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MSC Industrial Direct Co. (NYSE:MSM)

F2Q10 Earnings Call

April 7, 2010 11:00 am ET

Executives

Eric Boyriven – FD

David Sandler – President, Chief Executive Officer & Director

Charles A. Boehlke – Chief Financial Officer, Executive Vice President & Director

Erik Gershwind – Chief Operating Officer & Executive Vice President

Shelley Boxer – Vice President Finance and Accounting

Analysts

Analyst for Sam Darkatsh – Raymond James

Hamzah Mazari – Credit Suisse

Jeffery Germanotta – William Blair & Company, LLC.

Analyst for David Manthey – Robert W. Baird & Co., Inc.

Yvonne Varano – Jefferies & Co.

Brent Rakers – Morgan Keegan & Company, LLC.

Analyst John Inch – Bank of America Merrill Lynch

[Ryan Martel] – William Blair & Company, LLC.

Derek Jose – Longbow Research

Analyst for Adam Uhlman – Cleveland Research Company

Operator

At this time I would like to welcome everyone to the MSC Industrial Direct second quarter conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question and answer session. (Operator Instructions) I will now turn the call over to Eric Boyriven, of FD.

Eric Boyriven

Welcome to the MSC Industrial Direct fiscal 2010 second quarter conference call. An online archive of this broadcast will be available one hour after conclusion of the call and available for two weeks at www.MSCDirect.com in the investor relations section which you can find under the tab about MSC. Certain information pertaining to non-GAAP financial measures may arise during this broadcast and also can be found in the earnings announcement which is also posted in the investor relations section of our website.

In addition, during the presentation management will refer to financial and operating data included under the section operational statistics which you can also find in the investor relations section of our 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 US securities laws including guidance about expected future results, statements regarding expected revenue, margin and earnings growth, expectations regarding the company’s ability to capture market share and expected benefits from the company’s investment and strategic plans.

These forward-looking statements involve risks and uncertainties that could cause the actual results to differ materially from those anticipated by these statements. Information about these risks is noted in the earnings press release in the risk factors and MD&A sections of the company’s latest annual report on Form 10K filed with the SEC as well as in the company’s other SEC filings.

These forward-looking statements are based on the company’s current expectations and the company assumes no obligation to update these statements. Investors are cautioned not to place undue reliance on these forward-looking statements. I would now like to introduce MSC Industrial Direct’s President and Chief Executive Officer David Sandler.

David Sandler

With me are Erik Gershwind, Executive Vice President and COO; Chuck Boehlke, Executive VP and CFO; and Shelley Boxer, Vice President of Finance. Today I’ll cover our strategic view of the company. Erik will provide an update on the landscape and competitive environment as well as the execution of our model and Chuck will give some detail on Q2 performance and our Q3 guidance.

I’d like to begin this call by updating what we’ve talked about throughout this recession and what I said just three months ago. During the last 18 months, we’ve lived through the most challenging economic climate of my 35 year career in industrial distribution. We were faced with an unprecedented decline in confidence which translated in to a breathtaking reduction in revenues. This was an environment which caused every company to rethink the way that they manage their business and did cause many of our competitors to react.

As we have done throughout our almost 70 year history, we met the challenge head on in a way that was consistent with our core values and with a focus on the long term opportunities that dislocation would inevitably create. We did so in a way that was consistent with our unique culture and our mission statement. This compass has served us well through historic downturns and has done so once again. As a result, we emerged from this downturn with the best group of committed associates in our industry and are positioned to win and win big.

Just to remind you, while we protected our associate population through reduction in our hours in our volume sensitive areas instead of implementing layoffs, we also protected our owners and balance sheet by suspending raises and incentive compensation and generally shared the burden throughout the company. During Q3 almost all of those hours have been restored and we have also taken steps to restore a significant amount of compensation and benefits. We expect this restoration to continue because as you will see from Q3 guidance, we are experiencing rapid top line growth.

However, unlike many of our competitors, we are not scrambling to service customers as we grow. We have the financial, physical and human assets in place to be proactive rather than reactive. While competitors cut back on inventory, inside and outside sales staff and facilities, we kept our work force intact, increased our service levels through extended order cut off times, expanded our next day reach to the entire company, enhanced our fill rates and often helped in the form of increased credit lines and longer payment terms where possible. We also aggressively signed new business.

