Msc Industrial Direct Co Inc Q4 FY2025 Earnings Call

Thank you, and good morning, everyone. Welcome to our fourth quarter and fiscal year 2025 earnings call. Erik Gershwind, Chief Executive Officer; Martina McIsaac, President and Chief Operating Officer; and Greg Clark, Interim Chief Financial Officer, are on the call with me today. During today's call, we will refer to various financial data in the earnings presentation and operational statistics documents, both of which can be found on our Investor Relations website. Let me reference our safe harbor statement found on Slide 2 of the earnings 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 are noted in our earnings press release and other SEC filings. Lastly, 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.

Thank you, Ryan. Good morning, everyone, and thank you for joining us today. I'll begin the call with some perspective on our recent performance and a view into our mission-critical path forward. I'll then offer some commentary on our end markets and overall economic conditions. Greg will cover our results for the fiscal year before passing it over to Martina to provide her perspective on our recent performance and our expectations for fiscal year 2026. I'll then wrap things up by providing some additional color on today's announcement regarding our upcoming leadership transition. As we turn the page on fiscal 2025, I'm encouraged by the progress that's happening inside our company. We entered the year with three top priorities, which were to maintain momentum in our high-touch solutions, to reenergize our core customers, and to optimize our cost to serve. We're making strides on all three fronts and are doing so in the face of an uncertain environment. While there is still plenty of work to be done, our recent progress is beginning to evidence itself in our financial performance as we return to daily sales growth, and we're poised for operating margin expansion once again. First, our high-touch solutions, including vending and implant, continue the strong track record that we've seen all year long. Martina will provide more details shortly. Second, and most notably, we've begun to see our core customer average daily sales growth rate inflect and turn positive. As you recall, we launched four initiatives aimed at reenergizing our core customer base. And those were realigning our public-facing web pricing, which was completed during fiscal 2024, upgrading our e-commerce experience, accelerating our marketing efforts, and optimizing seller coverage. The largest milestones occurred at the end of our fiscal second quarter as we launched our upgraded website and our enhanced marketing efforts. Since that time, we've seen a steady improvement in core customer performance. Third, we've made progress in optimizing our cost to serve. We're on track with the supply chain productivity improvements that are yielding between $10 million to $15 million in annualized savings. We improved seller coverage and effectiveness by leveraging an enhanced data-driven territory model and tools that help reps more easily identify white space opportunities. And we have a growing pipeline of additional productivity programs that we expect to fuel more gains in fiscal 2026. I'll now turn to the specifics of our fiscal fourth quarter on Slide 4, where you can see average daily sales performed better than expected and improved 2.7% year-over-year. The return to growth in our core customer base, along with continued strength in the public sector, resulted in better-than-expected volumes and was the primary driver of the beat. Benefits from pricing came in as expected during the quarter, contributing 170 basis points to growth year-over-year and 90 basis points sequentially. As a reminder, we took a broad-based low single-digit pricing action towards the end of our fiscal June. That said, gross margin came in below our expectations at 40.4%, declining 60 basis points both year-over-year and sequentially. The primary driver here was tariff-driven purchase cost escalation, which came in faster and hotter than we expected during July and August. We also saw some other headwinds such as public sector-related customer mix. We have since taken action with pricing moves in the fiscal first quarter and have begun to see gross margins improve. Operating expenses in the quarter were approximately $306 million on a reported basis. And on an adjusted basis, operating expenses stepped up approximately $8 million year-over-year to $305 million for the quarter, but remained flat on a percentage of sales basis. The primary drivers of the year-over-year increase were driven by higher personnel-related costs and depreciation expense. Sequentially, adjusted operating expenses performed slightly ahead of expectations and declined approximately $6 million compared to the fiscal third quarter. Reported operating margin for the quarter was 8.6% compared to 9.5% in the prior year. An adjusted operating margin of 9.2% declined 70 basis points compared to the prior year. This did, however, exceed the high end of our outlook by 20 basis points. We delivered GAAP EPS or earnings per share of $1.01 compared to $0.99 in the prior year's quarter. And we also saw year-over-year improvement on an adjusted basis, with EPS growing nearly 6%, coming in at $1.09 compared to $1.03 in the prior year. The positive trend we saw in the fiscal fourth quarter has continued into the first couple of months of fiscal 2026 as our daily sales growth rate ticked up further to 5% in September, and we're expecting to grow between 4% and 5% in October despite impacts from the government shutdown. As we look ahead, we expect the step up in operating expense to moderate and productivity to build. All of this positions us well in our efforts to restore profitable growth and operating margin expansion in fiscal 2026 and beyond. Turning to the environment, we characterize conditions as stable with some pockets of improvement while the ongoing overhang of uncertainty remains. Tariffs have moved from a possibility to a reality as we're now experiencing meaningful price inflation across many areas of the business. Customers are generally understanding of price increases as long as we provide sufficient transparency into tariff-related impacts. That said, the need to provide customers with offsetting cost savings measures is very real. And this plays well into our high-touch and technical value proposition. Our suppliers are describing continued cost pressures on certain raw materials that are heavily China-based or influenced, and if this sustains, it could lead to further price inflation in the coming months. From an end market perspective, we've seen stabilization and even firming up in some of our larger verticals. Aerospace remains strong, while end markets such as heavy equipment and agriculture, which have been particularly weak over the past two years, are at least stabilizing. Some areas of acute softness do remain, such as heavy truck. Looking at Slide 5, I'm encouraged to see how MSC is faring in this environment. Average daily sales in the quarter began to outpace the Industrial Production Index once again, supported by our improved customer performance and continued strength in the public sector. With that, I'll now pass things over to Greg for an overview of our financial results for the fiscal year.

