transparent about a couple of contract losses and government changes we've been making. But when pulling out government, if you look at our core business which is where most of the changes were aimed, Q1, Q2 even into March which granted March was helped by Easter; the core business is up high single digits, okay? So part of the changes or part of the benefits are being seen in the performance of the core. The core is outperforming the company average right now. The comment about the one point was related specifically to one aspect of these changes which is the new business generation. So from where we sit today, first of all realize that our Q3 guide is contemplating some unexpected softness continuing. That may or may not continue. But regardless of the environment, what I'm isolating is the new business generation, we anticipate adding and what I said was at least one point and then building. So realize the way this works Rob is we've hired a lot of hunters. As you heard, the numbers went from a handful up to 100. And it takes roughly -- what we found is it takes a hunter somewhere three to six months to sort of build their funnel and be able to start hitting their stride. As they do each month that goes by, they are -- we are seeing new account signings add. These new account signings are going to layer on top of each other. And so what I was describing in the one point was looking out over a couple of quarters getting at least one point. I absolutely expect if we continue to execute as the early signs indicate we will that builds because these account signings layer on top of each other.

Got it. All right. Thank you.

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

Hi, good morning all.

Good morning, Scott.

I was wondering, I know Erik you commented that the more moderating sales in manufacturing in particular in February and March that in fact you saw a little bit of a snapback in early April that the moderation was broad-based. I'm wondering was the snapback similarly broad-based?

Yeah. And the only caveat is snapback I wanted to -- so what we saw was a week. And granted it was an important week we felt because it was the start of the calendar quarter. So if the destocking hypothesis had held, we felt it was an important week but only a week. To answer your question, yes, it was broad-based. So very much the way softness was broad-based what came back was broad-based.

Got it. Rustom, I was hoping that you could maybe shed a little bit of light on your thinking around third quarter free cash flow. Obviously this quarter was impacted by some of the working capital build that you've talked about here. Does the lack of pre-purchasing as well as the sales allow you to have -- should third quarter be a really strong free cash flow quarter up year-over-year and all that?

Yes. Hey, Scott. And the answer is yes. We do expect the third quarter to be significantly better than the second quarter.

And working capital would be a source of funds in the third quarter?

Well, inventory for sure would go down. We expect inventory to go down. I mean, as sales grow and we continue -- I mean, I'm not sure if receivables will be a source of funds they're not going to be an aberrationally high use of funds, but they're not -- that's really a source. So the drivers are going to come from -- and also remember in the second quarter, we pay -- we have -- the way it works we have two tax payments. That happens every single year. So that alone gives us a ton of cash.

Yeah, fair. Thanks. And my last question is, you guys are kind of the last couple of years just give us this price/mix net of discounts within your supplementary data -- supplemental data. What I'm wondering is it's been positive now for five straight quarters. One of your competitors started, I guess a little over a year ago to say what they estimate mix is each quarter. Essentially they wake up in the morning and they have certain -- negative mix is a certain range of basis points. Is that something that you guys might be prepared to talk about what you would -- you sort of your wake up in the morning negative mix, whether it's large customers vending other e-commerce? Is that something you could maybe give us a little more detail on?

Got it. So I think a fair point. And look we have pointed to ongoing that there is a mix element to the gross margin equation a negative mix element. You're right, we haven't specifically colored it. Let us take it back and chew on it. Part of the reason by the way when you see our decomposition, you're right what you is price/mix together. And look the fundamental reason is in a business with one million plus SKUs, several hundred thousand customers there's a lot of permutations. Getting at price realization there's multiple ways we look at it. It's in many cases very hard because a lot of our customers are not buying the same items every quarter, every year they're random purchases. It's very hard to disaggregate mix from price, which is why you see them together. Let us see if there's something we can do to give you some more and point you in the right direction.

Great. That’s all I had. Thank you all.

