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

Q3 2014 Results Earnings Conference Call

July 9, 2014 8:30 AM ET

Executives

John G. Chironna – VP, Investor Relations & Treasurer

Erik Gershwind – President, CEO

Jeffrey Kaczka – EVP and CFO

Analysts

David Manthey – Robert W. Baird & Co.

John Inch – Deutsche Bank

Ryan Merkel – William Blair & Company

John A. Baliotti – Janney Capital Markets

Hamzah Mazari – Credit Suisse

Matthew Duncan - Stephens Inc.

Kwame Webb – Morningstar

Eli Lustgarten – Longbow Securities

Sam Darkatsh – Raymond James

Operator

Welcome to the MSC Industrial Direct Fiscal Third Quarter 2014 Conference Call. All participants will be in a listen-only mode. (Operator Instructions) After today’s presentation there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to John Chironna, Vice President Investor Relations and Treasurer.

John G. Chironna

I’d like to welcome you to our fiscal 2014 third quarter conference call. An online archive of this broadcast will be available one hour after the conclusion of the call and for one month on the investor relations’ homepage at www.investor.mscdirect.com. During today’s call we will refer to various financial and management data in the presentation slides that accompany our comments as well our operational statistics, both of which can be found on the investor relations’ section of our website.

With regard to our Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995, please note that our comments on this call as well as the supplemental information we are providing on the website contain forward-looking statements within the meaning of the US securities laws including guidance about expect future results, expectations regarding our ability to gain market share and expected benefits from our investments and strategic plan including the BDNA acquisition, the expectations regarding future revenues and margin growth. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those anticipated by these statements.

Information about these risks is noted in the earnings press release and the risk factors in the MDNA sections of our latest annual report on Form 10K filed with the SEC as well as in our other SEC filings. These forward-looking statements are based on our current expectations and the company assumes no obligation to update these statements. Investors are cautioned not to place undue reliance on these forward-looking statements.

In addition, during the course of this call we will refer to certain adjusted financial results which are non-GAAP measures. Please refer to the tables attached to the press release and the GAAP versus non-GAAP reconciliations in our presentation which contain the reconciliation of adjusted financial measures to the most directly comparable GAAP measures. Finally, please note that we recently renamed BDNA to Class C Solutions Group so future references will use that name or CCSG. Also, now that the acquisition has passed its anniversary date, this will be the last quarter where we will be breaking it out specifically. We will of course, continue to share information about performance and synergies as well as comment on the CCSG in general from time-to-time.

I’ll now turn the call over to our Chief Executive Officer Erik Gershwind.

Erik Gershwind

Also in the room with us this morning is Jeff Kaczka, our CFO. I’ll begin by saying that I’m pleased with our execution and our overall performance during the first three quarters of our fiscal 2014. On today’s call I’ll discuss the current environment where we continue to see somewhat improved momentum, our Q3 performance where we produced solid results, and progress on our infrastructure and growth initiatives including CCSG which continued to go quite well. Jeff will discuss our financial results and provide our fiscal fourth quarter guidance and I’ll then conclude with a summary and of course, we’ll open the call up for Q&A at that point.

I’ll start with the environment. After leaving behind the weather related disruptions and holiday season that we faced in our fiscal second quarter, overall market conditions improved during our March through May 3rd quarter. I mentioned on the last call that the ISM readings and the metalworking business index had recently converged to similar levels that remained true during the past three months with both in the mid 50s range. Both of those macro indicators are generally consistent with what we’re seeing and hearing from customers. That feedback includes a firmer demand environment, more robust order flows, and some talk of order backlogs.

With that said, despite these encouraging signs and significant improvement over prior year, we would still characterize the current environment as one of moderate growth. Customers remain slightly more confident but they also remain appropriately cautious with their spending and capital investments. On a related note, while customers’ order backlogs are generally solid for the next few months, we’re not hearing much about visibility longer term which would be more typical of a high growth environment.

While the demand environment has improved considerably over prior year, we would not say the same of the pricing environment which remains soft. Our gauge here is the rate and pace of manufacturer list increases which remains sparse. There are some indication of potential commodities inflation in products made with nickel and other steel used in many of our cutting tools. If that were to continue for a sustained period of time it would likely result in a more robust pricing environment in quarters to come. To summarize, the overall market environment remained positive and stable throughout the third quarter and into June. I’ll now turn to our recent results.

For the quarter, we posted organic growth of just over 7% on the base business which was towards the lower end of our guidance range. As we reported on our last call, March growth was strong. We saw that trend continue through much of April up until the Easter holidays when we saw things soften relative to the prior two months. That softness continued into May as if you see from our June average daily sales growth of 7.6%, things have picked up since then in part aided by the timing of the July 4th holiday.

We don’t make too much of the month-to-month variability. When we look to the bigger picture we see growth in excess of the market and we see continued execution of our share gain initiatives against the backdrop of an improved but not robust demand environment. As I mentioned on our last call, the government sector performed quite well in March and that continued throughout our fiscal third quarter. Our performance is in part based on a strong government spending environment and in part based on share gains that have been achieved over the past couple of years. Overall, government currently represents 8% of total company sales.

