Good morning. Welcome to the MSC Industrial Direct 2020 first quarter conference call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key, followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star, then one on your touch-tone phone. To withdraw your question, please press star, then two. Please note, this 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, Alyssa. Good morning, everyone. I'd like to wish everyone a Happy New Year and welcome you to our fiscal 2020 first quarter earnings call. With me are Erik Gershwind, our Chief Executive Officer, Rustom Jilla, our Chief Financial Officer, and Greg Clark, our Vice President of Finance and Corporate Controller. As you all know, Greg will become our interim CFO when Rustom leaves the company at the end of the next week. During today's call, we will refer to various financial and management data in the presentation slides that accompany our comments, as well as our operational statistics, both of which can be found on the investor relations section of our website. Let me reference our safe harbor statement under the Private Securities Litigation Reform Act of 1995.
Our comments on this call, as well as the supplemental information we are providing on the website, contain forward-looking statements within the meaning of the U.S. securities laws, including guidance about expected future results, expectations regarding our ability to gain market share, and expected benefits from our investment and strategic plans, including expected results from acquisitions. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those anticipated by these statements. Information about these risks is noted in our earnings press release and the Risk Factors and the MD&A sections of our latest annual report on Form 10-K filed with the SEC, as well as in our other SEC filings. These forward-looking statements are based on our current expectations. The company assumes no obligation to update these statements. Investors are cautioned not to place undue reliance on these forward-looking statements.
In addition, during this call, we may refer to certain adjusted financial results, which are non-GAAP measures. Please refer to the GAAP versus non-GAAP reconciliations in our presentation, which contain the reconciliation of the adjusted financial measures to the most directly comparable GAAP measures. I'll now turn the call over to Erik.
Thank you, John, good morning, everybody. Thanks for joining us today. I'd also like to reiterate a happy and healthy new year to everybody. As our fiscal 2020 is now in full swing, I'll begin this morning's call with some strategic context before getting into the usual specifics of the quarter. Over the past several years, we've repositioned MSC from our historic role as a spot-buy-only supplier to a mission-critical partner on the plant floors of North American manufacturing and industry. We undertook this journey primarily because we saw an opportunity to partner more closely with our customers who've been calling out for help in running their businesses better, and MSC is uniquely positioned to fill that void. We also foresaw increasing pressure coming over time on our legacy spot-buy-only model, mainly from increased pricing transparency in this more transactional side of the business.
Over the past several years, we've taken a number of steps to realize our vision. First, we focused on building trust with our customers, the kind of trust that allows us to play a bigger and deeper role in their business. We've done so by developing a new sales model and new tools to facilitate trust building, such as robust cost savings documentation, which we recently patented. While the implementation of our new sales plan has taken time, we're seeing the early results pay off in higher levels of customer satisfaction and loyalty. This is important because our data shows that higher loyalty leads to higher growth over time. Second, we doubled down on product and service categories that are technical and high touch in nature, bringing us closer to the center of our customers' operation.
We've invested in our traditional core of metalworking through a further build-out of technical specialists, through product innovation, and the introduction of additional value-add services. We expanded our footprint with the acquisition of Barnes Distribution, or now CCSG, to build leadership capabilities in the Class C parts category. We also acquired AIS, an OEM fastener business, to build out another platform that's both technical and high touch. Each of these categories entrenches us at the heart of our customers' operations and provides us a position from which to grow share of wallet through account penetration. Third, we are expanding our supply chain onto our customers' plant floors through inventory management solutions and primarily vending and VMI.
Since the start of our fiscal 2013, revenues to customers with those solutions are up 1,800 basis points and approaching half of total company sales, driven by the growth of MSC's vending and VMI initiatives, along with the benefit of the Barnes and AIS acquisitions. Two-thirds of that lift, though, was organic. Looking forward, we expect continued growth in solutions. A noteworthy characteristic of our new strategy is that it yields revenue streams correlated with higher retention rates, and that increases customer lifetime value. This becomes meaningful as we model our growth over time. Less customer churn and higher retention produce a more effective growth model and higher ROIC by better leveraging our fixed costs. During last quarter's call, I outlined three initiatives that have our near-term attention in order to restore operating margin stability and ultimately expansion. They are, first, refining the sales effectiveness plan.
Second, improving the profitability of our supplier programs. Third, improving productivity by reducing operating expenses. We will remain focused on these three through the course of our fiscal 2020. I'll now explain how they fit into our journey to reposition the company. First, getting the new sales model right is the cornerstone of our new value proposition. Our journey from a simpler spot buy value prop to a more technical one required a change in our sales model. With the new leadership team providing a fresh perspective on our plan, we're finding that the design was on target, but its implementation needed refinements. More specifically, certain areas were under-resourced while we were over-allocated to others. These recent refinements are preparing us to accelerate growth.
You can see from our operating stats that we took sales headcount down in the first quarter, reflecting the areas in which we were over-allocated. We will increase sales headcount from here with investments into growth areas over the coming few quarters. These growth areas include business development or the hunter roles, CCSG, and a couple of others. Our ultimate measure of success, of course, is our growth gap to market. In the meantime, we're focused on interim measures such as the business development funnel of new wins, which have us encouraged about progress. Our second initiative is improving the profitability of supplier programs. As we've migrated from spot buy supplier to mission-critical partner, the value proposition that we offer our suppliers is changing just as it is for our customers.