Thank you, Erik. Good morning, everyone. Please turn to Slide 6, where you can see key metrics for the fiscal year on both a reported and adjusted basis. Average daily sales declined 1.3% year-over-year primarily due to softer volumes in the first half of the fiscal year and a slight FX headwind. These headwinds were partially offset by positive price that contributed 60 basis points to growth and some carryover benefits from acquisitions in the prior year. Moving to profitability for the year, gross margin of 40.8% contracted 40 basis points compared to the prior year due to negative price cost and customer mix. Operating expenses stepped up approximately $56 million and $55 million on an adjusted basis as expected. Combined with slightly lower sales, this resulted in a 190 basis point increase in adjusted operating expense as a percentage of sales. However, we exited the fiscal year with adjusted operating expenses as a percentage of sales performing in line with the prior year. Reported operating margin for the fiscal year was 8% compared to 10.2% in the prior year. On an adjusted basis, operating margin declined 230 basis points compared to the prior year. Together, this resulted in GAAP EPS of $3.57 or $3.76 on an adjusted basis, compared to $4.58 and $4.81 in the prior year, respectively. Now, let's turn to Slide 7 to review our balance sheet and cash flow performance. We continue to maintain a healthy balance sheet with net debt of approximately $430 million, representing roughly 1.1x EBITDA, continuing to generate healthy cash flow in the quarter despite the increase in receivables through lifts and sales. We delivered free cash flow of $58 million during the fourth quarter, representing 104% of net income. This resulted in free cash flow conversion of 122% for the fiscal year, ahead of our annual target. Turning to capital allocation on Slide 8, our highest priorities remain organic investment to fuel growth and advancing operational efficiencies across the business. Returning capital to shareholders also remains a priority. We purchased approximately 496,000 shares throughout the year. Combined with our quarterly dividend, which we increased by approximately 2% this month, we returned $229 million to shareholders in the fiscal year. I will now turn the call over to Martina for a deeper dive into our quarterly performance and expectations for the new fiscal year.