Turning to our national accounts program, it’s continued to grow above the company average as we continue to take share by winning new accounts and executing on our growth initiatives. Our value proposition continues resonating with the procurement and supply chain functions at larger companies who are looking to consolidate suppliers and gain visibility into their MRO spend. As a result, we’re seeing success in current account penetration through better program implementation and in our new account signings.

I’ll now turn to an update on our infrastructure and growth initiatives as well as our progress on CCSG. Our co-headquarters initiative in Davidson, North Carolina has been completed for three quarters and all expenses are fully at our run rate. The project was completed on schedule and on target and this will be the last quarter that I’ll comment on it. We’re very happy with the talent pool that we’ve attracted and we now have about 250 associates located in Davidson. As a reminder, we’ll begin receiving the incentives related to Davidson in our calendar 2015.

Construction of our fifth customer fulfillment center in Columbus, Ohio is substantially complete. We’re staffing up and we’re on schedule to begin shipping in the fall of this year. As expected, the operating expense impact continues to grow and will do so into fiscal 2015 as we stock the facility with inventory and staff it in preparation for opening. Next, our project to relocate our primary datacenter is complete. It was finished slightly ahead of schedule and on budget.

I’ll now update you on our growth initiatives which continue to help us take share. Sales from customers with a vending machine added roughly four points to our revenue growth in the third quarter. Vending signings remained strong which is a testament to the program’s value and to the growing momentum of supply chain technology in the indirect procurement space. Excluding CCSG eCommerce reached 48.9% of sales for the third quarter as compared to 44.1% a year ago and 47.6% last quarter. This reflects our customers’ increasing interest in our inventory management solutions such as vending and VMI as well as the increasing traction of mscdirect.com.

We’re quite pleased with the recent and ongoing improvements to our website and are getting strong confirmation from our customers. mscdirect.com remains an important part of our value proposition and because of its sophisticated procurement functionality it’s a key element of the stickiness that we create with our customers.

Regarding sales force expansion, our target was to add between 5% to 7% to our field sales headcount for fiscal 2014. During this past third quarter we added a net of 25 sales associates bringing total net additions to 65 for the first nine months. We’re encouraged by the early performance of our new hires and based on current trajectory, we plan to finish the year slightly above the high end of our targeted range for sales force additions.

Finally, we added another 35,000 SKUs to our web offering in the third quarter and now have approximately 795,000 available on mscdirect.com. That brings our total SKU additions to 120,000 for our year-to-date and we remain on track to add a total of roughly 150,000 for the fiscal year. As those newly added SKUs mature over time so will their contribution to growth.

I’ll now turn to CCSG. While recent topline performance has been nothing to write home about yet, as I look to the future the outlook for CCSG is even more promising than it was a year ago. This past quarter we saw the US business return to slight growth while currency and market weakness in Canada remained challenging and yielded contraction, netting out in total to a slight decline. As it relates to the integration plan, synergy realization, and the achievement of our EPS accretion targets though, we’re right on track.

To-date we’ve closed three distribution centers and are on plan to close the Cleveland headquarters this summer. We began moving the first wave of associates to our Davidson location at the end of June and it’s been a very exciting time in Davidson as our new colleagues are joining us there. We also remain on track to achieve our targeted cost synergy run rate of $15 million to $20 million by the end of fiscal 2015. With respect to financial performance, we’re trending towards the high end of our $0.15 to $0.20 accretion range for the year.

Overall, as I said, I’m very encouraged by the actions that are being taken to improve this business and position it for growth in future quarters and there are three growth levers that we’re focused on. First is improved customer service or what we call core execution. That plan is well underway and can be seen in improving metrics like call answer rates, bill rates, and general customer coverage. Second, we’re refining the sales force model and as a result we’re beginning to expand the CCSG sales force. As a reminder, to-date the field sales metrics that we report on our website include only the base MCS business. We are at the same time, beginning to expand CCSG sales headcount which will serve as a growth tailwind as those new hires mature. Each of these first two growth levers of course takes some time to translate into improved results.

The third growth lever we’re focused on is realizing cross selling or revenue synergies. As I mentioned last quarter, we began pilot projects to equip our CCSG sales associates with our big book catalog, access to our website, and resources to assist them in selling the MSC products and solutions. We’re encouraged by the initial pilot results and during our fourth quarter we’ll be expanding that pilot more broadly. We expect to see continued good results and assuming we do during our fourth quarter, this should serve as a sizeable growth program for fiscal 2015.

As John alluded to earlier, we also launched a new brand by renaming BDNA to Class C Solutions, a business of MSC. We took one step in bringing the company under the MSC family while still retaining its own identity. To summarize CCSG, we achieved our 2014 financial and operating targets without the benefit of any topline growth to speak of. At the same time, we’re making significant improvements that will result in future revenue growth and given the high incremental margins inherent in the model we’re very encouraged about the prospects for future growth in both revenues and earnings. Overall, it’s an exciting time right now within CCSG.

I’ll now turn things over to Jeff to discuss the financial results in greater detail and provide our fiscal fourth quarter guidance.

Jeffrey Kaczka

Our monthly sales growth rate moved around a bit during the fiscal third quarter due to the Easter holiday impact but overall our average daily sales growth excluding CCSG came in at the low end of our guidance or about 7%. At the same time, we managed to achieve EPS towards the higher end of our guidance by posting an adjusting EPS of $1.06. Furthermore, as Erik mentioned, I’m happy to say our infrastructure and growth initiatives continue to progress in line with our plans.