As a result, we've enhanced many of our supplier programs to receive more support in exchange for more dedicated focus from MSC on market share capture. As I mentioned on the last call, we've negotiated roughly $20 million in annualized profit improvements, split about equally between the back half of fiscal 2020 and fiscal 2021. We're now turning our attention to implementing those programs and driving share capture for those suppliers who have invested in us. The third fiscal 2020 initiative is realigning our operating model to reduce operating expenses and improve productivity. This is critical because as we reposition the company, the new business often comes with lower gross margins. We've now built scale in some of our new revenue streams, such as inventory management, and we're therefore ready to focus on improving the cost structure and efficiency with which we run them.
We began this process in our fiscal fourth quarter with several more tactical measures. For example, we offered voluntary early retirement to associates with significant tenure in our distribution centers. We also ratcheted up performance management intensity and selectively eliminated positions where our focus is changing. As I noted on the last call, some of those actions would continue into our fiscal first quarter, and we guided to further headcount reductions and additional severance and separation costs, both of which took place, and Rustom will give the details in just a few minutes. For the balance of the year, we anticipate selective hiring in certain customer-facing roles and will maintain our intense focus on performance management. With some of these initial steps behind us, we're now focused on a more thorough assessment of additional opportunities to align our operating model with the new strategy.
We will also focus on becoming leaner. We look forward to sharing the results of this planning with you within the next quarter or two. With all of this as context, I'll now turn to the quarter. I'll start with a brief overview of our fiscal 2020 first quarter results. I'll then provide an update on the environment and our recent performance before turning it over to Rustom to review the details of the quarter and provide guidance, and then I'll wrap things up, and we'll open up the line for questions. Our fiscal first quarter results reflect solid execution in a weak demand environment. Sales and gross margin were both better than the midpoint of our guidance range. Operating expenses to sales, both as reported and excluding severance and separation costs, were slightly better than the guidance midpoint.
As a result, both our operating margin and earnings per share came in at the top end of our guidance range, and again, Rustom will provide more details. Turning to the environment, industrial demand remains weak. The softness is evidenced in the data points coming from manufacturing output, distributor growth surveys, and sentiment indices. In September and October, readings for the MBI were 48.6 and 48.3 respectively, and November was 47.0. The December MBI reading ticked back up but remained below 50 at 48.2, which takes the rolling 12-month average to 50.7. While that rolling average is still positive, it has been steadily declining. We continue to see customers and suppliers eliminate shifts, and in some pockets, announce layoffs and restructurings.
In terms of end markets, the weakness in industrial demand is broad-based, with some acute pockets of softness in areas like automotive, heavy truck, oil and gas, and agriculture. Aerospace is one of the few end markets that remains relatively strong, although the recent Boeing updates have created some choppiness there as well. With regards to the pricing environment, uncertainty due to tariffs and decelerating global growth continued. Combined with the price scrutiny that comes when customers' businesses slow down, and all of this results in a slightly softer pricing environment than we've seen over the past year. That said, we have seen some continued list price movement from our suppliers and fully expect to pass those increases along. We anticipate taking a mid-year price increase likely towards the end of our fiscal second quarter or the end of February.
Turning to our performance, national accounts grew slightly, while core customers declined in the low to mid-single digit range, as this is the portion of our business most heavily levered to metalworking, which is particularly soft right now. Government sales growth levels improved from the fourth quarter as anticipated, but still declined in the high single digits, weighing down overall growth. CCSG was a bright spot, growing in the mid-single digits. Looking at our most recent data point, the month of December is always difficult to extrapolate from due to holiday timing, shutdown schedules, and end-of-year capital purchasing and inventory burn-off decisions by our customers. This year, December was down 2% on an ADS basis, but that was aided by one fewer selling day. We decided to close on both Christmas Eve and New Year's Eve, largely because UPS was not processing ground shipments on those days.
On a total revenue basis, growth was down roughly 7%, which is a significant step down from where we had been running. We attribute much of this weakness to holiday timing. When Christmas and New Year's fall on a Wednesday, we historically experience the largest drag on sales. We also heard a greater prevalence of extended holiday shutdowns this year, which appeared to be customers anticipating slow conditions around the holidays. It's tough for us to say whether December was strictly about holiday timing or whether the underlying trends eroded as well. Unfortunately, we don't yet have a full week in January to see how activity rebounds. Rustom will describe the assumptions we make for the revenue guidance forecast. Before I turn it over to Rustom to cover the financials, I want to thank him for his four years of service.
We are grateful for his contributions and leadership, and we will certainly miss him. We're conducting a comprehensive search for a permanent CFO. As John mentioned, Greg Clark, our Vice President of Finance and Corporate Controller, will assume the position of interim CFO. We're privileged to have a deep bench of finance talent here at MSC, and Rustom and I feel very confident that Greg and the team will continue to strengthen our financial operations and ensure a smooth transition until a permanent replacement has been made. I'll now turn it over to Rustom.