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

Hey, good morning. My question is largely around operating leverage for the company. It feels like post the Barnes deal that took longer to integrate, we had a sales force strategy shift, and now it feels like somebody's growth investments are just late in the cycle. Do you think longer term the company can get op leverage in a slowing macro? Meaning, do you think that the share gain in a slowdown given these growth investments will materialize? Or we just have to wait for the next cycle to see these growth investments pay off?

So, hi, Hamzah. So maybe I'll take that and then take it in terms of incremental margins and maybe bring the conversation back to that. So we've talked about achieving a 20% plus annual incremental margins. And we said to do that we need a mid to high single digit organic revenue growth flat or modest erosion in gross margin, and OpEx productivity offsetting inflation, okay. So right now we are seeing greater than modest gross margin erosion. Our stepped-up growth investments are not yet producing payback. I mean, you've heard me mention that on the business development people we've come to break even but we're at that point. So, as a result, we're going to be well below the 20% level this fiscal year. But looking beyond, I mean, our current growth investments will abate and then it comes down to gross margin erosion. If gross margin erosion remains at current levels, we will need low double-digit sales growth to get it and we go from there. And probably the only other point to mention is OpEx productivity. I didn't cover that. But if you saw the last two quarters, we talked about it, I mean, on a $3 billion plus business I mean, if you look at the -- our productivity has offset in Q2 and in the projections of Q3 all, but a couple of million dollars of inflation. So, we continue to focus on that too. Does that give you enough of ...?

Yeah, no. No, that's helpful. I was just wondering, are these growth investments just coming too late in the cycle? Or do you think structurally these investments just take longer to payoff than some of the investments maybe you've made in the past cycles?

Hamzah, I mean, from our perspective, when we look at growth investments really we try to do it in a cycle agnostic sort of way and say, "Are these good return on investments? Are we going to get high payback from the investments over cycles?" Because it's very hard to run the business throttling up, throttling back. Now certainly, at the margin, we can temper based on environment. But we look at over a cycle saying, "Are these investments going to produce payback?" We're confident in these investments. And I would say so far, while I understand all of us would like it to happen faster, no question. Relative to past investment growth investments that we've made, I'm not necessarily seeing that it's going to take that much longer. I think we -- all the signs point towards improved growth. So, the only last comment I'd make it is, right now, I understand your point about late in the cycle. But just to be clear, nothing we're seeing indicates that the macro is going way down. It may be moderating. But even in a moderate economy, there's an opportunity for us as these investments yield payback to improve our growth rates and produce the kind of growth rates that you're used to seeing from us.

That's very helpful. And just a follow-up, I'll turn it over. I may have missed this. But did Easter have any impact in sort of the first week of April pickup that you're seeing? Or it's just -- it didn't really have an impact?

Easter helped our March number -- our estimated March numbers by a couple of hundred basis points. But it will get wiped out completely in April. So, by the time, we finish the quarter, net zero.

Got it. Thank you.

Our next question comes from John Inch of Gordon Haskett. Please go ahead.

Thank you. Good morning, everybody.

Hi, John.

Hi, John.

Hi. So, I want to start with the gross margin guidance for the third quarter. I guess, we've got AIS and Mexico kind of 40, 50 basis points. The core, right, the 42.7% shows sort of no benefit from the sequential volume improvements. So, I'm assuming this is the -- Rustom, what you've talked about the gross margin degradation. But we've got price, I guess, with 80 basis points of realization should be a lot more this quarter. What's the -- is there anything else you can comment on with respect to why there's not better gross margin leverage, given the volumes and the price increase put through?

Sure, John. Sure. So, the 42.7% is the total -- is the total, right, which includes all the acquisitions and everything, all the negatives and everything from there already in that number. If you looked at the -- if you looked at our base number, without even AIS, so if we're comparing complete apples-to-apples, so I mean, that number was -- is still up 20 basis points. And so, we're seeing sequential rise coming through. It's fundamentally the same thing that we -- that I tried to explain earlier, which is that the price increases are going through, right, but you're having the lag effect of costs coming through. And that's coming, right, with that. And then finally, there is, of course, a mix element when we do more vending and some things so that they come through at a lower gross margin, for sure. I mean, vending is about minus 40 basis points compared to -- yeah, it's pulled us down about minus 40 basis points a quarter, pretty consistent with what we've seen. And then finally, as you said, there's the 60 basis points also coming from the two acquisitions.