Thank you, Greg, and good morning, everyone. On Slide 9, we're pleased to see our daily sales trend improving across all customer types. In the fiscal fourth quarter, we were particularly happy about the return to growth in our core customer segment, with daily sales rising 4.1% year-over-year due to both price and volume increases. National Accounts saw a decline of 0.7% compared to last year, as this segment is experiencing a greater impact from the macro environment, with just 44 of our top 100 customers showing growth during the quarter. Nonetheless, on a sequential basis, national accounts performed similarly to core customers, improving by just over 1%. The public sector continued its strong performance with daily sales growing 8.5% year-over-year and 10% sequentially. Although this segment faced challenges from the government shutdown, which caused negative sales growth in October compared to positive growth in September, we believe this situation is temporary. Let’s take a closer look at some key initiatives and KPIs that supported the daily sales improvement in the quarter as shown on Slide 10. I am particularly pleased with the ongoing expansion of our solutions footprint. Our installed vending count increased by 10% year-over-year and 3% sequentially to over 29,600 machines. Average daily sales for vending also rose by 10% year-over-year, accounting for about 19% of total company sales. Regarding implants, our program count at 411 grew by 20% year-over-year and 3% sequentially. Daily sales from customers with an implant program increased by 11% year-over-year and represented approximately 20% of total company sales. Improvements in our core customer growth rate stem from various programs mentioned by Erik earlier, including sales territory optimization. As highlighted in the middle of the slide, we saw increased coverage effectiveness, allowing us to be more present at customer locations. The number of customer interactions logged by our field sales team increased by double digits year-over-year and mid-single digits sequentially, all achieved with fewer sellers, indicating the potential for greater sales effectiveness. Additionally, we've invested in website upgrades and enhanced marketing efforts to support core customer growth. In the fourth quarter, average daily sales through the web saw positive growth year-over-year in the low single-digit range. We also noted improvements in KPIs such as direct web traffic and conversion rates in our top channels. Our improved checkout experience contributed to lower abandonment rates in the quarter, and enhancements to our search function showed early positive results. The percentage of users adding items to their cart within the first 0 to 5 minutes improved in the low single-digit range, indicating that users are finding what they need more efficiently. Before moving on from our quarterly results, I want to address our gross margin. In Q4, our gross margins were about 50 basis points below expectations. Two0 basis points of the miss were related to mix and other factors, while 30 basis points were due to price cost. Although our price realization met expectations, cost realization fell short. A mix of rapid supplier price hikes, compressed notification periods, higher sales volume, and a larger proportion of direct ship orders led to higher costs than anticipated during the quarter. In response, we have implemented further pricing adjustments in the fiscal first quarter and are seeing an improvement in gross margins compared to Q4. Now let's discuss the changes in our leadership team, which will enhance our commitment to growth and customer experience, as seen on Slide 11. We're excited to welcome [candidates' names] as our new Senior Vice President of Sales, bringing two decades of engineering and field sales management experience from their time at Hilti, with a strong record of achieving above-market growth. In this role, they will continue to advance MSC towards sales excellence. With their addition, Kim [candidates' name] will take on a newly created role as Senior Vice President of Customer Experience. Utilizing Kim's 30 years in the industry, this new team will focus on ensuring every customer interaction with us is seamless and memorable, driving customer retention and growth. I congratulate both [candidates' names] and Kim on their new positions and look forward to their future successes. As for the rest of the management team, John Reichelt is settling into his role as Chief Information Officer. He and his team are making progress on evaluating our systems design. Finally, we are actively searching for a permanent CFO and have begun discussions with both internal and external candidates, hoping to fill the position within the next quarter or two. Moving on to our expectations for fiscal 2026, we will start with our outlook for the fiscal first quarter on Slide 12. We anticipate that average daily sales will grow between 3.5% and 4.5% year-over-year. The lower end of this range assumes the government shutdown continues for the remainder of the quarter, while the upper end assumes that it ends before our fiscal quarter concludes. Our expected range also reflects quarter-to-date sales, with September showing a 5.1% increase and October trending towards 4% to 5% growth. It's important to note that our return to growth occurred last fiscal November, making this a tough comparison to the prior year for the fiscal first quarter. We expect our adjusted operating margin to be in the range of 8.0% to 8.6%, taking into account the anticipated improvement in gross margin from Q4 levels, targeting approximately 40.7%, plus or minus 20 basis points, and a projected increase in adjusted operating expenses of roughly $7 million to $10 million compared to the fiscal fourth quarter. This increase is primarily driven by annual depreciation and amortization adjustments, higher incentive compensation expenses, a month of merit increases, and increased marketing investments, partially offset by continued productivity gains. These increased marketing efforts are in response to the progress we are witnessing with our core customers and are directed towards high-return areas of our expanded marketing program. On Slide 13, we detail our expectations for certain line items for the full year. We estimate depreciation and amortization costs to be around $95 million to $100 million, reflecting a year-over-year increase of approximately $5 million to $10 million due to ongoing investments in technology and digital capabilities, as well as growth in vending. Other assumptions include roughly $35 million for interest and other expenses, capital expenditures of $100 million to $110 million, and a tax rate between 24.5% and 25.5%. We expect free cash flow to be around 90% of net income, which is lower than the previous year due to working capital needs to support top-line growth. To assist with sales modeling for the remainder of the fiscal year, we have provided historical quarter-over-quarter averages and key considerations for the second quarter and the latter half of the fiscal year at the bottom of the slide. Lastly, there is one additional business day this fiscal fourth quarter compared to the previous year, as indicated at the bottom of the chart. Looking beyond the fiscal first quarter, we anticipate incremental margins of around 20% with mid-single-digit revenue growth as gross margins return to expected levels and the benefits from our productivity initiatives continue to build throughout the fiscal year. I will now turn the call back to Erik for closing remarks before we proceed to Q&A.

