Msc Industrial Direct Co Inc (MSM) Q1 2020 Earnings Call Transcript

Good morning, and welcome to the MSC Industrial Supply 2020 First Quarter Conference Call. I would now like to turn the conference over to John Chironna, Vice President of Investor Relations and Treasurer. Please go ahead.

Thank you, Melisa, and good morning everyone. I'd like to wish everyone a Happy New Year and welcome you to our fiscal 2020 first quarter earnings call. With me are Erik Gershwind, our Chief Executive Officer; Rustom Jilla, our Chief Financial Officer; and Greg Clark, our Vice President of Finance and Corporate Controller. As you all know, Greg will become our Interim CFO when Rustom leaves the Company at the end of next week. During today's call, we will refer to various financial and management data in the presentation slides that accompany our comments as well as our operational statistics, both of which can be found on the Investor Relations section of our website. Let me reference our Safe Harbor statement under the Private Securities Litigation Reform Act of 1995. Our comments on this call as well as the supplemental information we are providing on the website contain forward-looking statements within the meaning of the U.S. securities laws, including guidance about expected future results, expectations regarding our ability to gain market share and expected benefits from our investment and strategic plans, including expected results from acquisitions. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those anticipated by these statements. Information about these risks is noted in our earnings press release and the Risk Factors and the MD&A sections of our latest Annual Report on Form 10-K filed with the SEC, as well as in our other SEC filings. These forward-looking statements are based on our current expectations and the Company assumes no obligation to update these statements. Investors are cautioned not to place undue reliance on these forward-looking statements. In addition, during this call, we may refer to certain adjusted financial results, which are non-GAAP measures. Please refer to the GAAP versus non-GAAP reconciliations in our presentation, which contain the reconciliation of the adjusted financial measures to the most directly comparable GAAP measures. I'll now turn the call over to Erik.