Okay.

And John, the only thing I'll add to Rustom's comments is take a look. So, if you go sequentially -- and what I would suggest you do is put Mexico to the side and I say that because Mexico was in one period and really essentially not in the other. And if you compare Q2 to Q3, plus 20 -- take a look at our last few years and look at it without a meaningful price increase, because we really haven't had a meaningful mid-year price increase in the past few years and look at the gross margin performance over those -- from Q2 to Q3. And when you compare this year on those, you'll see a pretty sizable difference, that's effectively pricing net of costs.

Okay. So, the core growth in March, I think, ex-Easter and acquisitions was about 4%. But you talked about core -- I'm sorry, the organic growth. But the core account growth was high single digit. That almost sounds as if it was holding up throughout. So, was it the large accounts that stepped down if you were to parse that out? Or was it the drag from government got even worse? Just because you talked about the core stuff still being pretty resilient, what actually happened ex those other moving parts?

John, so you're -- and you're talking about specifically March?

Yeah. Yeah. That seemed to be kind of the big month here.

So, to be clear, I want to make sure I'm transparent. So, core was high single digits in March. That was relative to the 6% for the company. You have to take off -- that's inclusive the Easter effect, okay? So we're estimating the Easter effect had about 200 basis points, which brings the 6% down to an effective 4%. It would bring core down also.

Okay. Got it.

So also, it's John, sorry. But also Government as we have indicated was going to be down double digits for the quarter and March is the first month for the quarter. So yes, Government took a step down from the Q2 levels.

Right with 3Q being the worst inflection. Do you think there was any kind of -- considering you guys were raising prices, do you think there was any kind of a pull-forward, if you go back to the fiscal second quarter, as you looked at sort of the trends within your accounts Erik that maybe have accounted part of the step-down versus the broader economy or maybe disruption from your sales force initiatives or something that's more idiosyncratic to MSC?

John, it's a good question. Generally with price increases given the percentage -- of one of our customers, if you look at the stuff we supply, industrial MRO supplies as a percentage of their total spend, it's not that big. It's not the kind of thing where they would be buying in advance, because it's just not that big dollars. Look what is possible, because we did hear some destocking as I said anecdotes tough to quantify. But more anecdotes than we've heard in recent quarters is more of being macro buying I guess because of tariffs or whatever late in calendar 2018 that's possible. I don't know. I don't think it would be to your -- like idiosyncratic MSC-specific on price increase, don't think so. Nor do I think by the way that there was any sort of price connection between pricing and volume. We look at that pretty carefully as part of our price realization and saw no difference between where prices were raised and they were in terms of units.

Got it. A couple more quick ones. Rustom, is the 30 basis points from Mexico, is that kind of onetime based on step-up of inventory and amortization? And then Erik, how are you thinking about maybe firepower to do a larger deal? It was announced that Kaman's exploring a sale -- that would be a very large deal. But I'm just curious about your own thought process now that you opened Mexico, AIS seems to be under your belt, what are you thinking going forward?

So I'll let -- Rustom will hit...

Right. So I'll go first. So not a major inventory step-up over there. But yes, when they -- in the go-forward quarters, we'll expect Mexico to be rough closer to 20 basis points of downward. Erik?

Yes. And John, to your question on M&A, I mean, I'll even take it up a notch on capital allocation. Our approach pretty much the same this idea that we refer you inside the company of think like an owner, which means spend the next dollar of free cash flow where we see the highest risk-adjusted return. I would say a couple of things of note right now two factors. And certainly, we have a robust M&A funnel no question, but two factors I'd point out. Number one, we're seeing valuations as being pretty high right now, pretty robust. And number two, look you've heard we've got a bunch on our plate. We're heavily focused on our organic growth investments and seeing the early signs of progress translate into results and that's where we're putting most of our focus. So certainly, M&A there's always a funnel, but I would say right now the bar would have to be pretty high to do a large deal.