On our last call we branded the next couple of years for MSC as the greatest land grab opportunity in the history of our industry. Make no mistake about it, we will be one of the most opportunistic during this once in a life time period. The share gain opportunities are even more compelling now than during the recession because we expect that as the economy recovers, the smaller competitors who have already been severely impacted will struggle even more to satisfy customer needs.

We believe that weak balance sheets will crumble and service levels will deteriorate further as customer demands increase. Just as we did in the downturn, we will build upon our success in taking share through the upturn in the economic cycle taking advantage of our proven track record of turning our human capital, our investments, our balance sheet and our ability to execute our business model in to significant long term earnings growth for the benefit of our associates, customers, owners and suppliers. We believe there has never been a more exciting time in MSC’s history.

I’d like to take a moment to outline our thinking on operating margin expansion and the relationship between revenue and earnings growth and our investment program. Operating margin expansion is a function of three main elements: revenue; trajectory; pricing power; and our growth investment plan. The timing of these elements won’t necessarily move in lock step and we exert the most control of course, over the pace of growth investments. In that regard, we’ve chosen to take advantage of the period when we viewed opportunities to be at a historic high by increasing our investment rate even though pricing power was at a historic low.

Our goal has been and remains achieving double digit revenue growth and earnings growth that outpaces revenues. As revenue growth accelerates, earnings growth accelerates at disproportionate rates. You can see this by comparing our Q2 results to our Q3 guidance. We would describe Q2 as moderate revenue growth with earnings growth that outpaces revenues but not by a lot. We would describe Q3 guidance as accelerated revenue growth with rapidly accelerated earnings growth.

This happens because our investment program is targeted to access dollar amount not a percentage of sales. As a result, the additional revenue growth is highly leverageable. Should we see an inflationary environment leading to gross margin expansion, we should expect even more leverage. All of this is why we see our story as so exciting.

With that said, I’d like to provide some guidance for the third fiscal quarter. We expect sales in Q3 to be between $436 and $448 million and fully diluted earnings per share to be between $0.63 per share and $0.67 per share. Thanks and I’ll now turn it over to Erik to review the landscape and our execution.

Erik Gershwind

I’ll start with what we’re seeing in our customer landscape. Consistent with the rising ISM, there’s a lot more stabilization. Layoffs have greatly diminished and there are now pockets of hiring. Many companies are restoring work hours that were previously removed. We’re seeing an increase in the number of customers who are experiencing real growth. To be clear, this is the most optimistic that we’ve been since the downturn began. We believe that the revenue momentum is real and sustainable as there is little in the way of inventory restocking to date.

In fact, while we see signs of spotty inventory replenishment in our large customer segment, inventories in our core customers remain at rock bottom levels. We do continue to see extensive price competition as smaller local competitors play one of the only cards they have left. While the landscape has improved over the last three months, the recovery is not yet robust. MSC however, is growing at an increasing pace.

Q2 sales growth was 12.4%, March grew at roughly 22% and Q3 sales growth at the middle of our guidance range is expected to be approximately 24% based on average daily sales. The payoff from our investment programs is showing in our results as sales momentum builds. We consider this to be strong evidence of share gains as the upturn in the manufacturing environment is just beginning to gain traction.

Turning to the execution of our model, we continue to perform at all time highs and to deliver an outstanding service experience for our customers. All of our service metrics remain strong during Q2. Our high inventory fill rates are especially critical in differentiating MSC during an economic upturn. Customers are running lean and they depend on their distributor for off the shelf availability. The service disruptions that are occurring daily with traditional local distributors result in share gains for MSC.

We’re also executing on our investment programs. We continue to adjust our spending by focusing on those that provide the greatest returns and yield the strongest gains for the future. I’ll touch on several of these programs without going in to greater detail for competitive reasons. First, direct mail, this program remains at reduced mailing levels yielding greater productivity. In fact, we’ve increased the efficiency of this program by over 50% against prior year. Our efforts through electronic channels continue to be highly effective, allowing us to accomplish these gains while maintaining our total number of customer touches.

Second, eCommerce, we have a vibrant eCommerce program which has been very successful in both generating sales growth and improving productivity. We’re investing in our eCom infrastructure in order to better service customers and to significantly reduce channel costs over time.

Third, our large account program; we’re building brand and we’re benefiting from the momentum that we built during the downturn. 86% of our growth came from this program in Q2 which demonstrates the success that we’re experiencing.

Fourth, buy side investments. Expansion of our Asian sourcing and our private branding initiatives remains an important part of our gross margin story for the future. These investments coupled with an improved product management approach are delivering excellent values for our customers and beginning to yield improved margins. They are also producing share gains for our supplier partners.