Good morning, everyone. Thanks, Erik. Before discussing the numbers, let me start by thanking Erik, not only for his kind words, but for a great four-plus years of partnering closely with him. My heartfelt thanks to the board and to my fellow associates, especially those in finance, for a host of good memories. As to financials. Let me remind you that we provided Q1 guidance both with and without the severance and separation charges we expected to incur. As such, I'll speak first in terms of our reported results and then in terms of our adjusted results, which reflect the exclusion of those costs. Our first quarter total average daily sales, ADS, was $13.3 million, a decrease of 1% on an ADS basis versus the same quarter last year. This was slightly better than the negative 1.5% midpoint of our guidance range.
Versus fiscal 2019, our MSC Mexico business, which was not in the prior comparative period, contributed roughly 100 basis points of growth to first quarter sales. Our Q1 reported gross margin was 42.2% at the high end of our guidance range as a result of lower inventory provisions and higher vendor rebates and credits. Versus prior year, our gross margin was down roughly 80 basis points, with Mexico accounting for roughly 20 basis points of the decline. Total reported operating expenses in Q1 were $256.9 million, slightly better than expected as a percentage of sales. As such, our reported operating margin was 11% versus a guidance of 10.7%. Our tax rate for the first quarter was 25%, slightly better than guidance and the prior year, due to the favorable impact of stock compensation expenses. All of this resulted in reported earnings per share of $1.18.
Now let me move to the adjusted results. Excluding $2.6 million of severance and separation charges incurred in Q1, adjusted operating expenses were $254.3 million or 30.9% as a percentage of sales. Again, slightly better than the midpoint of our guidance. This was mostly due to ongoing controls on discretionary spending and the execution of Q4's cost reduction actions. Total headcounts in Q1 declined by 78, with the bulk of the reduction coming from the sales function effectiveness refinements previously mentioned by Erik. Our field sales and service headcount was down 65 associates sequentially. Versus last year, adjusted OpEx was down $0.7 million as lower volume related costs and cost reduction initiative savings more than offset the additional OpEx for the Mexico business that was not owned last year and other increases.
Our fiscal first quarter adjusted operating margin was 11.3%, 30 basis points above the midpoint of guidance with a higher gross margin and the slightly lower OpEx to sales both contributing. On a year-over-year basis, adjusted operating margin was down roughly 110 basis points with lower gross margin as the main driver. On an adjusted basis, EPS for our fiscal first quarter was $1.21 at the high end of our guidance range. Last year's reported EPS was $1.33. Turning to the balance sheet, it remains very healthy. Our DSO was 60 days, up two days from fiscal 2019's Q1, with higher growth in national accounts receivables continuing to be the main driver. Our inventory decreased by $20 million during the quarter to $539 million. Total company inventory turns were 3.5 times, unchanged from Q4 and slightly lower than last year's 3.6.
We expect inventory to increase in our fiscal second quarter due primarily to our usual year-end buys. Net cash provided by operating activities in the first quarter was $85 million versus $77 million last year. Our capital expenditures in the first quarter were $13 million versus last year's $10 million, and so after subtracting capital expenditures from net cash provided by operating activities, our free cash flow was a solid $72 million as compared to $67 million in last year's Q1. We paid out $42 million in ordinary dividends during the quarter, reflecting our regular dividend of $0.75 per share. In last year's Q1, we paid out $35 million in dividends and bought back $64 million in shares.
Consistent with our balanced capital allocation philosophy of returning cash to shareholders, as announced last month, the board of directors also declared a special dividend of $5 per share in addition to our regular quarterly dividend of $0.75 per share. These payments totaling almost $320 million will both be made on February 5th, utilizing our existing cash on hand and revolving trade facility. Our total debt as of the end of the first quarter was $406 million, primarily comprised of $137 million balance on our credit facilities and other short-term notes, and $265 million of long-term fixed rate borrowing. Our cash balance was $28 million, net debt was $379 million at the end of the quarter. Our leverage ratio decreased to 0.8 times as compared to 0.9 times at the end of Q4 and 1 times as at last year's Q1.
Looking ahead to the end of February and after we pay out our special and ordinary dividends, we expect our leverage ratio to be around 1.5 times, and it should decline from there. At these levels and given our cash flow generation capability, we are maintaining adequate flexibility. Now let's move to our guidance for the second quarter of fiscal 2020, which you can see on slide four. Similar to last quarter's guidance, this includes the MSC Mexico. We do not expect severance and separation expenses to be significant in our fiscal second quarter. We expect Q2 ADS to come within a range of -1.5% to -3.5% versus the prior year. You can see on the ops stats on our website that December's total ADS growth was -2.1%.
Given the significant step down in December and the uncertainty around its drivers, our guidance for Q2 is modeled off a typical lift from November to January. This implies an average ADS growth rate of roughly -2.9% for January and February. Our Q2 gross margin is expected to be 42.0% ±20 basis points. That's down roughly 20 basis points sequentially from Q1's 42.2%. This would be down roughly 70 basis points year-over-year due to purchase cost escalation, mix headwind, and a 20 basis point negative impact from Mexico. As expected, the gross margin gap to prior year is beginning to compress. Purchase cost escalation is waning, and we will begin to see the benefit of our mid-year price increase flow through from Q3 onwards. Finally, the benefits from our supply initiative begin to flow through our P&L in our fiscal fourth quarter.