Thank you, John and good morning everybody. Thanks for joining us today. I'd also like to reiterate a happy and healthy New Year to everybody. As our fiscal 2020 is now in full swing. I'll begin this morning's call with some strategic context before getting into the usual specifics of the quarter. Over the past several years, we've repositioned MSC from our historic role as a spot buy-only supplier to a mission critical partner on the plant floors of North American manufacturing and industry. We undertook this journey, primarily because we saw an opportunity to partner more closely with our customers, who have been calling out for help in running their businesses better. And MSC is uniquely positioned to fill that void. We also foresaw increasing pressure coming over time on our legacy spot buy-only model mainly from increased pricing transparency in this more transactional side of the business. Over the past several years, we've taken a number of steps to realize our vision. First, we focused on building trust with our customers. The kind of trust that allows us to play a bigger and deeper role in their business. We've done so by developing a new sales model and new tools to facilitate trust building such as robust cost savings documentation, which we recently patented. While the implementation of our new sales plan has taken time, we're seeing the early results pay off in higher levels of customer satisfaction and loyalty. And this is important because our data shows that higher loyalty leads to higher growth over time. Second, we doubled down on product and service categories that are technical and high-touch in nature bringing us closer to the center of our customers' operations. We've invested in our traditional core of metalworking through a further build-out of technical specialists, new product innovation, and the introduction of additional value-add services. We expanded our footprint with the Acquisition Of Barnes Distribution, now CCSG, to build leadership capabilities in the Class C parts category. We also acquired AIS, an OEM fastener business to build out another platform that's both technical and high-touch. Each of these categories entrenches us at the heart of our customers' operations and provides us a position from which to grow share of wallet through account penetration. And third, we are expanding our supply chain onto our customers' plant floors through inventory management solutions, primarily vending and VMI. Since the start of our fiscal 2013, revenues to customers with those solutions are up 1,800 basis points and approaching half of total Company sales, driven by the growth of MSC's vending and VMI initiatives along with the benefit of the Barnes & AIS acquisition. Two-thirds of that list, though, was organic. And looking forward, we expect continued growth in solutions. A noteworthy characteristic of our new strategy is that it yields revenue streams correlated with higher retention rates and that increase customer lifetime value. This becomes meaningful as we model our growth over time; less customer churn and higher retention produce a more effective growth model and higher ROIC by better leveraging our fixed costs. During last quarter's call, I outlined three initiatives that have our near-term attention in order to restore operating margin stability and ultimately expansion. They are first, refining the sales effectiveness of this plan; second, improving the profitability of our supplier programs; and third, improving productivity by reducing operating expenses. We will remain focused on these three through the course of our fiscal 2020. So I'll now explain how they fit into our journey to reposition the company. First, getting the new sales model right is the cornerstone of our new value proposition. Our journey from a simpler spot-buy value prop to a more technical one required a change in our sales model. With the new leadership team providing a fresh perspective on our plan, we're finding that the design was on target but its implementation needed refinements. More specifically, certain areas were under-resourced while we were over-allocated to others. These recent refinements are preparing us to accelerate growth. You can see from our operating stats that we took sales headcount down in the first quarter, reflecting the areas in which we were over-allocated. We will increase sales headcount from here with investments into growth areas over the coming few quarters. These growth areas include business development or the hunter roles, CCSG, and a couple of others. Our ultimate measure of success, of course, is our growth gap to market. In the meantime, we're focused on interim measures such as the business development funnel of new wins, which have us encouraged about progress. Our second initiative is improving the profitability of supplier programs. As we migrated from spot-buy supplier to mission-critical partner, the value proposition that we offer our suppliers is changing just as it is for our customers. As a result, we've enhanced many of our supplier programs to receive more support in exchange for more dedicated focus from MSC on market share capture. As I mentioned on the last call, we've negotiated roughly $20 million in annualized profit improvements split about equally between the back half of fiscal 2020 and fiscal 2021. We're now turning our attention to implementing those programs and driving share capture with those suppliers who have invested in us. The third fiscal 2020 initiative is realigning our operating model to reduce operating expenses and improve productivity. And this is critical because as we reposition the Company, the new business often comes with lower gross margins. We've now built scale in some of our new revenue streams such as inventory management and we're therefore ready to focus on improving the cost structure and efficiency with which we win them. We began this process in our fiscal fourth quarter with several more tactical measures. For example, we offered voluntary early retirement to associates with significant tenure in our distribution centers. We also ratcheted up performance management intensity and selectively eliminated positions where our focus is changing. As I noted on the last call, some of those actions would continue into our fiscal first quarter and we guided to further headcount reductions and additional severance and separation costs, both of which took place, and Rustom will give the details in just a few minutes. For the balance of the year, we anticipate selective hiring in certain customer-facing roles and will maintain our intense focus on performance management. With some of these initial steps behind us, we are now focused on a more thorough assessment of additional opportunities to align our operating model to the new strategy. We will also focus on becoming leaner. We look forward to sharing the results of this planning with you within the next quarter or two. With all of this context, I'll now turn to the quarter. I'll start with a brief overview of our fiscal 2020 first quarter results. I'll then provide an update on the environment and our recent performance before turning it over to Rustom to review the details of the quarter and provide guidance, and then I'll wrap things up and we'll open up the line for questions. Our fiscal first quarter results reflect solid execution in a weak demand environment. Sales and gross margin were both better than the midpoint of our guidance range. Operating expenses to sales, both as reported and excluding severance and separation costs, were slightly better than the guidance midpoint. As a result, both our operating margin and earnings per share came in at the top end of our guidance range, and again Rustom will provide more details. Turning to the environment, industrial demand remains weak. The softness is evidenced in the data points coming from manufacturing output, distributor growth surveys, and sentiment indices. In September and October, readings for the MBI were 48.6 and 48.3 respectively, and November was 47.0. The December MBI reading ticked back up but remained below 50 at 48.2, which takes the rolling 12-month average to 50.7. And while that rolling average is still positive, it has been steadily declining. We continue to see customers and suppliers eliminate shifts and in some pockets announced layoffs and restructurings. In terms of end markets, the weakness in industrial demand is broad-based with some acute pockets of softness in areas like automotive, heavy truck, oil and gas, and agriculture. Aerospace is one of the few end markets that remains relatively strong, although the recent Boeing updates have created some choppiness there as well. With regards to the pricing environment, uncertainty due to tariffs and decelerating global growth continued. Combined with the price scrutiny that comes when customers' businesses slow down, all of this results in a slightly softer pricing environment than we've seen over the past year. That said, we have seen some continued list price movement from our suppliers and fully expect to pass those increases along. We anticipate taking a mid-year price increase likely toward the end of our fiscal second quarter, with the end of February. Turning to our performance, national accounts grew slightly while core customers declined in the low to mid-single digit range as this is the portion of our business most heavily levered to metalworking, which is particularly soft right now. Government sales growth levels improved from the fourth quarter as anticipated but still declined in the high single digits weighing down overall growth. CCSG was a bright spot, growing in the mid-single digits. Looking at our most recent data point, the month of December is always difficult to extrapolate from due to holiday timing, shutdown schedules, and end-of-year capital purchasing and inventory burn-off decisions by our customers. This year, December was down 2% on an ADS basis, but that was aided by one fewer selling day. We decided to close on both Christmas Eve and New Year's Eve largely because UPS was not processing ground shipments on those days. On a total revenue basis, growth was down roughly 7%, which is a significant step down from where we had been running. We attribute much of this weakness to holiday timing. When Christmas and New Year's fall on a Wednesday, we historically experience the largest drag on sales. We also heard a greater prevalence of extended holiday shutdowns this year, which appears to be customers anticipating slow conditions around the holidays. It's tough for us to say whether December was strictly about holiday timing or whether the underlying trends eroded as well. Unfortunately, we don't yet have a full week in January to see how activity rebounds. So Rustom will describe the assumptions we make for the revenue guidance forecast. Before I turn it over to Rustom to cover the financials, I want to thank him for his four years of service. We are grateful for his contributions and leadership, and we will certainly miss him. We're conducting a comprehensive search for a permanent CFO. As John mentioned, Greg Clark, our Vice President of Finance and Corporate Controller, will assume the position of interim CFO. We are privileged to have a deep bench of finance talent here at MSC. Rustom and I feel very confident that Greg and the team will continue to strengthen our financial operations and ensure a smooth transition until a permanent replacement has been made. I'll now turn it over to Rustom.