Let me start by getting into the details of our third quarter results. While the remaining non-recurring costs related to our co-located headquarters are not material, we do still have non-recurring integration costs related to the CCSG business so I’ll continue to speak of our results in terms of reported and adjusted results.

Our reported sales growth on an average daily sales basis was just about 13% compared to the same period last year. This includes a full quarter of CCSG sales whereas the prior year quarter only included sales from the acquisition date of April 22nd. Excluding CCSG, our base business organic sales growth on an average daily sales basis was roughly 7%. The growth rate benefitted from the significant improvement in our government business as well as some customers within our vending program which contributed roughly four points of growth.

With regards to gross margin, we posted 46.3% for the quarter above the midpoint of our guidance of 46%. We were very pleased with this but I would mention that the gross margins benefitted partially from a couple of items that are unlikely to repeat. Our reported EPS for the quarter was $1.03 or $1.06 on an adjusted basis which excludes non-recurring costs for the CCSG integration. The adjusted EPS of $1.06 which was towards the higher end of our EPS guidance range of $1.03 to $1.07, reflects the impact of slightly higher gross margin as well as the effective management of our operating expenses. Finally, the tax provision came in at 37.9% slightly below our 38% guidance.

Turning to the balance sheet, our DSOs were 48 days, slightly higher than last year’s Q3 and we’re pleased that our inventory turns continued to improve to 3.54 from last year’s level of 3.32. As expected, we did add roughly $35 million in inventory during the quarter to support growth and to stock the new Columbus distribution center. We would expect the build to continue during our fiscal fourth quarter but at a slightly lower level.

From a cash flow perspective, we continue to generate significant levels of cash as evidenced by our positive operating cash flow, $75 million in the quarter. In addition, we paid out over $20 million in dividends and incurred total capital expenditures and infrastructure investments of $23 million. Capex was in line with our plan and our expectation for total year capex of slightly over $100 million remains on target.

At the end of the third quarter we had $275 million in debt mostly comprised of $241 million outstanding on our term loan and a $5 million balance on our revolving credit facility. We closed the quarter with $45 million in cash and cash equivalents and our current cash balance now stands at $47 million.

Now let me turn to our guidance for the fiscal fourth quarter of 2014 and consistent with previous quarters our guidance will continue to exclude the non-recurring CCSG integration costs. We expect total revenues to be between $718 million and $730 million, up 7.5% from the prior year quarter at the midpoint. This includes CCSG sales which are expected to have a lower growth rate than base MSC. We expect gross margins to be in the range of 45.9% plus or minus 20 basis points which is down from our fiscal third quarter and reflects the typical seasonal trends we see when going from our fiscal third quarter to the fourth quarter as well as continued growth in our national accounts business. Relative to the company average national accounts tend to be a headwind to our gross margins.

I would point out that the sequential decline in gross margin is lower than historic norms thanks in large part to our strategic programs particularly in the current soft pricing environment. We expect adjusted operating expenses will increase at the midpoint of guidance by roughly $5 million versus the fiscal third quarter. Now roughly half of the increase is from CCSG including gross investments related to sales force expansion and our catalog rollout. The other half of the increase pertains to the base business and includes investments in sales force expansion, the Columbus distribution center initiative, and staffing ramp up ahead of normal fiscal first quarter seasonal volume growth.

The midpoint of our guidance implies an adjusted operating margin of approximately 14% in fiscal fourth quarter which keeps us well within our fiscal 2014 annual framework of 14% to 15%. This adjusted operating margin reflects the typical seasonal trends in gross margin and the continued ramp in investment spending for initiatives like the Columbus distribution center and sales force expansion. The distribution center will not begin shipping until early fiscal 2015 so the related operating expenses are still ramping higher.

With regards to the sales force additions we don’t expect to see a material impact on the topline from hires made during the first half of this year until fiscal 2015 and of course, we’re continuing to hire new sales associates every quarter. Our tax rate is expected to be 37.7% and all this results in adjusted EPS guidance of $0.98 to $1.02. This earnings guidance includes CCSG operating results and excludes approximately $0.02 in integration costs. Also, the CCSG business is expected to be accretive by about $0.04 in the fourth quarter which would put total accretion for fiscal 2014 at $0.19.

In summary, we’re now 10 months through our fiscal 2014 and well on track with respect to our infrastructure and growth initiatives as well as our financial commitments when it comes to our fiscal 2014 framework.

Thanks and I’ll turn it back over to Erik.

Erik Gershwind

Before we open up the call for questions, I’d like to take a step back and assess the company’s performance in a broader context. We’re heading towards the home stretch of our fiscal 2014, the second of two years of heavy infrastructure in the company. I remain very pleased with progress against our plan and our prospects for the future.

Our infrastructure projects have been well executed, delivered on time, and on budget. We kept focused all the while on market share gains through a challenging market environment and are beginning to see the payoffs in the form of early topline momentum. We completed and are integrating the largest acquisition in the history of the company, one that holds great promise for the future. We’re moving the MSC portfolio of business towards sticky high retention channels including vending, eCommerce, VMI and more. Finally, we’re on track to deliver financial performance in line with the annual framework that we laid out at the start of the year.

