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

F4Q11 (Qtr End 08/27/2011) Earnings Call

October 26, 2011 11:00 pm ET

Executives

Eric Boyriven - IR, FTI Consulting

David Sandler - President and CEO

Erik Gershwind - President and COO

Jeff Kaczka - EVP and CFO

Shelley Boxer - VP, Finance and Accounting

Analysts

Sam Darkatsh - Raymond James

Hamzah Mazari - Credit Suisse

Ryan Merkel - William Blair

Matt Duncan - Stephens Inc.

Adam Uhlman - Cleveland Research

David Manthey - Robert Baird

Scott Graham - Jefferies

John Inch - Bank of America-Merrill Lynch

Brent Rakers - Morgan, Keegan

Operator

Good Morning and welcome to the MSC Industrial Direct Fourth Quarter 2011 Conference Call. (Operator Instructions) I will now like to turn the conference over to Eric Boyriven, FTI Consulting.

Eric Boyriven

Thank you, and good morning, everyone, and welcome to the MSC Industrial Direct fiscal 2011 full year and fourth quarter conference call. An online archive of this broadcast will be available one hour after the conclusion of the call, and available for four weeks on the homepage of the Company's website at www.mscdirect.com.

During today's presentation management will refer to financial and management data included under the section Operational Statistics, which you can find on the Investor Relations section of the Company's website.

Let me now take a minute to reference the Safe Harbor statement under the Private Securities Litigation Reform Act of 1995. This call contains forward-looking statements within the meaning of the U.S. securities laws, including guidance about expected future results, statements regarding expected revenue, gross and operating 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 this statement. Information about these risks is noted in the earnings press release and the risk factors and the MD&A sections of the Company's latest Annual Report on Form 10-K 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

Thank you Eric. Good morning everyone and thank you for joining us this morning. With me are Erik Gershwind, President and Chief Operating Officer; Jeff Kaczka, our Executive Vice President and Chief Financial Officer and Shelley Boxer, Vice President, Finance and Accounting.

Before getting into the quarter, I want to take this opportunity to say a few words about the promotions of Erik Gershwind and Eileen McGuire. We are fortunate to have two such outstanding executives among those leading our company. It's been gratifying for me to watch their continued growth and development, through the many years we've been together.

I have the privilege to work closely and get a first hand view of their integrity, incredible skills in business acumen, intense focus and their passion for fulfilling our mission statement to be the best, the long term growth vision that MSC has for the future has never been more secure then with the team leading our company today.

Turning to the quarter, I'll give our perspective on fiscal '11 to current economy and how we intent to manage our business during this time. Erik will provide an update on the execution of our model and Jeff will provide details on our financial performance.

We achieved and surpassed many important milestones this past year. We passed the $2 billion mark in sales and did so while delivering record levels of profitability. We make two acquisitions in the metalworking states, our first in several years. The business development team put in place during this past year will continue their focus on targets that meet our strict criteria with the goals of generating faster topline growth and greater share gains, becoming quickly accretive to earnings, further enhancing our metalworking capabilities and lengthening our lead in this key marketplace.

The growth that we achieved reflects our market share gains as we continue to outgrow the market by a wide margin. Operating margins return to near record levels and incremental was strong. It is clear that our investment program and operating plans delivered substantial results. And I am gratified that we were able to achieve all that we promise to 2011. These accomplishments are indicative of our leadership position in the marketplace.

Now let me provide our view of the broader picture. Like everyone, we've been concerned by recent market volatility, a moderating ISM trend, domestic and world events and how they are impact, might translate within our customer base.

Given the uncertainty of the current environment, I wanted to spend some time laying out what we are hearing from our customer's about business conditions. And then explain our approach to managing our business.

Let me start with business conditions. As you know, we have a thorough process to provide us with field data from all markets across the country. That process is used in conjunction with the field and customer business regularly made by our management team. To provide us with as clear a picture as possible of customer sentiment and up-to-date trends as much as possible.

We pushed hard to identify where customers might be slowing down and how they are being affected by current conditions. Well, there are always pockets of customers who are outpacing or underperforming the market. In general, we are pleasantly surprised by what we continue to consistently hear.

The clear scene is that business conditions throughout the bulk of our manufacturing segment generally remain quite solid. Customers also broadly reiterate their focus on doing more with less, which bodes well for the MSC model and our share gain prospects.

And while we view this as very good news, customers also do express concerns over potentially slowing backlog, their continued resistance to hiring and caution over world uncertainty and its potential impact on future business conditions. However, to date, that has not materialized in their businesses, as of now. And we continue to operate in a moderate growth environment.

Our approach to managing through uncertainty in the environment remains the same. First of all, we are proactive. As soon as we sense a wave of volatility in 2008 we began to slowdown spending. We did this early on, so that we were operating on our toes not our heels, poised to capitalize on the opportunity that invariably comes with any market dislocation. You'll hear these things through Erik and Jeff's comments regarding the actions we took in Q4 and what we anticipate in Q1.