Thank you, Martina. I'd like to close out the call on a more personal note. It has been an honor and a privilege to serve as MSC's leader for the last 1.5 decades. While I'm stepping away from day-to-day leadership, I will continue to serve MSC as Non-Executive Vice Chair of the Board. As I prepare to transition, I've taken some time to reflect on my 30-year history at MSC. Working alongside such an exceptional team has been one of the greatest privileges of my career. Together, we have grown and transformed this company from a traditional spot buy distributor into the trusted mission-critical adviser and industry leader that you see today. Most importantly, we achieved this while living up to the values set forth by my grandfather when he began selling cutting tools from the trunk of his car all the way back in 1941. Succession planning and leadership development have been pillars of MSC's values since its inception over 80 years ago. Leaders are chosen carefully, and they're thoughtfully developed over time. Like my grandfather, like Mitchell and David before me, one of my most important responsibilities is developing our next leader and then stepping aside when that person is ready. It is with great pleasure that I hand the baton to Martina, who will succeed me as MSC's fifth CEO. As you all know, Martina has been with MSC for over three years, and she knows every operational corner of the company. We've worked hand-in-hand during a critical phase at MSC, and she's been instrumental in shaping our operational improvements and our strategic growth initiatives. The Board and I have the utmost confidence in her, and we look forward to seeing her build on the momentum seen in our recent results and provide a very bright future for MSC. Thank you all for your friendship and support over the years. It's been a pleasure working with each and every one of you. Martina, I'm going to turn it back over to you to close the call.

