Good day, and welcome to the MSC Industrial Supply Company's fiscal 2019 Second Quarter Results Conference Call. All participants will be in listen only mode. Please note this event is being recorded. I would now like to turn the conference over to John Corona, Vice President of Investor Relations and Treasurer. Please go ahead.
Thank you, Nicole, and good morning, everyone. I'd like to welcome you to our fiscal 2019 Q2 conference call. With me today are Eric Gershwin, our Chief Executive Officer and Rustom Jila, our Chief Financial Officer. 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 benefits from recent 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 in the MD and A sections of our latest Annual Report on Form 10 ks filed with the SEC as well as in our other SEC filings.
These forward looking statements are based on our current expectations and the company assumes no obligation to update these statements. Investors are cautioned not place undue reliance on these forward looking statements. In addition, during the course of 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 Eric.
Thanks, John. Good morning, everybody, and thank you for joining us today. To kick off this morning's call, I'll provide a brief overview of our fiscal Q2 results. I'll then offer specifics about the environment and our recent performance before turning it over to Rustom, who'll review the details of our Q2 and provide Q3 guidance. I'll then wrap up before we open up the line for questions.
Our fiscal second quarter earnings per share came in slightly below our midpoint due to a lighter than expected top line, particularly in February. Gross margins were as guided and in fact slightly ahead for the base business and operating expenses were also in line. Included in our total company results this quarter was our expansion into Mexico. While it was not material to our overall results, it did mute our gross margins by roughly 10 basis points and more coming on these subjects in just a bit. Turning to the environment, conditions generally remain solid in the industrial economy, although the last couple of months were softer than we've seen in recent quarters.
Sentiment indices like the MBI remain in positive territory, but have come down from previous levels. The last 2 months readings for February March were identical at 53.6. The rolling 12 month average for the MBI is now 56.2, which is still very healthy. However, a combination of some weather, destocking, softness in automotive and oil and gas and some ripple effects from the prior government shutdown were factors. To be clear, nothing we see indicates a dramatic step down, but demand moderated at least for those 2 months.
Customer sentiment generally confirms this picture. Things have gotten off to a slower start than expected in the beginning of calendar 2019, but the outlook remains generally positive. With regards to the pricing environment, things have remained stable, providing a solid backdrop as we implemented our mid year price increase. The tariff landscape also remains stable with no indications that we're headed towards the 25% level. As a reminder, our own tariff exposure is relatively small at roughly 5% of cost of goods sold.
I'll now turn to our performance within this environment. While our overall growth rate came in below our expectation, it's important to understand what's happening under the surface. Our core customers maintain growth rates in the high single digits. This is particularly important because core is where most of our sales transformation efforts have been aimed and demonstrates ongoing traction of our changes. National accounts also remained in the high single digits And as expected, government
was negative in
the quarter, weighing down our overall growth rate. As you'll hear from Rustom in greater detail shortly, we're projecting our 3rd quarter growth rate to tick down, and this is primarily a function of 2 things. 1st, the slower growth rates from February continued into March when factoring out the Easter holiday benefit. To be clear, we're not seeing acute weakness in specific accounts. If we were, it could point to competitive movement or change in share.
However, neither one has changed meaningfully. Instead, we saw lower growth across the board, particularly towards the end of the calendar quarter. A good example of this within our highly penetrated national accounts where our relationships are strong. Many of these accounts saw lower spending levels in March even as compared to December. This is consistent with softening demand or inventory destocking.
I should note that the last week of our fiscal March, which was the 1st week of calendar April or the calendar Q2 rebounded and was much stronger. Should that sustain, it would suggest the February March softness was just temporary. Our fiscal Q3 guidance does not anticipate that this strength continues for the rest of the quarter. If it does, it would mean upside to our guidance. The second factor impacting the 3rd quarter revenue guide is government, which as we anticipated will hit its peak headwind in the 3rd quarter with the low double digit decline projected.
This is a function of year over year comparability as both of our previously communicated contract losses hit hardest this quarter. As I've shared with you in the past, we've been making significant changes in government. And as a result, our pipeline of new opportunities has improved considerably. Keep in mind that moving past this comparability issue will reduce a headwind of at least a point of growth, and this is before the changes that we've made bear fruit. Despite the lower projected 3rd quarter growth rate, my conviction in our sales transformation remains high.
I base this on several data points. First, our core customer growth rate remains solid. And given that core is where the bulk of our sales changes were aimed, this is important. 2nd, the sales changes have freed up our sellers to engage in more growth activities. And we're seeing the positive impact of this in inventory management signings and in particular vending.
Vending signings are up over 50% for the year. And while it takes time for signings to turn into revenues, they are a good indicator of future growth prospects and share capture. As a point of reference, spending did contribute 280 points of growth in our 2nd quarter. 3rd, we have stepped up our focus on new business generation considerably. Most of our sales force hiring has been aimed at business development.