Q2 operating expenses are expected to be around $255 million, down approximately $1 million from last year's second quarter. The main drivers are lower volume-related variable expenses. That's down roughly $3 million, and savings from Q4's headcount reduction actions of almost $2 million, offset by our annual merit increase of nearly $4 million. Sequentially, operating expenses are expected to be up about a half a million from Q1's adjusted OpEx. We expect a roughly $2 million benefit from lower volume-related variable expenses, offset by roughly $2 million of growth and productivity investments. The remainder is November's annual merit increase, net of our usual productivity. We expect the second quarter's operating margin to be approximately 9.7% at the midpoint of guidance, a 200-basis point year-over-year decline.
The drivers of this decline are the roughly 70 basis points of lower gross margin, and the remainder is due to the impact of lower sales on our OpEx leverage. Turning to our estimated tax rate for the second quarter, it's expected to be 25.1%, in line with Q2 2019. Our Q2 EPS guidance is $0.97 to $1.03, with a midpoint of $1. This guidance assumes a weighted average diluted share count of roughly 55.5 million shares. That takes me to the end of my prepared remarks. Let me wish MSC all success in the years ahead, and now turn back to Erik.
Thank you, Rustom. We remain focused on repositioning MSC from spot buy supplier to mission-critical partner to manufacturers and industry. In fiscal 2020, our focus remains on three initiatives. One, completing the sales effectiveness refinements to position our business to capture market share aggressively. This includes ramping up growth investments in areas that are delivering early returns. Two, implementing the new supplier program, which, when combined with an improving purchase cost trend and mid-year price action, will continue to close the gross margin gap. Three, continuing to streamline our cost structure and transform our operating model to be leaner. Recent progress on these priorities represents the beginning and not the end of our journey to fulfill our mission to be the best industrial distributor in the world. We'll now open up the line for questions.
We will now begin the question-and-answer session. To ask a question, you may press star, then one on your touch-tone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star, then two. At this time, we will pause momentarily to assemble our roster. The first question today comes from David Manthey with Baird. Please go ahead.
Yeah, thank you. First off, Rustom, congratulations and best of luck.
Thanks very much, Dave.
Sure. Erik, can you broadly compare the shifting model here from the spot buy to the shop floor solutions business? You noted an expectation for better sales and return on capital trends. Specifically, can you talk about the P&L and how you view secular gross margins and operating margins under the new paradigm?
Sure, David. Look, I think you're hitting at the heart of the opening this morning, which was about how the company's been repositioned to the new model, this mission-critical model, which, as you said, is a higher mix of recurring inventory management-related technical business. A couple of attributes that you're highlighting that come from it. Number one is what we're seeing is higher retention. The reason that becomes so important as we model out over time customer lifetime value, as you can imagine, small movements in customer retention, small increases in retention, when you blow that out over a number of years, yields significant increases in lifetime value. We are encouraged there, and it's one of the reasons why sort of reinforcing that this is the right strategy.
Not surprisingly, probably one of the other attributes is that at least for many of the revenue streams, some of the more technical-related metalworking and vending being two examples, come with lower gross margin %. That's one of the reasons, of course, why over the past few years, you continually hear us talk about a mix headwind. We shared today how we've moved the business. If you think about an 1,800-basis point movement towards solutions business over the past six years or so with lower margin % on vending and technical metalworking, that will come with a headwind.
What that does is it leads to, particularly as we now have some scale in these businesses, that tees up the other opportunity that we talked about this morning, which is to take a broader, more holistic end-to-end look at, as we refer to it, the operating model, recognizing that, look, the supply chain and the whole operating model for a spot buy business is, of course, going to be a higher cost model than the model for a planned managed inventory model because spot buy comes with a very high premium level of service. With the scale now built up, we see considerable opportunity to take cost out, quite frankly.
Okay. No change in the secular operating margin expectation of the company? You used to be in the high teens. Is that still achievable under the new paradigm?
Look, Dave, what I'd say there is for me, one step at a time, which is what we want to see right now is stabilization and then return to op margin expansion. Certainly, we see those things as part of the formula, so no change there. Once we start getting some traction, I'll return to you and talk about high teens. How about that?
Okay. Thanks for that, Erik. Then second on the guidance, if you triangulate the variables that you gave us, it looks like SG&A is expected to be roughly flat from the first quarter to the second quarter, which is fairly typical for the company. Given the severance actions, you've got one fewer day versus typically flat or higher. The sales are flexing down. I just would've thought we would see a decline in SG&A sequentially. Any color that you can provide on operating cost trends into next quarter?
Sequentially, it's interesting. The way that the holiday works out, in December, we keep our staff online during that period because we don't want to take out people and then have to hire them again come the next month. That's a big contributor to that, actually. We are seeing savings. We're seeing close on $2 million of savings from the cost takeouts of Q4. Of course, not sequentially because we saw that in Q1 as well, but compared to last year.
Dave, the other color I'll add, I think Rustom's right in that I think you're right to note this because clearly it does stand out. Why wouldn't OpEx be down when sales are down sequentially as the total revenues are down as they are? Q2 is a bit of an outlier. Rustom mentioned one reason, which is the variable factor. We typically in Q2 for the holiday issue that Rustom described, and also because we generally see higher sales in Q3, we won't bring staffing levels down in Q2 the way we would in another quarter with sales dropping. That was one factor. The other one to hit on is we do have a couple of investments that we're making in Q2 that are not necessarily permanently embedded costs, i.e., they're not headcount.