Good morning, everyone, and thank you, Erik. Before diving into the numbers, I want to express my gratitude to Erik for his kind words, for the great partnership we've had over the past four years, and my heartfelt thanks to the Board and my colleagues, especially those in finance, for many good memories. Now, let's move on to the financials. First, I would like to remind you that we provided Q1 guidance both including and excluding the severance and separation charges we anticipated. I will first discuss our reported results, followed by our adjusted results that exclude those expenses. In our first quarter, the total average daily sales (ADS) was $13.3 million, marking a 1% decline on an ADS basis compared to the same quarter last year, which was slightly better than the negative midpoint of our guidance range. Our Mexico business, which was not included in the previous period, added about 100 basis points of growth to first quarter sales compared to fiscal 2019. Our reported gross margin for Q1 was 42.2%, at the higher end of our guidance range due to lower inventory provisions and increased vendor rebates and credits. Year-over-year, our gross margin declined by approximately 80 basis points, with Mexico accounting for about 20 basis points of this decrease. Total operating expenses reported in Q1 were $256.9 million, slightly better than expected as a percentage of sales. Consequently, our reported operating margin was 11%, exceeding our guidance of 10.7%. Our tax rate for the first quarter was 25%, slightly better than our guidance and last year's result, largely due to the positive effects of stock compensation expenses, leading to reported earnings per share of $1.18. Now, moving on to the adjusted results. Excluding $2.6 million in severance and separation charges from Q1, our adjusted operating expenses were $254.3 million, or 30.9% of sales, which was again slightly better than the midpoint of our guidance. This was primarily due to ongoing controls on discretionary spending and the execution of Q4's cost reduction measures. The total headcount in Q1 decreased by 78, mostly in the sales function effectiveness improvements noted by Erik. Our field sales and service headcount decreased by 65 employees sequentially. Compared to last year, adjusted operating expenses were down $0.7 million as the savings from lower volume-related costs and cost reduction initiatives offset the additional operating expenses related to the Mexico business and other increases. Our adjusted operating margin for the first quarter was 11.3%, exceeding the midpoint of guidance by 30 basis points, supported by a higher gross margin and slightly lower operating expenses relative to sales. Year-over-year, the adjusted operating margin fell by about 110 basis points, primarily driven by lower gross margins. On an adjusted basis, the earnings per share for the fiscal first quarter was $1.21, at the top of our guidance range, compared to last year's reported EPS of $1.33. Turning to the balance sheet, it remains in excellent health. Our days sales outstanding (DSO) was 60 days, up two days from fiscal 2019's Q1, with strong growth in national accounts receivables being the main driver. We reduced our inventory by $20 million during the quarter to $539 million. Total company inventory turns were 3.5 times, the same as Q4 and slightly below last year's 3.6 times. We anticipate inventory will increase in the fiscal second quarter, primarily due to our usual year-end base. For the first quarter, net cash from operating activities was $85 million, compared to $77 million last year. Our capital expenditures in the first quarter totaled $13 million, up from last year's $10 million. After subtracting capital expenditures from net cash provided by operating activities, our free cash flow stood at a solid $72 million, compared to $67 million in last year's first quarter. We distributed $42 million in ordinary dividends, maintaining our regular dividend of $0.75 per share. In the previous first quarter, we paid $35 million in dividends and repurchased $64 million in shares. Consistent with our capital allocation strategy, the Board of Directors also approved a special dividend of $5 per share, in addition to our regular quarterly dividend of $0.75 per share. These total payments of nearly $320 million will be executed on February 5 using our existing cash and revolving credit facility. Our total debt at the end of the first quarter was $406 million, made up of $137 million in credit facility balances and short-term notes and $265 million in long-term fixed-rate borrowings. Our cash balance was $28 million, meaning our net debt stood at $379 million at the quarter's end. Our leverage ratio decreased to 0.8 times, down from 0.9 times at the end of Q4 and one time in last year's Q1. Looking ahead to the end of February, after paying our special and ordinary dividends, we expect our leverage ratio to be around 1.5 times, which should decrease from that point forward. Given our cash flow generation capabilities, we are maintaining sufficient flexibility. Now, let's go over our guidance for the second quarter of fiscal 2020, which is detailed on Slide 4. Similar to last quarter's guidance that incorporates the Mexican business, we do not expect severance and separation expenses to be significant in our fiscal second quarter. We expect Q2 ADS to range from a decline of 1.5% to 3.5% compared to the previous year. December's total ADS growth was down 2.1%, reflecting a sharp decline in December and uncertainty around its drivers. Our Q2 guidance is based on a typical uplift from November to January. This indicates an average ADS growth rate of about negative 2.9% for January and February. We anticipate a Q2 gross margin of 42% plus or minus 20 basis points, which represents a decline of about 20 basis points compared to Q1's 42.2%. Year-over-year, this would be a decrease of roughly 70 basis points due to rising purchase costs, unfavorable mix effects, and a 20 basis points negative impact from Mexico. As expected, the gap in gross margin compared to last year is decreasing, with purchase cost increases slowing down, and the benefits of our mid-year price increase will begin to materialize from Q3 onward. Additionally, our supply initiatives will start to positively impact our financials in the fourth quarter of this fiscal year. We expect operating expenses to be around $255 million for the second quarter, which is about $1 million lower than last year’s second quarter. The primary factors contributing to this are lower variable expenses related to volume, down approximately $3 million, and nearly $2 million saved from Q4's headcount reduction measures, offset by our annual merit increase of almost $4 million. Sequentially, operating expenses are forecasted to increase by about $0.5 million from Q1's adjusted operating expenses. We expect around a $2 million benefit from lower variable expenses, offset by a similar increase in productivity investments. The rest comes from November’s annual wage increase adjusted for our standard productivity gains. We estimate the second quarter’s operating margin to be approximately 9.7% at the midpoint of the guidance, reflecting a 200 basis point decline year-over-year. This decline is mainly due to approximately 70 basis points of lower gross margin and the rest attributed to the reduced sales' effect on our operating expense leverage. Regarding our estimated tax rate for the second quarter, it is expected to be 25.1%, consistent with Q2 of 2019. Our Q2 EPS guidance is between $0.97 and $1.03, with a midpoint of $1. This guidance assumes a weighted average diluted share count of about 55.5 million shares. This concludes my prepared remarks, and I wish MSC all the best in the future as I turn it back to Erik.

