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

F4Q09 Earnings Call

October 21, 2009 11:00 am ET

Executives

[Eric Borgenden – FD]

David Sandler – President, Chief Executive Officer

Eric Gershwin – Chief Operating Officer

Charles Boehlke – Executive Vice President, Chief Financial Officer

Analysts

Holden Lewis – BB&T Capital Markets

Adam Ulhman – Cleveland Research

John Inch – Merrill Lynch

Hamzah Mazari – Credit Suisse

John Baliotti – FTN Equity Capital Markets

[Sam Dawkis – Raymond James]

David Manthey – Robert W. Baird

Brent Rakers – Morgan Keegan

Operator

I would like to welcome everyone to the MSC Industrial Direct fourth quarter ’09 earnings call. (Operator Instructions) I’d now like to turn the conference over to [Mr. Eric Borgenden of FD.]

[Eric Borgenden]

Good morning everyone and welcome to the MSC Industrial Direct fiscal 2009 fourth 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 212-285-5600 and copy will be sent to you. A normal archive of this broadcast will be available one hour after the conclusion of the call and available for two weeks at www.mscdirect.com.

Certain information pertaining to non-GAAP financial measures may arise during this broadcast and can also be found in the earnings announcement which is posted on the same website on the investor relations section which you can find under that 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 tap About MSC on the 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 the next quarter, expected benefits from the company’s recently launched new enhancement, expectations regarding conversion of net income into operation 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 result 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 in the MD&A section 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 Directs President and Chief Executive Officer, David Sandler.

David Sandler

Good morning everyone and thanks for joining us today. With me are Eric Gershwin, Executive Vice President and COO, Chuck Boehlke, Executive Vice President and CFO, and [Shelley Bochter], VP of finance.

Before I get into the quarter, I’d like to introduce Eric Gershwin, our new Chief Operating Officer. In his new role, Eric will continue to report to me and will take on increased responsibility including overall responsibility for the company’s sales and operation. Eric is the grandson of our founder, Sid Jacobson and has had MSC in his blood his whole life.

He spent many summers working at MSC before joining the company in 1996 after completing his academic career. Eric’s 13 years with MSC have prepared him well to tackle the challenges that lie ahead. He has successfully led numerous projects and excelled in a succession of more challenging leadership roles. These include business development, branch integration, sales management, e-commerce, marketing and product management.

The last four years, Eric has also led our strategic team which has the responsibility for formulating the company’s strategic and steering its direction. Eric has a proven track record of success in all of these areas and most importantly, has demonstrated that he is a cultural leader of the company.

From the moment he joined us, he has demonstrated his commitment to the fulfillment of our mission statement of making MSC the best industrial distributor measured by all of our stakeholder.

I’ll now turn the mike over to Eric for a few words.

Eric Gershwin

Thank you David for the introduction and thank you for the wonderful support that you’ve provided to me over the years. I’d also like to thank our Board of Directors for entrusting me with these responsibilities. And finally, I’d like to thank the many people whom I’ve worked so closely with over the years here at MSC. My success has been the direct result of the team of people that I’ve been fortunate to be surrounded with.

I’m honored to accept the challenge that comes with this job and I remain to fulfilling MSC’s mission statement. It’s a great privilege for me to continue the legacy that was started by my grandfather, Sid Jacobson so many years ago. I look forward to ensuring continued success for all of our stakeholder.

Thank you. And now I’ll turn the microphone back to David.

David Sandler

While not the case for this call, Eric will be available to take questions on future calls after he transitions into his new role.

Included in the call today will be an overview of the industrial landscape in which we operate a review of the execution of our plans for the quarter followed by guidance for the first quarter. Chuck will follow with some details on the financial performance of our business.

Let me begin by providing an update on the competitive environment. The small distributors that comprise the bulk of the market are struggling to meet the needs of their customers. They have burned down their inventories to very, very low levels, significantly reduced their service levels and dissatisfied many customers.

A number of them have closed branches, laid of staff and have begun to take orders at very low margins to contribute to their overhead. This type of pricing environment has a negative impact on gross margins that bodes well for our future.

As revenues snap back, the small distributors will face increasing pressure on their balance sheet as they are called on to carry more receivables and inventories. This will inevitably lead to ever increasing service failures.

We in contrast, continue to gain share by executing our model, using our balance sheet as a weapon, having the inventory on hand, extending credit and providing value through our e-commerce tools, inventory management programs and our solution suite. Quite simple, we continue to further enhance our service while the local distributors are eroding their business models.

While it’s impossible to statistically measure, we remain convinced that we are gaining share in this market and believe we are beginning to see some of that share gain in Q4 results. We expect this to continue and accelerate through any recovery as customer’s demands on their suppliers generally increase as they order more items, demand faster delivery and larger credit lines and move toward just in time management of their own inventory. The small distributors often cannot meet those demands as they do not have the capital or liquidity to do so.

Customer’s order flows remain depressed although some of them have begun to experience small improvements. Overall, optimism continues to mount that the environment will soon improve. This optimism was more pronounced towards the end of the fourth quarter and carried over in the first quarter.

We’ve seen the ISM improve with two consecutive readings above 50 which if continues at historical patterns would indeed indicate growth for our business in the months to come.

Customer inventories of MRO products continue at rock bottom levels and customers are only ordering what they need to fill current orders. There is no evidence of any restocking. Customers are manufacturing to current orders and are not building their finished goods inventories.

We look at the eventual recovery as a huge opportunity for our company. We view this as an extraordinary time to gain share and we intend to take advantage of it. We’re taking a hands on approach to how we manage our investments. We have a track record of knowing how to adjust the dials and actively managing the right levels of investment spending to maintain what we think is the right balance between short term profitability and long term growth objectives.

