Msc Industrial Direct Co Inc (MSM) Q2 2023 Earnings Call Transcript

Good day, and welcome to the MSC Industrial Supply Company's Second Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode. After today's presentation there will be an opportunity to ask questions. Please note today's event is being recorded. I would now like to turn the conference over to John Chironna, Vice President of Investor Relations and Treasurer. Please go ahead.

Thank you, and good morning, everyone. Erik Gershwind, our Chief Executive Officer and Kristen Actis-Grande, our Chief Financial Officer, are both on the call with me today. 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 our Investor Relations web page. Let me reference our safe harbor statement, a summary of which is on Slide 2 of the accompanying presentation. 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. 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 our other SEC filings. 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 or on our website, which contain the reconciliations of the adjusted financial measures to the most directly comparable GAAP measures. I'll now turn the call over to Erik.

Thanks, John. Good morning, everybody, and thank you for joining us. On today's call, I'll begin with some perspective on our recent performance and our longer-term outlook. I'll then provide color on the current environment. Kristen will provide more specifics on our fiscal second quarter Mission Critical accomplishments and our financial performance and then she'll share our expectations for the back half of our fiscal year. I'll wrap things up and then we'll open up the line for questions. As we move into the back half of our fiscal 2023, there is a growing momentum inside of MSC, and it has me encouraged about our future. Let me provide you with some color so that you can see from the outside what we see on the inside. First, we continue outgrowing Industrial Production by numbers in excess of our long-range targets. We're seeing the strongest contribution from the programs most closely tied to the repositioning of MSC to a Mission Critical partner on the plant floor. In-plant, vending, and vendor-managed inventory are all examples of high touch, high retention programs that are growing ahead of company average. I'm equally encouraged by the momentum on new account wins that we see developing through our national accounts and our public sector teams. And while a portion of our performance above Industrial Production is price-driven, we're excited by the trajectory of these market share capture programs. On the M&A front, we continue to bolster our technical and high touch product categories. Our recent acquisitions are living up to our high expectations in their early days and are fortifying our position within metalworking and OEM fasteners, areas where we continue to see significant opportunity for long-term growth. Most recently in January, we completed an acquisition that fits nicely into our core metalworking business. Buckeye Industrial Supply Company is a metalworking distributor located in Ohio and that serves planned production needs of manufacturing businesses in the area. Tru-Edge Grinding, also located in Ohio, brings us new capabilities in the way of custom tool manufacturing and regrinding. Tru-Edge, along with our existing regrinding business, represents an adjacent value-added service to our core cutting tool business and therefore creates a new growth path for us. It also supports our company's effort to drive cost savings for our customers. Second, on the gross margin line, our success over the past couple of years has come largely from achieving strong price realization during historic levels of inflation. As the market settles, we have reoriented our focus towards improved product assortment, supplier portfolio, and cost position. The category line reviews that we announced last quarter have kicked off with our first wave in full gear. Wave 2 has been launched as we will roll through our entire product offering over the next several months. We expect to see a slight gross margin benefit in our fiscal fourth quarter and then more substantial savings will come in fiscal 2024. Third, our productivity efforts remain in full force and continue to yield strong operating leverage in the form of lower operating expenses to sales ratios. As we move towards the close of our three-year targets, our Mission Critical program, under the leadership of Kristen and Martina, is transitioning from a one-time program to an ongoing way of life or continual improvement. Beyond the numbers, there are four other important elements to our story. First, strategy. The repositioning of MSC into a high touch Mission Critical partner is taking hold. Customer reception to our enhanced role is high. And this is evidenced in the growth rates of our high touch programs and the rate of new customer wins. The plan is working. Second, culture. MSC has always had a strong culture, one that's grounded in respect for people and an intense focus on the customer. Our new management team is building on that strong foundation. We're adding new elements, including more aspirational target setting, a more robust execution model, and more extensive collaboration across functions. In other words, thinking end-to-end about our business. Third, technology. It's been nearly a year since John Hill joined us as MSC's first Chief Digital and Information Officer, and progress with our technology function is encouraging. We are enhancing our e-commerce functionality and expect to see incremental benefits in the coming quarters. We are improving our product information and customer data, making for a better customer service experience and a more efficient business. We’re eliminating inefficiencies as part of Mission Critical where older systems inhibit productivity or where improvements can unlock further value. And fourth, the market. We continue to operate in a marketplace with attractive dynamics that support continued growth. The North American distribution market is over $200 billion and remains highly fragmented with the top 50 distributors still holding just over 30% of the market. The opportunity for organic and inorganic share capture remains vast. In addition, MSC's concentrated manufacturing exposure sets us up well for the next decade. The reshoring trend that we've all heard about is moving from a remote possibility, as we are seeing an increased number of new plant construction projects. And while our participation in the early stages of construction is minimal, this bodes well for growth in our end markets over time and should serve as a further growth tailwind. Before turning it over to Kristen to discuss our second quarter performance, capital allocation priorities, balance sheet and our reaffirmed fiscal 2023 guidance, I want to spend a few moments discussing the environment. While sentiment in Industrial Production readings continued moderating, the tone on the ground is stable. Most of our customers continue to see solid order levels and demand activity. Of course, we're watching the banking situation closely to monitor any potential ripple effect on the broader industrial economy. At this time though, our overall read on the environment remains constructive. With respect to pricing, the situation is pretty much the same as we reported last quarter. We continue seeing increases from our suppliers, albeit not at the rate or level of the past two years. As such, we are passing those along as warranted and we continue seeing strong realization. All of this means that the need for our customers to find productivity that offsets their own cost headwinds remains as strong as ever, and this plays very nicely into our value proposition. So we remain focused on delivering that productivity for our customers. Kristen will now take you through our quarterly performance, capital allocation priorities, balance sheet, and our reaffirmed fiscal 2023 guidance.

Thank you, Erik, and good morning everyone. Please turn to Slide 5 of our presentation, where you can see key metrics for the fiscal second quarter on a reported basis. Slide 6 reflects the adjusted results, which will be my primary focus this morning. Our second quarter marked another quarter of strong execution and results. We remain on track or even ahead of schedule on our primary goals for fiscal 2023 of gaining market share, expanding adjusted operating margins, and improving adjusted ROIC. Our five growth levers and productivity improvements have us positioned to meet or exceed our Mission Critical goals. The execution of our growth drivers, as well as price contribution and our bolt-on acquisitions continued to fuel our results. Our revenues came in at $961.6 million, which represents average daily revenue growth of 11.5% versus the same quarter last year, well above the Industrial Production Index, which was basically flat in our fiscal second quarter. Growth from acquisitions contributed just under 4 percentage points of that increase. Looking at growth rates by customer type, public sector sales increased roughly 20%, national accounts grew in the mid-teens, and core and other customers continued to grow in high single-digits. Another way to view our sales performance is through the growth drivers we initiated as part of the Mission Critical program, solidify metalworking, expand solutions, leverage the portfolio strength, grow e-commerce and diversify customers and end markets with an emphasis on the public sector. Let me update you on each of these growth drivers. Our expertise in metalworking remains the cornerstone of our value proposition, driven by the depth and breadth of our portfolio, our large network of technical metalworking experts, and focus on innovation as a tool to elevate productivity while lowering costs for customers. This expertise is helping us win new customers and penetrate high growth end markets like aerospace, commercial space, and medical. These industries consume large amounts of metalworking tooling by working on intricate, complex, and lightweight materials. Our technical expertise applied in these situations is often able to yield considerable savings and throughput improvements. In a recent large scale win in the aerospace industry, the customer told us that no other competitor was able to bring the kind of technical advice and productivity savings that MSC offered. It was the primary driver behind the win, which will ramp up over the next couple of quarters. Instances like this are becoming more and more common and are fueling our National Accounts performance. Our solutions growth driver is anchored by our vending and in-plant programs, both of which have been delivering market share capture over the past several quarters. Vending machine revenues continued to grow in the mid-teens and represent 15.5% of total company sales. That compares to 15% of sales a year ago. Q2 in-plant signings remained quite strong and in-plant customer revenues grew nearly 20% year-over-year and now represent 12.5% of total sales. Sales to customers with our solutions offerings, that includes vending, VMI, and in-plant represent over 56% of the company's total sales, up over 200 basis points from prior year. The third priority is selling the portfolio, which is about increasing share of wallet through ancillary products, especially our Class C consumable product category. Here, we provide an outsourced vendor-managed inventory service that keeps plants running. So, we also include this business as part of our overall solutions offering. Q2 growth for this business remained solid with an average daily sales growth rate of low teens. Our fourth priority is digital, which includes all aspects of MSC's digital engagement with customers, suppliers, and associates. E-commerce sales reached 62% as a percent of total company sales in our fiscal second quarter, up roughly 130 basis points compared to the prior year. As Erik mentioned, John Hill and team are enhancing our e-commerce functionality and we expect this number to continue growing over time. Fifth is customer diversification through our public sector business. And I already mentioned our Q2 average daily sales growth of roughly 20%. Based on additional program wins, we expect momentum to continue during the back half of fiscal 2023 and into fiscal 2024. Each of our five growth levers are not only powering our performance, but they are positioning MSC as a trusted productivity partner to our customers, expanding our role from solely a spot buy supplier. Our gross margin for the fiscal second quarter was 41.3%, down 120 basis points year-over-year. The impact of acquisitions accounted for roughly 50 basis points of the dilution. The remaining 70 basis points are made up of lapping last year's large price increase, the increasing impact of costs through the numbers and mix. Sequentially, gross margin ticked down 20 basis points as expected, due to a slight compression in the price cost spread and the impact from the Buckeye acquisition in our numbers. Looking forward, while inflation has tempered, we are still seeing some suppliers move on price, still not at the levels of the past year. In March, we implemented a small increase of 1% to 2%, which follows our similar size increase in late January. The customer cost savings and productivity gains we deliver continue to support strong realization rates. Reported operating expenses in the second quarter were $281 million versus last year's reported operating expenses of $266 million. Adjusted operating expenses were $280 million or 29.1% of net sales versus last year's adjusted operating expenses of $266 million or 30.8% of net sales. This yielded a 170 basis point reduction in adjusted operating expenses to sales year-over-year. Our reported operating margin was 11.9% compared to 11.3% in the same period last year. Adjusted for restructuring costs, costs associated with the proposed share reclassification and acquisition-related costs, adjusted operating margin was 12.2% as compared to adjusted operating margin of 11.6% last year, a 60 basis point improvement year-over-year. That improvement was driven by the continuation of our Mission Critical initiatives, which yielded additional savings of $4 million in the quarter. That puts us at $10 million for fiscal 2023 and $95 million for the programs cumulative savings. We remain on track to achieve our goal of at least $100 million by the end of fiscal 2023. Already last quarter, our Mission Critical initiatives and the efforts of our entire team on cost containment and productivity boosted our adjusted ROIC to 18.3%. During our fiscal second quarter, we increased our adjusted ROIC to 19%, which includes the impact of the $300 million securitization facility we put in place back in December. Turning to earnings per share. Our reported EPS was $1.41 for the quarter as compared to $1.25 in the same prior year period. Adjusted for restructuring costs, costs associated with the proposed share reclassification and current year acquisition-related costs, adjusted earnings per share were $1.45 as compared to adjusted earnings per share of $1.29 in the prior year period, an increase of 12%. This continues to reflect strong execution at all levels: sales performance; gross profit and operating expenses leverage. Turning to the balance sheet, at the end of the fiscal second quarter, we were carrying $747 million of inventory, up $21 million from Q1 balance. The inventory build is consistent with our double-digit revenue growth, continuing inflation and calendar year-end opportunities. We do expect to bring inventory levels down by year-end. Our operating cash flow conversion rate for Q2 was 429%, which includes the benefit this quarter from the $300 million sale of receivables related to the securitization program. Excluding the benefit of securitization, we are still targeting an annual conversion of roughly 100% for fiscal 2023. Our capital expenditures were $15 million in the second quarter, and we continue to expect annual CapEx spend in the range of $70 million to $80 million in fiscal 2023. You can see on Slide 7. Our free cash flow is $325 million for the current quarter as compared to negative $16 million in the prior year quarter. Note, that we also spent about $12.5 million buying back shares during the quarter, just over 150,000 shares at an average price of $81.76. We currently have 4.4 million shares remaining on our current repurchase authorization. Our total debt at the end of the fiscal second quarter was $550 million, reflecting a roughly $230 million decrease from the first quarter of fiscal 2023 primarily from the benefit of the securitization facility. As for the composition of our debt, roughly 45% was floating rate debt and the other 55% was fixed rate debt. Cash and cash equivalents were $50 million resulting in net debt of $500 million at the end of the quarter, our net leverage at the end of the second quarter was 0.9 times. Before I reiterate our capital allocation strategy let me touch on the current banking environment. We recently conducted a comprehensive review of all of our main banks, those that participate in our revolving credit facility, as well as those banks with whom our recent acquisitions do business. Three of the six main banks are designated as systematically important financial institutions, such that they are more heavily regulated than regional banks. And all six banks have strong common equity and liquidity ratios. We continue to monitor the situation closely. As a reminder, we refreshed our capital allocation strategy last quarter, which you can see on Slide 8. Our top two priorities remain reinvesting into the business and returning capital to shareholders through our ordinary dividend. From there, our next two priorities are tuck-in acquisitions and share buybacks at the right valuation levels. We are deprioritizing the use of special dividends as we see higher return prospects in the other uses of cash. We continue to see buybacks as an attractive way to return capital and enhance shareholder value. In the near term, however, we will not be buying shares in the open market while based on legal advice we work through the share reclassification proposal. As a reminder, the Special Committee of our Board of Directors remains engaged in evaluating the reclassification proposal and we cannot comment on the status of their evaluation at this time. Now, let's turn to the fiscal year 2023 guidance and assumptions, which are shown on Slide 10. We are reaffirming our 2023 guidance of average daily sales growth of 5% to 9% and an adjusted operating margin between 12.7% and 13.3%. For modeling purposes, I'll provide additional color on our expectations for the back half of our fiscal year. As of now, we would characterize the environment as stable. Our growth trajectory likely temper a bit due to higher prior-year comparisons, including extra selling days last year, but should remain quite solid. March is indicative of this with estimated growth between 8% to 9%. I will note that our fiscal March, which extends through the end of this week, has a roughly 1 percentage point headwind due to the timing of Good Friday and Easter weekend, which will be a tailwind in our fiscal April. For the full year, we expect to trend somewhere between the middle and high end of our sales range. We continue to expect gross margins to be higher in the second half of the fiscal year than the first half, beginning with an expected sequential increase in Q3. This is due to several factors. First, the product cost increases in our P&L during the second quarter should be the peak for the fiscal year. Second, freight costs are moderating in the second half of our fiscal year. Third, as Erik mentioned, we have several gross margin initiatives that will be a tailwind over the remainder of the year and beyond. As of now, the benefits are modest this fiscal year and build for fiscal 2024. With respect to adjusted operating expenses, we expect our typical seasonal pattern to play out and adjusted operating expenses to sales ratio will decline sequentially in the second half. As of now, this would yield an adjusted operating margin in the middle of our range. As we can achieve a bit more gross margin improvement in the back half of the year, we can move the adjusted operating margin towards the higher end of the range. The last point I'll make is that we are not changing our full year guidance for our most recent acquisitions of Buckeye and Tru-Edge. These acquisitions add approximately 50 basis points of growth and dilute both gross margin and operating margin by an additional 10 basis points. We are proud of the growth in our business during the fiscal second quarter and we continue to take steps to align the business for further topline and bottom line acceleration moving forward. I'll now turn it back over to Erik.

Thank you, Kristen. As we crossover the halfway point of fiscal 2023 and we enter the final leg of our three-year targets, I'm excited by our company's performance. We are meeting or exceeding the targets that we set for ourselves nearly three years ago. The most exciting part for me, however, is that no one on our team is satisfied. In fact, we feel as if we're just getting started. We recently begun our strategy refresh process to create a new set of long-range targets and we look forward to sharing those with you in a couple of quarters. In the meantime, I'd like to thank all of our associates for their hard work, dedication and strong execution for our customers. Before I open the line for Q&A, I do want to take a minute to let you know that John Chironna has decided to retire at the end of June. Kristen, we'll keep you updated on progress in replacing John over the next few months. Let me spend a moment though thanking John publicly and recognizing the great job that he has done over the past decade. John has been a steadying, reliable, and consistent face to our investment community, as well as inside the company with our associates. During a time of change and transformation, both within the company and across the industry, John provided clarity, transparency, honesty, and most of all, integrity. John, on behalf of our entire team, thank you. And on a personal note, it's been a pleasure working closely with you and I wish you all the best as you venture into your next chapter in life. And we will now open up the lines for questions.

Thank you, sir. We will now begin the question-and-answer session. Today's first question comes from Tommy Moll with Stephens. Please go ahead.

Good morning, and thanks for taking my questions.

Good morning, Tommy.

Good morning, Tommy.

I appreciate the insight you provided on the demand environment and wanted to start on the revenue or average daily sales guidance that you've provided here. So if I'm doing the math correctly, even at the higher end of the range, if you look at the dollars per day, it implies something below the $16 million run rate that you've achieved the last few months. So I'm just curious if there's something you're seeing in the macro in the back half that might change to the downside, if it's a conservative outlook based on limited visibility or something else?

Yes, Tommy. So I think first broadly, let me just reiterate what you heard us kind of echo in the prepared remarks that we feel very good about what we're seeing right now in terms of the demand environment. The tone on the ground is stable. We're really confident with how we've been executing, confident in our ability to continue executing well. That being said, I think I'd be remiss if I didn't throw the word cautiously optimistic in front of that, just given all the same macro information that I'm sure you're looking at around Industrial Production and the Industrial Production Management Index. But the good thing is that we contemplated all that within the guidance framework, so we always anticipated that the year was going to slow down. When we set that range at the beginning of the year, we assumed Industrial Production was flat to down low single digits at the start of the year with the first half positive and the second half negative. And that's still what we expect to play out, although we see the bottom end of that range probably as being less likely at this point. But if you're thinking about kind of the first half into the second half, there's a few things you need to think about with respect to modeling on the topline. And the first is that the benefit from price does continue to decelerate sequentially, so we lapped the biggest increase in the second quarter, but that price benefit does continue to decelerate through the second half. The second thing I would mention is a similar dynamic on the acquisitions decelerating. And then, of course, we're seeing the market softening, which is one of the things that plays into the sequential average daily sales changes. Maybe to put a little bit of a finer point on the modeling, because there is a lot of noise, especially if you think about the fourth quarter prior year with the 53rd week. I would think about for the second half that the contribution to growth from price is between 300 basis points to 400 basis points such that the year looks like a 400 basis points to 500 basis points contribution from price. And then on the acquisition side, I would say, think about that as a 100 basis points to 150 basis points of contribution to growth, such that the year ends up being 200 basis points to 300 basis points. And then, of course, depending on how you model Industrial Production and volume or other assumptions that would land you in the mid-to-high end of our guidance range.

Got it. That's helpful. Shifting gears to operating expenses and the significant leverage in terms of percent of sales that you showed in the second quarter, any additional insight you can provide on some of the company-specific initiatives there would be appreciated. And then in terms of the second half, if I heard you correctly, I think the way you framed it up was just percent of revenue should improve second half versus first half. Any additional insight you can provide there potentially in terms of a range of dollars per quarter on that line of your profit and loss or what the range on a percentage basis could be would also be appreciated. Thank you.

I completely agree with your interpretation of the remarks. We've seen a sequential decline, which is not unusual for us. Let me first discuss a couple of our initiatives. We're doing very well with Mission Critical, which will continue to support us in the second half of the year. It's probably not surprising that we're ahead of our $15 million savings target for the year. We are cautiously measuring reinvestment due to the uncertainty in the macro environment. While we haven’t provided a firm number for reinvestment guidance, I can assure you we will achieve at least $10 million in net savings from Mission Critical. Additionally, regarding your question about our initiatives, we are fostering a strong productivity culture within the company. This is part of the next evolution of Mission Critical, which includes implementing lean practices and continuous improvement, gaining more grassroots feedback, and generating project ideas and productivity opportunities. We're beginning to see that momentum pick up. While we’re focused on the operating expense line for now, our intention post-2023 is to apply these principles across our entire profit and loss statement and balance sheet to create opportunities. As for the second half, the financial impact will depend on your volume projections. However, I suggest we will definitely see an increase in dollars for the third quarter, and based on your Q4 volume adjustments, you might observe more productivity benefits than what has been typical in the past.

I appreciate it. And I'll turn it back. Thank you.

Thank you. And our next question today comes from David Manthey with Baird. Please go ahead.

Hi, thanks. Good morning, everyone.

Good morning, Dave.

First off, the Buckeye and Tru-Edge acquisitions, that's 50 basis points combined, not each, right?

Correct.

Yeah. And then you mentioned reorientation of category management focus, we talked about some benefits in the second half, could you touch on the efforts and the benefits from that initiative?

Yes. Hi, Dave. Go ahead.

Go ahead, Erik. Go ahead.

Good morning, David. I believe we began noticing this last time. Over the past couple of years, our category teams have excelled in a challenging environment, focusing on securing products and managing inflation effectively. I think we can say we've succeeded in both areas. As things stabilize, we see an excellent opportunity to restructure through a line review process, which is a standard practice for us over time. However, this will have a stronger emphasis on thoroughly evaluating our products and suppliers while optimizing purchase costs. We are currently engaged in this effort, approaching it in phases. In Wave 1, we're clustering our product lines. Right now, we are negotiating for Wave 1 and have officially started Wave 2. Concerning the benefits, gross margin will be the most significant financial advantage. It will be modest this fiscal year, particularly in Q4, but will become more substantial as we enter fiscal 2024. To provide some context, the last time we undertook a process like this, prior to COVID, we saw a profit improvement of around $20 million. I expect this initiative to at least match, if not exceed, that figure, considering we are now a larger company and it's been a few years since we made such efforts. We may also adopt a more proactive approach during this line review. Additionally, as you look beyond 2023, I wouldn't simply add the $20 million onto other gross margin considerations, as there will be various influences. At this stage, it’s too early for a detailed gross margin outlook, but without this initiative, we could face negative price costs, and this will certainly help mitigate that. I hope this provides some useful insight.

Yeah, that does. And just to clarify, I think last quarter you were saying that you didn't expect the typical seasonal fourth quarter downtick in gross margin. You're still tracking that given this initiative and your outlook relative to that 41.5% to 41.8% gross margin guidance?

Yeah, that's correct, Dave. So for Q3, as we commented on the prepared remarks that expect Q2 to Q3 step up to look pretty similar to what you had seen historically, so plus 30 basis points to 40 basis points. And then Q4, I would think about that being flat, maybe down 10 basis points. And then for the year on the gross margin guidance range, yes, we still feel confident with that original range. Although, I think a little bit more pressure probably towards the bottom end, given the Buckeye acquisition.

Got it. Okay. Thank you very much.

Thank you. And our next question today comes from Chris Dankert with Loop Capital. Please go ahead.

Hey, good morning, guys. Thanks for taking my question.

Good morning, Chris.

I guess, thinking about your Mission Critical, as we kind of move into the next phase here, should we be thinking about it more in terms of kind of offsetting some of the investment costs that you're undertaking here or do we kind of stay tuned until you kind of really talk about longer-term targets?

Yes, Chris. So, I would say stay tuned for more specific targets, which we'll give at the end of the fourth quarter. But what I would say is, obviously, the spirit of what we've been doing here over the past two and a half years definitely continues on in the Mission Critical 2.0, but it does look a little bit different in terms of how we execute inside the company, sort of the size of the projects that we're taking on and then where the benefit shows up. So largely the cost savings on Mission Critical has been very focused on the operating expenses savings in this Mission Critical 1.0 round. But we see a lot of benefit to be gained by expanding that focus to cost of goods sold, to the balance sheet. I think there's a lot of opportunity we can go after there. But the broad thing I would reiterate going back to your question is, yes, the idea is really to use Mission Critical as a productivity engine on an ongoing basis that helps us to cover sort of core inflation that we see every year at a minimum and then as much as we can fund through investment, that would be the goal.

Thank you for the insight. Regarding current discussions with customers, especially about cost savings and VMI, it was a significant selling point during the 2015-2016 slowdown. Erik, you mentioned this in your opening remarks, but could we place the current cost-saving conversations and what MSC offers in the context of previous downturns? Are we experiencing a noticeable increase in these discussions, or is it similar to what we've observed in 2022-2023 so far?

Chris, so I would say the punch line is, there has been an acceleration. And I think there's two factors I'd point to, a macro factor and a micro factor. So the macro factor is that our customers, they are experiencing unprecedented levels of inflation over the past couple of years of competitive intensity of a once-in-a-hopefully-once-in-a-lifetime experience with COVID. Our customers are under more pressure than I've seen in my 25 years in the business. So the drumbeat and the need for help is greater than it's been in past cycles. That's the first thing. The second, the micro factor is, look, Chris, relative to prior cycles, we really have changed the face of MSC. So this repositioning that we've talked about to becoming a Mission Critical partner, we've always had kind of like arrows in our quiver as it relates to helping customers with productivity and cost savings, but they're much greater now. And in particular, I think what's happened is they've extended from the procurement side of things, where we could offer productivity savings in the way of one-stop shopping, in the way of process savings to inventory management, we've really extended that to savings on the plant floor. And I think this is probably where we're fairly unique. And Kristen in the prepared remarks mentioned one of our recent wins where the customer said to us, nobody is doing this. It's extending the savings and the productivity from the process side to the production process where with our technical experts between metalworking and OEM fasteners and the C parts products, we're actually able to go in and help reengineer process. We're helping save labor hours, which right now are precious. We're saving material. So I think you're seeing, number one, a step up in customer needs and expectations. And then number two, really a changing of our role.

Got it. So it's more about share capture, not trying to read into much to customer, the needs versus past. I think that makes an awful lot of sense. Thanks so much, Erik.

You got it.

And your next question today comes from Steve Volkmann with Jefferies. Please go ahead.

Great. Good morning, everybody. And congrats, John, thanks for all your help.

Thank you, Steve.

Good morning, Steve.

Maybe just to go back to this kind of gross margin outlook. It feels like there's kind of cross currents for 2024. And Kristen, I think you said that you would see more of your line review benefits in 2024, I think you said that too Erik. But you'll, obviously, see some headwinds, I guess, on price cost. I mean, can you give us a sense can gross margin be up in 2024 or how are you thinking about just broadly, we don't need a number yet?

Yes, you're correct. At some point, due to our costing method, the price cost does turn negative. We observed our costs peak in the second quarter, so we anticipate that in fiscal 2023, the price cost will be slightly positive or flat. This suggests that fiscal 2024 may see a negative shift. The category line reviews are essential for mitigating that impact. As Erik mentioned earlier, increasing productivity in cost of goods sold will help counterbalance that effect. It's challenging to quantify right now due to ongoing cost inflation. We will provide a more specific figure in Q4, but significantly enhancing productivity is necessary for us to improve margins year-over-year after the price cost curve flips. However, we see substantial opportunities in cost of goods sold and are actively pursuing various initiatives. We plan to provide more detailed information in the fourth quarter.

Okay, great. That's helpful. And then can you just go back to this quarter and give us a sense of what price and volume were?

Sure. Yes, so price in the quarter contributed just under 500 basis points to growth, and then volume was just under 300 basis points of growth.

Okay. And then one final quick one from me. Kristen, you mentioned inventory maybe comes down this year, any order of magnitude?

Yes. So yes, we do expect inventory to come down. Of course, a bit of dependency there on how growth plays out in the second half, but I'd say in the 10-ish range is probably realistic coming down about $10 million.

Okay. So pretty modest. All right. Thanks so much.

Thank you. And our next question today comes from Ryan Merkel with William Blair. Please go ahead.

Hey, everyone. Good morning. Good morning, Ryan.

Hey, Ryan.

John, it's been a great run. Thanks so much for all the help. Wish you all the best.

Thank you, Ryan.

So my first question today is on the in-plant, which was up 20% and is now a little bit higher than 12% of sales. Can you just define what that is and how you execute to it? I imagine, there are MSC people on the plant floor more often? Just talk about how you do that and kind of what the outlook is?

Yes, Ryan, you really captured the essence of it. Essentially, this represents the most enhanced aspect of our solutions where we become a Mission Critical partner for our customers. We are assigning one or more full-time individuals to work directly within our customer’s operations. This typically involves more than just staffing; it also includes implementing an inventory management system, whether that’s a vending solution or Vendor Managed Inventory (VMI), along with regular visits and audits by our technical team for plant improvement reviews. The key element is definitely our full-time personnel being integrated. What we’re noticing is significant value for our customers, especially given the ongoing labor shortages. This is consistently one of the top two or three concerns we encounter during customer interactions. By placing our people on-site, we are effectively addressing a major need. When our team is present, they handle everything from procurement to assisting with operational improvements, allowing our customers’ staff to concentrate on more critical tasks within the manufacturing process. The benefits for the customer are evident, and the advantages for MSC are apparent as well. Generally, when we implement such a program, whether for a new customer as part of our sales strategy or for an existing customer to increase our share of wallet, we observe strong growth rates and exceptional retention in the one to two years following the program's launch. As we begin to leverage fixed costs with increased volume, profitability also seeps upward. This segment has been experiencing rapid expansion, and considering both macro and micro factors, I anticipate it will continue to grow robustly.

Appreciate that. That's helpful. And then you mentioned continuous improvement will be part of the DNA and the Mission Critical has gone very well. Can you just give us some examples of how you're thinking about that? And I don't know if you want to give a soft goal today, but how might that look going forward?

Yes, I can take that one, Ryan. So we've been doing a lot of work to improve execution up to this point of Mission Critical. But I'd say it's only recently where we've really shifted, really trying to educate the organization on lean principles and drive continuous improvement philosophies through the company, and we're definitely in the early innings of that effort. One thing I'll add that I'm really energized by having our new COO on board, who is a huge believer in these concepts, and she is going to be a great partner in helping us drive this through the organization going forward. So, I would hesitate to put a number on it again at this point, but I really see it being the engine for Mission Critical 2.0, whether you're talking about targeting operating expenses savings, whether you're talking about targeting cost of goods sold improvements, working capital improvements, this kind of becomes the mechanism or the motor that fuels all of that. Early wins we've had, I'd say a lot of the work that we've been doing to unlock working capital through the value streams right now have come this way. But again, it's really early innings of what a more energized and excited by is there's a ton of parts of the organization that you're not really seeing any material benefit yielding yet. So, I'm really excited about this, and I think it's a big step in the future of MSC and Mission Critical 2.0 specifically.

Ryan, I'll just add a little color on top of just from the CEO's perspective on this one. It's really exciting for me to see Kristen and Martina together. And two things I'd highlight, sort of zooming out from strict productivity. One is that, I mentioned this in the prepared remarks, more aspirational target setting, that I think the management team that's in place now is more comfortable setting stretched targets, even if it means you missed, but thinking really big and sort of that fits into the continued improvement umbrella. The second one is a concept that I think Martina has brought with her, which is problem elimination versus problem solving MSC. We've had a really strong customer-focused culture for a long time. We jumped through hoops when there's a problem. We solved it. But what we're trying to do now with Martina and Kristen leading it is, stepping back and saying, wait a second, get to root cause, why is the problem happening in the first place. And don't celebrate just solving it for the one customer. Get to root cause, justify why, then figure out how you eliminate it so the problem doesn't come up the next time. I think both of those are cultural shifts happening inside the company.

I appreciate, Erik. Thanks so much.

Thanks, Ryan.

And our next question today comes from Ken Newman with KeyBanc Capital Markets. Please go ahead.

Hey. Good morning, guys.

Good morning, Ken.

Hi, Ken.

Hi, Ken.

Many of my questions have already been addressed during the call, but I'll start by asking about the capital allocation priorities for both organic growth and potential mergers and acquisitions. I know you have been active with some smaller acquisitions, but given the current uncertainties in the banking sector, could you discuss the challenges of pursuing more M&A opportunities moving forward?

Ken, I'm glad to address this. Kristen outlined our priorities well. While there is some uncertainty in the macro environment and banking sector, we are confident in our strong balance sheet. If conditions were to worsen, our balance sheet would strengthen further, and our cash generation would increase. We believe we can remain alert and responsive. That being said, we will continue to exercise discipline. Regarding M&A, while I won't rule anything out, it would take a significant opportunity to deviate from our current tuck-in strategy. Therefore, I don't anticipate any major acquisitions or ventures outside our core focus areas. However, our execution capability for tuck-in acquisitions has significantly improved, and our confidence is increasing. This remains a priority in our capital allocation strategy. We will stay vigilant while adhering to our three evaluation criteria: strategy, financial, and culture.

Got it. And then for my follow-up, I think there's been a lot of good color on the demand outlook and I appreciate all the comments on both the customer mix and the modeling comments as well. I guess, just given some of the uncertainty that we've talked about in the prepared remarks, can we talk a little bit about what visibility you have in demand relative to the end markets that your customers are serving? Where are you seeing pockets of strength or maybe some incremental weakness relevant to your expectations?

Sure, Ken. Overall, I want to emphasize that the outlook is stable. There is more caution now and the sentiment indices are weakening, but we remain optimistic about the current environment. Our customers are active, although there is indeed more caution compared to two quarters ago, which has been worsened by the banking situation. However, activity levels, backlogs, and order flows are generally positive. The areas where we observe some softness include consumer-facing industries and, more recently, heavy equipment, which has shown a more negative trend. Conversely, sectors like aerospace and medical are experiencing strong conditions. While there are some areas of weakness, there are equally strong areas, leading us to describe the overall situation as stable.

That's really helpful. Thanks for all the color, guys.

Thanks, Ken.

And our final question today comes from Patrick Baumann with J.P. Morgan. Please go ahead.

Hi. Good morning, everyone. Thanks for taking my questions.

Hey, Pat.

I just wanted to say hello and wish John the best in whatever he decides to do next. He has been a trusted and respected voice for the company over time and will definitely be missed. So, best of luck, John.

Thank you, Pat. Appreciate that.

I appreciate all your effort over the years. My question is about the continued positive results from the Mission Critical initiatives, specifically in terms of solution sales growth and government sales growth, which were mentioned. Overall volume growth surpassed Industrial Production by 200 to 300 basis points in the quarter, which was an encouraging increase. I want to focus on the other 35% of sales that are not from solutions or government. How would you describe that segment of sales? What are you observing in terms of volume growth there? Additionally, what actions are being taken to energize that part of the business?

Yes, Pat. That's a great question. Overall, I'm feeling very encouraged by the business trends. We often assess what you might also be looking at, which is evaluating the base business by excluding Industrial Production and acquisitions to see how it's performing, especially beyond price, given the elevated pricing environment we've experienced. What excites me is how MSC has evolved over the years with our strategic repositioning. We've shifted our focus, and the standout areas now are where we've pivoted, particularly in high-touch solutions and sectors like public service where we see a strong competitive advantage. The segments growing faster than average are those where we maintain a technical, high-touch approach, which is very encouraging. Conversely, there are other segments growing slower than average, mainly from our legacy business, which includes small customers and simple commodity transactions. This is actually a positive sign for future growth. Kristen, Martina, and the team are currently exploring two strategies because we are not satisfied with our current growth and aim for improvement. First, we want to accelerate the scaling of new initiatives, such as in-plant solutions, vending, high-touch service, and our public sector efforts, where we are gaining traction and believe we can enhance our speed. Second, we need to uplift the legacy business to at least match the average company growth. I'm optimistic about this since it involves our foundational products and services. We've already introduced several measures to support this. To begin with, we’re enhancing our e-commerce capabilities, which is an ongoing process, and I'm really excited about the talent and energy John has brought to our e-commerce efforts. We are seeing positive outcomes in e-commerce, particularly among smaller customers, though there’s definitely room for improvement, and you’ll notice these advancements in the upcoming quarters. Secondly, we’re optimizing our product and supplier portfolio through category line reviews, which will include adding new products in some areas and streamlining offerings in others. This effort is aimed not just at improving cost efficiency but also at enhancing the customer shopping experience. Another point worth mentioning is our renewed marketing initiatives aimed at smaller customers. We are focused on how to effectively communicate our valuable, high-touch technical offerings, which have been successful with larger clients, in a cost-effective manner to smaller customers. Our marketing team is dedicated to this objective. These are the kinds of efforts we’re undertaking to energize our growth. If we can continue to elevate our performance across the board, it’s going to be very exciting.

That's helpful information. Do you think price is a barrier to growth in that part of the business, or do you feel like your pricing is in line with that portion of sales?

I believe there is always a balance to be struck between pricing and volume, and we've consciously chosen to focus on a Mission Critical segment. Our strategy has shifted towards a high-priced, high-value position. Achieving that value makes it challenging to also be the low-cost provider, which is not our aim. Most of our revenue comes from direct interactions with customers and we are competitively priced in those areas. However, there are instances with new or very small customers where we may be priced higher than other options. We recognize that this is an area needing attention and believe we can address it with a targeted approach rather than a broad one. This will not apply to all products or customers. Additionally, as part of our marketing initiatives, we will analyze this further.

It makes sense. Thanks for the color. And then on the cash dynamics in the quarter, Kristen, you can help on this. So how much of the free cash flow in the quarter was related to this facility? I guess I just didn't quite understand the mechanics around that. Remind me what exactly that facility is? I guess, it's off-balance sheet, right? And how does the cost flow through in terms of the profit and loss?

That's correct, Pat. Yes, if you're trying to adjust the cash flow, you should consider that you benefited by $300 million from the securitization. Regarding the profit and loss impact, I want to quickly highlight two points. First, you will notice a decline in interest costs due to the securitization, while other costs may increase. After the first year, the ongoing annualized benefit will be around $800,000 to the profit and loss.

Okay. We can follow up on that offline. And then I had to ask one last, I noticed you hit the buzzer. Any sense on timing of next steps with regard to the proposed share class consolidation, like what are the mileposts to watch there?

Yeah. I'm sorry, Pat, I can't really comment on that. As soon as we have news to share, we obviously will, but no further information at this time.

Thanks. Best of luck.

Thanks.

Thanks.

Thank you. Ladies and gentlemen, this concludes our question-and-answer session. I'd like to turn the conference back over to John Chironna for any closing remarks.

Thank you, Rocco. Before we end the call, I'd like to thank Erik, Kristen, and the entire MSC team for giving me the opportunity to continue doing what I truly love. I'd also like to thank our analysts and investors for the wonderful relationships we've forged over the last few decades. It's those relationships that have made coming to work each day a true joy. A reminder that our fiscal 2023 third quarter earnings date is set for June 29, and we look forward to seeing you in person at investor conferences or on the road in the coming months. Thanks again for joining us today.

Thank you, sir. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.