I mean, you could see headcount coming down, but discretionary type of investments specifically around aimed at growth and productivity, I'll kind of leave it there, but that are non-permanent in nature, but that are making the OpEx higher in Q2.
That was the roughly $2 million that I'd mentioned.
All right, helpful. Thanks, guys.
The next question today comes from Hamzah Mazari of Jefferies. Please go ahead.
Good morning. Happy New Year, and best of luck to you, Rustom.
Thanks, Hamzah. Happy New Year to you, too. Happy New Year, Hamzah.
Thank you. Erik, my first question is, you spoke about a lot of change, a lot of repositioning at the company. What's your level of confidence that this restructuring will be successful relative to others you've had? Has the culture changed internally? Is there more employee buy-in? I know you have a new head of sales from outside the company. Just any thoughts there would be helpful.
Yeah, sure, Hamzah. What I would say is my confidence is high. Let me start with that. Let me talk specifically because I talked a little about the operating. Let me talk specifically about what's happening in sales, and the refinements being made where my confidence is high. Over the last two years, we have done a lot of heavy lifting that you alluded to in changing the sales model, and this morning I tried to articulate why we went through those changes, which is about articulating the new value proposition that ties to this new strategy. The heavy lifting is primarily behind us, and as you said, we have a new Head of Sales, Edward Martin, who's come in with a fresh look and basically concluded that the plan is right and the implementation needed to be tweaked.
The tweaks are happening now, there's basically, when I say tweaked, two refinements being made. One is that there were a couple of areas in which he observed with data and intuition, that we were over-allocated. By over-allocated, I meant overstaffed. There's two areas, that's where you saw the headcount results in Q1. One would be management, to lean things out and increase spans of control a bit, where reductions in management. The second is he identified areas in which portfolios were undersized. What you saw happen with headcount going down was a consolidation of some portfolios. The flip side of that, and this is part of why the confidence is areas in which we're under-allocated.
Particularly, we highlighted a couple of them where we've already made some investments into the hunting function or the BD roles where we're pleased with early progress. Obviously, it's still early, but pleased with progress. In that area, for instance, in the new business area, we're seeing new signings up 27% year-on-year. Last year, we talked about hiring a bunch of people that were new that would need time to get up to speed. We're seeing that happen. The productivity per person year-on-year is up about 45%. Just as we suspected. It's still early, it's still a small percentage of total. We like what we're seeing there. The other side of the refinement here, what you saw in Q1 was the drop in headcount.
It will come back up in areas like this where we're seeing returns, and that's how we see throttling up share capture. To get to the last point before I wrap is your point about culture, I think is a good one. What I would say is it's a company that has become more adept at responding to and adapting to change. I think as time's gone on and more and more changes, we have become better at managing the change.
Actually, I'll add one final point. If you think about the restructuring actions of Q4, the dollar benefits of what we expected and the actions that we expected, the execution's going pretty much as planned, and we're seeing that. From that perspective, that is going successfully, too.
Great. Very helpful. My follow-up question, and I'll turn it over, is you talked about market outgrowth as a milestone to watch for success. You talked about retention rate. Any thoughts as to what that outgrowth is today? Are you growing under the market? Historically, I guess you outgrew the market by 300 to 400 bps. Is that the right metric to look at going forward once sort of the restructuring is behind us?
Hamzah, I think you honed in on it. Look, what we would say today based on triangulating all the different metrics, the surveys, the growth rates, et cetera, is we're somewhere growing in line with market right now given our exposure. We see really good things happening, as I mentioned, on the BD side, but it's still early, and it's still small as a percentage of total. There's a couple of areas that we're pleased with progress, but overall, roughly in line. Certainly what we're seeing of late is softening conditions, which are more acutely soft in metalworking, are weighing down. The water level's coming down across the business, quite frankly, and is sort of muting or masking some of the progress we see happening in these investment areas, but roughly in line.
Looking forward, yeah, certainly Hamzah, sort of minimum table stakes is to say, how do we get back to the kind of share capture or outgrowth that we've seen? Yeah, you're right. What we've talked about is the 300 or 300 to 400 basis point range. I mean, sort of that would be table stakes for us and being able to do it more effectively and efficiently than we've done with the past. We got three things we are just heads down focused on in order to restore that gap. One, as I mentioned, ramping up investment into the growth areas where we're seeing early returns. Two is going to be improving government performance, which for the past year, depending on the quarter, has cost us somewhere around a point of growth and a lot of progress happening under the covers in government.
The third is continuing to focus on growing solutions as we've done with our core customer to lift retention over time. That's where we're focused.
Great. Thank you so much. Best of luck.
Thanks, Hamzah.
The next question today comes from Robert Barry of Buckingham Research. Please go ahead.
Hey, guys. Good morning. Happy New Year.
Hey, Rob. Happy New Year to you.
Thank you. You mentioned that it sounds like the last week in December was pretty noisy with holiday timing, some extended shutdowns. Curious how things were tracking before that last week?