In this environment we think it’s prudent to remain flexible and opportunistic in our approach and we’ll manage that mix based on what we see happening with revenues and gross margin. We’ll dial it up or down dependant upon our progress.

To give you some color, the middle of the guidance range contemplates approximately $125 million in OpEx. This doesn’t represent a significant increase in spending over Q4 levels, but does have increased levels of investment spending in it. Overall, OpEx as a percentage of revenues would be lower in Q1 than Q4 in the middle of the guidance range. We plan to provide that type of information quarterly.

This is an unusual time. The economy appeared to be at the beginning of a recovery from a deep recession with an abundance of opportunities for our company. We’ll take advantage of them, but in the context of protecting cash flow and earnings. We also have a responsibility to restore compensation and benefits for our associates which we will do in a measured way over time as part of that mix.

So until we get back to what we consider normal, we’re going to keep our hands tightly on the wheel and will provide quarterly guidance on our projected spending levels. There are just too many dynamics in play to provide any specifics beyond a quarterly time frame. Hopefully, this gives you a sense of our thinking on how we’ll manage it and I’m also comfortable telling you that nothing has changed in our model that in the longer term, once normalcy resumes, we are confident that earnings growth will outpace revenue growth.

There were 939 field sales associates at the end of Q4 and we expect this number to increase to between 945 and 950 I Q1. Given that visibility remains poor, Q1 guidance is based on current sales trends, and includes the cost of our investments in growth and productivity initiatives.

We expect that sales will be between $378 million and $398 million and fully diluted earnings per share to be between $0.46 and $0.50 per share. Thanks, and I’ll now turn the mike over to Chuck.

Charles Boehlke

Results for Q4 came in above the top of our guidance range in both sales and earnings. We did experience summer shut downs that were more widespread and longer than last year’s fourth quarter but not quite as bad as we had anticipated and had included in our guidance.

Sales trends improved during the summer as year over year rates of decline in sales narrowed every month. Additionally, average daily sales improved throughout the quarter and total sales in Q4 exceeded Q3’s levels. September results and October to date have continued to trend in the same direction.

Gross margin in Q4 was below guidance primarily as a result of the disposal of excess inventory. These adjustments reduced gross margin by 45 basis points in Q4 and are not expected to be repeated moving forward. We expect gross margin in Q1 to be 45.6%, plus or minus 20 basis points.

Operating expenses were slightly under expectations even at higher sales levels, reflecting our continuing efforts to improve our productivity and control spending. We expect that expense levels will grow in Q1 from Q4 levels, reflecting higher sales volumes, increased investment spending and some reversal of the cuts in associate compensation that we made last year.

As David mentioned, we expect these reversals to occur in a slow and measured way. The amount and timing is solely dependant on the strength and trajectory of the economic recovery.

Balance sheet management continued at high levels in Q4. Inventory turns were basically unchanged and DSO’s decreased slightly from Q3. Cash conversion remained high and free cash flow, which we defined as net cash flow provided by operating activities less capital expenditures exceeded $260 million for all of fiscal ’09.

When sales begin to trend upward we expect absolute receivable and inventory balances to grow again. Our goal is to increase inventory turns as we grow so as not to add back as much as we took out during the recession.

Additionally, we anticipate a capital expenditure range of $30 million to $35 million for FY10 as we carry out our investment program. We spent approximately $23 million on capital expenditures in FY09.

Thanks, and now I’ll turn it back over to David.

David Sandler

Just to clarify on the guidance for the revenue range, we expect sales to be between $378 million and $390 million, so just wanted to double back on that.

And again, I’d like to welcome Eric to his new leadership position and look forward to working closely with him and our leadership team in capitalizing on the unique opportunity presented to us by this unprecedented economy.

I’ll close by offering my thanks and appreciation to all of our associates. Our team executed at historically high levels during all of fiscal year ’09 and made excellent progress in accomplishing out strategic objective in spite of the challenging times that we faced and the sacrifices made throughout our organization.

Thanks, and I’ll now open the lines for questions.

Question-and-Answer Session

Operator

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

Holden Lewis – BB&T Capital Markets

I wanted to touch on some of the stuff in the supplemental information that you provide. Specifically, discuss a little bit more the decline in the customer base. You talked about gaining share but then we see continued significant declines in the customer base. Provide some color to that. And then secondly, if you could just talk about what that means coming out. One of your competitors has grown new account growth due to down turn and that would suggest they have more ammo once customers start ordering more. You in contrast are in a situation where there’s fewer customers ordering more. Does that limit your growth possibilities at all?

David Sandler

Let me talk a bit about what we’ve seen historically in our customer count and I guess as a reminder it really has been part of managing our growth investment, and really based on how we manage them, it’s been a proactive choice on our part.

Our team is constantly looking at where we can improve productivity with things like our direct marketing programs, so we reduce it or we adjust those dials based on how they’re meeting ROI thresholds. It’s an area that we continue to dig into by the way currently, so we’ve talked about our strategy.

The focus on acquiring those large customers with multi ship to locations and specifically trading those small one time buyers and really that’s how we’ve focused our programs accordingly. So the attrition that we’ve seen among these small customers have actually been the primary driver of the decline.

We’ve done more research that I’m able to share this quarter as our team has continued to dig in, and it shows that about 97% of those customers that actually purchased in ’08 that have since been lost or have not come, have an average size of about $500 annual spend in revenues, and the total loss from this entire pool of customers overall actually is what I consider to be not material.

So we also know that many of these customers are among businesses that are struggling in many ways to cope with the severe recession. They’re in the process of downsizing their inventories, conserving really every dollar they can. And we’ve had a lot of research in this area.

It also shows that while some have gone out of business although that’s not what I’d characterize as the primary driver. Many are still out there and when you speak to them, they still consider MSC to be one of their suppliers. We believe that coming out of this thing, which I guess is the second part of your question, they’re going to resume back into their buying patterns when business picks up.