Next, we are long term planners. That means we realize that we must continue to invest for the future of this business. You'll see us do so, to varying degree, no matter what comes our way, just as we did in 2008 and 2009, during even the most extreme conditions.

Overall, we continue to invest in higher rates than anytime in recent history. And we are focusing those investments in a number of critical areas including sales force expansion, metalworking capabilities, wending solutions, private brand and e-commerce among others. I can't remember time throughout my 23-year career at MSC. It has presented as many opportunities to our company as those provided by today's land grab environment.

The final point I'll make is that we are balanced. Our mission statement drives us to be the best as measured by all of our stakeholders. That means that we're also balanced to long-term need to invest with the short-term to provide acceptable returns to our shareholders. We anticipate expanding our operating margins in a moderate growth environment or better. Should things deteriorate, that of course becomes more difficult to do.

However, we will continue to be mindful of keeping operating margin strong. Well, at the same time investing for the future. The results for Q4 and of the entire fiscal year '11 were excellent. I couldn't be more pleased with the company's performance. And I am very proud of our associates, their dedication, hard work and how well we work together as a team, which enables to us to accomplish great things in this pas year.

I'd like to give some guidance for the first quarter. Based on current market conditions, the company expects net sales for the first quarter of 2012 to be between $538 million and $550 million and diluted earnings per share to be between $0.91 and $0.95.

Thanks and I'll now turn the mike over to Erik.

Erik Gershwind

Thanks, David. I'd like to start with a sincere thank you to you, to our Board of Directors and to the entire MSC team for the continued vote of confidence and the additional responsibilities that you've granted me. It's an honor and a privilege to lead our company. As well as we performed over the past several years, I can honestly say that our future has never looked brighter.

I'll now turn to the quarter. We continue to execute well, and realized the benefit of our investments in the form of accelerated share gains. Q4 sales growth of 15.6% included manufacturing growth of 20.3%. Non-manufacturing sales growth drop to 3.3% for Q4 reflecting continued softness in the government sector. While government sales increased from Q3 to Q4, we did not see the same list that we saw a year ago. So growth rates were negative for the quarter relative to last year. This had the effect of reducing the growth rate in non-manufacturing sales for the period.

Looking ahead to the first quarter of FY '12, the mid-point of our guidance implies revenue growth of 15% inclusive of ATS and 12.3% on an organic basis. That forecast includes the assumption of continued softness in the government sector, reflecting the start of the new fiscal year in which spending restrictions are typically tight.

It also assumes continued strength in our manufacturing sales. Our new Big Book released on September 1st, included approximately 14,500 new products and the removal of 17,500 underperforming or discontinued products. We will add an additional 20,000 products to our online catalog during fiscal 2012 as well, for a total of 34,500 SKUs for the year, approximately 50% of the new products that are added to the Big Book, our MSC proprietary brands, bringing our total private branded offering to 65,000 items.

Embedded in the new Big Book was a price increase of roughly 3%. Price realization in Q1 has been solid and as expected. Other tailwinds in Q1 include our growing manufacturing in core businesses and the benefit of our strategic programs including private brand, and global sourcing and our discount management program. We have seen additional headwinds in Q1, which is accelerated realization of purchase cost increases due to the sustained commodities inflation that we've seen over the past year. This is not a surprise and is essentially a catch-up to the price increases that we've taken to-date.

Looking to the future, we anticipate a mid-year price increase assuming the conditions hold, which should mitigate the effects of those cost increases. And Jeff, will provide more complete gross margin detail in just a bit. We were excited to bring American tool supply into the MSC family during the fourth quarter.

ATS has been a leading metalworking distributor and a top competitor in New England from many years. It's reputation as a well-run company with similar values to MSC, a customer focused culture, a highly skilled technically oriented team and value-added services such as (readlines) and special fabrication of cutting tools were all important factors that drove this acquisition. We're even more confident in the synergies that we see between our two businesses, now that we've been working closely together.

We plan to accelerate revenue growth on account penetration by brining the best of both company's values to our customers. We also plan to expand gross margins by leveraging MSC's purchasing power and by generating incremental revenues to the MSC Big Book offering that will come with higher margins. Well at the same time retaining the important brands that are unique to their business. The integration of ATS is proceeding on schedule and according to plan.

ATS results were breakeven in Q4 and should remain so in Q1, and will then become accretive during Q2, when we'll have completed the systems integration. Going forward we won't be breaking out ATS is result separately. As you hear from Jeff, ATS had a dilutive effect on MSC's overall gross margin and read through this quarter. However, we could not be more excited about the prospects for extended profitability resulting from the ATS integration and future acquisitions that we'll follow.

I'll take a moment to refresh you on how we think about M&A. There were two types of acquisitions contemplated in our strategy. One is the platform, which would represent a move into an adjacency such as a product-line or new end market. The other is a fold-in, which is a way to few our geographic build-out and penetration of the U.S. metalworking market.