By no means am I suggesting that our work is complete. We’re focused on executing the growth investments that we’re making to deliver faster topline growth. We’re working hard to get the topline growing at CCSG as well which will lead to even faster rates of earnings accretion and we’re focused on growing company earnings once again in the coming quarters as we gain leverage on our investments.

On our next call, as we normally do, we’ll share our outlook for fiscal 2015. Finally, I’d like to thank our entire team for executing our plan over the last year and for their continued commitment to our mission. We’ll now open the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from David Manthey of Robert W. Baird.

David Manthey – Robert W. Baird & Co.

First off, CCSG, could you remind us what percentage of that business is Canada? And then is there anything else that’s inherent in the CCSG customer base or operations that would just longer term make it a slower growth business than core MSC?

Erik Gershwind

CCSG, first question Canada, figure roughly 15% of total. As you can imagine, we saw significant decline in that portion of the business to net out to a slight decline in the quarter given that the bulk of the business is US and did show some slight growth. To your other question, I think the answer is no. I feel really good as we look at the CCSG business. I think nothing particular to call out on its macro exposure other than the fact that it is more diversified than MSC’s base business, a little less manufacturing. I think the really relevant point, what we see, is a very compelling model that allows us to get these deep relationships with customers and ultimately start to spread our tentacles in those accounts and that’s really what’s been in the works now and what we anticipate in the coming quarters to get the growth moving.

David Manthey – Robert W. Baird & Co.

Then Jeff, when you were talking about the gross margin in the current quarter I believe you made a comment about some non-repeating items but you didn’t outline. Can you give us an idea of what those were and approximate magnitude?

Jeffrey Kaczka

There were two items primarily related to the timing of discounts and rebates and those two items combined just lifted us over the top end of our guidance range in terms of gross margin. The top end was 46.2 so a minor impact associated with those.

David Manthey – Robert W. Baird & Co.

You’re talking 10 basis points or something?

Jeffrey Kaczka

Or so.

Erik Gershwind

I think one other point I think Jeff made this in the prepared remarks is we are pleased with what we’re seeing and so while we got some benefit from non-recurring I think in general given the soft pricing environment that we see now we’re pleased with our execution and the gross margin discipline that we put in place.

David Manthey – Robert W. Baird & Co.

Just finally, on the manufacturing versus non, you mentioned government I guess that would be a driver there but is that also partially because of the inclusion of CCSG and the drag that that’s having? I would imagine that they’re primarily manufacturing rather than non?

Erik Gershwind

No, see I would chalk it mostly up to government and to some other sort of odds and ends segments in the base business that have been showing growth. But consider it primarily government driven and not CCSG in terms of the non-manufacturing.

Operator

Our next question is from John Inch of Deutsche Bank.

John Inch – Deutsche Bank

Jeff, just as a clarification, you made a commentary about the timing of the July 4th holiday. Were you trying to imply that June sequentially did a little bit better versus May because of July 4th? I don’t really understand what you were saying?

Jeffrey Kaczka

Yes, that’s right. For our fiscal month it included the July 4th holiday, the June fiscal month and because the timing this year of July 4th was on Friday versus Thursday, we believe there was a slight improvement to the growth rate associated with that.

John Inch – Deutsche Bank

But all else equal are we sort of seeing on a sequential basis kind of a 7% - we are sort of seeing the 7% mark, is that with about 4 points from the vending machine, is that about the cadence that you are seeing? Your monthly sales growth is kind of trending around 7% all else equal if you kind of adjust for Easter, and July 4th, and all this stuff, is that really what you’re seeing?

Jeffrey Kaczka

We’re actually seeing a bit of an uptick as we progress month-by-month through from the second quarter into what we saw in June. Certainly a slight uptick there and I think that’s reflected in our guidance for Q4.

John Inch – Deutsche Bank

Is CCSG also seeing that uptick or what’s happening to that business sequentially through June?

Erik Gershwind

I think Jeff’s right, I would say first of all is - between the weather and the holidays there’s been a lot of month-to-month variance in the growth rate and as we said, we don’t make a whole lot of the month-to-month variability. We’re looking at the trending. If you look the base business is 7% all in for Q3. As Jeff points out you could take our implied guidance of 7.5% inclusive of CCSG which is lower meaning the base business is higher. So I think there is some momentum that we’re encouraged by. Not satisfied but encouraged is what I said.

CCSG, if you look back over the last few quarters has been hovering around flat. Up a little bit, down a little bit. In June it was down slightly, in Q3 it was down slightly, but I would say directionally hovering around flat and for the reasons I described we are very encouraged about what we see turning into growth in quarters to come.

John Inch – Deutsche Bank

Erik, based on your guide or Jeff, if you were to look at your sort of growth initiative spending, so that would be however you want to characterize it, the cost of warehousing these new SKUs, the sales force additions, what would be the fiscal ’14 magnitude of that spending? And, based on everything you know today, I’m not asking for guidance, but is the spending up, flat, or down in fiscal ’15? There’s perspective that you guys have been spending to capture market share for a long time and is there a point at which you can kind of pull off the levers to let some more of the earnings flow to the bottom line? I’m just curious, maybe you can frame that for us a little bit?

Erik Gershwind

Two parts, let me take sort of a look back, we’re kind of sort of right now at ’14 and then talk a little bit about ’15. For ’14 what we described was – I want to go back to our framework, but it was around 100 basis points of op margin impact in the base business. About 50 basis points of impact was being driven by infrastructure investing i.e. Columbus/Davidson/datacenter and around 50 basis points of op margin impact from growth investment spending, the things you rattled off. So, in ’14 yes, elevated spending.

As we look ahead to ’15, and we’re going to come back, we are right in the midst of our normal planning process where we put all the pieces together to refresh the ’15 view, but if you go back to what we said at the start of the year when we laid out our three year perspective, we had anticipated ’14 being the trough in op margin, what we call modest or slight uptick in op margin in ’15, and more aggressive op margin uptick in ’16 and all of that was premised on what we termed moderate growth environment and moderate pricing environment.

We’re putting all the inputs together on ’15. What I would tell you is certainly we have some portion of the infrastructure investment that’s going to be dropping off. By dropping off what I mean is largely in our run rate not incremental. So that is Davidson, datacenter is behind us, Columbus will be behind us as we move to the back half of ’15 for sure. Growth investments will continue. So, to answer your question we’re putting it all into the mix now and we’ll be back on the next call and give you a framework for ’15.

John Inch – Deutsche Bank

It sounds sort of like when the infrastructure kind of gets some anniversary and growth investments, because you called out hiring, CCSG, etc. and it sounds like that’s probably on a path to continue so maybe the net is a slightly less of a run rate? Is that fair?

Erik Gershwind

I would say CCSG will continue. I would say we are lapping Davidson, we are lapping datacenter. Columbus, as we described, will be a headwind into ’15 as we staff up. We also had the depreciation that will kick in so Columbus will remain a headwind. So I would say sort of somewhere between your answer there.

John Inch – Deutsche Bank

One more quick one, June I believe, is government fiscal year end and I think there was a bit of a budget flush for government last year. There was kind of concern that government, certainly at the state level, had maybe spent a lot on snow removal and other things. It sounds like government was pretty good for you in June, did you see any sort of a less of a budget spend? I realize it’s only 8% of your mix and that would be split federal versus state but did you guys see any kind of impact you think from weather that maybe caused government to spend a little bit less in June versus last year?

Erik Gershwind

You’re hitting the right theme here because the yearend of government really does drive a lot of activity. It’s actually end of September for Federal. You are correct, last year was a pretty soft year for government but we did see at the end of their fiscal year a pretty aggressive ramp up in average daily sales. We’ve been talking about with government we’re pleased with performance. I think the headline on government is generally more spending, a more certain environment with budgets being set now so there is more spending. The other headline would be I think we’re benefitting from some share gains that we achieved while things were soft. To answer your question we are still seeing nice growth. We anticipate growth in the fourth quarter, although I will tell you that baked into our guidance is a slightly lesser growth rate accounting for the fact that we have big comps at the end of their yearend spend from prior year.

Operator

Your next question comes from Ryan Merkel – William Blair & Company.

Ryan Merkel – William Blair & Company

I want to ask a question about 2015 too and I know you’re going to talk about it more on the next call but I just want to ask we shouldn’t extrapolate the fourth quarter margin guidance into 2015? Am I correct with that statement?

Erik Gershwind

That’s a really good point. I’ll touch on ’15 a little more than I did in John’s question. In general what I would say to you is this is the time of year when we go through our planning right now, so we’ll have a much better feel on the next call. Just to remind you, we said slight uptick in margin based on moderate growth moderate pricing as we look at it now. Certainly, the moderate growth part of the equation is a check, the moderate pricing part of the equation is not a check it would be an X at this point, all subject to change. So that is certainly a relevant factor but only one of several factors that we’ve got to put into the mix along with the demand environment and along with our own spending and other decisions and executions. All that’s being factored in now.

I do think you’re right to point out – I wouldn’t make too much of Q4 as it relates to ’15 because Q4 is seasonally for us, if you look, a lower margin quarter because of the seasonal downturn in gross margin combined with the uptick in expenses that we normally do to prepare for Q1 which is a higher growth level. Net-net, you’re right I wouldn’t make too much of Q4.

Ryan Merkel – William Blair & Company

Based on what you’re seeing in the business today, call it moderate growth, and then thinking about the growth investments ramping, do you think double digit organic growth is achievable sometimes in the next call it three to six months?

Erik Gershwind

On growth here’s what I’d say, I would say we are encouraged by what we’re seeing but not satisfied. I think we can do better, we can continue to do better, but we are encouraged by what we are seeing. I think there are three things I’d point to that make me encouraged. Number one is sequential momentum in the growth rate from quarter-to-quarter as we discussed from Q2 to Q3 to Q4 which is coincident with the demand environment firming up. Not robust, but firming up. Number two, most important to me is seeing a consistent gap in our growth rate relative to market and we are seeing that. Basically any way we look at that whether that’s relative to macro indicators, to research that’s been recently done, our growth rate relative to peers, supplier feedback and so I’m satisfied on the share gain side. I like the fact that we’re seeing momentum.