Rob, good question. December was a really funky month, I'll call it. Let me start by saying it was actually acute softness the last two weeks. We actually tracked back. The last time we saw this, it was actually our fiscal 2014 was the last time when the Christmas and New Year's fall on a Wednesday. What we've seen is basically two weeks that are lost weeks. What I would say this year that was different from on top of the holiday timing, we heard from our sales team a lot more customers using it, and I think it's because things have been soft to begin with. It's not just the holidays, but because customers were soft, they were using the two weeks to do more extended shutdowns than what we've seen for the past several years.
You sort of have a double whammy there. I'll now get to your question. Interestingly, it's a good question about the first portion of December was certainly stronger than the last two weeks on a relative basis, but not as strong as we would typically see. One of two theories going on, and again, this will prove itself out in January. One is, as crazy as it sounds, the late Thanksgiving may have made November a little better and December a little worse. Interestingly, we usually see the first post-Thanksgiving week to be not quite as strong. That this year moved into December. The first week was a little softer than we thought. The other two weeks, pretty much in line. The big headline being holiday timing and more shutdowns. For us, Rob, the real question will be what happens in January.
That will sort itself out as to whether this was all noise or whether we've hit a different point in terms of economic activity.
Right. That's very helpful. Just to be clear, whenever you set the guidance for the sales for the quarter, which of the weeks did you choose as kind of the base off of which to kind of build the seasonality improvement?
We went back to November. We actually based January, February off November, off the typical sales movement that we would see from November. We gave December a pass. We put the actuals in, or the estimate of the actuals. We haven't actually fully finalized the numbers for the estimate of the actuals, and then we moved on.
Got it. Then just I guess for me, lastly on gross margin quickly, I think you're guiding down at the midpoint 70 basis points in the second quarter, which I think would account for the pressure from Mexico and sources of growth, right, which I think reach about 20 and 40-50 basis points respectively. Does that mean that everything else is kind of neutral, like price cost is neutral in 2Q?
The price cost remains negative, that sequential drop from Q1 to Q2 is well within our normal range. I mean, 20 basis points, and particularly when you think about how I talked about Q1, some of the drivers of that being inventory and vendor rebates and credits and all the rest of that, we're not too worried by that. Gross margin, we think, is performing as planned. Let me look beyond Q2. There's two other factors that should buffer the typical downward trend, right? One is the mid-year price increase, which as Erik said, is coming late, right? It's pretty much going to come in into Q3 and onwards, right, the benefits. The second is the supplier program benefits, which we both talk about, right? We say it's $10 million in the back half of the year.
Yes, it's mostly in Q4, as we've communicated, but you'll definitely see it coming in from Q3 onwards. You combine all those things, so that's our gross margin outlook.
Got it. Just to clarify, in 1Q was price cost, what was price cost to gross margin?
It was about 90 basis points. At the moment, if you looked at our decomp, which we usually use in there, the earnings decomp, that probably gives you the best sort of price mix estimate of what's in there. The price costs, what we go is also, yeah, the movements on the margin. It's fundamentally being impacted by the fact that we took our price increases earlier, from that point until you get your next price increase, the price end of it keeps eroding, whereas the cost end of it is just average cost going through our system.
Yeah. Sorry, just of the 90, which was the total decline, how much was due to the dynamic between price and cost? The whole thing?
Well, Rob, just to be clear, Rustom's 90 basis points, I believe.
Got it.
he's referring to the price contribution in the growth decomposition. I think you're talking price cost. Look, if you think about the way we've talked about gross margin, price, cost, mix, three factors, right? What we've said is, over time, what we saw is price, cost kind of a wash, and we're left with a mix. There is a mix headwind in the business that's somewhere in the 40-50 basis point range.
Typically.
Okay.
Typically, right. Moves around quarter to quarter. For all the reasons we talked about earlier on with how we're moving the strategy, we don't see going away. What Rustom's describing is the dynamics of price cost. We've been negative price cost. It feels like, as it should, Rustom said, what's happening is sort of what we would expect to happen, that price cost dynamic is beginning to improve.
Yes.
For all the reasons you described.
I gave you the number that's out there in the public domain, and then I described how the price cost curve is moving for us.
Got it.
You'll see it looking better in the second half for sure.
All right, I'll pass it on. Thank you.
The next question today comes from John Inch of Gordon Haskett. Please go ahead.
Oh, thank you. Good morning, everybody. Happy New Year.
John, Happy New Year.
Happy New Year.
Thank you. Rustom, we'll miss you.
Yeah.
Erik, I just want to square, just so I understand the kind of the guide here. You're assuming that there's this average lift from November, but then daily sales for the quarter anticipated are going to be worse than December. Is that a compares issue or is that just Because obviously, I get it, the second quarter is seasonally soft?
Yeah, John
like a year ago.
You got it. You're hitting on it. What we did, Rustom described, so we basically didn't know what to make of December.
Right.
To Rustom's point, his team basically, if you model November to Jan, Feb, and go back a whole number of years, we're using more or less an average lift, and you're exactly correct. What happened was we saw a larger than average lift last year, which is why the growth rate in Jan, Feb is worse than it was September, October, November in Q1. The reason it was larger, we saw last year a number of large orders.
Right. Okay.
that we're not anticipating repeat themselves this year. Hopefully, they do, but that's not baked in, and right now we don't see it.