It's tough to paint the potential platform moves with one brush in terms of operating margins, as they'll very greatly based upon the product-line, end market, where the individual target being considered. Those will need to be described on a case-by-case basis. Conversely, based on our significant experience, we are able to broadly describe the characteristics of fold-ins.

As you know, virtually all of traditional industrial distribution operates at significantly lower gross and operating margins in MSC. This means that when we first buy a local distributor, it will almost certainly be dilutive to gross margin and to operating margin. However, because these businesses are in our core, synergies are large like the once we describe for American tool. Those synergies help make fold-in acquisitions accretive quickly and also serve to significantly increase the target company's gross and operating margins over time.

Our acquisition program from the 1990s, 10 or more years later, now gives us a solid understanding of what we can expect for the future. We've seen that over extended periods of time, the traditional branch space acquisitions we made, end-up looking pretty similar to an organic MSC branch. We are confident that our formula for acquiring and integrating these businesses will significantly expand their operating margins and is repeatable for the future.

The MSC value preposition continues to excel in delighting customers. A recent visit to a large machine fabricator in the North East was another validation point for me. I had a chance to meet with the plant manager who described to me the history of the relationship between MSC and his company. As he was doing so, he asked the question of me that I have to made me smile.

He asked, why would a metalworking shop need to business with anyone other than MSC. He was describing that there were several things he appreciated about MSC. First, the combination of our enormous product offering and superior logistics, which means he doesn't have to worry about keeping inventory on the shelf, nor does he have to worry about an out of stock, that could affect the production run.

Second, the technical strength of our local salesperson and a metalworking specialist means that we're providing advice on the plant floor to generate productivity and cost savings. Third, our technology solutions including e-commerce and now vending. As he was getting ready to install his first vending machine, streamline is purchasing process, and helped take inventory out of the system.

The best part about these customers is a fact that despite high levels of satisfaction and despite the fact that this is a six-figure account for MSC. We see runway to more than double our revenues based on additional opportunities within the plant. We continue to add to our industry leading sales organization. The sales force grew to 1,051 associates at the end of Q4 including 15 top producers who joined us from ATS.

We expect Q1 sales force headcount to be roughly flat with Q4. This flattening is strictly a matter of timing between Q1 and Q4 and does not indicate further spending slowdown. When taken together, our Q4 actual and Q1 projections are consistent with David's description of a gentle slowing and spending was continued investment for the future.

Thanks, and I'll now turn things over to Jeff.

Jeff Kaczka

Thanks, Eric. Overall, we had a great quarter and we're excited with the way we've ended our fiscal year. For the fourth quarter compared to the same period last year, sales grew 15.6% of which ATS contributed 1.2 points of growth. Gross margin is up 110 basis points and EPS grew 33%. Our earnings per share was $0.93 for the quarter and this exceeded the top end of our guidance range. The primary fact is contributing to this higher than expected EPS were higher sales, favorable operating expenses and lower than expected tax provision.

Let's talk briefly about this. First, our sales came in above the mid-points of the guidance range excluding ATS's contribution. Thanks, again to even stronger than expected growth from our core customer base. We continue to realize success from our growth initiatives. These incremental sales above our mid-point contributed about $0.015 of additional EPS. Second, our improved operating expenses were the result of some reduced discretionary spending as well as favorable results in such areas as professional fees, payroll and freight expenses. I should mention that a portion of the savings in professional fees is expected to spend in Q1 and is included in our guidance. The lower than anticipated operating expenses contributed an incremental $0.045 to EPS in Q4. And the remainder of the incremental EPS about $0.02 came from the lowered and expected tax provision which resulted from higher charitable contributions and favorable expiration of statutes.

So we had plenty of good news. We're also pleased with the 17.6% operating margin we achieved in Q4 including 30 basis points of ATS dilution and I should note that the incremental margin in Q4 was 32.5%.

Our tax rate for the quarter came in at 36.5% which was lower than expected for the reasons I mentioned earlier. I would expect this to return to more normalized rate in Q1.

Turning now to the full fiscal year, we achieved record sales in profitability levels. Sales were $2.022 billion and 19.5% increase over fiscal 2010. Our total year operating margin was 17.3% and incremental margin was 32.7%. Our EPS was a record $3.43 per share that's 44.7% growth over last year.

Q4 balance sheet metrics remain strong. DSOs were 44 days unchanged from Q3 and inventory returns were 3.46 down slightly from Q3 level and were as expected. Inventories increased about 7% from fiscal Q3 levels as we continue to take advantage of our liquidity and financial strength to ensure our ability to meet customer demand and enhance our service levels as well as protecting our gross margins in this inflationary period.

The increase in inventory is expected to continue to Q1. Cash flow conversion was outstanding. We converted 109% of our net income into cash flow from operations in Q4 and we had approximately $96 million in cash and cash equivalents at the end of fiscal 2011. Our current cash position stands at approximately $125 million.

