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

F1Q08 Earnings Call

January 10, 2008 11:00 am ET

Executives

Bob Joyce - Investor Relations

David Sandler - President, Chief Executive Officer, Director

Charles A. Boehlke - Chief Financial Officer, Executive VicePresident

Shelley Boxer - Vice President - Finance

Analysts

Sam Wong - Lehman Brothers

Yvonne Varano - Jefferies & Co.

Robert Mccarthy - Banc of America Securities

David Manthey - Robert W. Baird

Jeffrey Germanotta - William Blair

Brent Rakers - Morgan Keegan

Adam Uhlman - Cleveland Research

Gurinder Kalra - Bear Stearns

Holden Lewis - BB&T Capital Markets

Operator

Good morning. My name is Bobbi-Jo and I will be your conference operator today.At this time, I would like to welcome everyone to the MSC Industrial Directfirst quarter conference call. (Operator Instructions) I would now like to turnthe call over to Mr. Joyce. Sir, you may begin your conference.

Bob Joyce

Thank you and good morning, everyone. I would like towelcome you to the MSC Industrial Direct fiscal 2008 first quarter resultsconference call. You should have received a copy of this morning’s earningsannouncement. If you have not received a copy, please contact our offices at212-850-5752 and a copy will be sent to you. An online archive of thisbroadcast will also be available one hour after the conclusion of the call andavailable for one week at www.mscdirect.com. Certain information pertaining tonon-GAAP financial measures that may arise during this broadcast can also befound on the same website and in the investor relation section.

Let me take a minute to reference the Safe Harbor statementunder the Private Securities Litigation Reform Act of 1995. This call maycontain certain forward-looking statements that are subject to risks anduncertainties, including the future operating and financial performance of thecompany. The company believes that the expectations reflected in itsforward-looking statements are reasonable, they can give no assurances thatsuch expectations or any of its forward-looking statements will prove to becorrect.

Important risk factors that can cause actual results todiffer materially from those reflected in the company’s forward-lookingstatements are included in today’s earnings release and in the company’sfilings with the Securities and Exchange Commission.

In addition, the information contained in this conferencecall is accurate only to the date discussed. Investors should not assume thatthe statements made in this conference call remain operative at a later time.The company undertakes no obligation to update any information discussed onthis call.

With that said, I’d like to introduce MSC IndustrialDirect’s President and Chief Executive Officer, David Sandler. David, please goahead.

David Sandler

Thanks, Bob. Good morning, everyone and thank you forjoining us today. With me are Chuck Boehlke, Executive Vice President and CFO;and Shelley Boxer, Vice President of Finance.

I thought that it made sense to change the format a bittoday as I know that our shareholders are concerned about a potential slowdownin the industrial economy. I want to be sure that we do our best to articulateour vision for success should the weak data continue and that we clearlyexpress our confidence and excitement in the future of our company.

I have been active in industrial distribution for more thanfor more than 30 years. I love this industry and remain very excited about thelong-term consolidation opportunity. What I know is that there are and likelyalways will be cycles in our segment. What I have learned is that how we manageduring a downturn, if that is where the economy is headed, is critical to valuecreation when the cycle inevitably turns. I want you, our partners, tounderstand how we will prudently invest to enhance our customer experiencewhile driving productivity with even greater focus, thus enabling us tocontinue to improve earnings.

I will also provide some of the usual details about thequarter. Chuck will provide details on the financial results and on Q2guidance. After my closing remarks, we will open up the phones for questions.

I have said on numerous occasions that our expertise is atoperating this business, not making the big macro call on the economy. However,what we can offer is directional data that we gather on a regular basis, whichenables us to drive initiatives in the near-term.

Our customers tell us that market conditions are mixed.While there continues to be many pockets of strength, there is less optimism ingeneral and more concern over cost inflation, especially in raw materials andenergy costs.

What is somewhat recent is the degree to which our customersmention the possibility of a recession. That psychology is more driven by themacro news on housing, retail and job creation, et cetera. But the expectationsare beginning to find their way into our customers’ plans for CapEx and jobcreation. While this is of course a concern, it does bode well for our highservice level model which enables us to gain share as customers reduceinventory.

In terms of macro indicators, the weak durables orders,declining ISM numbers, and the recent employment report are also indicative ofa slowing market.

I have spent my entire career in industrial distribution,worked through a number of cycles and understand what they look like. I knowthat when things are busy, a down cycle will inevitably come and that when customersbelieve the economy will never recover, the boom cycle is never too far away.What I don’t know, of course, is when.

We have told you that in an environment of single-digitrevenue growth, we can grow earnings while continuing to prudently invest inour future. Our activities thus far are consistent with that commitment.

In order to protect one of our most significant assets, ourcustomers, we have invested in our inventory where we thought prudent. By doingso, we impacted short-term cash flow but will recover that cash over the nextfew quarters.

We will continue to invest in an enhanced customerexperience through this period of slowing economic growth so that we arepositioned to take even greater share when the direction of the economy reverses.

Over the course of fiscal year ’08, you will see us moderatethe incremental year-over-year growth investments if the economy continues todeteriorate.

MSC is very well-positioned to take share and we do notexpect to see any material decline in our operating margin. We are a verydifferent company than in the last recessionary period of 2001 and 2002, whenwe had just completed a program of national expansion, built three fulfillmentcenters and a completely new IS system, including a formidable Internet site,opened many branches, doubled our sales force, had significant excess capacity,and were burdened with an enormous fixed cost.

That is not the case today. Much of those investments havebeen depreciated and we carefully manage our capacity. We know how to quicklychange course in our growth investments and our headcount.