Fifth, productivity; investments in our operations continue to gain traction as we roll our program across our fulfillment centers. Our team’s work is enhancing customer service and improving operational efficiency. The productivity gains that we’re seeing today will be magnified as volume grows and passes historic highs providing further fuel to incremental profit margins.

Sixth, sales force investment; we continue to add some of the best and brightest in our industry to our sales team. In Q2 our sales force grew to 949 associates and we’ve raised our target for the end of fiscal 2010 to a range of 965 to 975 associates. This increase in hiring reflects our increased sales growth and our increased capacity to take advantage of the opportunities that are beginning to appear in the marketplace.

I’ll now turn things over to Chuck who will share the specific of our financial performance.

Charles A. Boehlke

Sales for Q2 came in near the top of the range even though we were adversely affected by some terrible weather in February. Gross margin was at the high end of our range. Operating expenses remained under control and were as expected for the quarter, yielding an operating margin of 12.6%. Earnings per share of $0.48 were $0.01 over our guidance primarily reflecting gross margins and revenues at the top end of our guidance range.

Sales guidance for Q3 at the midpoint is approximately $442 million which represents growth over last year’s third quarter of approximately 24% on an average daily sales basis. There is one more business day in Q3 this year than last year and consequently there will be one less business day in Q4. Gross margins is expected to be approximately 45.5% plus or minus 20 basis points in Q3.

We were able to sustain a modest price increase in the last week of Q2 to offset the effect of cost increases that we have taken over the past several months. Without this price increase, gross margin guidance in Q3 would have declined modestly from Q2 levels. Pressure from price competition continues and we are still being negatively affected by the changes in sales and product mix and from large orders as well.

The good news is that our industrial business is growing again and continued growth will result in higher margins as the effect of increased sales of metal working supplies is reflected in our numbers. Operating expenses will increase sequentially in Q3 primarily reflecting volume increases from Q2. The leverage that’s inherent in our business model will begin to be seen in the results as operating margin at the middle of the guidance range will increase to approximately 14.9%.

Balance sheet metrics remain solid. Inventory turns increased to 3.2 in Q2 and should continue to improve even as we add inventory to support our growth. DSOs improved to approximately 41 days and cash generation in Q2 is very good converting approximately 90% of net income in to cash from operating activities. Now, I’ll turn it back to David.

David Sandler

The moves we made during the downturn has come from our time tested and proven playbook that we’ve used through many cycles, are delivering the market share gains and financial performance we expected. As we now move through the upturn we will once again follow the play book that has served us so well in the past. We will continue to invest in order to capitalize on the share gain and market opportunities afforded to us by the greatest dislocation we’ve ever seen in all our years in distribution.

We have tremendous confidence that executing that model will result in substantial value being created for all of our stakeholders over the long term. For that, I want to thank all of our associates for their efforts and dedication towards this vision. I’ll now open the lines for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Analyst for Sam Darkatsh – Raymond James.

Analyst for Sam Darkatsh – Raymond James

First of all I was wondering was there any way you can quantify the impact of the snow we saw in February? I know you said it negatively impacted the business but are we talking a couple of hundred basis points or is it something more than that?

Erik Gershwind

We did take a shot at estimating the impact of the snow storms particularly in February, roughly a range of $3 to $5 million overall. I will tell you that as we saw the weather, a heavy impact on the northeast in particular and if you look at our regional numbers you can see that reflected in growth rates. But, $3 to $5 million overall.

Analyst for Sam Darkatsh – Raymond James

My other questions is around the operating expenses leverage. Thanks for all the commentary there, that’s real helpful. I know you’ve talked in the past about an incremental $0.11 operating expenses for every $1 in sales and I think that’s what is inherent in the Q3 guidance but my question is beyond Q3 is that still the kind of range we should be looking at? When you talk about incremental investments do you think it’s something above and beyond that $0.11 or is that still the longer term range?

David Sandler

I think rather than commenting on a specific number, I think it’s probably good to step back and kind of reaffirm as we have that our goal is to continue to grow revenues at double digits and earnings certainly at a faster pace. That’s going to have the natural effect of expanding our operating margins over time. The issue of how quickly they expand, as I mentioned, really depends on the revenue trajectory, what the pricing environment looks like and of course our level of investment spending.