During the fourth quarter, we repurchased 1.2 million shares of our common stock for approximately $66 million. And I'm pleased to report that our Board of Directors has recently approved a replenishment of the plan to a total of 5 million shares authorized for future repurchase. The Board also approved an increase in our quarterly dividend to $0.25 per share.

Turning now to our guidance for Q1, our anticipated sales growth, that to mid-point is 15%. Excluding ATS, the anticipated growth at the midpoint is 12.3%. Both of these views reflect solid growth on top of the 20% quarter, a year ago.

We currently expect gross margins for Q1 to be in the range of 46.2% plus or minus 20 basis points and to be clear this is net of 60 basis points of dilution from ATS. Over time, we would expect the gross margin dilution from ATS to moderate as we execute upon the synergies that Erik described.

Excluding ATS, our organic gross margin of 46.8% is consistent with our expectations, taking into consideration all the factors including the product cost catch up which is now flowing through cost of sales. Currently, we think gross margins in Q2 of fiscal 2012 will be that to same as in Q1 as the benefit of tailwinds from pricing and strategic programs will offset the headwinds from the accelerated purchase cost catch up. We intent to provide more color on this on our next call.

In Q1, we expect operating expenses will increase at the mid-point of guidance by about $4 million over Q4 reflecting the inclusion of ATS's operating expense for the entire quarter. Some deferrals from Q4 and expenditures necessary to support anticipated future growth.

We expect our incremental margin in Q1 to be about 26% and I should mention that if you exclude ATS we would achieve 32% incremental margin. We won't be providing incremental margin guidance for the remainder of 2011 at this time due to somewhat limited visibility and uncertainty regarding the economic environment but we will revisit this on our next quarter.

Finally, the Q1 tax rate should be about 38.3%. And so Jeff could be clear with our Q1 sales guidance at the mid-point being up 11% from Q4 and our gross margin increasing. He might expect the sequential increase of $0.04 or $0.05 in EPS. However, this is all essentially offset by the fact that Q4 benefited from the lower tax rate and the discretionary spending deferrals that won't repeat in Q1. Again, we're thrilled with our results and we were headed for fiscal 2012 and beyond.

Thanks, and now, I'll turn it back to David for the wrap up.

David Sandler

Thanks, Jeff. Three years ago, we outline our plan to take disproportionate share during the land grab opportunity that we saw emerging. Our results and accomplishments for fiscal '11, once again highlight, how we have capitalized on the environment and delivered on that plan. We see a continuation of that opportunity for fiscal year '12.

Over the last three years, the economy has taken its toll throughout the fragmented landscape comprised of thousands of local competitors. The strongest have rebuilt balance sheets and repaired their service models, and are competing effectively. The greater part of that population, however, has been weakened over that period.

They struggle to maintain inventory levels and a competitive service experience, especially so in today's world where customers are demanding more. And we're saving time and money from a consolidated supplier base as became mandate. Regardless to what the economy might have been store this year? One thing is for sure, expect the MSC team to be aggressively taking market share and expect us to continue to press our advantages and accelerate our lead as we invest in further building out our capabilities.

Question-and-Answer-Session

Operator

(Operator Instructions) And now our first question comes from Sam Darkatsh of Raymond James.

Sam Darkatsh - Raymond James

Jeff, I respect that you're not going to be talking about incremental margins for the entire year of 2012, fiscal year '12. Could you talk however about what organic growth would be required in order to leverage operating expenses at this point?

Eric Boyriven

Sam, it's Eric. I'll actually take it. You heard in our prepared remarks, David, talked about that where we turn the moderate growth environment of better, we're pretty confidence in our ability to expend operating margins.

So that's really the color that I gave you now. Of course the question is that we had a moderate environment and what I tell you that if you asked us right now for snapshot of how we see things, right now we would say yes, we're in a moderate growth environment and therefore we see this likely that we could expand operating margins. And I think they are the proof is in the pudding. So you look at our Q4 performance, you look at the guidance we gave for Q1, which were strong revenue growth and expanding operating margins and really strong read-throughs.

And we also hear that reflected in the customers' sentiment that David described which as a snapshot right now is solid. The real trick for us is our availability to see around the corner and know what's coming. So if we knew that the future could look as it looks right now. We would be able to state a good degree of confidence that we would expect to expand operating margin. The challenge of course is we don't know what's coming around the corner.

Sam Darkatsh - Raymond James

Two other questions, first, with a very heavy share repurchase, or relatively heavy share repurchase in the quarter, does that signal a change in strategy on a go forward basis as to usage of excess cash? And then if you could help us, if that's the case. How that might manifest itself on a decision basis to buy stock?

David Sandler

Sam, David. No change in strategy whatsoever I think that what you had a window in this quarter I think was actually a really good window into our formula in general. So between what you saw for this quarter buying back stock, solid M&A activity, and increase in the dividends and then not longer what you also saw one-time dividend. I think those are the components that you seen from us over time. And those are the components you can expect us to continue to move forward with. So, now, strategy is the intact and the formula is operating exactly as we would have expected it.