Then the third piece is relative to historical performance. If we look back this company has a long track record, and you look over extended periods of time our organic CAGR is somewhere in the 9% range over long cycles. If you look at our Q4 guide, we’re guiding 7.5%, the base business is a little bit above that, we’re in that ballpark in spite of being in a soft pricing environment. All that said, I’m encouraged. I think that we have things in the works i.e. sales force expansion, i.e. CCSG that if they were to execute if the demand environment were to hold, that’s where I’d like to be is double digit growth rate.

Ryan Merkel – William Blair & Company

If I can slip in one more, can you just comment on the core MSC accounts? Those small and medium size metal working customer, are they coming back to life at all? Maybe you could just talk about the growth rate year-over-year if you have it?

Erik Gershwind

I think the relevant point to the base business, the headlines would be certainly national accounts and government out ahead of company average and growth rate. We view that as an encouraging sign, particularly on the national accounts front. If you go back and look at the business over cycles, historically national accounts has served as somewhat of a leading indicator both on the way up and the way down. We view that as an encouraging sign on what could come particularly if the metal working environment stays as it is.

I also think I’d point to we are seeing a tick up in our customer count which in part I don’t make too much of but certainly in part is reflective of an improved environment. So we are again, encouraged and I think should the environment hold and we execute, which I expect us to do, there’s a potential for improved momentum.

Operator

Our next question is from John A. Baliotti of Janney Capital Markets.

John A. Baliotti – Janney Capital Markets

Erik, you mentioned in your opening comments that customers remain cautious about spending and I don’t think that’s too much of a surprise given all the different kind of macro factors put in the pot together. But it looks like, as you’ve talked about your core growth is sequentially improving margin impact from these strategic investments is declining through this fiscal year. So it seems like you’re more in a phase to leverage these investments out to the customer along with CCSG versus let’s say being in an internal implementation phase. Is that how you feel about things at this point?

Erik Gershwind

I think if you told the MSC story, the past two years the title of the story would be heavy infrastructure investment. Certainly, combined with growth investment in market share but heavy infrastructure investment. I think as we look forward, yes I think it’s fair to say that it’s going to more be able leverage investment, continued investment in growth and leveraging the infrastructure investments being made.

John A. Baliotti – Janney Capital Markets

It seems like you’re now with the stage that you’re at with this program as we see this sort of declining impact of the margin that you’re more at a point where you’re rolling this out and you can take advantage of let’s say customers being concerned about the efficiency of their spend.

Erik Gershwind

I think that’s at the heart of – if you look at the MSC plan at the heart of the priorities we have set out for ourselves in the coming years, it’s all driven by what’s happening with customers and that’s dynamic a bit of what we described in the opening remarks. Customers are looking to get their arms around indirect spend, they’re looking for supplier partners that are going to help them do that, more visibility, more technology, and a heavier focus on using digital channels. If you look at where MSC is placing its chips and the things we’re doing it’s all driven by the customer. It’s heavy investment into inventory management, into technology that’s going to help our customers get their arms around their spend, and heavy investment into digital channels as evidenced by the growth in eCommerce. So yes, I think that’s right and I think the point being the whole plan is driven around where we see the customer heading.

Operator

Our next question is from Hamzah Mazari of Credit Suisse.

Hamzah Mazari – Credit Suisse

Just a question on the potential for revenue synergies from Class C Solutions. You spoke about piloting around the sales force in fiscal Q4, could you give us a sense of timing wise when you think revenue synergies from Class C Solutions?

Erik Gershwind

What I would tell you first of all is I think we will have a better feel on the next call. I’d like to get a quarter under our belts with the roll out of the catalog and such. I think bigger picture the message with CCSG is while the top line growth has been nothing to write home around hovering at flat, the actions being taken under the surface and those three growth levers that I pointed to, I’m very encouraged by our execution. On two of those three levers, I know from experience and even we know from experience that they translate into results. It’s tough to pinpoint exactly when. On the cross selling synergies I do think there’s a case to be made that could happen sooner. I think it’s a little early to tell. But certainly, as we said, should we execute as we expect we would anticipate it being a nice growth program for our fiscal ’15.

Hamzah Mazari – Credit Suisse

Just a bigger picture question around national account business, this cycle amongst the publically traded distributors, the distributors are getting a lot more diversified. One of your competitors got into metal working a few years ago, another competitor is getting more bigger on the production assembly line on manufacturing. Are you beginning to see the national account business get more competitive this cycle versus prior cycles?

Erik Gershwind

I would say in general national accounts as certainly been a competitive arena for a while and I think it remains as such and it’s why Jeff pointed out it is gross margin headwind. I think the exciting part to me is it’s a sector in which we can begin to see the early stages of the consolidation story start to play out. I think that’s a piece of what’s driving our national accounts growth rates so strongly along with some of the other larger nationals because for these businesses who are again, really looking to get their arms around this neglected area of spend of indirect materials, they need - the procurement and supply chain functions at our customers need distributors that have national capabilities that have all of the technology and inventory management solutions to bring that let them get their arms around it. That to me, is the big story. It’s an arena where the consolidation story can really be evidenced.

Hamzah Mazari – Credit Suisse

A few quarters ago Jeff, I think you folks had mentioned how to think about incremental margins depending on whatever one assumes on revenue growth. Could you maybe remind us on how to think about off leveraging your business model? I realize there are a lot of moving parts with the acquisition integration and investment spend. But how should we think about incremental margin given the current environment?

Jeffrey Kaczka

A lot of factors affect the incremental margin, as you know and this year the decision to make those investments in infrastructure and growth have kept that incremental margin down. We’ve given our annual framework in terms of the operating margins but as we lap and head into FY15, I think Erik had given you a sense of what would happen with the infrastructure expenses and we would begin to leverage those. The growth investments will continue as long as we’re getting the type of results that we expect. Then another factor is the pricing environment.

Hamzah Mazari – Credit Suisse

Fiscal ’16 is more of a normalized op margin for you folks? Is that fair?

Jeffrey Kaczka

I think that’s very fair.

Operator

Our next question is from Matthew Duncan of Stephens.

Matthew Duncan – Stephens Inc.

Erik, you talked a little bit about where you’re seeing better growth versus other places and it sounds like it was both government and other places. Are there any other end markets within the manufacturing sector that are showing any more strengthen than others?

Erik Gershwind

Yes. I think in general it’s probably no big surprises and we’ve called them out over the last couple of quarters. There are certainly pockets. For us I think the bigger story in the general manufacturing area where we have heavy exposure, areas like heavy equipment, the metal fabrication market, the primary metals, have been stable and okay and firming up but not great. For us, that’s the biggest chunk of our revenues in the core is in those sectors where it’s been okay but certainly not explosive growth. That’s how we characterize it.

Matthew Duncan - Stephens Inc.

That’s really what I’m getting at, are you sensing from your conversations with that customer base that there is potentially an improvement in the tone of growth coming there or should we still sort of expect the same kind of environment we’ve been in?

Erik Gershwind

The tone we want to get across is definite improvement. There is certainly improvement particularly relative to prior year where things were soft. The fact that we’re talking about order backlogs at all is a significant change from where we were a couple of quarters ago so definite improvement. I think we’re stopping short thought of saying absolutely robust. Some of the examples there are the kind of cautious outlook on capital spending and the lack of visibility beyond the next few months which normally we would associate with kind of really strong demand environment. I think what we’re seeing now in the metal working business index is kind of consistent with that, what we term a moderate growth environment.

Matthew Duncan – Stephens Inc.

The last thing for me on the M&A landscape, what are you guys seeing out there right now? Do you feel like you’re far enough down the path with integrating the Barnes deal that you can get a little active on the M&A side?

Erik Gershwind

What I would say about M&A Matt, is definitely as a reminder, it is certainly part of our growth strategy. We see it as, and what we had talked about at the time, was M&A being a vehicle to achieve the growth plan. One of the primary places that we would put it to use is product line adjacencies outside of metal working. You saw us do it once with class c products with the Barns acquisition which is now CCSG. What I would tell you that is as each quarter passes and we like our execution and we’re getting CCSG under our belts, our confidence grows. I think seeing a continuous path to use M&A as a product adjacency move certainly makes sense. We’ve outlined in the past a number of other product lines we think make sense where we have discussions, where we have our eye on things. In general, what I would say is as each quarter passes we’re growing more confident and using that as part of our plan.

Matthew Duncan – Stephens Inc.

Are you okay with the multiples that you’re seeing out there right now with potential targets? What are valuation expectations?

Erik Gershwind

What I would tell you on multiples, it’s a lawyer’s answer, it’s so much depends on the business because so much of it the way we look at it is what are the underlying economics of what we could do to a business with synergies and that is just so target specific it’s tough to give you general answers.

Operator

Our next question is from Kwame Webb of Morningstar.

Kwame Webb – Morningstar

I just want to start with CCSG. Number one, you mentioned a lot about headcount additions. I think historically you guys have said 12 months is really where you expect to start to see productivity. Is that the right way to think about that? Then also, if you could kind of comment on customer service issues that you are working through? I was kind of surprised to see that was so high on your growth driver’s list.

Erik Gershwind

I’ll take both of them. Your first one was round headcount additions, yes the message there is we use the first year of the business to really refine the salesforce model in that business. A lot of leverage and a lot of learnings with the MSC salesforce and we have some really good people who we’ve brought over from the MSC side that are bringing those learnings to life. We are beginning now, in the early stages, of accelerating and expanding that sales point. To your point, yes we’re not going to see the benefits of that until the following fiscal year. That is a fair assessment.

The second point on customer service, I’ll tell you that for us really is cultural and at the heart on the MSC side. While we don’t talk about it a lot it is at the heart of what we do and I guess it’s because we’ve done it so consistently for so long that we don’t need to talk about it. On that business, we have, and this has been a steady process over the past year, made a lot of improvements to areas like inventory fill rates, like call answer rates. Those are things that we know from experience translate into improved customer satisfaction, that translates into retention, and that translates into growth. It’s just tough to pinpoint the timing.

Kwame Webb – Morningstar

Then just the last one for me was vending, if you could maybe sort of comment on how does that profitability look versus the rest of your business and maybe to the extent that optically it doesn’t look as good as the rest of the business? How should we think about vending strategically as supporting the rest of the business?

Jeffrey Kaczka

Vending has been an important element of our growth strategy in adding to the value added services that we’ve been providing our customers. We have, as we spoke about before, a vending improvement program designed to increase the operating margin of those vending accounts over time and we’re progressing quite well. We’re seeing some improvement in terms of the gross margin trends in the vending accounts as well as the way we service and the operating expenses associated with that so we’re progressing quite well.

Kwame Webb – Morningstar

Is that more just sort of a SKU management sort of issue or is it more of a pricing issue in terms of improving those GMs?

Jeffrey Kaczka

It’s a combination of many things within the vending improvement program including again, in on the op ex side but in terms of the mix of product, some of the exclusive brands, and the overall value we bring to the customer.

Operator

Our next question is from Eli Lustgarten of Longbow Securities.

Eli Lustgarten – Longbow Securities

I have two questions. One, you talk a lot about soft pricing environment, can you elaborate or give us some color on soft pricing both by product line, is it broad based, is it cutting tools [inaudible]? I mean you almost characterize as lack of price increases but is there price concessions going on? Can you give us some idea? Can you also do it by customer account whether the national accounts are beating everybody up for concessions in this kind of environment? Just give us an idea of what soft pricing really means?

Erik Gershwind

The big message on soft pricing is it’s directly related to – this is not change in customer behavior, change in competitor dynamics, this is commodities. The fact that it is broad based and the fact that commodities really haven’t moved, that is the trigger in our industry for manufacturers moving prices and manufacturers lift price changes is what triggers the distributor pricing moves. That cycle just hasn’t kicked in. We did mention a couple of pockets where we potentially saw signs of life in lift and commodities prices, it just hasn’t been sustained enough to the point where manufacturers are bringing increases to market. That’s the story though.

Eli Lustgarten – Longbow Securities

It’s not any spillover into price concessions in the business?

Erik Gershwind

No. Certainly, as evidenced by I think we have done a nice job managing table gross margins through the year, no price deflation.

Eli Lustgarten – Longbow Securities

One other follow up question to your growth program and growth investments, with a moderate growth environment and pricing not matching anybody’s expectations at the moment, can you talk about the level and timing of your growth investments? Whether or not you have them appropriately timed in size or should there be some stretch out if things continue to sway, or just get an idea of how you’re matching your growth investments compared to the environment particularly when the environment is not sort of kept up with people’s hopes?

Erik Gershwind

I think it’s a good question and I imagine particular in relation if you look ahead to ’15 and the op margin framework, I think what I would say there is our approach to – let’s assume the moderate growth environment holds but the moderate pricing environment doesn’t come to bear and we’re in a soft pricing environment what happens with growth spending? I think our answer is, as it relates to op margin versus growth investments and the tradeoff there, we don’t see that as an either or, we are striving to achieve both. We’re in the midst of kind of putting that all into the mix now as we get ready for ’15.

Eli Lustgarten – Longbow Securities

In essence you think you probably continue on your plan because the execution is so much better there?

Erik Gershwind

I think what we would strive to do is invest in growth and achieve the op margin frameworks. Of course, we’ve got to be mindful of the soft pricing environment and put that all in the hopper, but that’s what we’re shooting for.

Operator

Our next question is from Sam Darkatsh of Raymond James.

Sam Darkatsh – Raymond James

Two quick ones. First off, I’m a little confused with the inventory commentary. I know you mentioned a fair amount of safety stock with Columbus and also the new SKUs, yet inventories, at least on a year-on-year basis were only up about 3% with organic growth up about 7%. Where is the disconnect? Are you pairing back on inventories in the base business outside of the initiatives or where is the disconnect?

Jeffrey Kaczka

Actually, I think it’s strong execution. We have a new forecasting system that was put in place and we’re levering that quite well across our distribution network.

Sam Darkatsh – Raymond James

Last question, and I apologize for asking this question a different way than has been asked over and over today, you have the absence of the infrastructure spending, the 50 basis points that you referenced for fiscal ’15, if you continue at this general volume growth rate next year, the high single digit growth rate, at present time would you leverage op ex more so than the 50 basis points next year or should that be just what we’re expecting because of the additional growth spending?

Erik Gershwind

You’re getting in ’15 and I’ll tell you we are right in the midst of doing the work. We have a few factors. First of all remember, even at the start of last year what we said was the op margin uptick in ’15 would be modest, slight, whatever we called it. That was in recognition of the fact that while execution of the infrastructure would largely be behind us, particularly as it relates to Columbus, there was a significant step up in expenses. There will be op margin, if you will, eaten away by Columbus in FY15 and that’s the case regardless. That is part of what was driving the modest uptick in ’15 and we weren’t into what Jeff described as full incremental margin mode until ’16. Certainly, that’s a factor.

What you’re doing is sort of giving me a growth assumption and saying, “We continue in a moderate growth environment.” I think we’re going to need to get a better sense of what happens in the pricing environment and line that up with some of our internal priorities and put that all together and then that’s what we’ll give you next quarter. It’s just a little early to say.

Operator

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

John G. Chironna

Thanks again everyone for joining us today. Our next earnings date is set for Tuesday, October 28th and we look forward to speaking with you over the coming months.

Operator

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.

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Source: MSC Industrial Direct's (MSM) CEO Erik Gershwind on Q3 2014 Results - Earnings Call Transcript
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