I think important to note, I referenced it in my prepared comments, that we target a set dollar amount of our investments which really won’t be variable with sales. So that means that once revenue levels have covered the impact of our investment spending, the read throughs on those incremental sales dollars are going to be very high. In fact, at that point you’d expect to see all of the incremental gross margin dollars reading through to the bottom line less the variable of course that’s required to service that extra volume.

I think what you’ve going to see as we move forward is that read throughs will accelerate rapidly as the growth increases which is why you see such a dramatic difference between looking at EPS growth in Q2 versus what we expect to happen in our Q3 guidance. There’s another big wild card to this which of course is gross margin. We’d expect that as we see our capacity utilization levels beginning to get back to normal that pricing should firm and in fact, the likelihood is that inflation will return to the environment as well.

As that happens we’d expect to see significant gross margin expansion and of course read throughs and the leverage that we get is that much more pronounced in that environment. So as this recovery gains traction, a combination of high growth and a high gross trajectory and expanding gross margins, we’re confident would produce powerful read through results.

Operator

Your next question comes from Hamzah Mazari – Credit Suisse.

Hamzah Mazari – Credit Suisse

Just a couple of questions, could you maybe touch on your inventory levels right now and then what we should expect there going forward given that our demand environment has picked up? Do you still expect working capital to be a source of cash as we look out over the next 12 months?

Charles A. Boehlke

The inventory as you’ve seen in our past results are down substantial from where it was a year ago. We’re right now in the $243 million range, this time a year ago we were at the $289 million range and frankly Q2 ended just about where we were in Q1. So, you haven’t seen any real significant change since the beginning of the year although we’re down dramatically from last year.

We think from here forward, that we are going to be adding back to inventory and certainly some of our cash flow is going to be required to finance that. That being said, as I mentioned in some of my prepared comments, we expect the inventory turns to improve even though we’ll be adding back inventory dollars to support our high service level and our sales growth. Yes, we believe we can still generate cash but we clearly in the short to intermediary term as we get down the curve of this growth spurt are going to be redeploying a fair amount of that cash back in working capital. But, on balance, yes we still expect to be cash positive.

Hamzah Mazari – Credit Suisse

On pricing competition, you mentioned that in your comments, is that mostly coming from smaller private guys? Are you seeing that across your portfolio? Any color you can add there?

Erik Gershwind

I think yes, you’re right. You heard from our comments that we [inaudible] small local competitors. Despite the economic upturn, we’re still absolutely seeing price competition as David talked about in his comments from many of the small competitors. It’s actually as difficult or more difficult for them on the way back up because of the working capital strains so there are some desperate actions going on playing one of the cards they have left. So to answer your question yes, mostly from locals.

Hamzah Mazari – Credit Suisse

Just the last question, if you could maybe give us detail on how your top line trended sequentially as you exited the quarter month-over-month on the manufacturing and non-manufacturing side if you could?

David Sandler

Manufacturing versus non-manufacturing, so we post what happens with the quarter just to give you a little bit of additional color. We actually don’t break it out by month but we would tell you that we saw the momentum building in both of those segments sequentially throughout the quarter.

Operator

Your next question comes from Jeffery Germanotta – William Blair & Company, LLC.

Jeffery Germanotta – William Blair & Company, LLC.

The sales force increase is that largely trying to pick up established sales people will existing books of business or is this developing younger people?

Erik Gershwind

As you know, expanding our sales force has been one of our primary investment areas for a while. What you see in the increase is a combination of us being encouraged by what we’re seeing on our top line numbers and also being able to be opportunistic to really capitalize on hiring people that we otherwise couldn’t have gotten in a normal environment. So I tell you it tends to be a blend of what you described and again, the uptick in the number is reflective in the opportunity we see.

Jeffery Germanotta – William Blair & Company, LLC.

With demand ticking up, I would hope capacity pressures are abating somewhat. Are you seeing any improvement in the selling price inflation environment and if so can you quantify that?

Erik Gershwind

In terms of the pricing environment that we’re seeing I would describe it as stable with signs that pricing is beginning to creep in to the market. We haven’t seen a whole lot of movement, we’ve seen a little bit of movement and as you know that is a good sign for us. We’re encouraged by the initial signs of what we’re seeing and if it continues it tends to bode well for us over time in terms of margin expansion in an inflationary environment.

Jeffery Germanotta – William Blair & Company, LLC.

As we look forward, while you’ll be investing in working capital and growth initiatives what is the likelihood of some stock repurchase activity or an opportunistic acquisition?

