MSC Industrial Direct Co., Inc. (MSM) Q3 2019 Earnings Report, Transcript and Summary

Good morning, and welcome to the MSC Industrial Supply Company Fiscal 2019 Third Quarter Earnings Results Conference Call. All participants will be in listen-only mode. [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. Mr. Chironna, please go ahead.

Thank you, Anita, and good morning everyone. Today I’d like to welcome you to our fiscal 2019 third quarter conference call. With me in the room 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 contained 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.

Thank you, John. Good morning and thanks everybody for joining us today. To kick off this morning’s call, I’ll provide a brief overview of our fiscal third quarter results. I’ll then offer specifics about the environment and our recent performance and I’ll discuss our plan moving forward, before turning it over to Rustom to review the details of the third quarter and provide our fourth quarter guidance. I’ll then wrap up before we open up the line for questions.Our fiscal third quarter results were disappointing. Sales were below our expectations for the quarter, while gross margin was at the low end of our guidance range, although operating expenses were below anticipated levels, our earnings per share were below the low end of our guidance range. We’ll dissect the reasons in detail this morning, and I’ll share with you the actions that we are taking to address them.First, I’ll star with the environment. We’ve seen a step-down in industrial demand since our fiscal April. On the last call with you we describe the softer than expected March, with the rebound during the first week of calendar April, which was the last week of our fiscal March. As we said at the time, we weren’t sure what to make of it.As it turns out, the softness from March not only continued, but it is worse since we last spoke and we’ve seen this softness evidenced in discussions with customers and suppliers, along with data points coming from many sources, including manufacturing output numbers, distributor growth surveys and the sentiment indices.In April and May, the last two months of our third quarter, readings for the MBI were 53.6 and 51.6 respectively and June was at 51.8. The rolling 12-month average for the MBI is now 54.7. While still reflective of growth, there is a continued deceleration.With regards to the pricing environment, there continues to be an overhang of uncertainty, mostly due to tariffs and trade. In the fiscal third quarter realization of our midyear price increase continued to be positive. As we look forward, our plan is to take our late summer increase as we usually do, although it will likely be slightly later than last year, to give ourselves more time to understand how the tariff situation is shaking out.In terms of our performance within this environment, our core customers had growth rates in the low single digits, while national account growth was mid-single digits. Both were slightly lower than expected, impacted by the softness that I just mentioned.As expected, government sales growth declined mid-teens this quarter, weighing down our overall growth rate. You’ll remember that our fiscal third quarter was expected to be the peak of the government headwind, and while the headwind continues for another couple of quarters, it does begin to abate in this coming quarter.Let me now step back and share my assessment of our performance, along with an overview of our action plan moving forward.Clearly the biggest difference between our actual results and our previous guidance has been a change in industrial conditions, and because of that softening environment we’ve implemented a three-part action plan, designed to achieve improvement in the following: One, field sales execution, particularly around new account implementation; two, profitability of our supplier programs; and three, expense control and productivity.Part one, improve field sales execution, and new account implementation. We are winning new account at a fast clip. However, revenue growth form our new account wins is taking too long to materialize as these new account wins have outpaced our expectations and hence our resource planning. I would have liked to have seen more contribution from these wins heading into our fiscal fourth quarter.In response, we have focused one of our top sales leaders on new account implementation and have allocated additional resources to keep up with the rate of new account signings. This is one of the key actions that we’re taking to improve field sales execution. Overall, I continue to have strong conviction in our plan.I should also note that Eddie Martin who we recently announced as our Senior Vice President of Sales has hit the ground running, and is playing a significant role in filed sales execution improvements.Action plan part two: Improve the profitability of our supplier programs. We are working to deepen our relationships with our suppliers in a win-win fashion. Those that improve their programs and invest in MSC and our customers will be rewarded with focus and investment on our part. Suppliers that do not step up will see moves away from that and towards their competitors who choose to invest in our partnership.Related to this, the softening demand conditions and reductions in commodities prices have led us to reassess product cost increases. Whether its tariff related or otherwise, we are pushing back when we don’t think its increase is justified for our customer. And when it comes to our own tariff exposure on direct imports, we are also pushing back on our Chinese suppliers to offset tariff related increases.Action plan part three. Increased operating expense controls, and improve productivity, and we’re taking three steps to do so. First; curb hiring and clamp down on discretionary spending. Second; ratchet up performance management and review resourcing needs department by departments. And third; reengineer inefficient processes to drive productivity. It’s a bit too early to quantify additional details right now, but we will do so as part of our fiscal 2020 framework on our next call.I’ll now turn things over to Rustom, before I come back with some concluding remarks.