Thanks, Erik. First and foremost, on behalf of all of us at MSC, I would like to take a moment to acknowledge your extraordinary leadership and the lasting impact you've had on the company. Over our nearly 30 years here, you've guided us through remarkable growth and transformation. Erik, your leadership means a great deal to all of us. It has shaped the company we are today. Personally, I also want to thank you and our Board of Directors for your confidence in me and for this opportunity to continue driving MSC's growth and operational performance. During my time leading our day-to-day operations for the past three years, I've been deeply engaged in listening to our associates, customers, suppliers, and shareholders, and this has helped shape the strategic initiatives, which are starting to be reflected in our results today. With these building blocks and a strong leadership team now largely in place, MSC is set to achieve new levels of growth and further strengthen its leadership position. I could not have asked for a better opportunity. As I look ahead and prepare to step into the CEO role on January 1, our focus will be on value creation, maintaining our recent growth momentum, and delivering a balanced capital allocation strategy, all while living up to our core values. I believe this is possible by turning our attention to three key areas. First, we must harness the incredible commitment of MSC's talented associates to strengthen our culture. We want to raise our own expectations and inspire curiosity, self-responsibility, and a spirit of continuous improvement. Second, we must build on the momentum from the initiatives that have resulted in a return to growth you see today. We do this by executing on our recent organizational changes to drive disciplined sales excellence and a relentless commitment to customer experience. And third, MSC needs to deliver on its commitment. We must bring productivity and consistency to our everyday work and use data to drive speed and accountability through our operating system. I could not be more excited to step into this role, and I look forward to building stronger relationships with everyone on today's call. With that, please open the line for questions.

Your first question for today is from Ryan Merkel with William Blair.

And great to see the inflection in the business and, of course, to Erik and Martina congrats on the new roles. My first question is just on gross margin, the 30 basis points of the negative price cost. I don't recall ever hearing Erik, a surge in supplier price increases and costs working through the P&L sort of faster. Can you talk about what sort of happened there? And then how you addressed it. It sounds like you raised prices a bit more.

Yes, Ryan, so I'll start, and then I'll turn it over to Martina just to provide some historic context. You are correct that this is unusual. Obviously, you and I together have seen in this industry a lot of inflation cycles. This one has been fairly unique. Looking back, the concentration of increases that we saw really in a very short window of time was unusual, even relative to a post-COVID inflation period, which had also been historic. So I do think it's played out a little differently from prior cycles. I'm going to turn it over to Martina to talk about how we're handling that, and we're encouraged about what we're seeing in a bounce back in Q1. But I'll let Martina talk in a little more detail.

Yes. So Ryan, the 30 basis points, I was price behaved exactly as we expected. We were very pleased with the work that our team did. Price contributed 170 basis points right on our forecast, and we were able to work with customers. I think you heard in Erik's prepared remarks, customers are understanding of what we're doing and why we're doing it, and we're helping them navigate a very uncertain time. Cost, to give you a little bit of context of what Erik just said, we took a price increase at the end of June. So sort of between mid-June when we locked that increase in and the end of August, during those weeks, we took more inflation than we took in nine months post-COVID in 2022. So that kind of gives you a feeling for scale. It was both the number of increases, the changes in these increases, and the changes in supplier behavior that compressed lead times. We amassed this amount of inflation in the business, and we had committed to pricing stability; therefore, we did not plan to take another increase until Q1. We didn't react, and we have now since taken, I think, the right actions in Q1. Gross margin is restoring. We headed into the quarter with a headwind on price cost. We will exit the quarter in a much better position. We have taken a hard look at our processes. When you think about where we want to take the company, we're happy with the accountability and the way our team reacted in September. But this is a great example of where our operating system where we could have where we need increased visibility because we would have taken more price in the quarter.

Got it. Okay. Very helpful. And then for my follow-up, I heard you say mid-single-digit revenue growth was achievable this year if you just use the sequential and then 20% incremental margins. So that's great to hear. On the 20% incremental margins, I know you're not giving specific guidance, but are you expecting to have gross margins sort of up year-over-year given initiatives? And then SG&A as a percent of sales, do you think that you can work that down year-over-year because you talked about some productivity and then maybe leveling off of the cost increases? So a little more color there on what your expectations would be helpful.

Yes. So let's start with gross margin. I think we've taken the price increase actions now in the first quarter. We expect to be price-cost stable over the cycle and stable through the rest of the year. I think, obviously, our best opportunity is to accelerate growth and leverage our cost structure, but we do have a very healthy pipeline of productivity projects that will continue to build through the year. So we're looking we're expecting incremental margins in the teens in the first quarter, and we expect that to build through the year.