Got it. Thanks guys. Appreciate it.

Thanks, John.

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

Hi, guys. Thanks for fitting me in. First off, could you give us your specific definition of what a core customer is and approximately what percentage of your sales are to core customers today?

Yes. Very fair David. So I'll give you a definition and by subtraction here, which is a sense -- I mean the cleanest definition is, if it's not National Accounts and it's not Government we're referring to it here as core. But when it gets that -- and as a percentage of revenues, look it's over -- we've given you National Accounts, we've given you Government, so look it's over half the company's sales. And it is reflective when you look at what makes that up of -- could be anything from small, medium to even some large. But our sweet spot of manufacturing customers that is where you see that most strongly.

Okay. And the remainder I guess beyond end market would primarily be a transactional type customer. Is that fair?

Sorry not following, Dave.

Well rather than having a National Account relationships, some sort of a vending solution, integrated supply BMI sort of what you would consider not in that core group would be more of a simple relationship with MSC, maybe more transactional in nature. Is that correct or no?

I see your point Dave. So what I would say is within that core bucket there are different types of relationships. So even within core, even for a customer that's not a National Account, there may be a very formal relationship in place with a program ala [ph] National Accounts just not at the size and scale of National Accounts. There may be something that's a program, but a little simpler an inventory management solution that's in there, or it may be a small customer where the relationship is through telesales or even through our direct marketing channel. So that core can span anything from a small transactional relationship with our -- through our direct marketing channel through a program.

Okay. Thank you. And then last question in terms of your strategy to target that noncore customer I think you've clearly outlined with sales force effectiveness, how you're going after the core. But I'm not sure, I'm clear on how you're targeting the rest of the customer group in terms of that transactional customer, your sort of web pricing, catalog pricing. Can you just give us any kind of color Erik on the strategy that you have for the rest of the business that's not really focused in this sales force effectiveness initiative?

Absolutely, Dave. So we have within that core bucket are many customers who don't have a formal relationship with a salesperson. They go through what we refer to as a direct marketing channel. And what we've done interestingly as part of the sales transformation effort is we've taken pieces of it. Not the sales force, but pieces of particularly around the value proposition, and we've applied it to those small customers who are doing business with us through the web, through marketing campaigns, through inbound call centers. And what we've done and it's actually translated, Dave, and it's one of the things, we didn't talk about today, but we have over the last couple of quarters is seeing considerable pickup in the growth rate in that small direct marketing channel. We've moved it from being a more transactional relationship to focusing more on some of the value-add ways to help with cost savings and just doing it without a person.

All right. Thanks Erik.

Great.

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

Hey guys. Good morning.

Hey Adam.

Thanks for squeezing me in here. I was wondering if we could just step back and talk about the Mexico business, maybe if you could give some more insights and on what your plan is over the next year or two. Some specifics about the size of the business and kind of the margin profile, customer profile would be helpful.

Sure Adam. So look I think the core the essence of that strategy here was twofold. One, reinforce the core business. And by core business, what I'm talking about here is the business in the U.S. Many of our customers be it a national account or otherwise have plants or contemplating a plant in Mexico. And being able to present ourselves there we now have Canadian presence through the CCSG business, this gives us a footprint to present ourselves to those customers as a North American supplier. We think that's important. The second piece to the strategy is that Mexico over time we still see as a growth market for manufacturing and it's an opportunity to have a direct presence to a growing manufacturing market. It's something that we've had our eye on for a while. And really it was about waiting until we found the right partner, which we did. Size of the business is small. As we said, it's immaterial. But really this is about a foothold and a foundation for growth.