Sam Darkatsh - Raymond James

Last question, your government business being down in the quarter. I don't think that's much of a surprise based good budgetary restrains, but your largest competitor mentioned that their government business was up in the quarter, any sense of what's happening a competitive standpoint?

Eric Boyriven

I think you characterize that rights sequentially from Q3 to Q4, as we expected, we did see a lift in sales, but not like the lift we've seen in the prior year. So you are correct, that it was negative for the quarter. And as we said, our guidance implies included in the guidance is continued softness in government. Tough to comment on another company's performance, there is lots of mix elements within government depending on where exposure is.

What I will tell you is we're very confident in our plan. And confident in the fact that we're executing or achieving share gains. And we're sticking with this segment just as we stuck with metalworking in '08 and '09 when it was declining knowing that that will lead to further share gains upon a rebound. So we're confident in our plan.

Sam Darkatsh - Raymond James

Are you seeing the risk of benefits yet or not yet?

Erik Gershwind

We are just starting to. Early stages of it Sam, but we're just starting to.

Operator

Our next question comes from Hamzah Mazari of Credit Suisse.

Hamzah Mazari - Credit Suisse

The first question is just on pricing. Could you remind us what the, given the fluctuation in commodities and your ability to adjust pricing what the lag is associated with the product cost catch up? And whether you're getting any push back from customers on current pricing given the uncertainty out there?

Erik Gershwind

I'm happy to adjust pricing. For the last couple of years, we've been talking about how inflationary environments are generally good for MSC and yield gross margin expansion. And I think what you've seen play out since the downturn has been basically the formula working just as we would have thought, it would work. We are seeing gross margin expansion.

So we've talked about our price increases. Realization, I mentioned in the prepared comments, realization is strong. Solid, just as we would have expected. So to answer your question specifically, yes we're seeing pricing stick.

When we talked in the prepared remarks about the purchase cost catch up essentially what's going on is there is a timing lag between a sale price, and this is part of by the way, the gross margin expansion opportunity that we have is a combination of a lag between when we're able to pass along the sale price in advance of realizing a cost increase. And also this is an opportunity for many of our strategic suppliers in inflationary environments to hold that cost increases to us which is a further way to expand margins.

Hamzah Mazari - Credit Suisse

And then just a last question on your growth initiatives, global sourcing, vending private labels and others. Is there one, where you find that you have the most running room or low hanging fruit. And how should we think about that or are you taking, more of sort of a, broad based approach to all these initiatives?

Erik Gershwind

What I would say is we're in a fortunate position where I couldn't pick out one. There are several and it's the investments that we've continued to highlight in the last few calls. We see significant run way and significant returns on investment in all of the ones that we've been highlighting. And that really, that's quite frankly why we pushed them to the top of the list. So I wouldn't call out any one. What I would say is the ones that between David and I have, we have highlighted on the last few calls, all good return and all significant run way.

Hamzah Mazari - Credit Suisse

Do you guys have any specific targets or are you guys don't disclose on global sourcing or where you want to be on private label?

David Sandler

Sorry, on private brand in particular, yes and yes. We absolutely do have targets. We have aggressive targets internally that our product management team drives to. Yes, you're correct. We don't share them publicly. You may not have noticed we did share one piece of information that we have not shared before which is the SKU count of private brand which is at about 65,000. So at least directionally that gives a feel for the fact that there is critical math in the program and yet there also is a heck of a lot of run way for the future.

And going forward, what we will do is, annually as we update you on these stats on the big book, addition each year with new products. We'll give you an update on the private brand, SKU count as well.

Operator

Our next question comes from Ryan Merkel of William Blair.

Ryan Merkel - William Blair

My first question is on pricing. Can you, may be discuss which categories you're seeing in the price increases? And then second part of that question is what gives you the confidence that you could get a midyear price increase this year?

Erik Gershwind

Pricing, we typically don't Ryan disclose within, so we gave you the roughly 3% increase, not going to break it out by product line. Directionally what I would tell you is its inline with where we're seeing significant commodities inflation. So you can certainly look at steels, tungsten is another example of the raw material that's been up considerably So those product lines that are directly impacted by those raw materials would see disproportionately bigger increases.

Regarding your point on the midyear pricing line, so it is really a couple of factors that we look at. One is customer sentiment and pricing in deceits. And the fact that we believe that the market still supports commodities pressure is absolutely still there, our customers are feeling it. So we think the environment is right.

And the other thing that we talked about in the prepared remarks is that customers are doing more with less. And in environments like that the MSC value preposition gets even stronger and the gap to the rest of the market even wider so we believe that we're able to command it by offering the tremendous amount of value to our customers.

Ryan Merkel - William Blair & Company

And then second question, with one month left in your quarter, the sales guidance range to just quite a wide range for November sales. Anything to read into there or is that just simply consistent with your formula?

Erik Gershwind

Ryan nothing to read into, just timing month-by-month, nothing to read into in terms of any movement.

Operator

Our next question comes from Matt Duncan of Stephens Inc.

Matt Duncan - Stephens Inc.

The first question, I've got maybe this one is for you Erik. If you can talk about the various end markets within your manufacturing customer base, where you're seeing strength and are there any way you're starting to see any kind of weakening on the fringes, within specifically manufacturing?

Erik Gershwind

Matt, what I characterize is that we usually do, it's really where we're seeing the strength is within our core market which is durable manufacturing. It's pretty broad-based strength. As David said, it's interesting because the snapshot right now is strength. We're not sure about the future hold, but I would characterize, it is pretty broad-based across durables.

And really, I would just highlight, government is the one area that we've already spoken about in terms of where there is continues to be significant softness to the budget constraints.

Matt Duncan - Stephens Inc.

When you talk about uncertainty in terms of what the future holds, is that tied to any change in customer tone you're picking up or is that really sort of what we see in the media more than maybe what you're seeing in your business?

Erik Gershwind

Matt, I thought David did a good job of capturing it. What he said is, as we do we're asking customers now is generally business conditions right now are solid. There are a couple of yellow flags that could indicate an issue down the road. So, looking at order backlogs perhaps not being strong, looking at reluctant to higher or invest in capital equipment indicate things might not be as strong down the road.

So, from a customer standpoint that's how I described it. And the other measure that we look at and everybody does this, the ISM which last few readings, we kind of, consider as borderline readings in terms of whether we would characterize it over the moderate growth environment right now or not. Last few readings have been borderlined, so that's where we're looking at.

Matt Duncan - Stephens Inc.

On the operating expenses, it sounds like there is some discretionary cuts or maybe just holding back on increases occurring during the quarter. Obviously you would add into your sales force. So what types of operating expenses, where you guys maybe sitting on a little bit this quarter and do you expect to reaccelerate those?

Jeff Kaczka

Matt, this is Jeff. The operating expenses that were deferred really were discretionary expenses are mostly on low priority projects and associated consulting fees and so it's not necessarily mission critical, nothing that on materially affect us at long-term. Some of these particularly professional fees were on specific projects were deferred into the first quarter. So you'll see those incurred in the first quarter and that is included in our guidance.

Operator

Our next question comes from Adam Uhlman of Cleveland Research.

Adam Uhlman - Cleveland Research

First to start, appreciate the extra disclosure you guys are providing. That's pretty helpful. But Erik, when you were going through the acquisition strategy, I guess, I am wondering, if we should expect an acceleration of acquisition activity from doing out small deal, once every nine or twelve moths to something more frequent and potentially larger?

David Sandler

We have talked about the fact that we built the plan. We have a development team that's now in place very, very focus. And I will tell you Adam, that our funnel of opportunity is pretty full. Having said that though, we're going to continue to maintain our discipline and our focus on really strict criteria, so I think you'll see us continue to execute here in a very measured way.

Relative to the past several years, obviously the activity has increased, evidenced by two (fold-in) type acquisitions that we did in 2011. And I think, that's probably the best way to characterize our thinking about what you might expect moving forward. And also just to let you know, that the process that's been built coupled with the team that's in place, gives us a lot of confidence in our ability to execute in this area.

Adam Uhlman - Cleveland Research

And then, couple of clarifications. The average transactions size jumped a lot this quarter relative to last. Can you talk about what's you're seeing there? And then on the regional sales, what the (inaudible) growth rate accelerated in the quarter. And I'm wondering, what you're seeing there if you got help some from the hurricane or what exactly that was?

David Sandler

Yes, Adam so just to take them in order, average transaction size, you're right. It was up roughly 4% and nothing specific to call out there. So that was strength we saw pretty much across most of our segments. I wouldn't call out anything unusual.

And regarding the Northeast, you're right. And really what I would point to more than anything is just a solid performance within our core business, which is a big percentage of our Northeast segment, so more so than any one isolated event like a hurricane.

Operator

Our next question comes from David Manthey of Robert Baird.

David Manthey - Robert Baird

First off, could you tell us what average daily sales were in September and October excluding ATS?

Jeff Kaczka

I don't have the number. So we don't give that.

Erik Gershwind

So, David, what you're really looking for, David, I think is our estimate for the first quarter, right, on ATS?

David Manthey - Robert Baird

I'm just looking for same-store sales in those numbers.

Jeff Kaczka

The number we can't give you is the guidance for Q1. So organic meaning without ATS, the guidance is 12.3% organic growth for Q1. That's all in for the three months of projection.

David Manthey - Robert Baird

So in a given month, would it be a couple of percentage points, or what would it contribute?

Jeff Kaczka

I would just about straight line it, because if you go look at the stat sheet, Dave, you'll see that there is not a lot of variation going on right now.