Thank you, Rustom. We remain focused on repositioning MSC from a spot-buy supplier to a mission-critical partner to manufacturers and industry. In fiscal 2020, our focus remains on three initiatives. One, completing the sales effectiveness refinements to position our business to capture market share aggressively. This includes ramping up growth investments in areas that are delivering early returns. Two, implementing the new supplier program, which when combined with an improving purchase cost trend and mid-year price action will continue to close the gross margin gap; and three, continuing to streamline our cost structure and transform our operating model to be leaner. Recent progress on these priorities represents the beginning and the end of our journey to fulfill our mission to be the best industrial distributor in the world. We'll now open up the line for questions.

We will now begin the question-and-answer session. The first question today comes from David Manthey with Baird. Please go ahead.

Yeah. Thank you. First off, Rustom, congratulations and best of luck.

Thanks very much, Dave.

Sure. And then Erik, can you broadly compare the shifting model here from the spot-buy to the shop floor solutions business? You noted an expectation for better sales and return on capital trends. But specifically, can you talk about the P&L and how you view secular gross margins and operating margins under the new paradigm?

Sure, Dave. I think you're getting to the core of our discussion this morning, which focused on how the Company has transitioned to a new mission-critical model that, as you mentioned, emphasizes a higher proportion of recurring inventory management-related technical business. One key point is that we are observing increased customer retention. This is important when we consider customer lifetime value; even small improvements in retention can lead to significant increases in lifetime value over the years. We see this as encouraging and a validation of our strategy. Additionally, many of our revenue streams, particularly in technical metalworking and vending, have lower gross margins. This has contributed to the mixed headwind we've discussed in the past few years. Over the past six years, we've shifted about 1,800 basis points toward the solutions business, which, despite having lower margin percentages in vending and technical metalworking, has presented us with a headwind. However, with our scale in these businesses, we now have the opportunity to take a broader, more comprehensive look at our operating model. It's important to note that the supply chain for a spot-buy business operates at a higher cost than a planned managed inventory model, as spot-buy involves a premium level of service. Given our current scale, we see significant opportunities to reduce costs.

Okay. So, but no change in the secular operating margin expectation of the Company, used to be in the high teens, is that still achievable under the new paradigm?