Charles A. Boehlke

I think the key there is that with our cash generation and frankly our ability to even borrow more, we’re very opportunistic. We’ve got the flexibility to do just about anything we want right now with the cash whether that’s buy back, acquisitions or some other use. I think the key point is we’re open to it and the flexibility is there to do what we might want to do and opportunistically take advantage of situations as they come up.

David Sandler

I think as we’ve kind of moved through this we obviously wanted to be very protective and defensive of our cash very early on. We’ve obviously moved through that phase. I think that phase then led to where we are today which is the ability to really capitalize on any opportunity that we would see out there. We are actively looking. I think it’s also given us a window in to making sure that we have good visibility in to our working capital needs. I think we’re beginning to see that as well. We’re really confident with the balance sheet strength that we’re going to have is going to lead to a lot of great opportunities for us moving forward.

Jeffery Germanotta – William Blair & Company, LLC.

My last question, based on what we saw in the fiscal second quarter and the guidance for the fiscal third quarter, it would look like we should be seeing minimum read through our incremental operating margins of 25% plus. Am I out of line thinking that?

Charles A. Boehlke

I just want to make sure I understand the question right. Looking from Q2 to Q3, and we talked about this earlier, you have fairly rapid revenue acceleration. On an ADS basis, Q3 is actually 8.5% higher than Q2 in terms of revenue acceleration there. So as David had mentioned, when you get that quick acceleration you have an opportunity for margins to firm and pricing and you can see our gross margin guidance a little bit higher than Q2. You start to get read through beyond the investment spending that we have layered in. The read through calculation sequentially from Q3 to Q2 is in the 34% range.

We still don’t think it’s valid compared to prior years given this is a transition year. Last year had some compensation and benefit type things coming out, this year they’re going back in but as David mentioned, once you get past covering the investment spending here you’re basically seeing all the incremental sales minus the gross margin less the variable expense dropping right through and it’s plus or minus in that 34% range over Q2 sequentially.

Jeffery Germanotta – William Blair & Company, LLC.

But you won’t be operating at 34% for several quarters to come?

Charles A. Boehlke

You’re talking about the absolute operating margin?

Jeffery Germanotta – William Blair & Company, LLC.

The incremental.

David Sandler

You mean the read throughs?

Jeffery Germanotta – William Blair & Company, LLC.

Yeah the read throughs.

David Sandler

I think we’d rather stay away from a specific number. It’s important to remember as we talked about, it’s a transition year. We’ve got the issue of our ad backs. Yes, we have been investing. All those things we think we need to kind of settle out. I think the important point here is that as revenues come in faster than let’s say the threshold of the revenue levels that cover the impact of our investment spending, it’s at that point that you can expect to see the gross margin dollars from the revenues incremental to that to be flowing pretty much to the bottom line with the exception of the variable to service it.

The other thing going on is as you know from history, as the revenue trajectory is high, we’re not even able to staff up fast enough and that helps us to improve and really have pretty dramatic read throughs during those periods as well. As the revenues come in fast you can’t even staff the variable and you see real expansion in productivity during those periods. The other thing that of course is very helpful to us right now is that we’re getting the benefit of being able to leverage a fully trained work force since we didn’t have to staff incrementally to service the volume because of the hours that we restored by keeping our entire associate population in place. That was a huge benefit and that was a huge win for everyone.

Operator

Your next question comes from Analyst for David Manthey – Robert W. Baird & Co., Inc.

Analyst for David Manthey – Robert W. Baird & Co., Inc.

Looking at the growth in national accounts, when thinking about these customers, what was really driving that growth? Was that signing up new national accounts, higher demand from existing customers, or some level of restock?

Erik Gershwind

I think it’s a little bit of everything you described. Overall, I’d tell you and you heard me characterize the customer environment, in general what we’re seeing is stabilization and some improvement. In our large account segment we did see some pockets of restocking although I would tell you that it wasn’t wide spread and pervasive. The growth that we’re experiencing I think it’s more a function of two things, an actual pick up in customer demand and quite frankly some of the share gains from the investment programs and the investments that we made are paying off in the form of higher than market growth.

Analyst for David Manthey – Robert W. Baird & Co., Inc.

Erik, you talked about some of your investment areas in the prepared remarks, are there any large additional growth programs planned as we go forward beyond where we are today and is there any immediate plans to begin again expanding your branch network?

David Sandler

I’m going to jump in, Erik had described many of the initiatives that we’re working on today. It’s probably helpful to kind of step back a little bit and we’re just now going in to our strategic planning process the back half of the year, that’s going to lead to our FY ’11 plans. We think that we’re executing upon some great programs right now and there’s always new things in the hopper but we think it’s better to get in to process, go through our strategic planning and we’ll communicate more late in this year or the beginning of next fiscal with where the programs are going to be headed moving forward.

Operator

Your next question comes from Yvonne Varano – Jefferies & Co.

Yvonne Varano – Jefferies & Co.

As you start to build out national accounts, have you started to see your other two large publically traded competitors more so than you have in the past or is it still mostly taking share from the smaller guys?

Erik Gershwind

I think it’s a combination of both and I would say there’s not been any major change in trend over the past year or so. We’ve always when we go in to national accounts, we compete with a combination of the large nationals that you described and also with locals and I would say that it the case.

David Sandler

I’m going to jump in a bit as well, what’s interesting about kind of what’s been happening in the landscape which is why it’s so difficult for the locals and why frankly those with the national platform have such an advantage is that even when a local is doing a great job servicing a facility when the mother ship comes in, headquarters, and says, “You know what we want to consolidate our spend. We want to go on an ePro platform or whatever.” The locals, even when they’re successful in a plant, they’re often going to get displaced because they’re not able to provide that national scale, they’re not able to provide what a national account these days are looking for.

That’s been a trend that if anything has been gaining steam now for a period of years, especially in this environment it’s that much more pervasive and many of these national account customers have more and more control over their spend which means that when we get awarded, or any of our national gets awarded frankly we displace many of the locals that are in that local plant. That’s been one of the kind of prevalent landscape shifts that has really boded well for our model and one of the reasons we’re so excited about what we see moving forward.

Yvonne Varano – Jefferies & Co.

I know that the government is part of your business, has anything started to filter through that you might have considered as being from the stimulus?

David Sandler

We’ve seen very little, if anything, from stimulus so the short answer would be no.

Yvonne Varano – Jefferies & Co.

I know international was up a big number off of a real small base but any more commentary about what’s going on there in regards to growth plans for that business?

David Sandler

I guess the additional commentary that I can give you is yes, you are right, when you look at our regions and you look at other, that’s primarily the UK. They’ve been doing a really good job growing organically at roughly 19%. The difference in that number for the most part is favorable currency, right now we’re getting the benefit of that. We are investing in that business. There’s a solid platform there, an excellent team with solid leadership so we’ve begun to take advantage of what we consider to be a solid market opportunity given how fragmented that market is and how much it looks in some ways to some of the characteristics in the US market so we’ve begun to make some moderate investments there and we’ll continue to do so although we don’t have plans beyond that at this point.

Yvonne Varano – Jefferies & Co.

Does growing that business through an acquisition make sense?

David Sandler

I wouldn’t take the option off the table certainly but at the same time the US has an awful lot of run way and I guess while it’s possible it would be more likely that we’d look domestically first.

Operator

Your next question comes from Brent Rakers – Morgan Keegan & Company, LLC.

Brent Rakers – Morgan Keegan & Company, LLC.

Several questions, first just a follow up on the weather impact in February, is all of that permanently lost business or would any of that push in to and possibly help maybe artificially inflate the March numbers?

Erik Gershwind

In general when we see weather impact there’s a little bit of both that goes on. There’s some business that we just don’t get back, there’s some that gets pushed forward. When we gave you the range though of the $3 to $5 million lost that was our best estimate of what we actually think the true impact was of dollars lost.

Brent Rakers – Morgan Keegan & Company, LLC.

I know you guys don’t typically talk a lot about regionals on a monthly basis but when you look in to what happened in the Northeastern region in March and early part of April, does that tell you anything about recovery or not there?

Erik Gershwind

Recovery specifically regarding weather you mean?

Brent Rakers – Morgan Keegan & Company, LLC.

Yes, regarding the weather.

Erik Gershwind

In general when we look at the northeast Brent, and in terms of march we’re not going to break out the March numbers but looking back through Q2 I think really what’s going on in the northeast is a couple of things. Weather’s a piece of the story, the other story going on in the Northeast is a high concentration of our core customer base which you can see from the numbers just started to turn in Q2. We actually view that as an encouraging sign moving forward for all the regions quite frankly, northeast in particular to see the core business start to lift.

Brent Rakers – Morgan Keegan & Company, LLC.

Obviously you guys have talked a lot about the share gain that’s been going on recently and I guess go forward but maybe if you could talk about specific to the manufacturing customer category, I don’t know if you get any insights from your vendors or such but when you look at industrial production roughly flattish maybe plus one year-over-year and your manufacturing customer growing at about 12, certainly a large portion of that is the share gain but maybe if you could give us a sense of what you think the market is growing at, let’s say for even a core metal working customer over that time, that would be helpful.

Erik Gershwind

Very tough for us to say. When we look at market share metrics and the way we measure share, in a market that’s this big and this fragmented, we don’t think there’s any one metric you can look at that is the answer so what we do is we triangulate. We have several measures that we look at so we’ll compare our performance by segment against macro indicators, kind of like the ones you mentioned, we’ll compare them against competitor and supplier benchmarks by segment and then we also have a pretty good field intelligence process from the bottom up where we’ll look at share gains, wins and losses by accounts.

What we do is we triangulate all those. So to answer your question, I don’t think there’s any one metric that we’re going to look at and give us the answer but we take all those and put them together in one story.

Brent Rakers – Morgan Keegan & Company, LLC.

Then just final question, just to clarify there was mention of a small price increase at the end of the second quarter, I’m assuming less than a percentage point. And then I guess also, a second question related to that is on a year-over-year basis, I’m assuming price increase contributed modestly positive year-over-year because you kind of had some pressure on pricing over the course of last year, is that correct?

Erik Gershwind

Let me start with your first one, we don’t break out price increases other than the annual big book price increase that we do. As you mentioned, it was at the end of the second quarter and the increase was in response to some cost pressure, some competitive moves that we saw and it is factored in to the guidance that Chuck gave for Q3. You asked another question, I’m sorry?

Brent Rakers – Morgan Keegan & Company, LLC.

The second question was you guys usually break out how much price contributed in the quarter and I guess as price competition kind of went in to effect through the course of last year I assume pricing was probably a modest positive for the quarter.

Erik Gershwind

Here are the numbers Brent, total growth for the quarter was 12.4%. Of that 10.6% came from our large account segment, 2.3% from the core and actually a -.5% from pricing. So Brent, if that was your question, just a reminder the way we calculate that number is it’s the price increases that we’ve taken net of the accumulative effect of discounting. So to answer your question, that’s still a negative.

David Sandler

I think we also put it in the data sheets next quarter.

Operator

Your next question comes from Analyst for John Inch – Bank of America Merrill Lynch.

Analyst John Inch – Bank of America Merrill Lynch

I want to ask you about volume rebates. You mentioned you’re seeing some inflationary cost pressures so maybe you’re not seeing any rebates coming back in right now but when should we expect that to start pulling in and help your gross margin?

Charles A. Boehlke

You won’t see real evidence of that probably until you get in to our fiscal ’11 numbers. Rebates are done on a calendar year purchasing situation rather than our fiscal year. You heard what we said about inventory levels, they are virtually flat, really for all of this year to where we kind of ended the year at the end of the year. Yes, we intend to increase our inventories to support our growth here but by the time that translates through annual purchases on a calendar year basis it will really be 2011 before you can expect any type of uptick in gross margin from that.

Analyst John Inch – Bank of America Merrill Lynch

Then on hiring, it looks like the associate hiring process has slowed versus previous quarter. Is it more of a timing issue or are you seeing more competition out there from other distributors?

David Sandler

No, we see a lot of opportunities out there which is why you can see one reason certainly that we’ve raised our kind of guidance for how our sales force will finish through the year so it’s purely related to timing.

Operator

Your next question comes from [Ryan Martel] – William Blair & Company, LLC.

[Ryan Martel] – William Blair & Company, LLC.

Two questions for me, number one, what’s in your guidance for investment spending in the fiscal third quarter? And, does investment spending peak then in the fiscal third quarter?

Charles A. Boehlke

We’re not going to disclose what we’ve put in each quarter for investment spending. There’s more in Q3 than in Q2 but as we mentioned we talked about read through, once you covered that you get to the point where the entire gross margin less the variable expense is reading through so that’s how we want to answer that one.

[Ryan Martel] – William Blair & Company, LLC.

Then my second question, I know it’s early but how are some of the newer products in the catalog performing so far?

Erik Gershwind

If you’re going back to the catalog that we launched in September of ’09, there were roughly 21,000 new products. We don’t disclose the metrics but in general I would tell you that they’re performing pretty well and particularly along with the rest of the business seeing accelerated momentum.

[Ryan Martel] – William Blair & Company, LLC.

Then maybe just one more, can you provide some color on the website project and how that’s coming along?

Erik Gershwind

Sure. As we’ve said for the last few quarters Ryan, the web remains one of our top investment priorities. We’ve already seen a lot of traction and you can see it in the growth that we’ve experienced in the website and it remains, as it has been for the past few years, it remains one of our top priority investments, it’s getting a lot of mind share and attention in terms of our web infrastructure and the product information and data that goes behind that infrastructure.

Operator

Your next question comes from Derek Jose – Longbow Research.

Derek Jose – Longbow Research

Can you talk about the new national account growth, how many of those firms implemented a BMI or CMI system with you? Then, kind of a carry on to that, how many new systems overall were added if you release that?

Erik Gershwind

Not something that we disclose publically. In general I can tell you that the BMI inventory management trend has been growing and it’s a vibrant program for us but it’s not something that we break out separately and share numbers on.

Derek Jose – Longbow Research

Can you go back to the website and the MSC direct, how much of that in the quarter was actual new business, how much of it was kind of existing customers and how much of it was kind of a like a transfer from your regular call business?

Erik Gershwind

Not numbers that we share. Again, I can give you a general perspective on it which is it is both a combination of what we see business coming from the web is a combination of there is certainly incremental business, it’s new customers coming to us and there also is some transfer which is if you heard in the prepared remarks we talked about the web being powerful on two fronts. As the customer service enhancement and revenue driver and also as a cost savings over time and that’s a piece of what we’re seeing.

Derek Jose – Longbow Research

The last one and hopefully you’ll be able to comment on this one is in general what product categories have you seen the biggest tick up and has it been more one time purchases or stuff kind of like MRO business?

Erik Gershwind

In general the way I characterize this one is it is really tied to the customer segments that are performing so as I mentioned we’re first now seeing really encouraging signs in our core business that’s starting to pick up. You saw that with a little bit of growth in Q2 and generally what that means for us is when we see the core business grow our metal working products start to pick up so you could expect to see a correlation there overtime. As the core grows so does our metal working volume. Again, Chuck and David had mentioned what’s encouraging to us about that is the long range margin implication as we see our core growth, as we see metal working growth, there’s tailwinds on gross margins.

Operator

Your final question comes from Analyst for Adam Uhlman – Cleveland Research Company.

Analyst for Adam Uhlman – Cleveland Research Company

Just one question on the customer count, can we talk a little bit about what you see going on there? We talked a lot today about share gain opportunities yet the customer count continues to decline. When do you see this customer count stabilizing for you guys?

Erik Gershwind

I’ll give you some perspective on our customer count number and you see it declining, really this is a trend that’s consistent with how we’ve chosen to drive our investment strategy. Let me put a little more color on that and how we look at our customers because we look at our customers in tiers. The tiers are based on really two factors, how much business they do with us and then even more importantly is the potential for growth that we see with them over time.

What we’re seeing in the customer number, virtually all of the drop off in the accounts, the drop off accounts are coming from our lowest tier so that means small dollar volume with us and limited growth potential. So to put some color on that, our average drop off account does less than $500 a year with us. So if you’ve heard us over a number of calls site the fact that it’s minimal impact on revenues that’s why. A couple of things we see happening in that tier is a combination that certainly the economy has impacted us and it’s also been an area where we’ve pulled investment away from as you can see with some of the direct mail numbers coming down.

The flip side to that is we’re really encouraged by what we’re seeing in the customer tiers that we’re focused on. The ones that we’re focused on are where we see – there are different ranges of customer volume, but most importantly where we see growth potential. So in the tiers that we’re focused on where we see the potential, I’ll tell you that even through the downturn retention rates were pretty close to historic highs and we view that as a really encouraging sign given that we’ve been through a pretty rough recession. So overall if your question was around market share and how does it reconcile with the customer count, that’s how. It’s really about looking at the customer base and tiers.

Analyst for Adam Uhlman – Cleveland Research Company

Is it fair to say that some new customer opportunities are focused in the tiers that you’re looking at, those higher than $500 tiered customers?

Erik Gershwind

Absolutely.

Operator

There are no further questions. Management do you have any closing remarks?

David Sandler

Thank you all for joining us today. We appreciate your time and attention and look forward to speaking with you again next quarter.

Operator

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

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Source: MSC Industrial Direct Co. F2Q10 (Quarter End 2/28/10) Earnings Call Transcript
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