I guess the overall of it is that based on all of our research, and the analytics underlying this issue is that we’re very comfortable that there’s no material effect on our current business and certainly only opportunity moving forward.

Holden Lewis – BB&T Capital Markets

Am I hearing that these guys are typically small, $500 per year and that they’re struggling so they’re not spending but they’ll come back and therefore your active customers will rise or am I hearing that they’re too expensive to serve and therefore you’ve kind of made a strategic decision largely to not serve them in favor of bigger. I guess I’m hearing both proactive and opportunity. I’m not sure which one it is.

David Sandler

I think it’s more that we proactively kind of dialed down where we focus our investments in order to get that type of customer and of course it’s not a perfect science, but to the extent that we don’t continue to attract that type of a customer that’s going to be small and it’s not going to grow, that’s kind of one way we refocused our investment programs and that’s something that we’re constantly doing.

And then I guess the other part of that is just in really folding into that customer base, we find that largely what has attrited are those that are small and that overall they’re not significant. They don’t contribute meaningfully to our revenues.

But because they consider themselves to still be customers that are just based on their pattern of cutbacks, trying to conserve their spending, we would expect, and we’ve heard from them that as they either hire or as business condition improve we would expect to see a lift from that specific segment as well.

Holden Lewis – BB&T Capital Markets

You’re not going to market to them? You’re kind of indifferent by if they want to come back because you’re a historic supplier, they’re welcome to place orders in a cost effective way, is sort of the mindset?

David Sandler

Absolutely, and the only thing I would say, I would not want to make an absolute statement that we’re not going to market them. I think that we definitely adjust our marketing dollars away from group, but to say we categorically cut them off is not the way I’d want to characterize it.

Holden Lewis – BB&T Capital Markets

By the same token on larger customers that have been sort of the focus do you have any statistics or anything that would lend to support to the idea that maybe you’ve actually penetrated them more deeply in the downturn so that when their ordering does come up, in fact there is more ammo there?

David Sandler

Yes. The focus of our program really has got to do with both penetrating our existing base of large customers as well as attracting both new ones and penetrating additional ship to locations which is another part of the metric that because of our ship to relationship, the bill to that we measure, which is only one customer, where a ship to may have many, many locations, is not the best metric to have you be able to gauge what our progress is there.

But we know that we’re penetrating solidly there. Of course we measure the absolute size and growth of where we’re putting our investments and we feel very confident in the traction that we’re gaining in that segment of our business.

Operator

Your next question comes from Adam Ulhman – Cleveland Research.

Adam Ulhman – Cleveland Research

A follow up to that last question, what would the ship to location trends be looking like right now? Are you actually positive on that metric?

David Sandler

It’s not positive. I will tell you that it’s gone down much less than the active customer base and that the ship to universe is significantly larger. It’s something that we measure internally. It isn’t something that we share externally.

Adam Ulhman – Cleveland Research

A question on the guidance, if I understand it correctly it was at the mid point of the range of $125 million of SG&A expense and a 45.6% gross margin. If I do the math correctly, it would seem like earnings would come in at the high end of your guidance range at the mid point of the sales range, so I’m wondering if there’s anything unusual happening with the tax rate or share count.

Charles Boehlke

No, I’m not sure what element of that wouldn’t hang for you to make total sense there. The implied operating margin, we’ve basically given you all the pieces is obviously 12.8%. I think if you run that through with tax rate, think about for planning purposes using 37.8% and run it through, we think you’d get pretty close to the mid point of the range.

Adam Ulhman – Cleveland Research

Can you help me understand the sequential uptick in SG&A expense a little bit better? I know you talked about it in the prepared remarks, but it’s about $8 million and I’m wondering how much of that would be a resumption of investment spending and how much of that would be kind of turning back on the temporary cost reductions.

Charles Boehlke

Let’s look at it sequentially over Q4 which is much better than going back to maybe a year ago. There’s roughly $7 million to $8 million of additional operating expenses. You can see that the mid point of our guidance for sales is a sound $30 million or so where we were in Q4. We’ve told you in the past that the margin, the variable to support something like that is in the neighborhood of 11%.

So you’ve got to factor that in. And then the remainder of it is as David said in the remarks a combination of investment spending and some element of the add back for some of the things that were taken away last year. That makes up the difference between the variable and the total of $8 million.

Adam Ulhman – Cleveland Research

Could you talk about what you’re seeing with your government counts and also in the quarter sales came in a little bit better, some customers didn’t have as long a production shut down days as you expected. What industries did you see that phenomenon occur?

David Sandler

We don’t like to be real specific about how we characterize or further break out even our large customer segments of which as you know is really comprised of two main pieces; the government segment of the business and our large national accounts. I can tell you that as you look across at what’s happening across the United States and you get a flavor of it in our regions, you see that durables continues to get pounded.

When you look at manufacturing versus non, of course the websites that show that manufacturing has improved slightly, but continues to experience severe declines. And then when you get under the manufacturing into durables, the declines are far steeper and I think that that’s evidenced by, especially when you look at the region and you look at the high concentration of the durables business in particular in the Midwest and in the Northeast.

Adam Ulhman – Cleveland Research

It would improvement that you saw in the Southeast be reflected in non durable manufacturing picking up a bit?

David Sandler

We see pockets of that across the country. I wouldn’t say it was anything disproportionate there. Remember, there’s a lot of segments which include the large customer segment that you see spread across the United States. We really don’t like to signal where we may be seeing some of those pockets in specific segments obviously for competitive reasons.

But I will tell you that’s part of how we manage our sales force, making sure that we’re disproportionally spending time on those pockets that we think are either growing more quickly or have the potential to grow more quickly.

Operator

Your next question comes from John Inch – Merrill Lynch.