And Ryan, just to give a little bit more perspective on that incremental margin commentary, if you look at where we ended up at the fiscal year and at a mid-single-digit growth, assume gross margins stay stable, it implies roughly a $30 million to $40 million step up in OpEx. We feel pretty comfortable achieving that where the business currently sits today.

I wanted to ask about some of the seller effectiveness KPIs that you updated us on today. Customer touches and sales per rep per day both moved up significantly this quarter. What's behind those inflections? And what inning are we in, in terms of some of the operational changes that you've made and the improvement that they can drive going forward?

Yes, definitely. I would say we're around the third inning. We have started the initial steps, and I'm very enthusiastic about the new addition to our team who will help us progress further. We now have a sales management process that assesses various leading and lagging indicators, tailored to different roles and levels. Overall, we focus on two main aspects: how frequently we engage with customers, which is a key leading indicator, and measuring sales per representative each day. I believe that sales is a scientific approach with essential fundamentals. We have initiated the first stage, primarily regarding effective territory design. It is crucial to ensure our salespeople are targeting the right opportunities, and we will continue to refine our approach as we move ahead.

I wanted to follow up with a question on macro. Erik, I'm looking back at some of your comments. I think you talked about some of your verticals you're seeing some firming up, maybe even some pockets of improvement. It's hard to parse though because clearly, you have some internal initiatives that are helping on the core customer side that may not apply outside of MSC. I'm just curious on your thoughts about how we can parse the results today and better understand the macro environment. Basically, the question is, how much of this is self-help where you're clearly benefiting versus a broader macro, where there are still some acute challenges.

Yes, Tommy, it's a really good question in a very murky environment. I think the headlines that we were trying to get across this morning are a couple. One is, I would say, I wouldn't necessarily call things firming up, but we have pockets and end markets that are meaningful to us that we would refer to as stabilizing. Take heavy machinery and equipment, ag-related end markets where things have been really soft for the last couple of years. It's not like things have inflected positively that much, but they're at least stable, which in a sense is up from where we've been. What I would say is then you have pockets; there continue to be pockets of strong growth, i.e., aerospace, but also there remain some of acute softness. A great example of that is heavy truck, which would be an example of an end market that, when we talk about the influence on our national accounts program, would be weighing us down. So as it relates to national accounts, I would say we're seeing some encouraging signs here in September and October. We definitely saw the numbers we shared slightly down year-on-year but have turned positive in September and October thus far. You can imagine October, especially with public sector moving from healthy positive to negative with the shutdown, core and national accounts actually are doing better and better. I think that's turning. Overall, it's stable, with an overhang of uncertainty that remains. If you're trying to parse out how much of this is macro versus micro, there's probably some of both going on. Hopefully, you could hear in our prepared remarks, we're encouraged by what's happening in the core customer and particularly it is probably more self-help and micro than it is macro. Obviously, there's a little bit of price benefit too. But clearly, when we track back the inflection in the improvements, they do go right back to the initiatives that we've been talking about now and what got put in place sort of midway through our fiscal year with the website upgrades and marketing. I think that part of it is a good deal of self-help, and the rest is stabilizing with still an overhang of uncertainty.

And Tommy, maybe where you can see a little bit of that self-help if you think about the core customer consecutive months of year-over-year growth. And then you look at the MBI; it still remains below 50. So that's starting to break that trend a little bit, which might show some of that self-help shining through.

I guess I just have the congratulations to both Erik and Martina here. I guess, Martina, on your comments around the level of price increases we've taken here being on par with 2022. I guess, does that imply that we're talking about 5 points or more of pricing in 2026? Can you kind of give us some context for how we think about pricing into the new year?