Right. Erik, is there anything you could say on the phase one trade deal? I ask because there's a little bit of anticipation of some tariff rollback. Do you have to give up price? As you guys are thinking about your price increase, is this going to be contingent on sort of what you're seeing with respect to China tariffs and costs and other things, or, how does this all play in?
John.
Are your customers saying anything about it?
Let me cut in there. There still remains uncertainty, of course, on tariffs, right? For us, as we pointed out before, the impact was fairly small. We'd made that point before, we looked at the tariff more recently, the List 4 tariffs. We've calculated 4 A and 4 B, we've looked at that, and the impact is really small on our numbers. Both from any inventory that we actually have right now that's come through at the higher tariffs, and the amount of the annual spend that will be impacted by this. We are not really seeing it as having any material impact on our GM.
Got it. Just I guess lastly, Erik, how do you interpret, or Rustom, how do you interpret sort of the flat trend of e-commerce sales? It's sort of been decelerating throughout the year. I'm just curious how you are thinking about your performance in e-commerce, kind of flat year-over-year, versus the structural transparency kind of growth of e-commerce generally in industry. Obviously, your attempts to move toward more of a high touch model, are you encouraged by that trend or do you expect it to rebound or how do you think about it?
Yeah, John, it's an interesting question because certainly, what we've seen is that the e-commerce as a %, it's flattened.
Right.
Honestly, don't make too much of it either way. Yeah, I think it's been lifting in part because of our focus on e-commerce, in part just because of sort of the landscape and how customers are buying. I don't make too much of it either way. To be honest, right now we are more focused on that other metric of how much of our business is going through solutions, inventory management solutions as a percentage of revenues, how much is coming from customers with a solution, and then, yeah, how much of our business is flowing through product categories, product and service categories that are technical and high touch. That's where the focus is. Less concerned either way, to be honest, about the e-commerce percentage.
Okay, given the new sales head, all the restructuring, kind of the strategic shift to the company, it sort of sounds like you're not necessarily expecting e-commerce as an outcome to get a lot better necessarily versus the overall company, or is that I don't want to put words in your mouth?
Yeah, I think that, look, we're going to continue investing, John, in e-commerce for sure. If the customers want to buy electronically, having a strong digital marketing presence is important, having a great transactional e-commerce experience is important. It's an underpinning of the value proposition, no question. I think what you're not hearing is an outright focus and full court press on lifting that percentage of total.
Yeah, understood. Thanks very much.
Sure, John.
The next question comes from Ryan Merkel of William Blair. Please go ahead.
Hey, good morning, everyone.
Hey, Ryan. How are you?
Good. First, I want to put a finer point on this idea of transforming to a leaner operating model. Two questions. First, what are the major changes versus the prior cost structure? Then secondly, can you just give us a sense of sizing the opportunity, Erik? I know it might be a little bit early, but maybe just the range of basis points in terms of OpEx to sales that you're thinking about.
Yeah, sure. Ryan, maybe I'll start and then turn it over to Rustom. In terms of the changes, look, yeah, I think, as I mentioned, this is about the move to the new strategy and aligning the operating model to it. What does that mean and what are some of the specifics? I think the biggest opportunity I'll call out, and Ryan, I'll start by saying we're going to be taking an end-to-end look at the business. Every nook and cranny of the business on are there ways for us to be more effective? Now, in some cases, that's going to mean cost out. In other cases, it may mean investment into the business to fuel growth. The key metric here for us as we look at effectiveness efficiency is OpEx to sales ratio. It'll mean some cost out, some investment.
A prime example would be supply chain for sure, in the sense that as you could imagine, if you're servicing spot buy business, which is you're getting an order at 8:00 at night and shipping it out the next morning in small quantities. Looking at everything from the way goods flow into our distribution centers from our manufacturers, how they're put away, how they're managed in a facility, and then how they get shipped out, how we manage freight. It's a different equation than when we're managing inventory for a customer through a vending machine where the replenishment may be periodic and not every day, and it can be planned out, and it's not emergency in nature. You would imagine that optimally, one, the spot buy model would be higher cost model given the premium services, the other one.
Within that as an umbrella, there's a bunch of opportunities, and it's still early, but a bunch of opportunities that, quite frankly, we're now teasing out to say, how do we look at the way goods flow? How do we look at our business process and how we manage freight, how we manage bulk purchases, et cetera. The nice thing here is it's an opportunity to not only improve cost and efficiency, but in a lot of cases, improve the customer experience too. That would be a little bit more color, and I'll let Rustom touch base on sizing.
Ryan, yes, as you know, it is too early to set a target on this, but look, the benchmarks suggest 200 basis points of potential for improvement.
Okay. That's meaningful. All right. That's helpful. Secondly, just going back to the ramping of the growth investments. Erik, you hit on this. You're going to ramp the investments that are seeing early returns. Can you just spike out the one or two that you're going to invest in more heavily? How much are you going to invest this year in growth investment?
Yeah, Ryan. Good question. I gave a little color. Basically what we're doing, and again, going back to these sales refinements, step 1 was where we were over-allocated in those two buckets, take them down, which we did. Step 2 was look and say, where are the areas that are not only critical to strategy, to the new strategy, but that are showing early returns. The hunting function, the BD role is sort of one poster child for that will be probably one of the biggest areas or drivers of the increase. We mentioned CCSG, which is showing some nice traction as another area. There's a couple of others behind that as well. In terms of sizing and timing, Ryan, what I would say is, look, obviously we took a big chunk down in Q1.
You can expect the number to lift in Q2, again in Q3, and again in Q4. Given the nature of hiring and headcount management and attrition, it's hard to be precise. What I would offer is that we would expect that by the end of Q4, Ryan, sales and service headcount to be above where it was when the year started. It'll be a meaningful rise from here. Again, it'll be driven in areas that are showing returns.
Okay. Very helpful. Rustom, best of luck. Great working with you.
Thank you. Likewise.
The next question comes from Michael McGinn of Wells Fargo. Please go ahead.
Hey, guys. Thanks for the time.
Good morning.
Morning. Rustom, best of luck.
Thank you.
I just wanted to hone in on, if I heard you right, it sounded like CCSG was growing mid-single digits, but metalworking was down. Is that correct?
That is correct.
Basically my working assumption of gross margins would've been, and mix would've been you guys would've needed to grow in both those categories for maybe hit the top end of your gross margin guidance.
End market fundamentals seem a little similar. Can you just talk about the dichotomy between those two businesses and why that is?
Yeah. Absolutely, Michael. By the way, on the gross margin, the 20 basis points over the midpoint being the top of the range, Rustom gave a couple of the drivers there. In terms of the fundamentals of the bit, look, the biggest thing I'll point to, Michael, is that metalworking products are sold into metalworking manufacturing. Metalworking manufacturing is acutely soft right now. If you look at most of the surveys and then look at the end markets where there's weakness, they tend to have strong metalworking presence. Examples would be automotive, heavy truck, ag, oil, gas, weak. Metalworking is being influenced by really end market exposure.
Okay. Just switching gears to capital allocation. I think the last time you did a special or a reverse tender. Now we're going back to the special dividend. Is there a rhyme or reason to that? Is that the path going forward for you guys after you de-lever from the one and a half times I think you mentioned?
Maybe I'll take a crack at that, Mike, and then Erik can add more if he wants to. Look, what we have is a balanced capital allocation strategy. We try to increase shareholder returns using various means, and so we've done a lot of buybacks in the past. That doesn't mean that they won't happen again at some point. It's Dutch auction tenders, open market purchases, all that. This special dividend, it basically returns funds to our shareholders and improves total shareholder returns. Importantly, with our balance sheet remaining and our cash, our balance sheet being as strong as it is, and our cash flow generation as strong as it is, you're talking about 1.5 times leverage that will reduce as time goes on if nothing else happens, right? Plenty of opportunity to do more going forward, too.
Just to add on to that in terms of the go forward, what I would say is, look, Rustom hit it. We've hit a balanced approach over time. I think we're focused on right now, as we've said, while we're going through all of these changes in the business, the bar is pretty high for us on any meaningful M&A. Right now, when it comes to capital allocation, we're not necessarily tied to anything other than saying we're going to return cash to shareholders as appropriate in a way that's going to enhance shareholder returns. This special dividend, we think checks both those boxes.
Great. Very helpful. If I could just sneak one more in on the growth initiatives. Obviously, you want to run the business for long-term success, but is there a point where you step back and say, "Hey," to your segment leaders, "let's drive margin, fixed cost improvement, and fund it internally before we step up headcount here." Where is the breaking point for that where you're forcing managers' hand to show that improvement before maybe starting that hiring again?
Yeah, Michael, look, it's a good question. I think we've taken headcount down nicely over the last couple of quarters, and we're talking about it going back up. To be clear, there'll be some selective rehiring. One example where there's selective rehiring is it was a pretty heavy focus on increasing performance management intensity inside the company. We feel it's important that the message is, if you're going to manage out somebody that's not performing, that you can replace that person with somebody who is performing. It creates a good incentive to keep doing it. That's one example where headcount would come back in. The big driver is going to be in sales and service, which is customer facing, and we think really critical to capturing share. Look, this is still a hand-to-hand combat business, very fragmented, street-based.
We do to capture share over time, do need to increase sales headcount. The goal, of course, is to do it more efficiently. That's why where we're adding backheads in sales, it's in areas that are showing returns so that we can do it more efficiently.
All right. I appreciate the color. Thanks for the time.
Our last question today comes from Blake Hirschman of Stephens. Please go ahead.
Yeah, good morning, guys.
Good morning, Blake.
Real quick on auto, you call it out as a little soft again. How much of that do you think was due to the GM strike, and did you see things pick back up after that ended?
Look, what I would say, Blake, is auto has been soft notwithstanding the GM strike. I think it's bigger than GM. Early to say right now, I'm thinking of the numbers. Auto is still pretty soft for us. Look, I would expect certainly it'll help a bit, but I think the headline is more that auto is soft notwithstanding the strike.
Got it. All right. I'll leave it there. Thanks, and good luck to you, Rustom.
Thanks, Blake.
This concludes our question and answer session. I would like to turn the conference back over to management for any closing remarks.
Thank you everyone for joining us today. Our next earnings date is set for April 8th, 2020, and we look forward to speaking with you over the coming months. Again, I'll wish each of you a great start to 2020. Thank you.
The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.