David Manthey - Robert Baird

As you look back to fall of 2008, you've gone over some of the things that you're seeing today, we can sort out the similarities and differences. But anything else you want to touch on as it relates to this environment versus that one? The second question is related. I'm wondering if you're hearing any chatter among your customer group regarding yearend shutdowns or taking off extra time around the holidays, which I think was something we heard back then?

David Sandler

David, I guess I'll start on the first and then Erik can add any color about what might be coming for shutdowns. In terms of the environment today versus what was happening in 2008, thankfully there are not many, if any, real similarities. If you remember back then, the world was falling off and was gaining momentum. And I guess the metric that probably best brings it back to specifics for our business was what we saw happening with the ISM.

While there is a lot of uncertainty right now and we're having some caution coupled with a bit of a moderating trend with ISM, et cetera, and of course there is a lot of world uncertainty that's out there as well, that's kind of contributing to the overall uncertainty and a bit of lack or disability. We are prepared for it, but thankfully what we saw in 2008 is very different than anything that we're seeing right now.

Erik Gershwind

First of all, just to reiterate what David said, if you went back to 2008 and looked at our comments, I'm pretty sure they were pretty decisive in terms of what we were seeing. And as we said, we're describing it now as if you took a look at the current snapshot, it's pretty solid. It's just much more of an uncertain picture moving forward.

To be honest, on yearend shutdowns, not hearing much talk of it at all yet. The discussions with our customers have been so focused on what's going on now, what's happening to backlogs, don't have a good answer to it because it's really not been on top of mind. We will obviously give you a lot more color on that on the next call as to what we saw in December.

Operator

Our next question comes from Scott Graham of Jefferies.

Scott Graham - Jefferies

I just had two questions for you, specifically about your private label strategy, your decline in direct mail. I'll take the second one first. I know that the direct mail decline is orchestrated or what have you. I was just wondering where those resources were being redeployed.

Erik Gershwind

You saw a pretty big preview. It's typically in Q4, if you go back over the years, you will always see a drop from Q3 to Q4 in mailings. But you're absolutely right that the drop was more pronounced this year. A couple of things to say about that.

One is, in terms of where the funds get redeployed, it's to the growth investment initiatives that David highlighted in his opening remarks. So part of our process is to basically moving to what we see as the best opportunities, the highest.

The other thing I'll say is that another part of the story here, Scott, is the success of our electronic marketing program. So we're getting as many or more customer touches with better performance and a much lower cost. This is a beautiful thing in that. Yes, we're redeploying money and we don't think we're giving anything up in the process.

Scott Graham - Jefferies

I know that private label is another strategic area for you guys. Did you give an indication of what private label sales were up of what they were as a percent of sales? Maybe you could just shed some light on that for me as well as maybe a long-term target if you have one?

David Sandler

We've got long-term target. We have near-term targets. And percent of sales, we don't disclose them publicly. As you know, we've been, for competitive reasons, fairly opaque here.

What we did share in the opening remarks was our SKU count on private brand. And that should give you a directional sense of how far penetrating we are. That was 65,000 SKUs in the catalog that are private branded. So that should give you a feel for some critical mass in the program and a ton of run rate for the future.

Operator

Our next question comes from John Inch, Bank of America-Merrill Lynch.

John Inch - Bank of America-Merrill Lynch

I guess my first question is it looks like a year deferred spending was something on the order of $3 million versus what was going to be incurred in the fourth quarter. Is that about right in this wrapping number that you expect to incur in this first fiscal quarter?

Jeff Kaczka

That's in the range, John, $3 million to $4 million. And in fact, a portion of that would be deferred into the first quarter.

John Inch - Bank of America-Merrill Lynch

I know you said $4 million was the original deferral. I'm just trying to focus on the spending part. That was about $3 million. Is that about the number?

Jeff Kaczka

That's in the range, John, yes.

John Inch - Bank of America-Merrill Lynch

I think, Jeff, you mentioned these were small projects and so forth. Why did you actually defer them? If the company is doing so well now, particularly if there is a risk of a slow incoming, why not do the projects now given your earnings strength and demand strength, absorb the cost versus deferring them? Why did you actually defer them?

Erik Gershwind

I think what you're getting at really tracks to David's opening comments about how we like to manage the business through an uncertain time. And the answer is that we like to be proactive. And if we see uncertainty coming and you saw this is David said, of course in a much more extreme case in 2008, we got ahead of it early. We took actions probably faster than most and we cut spending aggressively, faster than most. And we did that.

So we were proactive in that we could be on our toes when we saw opportunities. And that's really the formula that we followed this time, obviously to a much lesser degree, but it's to be proactive and get ahead of it and positioned to be able to move when we see opportunities.

John Inch - Bank of America-Merrill Lynch

I think what you're just saying, Erik, is that the project spending, if you had actually started them, was going on for a few quarters. And we we're taking a slowing, I think we'll prefer to not have these cost headwinds in that context. Is that accurate?

Erik Gershwind

John, for a portion of it, I think that would be a good description.

John Inch - Bank of America-Merrill Lynch

So I want to ask you guys, you're forecasting gross margins a little bit sequentially. If I go back a year ago, your gross margins went from 44.9 to 46. This time your volumes were 15% less. They were 23%. And your profit conversion looks about similar. Why were your gross margins not going up a little bit more than your forecast guidance?

If I just take the year-over-year trend of what happened from the fiscal quarter in 4Q'10 to 1Q'11, that period is not as robust in opportunity for margin expansion.

Jeff Kaczka

John, if you look at the gross margin numbers excluding the impact of ATS, you should see it's going up about 50 basis points. And if you track last year and the last several years, an increase anywhere from the range of 15 basis points to 110 basis points occurs during that Q4 to Q1 period and of course the benefit of the big book price increase.

This year, as Erik mentioned in his comments, we're going to face with the purchase cost catch-up, and that's the primary factor keeping it at the 50 basis point level. I remind you that that purchase cost increase also was one of the things that aided us in achieving the price increases we have over the past year.

John Inch - Bank of America-Merrill Lynch

Can I just then ask you finally here if you guys could give us a little color on the impact of basically rebates, how that affected the quarter and your outlook and then the drop ship, what was the impact there this quarter in your outlook.

Jeff Kaczka

I'll take the rebate portion of that. I think during the last call, we had mentioned that the rebate levels in Q4 would drop from the previous quarter. FY'11 was an unusually high year for rebates. We did return to those more normalized levels and we would expect that to continue through FY'12 and again came in as expected.

Erik Gershwind

John, regarding the drop ships, are you referring to some of the large order activity that we prescribed overtime?

John Inch - Bank of America-Merrill Lynch

Yes, exactly. Was that significant this quarter and what's your outlook?

Erik Gershwind

Continued sort of large orders that we prescribed to come in at a lower gross margin percentage, continue to be positive mix of business. The one thing I'll point out with government down, we said that the large orders are more prevalent in the large account segments and one of those being government. So with government sales being soft, slightly moderated, but still an ongoing presence, yes.

John Inch - Bank of America-Merrill Lynch

In other words, that probably helped you mix a little bit, right?

Erik Gershwind

Yes.

Operator

And our last question comes from Brent Rakers of Morgan, Keegan.

Brent Rakers - Morgan, Keegan

Maybe just three quick questions. Maybe hoping you could explain in a little bit more detail what this purchase cost catch-up you're referencing. That's question one.

Number two, I know you talk a lot about the government sector and some of the impact last quarter. Could you maybe talk about it going forward? In the quarter last year, the business starts to decelerate pretty sharply. So I wondered a de-impact of the comps.

The last question, just if you could maybe the number of ATS employees.

Erik Gershwind

Brent, it's Erik. I'll take the last question first, because it's the shortest answer, which is 90, ATS associates. Let me go back to your two that will take a little more time.

So purchase cost catch-up, I talked a little about it earlier. Essentially what you have going on is, as I talked about, inflation means margin expansion for the company because we're able to take prices ahead of cost increases. And while we certainly pushed back on suppliers and I think did a very good job on the buy side, given the sustained commodities' pressure, at least a year now over prolonged period of time, on an absolute level we do see elevated levels of purchase cost. And that takes time to go through the P&L.

Whereas, with sale price, we are getting it earlier on. So in general, the formula has played out to produce sizeable gross margin expansion, but there is a bit of mismatch in timing, and that's when we talk about purchase cost catch-up. So that's what we're referring to.

Brent Rakers - Morgan, Keegan

And then just the question on government comps going forward?

Erik Gershwind

Let me talk specifically about Q1, Brent. Despite the softness that we described in Q4, we actually have government average daily sales implied in our forecast to be down from Q4 levels. The primary factor there is the yearend spend of the government, which their fiscal year is end of September. We normally see a drop-off after yearend because of tighter budget restraints after the end of fiscal.

What I would tell you is that with continued pressure on federal and state governments, we're seeing and expecting to see an either further clamping down at the end of this yearend.

Brent Rakers - Morgan, Keegan

I know it's time to wrap up the call, but just to clarify that, you said government went negative year-over-year in the August quarter. It sounds like both in the guidance for the next quarter, but also going forward, you see it being at a sustained modest negative level for the next several quarters?

Erik Gershwind

I can't talk about that, Brent. Certainly for Q1, and that's what's implied in our sales forecast. Beyond that, it's a bit of an unknown. I mean certainly the environment is not great. I wouldn't comment beyond Q1.

Operator

This concludes our Q&A session. I would like to turn the conference back over to management for any closing remarks.

David Sandler

Okay. Well, thank you. I appreciate your time and all of your interests today. And we look forward to speaking to you again next quarter. Thank you.

Operator

This concludes today's conversation. Thank you for attending today's presentation. You may now disconnect your line.

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