MSC Industrial Direct Co., Inc. F4Q08 (Qtr End 8/30/08) Earnings Call Transcript

| About: MSC Industrial (MSM)

MSC Industrial Direct Co., Inc. (NYSE:MSM)

F4Q08 Earnings Call

October 21, 2008 11:00 am ET


Eric Boyriven – FD

David Sandler – President and Chief Executive Officer

Charles Boehlke – Executive Vice President and Chief Financial Officer

Shelley Boxer - Vice President, Finance


Adam Uhlman - Cleveland Research Company

David Manthey - Robert W. Baird & Co., Inc.

Brent Rakers - Morgan, Keegan & Company, Inc.

Holden Lewis - BB&T Capital Markets

Susan McGarry - Granahan Investment Management

Yvonne Varano - Jefferies & Co.


Good morning. My name is [Kristen] and I will be your conference operator today. At this time I would like to welcome everyone to the MSC Industrial Direct fourth quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the conference over to Eric Boyriven of FD. Sir, you may begin your conference.

Eric Boyriven

Good morning, everyone, and welcome to the MSC Industrial Direct fiscal 2008 fourth quarter and full year results conference call. You should have received a copy of this morning's earnings announcement. If you have not received a copy, please contact our offices at 2128505600 and a copy will be sent to you. An online archive of this broadcast will be available one hour after the conclusion of this call and available for one week at

Certain information pertaining to non-GAAP financial measures that may arise during this broadcast can also be found in the earnings announcement, which is posted on the same website in the Investor Relations section, which you can find under the tab About MSC. In addition, during the presentation management will refer to financial and operating data included under the section Operational Statistics, which you can also find under the tab About MSC on the company's website.

Let me now take a minute to reference the safe harbor statement under the Private Securities Litigation Reform Act of 1995. This call may contain certain forward-looking statements within the meaning of U.S. securities laws, including guidance about expected results for the next quarter, expected benefits from the company's recently launched new customer enhancements, expectations regarding conversion of net income into operating cash flow, expectations regarding the company's ability to capture market share, the company's plans and expectations about the company's ability to manage costs.

These forward-looking statements involve risks and uncertainties that could cause the actual results to differ materially from those anticipated by these statements. Information about these risks is noted in the earnings press release and in the Risk Factors and MD&A sections of the company's latest annual report filed with the SEC as well as in the company's other SEC filings.

These forward-looking statements are based on the company's 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.

I would now like to introduce MSC Industrial Direct President and Chief Executive Officer, David Sandler. David, please go ahead.

David Sandler

Thanks, Eric, and good morning, everyone, and thanks for joining us. With me today are Chuck Boehlke, our Executive Vice President and CFO, and Shelley Boxer, Vice President, Finance.

Earnings for the fourth fiscal quarter exceeded our guidance range. We executed on our gross margin initiatives and controlled operating expenses. There was a non-recurring gain on the sale of certain property that Chuck will expand upon later. For the year, we were gratified to see our operating margin reach 18% and earnings per share increase by 17% over last year, even though there was one less week in fiscal '08 than in fiscal '07.

But we understand that August was a very different time from today, and in recognition of that, I'm going to depart from our usual format. I want to make sure that I highlight three thoughts that I hope will help you understand where our company is today.

The first is how we are positioned to take share as a result of the dislocations being caused by the seizure in the credit markets and the soft and likely worsening economy that will follow.

Secondly, I want to assure you that we are moving forward aggressively rather than watching things happen around us.

Third, I want to provide you a real-time feeling for what we are hearing in the marketplace.

MSC is on the move as we speak. In September we launched a new customer enhancement to our service levels. In fact, it's one of the more significant improvements in our history. We have been investing in this initiative for almost a full year, and while the service concept is easy to understand, building it required a huge cross functional effort of many associates and was actually quite complex. I congratulate the team on its execution and am pleased to note that it took the market by surprise when we launched on Labor Day. To date, it has been extremely well received.

Essentially, all qualified orders placed by 8:00 p.m. Eastern Time in the Lower 48 states are now not only shipped same day, but delivered to our customer next day at no additional cost. In order to be sure that you all understand the magnitude of this improvement, I want to take a minute to explain its benefits to our customers.