What I would say is that our focus right now is on stabilizing the business and then returning to expansion of our operating margins. We view these elements as essential to our strategy, so there’s no change in that regard. Once we begin to gain traction, I will update you on the potential for high teens margins.

Okay. Thanks for that Erik. And then second on the guidance, if you triangulate the variables that you gave us, it looks like SG&A is expected to be roughly flat from the first quarter to the second quarter, which is fairly typical for the Company, but given the severance actions, you've got one fewer day versus typically flat or higher. The sales are flexing down. I just would have thought we would see a decline in SG&A sequentially. Any color that you can provide on operating cost trends into next quarter?

It's interesting sequentially, but considering how the holiday period works in December, we keep our staff online during that time to avoid the need for re-hiring in the following quarter. This will contribute to savings, and we’re experiencing close to $2 million in savings from cost reductions in Q4. While this isn't sequential since we observed it in Q1 as well, it's an improvement compared to last year.

Dave, regarding the other color, I believe Rustom is correct. It's important to highlight this point because it raises the question of why our operating expenses wouldn't decrease when sales declined sequentially along with total revenues. Q2 is somewhat of an anomaly. Rustom pointed out one reason related to the variable factor, particularly concerning the holiday season in Q2, and it's worth noting that we usually experience higher sales in Q3. We won't reduce staffing levels in Q2 as we would in a typical quarter with declining sales, which is one factor to consider. Additionally, we are making a few investments in Q2 that are not necessarily ongoing fixed costs. While we might see a reduction in headcount, these discretionary investments are specifically intended to foster growth and productivity. I'll leave it at that, but these investments, though temporary, are contributing to higher operating expenses in Q2.

And that was the roughly $2 million that I had mentioned.

Alright helpful. Thanks guys.

Your next question today comes from Hamzah Mazari of Jefferies. Please go ahead.

Good morning. Happy New Year and best of luck to you Rustom.

Thanks, Hamzah. Happy New Year to you too.

Happy New Year, Hamzah.

Thank you. Erik, my first question is about the significant changes and repositioning at the Company. What is your level of confidence that this restructuring will be successful compared to previous efforts? Has the internal culture shifted? Is there increased employee engagement? I know you have appointed a new Head of Sales from outside the Company. Any insights on this would be appreciated.

My confidence is high regarding our progress. Over the past two years, we have significantly transformed our sales model to align with our new value proposition. The major changes are mostly behind us, and we have a new Head of Sales, Eddie Martin, who has evaluated our strategy and identified areas for refinement. These adjustments include reducing management layers to streamline operations and reallocating resources where portfolios were undersized, which is reflected in the headcount changes we saw in Q1. We also recognized areas where we were under-resourced, particularly in new business development roles, and have already started to see positive outcomes from our investments there. For instance, new signings in the business area have increased by 27% year-on-year, and productivity per person has risen by about 45%. While it's early in this process and still a small portion of our total workforce, we are encouraged by these results. As for the headcount reduction in Q1, it will rebound in areas where we're observing success, which will help us capture more market share. Lastly, regarding our company culture, we have become more skilled at adapting to changes over time, and I believe we are better equipped to manage these transitions now.

Actually I'll add one final point, if you think about the restructuring actions of Q4. I mean the dollar benefits of what we expected and the actions that we expected the execution is going pretty much as planned. And we are seeing that. So from that perspective, that is growing successfully too.

Great. Very helpful and my follow-up question and I'll turn it over is. You talked about market outgrowth as a milestone to watch for success. You talked about retention rate. Any thoughts as to what that outgrowth is today. Are you growing under the market, and you know historically I guess you outgrew the market by 300 bps to 400 bps? Is that the right metric to look at going forward, one sort of the restructuring is behind us?

Yes, Hamzah, I think you honed in. Look, what I would say today based on triangulating all the different metrics, the surveys, the growth rates, etc., etc., is we're somewhere growing in line with market right now given our exposure. We see really good things happening as I mentioned, on the BD side, but it's still early and it's still small as a percentage of total, it's a couple of areas that we're pleased with progress. But overall, roughly in line, certainly what we're seeing of late is softening conditions which are more acutely soft at metalworking are weighing down. So the water levels coming down across the business quite frankly and is sort of muting or masking some of the progress we see happening in these investment areas. But roughly in line and then looking forward, yeah, certainly, Hamzah sort of minimum table stakes this to say how do we get back to the kind of share capture or outgrowth that we've seen. And, yes, you're right, what we've talked about the 300 basis point and 300 basis point to 400 basis point range. I mean, sort of that would be table stakes for us and being able to do it more effectively and efficiently than we've done with the past. And we got three things, we are just head down focused on in order to restore that gap. One, as I mentioned, ramping up investment into the growth areas where we're seeing early returns. Two is going to be improving government performance, which for the past year depending on the quarter has cost us somewhere around a point of growth and a lot of progress happening under the covers in government. And the third is continuing to focus on growing solutions as we've done with our core customer to lift retention over time. So that's where we're focused.

Great. Thank you so much. Best of luck.

Thanks, Hamzah.

The next question today comes from Robert Barry of Buckingham Research. Please go ahead.

Hey guys, good morning. Happy New Year.

Hey, Rob, Happy New Year to you.

Thank you. So you mentioned that it sounds like the last week in December was pretty noisy with holiday timing and some extended shutdowns. Curious how things were tracking before that last week?

December was quite unusual, especially in the last two weeks. There was noticeable weakness during that time. Looking back, we last experienced a similar situation in our fiscal 2014 when Christmas and New Year's fell on a Wednesday, leading to two quieter weeks. This year, aside from the holiday timing, we noticed that many customers were using the last two weeks for extended shutdowns, likely due to the overall softness in demand rather than just the holidays. In terms of the first part of December, it was indeed stronger relative to the last two weeks, but still not as robust as we usually see. One theory we have is that the late Thanksgiving might have enhanced November's performance while slightly dampening December's results. Typically, the week after Thanksgiving is not our strongest, and this year that softness carried into December. Overall, we believe the main factors were holiday timing and increased shutdowns. The crucial question now is what happens in January, which will help us determine if this was merely temporary noise or an indicator of a shift in economic activity.

Right. Right. That's very helpful. So just to be clear, whenever you set the guidance for the sales, for the quarter, which of the weeks did you choose? And we have the base off of which to kind of build the seasonality improvement?

We reviewed data from November and based our forecasts for January and February on the typical sales trends from that month. We decided to forgo December's estimates and instead focused on the finalized figures we had before moving forward.

Got it. Got it. And then just I guess for me lastly on gross margin quickly, I think you're guiding down at the midpoint 70 bps in the second quarter, which I think would account for the pressure from Mexico and sources of growth, right, which I think reach about 20 bps and 40 bps to 50 bps respectively. But does that mean that everything else is kind of neutral like price cost is neutral in 2Q?

The price cost remains negative, but the sequential decline from Q1 to Q2 is within our normal range, around 20 basis points. Considering the factors from Q1, such as inventory and the timing of rebates and credits, we're not excessively concerned. We believe gross margin is performing as expected. Looking beyond Q2, two factors should help mitigate the usual downward trend. First, there will be a mid-year price increase, expected to take effect in Q3 and continue into the following quarters. Second, there will be benefits from our supplier program, which we anticipate will contribute $10 million in the latter half of the year, primarily in Q4, but you should begin to see some impact starting in Q3. Combining all these elements gives us confidence in our gross margin outlook.

Got it. Just to clarify in 1Q was price cost? What was price cost to gross margin?

It was around 90 basis points. If you examine our decomposition, particularly the earnings decomposition, it provides a solid estimate of the price/mix dynamics at play. The movement in margins is fundamentally influenced by our earlier price increases. Once we implement a price hike, the pricing aspect continues to evolve while the cost component reflects an average cost flow through our system.

Yeah, sorry just of the 90 which was the total decline, how much was due to the dynamic between price and cost? The whole thing?

We discussed Rustom's 90 basis points, which I believe refers to the price contribution in the growth breakdown. You're asking about the price-cost relationship. Generally, we've talked about our gross margin being influenced by price, cost, and mix as three key factors. Over time, we've observed that price and cost tend to balance each other out, leaving us with a mix effect. Currently, there is a mix headwind in the business of around 40 to 50 basis points.

Typically.

Okay.

Typically, it varies from quarter to quarter. For all the reasons we've discussed earlier regarding our strategic direction, we don't anticipate this changing. What Rustom is describing is the price-cost dynamics. We have experienced negative price cost, but as Rustom mentioned, the situation is developing as we expected, and the price-cost dynamic is starting to show improvement.

Yes.

For all the reasons you described.

I gave you the number that's out there in the public domain and then I described how the price cost curve is moving for us. You see it looking better in the second half for sure.

The next question today comes from John Inch of Gordon Haskett. Please go ahead.

Thank you. Good morning, everybody. Happy New Year.

John, Happy New Year.

Thank you. Rustom, we will miss you. Erik, I just want to clarify the guidance here. Are you suggesting that the average business lift from November is expected, but daily sales for the quarter are forecasted to be lower than in December? Is this a comparison issue, or is it simply that the second quarter is typically softer, given last year's performance?

John, you're right. We were unsure about December, and to Rustom's point, his team analyzed the trends from November through January and February, drawing on several years of data. We essentially used an average lift for our modeling, and you are correct in your observation. We experienced a larger than average lift last year, which explains why the growth rate in January and February is lower compared to September, October, and November in the first quarter. The increase last year was due to several large orders.

Right. Okay.

That we're not anticipating to repeat themselves this year. Hopefully, they do, but that's not baked in. Right now we don't see it.

Right. And Eric, is there anything you could say on the Phase 1 trade deal? I asked because there is a little bit of anticipation of some tariff roll back. Do you have to give up price? I mean as you guys are thinking about your price increase. Is this going to be contingent on sort of what you're seeing with respect to kind of tariffs and costs and other things? Or I mean how does this all play in and are your customers saying anything about it?

Let me address that. There remains some uncertainty regarding tariffs. However, as we've previously mentioned, the impact on us has been quite minimal. We've reviewed the recent tariff list and assessed categories 4A and 4B, which also show that the effect on our figures is very minor. The inventory we currently hold that falls under higher tariffs and the annual expenses affected by this don’t pose a significant challenge. Therefore, we do not anticipate any substantial influence on our gross margin.

Got it. Lastly, Erik, how do you view our insights and the flat trend in e-commerce sales, which has been slowing down throughout the year? I'm curious about your perspective on maintaining flat year-over-year performance in e-commerce compared to the general growth trends in the industry. Additionally, how do you feel about your transition to a more high-touch model? Are you optimistic about this trend, or do you expect it to pick up? How do you perceive this situation?

Yeah, John, it's an interesting question because certainly, yes, what we've seen is that the e-commerce as a percentage, it's flattened. Honestly don't make too much of it either way, I think it's been lifting in part because of our focus on e-commerce in part just because of sort of the landscape and how customers are buying. I don't make too much of it either way, to be honest, right now we are more focused on the other metric of how much of our business is going through solutions, inventory management solutions as a percentage of revenues, how much is coming from customers with the solution. And then, yeah, how much of our business is flowing through product categories, product and service categories that are technical and high touch. So that's where the focus is, less concerned either way to be honest about the e-commerce percentage.

Okay. So given the new sales head, all the restructuring, kind of the strategic shift of the Company, it sort of sounds like you're not necessarily expecting e-commerce as an outcome to get a lot better necessarily it's versus the overall Company? Or is that I don't want to put words in your mouth.

I believe we will keep investing in e-commerce. Customers prefer to shop online, so having a strong digital marketing presence and an excellent transactional e-commerce experience is crucial. It's a fundamental part of our value proposition. However, we are not solely focused on increasing the percentage of total sales from e-commerce.

Yeah, understood. Thanks very much.

Sure, John.

The next question comes from Ryan Merkel of William Blair. Please go ahead.

Hey, good morning, everyone.

Hey, Ryan, how are you?

Good. So first I want to put a finer point on this idea of transforming to a leaner operating model. So two questions. So first, what are the major changes versus the prior cost structure. And then secondly, can you just give us a sense of sizing the opportunity, Erik? I know it might be a little bit early, but maybe just the range of basis points in terms of OpEx of sales that you're thinking about?

Sure, Ryan, I'll start and then hand it over to Rustom. Regarding the changes, as I mentioned, this is about shifting to a new strategy and aligning our operating model accordingly. Specifically, I see the biggest opportunity in taking a comprehensive look at the business to find ways to be more effective. This may involve reducing costs in some areas, while in others, it could require investments to drive growth. The key metric we’re focusing on to assess effectiveness and efficiency is the OpEx to sales ratio. This will involve both cost reductions and investments. A notable example is the supply chain; for instance, when dealing with spot-buy business, which involves receiving an order late and shipping it the next day in smaller quantities. We need to examine everything from how goods move into our distribution centers from manufacturers, their storage and management within facilities, to shipping processes and freight management. This approach is different from managing inventory for customers with periodic replenishment, which can be planned. The spot-buy model typically incurs higher costs due to the premium services involved, but there are numerous opportunities to explore. Although it's still early, we are identifying ways to optimize the flow of goods, improve business processes, and streamline freight and bulk purchases. The exciting aspect is that we have the potential to enhance both cost efficiency and the customer experience. I'll let Rustom elaborate on the size of this opportunity.

So Ryan, yes. As you know that it is too early to set a target on this, but look the benchmark suggest a couple of hundred basis points of potential for improvement.

Okay. So that's meaningful. All right. That's helpful. And then secondly, just going back to the ramping of the growth investments. Erik, you hit on this, you're going to ramp the investments that are seeing early returns. Can you just spike out the one or two that you're going to invest in more heavily and then how much you're going to invest this year in growth investments?