John Inch – Merrill Lynch

I’m curious with respect to as the year unfolded here, did you experience a lack of volume rebates affected the mix in some manner and if so, just because volumes are down so you don’t get the customer rebates. When does that hit and what proportion impact would that have had on your financials?

Charles Boehlke

Absolutely during the course of the year, you can actually tell pretty significantly from our inventory reduction that obviously the implication is there’s a lot less purchases last year as we were able to take a pretty heavy duty chunk of inventory out there in the downturn.

Clearly that affected our rebates in our numbers partly towards that end of last year and some of that will continue into this year, fiscal year based on how the accounting works for that. That being said, we’re going back to our suppliers, those that understand that we’re taking share, willing to work with us, knowing that we’re going to come out the other side here.

We’re aggressively working to reset the bar on rebates, the clearly they were down last year and the trend would continue certainly into the first part of next year.

John Inch – Merrill Lynch

Did it hit you in any given quarter or was it sort of steady throughout the year?

Charles Boehlke

Based on how the economy works it was probably slightly more disproportionately in the fourth quarter, but it’s significant in terms of its importance, but there’s a million other things going on in gross margin, many of which had a much more significant impact than just the change in volume rebates from where we were a year ago.

So yes, it’s going to have some impact moving forward but that’s been factored into our guidance that we gave you for Q1.

John Inch – Merrill Lynch

Let me shift to revenue guidance. Your comparisons are about to become fairly easy. Are you assuming that your growth rate, say November/December begins to turn positive? What’s your current thinking with respect to the timing assuming that conditions to trend the way you’re seeing?

David Sandler

We share what the trend is on our website stats. You can also see that October to date, so you see sequential improvement in the quarter. October to date is a decline of about 12% and the decline at the mid point of our guidance is a little bit more than 11%. So based on everything that we’re seeing, we’re forecasting to that midpoint of the guidance that you’ll continue to see improvement throughout the quarter, and in fact, September and October we’ve continued to see that improvement.

And I guess just the math on the guidance would say that we’re expecting it to continue. Frankly beyond that, I really wouldn’t want to go beyond just one quarter just given the lack of visibility. Fortunately though to your point, as the year progresses, given what happened last year, comps absolutely do get easier.

John Inch – Merrill Lynch

Comps get easier actually in November. Wouldn’t that suggest that if it’s down to day at 12% for the quarter, if that’s the mid point of what you’re assuming; you’re being fairly conservative just based on the comparisons.

David Sandler

I wouldn’t want to characterize as conservative other than to the extent that we follow the same process as we always do, taking our very best look at the data and what we see ADS trends, etc., and doing our best to give you the guidance, low, medium and high what that mid point is. So it’s our best shot.

John Inch – Merrill Lynch

Your balance sheet net negative cash, historically you’ve done things like one time dividends and so forth. What is your current thinking as we come out of this downturn here? What is your current thinking with respect to capital deployment? How should we be thinking about the balance or mix between acquisitions, possibly some share repurchase, dividends and the like? And as a follow up to that, what are you spending more CapEx on? You’re going to $23 million to in the 30’s. What exactly are you spending that on?

David Sandler

Two parts to the question. In a minutes I’ll have Chuck give you a little bit more color on CapEx. But I guess that in itself is indicative of certainly how we’re going to use our war chest in the business.

I would say that we’re going to be very opportunistic. We have identified opportunities for example where we’re going to be increasing our CapEx which of course is a use of cash. I’d say that all of the things that we’ve historically done are there and available to us.

I characterize our thinking as opportunistic but also with a conservative bias to it. We don’t mind sitting on cash looking for the right opportunity. Our dividend program continues. Things like buy back three million shares continues to be authorized, so that’s out there.

And the other is, we have been considering taking a very hard look at acquisition opportunities and to the extent certainly that we find something that meets what I characterize as a high hurdle rate and something that longer term would be additive to our strategy and our plan, we’re absolutely not adverse to taking the plunge and moving down that path.

But we will be selective and we continue to spend time focusing on that area as well looking for the right opportunity given the success we’ve had with J&L.

Charles Boehlke

One comment on the cash, obviously as we start to come out of this thing and have accelerating revenue growth, there’s certainly investment and working capital to go back in. As we said, we’re going to work very hard to improve inventory turns and not add things back at the rate at which they came out.

But no question about it, from an absolute point of view, receivables and inventory hopefully will continue to go up as we trend out of this thing so some of the cash will go to that. It will remain very high on our conversion rates of net income and operating cash flow, but it will certainly at the rates of the past year when we were dropping inventory and receivables both coming down very quickly.

From a CapEx point of view for this year, some of the increases, we’ve talked a little bit in the past about what we call our warehouse optimization projects. We’ve finished two facilities now, both Harrisburg, Atlanta with very desirable results and we’re going to move forward with that situation and that program in a third facility this year. So we anticipate a fairly significant outlay of cash to finance that project which has a great return for us as we finish off our third facility.

Additionally we’ve talked about ramping up investment spending. I think it’s important to think of that both in terms of some additional OpEx as well as some additional CapEx. For example, one of the areas that we’re absolutely going after is to improve the overall customer experience with our website.

That will have ramifications from an operating expense point of view. We’ll also have some consequences in terms of how much CapEx we’re committing to that particular program. So I think it’s a combination of productivity and investment spending that leading the number a little bit higher than you’ve traditionally seen from us in the past.

John Inch – Merrill Lynch

Are you going to begin to invest in working capital in this coming quarter, or when does that begin to kick in?

Charles Boehlke

It looks like it will start in the first quarter. Again the average daily sales, you can see the rate has certainly improved from the levels we were at last year, so yes, there’s some little inventory build probably in the first quarter.

But if you project it out for the year, we just want to be conservative and let you know that certainly we’re not going to convert net income into operation cash flow with the rates when we were stripping out inventory on the way down. We just have plans not to add it back as quickly on the way back up.

Operator

Your next question comes from Hamzah Mazari – Credit Suisse.

Hamzah Mazari – Credit Suisse

You talked about month over month sequential improvement in your sales as you exited the quarter. Could you drill down a little bit and give us a sense of how the manufacturing business did, how the n non manufacturing business did, how MRO did and whether you saw any bigger improvement in any one of those business lines versus the other?

David Sandler

I think the way I’d like to characterize it is the same as we break it down into manufacturing and non manufacturing. What we actually saw is sequential improvement in both of those segments throughout the quarter and I will tell you that in both of those segments, both manufacturing and non manufacturing we’ve seen that continue in September and October and to date as well.

Hamzah Mazari – Credit Suisse

Could you frame for our your top line growth and cost structure as you see it coming out of this downturn and sort of a full blown economic recovery. Assuming GDP grows a certain amount, where do you see your top line growing at; two times GDP, two and a half times GDP, how should we think about that?

And then looking at your cost structure, you’ve taken out close to $175 million of cost total year on year. How much of that is permanent and how much of that will come back given volumes come back and using whatever assumptions on variable margins you want to use.

David Sandler

Very tough for us to give you any longer term guidance given I think no one could have ever predicted what was going to happen in this unprecedented economy and frankly I think there’s very 20 bright economists out there, 10 will talk about the B and others will talk about a W, will talk about why this thing is going to go back.

So we would rather frankly stick to our knitting, really look at this think quarter by quarter and continue to keep our hands tightly on the wheel. Suffice to say that we’ve got a long list of prioritized investment opportunities. We have a desire certainly to restore all of our compensation and benefits for our associates just as quickly as possible.

All of that is going to really be dependent upon the strength and trajectory of this economy. So we’re not going to hazard a guess. We’re going to stay very close to managing this business regardless of what’s thrown at us.

I think on the cost structure side as Chuck briefly spoke about, much of the cut backs that we made are temporary in nature; things like I said reducing costs and benefits, things like the work hours that were reduced for our associates.

As those continue to come back in, those were temporary in nature. What’s permanent in nature though is remember that we’ve got an ongoing productivity improvement program just like what Chuck laid out in some of the CapEx investments that we’ve made. Those have been historically and will continue to be permanent in our cost structure additive to our long term productivity and profitability.

Hamzah Mazari – Credit Suisse

Is there a way to quantify the productivity that’s permanent or is that impossible to do?

David Sandler

Actually for the programs that we invest into, we do significant ROI analysis, and then we monitor very closely to make sure that the program once executed was effective as what we had hoped. For example, in our warehouse optimization project, that is something that we have carefully measured. It’s an internal metric that we watch closely, but it isn’t something that we break out for the public to see.

Operator

Your next question comes from John Baliotti – FTN Equity Capital Markets.

John Baliotti – FTN Equity Capital Markets

It seems like the revenues came in better than the range you had given us and I understand that you called out the fact like you said in the last quarter that you were expecting some extended shut downs in the summer. You didn’t see it as much as you thought. The low that the margins, overall margins were better than I think many expected given the EPS results, it seemed like the mix was a little bit more toward the operating expense versus the gross margin. Can you talk about those things with the conjunction of revenue and maybe the gross margin was there? How did those things interact this quarter?

David Sandler

Revenues absolutely came in better. I think you really mentioned it was really a function of, we think the summer, I don’t want to give you the wrong impression. The summer was tough. Extended shut downs, reduction of work hours of our customers etc. Based on what has been happening from what we could tell, from what we heard from customers and just the environment on the last call, we had included what we thought would be a pretty significant effect of summer shut downs in our guidance.

I will tell you that that effect was very significant, but not quite as much as we had included in our estimates for guidance. We also think that given what we’re seeing, definitely starting to see some pockets of improvement although it’s probably more in terms of optimism and psychology which we think will definitely bode well for this thing coming out and hopefully the recovery gaining some legs and some traction.

We think that although we’re not able to point to a specific measurement that the progress that our team has made over the last year in really taking share, capitalizing on the weakness that we see from abroad, traditionally distribution base is really starting to pay off.

We’ve got a process internally that literally measures our wins and the hand to hand combat weekly and it’s a report that myself and others happen to see. And it’s one that really shows that we are really winning out there although the overall water levels of course are way down so it’s tough to show.

Gross margin as we had touched upon I think was pretty close to what we had expected when we first gave guidance with the exception of the excess inventory. And OpEx continued to be favorable just because of our solid cost controls. We did execute and continue to execute on our investment programs and we were able to begin to restore some of the add backs into our P&L.

And I think hopefully that gives you a bit more of a feel, of color into it.

John Baliotti – FTN Equity Capital Markets

You had mentioned earlier about gross margin there were a lot of other factors that went into it beside rebates and I wasn’t sure if you were referring to price as being part of that.

David Sandler

Definitely. If you think about gross margin, there’s just so many competing factors. You have head winds like we basically talked about earlier in the call, certainly what we see in the market place for discounting. To combat some of that, to add more value in a time like this, you’ve got headwinds that we face from our very effective promotional campaigns and of course the change in our customer mix because our core has been so hard hit.

That’s historically been our highest segment part of the business as well, so all of those are headwinds. We fortunately have made a lot of progress where we’ve been investing and where we continue to focus which really has a tendency to offset and where we increase margins is through things like our buy better programs, our overseas sourcing and our private brand initiatives as well as our support supplier program.

So all of those things contribute to fighting the headwinds and give us the results that we’ve gotten as well as for September we also had a small increase in our big book pricing. That also was factored into our gross margin guidance.

John Baliotti – FTN Equity Capital Markets

As we think about the first quarter I would expect that you were pretty cautious about summer shut downs and obviously as you go into the holidays you have traditional holiday shut downs. I’m not sure if you’re thinking those could be a little bit longer than traditional, but the gross margin, the range you’re giving us would imply that year over year you’ve got some more headwind in gross margin. Are you thinking like you have in the quarter that price would help you to combat or maybe stimulate some of the buying when you may have some seasonal; it might be a little quieter seasonally because of the holidays?

David Sandler

Two things; definitely what’s in our 45-6 plus or minus guidance includes the favorable effects of the big book pricing. Just to give you a little bit more color on the holidays; our team has actually done pretty extensive research at this point. Of course as it gets closer, it will be that much more meaningful, but we’ve not gotten any negative feedback, at least right now on what might happen for the holiday shutdowns.

Probably would have been the answer might have been different in people’s thoughts back in June. I will tell you our latest view of that is that we’re not seeing that we’re going to have any dramatic change to what might happen moving forward, but that is something that we’ll continue to watch and as we learn more and as we give you future guidance, we’ll certainly give you a better peek into that.

Operator

Your next question comes from [Sam Dawkis – Raymond James]

[Sam Dawkis – Raymond James]

Hopefully this puts the customer count like of question to bed. I know when you report that on a trailing 12 months basis, at what point do you anticipate the customer count on a year on year when you’re reporting your supplemental information to stabilize or to flatten out on a year on year?

David Sandler

I’d rather not give you any specific guidance. It isn’t something that we do within our customer count. We really do take it quarter by quarter. Part of that is because it would mean forecasting our attrition rate and part of that is that it would mean forecasting what we think is going to happen with our investment program, how much we’re going to be focused on circulation, how much we’re going to be focused on prospecting, and frankly that’s an area that we like to remain flexible and frankly turning the dials to the extent that we see more areas within that program that have a quicker payback and better returns on our investment we’ll ramp it up.

To the extent that those are pushed out as we’ve been seeing them, we may have a tendency to pull back even further as we manage our investments and we direct those dollars into what we consider to be more profitable place to go in the near term.

[Sam Dawkis – Raymond James]

The price increase that you just noted in September on the big book items, broadly speaking what was the percentage change in pricing?

David Sandler

It was about 1%. And just as a reminder, that compares to last year’s 3.5% to 4%.

[Sam Dawkis – Raymond James]

When I look at your average transaction count and the transaction count per customer, it doesn’t look like its declining as much as sales and maybe I’m over analyzing this, but it would appear to me that that might be a possibility that some of the more discretionary type of transactions might be coming in a little bit more or declining a little bit less which might be a bit of a leading indicator for things that are stabilizing or improving. So you look at transaction count in that fashion and is that a leading indicator in your experience?

David Sandler

You mean average order size and the line account associated with each order?

[Sam Dawkis – Raymond James]

Yes. As I think about it, more the MRO type or daily transactions would be the ones most easily discretionary and postponeable and so therefore by definition if your transaction count is doing better than your overall sales, I would think that that would serve as a leading indicator on the way back up much like it might have done on the way back down as I was looking at your history.

David Sandler

I think that’s reasonable. I think that this is the first quarter. I think it last three or four that we’ve actually see a slight pick up in our average order size. That was actually good to see and that might be indicative of certainly at a minimum stabilization and I think we would absolutely see it the same way.

Just as a point to point out on that, when you look at our average order size, and you break it down on what’s underneath, what actually drove that average order size, basically what we see is stability in our core; meaning it was about the same quarter over quarter. The fact that it hasn’t gone down we think is a good thing, and we did see an uptick in the size of our large customer segment orders, and that’s what drove that overall slight increase of average order size.

Operator

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

David Manthey – Robert W. Baird

Could you discuss the impact on gross margin from lower rebates and is it or is it not included in that 45 basis points that you called inventory disposal earlier?

Charles Boehlke

It’s definitely not in that 45 basis point. It’s a whole separate thing. As we said the rebates have been coming down in relation to, you can see our inventory reductions. So as I said earlier it’s factored into our guidance. It’s definitely not related to 45 points.

It’s one of the headwinds on gross margin. There’s stuff going both ways in margin. Rebates and smaller rebates are a piece that’s kind of headwind right now.

David Manthey – Robert W. Baird

Can you quantify it or no?

Charles Boehlke

No, we haven’t publicly quantified it.

David Manthey – Robert W. Baird

Could you discuss your key growth drivers next fiscal year and how they’ll roll out? Clearly you’re expecting some sort of volume recovery, a little bit of pricing. Could you talk about growth in sales people, SKU’s, mailing etc. that are going to be offensive moves rather than just waiting for the economy to come at you.

David Sandler

I think playing offense is a good way to describe it of course in the context of being mindful of that balance between short term profitability and how we invest in longer term growth. In terms of how we’re going to roll out, it really does come back to the strength and trajectory of the economy and we’re going to dial it up or dial it down depending on what we see happening there.

So I guess with that as the backdrop, we’ll continue to invest in our sales force. You’ll continue to see us part of that of course includes a focus on building our out west coast. Chuck had talked about our web experience and continuing to invest in that area, enhancing the quality, the speed, the shopping experience of our site.

And part of that is going to include investing in data management because that’s an important part for what makes for a great customer experience. We’re also going to continue to invest in technology to help improve productivity, specifically the productivity of our sales force is one area that we’ll be investing in.

Chuck had also talked about investing in productivity like our warehouse optimization program, things like that. I had also mentioned earlier that part of our investment focus will be continuing on global sourcing and our private brand initiative. We’ll continue to build that up, product offering, continuing to add selectively to keep brands that have strong brand equity out there as well as our own generics in particular, our own private label program.

So hopefully that gives you a kind of a sense. We have a large appetite and a long list of wonderful areas that we could consider to invest for growth and we’ve put that list together and we’re going to continue to seed all of the areas that I just described. The more that we get in the way of revenues or gross margin improvement, the more that we’ll be able to see components of that list.

David Manthey – Robert W. Baird

As you’re looking at the budget right now and as you see the world out there, should we expect the sales force growth, the number of sales people to increase by 13% to 15% again or is it something less than that?

David Sandler

I’d really rather just stay with quarterly guidance. Given the number of moving parts, I wouldn’t want to give you an absolute number there, in part because I can’t be certain what our investment program dollars might end up to be just based on what I described before. Or, that as we’re evaluating this, should we find an opportunity that’s even more compelling, we may re-direct some of our investment dollars there which might mean that the number that I give you on the sales force wouldn’t have been quite as large.

We could go the other way as well. And I didn’t mention before, direct mail. That’s another one that as we continue to mine and look for opportunity there, our team is constantly digging in and evaluating the return of investment there and what we see for payback versus others both in the short term and the long term.

It’s possible that we would look at that program, theoretically dial that down, and take some of those dollars and give them to our sales force. And of course it could go the other way as well. So it really does depend on what we continue to see as our best opportunities going forward in the context of how big the investment pool might be.

Operator

Your next question comes from Brent Rakers – Morgan Keegan.

Brent Rakers – Morgan Keegan

Do you have the numbers for the head count at the end of the year and then second, I think you usually break down three components of revenue into price, large customer and core. Would you mind providing that please?

David Sandler

We ended FY09 with a head count of 4193. Just as a reminder I guess we began the year at 4261. And the second questions was the composition of growth so let me give it to you in two ways.

It’s a bit more difficult to talk about it when it’s in decline mode. In the quarter, sales declined year over year around $94 million. Of that decline, $91 million of it came from basically our core overall volume. $6.6 million of it came from our large account base and $1.7 million came from exchange rates primarily related to the U.K., and finally positive offset came from pricing which offset some of the decline by $4.8 million.

So I guess if you want, I could also give it to your broken down of the minus 21%, I guess I’ll give it to you that way as well. 20% was attributable to our core to overall volume. 0.5% came from exchange rate. 1.5% came from our larger customer base and offsetting as a positive, about 1% came from pricing.

Brent Rakers – Morgan Keegan

In light of only getting what amounts to about a percentage point of positive price in the quarter after having announced a 3.5% to 4% price increase in the catalog last year, as you go into the months of September and October does that imply year over year declines on the price contribution?

David Sandler

I wouldn’t want to start breaking it out monthly. The one thing that needs to be factored in is that you would absolutely see declines in the normal course of the business if there weren’t so many other programs that were in place to fight those declines. So I’d rather stay within our guidance, let you know what we’re doing and continue to talk about the fact that we’ve got many programs that are margin enhancing programs to offset some of the headwinds that we face within our gross margin line.

Brent Rakers – Morgan Keegan

Back to the SG&A, I seem to recall three or four months ago you talked about $3 million for a sequential target, an increase in SG&A tied to investment spending. In light of the higher revenues coupled with that, I guess you came in $3 million to $4 million below that. Did you actually incur that $3 million investment spending and were there any year end true ups to speak of in the SG&A line?

Charles Boehlke

No year end true ups, normal process that we would always go through at year end which for us because of how we accrue and so forth there’s no major adjustment to top out in Q4 that would give you any reason that it’s different than other quarters.

Most of the investment spending sequentially from prior periods was around the headcount for the OSA’s. David elaborated a little bit more this morning on some other programs besides that that we’ll be considering investing in moving forward, but by and large given how we performed to the guidance we gave on the OSA’s, it’s relatively close to what we expected.

I’ve seen lots of offsets and lots of moving pieces but specifically, the investment piece is pretty close to what we had talked about in doing, and that was last year. We’re more focused on the OSA’s whereas next year it will be a combination of some other things that we’ve already talked a little bit about.

Brent Rakers – Morgan Keegan

On the comments on the gross margin about the disposal of excess inventory, I know you gave a number on that but I was hoping you could elaborate on what that really means and did that have revenue ramifications for the quarter?

Charles Boehlke

No revenue ramifications. Let me put a little more color on it for you. We always have a data process that identifies excess inventory and reserves. We reserve adequately in every quarter. Basically in Q4 with the slowdown in the economy, particularly in the Midwest, we had items that were multiple years of supply on hand and frankly the economics of disposing that inventory and truing up the space and so on, it make more sense to go ahead and write it off as opposed to try to sell it through our normal excess channels which could have taken a significant period of time and still occupied a lot of space and so forth.

So the economics from a tax perspective from a space perspective and everything else, it made sense to go ahead and do that and it was the bulk of it was inventory associated with where the markets have been hit the most, primarily in the Midwest.

Brent Rakers – Morgan Keegan

I think you’re now the fifth industrial distributor to report and honestly it looks like to me your revenues look quite a bit better on a sequential quarter basis than all of your peers. I just wondered if you could cast any more specific light whether and specific end markets, major competitors closing shop, major customer wins, auto sector exposure, anything that might help to explain that differential.

Charles Boehlke

You know we probably unfortunately went down further than most early on in the cycle given our exposure to manufacturing and durable goods. We got a couple of month here of ISM readings above 50. We obviously are doing a lot of things on the productivity front with our sales team and are actively involved in many projects to drive sales growth.

Just like on the down side, it was a tough time down. Maybe we’re getting the benefit of some recovery on the manufacturing side on the way up. Our sales mix as you know is very different than it is with some of our other competitors.

David Sandler

The only thing that I’d as is our focus in this market is against what is still the bulk of what we see which is that roughly 70% of the market is comprised of that small to mid sized traditional industrial distributor. Our motto is designed to help our customers, especially in an environment like this that as we spent the last year really continuing to enhance our value proposition and what we’re able to do to help our customers, get them through these difficult times with their inventories and really being able to rely on us.

Fortunately in that respect, we’ve been very successful we believe, and again we talk about the wins that we see literally captured on a constant basis. And remember that as this thing has dragged on and continues to drag on, the pain on that traditional distributor being able to maintain their business model we think has been weakened.

We think it’s been weakened substantially and continues as it drags on to make it more difficult to finance their receivables, continue to provide inventory that they have on hand and take care of their customers. That in itself has created lots of opportunities for us to come in where in a normal environment would be much more difficult for us to get in and take that business. We think that no question that’s also having an impact on the total mix of our performance.

Operator

Your next question comes from Adam Ulhman – Cleveland Research.

Adam Ulhman – Cleveland Research

A big picture question on the gross margin, we started the year at just about 47% and ended the year just below 45% and if I remember correctly before the J&L deal, MSC had gross margins of just over 47%. I’m just wondering in the future with no time frame attached to it, there’s a lot of pluses and minuses that have unfolded over the last couple of years. Do you think this is a company that can move back to that high water mark eventually or are we never returning to those levels of profitability?

David Sandler

I appreciate the way you asked the question not trying to put it in a box. I would answer it the same way that I would answer the operating margin question which is we think there’s opportunity for us to improve it over time. We think that’s true on the operating margin line.

Of course moving towards, in a methodical way we hope towards the kind of margins we had before, but we’ve got some ambitious plans on the gross margin line as well which over time is why you’ve seen us investing and even stepping up our investments in those programs that we think are going to add enormous value for our customers, really increase our competitive differentiator and advantage in the market place.

While adding all that value, we think also it will help us over time to increase our gross margin line as well. So over the long term, we don’t think we’re done there and we do see opportunity to continue to incrementally expand it.

Operator

Your next question comes from Holden Lewis – BB&T Capital Markets.

Holden Lewis – BB&T Capital Markets

In the past when there are incremental margins to discuss you’re always pretty good about talking about what those were. Looking at this quarter I think you outperformed at the top line in the operating margin line. When you think about much you’re over the top line, you dropped about half of that down, so a 50% incremental margin on incremental revenues on out performance. When you get to the point where revenues are growing again, and recognizing it’s not that unusual for you to do 35% to 55% incremental margins early in the cycle, can we expect that again or are the type of investments that you’re looking for for personnel and such greater than what you’ve done in past cycles and therefore you were not looking at 35% to 50% type increment margins early in the recovery?

Charles Boehlke

From where we are right now we don’t think the read through is a particularly valid metric given the comps, giving the environment we’ve been in the last two years. We’re not even looking at incremental read throughs on the metrics that we track really closely now.

The only way we could really answer that question is we believe the longer term we’ll return to normal. Clearly our earning growth should outpace our top line revenue growth. You mentioned some of the variables that would affect the read through. The gross margin change quarter to quarter would have an impact. How much we choose to invest moving forward would have an impact.

Again, I’m talking about return to normal levels here when the read through metric might become more relevant again, but I think the only thing we’re comfortable saying right now for use is we feel confident in saying that our earnings growth in any kind of scenario, when we return to normal, our earnings growth would exceed our revenue growth, and that’s about all we can say right now.

Holden Lewis – BB&T Capital Markets

Relative to past cycles, is your emergence out of this one looking a lot like the emergence out of past ones in that at what point in the past cycles you may have cut back on these staff adds and then early on you started ramping it back up. I’m just trying to get a sense of your exit from this cycle, does it look in any way shape or form different from exits from past cycles to you.

David Sandler

I think what’s different, which is why Chuck said and what we’ve talked about is really returning to normalcy, very important to really think about it that way. What’s different in this cycle, given the depth and given the unprecedented economy remember, is that we took certain actions which included compensation benefits, things that we cut back from our associate population which was a big sacrifice but done in order to take actions across and preserve our entire community.

In any event I think it’s important that it’s probably going to be, I don’t know how you characterize it in the cycle, but that’s very different from anything that we’ve ever experienced in the past. When Chuck talks about returning to normalcy, it really means that we think we’ve got a more predictable revenue growth stream as we’ve historically had other than in this very unusual time, that all of our benefits have been restored to what I’ll call normal levels across our associate population.

I think once the business gets back into what I’ll call that normal rhythm, I think we can then go back through our read through metric that I think will be very meaningful, and I think you could expect that we then begin to characterize what those numbers should be looking like when we look at earnings, leveraging the business and investment mix in the business.

Holden Lewis – BB&T Capital Markets

Obviously you haven’t cut pricing, but was there any activity, you made an allusion to marketing materials and initiatives and things like that. The price stayed stable but was there any bigger discounting or anything of that sort which might explain some of the stronger revenues or was discipline held as well on the discounting activities and the marketing activities.

David Sandler

Actually the team has done just a tremendous job in this environment of preserving, maintaining our gross margin. We’ve got our email effects campaigns, our promotional activity that we’ve consistently used throughout this downturn. We think it’s a really effective tool for us. Nothing changed in the quarter that would have explained the kind of thing that you’re digging for in revenues.

We think likely it more of a cumulative effect of our efforts throughout the year and that coupled with what we’re seeing in the environment in general.

Holden Lewis – BB&T Capital Markets

The 100 basis points of price in the big book, is that net of cost or is the cost you’re seeing somewhere in that ball park as well?

David Sandler

That’s what we would expect as the net incremental improvement from increase from the revenue.

Operator

There are no further questions at this time. I’d like to turn the call back over to management for any closing remarks.

David Sandler

Thank you all for joining us today. We appreciate all of your interest and we look forward to speaking to you again in future quarters.

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Source: MSC Industrial Direct Co., Inc. F4Q09 Earnings Call Transcript
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