Your first reaction might be that, well, we ship same day with UPS and UPS delivers the next day, so what's the difference? Well, there are a number of major differences that makes this an enormous value enhancement for our customers and vastly improves our logistics position versus our branch inventory based competition.

For example, if you had a manufacturing facility in Boston, your cutoff time for placing an order from our Harrisburg facility was 4:30 p.m. Now it is 8:00 p.m.

Prior to the enhancement, even if you placed the order before the cutoff time for Harrisburg, if the item that you needed was not in Harrisburg but in either one of our other fulfillment centers, ground shipment for that portion of the order took two to three days. Now if you place an order by 8:00 pm. and the inventory is in any of our centers, you will receive the item next day.

Our combined fill rate across all of these facilities is 99%, and our error rate is substantially less than 1%. Basically this means that almost anything ordered from MSC today will arrive flawlessly at our customer's dock tomorrow.

The difference is enormous. We can now firmly position ourselves as the first and only telephone call a customer makes rather than the customer taking the time to call a few local distributors and send a driver to spend precious time picking things up. Locking in our position as the first call will have an enormous long-term impact on revenue and gross margin.

The story gets even more compelling if you're in places like Denver, where delivery was two days or more. This improved service will greatly enhance our competitive position versus those with local inventory and former two-day markets.

By leveraging this service, we are sending a very strong message to our entire customer base, both large and small. For our large customers, the strength of our balance sheet, our suite of services, and this new logistics initiative enables us to position ourselves as protection against supply chain risk, something that is very real in today's economy.

Many of our customers risk disruption from suppliers who have cash flow constraints that impact product flows. MRO supplies represents a very small percentage of the finished cost of the products that our customers sell, but an interruption in supplies can be extremely costly. Our smaller competitors will not be maintain their inventory and will struggle to pay suppliers on time as their balance sheets get squeezed. And let me remind you that this remains a very fragmented industry.

For our smaller customers, we have a very strong and compelling message. We can extend credit as long as they remain creditworthy and give us a greater share of their spend. The smaller distributors cannot afford to do this and will need faster payment to support their cash flow.

Secondly, we are moving aggressively on the cost side. We will use our strong balance sheet and cash flow with our suppliers to achieve better cash discounts from those who need swift cash flow and better volume discounts from those who need order flow.

Since MSC's credit is excellent and considered to be very safe by suppliers, we will seek more field and more supplier preference for larger end users as well. We will remind our suppliers that if the customer's order for their goods goes through MSC, they will get paid quickly and reliably and their product will reach the customer quickly and without disruption.

On the expense side, we moved very quickly to clamp down on discretionary spending several weeks ago as we sensed that the troubles in the credit market were escalating. We continue to opportunistically seek great growth investments in outstanding field salespeople who might lose confidence in the strength of the company that they currently work for. Our field sales force grew 912 associates at the end of Q4, and we expect to maintain this level throughout the first quarter.

Finally, although the slowdown might be more severe than we have experienced in the past, our team has been through this before. We have navigated through tough economic periods and used them to position our company for rapid earnings growth once the economy turned. We've done this before, and we'll do so again.

In the last several weeks customer sentiment has turned dramatically downward. Here are just a few of the things that we've recently heard, and I'll quote a few of them.

One quote is: "Our new orders are down substantially in the last few weeks."

Another is: "Corporate has told us to reduce inventory."

What we've also heard is: "Make do with what you have."

And finally, another quote is: "Capital expenditures are on hold."

Customers are concerned about the economy and the lack of available credit. They are reducing inventories, orders, and order size, and there has been a trend toward deferring capital expenditures. There is a lack of visibility and until that improves customers will continue to act in this manner. This has affected the smaller manufacturers and machine shops that still make up a significant portion of MSC's sales to a greater extent than our larger customers.

Before turning the mic over to Chuck to talk in more detail about the quarter and our cash flow and balance sheet, I'd like to give some guidance for Q1. The deterioration in the credit markets has exacerbated the effect of the slowing economy on the industrial sector. The ISM is at its low point since the post-9/11 time period, and industrial production declined sharply in September. Our sales to the industrial sector, which account for about 75% of our total sales, have been declining as well. MSC continues to solidly grow its sales to the non-industrial sector, international and government accounts.

Visibility is extremely limited at this point. We don't know when the credit markets will return to a more normal state, nor do we know what effect, if any, that will have on the industrial marketplace. Therefore, we have chosen to project Q1 results on the basis of the first seven weeks of Q1 being representative of the entire quarter. And based on that assumption, we project the first quarter sales will be between $436 and $446 million, and fully diluted earnings per share will be between $0.68 and $0.72.

However, again, we caution that this guidance should be viewed in the context of the unprecedented market conditions and the resulting variability in actual results versus expectations.

Thanks, and I'll now turn the mic over to Chuck.

Charles Boehlke

Thank you, David. In Q4, MSC delivered excellent financial results given the market condition. We came in at the top of our guidance range in sales and over the top of our range in EPS.

Included in our earnings is a non-recurring gain from the sale of certain real estate that we no longer utilized in the business and a tax benefit from the utilization of a capital loss carryforward which, taken together, improved earnings by $0.025.

We anticipate that the effective tax rate for fiscal 2009 will be approximately 38%.

Gross margin came in as expected, and we anticipate an increase in gross margin in Q1 of '09 to approximately 46.8%, plus or minus 20 basis points, as we realize the benefit of the price increase in the Big Book just published. Given the limited visibility in this environment, we will be guiding quarter-by-quarter on gross margin.

We've continued to maintain tight control over operating expenses in Q4. As the macro environment continues to soften, we have aggressively reduced discretionary spending. This includes the obvious areas such as travel and entertainment and training, but also include strategic and growth spending, as evidenced by our flat guidance for sales headcount. These actions will serve to partially offset increased expenses associated with salary and fringe increases, the full year of associates hired in FY '08, and other inflationary increases.

Cash flow in Q4 and for all of fiscal 2008 was outstanding. We generated free cash flow, which we define as net cash provided by operating activities less capital expenditures, of $198 million in fiscal 2008, including $65 million in Q4. That represents an all-time high for the year. We purchased another 1,493,000 shares of our stock at an average price of $44.70 in Q4, bringing our total stock purchases for fiscal year '08 to 4,621,000 shares at a total cost of $187 million.

These purchases were funded out of our operating cash flow and through our revolving credit agreement.

We fully expect to continue to generate significant amounts of free cash flow from operations. When sales growth slows, cash conversion improves at MSC as we are able to reduce working capital. We currently have significant cash reserves on hand as well as committed lines of credit from a syndicate of top banks. As David noted, our strong cash flow and liquidity, combined with a strong, underleveraged balance sheet, gives us a powerful advantage against the small distributors who control the bulk of the market.

During these times there may also be more acquisitions that make sense, and generally in tough economic times acquisition multiples tend to decline. Our balance sheet remains significantly underleveraged and as credit markets improve we expect that we will have more freedom to utilize it as a weapon in the marketplace.

Thank you, and now I'll turn it back over to David.

David Sandler

Thanks, Chuck. In conclusion, we at MSC are on the move. We fully expect MSC to emerge from this extraordinary time with increased market share, continued strong cash flow, and a strong growth rate. While this team has not experienced the depth and extent of the current crisis, I can assure you that we are managing through these unprecedented times and will emerge stronger than ever. Our plan is very similar to how we managed during the post-9/11 period, and that worked very well.

Today we are a much stronger, better managed company, with many more customers, including a vibrant, large customer segment, many more skews to service our customers, extensive electronic tools that will enable our customers to reduce their costs, significantly improved service levels, and a well-trained, greatly expanded and highly motivated work force of associates ready to help our customers.

I offer my sincere thanks to all of our associates for their continued dedication, your hard work, and tremendous flexibility in the face of adverse conditions. Thanks, and I'll now open the line for questions.

Question-and-Answer Session


(Operator Instructions) Your first question comes from Adam Uhlman - Cleveland Research Company.

Adam Uhlman - Cleveland Research Company

I guess, Chuck, the first question for you on the guidance for the next quarter, sales up slightly but margins guided down quite a bit, with gross margin expansion. It sounds like there's going to be quite a bit of SG&A deleveraging, SG&A growing perhaps 7% year-over-year. Could you talk about what's behind that SG&A growth?