Thank you, Erik. Good morning everyone. Before getting into the details, let me remind you that we provided Q3 guidance for both, our total company and our base business, which is our total company excluding the impact of AIS acquisition and the Mexico business.Our third quarter average daily sales were $13.6 million, an increase of 4.6% versus the same quarter last year, and below the low end of our guidance range. AIS and MSC Mexico contributed 260 basis points of growth between them, slightly ahead of guidance. The entire shortfall therefore was in our base business which had ADS group of 2%. Erik has already covered the reasons, so I’ll move on to gross margin.Our Q3 reported gross margin was 42.5%, 20 basis points below our guidance midpoint. The majority of this GAAP was due to base business customer mix and slightly higher than expected purchase cross escalation. Our total company gross margin was down roughly 110 basis points from last year with about 40 basis points of this coming from AIS and MSC Mexico. Sequentially our base business gross margin of 43.1% was flat with Q2 as the February price increase offset both mix headwinds and purchase cost escalation.Total operating expenses, in Q3 they were $258 million or approximately $4 million lower than the guidance midpoint, mainly due to actions taken to reduce discretionary spending and avoid planned cost increases, as well as to lower volume related variable cost and a lower incentive accrual.We slowed our rate of hiring in Q3, tempering our headcount growth, which when combined with performance driven attrition resulted in field sales and service head count reduction of 22, and then overall reduction of 31 heads from Q2. But note that we do not expect – that we do expect to end Q4 with close to the Q2 level of field sales and service associate.Operating expenses were up $13 million from last year’s Q3. About $5 million of this year-on-year increase came from the acquisitions, another roughly $2 million was attributable to volume related variable costs such as pick, pack, ship and freight, and roughly $4 million came from higher field sales and service payroll costs, the headcount is up 63 versus the year ago.OpEx to sales of 29.8% was up 10 basis points from last year’s Q3 and 10 basis points above the mid-point of guidance, as our cost control actions helped, but did not fully offset the impact of lower than expected sales.Our fiscal third quarter reported operating margin was 12.8% within, but at the low end of our guidance range. This is down roughly 110 basis points from the prior year, with roughly 10 basis points due to AIS and MSC Mexico. Our base business operating margin was 13.2% at the low end of our guidance range and down about 100 basis points from the same quarter a year ago. Lower gross margins and the ongoing impact of people and project investments made earlier in fiscal 2019, both contributed to the year-on-year decline.Our total tax rate for the third quarter was 25.0%, slightly below guidance and lower than our fiscal 2018 Q3 effective tax rate of 29.3%. The year-on-year decrease was primarily due to the lower corporate tax rates resulting from the tax cuts and jobs act.So all of this resulted in reported earnings of $1.44 per share, $0.05 below guidance midpoint. AIS and MSC Mexico combined had a $0.01 negative impact on reported EPS. Last year’s reported EPS was $1.39.Turning to the balance sheet. Our DSO was 59 days, up 3 days from fiscal 2018’s Q3, with National Accounts continuing to be the main driver. Our inventory decreased during the quarter to $561 million, down $12 million from Q2, total company invent returns were down slightly to 3.5 times from Q2. We have slowed purchasing and expect inventory levels to decline again in our fiscal fourth quarter, but by a lower amount.Net cash provided by operating activities in the third quarter was $89 million versus the $112 million last year. Our capital expenditures in Q3 were $13 million versus last year’s $14 million and after subtracting CapEx from net cash provided by operating activities, our free cash flow was $76 million as compared to a strong $99 million in last year’s Q3. Note that we currently expect annual CapEx to $50 million to $55 million in fiscal 2019.We paid out $35 million in ordinary dividends during the quarter and did not buy back any shares on the outside market. In last year’s Q3 we paid out $33 million in dividends and bought back $4 million in shares.As you saw this morning, we increased our quarterly dividend to $0.75 per share, a 19% increase. Based on fiscal 2019 expected EPS, this will result in a payout ratio of about 57%. Our strong balance sheet and high levels of free cash flow generation comfortably support this level. Erik will elaborate more on this in his closing.Our total debt as of the end of the third quarter was $531 million, comprised of a $246 million balance on our credit facility and $285 million of long term fixed rate borrowing. Cash and cash equivalents were $39 million and net debt was $492 million. So our leverage decreased to 1.0x as compared to 1.2x at the end of Q2 and was flat with last year’s Q3.Now let’s move to our guidance for the fourth quarter of fiscal 2019 which you can see on slide four, and is shown with and without acquisitions. Please remember that DECO is in the base, whereas both AIS and MSC Mexico are included in the total company views, and note that when we get the fiscal 2020 guidance we will move AIS into the base, but leave Mexico in the total company view.Overall for Q4 we expect total company ADS to increase by approximately 1.2% to 3.2% versus the prior year period. This includes the range of 0% to 2% of organic growth and around 120 basis points from acquisitions. As you see on the op stats in our website, June’s total average daily sales growth is estimated at 3.7%. Note that this year’s June had one fewer selling day as we closed on the Friday following the July 4 holiday.Our Q4 total company gross margin is expected to be 41.8%, plus or minus 20 basis points. This is down 110 basis points year-over-year. Our base business gross margin is expected to be 42.3%, down 120 basis points from last year, but our price realization has continued at expected levels. We anticipate hirer purchase costs and sales mix to also continue as gross margin headwinds in the fourth quarter.Also the higher sales growth coming from vending and direct ships comes in at gross margins below company average. Gross margins for the base business are expected to be down 80 basis points sequentially from the third quarter. This is due to the normal seasonal Q4 decline, exacerbated by escalating product costs and a slight delay to annual price increase.Let me provide some additional context on gross margin. Our gross margin formula is made up of three elements; price, cost and mix. In recent years we averaged the gross margin decline 30 to 50 basis points and if price and cost are neutral, we would still expect year-over-year gross margin determination from sales mix.The past two years have produced quite a different picture, primarily due to the timing of price cost. In fiscal 2018 we benefited from our price increases before the cost increases flowed through our P&L. As a result, the price cost spread was positive and our base business gross margins were flat.This year, fiscal 2019, we are later in the price cost cycle. While price realization has been positive, the GAAP between price and cost has turned negative as we are now bearing the full impact of escalating product costs from fiscal 2018. As such, at our Q4 guidance midpoint, fiscal 2019’s base business gross margin would be down 80 basis points versus last fiscal year.On top of the price cost timing issue, the demand environment goes to a positive, discernible soft end in Q3. We don’t see this changing in the fourth quarter and addressing the purchase cost side of the equation.Moving now to operating expenses. They are expected to be around $258 million, up $6 million from last year’s fourth quarter, with the base business accounting for about $4 million of this. As you know, we added sales and service headcounts over the course of the year and total payroll and payroll related costs account for about $3 million up the year-over-year increase.You might expect a sequential decrease in operating expenses in Q4 rather than sequentially flat operating expenses. There are three reasons why OpEx is flat sequentially. First, most of the actions taken in the last two to three months were to avoid planned headcounts and cost increases rather than to reduce costs. To be clear, we will take cost reduction actions in the coming month and the savings will kick in more meaningfully in fiscal 2020.Second, we had a roughly $1 million incentive compensation accrual reversal in Q3; and third, we are expecting depreciation costs to rise sequentially, driven primarily by the strong growth in vending signings this year.We expect the fourth quarter’s total company operating margin to be approximately 11.2% at the midpoint of guidance, a 170 basis point decline over last year’s 12.9%. The year-on-year drivers are the roughly 110 basis point gross margin decline and roughly 50 basis point operating expense expansion due to our growth investments and the acquisitions. Assuming the midpoint of our total company Q4 operating margin guidance, we would fall below the lower left quadrant of our 2019 annual operating margin framework for the full year.Before turning to taxes, I’ll say a word on base business incremental margins. While we delivered a solid fiscal 2018, we would have taken a significant step back in fiscal 2019. Assuming the midpoints of our fourth quarter guidance, we expect operating profits to decline roughly $20 million on approximately $90 million of additional sales. This is of course unacceptable and we are taking actions to improve our performance.Turning to our estimated tax rate for the fourth quarter, it is 24.1% slightly lower than our year-to-date tax rate of 25.1%, which was due of the typical release of state tax reserve that occurs in our fiscal Q4.Finally, our Q4 EPS guidance range is $1.21 to $1.27 with the midpoint of $1.24. This includes AIS and MSC Mexico, which together should be EPS neutral in Q4. Our guidance also assumes a weighted average diluted share count of roughly $55.3 million shares.I’ll now turn it back to Erik.

Thank you, Rustom. As I shared earlier, we are taking actions aimed at improving sales and gross margin, and lowering expenses. You heard some of the detail today. But in summary, we are focused internally on improving execution, and this also means that any M&A activity that we may consider over the near term will have higher hurdle rates, particularly as valuations remain historically high.You also saw that we are adjusting our capital allocation philosophy, to return more capital to our shareholders via the quarterly dividend. As Rustom said, we have a strong balance sheet and generate high levels of free cash flow. This dividend leaves us with a comfortable payout ratio, and this would be true even if things soften further.Reflecting on the fiscal year thus far, we are disappointed with our performance and more importantly, we are taking action to address this. That said, I don’t want the progress that we’re making in some critical areas, lost on all of this.We are winning accounts and doing so at a very strong pace. Our vending implementations are growing more rapidly than they have in a long time. We are deepening our commitment through our valued supplier partners at a time when our shared goals are more important than ever, and our team of associates is working to deliver on our action plan. I thank each of them for taking it on with urgency and commitment, as we continue our journey from a spot by distributor to a mission critical partner on the plant floor.We’ll now open up the lines for questions.

Thank you. [Operator Instructions]. The first question today comes from Robert Barry with Buckingham Research. Mr. Barry please go ahead.

Hey guys, good morning.

Rob, good morning.

Actually before my question, I just wanted a house keeping item clarification on the ADS results; estimate for how much you think Easter impacted April and how much does having one less selling day benefit June ADS?

So the April impact washed out. I mean so we didn’t – in the quarter as we looked at it. The ADS impact of the one less selling day in June, if you do it purely mathematically, right, it would not be quite the way to do it Robert, because effectively the last – if I just disclose what the number was in Friday, I mean we had like just you know a little bit over $1 million in sales. So when you – if we didn’t have that $1 million and didn’t have that day, we would have really a negligible impact on the overall number.

I see, so it’s pretty minimal.

Erik, you want to add anything.

No, I’m good.

Sorry.

Feel free to keep going, if there is other...

Yeah okay, I’ll follow-up afterwards. So, on the price cost impact to gross margin, what was that impact in 3Q in the quarter?

So the price impact, the price mix impact. We haven’t disclosed the price cost impact specifically like that, but the price mix impact that we had was roughly around 60 basis points.

Right [Cross Talk] I guess you said it went negative, the price point equation turned negative, so I was curious how much of an – yeah.

Yeah Rob, so a little bit on gross margin. So essentially what happened was, as Rustom described, we came in on the bottom end of our gross margin range. So effectively 20 basis points off the mid-point and what he highlighted is that two drivers behind that in the base business, one being purchase costs slightly higher than expected, the escalation and then two being customer mix.He also put some context on price cost in terms of essentially what happens in our business. When we take price we get it right away, when we take a cost increase it bleeds into our P&L slowly and what we were describing in the prepared remarks was how this fiscal year price cost has turned negative as we are bearing the full brunt of the cost increases taken over this year and last year.

Got it, and I guess just lastly curious about what the outlook is there for that price cost equation, getting back to at least neutral. I mean is there a line of sight to that happening, because it seems actually like maybe the inflation leads from tariffs might continue to rise, especially if you’re seeing more coming through from third party vendors.

Yeah Rob, really good question, where does it go from here as it relates to gross margin and price cost. Here’s what I would say – on the pricing side – so right now absent – if we did nothing else and just trended things out, price cost would likely stay negative in ’20. However, an important however, two things could change; one, it’s pricing and as I mentioned we are going to be taking a summer increase. We would expect to see solid levels of realization as we did in the mid-year, and you raise a fair point that should – it’s still for us too early to say what’s going to happen with tariffs, but should that stimulate inflation there could be more coming on price.I think the second important thing that we talked about this morning was the fact that we’re taking aggressive actions on the buy side with our supplier community in a number of different forms. Still a little early to quantify, you know exactly how much of the cost, the embedded cost that eats into and we’ll certainly follow-up on the next call with the 2020 outlook.

Got it. Alright, thank you.

The next question comes from Ryan Merkel with William Blair. Please go ahead.

Hey, thanks. Good morning everyone.

Hey Ryan.

Hey Ryan.

So first off, can you provide a little bit more context around the organic slow down daily sales? Was it broad based or did certain end market drive the bulk of the weakness.

Ryan, so what I would say is two comments. One is, we saw some real pockets of weakness. A few that I would call out, automotive – it’s probably not going to be a surprise to you: Automotive, oil and gas, and then the Midwest was hit pretty hard with agriculture certainly.Pockets of strength: Aerospace continues to remain strong. That said, what I would say, outside of the pockets of weakness we did with most of our customer base see a change to the quarter and I would characterize the change as more uncertainty, and shorter backlogs, along with some softening in export demand and concerns about more softening in export demand. So that’s how I characterize it.

Okay, yeah that’s kind of what I expected. And then as a follow up, the 1% organic ADS guide for 4Q, it looks like this assumes a little bit of further market slowdown, but not that much right, because you are going from basically a 2% run rate to a 1% in 4Q, is that the right way to think about it.

Yeah, I think that’s right. If you look at the June number that Rustom mentioned, so the 3.7 is inclusive of a bit of an inquisitive growth. I think without that we’re somewhere in the 2.5 range, slightly benefited by the one fewer selling day and then you’re right, Ryan if you do the math and you did the forecast for July and August, it would be less than that. So yes, what we have assumed is a modestly softer July and August than what we saw in June.

Okay. And then just lastly, and then I’ll turn it over, you mentioned that the price environment is more uncertain, can you just expand upon what you mean by that and are there any implications for the P&L that we should think about based on that comp.

In terms of what I mean, it’s really – Ryan, what we were referring to is the tariff and trade situation. You know unlike the last round of tariff increases in 2018 which were smaller in size and more telegraphed; people saw them coming. This was larger in size and was not telegraphed and was a bit more of a surprise.So the uncertainty Ryan is really about what happens with our supplier community and how much of that attempts to get passed through and I think as or more importantly, what happens with the customer base, the end markets and how much of that makes its way through and gets accepted.So I think it’s just the overhang of tariff and trade is what I would describe. I mean I think in terms of the impact on the numbers Ryan, look you’re seeing acutely in our fourth quarter, our fiscal fourth quarter guide with gross margin and you know what you’re also hearing is we’re taking action.So I would highlight, we did choose to push back the price increase a little bit, which obviously cost us a little bit of gross margin in Q4, we did that so we get a little more line of sight into the tariff situation with customers and suppliers, and then as we mentioned a couple times here, we’re moving aggressively with suppliers.

Makes sense. Okay, I’ll pass it on, thanks.

The next question comes from David Manthey with Baird. Please go ahead.

Thanks, good morning everyone.

Hi David.

So, thinking about the action plan here, step one Erik, you said you’re gaining customers but not ramping them quickly enough and it’s been years since you’ve given us any insight on active customer data? I’m wondering if just in the spirit of that part of the action plan, can you give us a spot update on the number of active customers today and sort of what that is year-over-year?

Dave, I actually do not have the number handy to be perfectly honest with you, so we’ll have to follow-up. John, I’m just making a note for a follow-up.What I will – the color I’ll add there Dave is you know relative to my time in the business, the new account wins we are seeing now, and this is based on you know the changes that we’ve made in the sales force that put more focus on the hunter population, we are definitely seeing a greater rate of new wins than I’ve seen in a long time, maybe ever in the business.What we called out is quite frankly the rate and pace of the new account wins, was a bit faster than we projected and as a result we need to play some catch up on implementation and that’s what we called out as action plan part one, is we are investing, we are reallocating resources as needed. We get the wins in, because you know what you heard from me is I’d like to see the new wins translate into revenue faster.