That's a good question, Ryan. Essentially, what we're doing with sales refinement is to first reduce our over-allocated resources in certain areas, which we've accomplished. The next step is to identify critical areas that are not only essential to our new strategy but are also yielding early returns. The hunting function in the business development role is a prime example and is expected to be a major driver of our growth. We also mentioned CCSG, which is gaining traction, along with a few other areas. Regarding sizing and timing, we made significant reductions in Q1, and you can anticipate an increase in Q2, Q3, and Q4. Due to the complexities of hiring, headcount management, and attrition, it's challenging to provide precise numbers. However, we expect that by the end of Q4, our sales and service headcount will exceed where it was at the beginning of the year, marking a significant increase. This growth will be concentrated in areas that demonstrate strong returns.

Okay. Very helpful. Rustom, best of luck. Great working with you.

Thank you. Likewise.

The next question comes from Michael McGinn of Wells Fargo. Please go ahead.

Hey guys, thanks for the time.

Hey good morning.

Good morning, Rustom, best of luck.

Thank you.

I just wanted to hone in on, if I heard you right, it sounded like CCSG was growing mid single digits, but metalworking was down, is that correct?

That is correct.

My assumption about gross margins would have been that you need growth in both categories to potentially reach the top end of your gross margin guidance. Can you discuss the differences between those two businesses and why they appear similar despite their fundamentals?

Yes, absolutely, Michael. Look, the biggest factor, and by the way on the gross margin, the 20 basis points over the midpoint been in top of the range. Rustom gave a couple of the drivers there. But in terms of the fundamentals, look, the biggest thing I'll point to Michael is that metalworking products are sold into metalworking manufacturing and metalworking manufacturing is acutely soft right now. So if you look at most of the surveys and then look at the end markets where there is weakness, they tend to have strong metalworking presence. So examples would be automotive, heavy truck, ag, oil, gas, weak. And so metalworking is being influenced by really end market exposure.

Okay. And then just switching gears to capital allocation. I think the last time you did, you did a special reverse tender, now we're going back to the special dividend. Is there a rhyme or reason to that and is that the path going forward for you guys after you delever from the 1.5 times I think you mentioned?

I can address that, and Erik may want to add more later. We have a balanced capital allocation strategy aimed at increasing shareholder returns through various methods. In the past, we've executed many buybacks, and while that may happen again, right now we are focusing on this special dividend, which effectively returns funds to our shareholders and enhances total shareholder returns. Our balance sheet is solid, and we have strong cash flow generation. We're currently at 1.5 times leverage, which is expected to decrease over time if circumstances remain stable. This leaves us with ample opportunity for further actions in the future.

Yeah. To build on that, moving forward, we have maintained a balanced approach over time. Currently, as we've mentioned, the expectations for any significant mergers and acquisitions are quite high. At this point, when it comes to capital allocation, our primary focus is on returning cash to shareholders in a manner that enhances their returns, and we believe the special dividend accomplishes both of those goals.

Great. Very helpful. If I could just ask about the growth initiatives, it's clear that while you want to operate the business for long-term success, is there a point where you advise your segment leaders to prioritize margin improvement and fixed cost reductions internally before increasing headcount? What is the point at which you feel pressured to ensure that managers demonstrate improvement before considering new hires?

Yeah, Michael, look, it's a good question. I think as we taken headcount down nicely over the last couple of quarters and we're talking about it going back up. To be clear, the biggest, there'll be some selective rehiring and one example where the selective rehiring is, it was a pretty heavy focus on increasing performance management intensity inside the Company and we feel it's important that the message is if you're going to manage out somebody that's not performing that you can replace that person with somebody who is performing; it creates a good incentive to keep doing it. So that will be that's one example where headcount would come back in. But the big driver is going to be in sales and service, which is customer facing and we think really critical to capturing share. Look, this is still a hand-to-hand combat business, very fragmented, street-based. We do need to capture share over time and do need to increase sales headcount. The goal, of course, is to do it more efficiently and that's why we're adding back heads in sales, it's in areas that are selling returns so that we can do it more efficiently.

All right. I appreciate the color. Thanks for the time.

And our last question today comes from Blake Hirschman of Stephens. Please go ahead.

Yeah, good morning, guys.

Good morning, Gentlemen.

Real quick on auto, you call it out as a little soft again, how much of that do you think was due to the GM strike and did you see things pick back up after that ended?

What I would say is that the auto segment has been weak despite the GM strike, and I think the issue is broader than just GM. It’s still too early to provide a clear update, but the numbers for the auto sector remain quite soft for us. While I expect some improvement, the main point is that the auto sector has been struggling, regardless of the strike.

Got it. All right. I'll leave it there. Thanks and good luck to you Rustom.

Thanks, Blake.

Thank you everyone for joining us today. Our next earnings date is set for April 8, 2020 and we look forward to speaking with you over the coming months. Again I wish each of you a great start to 2020. Thank you.

The conference is now concluded. Thank you for attending today's presentation; you may now disconnect.