Okay. Got you. And then just from a high level as I think about kind of price versus cost going forward. Is it a fair assumption that the company is going to be maybe pushing more on trying to reduce the growth in product costs? Or should we expect maybe a pull-forward of the catalog increase earlier in the year to offset this lag of product cost? I understand the mechanics of how it moves through your P&L, but which one of those do you think you're looking greater at? Is it trying to reduce your cost growth? Or do you think you have to pull forward that price increase you normally do on Labor Day?

Adam, I would say yes and yes. We're looking at price and cost. It's a silly answer, but it's sort of the truth. But I would say on -- look on the cost front, yes, there is going to be some focus on particularly if conditions moderate, yes, there's going to be a focus inside the company. We have a meeting coming up with us some key suppliers and that's going to be part of an ongoing dialogue. Yes. So we will step up our focus on purchase cost particularly if things soften. So you will see that from us. In terms of pricing, I'd say it's too early to tell. I mean that's usually -- that's a decision Adam, we'll make based on market conditions and customer willing to accept as opposed to just the number. So I would say TBD on the pricing.

Got you. Thank you.

Our next question is from Sam Darkatsh of Raymond James. Please go ahead.

Good morning Erik, Rustom, John. How are you?

Hi, Sam.

A couple of quick questions. First, the total e-com platform sales were about what 6.5% year-on-year, which is real similar to your ADS organically excluding acquisitions. And that's the first time in recent memory that total platform sales haven't been a growth driver. I'm trying to reconcile that with the fact that, obviously, vending was still a significant driver to organic growth and vending is included within total e-com platform sales. So I'm trying to reconcile what that meant also why it wasn't a driver this quarter.

So, Sam, the one caveat and let us take a look at the numbers, but I do know that a lot of times that e-com as a percentage of total could be influenced by acquisitions.

Yes, exactly. Exactly right, Erik. So Sam those acquisitions are coming in at -- they're in the denominator but they're zero e-com. So that's why you're not seeing the same growth that you've seen historically.

Right. But I'm comparing the e-com sales to your ADS excluding acquisitions. I would think that's an apples-to-apples comparison. Isn't it?

Then I'll have to double-check that. But I'm not sure. I'd like to see how you do that, but okay.

Okay…

Let's assume it's the case though. If so, so two things I would caution. One is realized vending, you are correct. Vending is growing. We're actually excited to see it really taking off this year. The growth -- the kind of growth we're seeing this year in signings of these -- over 50% growth is not yet making its way to the numbers. I think that's a really important point. Another one of those examples of seeing it on the ground, and not translating into numbers yet. So the second thing about vending is that realize when we sell vending to a customer, only a portion of those sales will run through the vending machine. We see a lot of pick-up in sales we're seeing outside of the machine that may or may not be electronic.

Last question for me, the share repo activity was a little bit lower this quarter versus the prior couple of quarters despite the fact that the stock and the valuation was lower than in prior quarters. Was that because of your internal visibility with the Mexican deal? Or is that – does it have to do with the slowing trends you saw in February, March? What was the reasoning behind the share repo activity moderating?

Well, if you look at the last three fiscal years through 2018 right, just sticking with the fiscal years. We've done $515 million worth of buybacks. And then, we had some pretty – sort of pretty decent buybacks in Q1, and then the smaller number as you pointed out in Q2. So yeah, we continue to buy back shares. I mean, no there's nothing specific. I mean, Erik kind of said – talked about this earlier. So I'll just repeat very quickly. We are balanced and opportunistic. We continue with this. We focus fundamentally on our organic investment and then on steadily growing our dividends. And we're not really driven. We don't have a target per se that says we'll go out and buy back shares buy x or something matter. Because we're also quite willing to just build up cash. And so it's just a function of how it's played out there.

Very helpful. Thank you gentlemen.

Thank you, Sam.

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

I'd like to thank everyone for joining us today. Our next earnings date for the Q3 is set for July 10, 2019. We'll be out on the road and at various conferences over the coming quarter, so we look forward to speaking with you over the coming months. Thank you.

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