Okay and then the number two part of the plan here is the better realization from supplier programs. I’m wondering, are these conversations you’ve already had or those yet to happen and what about these is going to be different, you know vendor management is sort of a key ongoing function of any distributor. I was wondering what do you plan to do differently than you’ve been doing over the past several years there.

Yeah Dave, really good question. So what I would tell you is, the bulk of the conversations have already occurred. So it’s a bit early to provide results and outcomes, because as you could imagine, it’s not a one-time conversation. There is ongoing dialogue and we’re still sort of sorting through it, but most of the conversations have occurred.I would say that what’s different is a heavier emphasis this time around on providing growth, investment, sort of two way growth investment, and sales and marketing programs that we would commit to, to those suppliers that step forward, to give them heavy degrees of focus inside of MSC and in a way that would be stepped up from what we’ve done in the past.

Okay, and then finally Erik, more of a strategic question here. As you make this drive to become a mission critical partner on the shop floor, do you feel that today you have the people, tools, technology and you know products and services in order to do that and if so, I’m wondering why hasn’t the uptake been faster? If not, what do you need to get there?

Yeah, really good question. I would say Dave, so let me start out by saying my conviction in the plan is high; my conviction in the team, our management team in particular is high.So look, that said there have been considerable changes in the sales organization in particular. We mentioned Eddie coming on board and beyond Eddie, really largely a new sales leadership team around Eddie with several other members of the team, but my conviction in the team and the plan is high.So to your question about why the traction being slow and I think it’s fair to say, look I want to be clear. On the one hand I’m excited and encouraged about the new account wins, on the other hand, I want to be clear. I’m disappointed with the results we are producing and I’m disappointed in how fast the new accounts are materializing into revenues.You heard us making some adjustments. We’ll continue to make adjustments as needed until we get it right, but you know for me the headline is conviction in plan, and team are high.

Right, thanks Erik.

The next question comes from John Inch with Gordon Haskett. Please go ahead.

Oh! Thank you. Good morning everybody.

Good morning Gordon.

Good morning guys! Hey Erik, is part of the issue that, suppliers have been raising their list three prices, but that the market in terms of your peer are lagging. Is that part of what’s going on here? I’m just wondering if you could comment a little bit in terms of what suppliers are doing, with respect to what kind of what you are seeing kind of competitively in the market with respect to with list three?

With respect to list three on the tariff situation, Gordon?

Yes, correct, yeah the 20% [ph].

Yeah, I mean to be honest, with respect to the latest round of tariffs, still very early, still very early. So I would say too early to comment and that’s sort of part of what we describe as the overhang and uncertainty. What I would say is the last round of tariffs John, late 2018 most certainly triggered a greater incidence of list price increases from suppliers. So far, so far, and again I think that’s part of the reason why we’re waiting and seeing, there has not been significant about a movement I think in part because this was a surprise to many.

Do you think it has anything Erik to do with maybe there is a threshold of greater sensitivity given the uncertainty in the economy that all of a sudden there is just not going to be quite the ability or perhaps greater resistant to push through some of these increases.And I’m just curious how you think that maybe kind of ultimately mapped out for MSC. Are you comfortable that costs will ultimately be offset or is there – I mean you are obviously taking these supplier adjustments. I’m just curious how you are thinking? Are we reaching a bit of a threshold here in terms of how much you know customers are willing to accept?

John, I would say – yeah, I would say any time, this is largely cyclical and what we’re seeing is no question of change in the demand environment and many times there’s a correlation between how the demand environment goes and how the pricing environment goes. So softer conditions on the demand side will lead customers to be scrutinized and surprised and certainly will lead local distributors that make up the bulk of the market to get more aggressive. I think that’s real, and I think that’s why you are seeing us you know pull out our playbook on the buy side, absolutely.

No, it makes sense.

But you also asked – Sorry John, you also are seeing, as Erik alluded to, you know with the demand weakening and everything too, you are also seeing inflation in general than in commodities and also beginning to come down, that could very well have been this one..

By the way guys, how is metal working in general responding to the demand. It’s obviously a huge metal working data point, right. How was metal working in general, ex the MBI, how is the channel for suppliers, customers, competitors, how are they responding to the fluctuating tariff price changes and demand soft, what are you seeing there?

I would say in general John, what we are hearing – you know look, the bulk of our customers are going to be broad based metal working, is we’re seeing uncertainty. There is more uncertainty, there’s less confidence as it was, as I mentioned the backlogs are shorter and an impact on the export demand.

That makes sense. I guess lastly Erik, you guys at MST have been on a multiyear ramp with respect to SKUs and expanding you know the big book and the product offering. I’m kind of assuming that this supplier initiatives are going to result in some actually supplier rationalization? Where would you anticipate, like what would you anticipate coming out of that in terms of maybe your supplier account. Do you have a thought process in terms of how much it may decline and in turn would you anticipate for sort of an SKU product offering, kind of in totality going forward.

Yeah John, another good question, the SKU has been successful and actually it’s been an important part of the strategy to make sure that when a customer comes to us, they can get anything that they need, that’s industrial related. So I don’t see that changing and I don’t see this SKU count changing dramatically.To be honest, the supplier count may or may not change dramatically John. Really, what we are talking about here is where we put focus, effort and investment. So it may not necessarily mean that it could – it will really depend, it will be circumstance and product line specific. In some cases it may mean some pruning or rationalization of suppliers, but in other cases it may just be about where we put focus, sales focus and marketing focus in particular.

And when do you think this is finished or most of the bulk of the work on supplier is over, is it going to be six months, is it you know a bit of a longer process or how should we think about it?

I would expect by our next call, we’ll have a pretty good feel for you know what we can expect to see in terms of results and what moves we’ll be making.

Perfect! Thanks Erik. I appreciate it.

The next question comes from Adam Uhlman with Cleveland Research. Please go ahead.

Hey, good morning everyone.

Hi, Adam.

You know I was wondering if we could go back to the cost control efforts, and you know in particular what you are looking to do with head count. It sounds like most of the efforts here are focused on attrition and you are hiring rates and not layoffs or the like. But I’m trying to understand you know beyond that, what other levers you are pulling here in the medium term? You mentioned that there is more underway here in the fourth quarter, but you know assuming that flat demand environment persists for the next six months or year or whatever, what do you think your underlying rate of expense growth shakes out at?

Adam, I’ll take at least the first part of the question and talk to you a little bit about what we’re doing and what you’re seeing from us here and what Rustom and I described.What you can expect to see is, number one; more aggressive performance management. You can expect to see number two; a greater focus on productivity than we’ve had in the past. Look, I’ll mention that over the past few years we have made moves at times to align specific departments and make changes with the needs of the business. You’re going to see us step up those efforts.As a result of those things, certainly with the picture that we see now for the demand environment, you will likely see head count levels come down during fiscal 2020.

Yeah. And Adam, I mean yes, just to elaborate on that. I mean it’s more than simply attrition. I mean we are looking at – you know yes, we are looking at curbing, hiring and clamping down on discretionary spending, but the ratcheting up on performance management and reviewing resourcing needs department by department is something that we will you know be doing more intensively than we’ve done.I mean we have taken our OpEx down a couple of hundred basis points. I mean this is now going up to another level, but also reengineering inefficient processes to drive productivity. That’s something else that we will be taking up to another level. And we will provide some further details as part of our fiscal ‘20 framework when we come back and talk next quarter.

Okay. And then just a clarification on vending. It sounds like the signings have been ramping for some time. I missed what the sales growth contribution was this quarter, if you could repeat that for me. But, I guess I’m just wondering how that looks now for maybe the second half of the year? Should we be expecting an acceleration in the sales contribution, or is the weak manufacturing environment going to mute that?

No, vending is still contributing, I mean quite solidly in terms of the numbers. It probably contributed about you know 1.4% or something of our sales growth in this quarter. I expect vending to continue to contribute, I mean in terms of revenue.There is – it’s an area of focus. It’s something that we’re doing, it’s something that we’ve invested in, and along with vending, I mean just one thing to remind you of is that, yes, I mean it comes at lower gross margins. The contribution margins do vary greatly by account, but I mean one of the things is over the years, I mean all the insights we’ve gained through our net profitability analysis have led to reductions in cost to serve and so we continue working on that. And vending’s profitability also typically improves as the account matures and that’s the prospect. Does that helps?

Yeah, thank you.

The next question comes from Chris Dankert with Longbow Research. Please go ahead.

Hey, good morning guys. Thanks for taking my question.

Hey Chris.

I guess if we could kind of circle back to government, you know we’re looking for that headwind to kind of peak this quarter mid-teens. You said that it does kind of trickle as we get into the fourth quarter and fiscal ‘20. Can you kind of help us size what that headwind is moving forward? Just you know, it’s lower than mid-teens, that’s a pretty wide range I guess.

Yeah. So look, I mean the headwind, we talked about mid-teens – you know as you think about the third quarter as peak, mid-teens and government is 7%-ish of our business, 7%, 8% of our business. So you sort of do the math there Chris and that is a point headwind to the growth rate right now.Looking ahead to Q4, we still have government negative, but less negative and it will be certainly, I believe by the back half, so Q1 will still be slightly negative. As we move Q2 back half of the year, the headwind completely dissipates, which means that it’s no longer negative, and if the work that’s being done now in the program and I should add, by the way, I think there is some very good work going on in the government program right now, I expect that piece of our business to restore to growth. But that gives you a feel for the headwind and how long it lasts.

Thank you, that’s very helpful. And then we’ve talked a lot about the hunters and their impact I guess. Is the goal near-term still to kind of get them to add about 100 basis points? I mean I believe they are hitting that maturation rate. Just any color on what your expectation is for the actual kind of sales growth contribution from the nearer term?

Yeah. So Chris you remember from the last call I talked about you know what I saw from then in the next quarter or two. I think I described, at least 100 basis points in growth contribution. Absolutely, nothing has changed in terms of what I see as the size of the contribution from hunters, our confidence is growing, the payback looks strong.What has happened is quite frankly we’ve – I mean so this is good news, bad news. The good news is, it does appear that the value proposition is working, because the new wins coming in are greater than expected. The bad news is, it’s more than we planned for and as a result, the revenues are slower to materialize. But in terms of size of the price, absolutely nothing has changed.

Got it and just the last thing from me. You know thinking about pricing, obviously you guys waited a little bit longer than usual on the mid-year increase, tough to get the full realization, maybe kind of waiting a little bit longer on the late summer increase. I guess is there an opportunity to revisit some of these price negotiations on a more quarterly basis rather than the biannual given kind of how tariffs have changed the landscape a bit?

So Chris, one of the interesting, I haven’t thought about it, you’re right, that’s sort of two increases in a row and one of the things that we’ve done, I think we’ve put a strong pricing discipline in place in the company and one of our findings is that we’d rather wait a little bit and be really well prepared when we go and when we sit in front of a customer and talk about pricing and why the increase is justified.And so what we found, if it’s buying ourselves a little extra time, the results have been really good in terms of the kind of realization rates that we’re seeing, particularly if I look back at this last midyear, and so I think as much as anything else that’s part of our improved pricing discipline and practice.In terms of the frequency and cadence, look, what we try to do Chris as much as we can is, we know price is a sensitive subject for our customers and keep the cadence to some sort of regular time intervals and where it’s not too often that we’re introducing price changes. We would rather go you know once or twice and have a meaningful discussion, than go all the time and continuing or kind of sort of opening up that wound.

Yeah, it makes sense, always tough to have that discussion. Thanks very much. That makes sense.

Thank you, Chris.

The next question comes from Justin Bergner with Gabelli Research. Please go ahead.

Thank you for taking my questions.

Good morning, Justin.

I was curious as to what parts of I guess the sales disappointment in Q3 and in the Q4 guide you would attribute to you know company specific challenges versus end markets? Because it seems like what you’re seeing in the company specific side is that you are getting more account wins than you’re expecting the slower conversion to revenue, which would sort of be an offset. Is there anything else that you would sort of attribute to company specific factors versus end market factors?

Justin, so two points I’d make. One is, the biggest change. If you looked at the third quarter, our actual sales number to the guidance, the biggest delta there was change in environment that we didn’t see. Where I was disappointed is not – obviously we can’t control the environment. What I would have liked to have seen was the new account wins begin to materialize into revenues faster, therefore buffering some of that market downturn, but really you hit on the two key factors that are the headlines of the story.

Okay, that’s good. And then on the margin side, is there anything that’s happening outside of sort of list three and the surprise impact of that on price cost? Is there anything else that is material that’s affecting sort of the gross margin trajectory versus your expectations, be it sort of increasing mix headwinds or other factors?

No, I would say no other major change in terms of inside or outside of the company in terms of environment. I think you know you hit on sort of the key overhang in the environment with the tariffs and trade. I think there is nothing else I’d call out.

Okay, thank you for taking my questions.

The next question comes from Patrick Baumann with J.P. Morgan. Please go ahead.

Hey guys, thanks for taking my call. I just had a couple of questions. Maybe just to start, could you provide an update on the competitive intensity that you are seeing in the current environment and maybe just broadly from this perspective, you know how do you see this if it is a barrier to pricing versus historical inflationary cycles?

Patrick, I would say competitive intensity is high and it would be typical of what I’ve seen in past cycles, certainly, that as demand conditions soften, I think important to remember 70% of the market is made up of local and regional distributors and those distributors, when things get tight will hang on to business and will certainly use price as a weapon and a lever to retain accounts. So we’re seeing competitive intensity as high and I would you know specifically call out the local distributors as to where the ratcheting up has come from primarily.

Got it. And then on the tariffs, can you just remind us once again of the exposure as a percentage of your COGS for our list three and then list four, just the direct exposure?

Yeah, I mean the original exposure, I mean remember, what we buy from China is about 5%. I mean that is a fairly small number coming through, and we are by the way going back to our suppliers in China as well and specifically going to them as they go on to list three and then the higher 25%, and going back and looking for alternative sources, working with them to be more efficient and not just pass through those numbers as part of what Erik talked about as well.

And so it’s just 5% of COGS and the recent increase to 25% that has yet to hit your P&L, correct?

Yes, I mean the recent increases are coming into P&L as well as the tariffs and it would basically double it isn’t it, when you look at the further exposure if all of it came through again. And that’s why I’ve made the point that we not really necessarily seeing all if it come through yet.

So, the 5% will become 10% you are saying?

Yes. So just to – Patrick, just to explain, I think what we’ve described was, 10% is the total universe of what comes from China, what our direct impact, our direct sourcing is, the 5% is roughly what was covered by the first few lists that we had. What Rustom is describing is if everything else were covered by list three and four, there is a remaining 5% of potential exposure.

Potentially taking us up to 10%, yes.

Got it. And the move on list three from 10% to 25% that will start to be felt in your P&L in the fourth quarter and next year, that’s not yet in the numbers correct?

Correct. Also depending on it those 25% come through, that’s the point I am trying to make.

Yes, but you’re assuming it does come through in your guidance, correct?

We - minimal in Q4. Because of the way we buy and the time, the lag, the time lag we are overseas sourcing, it wouldn’t be in our numbers right now. I think Rustom is hitting an important point. If we were to take a tariff related increase, one would see that – would not see that in our numbers now. It would be next fiscal year. As I talked about, we are pushing back rather hard on anything that’s tariff related.

Understood! And maybe just kind of a different question. You know the top line environment is slowing obviously, but we’re not yet declining. I’m just curious if you could provide some perspective on how we should be thinking about detrimental margins if we do in fact see a lower top line, I don’t know 5% or something, if the environment could turn for the worse, and your top line goes down mid-single digits or so, what’s a reasonable range on detrimental? I mean I looked back in ‘09 and I think you guys did 30% to 40% or something like that. Just kind of curious if you can provide some perspective on that?

So you know you are really going into fiscal ‘20s guidance and then we try to avoid giving that guidance. We try to avoid giving more than a quarter’s guidance ahead, but maybe I can take another angle at it and say in fiscal ‘20 and just say, sales remain in low single digits, right. I mean we can still, our target would still be to grow earnings and that would depend upon price realization, the supplier actions that Erik talked about and the cost actions which are being undertaken and others that are being contemplated and we’ll share much more of this on our next call.

Yeah, no I was just thinking hypothetically if we had a recessionary environment, what kind of detrimental margins would the company target?

So Patrick, the reason it’s tricky to answer at the moment is Rustom just hit on three variables that will have a better feel for quantifying next quarter than we do right now. So one being even if things get softer, how does price realization hold up? Does it hold up as it did in the mid-year. Two is, quantifying the benefits of the supplier actions we’re taking. And three is, quantifying the benefits of the cost down actions that are under way. And right now, we don’t have those quantified. We will next quarter. So without those, it would be an incomplete answer.

Understood, okay. And then, last one for me, just the performance on recent acquisitions. Just curious, was there any change to the hurdle rate due to results from these deals? Just wanted an update on, you know you’ve done a bunch of deals over the last couple of years. I’m just curious if you give an update on performance of those?

Yeah. So Patrick, let me just answer the second piece first, which is the hurdle rate is a function of two things; it’s a function of what we’re seeing on valuations, one; and two is, look, the company is focused on improving our performance and you heard, we are internally focused right now. So those are the two drivers behind the higher hurdle rate.In terms of the acquisitions in flight now, really not much to report. The only news I would report is that what drove the $0.01 in negative in Q3 was really around the AIS acquisition and that is really focused on automotive. The business is solid, but we have seen a stark change. That business is heavily exposed to automotive in the Midwest and we saw a stark change in performance driven by automotive.

And that’s just the environment as opposed to share loss.

Yeah. I mean we go and particularly, that’s an OEM fastener business. So it’s pretty easy to determine share loss or not and we go in that business account-by-account. So the answer is, yes, its environment.

What is the auto as a percentage of AIS?

You know what, I don’t have the number handy. I don’t have the number handy. It’s a – one of their primary locations is right in Michigan, which is virtually all auto, but we could get back to you with the number.

Okay, thanks a lot guys, I’ll follow-up. I appreciate the time.

The last question today comes from Barry Haimes with Sage Asset Management. Please go ahead.

Thanks so much and thanks everyone for today. So I had a just quick question on the hunter situation, where you’re getting more accounts, but not quite as much volume upfront as you had hoped.So it sounds like that net is a slight negative, and I wanted to hopefully get a little color on the overall sales were below expectation. How much was from that factor versus just sales from existing customers? That’s one question.And then secondly, I was hoping if you could talk a little bit about what you see in terms of inventories out there, both your own, but more importantly customer inventories. Are they in line, are they a little bit heavy still from what you hear as you speak with customers? Thank you.

Yeah. So Barry, what I would say is for the quarter, the biggest change if you are reconciling what happened in the third quarter revenues to guidance as I mentioned earlier, the biggest change is environment. So the slower revenues coming from the new account was a factor, as I told you, I was disappointed it didn’t buffer the downturn. But environment was the biggest factor and that would of course, when the environment softens, what happens is sales from existing customers go down, that was the primary factor. Secondary would be materialization of revenues from new account wins.

But I think I picked up in your question, you were also checking on the economics of the program in there. So I just want to cut in and point out that, no, I mean actually the initiative is already covering its cost. The economics are strong. I mean basically these accounts as they do come, they provide significantly more revenue per head than our old sales model, and using all the cost to serve insights that we’ve been learning over the past few years, we focus on making them profitable as well.So right now, from a P&L perspective at the bottom line, I mean there’s no net negative coming from that. Erik answered that revenue entity.

Thanks. And just the inventory question?

Yeah, I would say on inventories, I mean when you see our inventory is coming down a bit, but more broadly, I think that’s reflective of what’s happening in the channel, you know manufacturer, distributor, end user, and I guess not surprising, given softening conditions, uncertainty, etcetera. I think what you are seeing from us is reflective of what’s happening in the market and I think if you spoke to others you’d find inventory levels coming down.

Any feel for – you know is that another quarter, another couple of quarters to right-size with reference to the overall?

I’m not sure and I’m not sure because I don’t know. You’d have to tell me what happens in the environment; whether things are kind of at a level now and they stabilize would be one answer. Whereas, if they were to pick up or if they were to fall further, I’d give you a different answer on inventories.

Fair enough. Thanks very much.

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

Thanks Anita, and thank you everyone for joining us today. Our next earnings date is now set for October 24, 2019 and we look forward to speaking with you over the coming months. Have a good rest of the day!

This conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.