Yes, I think it's so uncertain. I don't know that I can give you a good answer on that. Our intention is obviously to meet inflation as it comes. I think we've done that now with our actions in Q1, but it's so uncertain; I really don’t know what to tell you.

And Chris, what I would say is if you think about where we put the price increase we made at the end of June, it's in the low single-digit range. We talked about another low single-digit increase in Q1. So if you assume 1.5%, 2%, you're in that 4% range. As we said, we'll make additional pricing moves as warranted.

I'll echo comments from others, congrats Martina on the new role. And good luck, Erik; it's been great working with you over the years. I appreciate all the help. So on the OpEx side, maybe I missed this, but it looks like the headcount that you report in the earnings deck came down a bit at year-end. Just wondering what drove that? And then what's the outlook for headcount in, I guess, fiscal '26? And then on the marketing side, wondering if you could give some perspective on where your spend levels are today and where you think you might need to take that to sustain better results that you're seeing currently in the core?

Okay. Thanks, Patrick. I'll take the headcount piece. So our cost structure is too high right now for the size of our business. The best and highest way to remedy that is for us to accelerate growth, and we're at full speed ahead on initiatives. In the meantime, we're taking a look at how we perform work, and we're reviewing performance. What you see in those headcount numbers are two sets of actions. One of them was a reduction in our sales force. I believe strongly that we owe our sellers good territory design, so we point them at the right potential. We owe them a strong sales management process with clear expectations and good coaching. When you put these two in place, you can fairly and quickly assess performance. So we took out our underperformers, and our sales territory optimization drove right in. That's why we told you in the prepared remarks that we’re actually covering more customers more effectively with fewer people. I'm very happy about that. As for the rest of the headcount changes, we have an operating system. Same thing: we’re setting clear expectations. We know how to measure performance, and we take action. Asking me about headcount for the rest of the year, we will continue to self-help, and we’ll continue to look at our processes as we go forward.

And then maybe I'll take the marketing, Pat. What I'd say there is we're at our Q1 levels. Obviously, we’re going to be at a level that's up from where we were running in fiscal '25. Hard to say to give you a clear outlook, and the reason it's hard to say is our investment in marketing. The beauty about the way we're investing number one, it's been a driver of the core customer; we see the return profile on our investments relatively quickly. This number will be fluid based upon the returns that we see. So put another way, if we continue to see the returns in the form of improved growth rates with core customers, we will continue to ratchet up marketing. If, for some reason, those returns subside, you'd see us tone it down. But either way, it would be captured in our outlook on incremental margins.

This is Katie on for Ken. I wanted to dig in a little bit more on the supplier price notifications. What's the risk that it's more difficult to pass these on to customers as we go through the year, especially if they accelerate? I know tungsten prices are up a lot year-to-date. Just curious how you're thinking about that in the context of further increases from your suppliers?

Yes. Thanks, Katie. So far, we have been really pleased with the price realization. I'm not worried that we'll be able to pass it on in a constructive way with our customers. We're obviously working with them always to optimize their costs as part of our technical value proposition. I think we're in a great place right now. We were happy with price realization, and we continue to be. We do see more inflation coming; obviously, it will put pressure on us. But I’m not worried about that part of the equation.

Maybe I'll just chime in, Katie. It's funny, you mentioned one of the raw materials that obviously we're keeping our eye on and hearing about from suppliers, tungsten. There's almost like a knock-on effect here from the tariffs, which is out of the gate what we've been experiencing from our suppliers is direct tariff-related inflation. We do see bubbling, the knock-on effect being impacts on certain raw materials that are drivers of the products we sell. So tungsten is a great example for cutting tools. Our experience with price realization has been quite good. Should there be further inflation? If tungsten pricing sustains, I think you're right. We would expect more pricing from suppliers. It's an unknown, but if it does, we would expect to pass it along. One of the things we tried to highlight in the prepared remarks is that customers are understanding right now because the headline is that everything is going up. The key is, number one, we have to be transparent about it, which is why Martina and the team made the choice to stick with our pricing cadence and not react in Q4, being clear and transparent. The other side is how we, as a distributor, are bringing productivity to our customers. This is something that's right in our sweet spot. For all those reasons, if the inflation does sustain in this uncertain world, we feel confident in the ability to pass it along.