Charles Boehlke

Well, the first thing I would say, you saw that we significantly exceeded our expectations for sales headcount in Q4, so the sales hires that were on board for a partial, if you will, Q4 OPEX experience are all embedded and in for an entire quarter in Q1.

We also have an uneven distribution, if you will, of our annual merit review pull. A significant portion of our organization has their merit reviews done in the first quarter of every year, so there's embedded spending in salaries and fringe benefits probably of $2 million, if you will, Q1 versus where we were in Q4.

You also have things like advertising in Q4 are at their low levels during the year as plant shutdowns and so forth means we generally reduce circulation and advertising spending. Just getting that back to levels of last year or even slightly higher than that is about an additional $1 million in advertising expense above the Q4 levels here.

So there's some embedded spending that's in place. Yes, there's a net increase in overall spending because of some of those embedded things, but anything that's discretionary, it should be very clear that Q1's spending number is not a function of adding stuff during Q1. It's a carry in of what happened last year, with a return to more normal levels at Q1 traditionally that we spend in advertising that's caused that number to be higher on the OPEX line.

The other piece, Adam, I need to point out is freight expense, both versus Q4 and versus last year. Yes, over time this year, with the reduction in oil, we'd expect some of the surcharges to hopefully abate a little bit. But where we were in Q4 and frankly where we were in Q1 a year ago, the freight expense is much higher than it had been this time a year ago.

So those factors all net to an increase in OPEX over where we were in Q4.

Adam Uhlman - Cleveland Research Company

It also sounds like you're absorbing some of the incremental expenses for next day delivery for your customers, I guess. Could you talk about what the expected benefit is in terms of revenue the initial year that this new service is launched?

David Sandler

You know, we want to be careful about how much we would share publicly with that. Certainly, your point about a component of our freight expense coming from this program is part of our OPEX moving forward, as Chuck had commented.

You know, we're really excited about what this enhancement will mean. Understand that it's going to take time to actually work its way in. Part of our expenses, frankly, one of our advertising expense is going to be on marketing this new program, and it's going to take time for our customers that have been typically knowing that late in the day or for their second shift they now need to either send a driver out or they need to start shopping around to another local distributor that they're going to be able to now rely on MSC up until very late in the day, knowing that product is going to come tomorrow.

We're excited because we've already started to see with some customers buying behavior where we're now able to reach that second shift and we're seeing our late orders start to rise, which is really indicative of the fact that we're now taking business that we hadn't previously been able to take.

So I'm not going to share what our revenue projections are. I will tell you that we think that the return on this investment is going to prove to be a really good one over time and that the competitive advantage is something that we're going to be able to capitalize on for years to come.

Adam Uhlman - Cleveland Research Company

It looks like the active customer count slipped again sequentially this quarter. Can you talk about what's unfolding there?

David Sandler

To a large degree the customer count really is a part of managing really proactively and making choices proactively on our part. We've said that we tweak the dials on where we see we want to spend our growth investment dollars and how we kind of shift those around, and one of the areas that we've cut back, at least a piece of, is in prospecting those areas where we tend to find that the payback is going to take longer and therefore we get a lower return on that investment. That's something that we have cut back on because we think it makes good bottom line sense to do that.

And so, as a result of some of that, we have less new accounts being generated, and we also adjust some of our circulation mailings as well. But I think the overall effect of these changes do represent a reduction in what we've really targeted the cutbacks in, which is that one-time small buyer where revenue implications are very, very small in the near term and in the longer term as well.

Remember, the other thing that is a metric that we don't share that we do actually see continuing to grow is that our active customer base is based on billed to, not on shipped to. And remember, a large part of our focus for several years has been on that large customer segment which tends to have multi locational buyers. Those multi locations, that shipped to number, we do see growing, but you're not able to actually see it in the way that we measure our active customer base.


Your next question comes from David Manthey - Robert W. Baird & Co., Inc.

David Manthey - Robert W. Baird & Co., Inc.

Just for clarification, could you let me know what average daily sales growth was in the month of September?

Charles Boehlke

ADS in September was 3.9.

David Manthey - Robert W. Baird & Co., Inc.

And are you releasing a schedule of the other months that I haven't seen yet?

Eric Boyriven

It's on the website, David.

David Sandler

Yes, we'll read them to you right now, though. Chuck, you have them right there?

Charles Boehlke

Yes. David, July was 8%, August was 4.7%, September, 3.9%. And again, through a couple weeks in October, it's basically flat.

David Manthey - Robert W. Baird & Co., Inc.

And in terms of the environment we're dealing with here today, I'm interested in all of your opinions and your viewpoint in terms of how does this current environment look to you relative to past downturns that we've seen? Are there pros and cons? And just how are you thinking about it as it relates to past slowdowns?

David Sandler

You know, David, I'll tell you, one thing is that really we view this time as unprecedented in history. The economy is undergoing a huge change. How that's going to shake out all remains to be seen. But I think what's important to note is that it's a huge sea change that, frankly, no one had a chance to really see coming. So we know that specifically in our customer base, there's a tremendous amount of fear that's gripping customers, evidenced by what we've seen in the last couple of weeks in October - almost buying paralysis. That's really the way that we think about it and frankly, in speaking to so many customers, what we see happening.

I think one of the things that, even in the 9/11 period, was that, if you go back to 9/11, pre9/11 the economy was coming down. In fact, on a sequential basis over a period of many, many months it had slowed down and then there was the obvious tragic event of 9/11. What's happening here with the credit crisis, though, is that while the economy was by no means booming, it was kind of rolling along. And we almost think that nine months of what would typically have taken six, seven, eight, nine, 12 months to actually start to come down happened almost literally overnight.

If you think about the ISM and you look at the ISM being in a kind of a flat 49-ish, 50 range for many, many month, probably throughout this year, and then to have it swoon as it did in September at 43, which, by the way, as I'm sure you know, is at 9/11 levels, from all the time that the ISM has ever been tracked, I don't believe there's ever been a point where we've come upon or the ISM measurement has ever dropped off the cliff as fast.

Even pre9/11, the ISM had been drifting downward to ultimately hit that level. But it was not at kind of the steady stay where it was, which was a slower economy. But frankly, what the latest measurement shows is that things absolutely fell off a cliff.

So until we can get some more visibility into this thing we're just going to stay fast, really fast and flexible, and we're going to use this time. We intend to take share and leverage the great investments that we've been putting in place for the last few years.

Charles Boehlke

Just one other thing. Compared to the last slowdown, around 9/11, we were in single-digit operating income land. So even a slowdown now, there'd be significantly more cash flow generation and more opportunity to use that cash in the most productive way. That's very different than the environment we as a company experienced back in the 9/11 or 2001 era.

David Sandler

One more thing is to also note that our customer base is much more diversified, very different than it was back then. We were just getting started with our large customer segment, for example, where today the large customer segment is a much larger and vibrant part of our growth equation. And that will, as it's already shown, will help to diversify us from that small to midsize manufacturing customer where the pressure on them is just enormous.


(Operator Instructions) Your next question comes from Brent Rakers - Morgan, Keegan & Company, Inc.

Brent Rakers - Morgan, Keegan & Company, Inc.

Chuck, I think in past calls you've given some information on the growth rate broken down into price increases, large account programs and other. Could you maybe provide that again for this fourth quarter?

Charles Boehlke

Sure, Brent, I'll take it. I have it right in front of me. So growth in Q4 on an ADS basis was 5.8%, and the breakdown of that is 3.9% or 68% of the growth came from our large customer segment, pricing accounted for 0.9% or 16% of the growth, and about 1% or 16% came from all other volume in the business.

Brent Rakers - Morgan, Keegan & Company, Inc.

Could you also maybe expand upon - I know we saw some pretty sizeable price increases in the catalog, I think effective at the end of August - could you maybe comment what that price factor is looking like through the months of September and October?

David Sandler

I'm not going to break out specifically September and October, Brent, but we did take about a 3.5% increase in the Big Book. What we are seeing on the cost side of the equation is that many raw materials have started to come down over the past few weeks as the economy has slowed. So things like aluminum and nickel and stainless and obviously petroleum and petroleum-based products have dropped.

But interestingly, cost pressure from suppliers has still remained high so, given the changing environment, we're certainly taking steps and some very aggressive actions on the supplier front to mitigate those increases by resisting any proposed incremental increases to where we are and, frankly, based on what's happened to the raw materials and petroleum environment, reopening negotiations on previous increases where it was those increases that frankly drove or justified what was happening on that front.

And I guess finally we're also starting to see opportunity buys where suppliers really need the volume. They look to MSC to provide some large orders at favorable pricing, and we'll use our strong balance sheet to use that as an opportunity for us.

So you put all of that in the blender and that's where we come up with our gross margin guidance of 46.8% plus or minus. Everything that we see right now is factored in.

Brent Rakers - Morgan, Keegan & Company, Inc.

And I think you talked about a $0.025 impact from the items in the quarter. I guess I was computing closer to a $0.05 impact. Was there something with regards to kind of the core tax rate that was also maybe lower than that 38% that's kind of been normal lately?

Charles Boehlke

Yes, there absolutely was. We've had, I mean, the sale of the building, the gain on that was in the neighborhood of $1.5 - $1.6 million. That would normally after tax yield $0.015 in EPS, so there was other things going on there with the tax loss carryforward and some other true-up of taxes and state things that closed out that basically provided the other penny.

So between the sale of the building and other tax things that were going on, that was about $0.025 of the $0.05 difference that we experienced above the midpoint of our guidance. And you add another $0.025 beyond that that was made up of the fact we were at the top end of the sales range, which caused us to be in a better position, and some other things embedded in the business that provided that upside to the midpoint of our guidance.

Brent Rakers - Morgan, Keegan & Company, Inc.

I guess, Chuck, maybe one more question. It looks like from the cash flow statement that you had some, I guess, true-ups, if you will on the bad debt expense line in the quarter.

Charles Boehlke

We did.

Brent Rakers - Morgan, Keegan & Company, Inc.

Do you have a sense for where that trend might be occurring going forward?

Charles Boehlke

Yes. I would say, Brent, we did a great job in the fourth quarter. Our credit team and our collection team are actually collecting some monies that we had previously thought were uncollectible and did a tremendous job cleaning up our outstanding receivables. So you're absolutely right. In the fourth quarter we actually had virtually no expense for bad debt other than our normal accrual and that got reversed out.

So I wouldn't say that would be the trend going forward. I would say for the environment we're in right now - again, because of lack of visibility, I wouldn't want to predict exactly where we'll be  but at this point in time we've seen no deterioration in the quality of our receivables at all.

But fourth quarter, that was a one-time event, if you will, by collecting some monies that we previously thought weren't collectible, and that's what you saw with the bad debt reserve reversal.


(Operator Instructions) Your next question comes from Holden Lewis - BB&T Capital Markets.

Holden Lewis - BB&T Capital Markets

I believe that you've sort of been going through your five-year planning as you do every five years or so, and I just want to know if you would give any insight into sort of what elements may have come out of that that represent - not necessarily like the next quarter's benefit, but over the next couple of years, initiatives that might support margins and that sort of thing. Can you give any color in terms of the initiatives that have come out of that?

David Sandler

You know, Holden, we've made a tremendous amount of investments in our website, in our service enhancements to our customers, value added services. Those are all things that we've been investing in that are still core to our strategic plan. We're also investing in our private brand products to help us bolster on the margin side. So we're pretty comfortable that the plan that we're marching towards is going to give us the kind of results that over the long term we aspire to deliver.

Obviously in the short term we've pulled back and temporarily shut down spending on lots and lots of fronts, just until we can kind of let the economy and customer base regain its footing so that we're able to regain our visibility.

But we continue to now leverage the great investments that we've made on the customer front, on our service enhancement front, sales force build out, what we're doing with our product development area, and building out our private brand products, all of which will help drive growth and revenues and profitability.

Shelley Boxer

There's just a lot of initiatives in that five-year plan as it stands right now, and our history has been that we don't tell you guys about them until the actually get initiated. So the service enhancement was in our strategic planning for awhile and went through a build out or whatever, and we were able to initiate it over the Labor Day weekend along with improvements in our website that make a transaction much easier for our customers.

So we would not normally share those types of things with you because of their competitive nature.

Holden Lewis - BB&T Capital Markets

But if you take them over a long period of time - say the five-year period - and if you just lump them all together so they're not distinguishing, do you have a sense of what kind of savings you're expecting out of that or what it could do to growth rates and maybe compare to sort of like the last five-year plan? I mean, any guidance in terms of what we can expect or how we can expect these things to impact your model going forward?

David Sandler

Can't really give you any guidance there. And frankly, I don't know that I could say let's use a quarter blip or two that would change that guidance in any way regardless. So I think right now we've got a sea change, something that we're tightly managing to. We really feel very comfortable that we've got our hands on the wheel.

This ship was sailing through smooth seas, taking a look at beautiful clouds and pylons out there, and all of a sudden now there's glaciers and the water is very rough. So to the extent that that calms quickly, frankly, I don't know that there's any change to the wonderful islands that are ultimately on that horizon.

Holden Lewis - BB&T Capital Markets

And then just taking sort of the full year look at the balance sheet, the working capital assets, it seems like you did a pretty good job. Inventories, it looks like they were down year-to-year, not a lot of movement on the receivables. Your DSR growth and your total revenue growth was certainly up. So it seems like you did a pretty solid job on your working capital assets.

Do you expect to continue to keep a lid on that or do you think that because of the opportunity buys and that sort of thing that maybe the working capital assets will become a bigger use of cash this year? How should we view that?

Charles Boehlke

You're right. First of all, let me just say fourth quarter over third quarter we dropped the inventory by $27 million. Historically in a down cycle or slower time, we've actually converted cash at a better rate because of our ability to manage working capital actually increases in a downturn. But we've had these opportunities before in a downturn as it relates to opportunity buys. To the extent they make a lot of economic sense for us, it's pretty easy to determine we're willing to take a few more dollars in working capital on the inventory side for a big reduction in cost.

So I'd have to see every deal before I could tell you whether it's good enough to take advantage of or not, but I would say in general terms you've seen in the past in slowdowns, even with opportunistic buys on the inventory side and with just a slight deterioration of DSOs, we've converted a lot of our income into cash because we've managed our working capital even in the downturn.

So I don't see any major change from where we're operating today in terms of management of working capital, and we will take advantage of those economic opportunity buys that make tremendous sense for us.

David Sandler

The only thing I'll add to that is that the team - in fact, we met with many of the members last week on one of our review sessions - the team has been through this many times, both on the credit side, the inventory side, both understanding how to, frankly, mine the opportunities that are out there, at the same time doing a great job of managing our working capital. And at the end of the day, it's that great management and execution that produces the solid cash flow generation and conversion that we've historically seen.

So while we'll take advantage of opportunity, we think we'll manage that in conjunction with being able to still provide some great cash flow conversion.

Holden Lewis - BB&T Capital Markets

And given the trends that you see in the inventory, what have you seen in terms of rebate levels? I mean, is gross margin pressured because you didn't clear the same sort of rebate thresholds, and in 2009 can we kind of expect that rebates are going to be better or worse as a percentage of sales? How should we be looking at that variable?

David Sandler

You're point to an item that, as you know, there's lots of puts and takes in the gross margin line. Rebates are adding some downward pressure to margin. Frankly, that's all factored into our guidance. And I'd rather not characterize or give you guidance into '09, but definitely that is a component. One of the negative items of what puts pressure to the downward side on gross margin is rebates, but that's all been factored into our guidance.


Your next question comes from Susan McGarry - Granahan Investment Management.

Susan McGarry - Granahan Investment Management

I have two questions. The first is on your anecdotes about your customers, and I was wondering if you're hearing from any customers, big or small, about funding constraints and whether they're caution or their shock paralysis is based more just on fear and prudent measures or are they actually having difficulty accessing cash?

Charles Boehlke

Again, we keep pretty close tabs through our feet on the street, which is our sales team, and we're hearing basically things like, "I don't know where this is going, so I'm going to conserve cash. And one of the first things that would go that - gee, I might normally keep two in safety stock, I'm keeping only one in safety stock," and things of that nature.

Again, this is changing pretty quickly. We don't get instantaneous feedback. But I'm saying the last couple of weeks, the last five or six weeks, it's been more along the lines of cash conservation is the driver behind the lack of spending on MRO items and everything else they have to buy going forward.

That may soon translate into I really can't get the credit I need, but what it's been so far from what we've heard anecdotally has been, "I've got to sit on cash because I don't know where this is going. I've got to make my payroll. I've got to do other things."

Susan McGarry - Granahan Investment Management

Then the other question is about stock repurchase and what your plans are for that in the current environment.

Charles Boehlke

We don't publicly advertise what we are going to do on our stock buyback. We obviously have pretty strong operating cash flow. We tend to use that historically opportunistically on stock buybacks; we've periodically increased the dividends, and we've got a reasonable war chest if we decide to go do something on the acquisition front. So it's a combination of those events and those things is where we would keep our cash without specifically talking about a plan that's already in mind to buy stock back.

We do have 3 million shares left under our authorization. I'm sure if we needed more the Board would consider that and typically has approved it.

Susan McGarry - Granahan Investment Management

But you haven't changed your thinking, kind of getting a bit more conservative given what's going on about stock repurchases?

Charles Boehlke

I think that's fair. I think, like I mentioned on the customer side, given where the credit markets certainly were and are in the last few weeks, cash is king and we've kind of taken a more conservative approach. Until things settle down and the visibility comes about, it clears out here, we're going to probably sit on some cash.

David Sandler

I guess the only thing I'll add is that, you know, as Chuck has mentioned, we've got a pretty conservative and underleveraged balance sheet, and frankly, at times like this, it's nice to have an underleveraged balance sheet. So that's not something that we're going to quickly be looking to change.


Your last question comes from Yvonne Varano - Jefferies & Co.

Yvonne Varano - Jefferies & Co.

I wonder if you could just talk a little bit about your sales associates, because I know they came up in the quarter. It seems like you're on hold right now, but if things get materially worse, do you think that that number is going to come down or do you want to maintain good people for the upside? How shall we think about that?

David Sandler

No question we will always maintain and keep a great sales force. But we're really going to take this thing quarter by quarter. You can see that we added a lot of new associates that we were fortunate to have available in this marketplace that actually exceeded where we had initially targeted in Q4. The associates flow in adding to our team actually pleasantly exceeded our expectations. And for Q1, given how we've pulled back, we absolutely want to maintain roughly the same number, which is the guidance that we've given.

Having said that, as great people become available in a market that - oftentimes you work for a small local distributor for a long time and it's only during very stressful times where that distributor is no longer able to service their customer that one of the great folks that has been there finally says, "You know what? It's time for me to move on." We'll certainly take advantage of those opportunities.

Yvonne Varano - Jefferies & Co.

And then I would think at this point acquisitions are probably few and far between given the constraints in the credit market, but maybe talk a little bit about what you're seeing there. Are there companies that are in dire positions that are coming up and available, and what would you be looking for?

David Sandler

We're not going to specifically say what we're looking for other than to certainly characterize that the type of company that we'd want to buy has got to be similar to J&L in terms of opportunity, meaning the threshold that we would make this acquisition because we think it's going to position us five years out better than just maintaining the status quo of our organic strategic plan. And so we will continue to look for opportunities that way.

We are seeing that deal flow had actually begun to pick up, and we were starting to see some opportunities that may be attractive beginning to fill the pipeline. Having said that, some projects we've even seen put on hold because of the credit crunch. And to your point of until there's more liquidity out there, we suspect that the deal pipeline is going to be pretty locked down. But we expect that at some point that will change, and we think that acquisition evaluations might also be attractive.

So that's certainly one of the opportunities that we're putting in the mix in terms of how we think about using our very strong balance sheet and building on our plan moving forward.


There are no further questions at this time. I will turn the call back to management for closing remarks.

David Sandler

Okay, well, thank you, Kristen. And thank you all for listening in today. We appreciate your attention and look forward to speaking to you next quarter. Bye bye now.


This concludes today's conference call. You may now disconnect.

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