Our larger size and much more efficient systems have helpedus to increase our operating margin dramatically over the past several years.We are in a better position than ever to prudently invest in the business,protect our associates and customers, drill down even harder on productivity,continue to grow earnings, and generate significant amounts of cash.

Turning to the quarter, first quarter results were solid. Wecontinue to make progress executing our growth plan and are on plan to sell MROproducts and other MSC brands to our J&L customer base.

Our West Coast initiative is making solid progress andcontinues to meet our goals. Our new sales offices in Seattle, Portland, andSalt Lake City are now open. We grew our sales force to 854 associates at theend of Q1 and expect that we will reach 860 by the end of Q2.

However, due to timing, in Q1 the sales force continued togrow at rates well in excess of our sales growth. Q1 reflects spending in othergrowth areas as well. At the same time, we have increased our focus on managingour overall expense levels and we are pleased with the results in Q1 operatingmargin.

I’d like to give some guidance for the second quarter. Chuckwill add some details about this in his section. At this point, we think thatsales will be in the range of $430 million to $436 million and diluted earningsper share will be in the range of $0.68 per share to $0.70 per share.

Thanks, and I’ll now turn the mic over to Chuck.

Charles A. Boehlke

Thanks, David. In Q1, sales came in roughly in the middle ofour guidance range and earnings came in at the upper end as we executed on ourplans and controlled operating expenses tightly.

Sales projections for Q2 incorporate the effect of externalindicators such as lower durables orders, the decline in the ISM index,increasing feedback from customers concerned about slow downs, and the effectof the timing of the Christmas and New Year’s holidays.

Our revenues were impacted by the timing of this year’sholiday season. The holiday week brought more in the way of shut-downs thanlast year and the timing of the holidays, on Tuesday rather than on Monday asin the prior year, meant that we experienced significantly weaker sales on thebusiness day before Christmas and New Year’s than last year. In fact, morecustomers this year decided to shut down for the entire week.

We estimate that the change in the timing of these two daysprobably cost us between $4 million and $5 million in sales in Q2.

Gross margin in Q1 came in within our guidance range and wecontinue to forecast gross margin in the range of 46.3%, plus or minus 20 basispoints. Operating expenses have been under tight control, even as we havecontinued to incrementally invest in our future at historically high levels.

Operating metrics remain solid as do most balance sheetmetrics. We experienced a slight increase in receivable DSOs to 44.7 days from43 days in the prior quarter. This appears to be mainly seasonal and we wouldanticipate a lower number at the end of Q2.

We also built inventory during Q1. There are several reasonsfor this. The primary reason was to ensure the best possible service experienceto the J&L customer base as they transition from J&L’s fulfillmentsystems to MSC's system and to also ensure that same experience for all the MROSKUs that will be offered to them as well.

We also plan to build inventory to support a higher saleslevel and protect our fill rates. That inventory build started last summer andpeaked in Q1. We plan to adjust our inventory to the right size over theremainder of the fiscal year.

Free cash flow, which we define as cash provided byoperating activities less capital expenditures, was $29.4 million for thequarter and was adversely affected by the growth in inventory and receivables.We will convert a higher percentage of net income into cash provided byoperations over the balance of the year.

Capital expenditures were $2.6 million, somewhat lower thanexpectations due to timing.

In Q1, we also purchased $24.4 million of our stock in theopen market.

Thank you and now I’ll turn it back over to David.

David Sandler

Thanks, Chuck. I know that every quarter is important to ourshareholders. I think that this team has proven its ability to translaterevenue and cost control into earnings and cash flow and we fully intend tocontinue to do so in the future. We are mindful of our partners and takeseriously our job of enhancing shareholder value.

Our partners want a team that can execute in the short-termyet has the vision and the drive to deliver short-term performance whilekeeping its eye on the prize of long-term value creation. Our company has doneso since its founding by Sydney Jacobson in 1941.

We will invest in and continue to enhance the experience forour associates and our customers through a downturn if that’s where we areheaded. A slow-down will permit more time for us to focus on productivity andeliminate non-value add costs. We will do so relentlessly. We have a vision.It’s a clear one. We have a plan. It’s tight and it’s aggressive.

Our team is committed and very clearly focused on the prize-- execute, execute, execute during a slow-down and position our business forleverage in the recovery. If it sounds familiar, it is. We know that a slowgrowth economy requires real focus on the cost side. I can say with absoluteconfidence on behalf of the entire MSC team that we are prepared for thechallenge.

I’ll now open the line for questions.

Question-and-AnswerSession

Operator

(Operator Instructions) Your first question comes from the line of[Sam Wong] from Lehman Brothers.

Sam Wong - LehmanBrothers

Good morning. First question was you had talked about thechanging sentiment of the customers and there are different pockets of strengthout there. Could you go into a little bit more detail about perhaps moredetails around the industries where you are seeing those different signals?

David Sandler

We don’t like to signal specific industries that are up anddown. Part of how we actually adjust our plan and focus our sales force isspending a disproportionate amount of their time in the areas that we see thegreatest opportunity, as well as servicing our entire general customer base.

I guess to characterize a bit across, related across theregions is that we are clearly being affected by softness in the industrialeconomy. The greatest areas of slowdown are concentrated actually in thedurables sector more than any other sector. And within manufacturing, lightmanufacturing, as we refer to it, is actually growing faster to that segment aswell.

Basically the mix that we are seeing is really spreadthroughout all of our regions where we are seeing pockets of strength andweakness throughout our varying customer segments, and also you see that ourwestern region continues to grow strongly and outperform, as we’d expect, giventhe significant investments that we’ve made into our expansion program there.

Sam Wong - LehmanBrothers

And the follow-up, I mean, I think you had comments in yourrelease about customers in the current environment minimizing their MROinventory levels. Where are we in this process as the customers adjust theirinventories? Should we interpret this obviously as kind of a near-term negativeimpact, but one they reach a certain optimal level of lower inventory thatyou’ll continue to see it as an opportunity for market share growth and soforth?

David Sandler

We absolutely see it as an opportunity for market sharegrowth, Dan. You know, we think that some of the tone that we are seeing hasjust -- we’ve seen it but it is getting a little bit more pronounced. Iwouldn’t say that we are seeing anything dramatic in that respect, and I don’tfeel like the build-up of inventory or that there’s been a significant build-upof inventory.

I think in general, customers have been more cautious thanhistorically, given some of how they were burnt many, many years ago. But tothe extent that customers are more and more cautious or become more and morecautious about inventory and want to reduce their levels, they will want torely on a supplier where we are perfectly positioned to actually help them totake their inventory levels down, rely on ours, and that’s where our modelreally begins to get traction as customers become more cautious in that regard.

Sam Wong - LehmanBrothers

Okay. Thank you. I’ll limit it to those questions for now.

Operator

Your next question comes from the line of Yvonne Varano fromJefferies.

Yvonne Varano -Jefferies & Co.

Can you just address the slight increase in the tax rate inthe quarter and what we should be forecasting going forward?

Charles A. Boehlke

It’s just a slight tweak in the tax rate, as outlook on earningsand so forth change, there’s lots of variables that go into that. We have fixedelements of our tax rate in terms deductions and credits that become adifferent tax percentage, depending on how the net income plays out. There’snothing underneath of that that’s moved it substantially. I think the planningat 38-16, which was the actual tax rate for the quarter is sufficient for therest of the year.

Yvonne Varano -Jefferies & Co.

And then I know we’ve continued to add sales people here,but what has to change in the overall outlook for the environment for you toslow that growth?

David Sandler

We’ll continue to monitor that very carefully. We’ve alwaystalked about that balance between short term profitability and long-term growthinvestment, and kind of tweaking the dials. You have seen us really beginningthis quarter to do a little bit of that tweaking, so we’ll continue to adjustto maintain that balance depending on what we see coming down the pike.

Yvonne Varano -Jefferies & Co.

And then you did announce a pretty sizable share buy-back.Given your projections for free cash flow, over what time period do you thinkwould be reasonable to potentially complete something of that size? I know it’spartially dependent on the share price but just looking at the price today.

Charles A. Boehlke

We’ve never really telegraphed our strategy for when and howmuch we would buy back. It is a big allocation for us to go do so. Youmentioned that the cash flow, we would project that net income converted a muchhigher percentage of cash flow than we experienced in the second quarter as weburn off the inventory and the receivables come back in line.

So the cash flow will be there to support it. It’s just itwill be more opportunistic and we generally don’t telegraph when and at whatprice we would do it.

Yvonne Varano -Jefferies & Co.

Okay, great. Thanks.

Operator

Your next question comes from the line of Robert Mccarthyfrom Banc of America.

Robert Mccarthy -Banc of America Securities

The first question, either we’ve already been kind of in afed easing environment. From your historical perspective, given the fact thatwe are anticipating a pretty significant slowdown here, thinking about the backhalf of the year in terms of the comparison and given the fact that we arealready in an easing environment, how do you think about how the back half ofthe year treats you, Q3, Q4 qualitatively? Obviously you don’t give guidancebecause you don’t know until you roll out quarterly guidance but do you haveany kind of flavor for the compare and what you’d expect in terms of the impactof the back half of the year?

David Sandler

We don’t give guidance beyond what we see, given the limitedvisibility that we have. I guess the best that I can say is that we’ve got anabsolute plan to continue to adjust, be really opportunistic in thisenvironment, take share.

You’ve seen some of the adjustments that we’ve made with oursales force guidance. We’ve also made some adjustments with our direct mailprogram. That’s something that we post and we are constantly looking there.We’ll continue to invest prudently. We’ll continue to really balance and takeadvantage of the -- what comes along in this environment for us. But we reallydon’t want to go further in what we see as the back half of the year other thanthat we’ve got a plan to continue to adjust and continue to ensure that we arebalancing delivering our short-term earnings, coupled with investing for growthin the future.

Robert Mccarthy -Banc of America Securities

I think you’ve also reaffirmed your margin targets. Youdon’t see much deleverage in the near term or on the earnings front. I thinkit’s still positive earnings. I think that probably contemplates a relativelyshallow recession. Is that fair to say? I mean, if you saw 5% to 10% declinesin North America, would there be an update? What is the underlying economicassumption for the decline?

David Sandler

You know, I think, in speaking to a shallow recession, Rob,which is what you just talked about, I think the way to think about it,certainly the way that we do is that we’ve grown through every recession in our66, 67 odd year history really with the exception of the tumultuous times thatfollowed 9/11 and we believe that given our tremendous positioning today andthe progress that we’ve made in the many years with our business that frankly,and you mention a shallow recession, that we’ll grow through a recession unlessit’s extraordinary in terms of depth and duration.

And as we are growing through the recession, what we wouldexpect to see happen is that at mid and even low single digit growth, that wewould expect to continue to invest but that we’d invest in a way that ourearnings would grow somewhat faster than our revenue growth. And to the extentthat revenue growth grows more quickly, than our earnings will grow morequickly in terms of the delta with how much faster earnings will grow thanrevenues, and to the extent that they moderate then that delta will shrink.

Robert Mccarthy -Banc of America Securities

And finally -- thank you for that -- and finally, this maynot be something you really want to talk about at this juncture but anyincremental flavor for what we saw in December?

David Sandler

Yeah, no, we’re happy to talk about it, actually. Decemberwas -- boy, I’ll tell you, the vacations and the way that they fell, theholidays, the way that they fell, were very difficult. Last year the holidaysfell on a Monday. This year they fell on a Tuesday. Effectively, what that meantwas that the two Mondays, we’ve done work to quantify them. We think thisDecember actually got hit to the tune of $4 million to $5 million, which if youfactor that back into what December growth would have looked like, we estimatethat it would have been in the 7% to 8% range, if holidays had fallendifferently. And I guess in addition to that, we did see more customersshutting down in that month.

But we think that just because of the positioning of theholidays, it probably cost us a few points in growth to the tune of maybe evenfour or five, based on what we lost there. And I guess just to go beyondDecember, when you think about that in the context of the midpoint of theguidance that we are giving for Q2, we think that, which is currently at 7%, wethink when you factor in the loss in December, it probably would have pushed uscloser to 8% had the holidays been in a different position.

Robert Mccarthy -Banc of America Securities

So you really haven’t seen core deceleration in December dueto this compare -- there was nothing underlying that, aside from kind of thecompare, is what you would say?

David Sandler

I think that’s fair. I think that when you consider that, itmeans that December was pretty closely in line to what we’ve been seeing butwhat’s important is, what we really wanted to telegraph, a slightly differenttone that may or may not bode well, depending on what happens moving forward --meaning if the ISM continues to go down, if this sentiment continues to build,then we are signaling caution for revenues in the back half of the year andbeyond. To the extent that that changes, which it very well could, but we can’tpredict, then that’s a different story.

Robert Mccarthy -Banc of America Securities

That’s very helpful. One more question and then I’ll pass iton because you’ve been very indulgent; I think for the Q4 fiscal year ’07results, there was one additional week, right? That is the one compare we haveto think about going into ’08, correct?

Charles A. Boehlke

Correct. Obviously when we get the comps for the fourthquarter, we need to talk about that as to how that week impacted this yearversus last year absolutely with an extra week worth of sales and profitassociated with that in the last quarter of last year.

Robert Mccarthy -Banc of America Securities

Because the comp, does it work just on errata basis throughthe first three quarters then in terms of incremental benefit? Do you see whatI’m saying? Or is that --

Charles A. Boehlke

No. It’s a pure fourth -- I mean, David’s talked about theholidays and those types of things and maybe during the quarter, there’s shiftin days from quarter to quarter, but that would be not related to the extraweek. I think purely the extra week needs to be viewed in the fourth quarter.

Robert Mccarthy -Banc of America Securities

Any issue with Easter this year?

Charles A. Boehlke

With what?

Robert Mccarthy -Banc of America Securities

With Easter.

David Sandler

We’re looking to see when Easter is.

Robert Mccarthy -Banc of America Securities

It’s March 23rd, I believe.

David Sandler

We’d have to get back to you, Rob. We don’t have Easter onthe radar in this -- with the data in the room.

Robert Mccarthy -Banc of America Securities

Okay. That’s Catholic, not Greek Orthodox. I’ll leave itthere.

Operator

Your next question comes from the line of David Manthey fromRobert W. Baird.

David Manthey -Robert W. Baird

Good morning. My question is mainly related to I thinkChuck, you made a comment about the percentage of your cost structure that wasfixed back in the early 2000, and I am wondering if you can just give us anidea, if not a magnitude maybe a relative percentage to say it was X percentfixed back then and today, it’s less so by what percentage?

Charles A. Boehlke

Dave, I think what might help is that we look at -- we’vetalked about this in the past a little bit, that the out-of-pocket variable isplus or minus 10%. I think you can get to the same place the way you are goingthere, so when we look at incremental sales volume and so forth, plus or minus,we generally considered with the freight costs, the warehouse, pit cost, thecost to take the order up-front and so forth, plus or minus about 10%. Thatshould help you get where you need to go.

David Manthey -Robert W. Baird

And how is that different from what it was back in fiscal’01, ’02?

Charles A. Boehlke

We’ve had a pretty regressive cost down program that hasincluded attacking the freight cost as well as order entry cost, which is a pieceof that variable. You can see from some of the things we’ve done at increasingthe percentage of our sales that go through the website and everything else,we’ve driven down the variable cost. It’s down several hundred basis pointsfrom where it used to be in terms of -- and that’s been a major focus becauseobviously it’s spread across the entire sales base.

David Sandler

And your fixed cost as a percentage of your total cost isalso down because total cost in general, as a percentage of sales is down.

David Manthey -Robert W. Baird

Thank you. The second question is in the recession earlierin the millennium here, your sales in some months were down prettysignificantly. What I’m wondering is how do you plan to mitigate that type ofweakness this time around? If we do go into a garden variety recession, giventhat -- I suppose over the past five years or so the model hasn’t changed thatmuch on the sales side. I’m just wondering, what would you do in terms ofchanging your sales tactics? And then also, I think you’ve address a little biton the cost side, but if there is anything else you want to add there.

David Sandler

Actually, I think that things have changed prettydramatically in the last seven years, so maybe talk a little bit about what wethink happens and just a step back I guess -- you know, our model, as you know,is designed to take share from smaller distributors through our value creationmodel with our customers. We think that share gains actually accelerate duringa business slowdown as we out-compete the small distributors who really aregoing to struggle to service their customers.

So during the period, we’ll balances short-termprofitability with long-term investment spending and we’ll also focusrelentlessly on reducing our costs. That means that we’ll continue to invest inthe sales force and in many of our other growth drivers, albeit at slower ratesthan during expansionary times.

We’ll also stay very focused on enhancing the customerexperience, continuing to build our value basket through enhanced service,continuing to build out our technology solutions, our huge product SKU base andso on.

I think it also importantly, it give us the opportunity todevote more of our time to cost-down programs, things like our fulfillments atour optimization program, taking that across our other centers, really focusingmore of our time and our associates’ efforts on lean type programs, takingnon-value-added costs and waste out of the business and things that don’tenhance customer value, coupled with a real -- an even further focus onproductivity.

So we’d expect to convert our net income into free cash flowand increasing levels as we concentrate on asset management, and that we’dutilize our cash to further our stock buy-back program, our dividend program,and if there is an acquisition candidate or candidates out there, we think thattype of environment likely we’d see increases and if it were long in duration,likely we’d see valuation levels moderating as well, which could be veryopportunistic for us, as part of how we think about our strategic plans.

So I guess the other thing that I would say is that once wecome to the other end of all that, once the direction of the economy wouldchange and what I’ll call the inevitable expansionary cycle begins, we’re goingto be perfectly positioned to grow sales and earnings just dramatically, aswell as gained a ton of share, we’ll have increased our total growth driverinvestment base, we’ll have a business that’s much more lean with loweroperating costs and -- you know, you’ve followed us for a long time. What I’vedescribed isn’t a new plan. It’s one that we’ve executed on before and I amconfident in our ability to do it again.

David Manthey -Robert W. Baird

Okay, David, thank you very much for the color.

Operator

Your next question comes from the line of Jeffrey Germanottafrom William Blair.

Jeffrey Germanotta -William Blair

Good morning. A couple of questions, the first one; can wetalk a little bit about the sources of inventory build, whether it’s priceincreases, freight in, expanding the products in the catalog, more salespeople, locations, or something else?

Charles A. Boehlke

The inventory build really isn’t much of any of thosethings. It was really a defensive play to take care and absolutely ensure thatwe protected service levels through a major shift in systems and so forth forus.

So it’s really two-fold; it was to protect the J&L fillrate, as well as the MSC fill rate as we went through a pretty significantsystems conversion. Also, with the advent of the J&L team having access tothe MRO items, we wanted to make sure that was a good first time buyingexperience for the J&L customers, so it was really that kind of a defensiveplay.

We believe it’s peaked. In fact, we’re confident that it’speaked and I think you’ll see as we progress throughout the year, we’ll burn --in any growth scenario, frankly, we’ll burn a good bit of that inventory offand end up in a better spot by year-end.

Jeffrey Germanotta -William Blair

So we should be generating a lot of good free cash flow inthe year ahead, plus the dividend program?

Charles A. Boehlke

Absolutely, and --

Jeffrey Germanotta -William Blair

I mean and the share repurchase.

Charles A. Boehlke

Right. If you look at historically the last three or fouryears, we’ve converted nearly dollar for dollar of net income into operatingcash flow. That wasn’t the case with the results for this quarter and it wasbecause of primarily the inventory build with some contributions to thereceivables build. We expect both those metrics to improve as we move forwardthrough the rest of the year, which will lead to much higher conversion of ournet income into operating cash.

Jeffrey Germanotta -William Blair

Let me be clear -- for fiscal 2008, do you think operatingcash flow will be one-to-one, or do you think it will be a little better thanwhere you’ve been in the past?

Charles A. Boehlke

I would say given that we’ve got to burn off this inventoryand go through -- this is not going to be a one-month or one quarter and done.It’s going to take some time to do that but I would expect by year-end, youwould see metrics for the year-end result that are similar to what we’ve donein the past.

So in other words, instead of as we did this quarter, 67%conversion of net income to cash, I think you’ll see a higher metric throughoutthe rest of the year, approximating the historical levels as we get near theend of the year.

Jeffrey Germanotta -William Blair

And the next question has to do with CapEx and investmentspending, whether it’s facilities, IT, mailings, or sales people; can you givesome relative indications of what you are thinking for this year, vis-à-vis theyear past?

Charles A. Boehlke

Again, a lot of our investment spending -- Jeff, you knowthis so just for everybody’s edification -- investment spending for us is oftenon the OpEx side with sales force expansion, direct mail, et cetera.Specifically from the CapEx side, we see numbers we believe similar to lastyear’s CapEx spending in the $25 million range.

We have cost-down opportunities. We’ve talked in the pastabout our optimization project at our Harrisburg fulfillment center. We havethe opportunity to roll that similar type of program out to other fulfillmentcenters and we would start to do that during this year, which requires someCapEx.

So it’s a combination of maintenance CapEx, some facilityexpansion, as well as some cost down optimization projects that will be kickingin throughout the year.

Jeffrey Germanotta -William Blair

And in terms of mailings or sales people, is that going toremain rather fluid or how should we -- or more consistent with historicallevels?

David Sandler

I think that being a bit fluid is probably a good way todescribe it. You know, we’re going to keep our hands on the controls andfrankly on the dials and watch very carefully. To the extent that we continueto see a deteriorating economy, you’ll see us invest but you’ll see us moderatethose levels. And to the extent that we see debt going the other way, thenwe’ll ramp it up a bit more. So we’ll always keep a thread of investment goingbut we are going to be very mindful of that short and long term balance and weare going to watch it very carefully.

You’ve seen us make a few modest adjustments actually inthis quarter leading into Q2 with our direct mail estimates being slightlydown, as well as our sales force expansion being slightly ratcheted as well,given how well we did in actually over-achieving our goals and our expansiontargets for Q1.

Jeffrey Germanotta -William Blair

And you opened three locations recently. Your thoughts --well, one, how are they performing? And two, your thoughts regarding morelocation expansion going forward?

David Sandler

The west is a really exciting program for us. It’s stillearly in the game. It’s been about three years but we still think that that’svery early. Seattle, Portland, and Salt Lake, exciting to have the new membersof our team in, digging in and we’re excited. It’s obviously very early interms of talking about any meaningful results there but it’s very additive toour program.

We still see a lot of opportunity there and we think thatthe runway is long for investment, whether it’s branch or expansionopportunities with new sales associates, both inside and outside.

Jeffrey Germanotta -William Blair

And the focus in terms of adding sales people and/orlocations will be on the west coast in the year ahead?

David Sandler

The west coast will certainly be one of our kind ofcenterpiece investment areas. It’s not the only area that we are investing inbecause we don’t like to broadcast that too much, but certainly it will be anarea that we continue to focus on.

Jeffrey Germanotta -William Blair

Thank you.

Operator

(Operator Instructions) You have a question from the line ofBrent Rakers from Morgan Keegan.

Brent Rakers - MorganKeegan

To follow-up on the question about the sales additions,looking back, it looks like this first quarter was one of the -- maybe it wasthe most number of sales people you’ve added in any one quarter. You’ve talkedbefore about the timings of hires during a quarter to give us a better sense ofwhat the operating cost might be going forward. Could you give us a sense forthis first quarter?

Charles A. Boehlke

Actually, it’s not only the first quarter but I think if youlook at some of the statistics that we put on the web, the second half of lastyear we hired significantly more faster -- more folks, if you will -- than wehired in the first quarter of last year. And what that does, obviously, untilthose folks anniversary, you have the OpEx of people that were hired in Q3 andQ4 of last year as brand new incremental OpEx, Q1 of this year versus Q1 of lastyear. And then it will happen again in Q2. You add to that the large number ofhires we had in Q1, which just to pick the midpoint, you had a half a quarter’sworth of salary. You’ll have that full salary in the OpEx for Q2.

So we actually think investment spending, because of theprocess I described here will probably peak in Q2, doesn’t mean we won’t behiring and adding folks for the rest of the year. It just means we anniversarya significant piece of those folks that were hired in the second half of lastyear as well as fully absorbed the first quarter of this year.

Brent Rakers - MorganKeegan

Great, and then maybe further comment on the direction ofspending in terms of hiring the new sales people. You see that obviously at asignificant ramp for the last I think two or three years or so, and you seecontinued contraction though in terms of your direct mail. I think your numberfor next quarter I think is down 15% to 20% or so year over year. Anything toread into on a strategic sense from those decisions there?

David Sandler

I think strategically on direct mail, it continues to be animportant part of our program. It is one of the areas that we turn the dials onand moderate our spending. Specifically what we do in an area like that is thatwe try and focus on cutting out of the part of the program that has the longestreturns. It doesn’t mean it’s not a good investment -- it just takes longer forthat investment to produce, so that’s actually where we moderate.

The other thing that you’ve seen in direct mail and youcontinue -- it’s not really evident in our numbers but it’s something that wework on here is continuing to find better ways to reach our customers throughthat vehicle and make the program that much more productive. So we’ve been verysuccessful in doing that, in frankly getting more from less. We tested manythings that some work, some don’t, which we then implement across the programand we are continuing to do exactly that.

So strategically, we absolutely will continue with thatprogram. Of course, another element of it is that over time, more and more willfall into our electronic channels. Having said that, we get the question allthe time about gee, is paper still going to survive, both in the big book andour brochure program. And we don’t see anything in the near or frankly the longterm that will replace that.

Brent Rakers - MorganKeegan

Two more questions; one is housekeeping. I guess first thehousekeeping. In terms of the number of shares your purchased during the quarter,could you give us that number? And then also maybe a sense for if you continuedbeing active in the market in December and the first part of January?

Charles A. Boehlke

I can tell you for the first quarter, we bought roughly600,000 shares for $24 million and the rest of your question, just like Ianswered early on, we don’t advertise our strategy. I wouldn’t comment on whatwe’ve done since the end of the quarter.

Brent Rakers - MorganKeegan

Fair enough, and then last question, a lot of people areusing the “R” word quite often now. I just wondered if you can compare what youare seeing now to what you saw October, November, December 2006? We had apretty significant factory slowdown there that I think -- we call it a softpatch I guess now, but I was wondering if you can compare those conditions thento your current business conditions now?

David Sandler

We’re actually looking -- I’m trying to get what the ISMdata points looked like back then.

Brent Rakers - MorganKeegan

Okay. I think it touched maybe a low of 49 I think at onepoint in there.

David Sandler

Okay, which is pretty consistent with what we’ve been seeingfor trending in the last few months, was coming down to right on the cusp ofexpansion and contraction, although I will tell you that the tone in the lastseveral months has been pretty decent, actually, in the marketplace. It’s stillbeen in expansionary territory. I think that we had touched down and kind oftweaked contraction a bit. Of course, right now our most current data point, wedon’t know where that’s going to go, is in contractionary -- pretty significantcontractionary territory at the 47.7 that just occurred.

But remember that it takes time, that what we see for acurrent data point generally takes a series of months before it comes out,before we actually see that in customers’ buying behaviors.

So I would say that what we saw back then was reasonablysolid and what we are seeing right now has been roughly the same and we aregoing to wait and see if the tone and a little bit of what’s creeping into thetone actually converts into buying behavior.

Brent Rakers - MorganKeegan

David, is it a fair conclusion then to make that a lot ofyour more cautionary tone than maybe the last time around really rests prettyheavily on that last ISM number?

David Sandler

It’s a combination of the ISM, as you know, is one importantdata point that we watch but it’s not the only data point. We watch all themacro and probably the most important, and it’s anecdotal but it’s reallysomething that we spend a lot of time on, is getting out with our customers andreally gauging from them how they are doing in their business and what theirpsychology and sentiment is.

And while there is still a lot of strength out there, we areseeing that psychology creeping more and more into the customer base, probablyjust based on what people read in the newspaper every day, what you come andget blasted with in the news every night when you get home. When that’s goingto change -- don’t know and how much further that would get into customers’psyche that ultimately would affect their business, we just can’t call that.

But whatever happens, we’re prepared for it.

Brent Rakers - MorganKeegan

Thanks a lot, David.

Operator

Your next question comes from the line of Holden Lewis fromBB&T Capital Markets.

David Sandler

Holden, are you there?

Operator

Holden, your line is open. He seems to have disconnected.Your next question comes from the line of Adam Uhlman from Cleveland Research.

Adam Uhlman -Cleveland Research

Chuck, a question for you on the earnings guidance; whatshare count are you using in the earnings forecast? Does that incorporate thenumber of shares that you ended the quarter with or does it incorporate yourexpanded repurchase authorization?

Charles A. Boehlke

Well, a couple of things -- it for sure incorporates what wetalked about for Q1, the 600,000 shares we bought but I think as you know, thestock price and how that affects diluted shares is a pretty significant elementto determining the absolute value of the shares, so what’s been baked in thereright now is the known purchases in Q1 and a stock price that is similar towhat it is now. That’s basically it.

Adam Uhlman -Cleveland Research

Okay. And then a couple of questions on the revenueperformance for the quarter -- could you break out what the contribution tosales growth was from pricing and from your large account programs?

David Sandler

Sure, Adam, be happy to. On the large account front, roughlyhalf of the growth or about 4.25% of the 8.8% that we reported came from thatsegment. About just under 2%, about 1.75% came from pricing and the balancecame from our core, which was about 2.75%, all based on average daily sales.

Adam Uhlman - ClevelandResearch

Okay, and then can you give us a little more color about thegrowth that you are experiencing on the west coast? It had slowed in recentquarters. Can you talk about how that region has performed versus your budgetsor your plan? And with the investments that you are making out there now,should we expect double-digit sales growth to continue out there or is thatgoing to slow as well to a single digit range? Could you give us some morecolor on --

David Sandler

Sure. Listen, I’m not going to predict or forecast. Ofcourse, we’ve got our internal plans which we don’t share and I’m not going toforecast what the growth rate specifically out west may be in the future.

The west is no different than the rest of the country interms of being exposed to a slowing industrial economy. There’s the combinationof manufacturing, both light and durables out there and all the things that allof our other regions are kind of subject to holds true for the west as well.

I guess what’s different is that out west, we have put adisproportionate amount of focus and investments there, which we think isdriving disproportionate growth and we would expect to continue to see adisproportionate performance, significant performance outperforming otherregions moving forward.

Adam Uhlman -Cleveland Research

And then the last question for you, David, you had talkedearlier about customers being concerned about inflationary pressures. What areyou hearing from your vendors regarding potential price increases for 2008? Andwhen you look at your volumes for 2008, how much of that do you think you areprice protected and in this year’s big book?

David Sandler

Adam, good question. I am not going to give the specifics oftracking to how much is protected in the big book, et cetera because I wouldn’twant to give away any specific strategies that we have in that regard, but I’llcertainly be able to give you some color on what we are seeing in the macro,which is really we have begun to see a bit of an up-tick in volatility in thatpricing environment.

I’ll give you a couple of primary drivers there. One is onraw materials and the other is what we are seeing on our Asian products,specifically our products bought from China.

On the raw materials front, we are seeing continued pressureon petroleum-based products. That has remained unabated and in fact continuesto escalate. Raw materials, it moves around a bit but raw materials likecopper, tin, carbon steel, and metals like tungsten and molybdenum we’ve alsoseen increasing of late.

On the China sourcing side, those products which we sourcethere have been under cost pressure. Really two factors -- one is due tocurrency and then the other is a back tax which has been imposed by the ChineseGovernment.

What’s really good news there for us is that our team hasdone just a tremendous job of being able to offset some of the effects of thoseincreases by executing our purchasing strategies in that area.

I guess I’ll throw in a couple of other, on positive notes-- we’re taking advantage of, you see it a bit in our inventory, takingadvantage of opportunity buys, which we’ve continued to see in the marketplaceand that we’ve got suppliers that are slower, especially slower and othersegments that are down, that are coming to us with great deals.

And another component of our program is that suppliers whoinvest in MSC, which touches a bit on what you said earlier about protectingthe price, et cetera, those suppliers that invest in our company, really theygain a disproportionate advantage with us in the way that we are -- the waythat we position them as a preferred supplier.

And I guess finally, the net of all of this important to thepunch line is that we’ve given you some gross margin guidance both for thequarter and for the balance of this year, which is 46.3 plus or minus 20 basispoints, and there’s so many things that factor in our margins. The net of allof those moving parts is that we are staying right on point with the guidancethat we’ve given.

Adam Uhlman -Cleveland Research

Okay, thanks. And just a clarification, you had mentionedopportunity buys in the quarter. Was that a material piece of the pick-up ininventory in the quarter?

David Sandler

I think the biggest piece is what Chuck had described. We’vealways got -- opportunity buys are factored into our inventory plan and themost significant certainly was protecting our fill rates, especially with ournew J&L customer base.

Adam Uhlman -Cleveland Research

Great, thanks.

Operator

Your next question comes from the line of [Gurinder Kalra]from Bear Stearns.

Gurinder Kalra - BearStearns

I’m sitting in for Scott Graham at Bear Stearns and I justhave two questions. The first question actually was on your sales; if you cangive some flavor on your progress on selling MSC products to the J&Lcustomer base?

David Sandler

We’ve trained our sales force on selling the products, theMRO product line and the MSC offering. We’ve expanded that training from thefield through our tele-sales and our entire team. We are really pleased withthe progress that we are making but as we’ve described, we said that would be akind of slow assimilation and build as customers get more comfortable andchange their buying habits to move their product from a competitor to now moveto MSC and J&L.

So we are pleased with the progress that we are making,albeit for this year we don’t expect the sales to be significant and it willbuild in ’09 and beyond.

Gurinder Kalra - BearStearns

Okay, thanks a lot. And the next question actually was onyour gross margin -- the number which you gave, 46.3 plus minus 20 basispoints, was that for fiscal ’08?

David Sandler

Yes, that is for -- we are giving that guidance actually forthe coming Q2 but that we also see that playing out for the balance of theyear, being in that range.

Gurinder Kalra - BearStearns

Okay, and how are your national accounts and governmentsales going to weigh on gross margin?

David Sandler

We don’t -- we’ve always said that that is one of the segmentsof our business that actually puts pressure on our gross margin and that’sconsistent with our planning and that’s factored into our guidance.

Gurinder Kalra - BearStearns

Okay. Thanks a lot, guys.

Operator

Your next question comes from the line of Holden Lewis fromBB&T.

Charles A. Boehlke

Got you back this time, Holden?

Holden Lewis -BB&T Capital Markets

You know, I had the wrong key. I am glad that you were ableto answer questions while I was able to get back in queue. The average ordersize of about 302 is up about 4%. Can you just talk sort of about thecomponents moving upwards and downwards that’s affecting that? I mean, to whatextent is that price, new SKUs, any other elements that might be affectingthat? And how you expect those elements to play out as the year progresses?

David Sandler

I think one of the biggest impacts, the J&L ordersactually are dilutive to that average order size, our large customer strategyare accretive to it, and that’s probably net net the large customer averageorder size is the thing that’s the primary driver there, Holden. So as wecontinue to disproportionately grow that program, that will continue to impactaverage order size favorably.

Holden Lewis -BB&T Capital Markets

Okay. What about the elements of price and new SKUs andthings of that sort? Are those having meaningful impacts?

David Sandler

I can’t say that we break it out quite that way, though wedo look at our core, we do look at the impact of our Internet orders throughour varying portals, et cetera. So the core of our business though you wouldimagine that as things potentially slow down, there will be pressure on averageorder size on our core, which is historically what we see anyway as customerssqueeze that order. But that’s offset by what we are seeing on our largecustomers.

Holden Lewis -BB&T Capital Markets

And are you seeing anything, any sort of internal indicatorsof erosion, such as lines per order or on the receivable side, people havingdifficulty paying -- any sort of internal indicators like that that areshifting in a notable way?

David Sandler

There’s no internal metrics in the business that we areseeing eroding. Chuck will probably want to talk a little bit about what we areseeing on the AR side because we are getting a few -- we are seeing a littlebit of a tone change there but certainly with average order size, number oflines or things like that where we are really not seeing erosion in theunderlying metric. Chuck can talk a bit about what --

Charles A. Boehlke

DSOs has been aging up a little bit, anecdotally morequestions about can you extend me another 15 days -- the normal type of stuffthat sometimes comes when things may be slowing down a little bit. Nothingthat’s outrageous and completely different than any other time when thepossibility of something slowing down exists, but it’s anecdotal. You hear thatfrom the customers -- can I have 15 more days. But it’s not -- you know, it’snot pronounced, it’s not across the board. It’s just pockets of it and thosepockets really didn’t exist four or five months ago.

Holden Lewis -BB&T Capital Markets

And then lastly, you sort of commented about a branch up inSeattle and that sort of thing -- maybe this has changed but there was a timewhen you really didn’t have next day service into sort of the Northwesternpoint of the Pacific Northwest. I mean, have you found a way to extend the nextday service all the way up the coast and now that’s really covered? Or how doesthat history jive with putting branches of people now up --

David Sandler

No, you’re right on -- history still holds true, althoughour team in the last many years has gotten very creative in how we actually areable to reach what would have historically been two day and beyond territoriesinto one day. We are not able to reach every location and you mentionedSeattle. You know, our far west, while we’ve made tremendous progress there, wedon’t reach our entire West Coast customer base, although we are continuing toexpand the number of zips that we are able to convert from two day or more toone day and I am confident that we are going to continue to progress in thatdirection.

Fortunately, our model, while we get -- while it’s optimizedwhen we’re able to reach our customers one day, we are still getting very goodexperience and traction even when we’ve got two day service levels.

Holden Lewis -BB&T Capital Markets

Okay, great. Thank you.

Operator

At this time, there are no further questions. Management,you may proceed.

David Sandler

Well, thank you all for your time and attention today. Weappreciate all the interest and we look forward to speaking to you nextquarter. Bye-bye now.

Operator

This does conclude today’s conference call. You may nowdisconnect.

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Source: MSC Industrial Direct F1Q08 (Qtr End 12/1/07) Earnings Call Transcript
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