Great. That's really helpful color. My follow-up is regarding the government shutdown. How do we think about any impact year-to-date from this? I know the lower end of your guide implies that it should last through the remainder of Q1. But is there any way to think about what you've seen year-to-date within the business?

Yes. I'm sorry, you broke up in the middle, Katie, but I think you're asking how we see the government shutdown impacting the business? What are we forecasting? We had, as you heard in the prepared remarks, a very strong fourth quarter in the public sector, and that growth continued into September. We've seen some softening now with the shutdown. That will have a small positive mix effect. We don't expect that to be more than about 10 basis points on our margin. The outlook that we gave is predicated on both ends of the scenario. The high end of our growth range assumes the shutdown ends and the low end of our growth rate assumes that the shutdown continues to the end of the quarter.

Then, Katie, the additional color I'll add there is just who knows when the shutdown is. But one thing we can be pretty sure is that at some point, it will end. Looking back on my career, especially recent years here, I’m proud of the public sector team's performance. They continue to deliver and outgrow markets and take market share. We don't see that changing. Obviously, Martina mentioned, we went from double-digit growth in September to negative in October; that's just a reduction in spend. The exciting thing for us is that, at some point, that will restore. We expect our share capture to continue, and if our momentum in core and national accounts continues while the public sector goes back to doing what they've been doing for a while, it creates a potentially encouraging picture.

I see you in Chicago in a few weeks here. My first question is, you mentioned direct ship orders. I'm just trying to get a read on what percentage of your sales does that represent today? And maybe if you could outline the types of products that are primarily affected by direct ship.

Yes, Dave, I'll take it. We don't really break out direct ship orders specifically as a percentage of sales. I'll tell you it is the minority but particularly, it's grown in recent years as we've penetrated customers more and more, whether through our implant program, or whether through some of our public sector relationships where we're doing more and more sourcing and value-added for a customer. Typically, as those programs ebb and flow, so goes our direct ship volume. I don't think there's anything structural or systemic that I'd call out. If you're looking forward, it's something to note as a major headwind or tailwind, but we did see and look, the team mentioned that sequentially from Q3 to Q4, our public sector business was up considerably. There's a correlation there, and when it comes in the form of public sector, you can imagine it's a lot of MRO product more so than metalworking. This is just a little color. But I wouldn't make much of it for the future, but it was brought up because it was a piece of the 50 basis point gap versus where we thought it was a piece of the story.

Okay. But it sounds like it's measurable. And if you're saying it's driven by government and implant or things like that, it does sound like we should see that continue to at least gradually move up over time, right?

Yes, I guess if the definition of reshoring is new plant build-out, we're not seeing it. If the definition of reshoring is an existing global manufacturer that has capacity in multiple locations inclusive of the U.S. shifting manufacturing to the U.S., then we are; there are tangible data points there, some of which were released, I think, this week and last week. So that we're seeing; we're not seeing new greenfield build-out.

Right. Yes, I was thinking that if not necessarily that you're selling directly to that factory that's reshoring or expanding in the U.S., but your machine shops and the metalworking job shops might be seeing an increase in business as they're selling more products to domestic manufacturers. But yes, I don't know; I was just seeing if you're hearing anything along those lines.

I don't think we're seeing it, like we're not seeing it in the numbers yet. I would say that there remains some optimism about more production coming to the U.S. though. That headline is still there.

We have reached the end of the question-and-answer session, and I will now turn the call over to Ryan Mills for closing remarks. Thank you, everyone, for joining us on today's call. Our next earnings call will be on January 7. In the meantime, we look forward to seeing you all at upcoming investor conferences. Have a good day. Bye.

This concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation.