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

Q1 2009 Earnings Call

January 8, 2009 11:00 am ET

Executives

David Sandler – President, CEO

Charles Boehlke – Chief Financial Officer

Analysts

Adam Uhlman – Cleveland Research

David Manthey – Robert W. Baird

Jon Baliotti – Ftn Midwest Securities

Brent Rakers – Morgan Keegan

John Inch – Merrill Lynch

Richard Marshall – Longbow Research

[Vin Shimsean – Aridian]

Susan McGrarry – Granahan

Operator

Welcome everyone to the MSC Industrial first quarter 2009 earnings conference call. (Operator Instructions) Mr. Joyce, you may begin your conference.

Mr. Joyce

Good morning everyone and welcome to the MSC Industrial Direct fiscal 2009 first quarter conference call. You should have received a copy of this morning's earnings announcement. If you have not received a copy, please contact our office at 212-850-5600 and a copy will be sent to you. An online archive of this broadcast will be available one hour after the conclusion of the call and available for one week at www.mscdirect.com.

Certain information pertaining to non GAAP financial measures may arise during this broadcast. Accounts can be found in the earnings announcement which is posted on the same web site 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 Operation Statistics which you can also find under the tab About MSC on our web site.

Let me know 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 the next quarter, expected benefits from the company's recently launched new customer enhancement, expectations regarding conversion of net income and to operating cash flow, expectations regarding the company's ability to capture market share, the company's growth 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 than those anticipated by these statements. Information about these risks is noted in the earnings press release and in the risk factors in MD&A section of the company latest annual report filed with the SEC as well as the company's other SEC filings. These forward-looking statements are based on the company's current expectations. The company assumes no obligation to update these statements. Investors are cautioned not to place undue reliance on these forward-looking statements.

I now like to introduce MSC Industrial's President and Chief Executive Officer, David Sandler.

David Sandler

Good morning and thanks for joining us today. With me is Chuck Boehlke our CFO and Executive Vice President. [Shelly Valkner], our Vice President of Finance isn't here today as he's feeling a little bit under the weather.

Before I begin to discuss our financial performance I want to be very clear about how the leadership of our company views the current economic climate. First of all, like many of you, we are saddened by the number of people who are without jobs and by the devastating loss that continues throughout our country. However, we remain optimistic about our country, the future and the world in which we live.

Our leadership team has always been careful to keep the company balanced and capable of prospering through boom and rough times with high degrees of leverage with the order of today, we avoided, and we understood that it would limit our options should the economy turn on us. In August when we said that things were changing we moved quickly to shut off any spending which might jeopardize our ability to capitalize on this downturn. That is how we are positioned today.

We view this downturn as an enormous opportunity for our company to take disproportionate share from the competition. We are uniquely positioned to prudently add to our performance, open new geographies, strengthen our position with key customers and suppliers and invest in accretive technology to position our company to benefit greatly when the economy turns.

While we do not wish for a long downturn, our smaller and mid-size competitors will suffer the most and as this downturn grinds along, they will be forced to eliminate investment spending, reduce inventory, slash capital spending and also may suffer from deteriorating customer service. They will fall further and further behind and we will be there with the infrastructure and team to take advantage of those opportunities. When the economy returns, and it will, we will have taken tremendous share from these competitors.

Recently, I received a telephone call that illustrates the share gain. For seven years, we've been trying to break into a large manufacturer in the west. All of the metalworking supplies were being purchased from a local distributor with whom they had been doing business with for years. That distributor experienced exactly what we have described.

Due to a downturn in revenues and the effects of the credit crisis, they're cash flow was impacted. They reduced inventory and service, and ultimately were placed on credit hold by several suppliers. They could no longer service the customer, and today, we are fulfilling the metalworking needs of that plant. We believe and expect to see such increase as the environment continues to worsen.

Moving to our results and what we are seeing today, net sales decreased by approximately $4.5 million dollars in Q1 versus last year as a result of the slow down in the global economy. This decrease consisted of a core business decline of $28 million, partially offset by approximately $15 million in pricing and approximately $8.5 million related to the growth of our large account customer programs.

Earnings per share for Q1 came in at the top of our guidance range even though revenues came in just below the guidance range. Revenues for the last two weeks of November were lower than originally anticipated and reflected a change in the overall market environment as the effects of the economic slowdown have broadened and deepened.

Gross margins improved as we took advantage of previously announced price increases. As I said earlier, we moved quickly to control spending and benefited from these early moves. Improved gross margins combined with our strong controls over spending more than offset the effects of the lower than anticipated revenues.

I'd like to share with you what our customers are telling us about business conditions. They have reported that conditions have worsened substantially in the quarter compared to the previous quarter. There are very few customers who are growing. Many report declines in orders and revenues.

Customers continue to reduce their inventories as conditions worsen, and as we anticipated and discussed on the last call, shut downs for the holiday season were greater in number and longer in duration that at any time in recent memory. Large and small customers are reporting layoffs and a virtual lock down on non essential spending.

Revenue trends in December were consistent with what we have seen from our customers. Our team is focusing on taking share in this market and we believe that we have been successful as the competition begins to show the stress of reduced revenue and reduced credit availability.

Customers that we have talked to have confirmed that in many cases, we're taking share from the competition as they shift their product to MSC and as expected the positive effect of share gain are masked by the excess of this downturn.

Affecting these margin cost control is very attractive to customers during times like these. Our huge assortment of skews combined with our very high tow rate, very late cut off times, next day delivery and services such as VMI, CMI and other e-commerce tools make MSC the choice for lower total cost and supply chain security.

We have continued to invest in our business during this quarter while maintaining our sales force as 912 associates. We expect head count to be in the range of 910 to 920 for Q2 and we will take an opportunistic approach moving forward as we continue to invest prudently in sales, geography and technology.

We do not have the same degree of confidence in the reliability of our Q2 guidance that we historically have. Given the month of December being as unusual as we can remember due to the degree of plant shutdowns, it provides limited insight into January and February. We have therefore formulated in Q2 guidance we relied upon the December data point, the [inaudible] other external factors and our customer feedback.

Based on that, we estimate sales to be in the range of $354 million to $366 million and EPS to be in the range of $0.39 to $0.43. 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.

Thank, and I'll now turn the mike over to Chuck.

Charles Boehlke

We are pleased with the execution on our gross margin and cost control initiatives in Q1. Despite revenues below guidance, we achieved earnings at the top end of guidance primarily by reducing expenses below forecast. Many of the actions taken in Q1 will continue in Q2 as well.

These include re-opened contract negotiations, avoiding filling positions that we've attrited, encouraging voluntary time off, reducing travel and further encouraging all departments to find creative ways to reduce costs.

I would like to share just a couple of examples that gives you the flavor for how our associates are getting creative on reducing costs. One is repairing and reusing pallets in our fulfillment centers rather than buying new ones, and another is utilizing our own in house labor pool where our associates have identified that we could reduce third party contract costs.

We have also recently announced a salary freeze which will be in effect throughout calendar year '09 and we continue to invest in productivity projects such as warehouse optimization.

We estimate gross margin for Q2 to be 46.2% plus or minus 20 basis points. This is a significant drop from Q1's 47.1%. Our customer mix is driving accelerated gross margin declines as large accounts continue to outpace the core business. Additionally, the success of our promotional campaigns accelerated in December and we expect that trend to continue throughout Q2.

Our balance sheet remains very strong. We have significant sources of available credit in addition to the significant cash balance that we have built. Our total borrowings outstanding less cash balances at the end of December were approximately $112 million, down from $190 million at the end of fiscal year '08.

In Q1 we converted net income in cash flow from operations at a rate of 160%. We expect to convert our earnings into cash at rates in excess of 100% for Q2.

We have been modeling for sensitivity purposes with business conditions at levels significantly worse than current expectations for very long periods of time. Based on the modeling results, we believe that MSC will remain profitable with significant cash generation should these conditions materialize. We have every confidence that we can execute our plans while taking share to be well positioned for the recovery.

Thank you. Now back to David for the wrap up.

David Sandler

There is no longer a question as to whether this downturn will be the most severe in my career and I suspect of the careers of most of us. However, if you look at our history, take a look a look at other industries; it is clear that companies with superior value propositions, developed infrastructure, seasoned leadership teams and strong balance sheets perform significantly better than the sectors in which they operate.

In fact, during severe downturns the gap between strong industry leaders and second tier performers gets larger. We understand this and are taking advantage of the downturn to lessen our read over the smaller distributors. We will prudently invest during this downturn in order to maximize our position in the marketplace.

To reiterate, we are in a position to hire top associates, penetrate new geographies, acquire technology at relatively inexpensive prices in order to increase our advantage in this area and strengthen our position with suppliers.

We were fortunate to anticipate this downturn and move quickly to rein in spending. We did so in order to maintain as much dry powder as possible as we knew that opportunities grow in a protracted downturn. These opportunities have just begun to surface and we believe will grow in the quarters to come.

We will be prudent. We will maintain our discipline and we will be sure the capture the best opportunities across all the investments outlined above. We do thank our shareholders for their support and our associates for their hard work and dedication to this vision.

I'll now open up the lines for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first call comes from Adam Uhlman – Cleveland Research.

Adam Uhlman – Cleveland Research

My first question is on the revenue guidance for the second quarter, sales down 16% so far in December and the guidance suggests that sales growth becomes even worse over the next couple of months. You talked about that a little bit in the prepared remarks, but could you flush out some of the issues, the differences in selling days and presumably customer shutdown days should be less worse in January and February. Could you maybe talk about what your customers are saying about their own production schedules?

David Sandler

We tried to hit it head on in the script that the reality is that our forecasting right now is about as cloudy as its ever absolutely been and so we tried to – I don't say be conservative with the guidance but to tell you the truth, the way that we see it given that the guidance was based on the only data point we have which is the holiday season, I could make a case that the guidance would be much better.

To the extent that things bounce back to let's call it pre vacation levels, but unfortunately that's on one side of it but unfortunately on the other side of it, I could probably also make the case that given what we're seeing with layoffs, the harshness of this environment, the fact that the ISM we know is something that historically anyway has been a leading indicator of what's to come, and the reality is that that trend continues to come down. I could make a case that based on that and the limited visibility that we have it could actually be worse.

We've tried to put it out there and caution as much as we can that it's just very cloudy for us right now and it's our best guess at this time.

Adam Uhlman – Cleveland Research

Chuck you had mentioned that you had done some modeling and expect the company to be profitable this year and understanding that you don't provide guidance more than one quarter out, would you care to share your current thinking on maybe what a high end, low end earnings potential is for the company in 2009?

Charles Boehlke

I can't do that. What I can tell you is what we did in the modeling is in ranges of -15% to -20% on the revenue line. Operating margins are in the 11% to 12% operating range. You can do your forecasting based on what you think. That guidance would include the current level of investment spending baked in there.

Obviously if conditions got better or worse than that and we choose to accelerate or decelerate investment spending, that would give you a different answer. But based on where we're investing today in a range of -15% to -20%, lots of cash and operating marking in the 11% to 12% range is probably the best I can give you.

Operator

Your next question comes from David Manthey – Robert W. Baird.

David Manthey – Robert W. Baird

I was wondering if you could address the number of days here in fiscal 2009. By our calculations, we have you losing a day in each of the first and second quarters and then picking one up in the third with the fourth even. Is that correct, and if not where are we wrong?

Charles Boehlke

We don't see it any different than '08. We have the same number of days quarter by quarter in '08 and '08. Maybe offline afterwards we'll straighten out where the difference would be.

David Manthey – Robert W. Baird

You're saying in each of the quarters of fiscal '09 you have the exact same number of days as fiscal '08?

Charles Boehlke

Right.

David Manthey – Robert W. Baird

In terms of the gross margin, I would expect that with volumes where you're seeing them right now based on your forward-looking guidance, you've made an adjustment in your gross margin also for lower levels of rebate. And I'd also assume that given you've seen that going into the end of the quarter here, did you already make an adjustment in the first quarter that we won't see an abnormally harsh adjustment in the second quarter for rebates? And to follow up on that, if you could address you ability to maintain selling margins in this inflationary environment.

Charles Boehlke

Rebates, we've talked about for the last couple of calls now with the potential for volumes coming down clearly on the surface that would have an impact on rebates, and that's been consistently factored in now for a couple of calls. We are challenging our teams and our product teams are going back to suppliers and looking for the opportunity to renegotiate thresholds.

As you know, we feel we're taking share and those suppliers that choose to work with us through this downturn will reap the benefits coming out the other side. All that being said, the absolute volume certainly is down and has been factored in for a couple of quarters now. So the change is not from Q1 to Q2 at an abnormally large drop in rebates quarter over quarter.

That major margin mix there or change in margin is a function of what we pointed out in the script are promotional offerings. We saw in December a significantly higher percentage of our sales were occurring around those promotion activities that were in the marketplace and as well, that mix we talked about forever where the large accounts continue to outperform the core. That's been even more exacerbated it looks in the second quarter.

So it's more of a mix issue and focus on the success of our promotional offering that are driving that change rather than a big change in the rebate.

David Sandler

The only thing I would add to it is that our team is doing a really good job out there on maintaining selling margins where we proactively have gotten more aggressive and really getting great results out of many of our promotional activities, helping their customers look for during times like this.

And we are also seeing a bit of additional discounting in this environment where we've got to meet competitor's pricing. But by and large, we're very comfortable with the way that that's being managed and that's not having a significant drag as one of the components on our margins other than the greater disproportionate success than we've been having on our promotional programs.

Operator

Your next question comes from Jon Baliotti – Ftn Midwest Securities.

Jon Baliotti – Ftn Midwest Securities

Just thinking about the trends of the first quarter obviously got worse than the fourth quarter, I'm wondering would it be fair, obviously with a total lack of visibility for a lot of companies to kind of think about the quarter after this one in a similar light that if people had placed orders in the fourth quarter where they may have that stuff sitting around that they're going to start to use when they do come back, and maybe that makes the recovery a little bit slower as we go through the year.

David Sandler

It is just so hard to say. I think you could make a case that things will begin to level off and consumption has been shut off, inventories that customers are low, perhaps at some point too low and that will begin to build. On the other hand, with the layoffs that we've been seeing at customer locations, perhaps that inventory and the amount of inventory that a customer has is still too high and will suffice longer.

So it's very hard to say where this thing is going to end, but whatever direction it goes, we're certainly managing and ready for it. But I think in particular as I said, through this time, we're going to use it to take share. Unfortunately if it goes very long, that doesn't bode well throughout because of the enormous pain that that puts on our smaller competitors that control the bulk of those markets.

Jon Baliotti – Ftn Midwest Securities

I would think that whatever you're feeling given that most of your competitors have far fewer customers that they're feeling it more acutely and credit is obviously going to be more of an issue for the private small guys. I would think that you would probably prefer that people think much more conservatively obviously as we go through the rest of this year given the layoff discussions you had and I would imagine that even those customers when they do start to come back, that they may even operate with fewer shifts.

David Sandler

I think we're seeing those shifts dramatically reduced, shortened or eliminated altogether for some that were running multiple shifts. I think the point that you make is a really important one. When you take a look at the market that we're in and how highly fragmented it is, the pressure on the small players who control the bulk of this market is absolutely acute.

So when you take a look at MSC and how well positioned and how well capitalized and how strong our balance sheet is, when you think about that across a small company as the credit crisis and the cross that they're under is magnified many, many times over.

Operator

Your next question comes from Brent Rakers – Morgan Keegan.

Brent Rakers – Morgan Keegan

I know you typically don't like to talk about trends between manufacturing versus non manufacturing customers in kind of this one month after the quarters period, but in light of the impressing conditions going on, I was hoping maybe you could give us some more color on manufacturing customers versus metalworking customers and even versus your non manufacturing customers, what the trends have been over the last four or five weeks or so.

David Sandler

I'll try to give you a little bit more color. We saw the slowdown broaden across our really entire industrial grade base with declines accelerating throughout the quarter. As we mentioned the holidays were like nothing we've ever seen because of the number of shutdowns, length and duration through the period.

What we also saw was the effect of these declines were not just in our small customer base but also affecting our large customers as well and that also was accelerating through the quarter. So that was another trend emerging.

Part of this of course is our historic base of small to mid-size shops and manufacturers that make up a considerable part of our business. But overall, small, large, durable goods manufacturers in general have also been really hardest hit. So as we said, we're seeing customers across manufacturing and non manufacturing really clamping down on spending, holding off on purchases wherever they can and moving to reduce inventories.

They layoffs that we hear about in the NY news, in the headlines every day on the news, they're the big ones, but I can assure you that under the way that we're plugged into our customer base, we hear many, many more throughout, really going on throughout the nation. When you look at our regional breakout, I think you can see the effect in particular of the concentration because the Midwest has a disproportionate share of that.

Hopefully that gives you a little color, but coming back to where you originally started, the pain through the quarter and the decline through the quarter absolutely not only affected manufacturing, although much more disproportionately so, but also non manufacturing as well.

Brent Rakers – Morgan Keegan

When you look at your disclosures for the first quarter, and actually over the last several quarters in manufacturing I guess it's very obvious that manufacturing has been a lot bigger drag on your business to the non manufacturing customers. Is this relationship with all the talk about the December shutdowns is that even being exaggerated more on the negative side for the manufacturing customers?

David Sandler

I think you can see the mix in the business between manufacturing and non manufacturing; $72 million manufacturing, 28% non manufacturing. Unfortunately, while our direction over the years has been to continue to buy our portfolio customers, unfortunately we've got the gain the wrong way by shrinking the manufacturing base. So I guess to the extent that that exacerbated, it will put more pressure on that mix.

Brent Rakers – Morgan Keegan

Obviously the guidance is hazy and conditions are hazy in general, but given all the plant shutdowns that you say in December and now that we are in January, have you seen or in conversations with these customers, have these plants that have gone down, have they come back as of yet? Do you have any information as to when the majority of some of these plants will come back?

David Sandler

There's still some that have not yet moved through this period, but by and large the area is essentially behind us. I'd love to share a couple of days in January. The reality is that until we get this full week under our belt, it's really not a meaningful data point so whether its better or whether its worse, until we get the week, I think it would only be misleading to share a couple of days.

Operator

Your next question comes from John Inch – Merrill Lynch.

John Inch – Merrill Lynch

I want to ask you the same day shipping program, how much dollar cost does that represent on an annualized basis? I'm not talking about the revenue benefits, purely the dollar, and does that have a material impact in the second quarter in terms of coming up with the 12% margin to get to your guidance range?

Charles Boehlke

The same day shipping, are you talking about the enhanced that we've just introduced?

John Inch – Merrill Lynch

Yes, the one that you talked about last quarter.

Charles Boehlke

The piece of that that's on the cost side to us is a little bit more. On the freight side with the obvious tradeoff and benefit of pulling the sales in and improving top line. I think in the environment we're in right now it's difficult to say dollar for dollar here's what we got on the freight side and here's what we expensed on the sales side.

We're confident it's working. Our customers tell us they like it. We can see order patterns and say that they like it, but it's rough to try to break it out in dollar amounts. It's just not something we're able to do.

John Inch – Merrill Lynch

So to go to the sequential margin decline, I think you're suggesting that there's no real material impact from this initiative, is that what you're saying?

Charles Boehlke

Not from Q1. If you're trying to go from Q1 into Q2, that's not the case. It's more the sales decline than the deleveraging that's taken place given the model and how it's structured. That's what's driving the margin change.

John Inch – Merrill Lynch

How much of the demand downturn would you, as you talk to your customers and done your modeling, would you maybe attribute to the liquidity squeeze or lack of availability of financing on the part of your customers?

David Sandler

I don't know that we can pinpoint that it's a lack of availability. It's end user demand that's driven back through the manufacturing channels that's driving the shutdowns. It's been a major driver of the change in our sales revenue not so much where they could make it and have customers to buy it. They just can't get the credit to finance their working capital. It's the manufacturing shutdown and then user demand.

To that extent, certainly the credit crunch that's affecting the end user demand is working its way back through the supply chain and it's the manufacturing piece with the shutdowns and so forth that's really hurting us.

John Inch – Merrill Lynch

I was just wondering if sequentially you're talking 16% to 17%, if you thought maybe anecdotally half of that might be attributable to a lack of credit on the part of customers. I don't know if there's a way to quantify.

David Sandler

It's impossible to break it out and quantify which component is contributable to that.

John Inch – Merrill Lynch

You have talked a lot about taking share and position for recovery. There's a fairly healthy contingent of folks who seem to think that this downturn could extend well into 2010. I'm wondering at what point do you begin to realize we're going to have to take a charge and lay people off. At what point do you say this is going to go on much longer than any of us would have anticipated. We need to adjust our cost structure.

Or conversely, are you just happy to let the earnings continue to drop and still focus on the top line?

David Sandler

First of all, we're not happy to let the earnings just drop. We will and are continuing to take action throughout the business to clamp down on spending, eliminate waste, figure out how to get more productive wherever we can. We've got a very extensive plan that's in place that we've taken many actions in conjunction with of course the normal attrition that occurs that we think position us appropriately moving forward.

By no means are we sitting still. As business conditions either persist or worsen we'll continue to take appropriate additional actions. We've developed many contingency plans. We've got steps that we'll take and will continue to take as the business moves forward. At the same time, we are going to prudently invest.

We're also going to stay very focuses on cost management and the organization frankly, is rallying around trying to perform our business performance as well, not only in the revenue side and on the share gain side, but being very mindful that conserving every dollar adds to the mix of our ultimate focus which is share gains and making sure that we can sit at a strong cash flow which is a very high priority and we're very confident that we'll continue to do that.

John Inch – Merrill Lynch

But your sales associate count is high. It sounds like you want to maintain that or do you want to manage it lower depending on market conditions.

David Sandler

We are as I said, we do attrite and we will attrite in the bargain area in the normal process. One of the things that Chuck mentioned in his script that I'll elaborate a little bit more on is how our team is getting creating to reduce costs by folding in from work that was previously outsourced, which is a great use of our workforce.

We're also doing many things. By being able to get to projects that are very focused on when things are busy, we're using today's opportunities to do that and we know that's going to create lots of activity in the future. So part of it is that, and part of it is you will see head count coming down through normal course.

Operator

Your next question comes from Richard Marshall – Longbow Research.

Richard Marshall – Longbow Research

I was looking at top line. Top line was a little bit weaker year over year. I think it was still a little bit stronger than many of us expected. To what extent to you feel that orders might have been pulled forward or year end budget slashes for those who are on calendar year end might have contributed to somewhat higher than expected top line growth this quarter?

David Sandler

I have to tell you that year end spending from everything that we could tell was basically non existent in our customer base. Typically at year end you have a company's budget or capital that they want to get in etc., and that usually gives a bit of a lull on a relative basis to some of what we see in December.

Our anecdotal feedback from customers was that that was absolutely shut down and that any release of budgets or any year end capital spending etc., was absolutely obliterated. So we don't think there was any of that and you can make the argument that based on having it in December perhaps it will come later on as the year progresses. We don't know.

Richard Marshall – Longbow Research

Any further color on end markets that were stronger, weaker, maybe any surprises in terms of markets that were stronger or weaker than you expected this quarter?

David Sandler

We do have an extensive process to look at our markets. There is some relative strength in some that we measure and watch and in part that's how we direct our sales force and some of our programs. That's not something that we like to share publicly for obvious competitive reasons.

Of course, as I said earlier in general durable have been more but I can't say that's a surprise. When we look at what's happening in manufacturing and certainly includes that multiple years, it's not surprising to see the kind of declines that are happening there.

Richard Marshall – Longbow Research

You talked a lot about market share gains in your remarks. I just was curious if you had any sense for what market share gains might add on a full year basis looking at '09.

David Sandler

Very tough to talk about specifically. We certainly look at things like many of the industry benchmarks, segment analysis, really relevant industry information, but very hard to specifically measure and I think the most compelling gauge that we use that's anecdotal, we really think that it tells an accurate story, is the feed back that we get from our customers, suppliers and from our own sales force.

Operator

Your next question comes from [Vin Shimsean – Aridian]

[Vin Shimsean – Aridian]

Could you talk a little bit about pricing? You've had the price increase go through. How do you see that maintaining going forward, especially with commodity prices as well as the general pressures that your customers are facing?

David Sandler

I'll talk a little bit about what we're seeing on the cost side which the environment has been extremely volatile, but we've experienced cost increases when commodity inflation was escalating but where product and raw material and petroleum sensitive. We're now seeing some lower prices and where those prices have abated our product management team has gone back and is negotiating with our suppliers to reduce our cost.

On that side, we really do view it as an opportunity. As I mentioned earlier, customers in this environment certainly are more price sensitive. We actually addressed that with our promotional campaign with the flexibility that we give our sales force. But we're very comfortable with the pricing that we've implemented so therefore we had a big booking increase and we don't see real risk on that side of the business.

Operator

Your next question comes from Susan McGrarry – Granahan.

Susan McGrarry – Granahan

I was wondering if you could address the international sales. They seem to be weaker than the other geographies.

David Sandler

Actually the international as you know is a small part of our business, but for now what you're seeing there had the effect of currency. The strength of the dollar has actually turned that metric to a negative where had that not been the case it would have been positive growth.

Susan McGrarry – Granahan

Did the non manufacturing sales deteriorate through the quarter following the same pattern as the manufacturing?

David Sandler

I can't say that it followed the same pattern but there was overall deterioration through the quarter although non manufacturing as you can see still grows quite strongly.

Susan McGrarry – Granahan

But it did weaken.

David Sandler

The web site has the growth broken out and yes for the non manufacturing sector which grew at 10.6% for the first quarter. That was down from 12.7% in Q4 and 13.4% from Q3. So yes, it's certainly weakened as well but the manufacturing piece which is obviously the bigger piece of our business weakened more substantially.

Susan McGrarry – Granahan

I just want to get a sense of in a sales weakened during the quarter month by month and that happened in both manufacturing and on manufacturing?

David Sandler

We saw the decline trend through the quarter affecting the entire business.

Susan McGrarry – Granahan

One other question about bad debt and just the credit health of your customers in general.

Charles Boehlke

There was a slight increase in our DSO's from year end so where we finished in Q1. Some of that is seasonal in nature with our quarter ending right around the Thanksgiving holiday pretty much every year. There's a bit of a stretch of DSO's over where we would have been the previous quarter.

But we did start to see for the first time some slowdown due to the economy and payment trends, and if you look at where our bad debt reserve is now, it's a percentage of receivables. From year end to the end of Q1 we actually increased that from about 2.6% of receivables to 3.1%.

The provision is really and end result of a process. We look very vigorously at our large accounts one by one and at any account in the region of about $100,000 in either credit line or balance, they go through a very rigorous process. That's the appropriate reserve and the end result is where the provision needs to be.

But to answer your question, a slight deterioration, but we think we're adequately reserved and don't anticipate any large write offs coming.

Susan McGrarry – Granahan

Just anecdotally what you're hearing from your smaller customers and bigger ones in terms of their access to credit. Not from the bank credit and other forms of credit. Have you heard about them being shut out?

David Sandler

I think it's fair to say obviously the smaller the customer, the more difficult but I think it's fair to say across the board it's certainly had some impact on their ability to get money and therefore to invest in capital expenditures and other things that would have an impact on our business. Clearly there's a piece of that going on.

Operator

Your next question comes from Adam Uhlman – Cleveland Research.

Adam Uhlman – Cleveland Research

Can you talk a little bit more about the average transaction size? It's been rising for some time now and a big piece of that is those large customers that are becoming a bigger piece of the mix. But it's somewhat counterintuitive now with even those large customers buying less and the smaller customers are still the majority of the business, and presumably they'd be placing smaller order sizes. Do you have any further color on what's unfolding there?

David Sandler

I think you hit it on the opening part of the question. The reality is that the large customer segment who has a significantly higher average order size given the weighting of the mix of our customers is driving the overall average order size higher. And that's really the driver.

Adam Uhlman – Cleveland Research

What would be the average order size for a small customer versus a large customer in dollars?

David Sandler

We have it but we don't break it out. We don't share that publicly.

Adam Uhlman – Cleveland Research

The active customer count has slipped again the first quarter. Could you talk about what's unfolding there, and it looks like you're ramping up a little bit relative to the previous trend. Those two issues together, is that trying to drive additional customer creation?

David Sandler

Historically the client, end customer count has been part of a proactive way that we're managing our growth investments and it's a choice on our part. As we've discussed on the past several calls, we're constantly looking to prune and improve productivity within our program, constantly testing, constantly looking to get the bigger bang for the buck.

I guess just a step back further, to kind of remind you of our strategy, it's been to focus on acquiring larger customers which typically have a multiple ship to locations and attriting those small one time buyers that really have very little potential for the future. As a result, our total customer count which never is measured in bill to only, you see it dropping and because of the multi-location effect, it really doesn't tell the whole story.

But that's what's been happening in our strategy to reduce those small one time buyers. Absolutely it's been effective. But I do want to say that for the first time, what we saw in Q1 was a big difference from previous quarters where while our direct mail metrics have all remained strong as we begin, we did see that the customer loss did extend beyond those one time small buyers into the next layer of customers, that small to mid-size revenue customer.

We expect that what we're seeing is absolutely the effects of the economy, a year of recession in the manufacturing sector. But we can't yet project whether what we recently saw is temporary or whether it's part of what we're going to see moving forward. I can tell you that the team is very closely focused on and watching it carefully and continuing to take action.

Adam Uhlman – Cleveland Research

Are you seeing growth with your ship to location customers in the way that you look at it?

David Sandler

We do.

Operator

Your next question comes from Brent Rakers – Morgan Keegan.

Brent Rakers – Morgan Keegan

You talked a little bit about deflation in terms of product cost but I was hoping you could quantify that a little more specifically. In this quarter year over year I think it works out to about 3.5% year over year increase. Given where we are right now and given your negotiations, do you still see pricing up up until the point where your anniversary to big book pricing increases next year?

David Sandler

Are you talking about interim price increases between now and the next big book?

Brent Rakers – Morgan Keegan

No, more so in terms of, obviously we're going to see some price decreases and you talked about on specific products that we already are, but will those price decreases be so large that in the third quarter or fourth quarter of this fiscal year, you'd actually be seeing net deflation.

David Sandler

Basically we're very fortunate that when you look at our business, the raw material costs are a relatively small component of the cost component in the bulk of our mainstay product lines. We've also got some additional protection there given our high gross margin which is kind of another shield.

For any lines that we've identified that we could have an exposure from a deflationary standpoint, if it's for example a commodity type product that has a very high contact like an extension cord for example, we're managing those areas very, very closely, but overall, we're very comfortable that the risk to the company is very minimal.

So to answer your question about through the year will we see overall macro decline, absolutely we don't see that at all.

Brent Rakers – Morgan Keegan

One other question and it relates to the guidance for the second quarter. It looks to me sort of backing through some of your guided numbers, it looks like your mid point revenue down about 17% I think sequentially and then SG&A down about 4.5% to 5% sequentially. Do you see that as the relationship giving us a sense of what your fixed and variable cost mix is meaning that somewhere in the neighborhood of variable costs being 25% to 30% of overall SG&A. Does that sound reasonable?

Charles Boehlke

I think more so what you're saying, I wouldn't draw any model conclusions out of it right away. Some of the cost reduction activities that I talked about in the script, some things are in place, some things that are in place and accelerating and some new things that we talked about that are going in there.

It's having an impact in the second quarter and will moving forward that's a little bit different perhaps than what it has in prior quarters. I wouldn't draw a conclusion about that. We've said publicly before that the margin in our variable cost is in the 10% to 12% range, something like that on incremental sales up and down.

We think in this environment, it's dangerous to think that way. Often the rate of change in the environment is a factor. When things fall off a cliff, even the ability to adjust some of the variable is different than if there is a precipitous decline and those types of things.

Other than the metric that at the margin variable within that 10% to 12% range, I'm not so sure I would use the guidance to draw a conclusion about variable and fixed mix.

Brent Rakers – Morgan Keegan

Is there anything at all in this first quarter SG&A that strikes you as somewhat either unusual on the positive or the negative side?

Charles Boehlke

No. If you're comparing it to prior quarters, the only thing I would mention is, and we talked a little bit about it already, we did increase our reserve for bad debt allowance a little bit relative to what you may have seen both last year and even in the fourth quarter, but that's not huge. It's somewhat of a factor but not big.

Operator

At this time I will now turn the call back over to management.

David Sandler

Thank you all for your interest today and participation and we look forward to speaking to you next quarter.

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Source: MSC Industrial Direct Co., Inc. Q1 2009 Earnings Call Transcript
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