Our hunters have gone from just a handful a few years back to about 100 associates today as part of our sales transformation efforts. And this number has nearly doubled just over the past year. These hunters are beginning to hit their stride and we are seeing a robust new account funnel that continues to build each month. They are not yet moving the needle on our growth rates, but they will as they move through implementation. We believe that our business generation efforts, including what we're seeing in vending, will add a point or more of growth over the next couple of quarters, and it will build from there.
As you can see from our operating statistics, we added another 16 net sales and service additions this past quarter and we'll continue on our moderate hiring pace given the success of the program. A 4th proof point, we continue generating considerable cost savings for our customers through our technical expertise on the plant floor. These cost savings are an indication of the value that we're bringing to customers and they help build loyalty. Finally, feedback from our sales team, from customers and from suppliers is consistent with the quantitative data and is telling us that we're on
the right path with our plan.
I'll now turn from the top line to our pricing actions. Since our last call, as expected, we implemented a meaningful price increase of 2% to 3% in February. We are pleased with the high realization rates that we're seeing, which are due to the solid efforts of our sales and marketing teams. It's also a testament to our strong value proposition as we're delivering the type of cost savings and productivity to our customers that justify the increase. A moment on AIS, which has generally performed in line with expectations over the course of the past three quarters since our acquisition of this OEM fastener business.
This past quarter, however, we did see some softness coming primarily in the automotive sector in the Midwest. As AIS supplies OEM fasteners, they will feel changes in automotive production rates acutely. And that is the case now with just a handful of customers driving the bulk of the softness. The team continues making early inroads with cross selling and we expect that to build over time. Before wrapping up, I'll talk about Mexico, which is an exciting development for the company.
We've established a majority owned business, MSC Mexico, working with an existing Mexican distributor, CAC or TAC. We view Mexico as a strategic foothold for us and a critical component of presenting ourselves to national accounts as a North American supplier. A direct presence there allows us to not only support current U. S. Customers with Mexican plants, but also opens up the Mexican market for us, which is a meaningful long term growth opportunity.
We've been looking for the right expansion opportunity for quite a while and we were excited to find an excellent partner in TAC, whose cofounder is now MSC Mexico's CEO. They built a strong value proposition as a BMI provider of MRO supplies into various industries within Mexico. And we're very much looking forward to a bright future ahead. I'll now turn things over to Wissam.
Thank you, Eric. Good morning, everyone. Before getting into the details, let me remind you that we had provided Q2 guidance for both our total company results and our base business or total company excluding the impact of the AIS acquisition. In addition, on February 1, MSC Mexico commenced operations, which Eric just spoke about. Our guidance did not include this business in which we have a 75 percent controlling interest, but 1 month of actuals are included in our total company results.
We will exclude MSC Mexico along with AIS when discussing our base business. Our 2nd quarter total average daily sales were 13,300,000, an increase of 8.8% versus the same quarter last year, just below the 9% midpoint of our guidance. AIS contributed 230 basis points of growth and MFC Mexico contributed 40 basis points of growth. Our base business growth was 6.1% versus the 6.5% midpoint of our guidance. Our reported gross margin was 42.7 percent for the quarter.
This was in line with guidance as the 10 basis point difference from the midpoint of guidance was entirely due to our MSC Mexico business, which of course was established post guidance. Our total company gross margin was down roughly 120 basis points from last year, with about 30 basis points coming from AIS and another 10 basis points from MSC Mexico. Our base business price contribution remained positive and in fact improved due to the price increase, although as expected, purchase costs continue to increase and mix remained the headwind. Our OpEx to sales at 31.1% was flat versus last year's Q2 and in line with guidance. Total OpEx was $256,000,000 up $17,000,000 from last Q2, with about $5,000,000 of this coming from the acquisitions, just under $4,000,000 of the increase was attributable to volume related variable costs such as pick back, ship, freight and commissions, another $6,000,000 related to growth investments, including additional field sales and service personnel and stepped up marketing.
Cost inflation and all other expenses net of productivity added nearly another 2,000,000 dollars Our fiscal 2nd quarter operating margin was 11.7%. That's down roughly 110 basis points from the prior year, with roughly 20 basis points of this due to AIS. Our base business operating margin was 11.9%, down almost 90 basis points from the same quarter a year ago and due to lower gross margins as noted earlier. Total company and base business operating margins were both in line with guidance. Our total tax expense on a percentage basis for the Q2 was 25.1%, also in line with guidance.
So all of this resulted in reported earnings of $1.24 per share, dollars 0.01 below the midpoint of our guidance. AIS and MSC Mexico had no impact on reported EPS while surrounding. Last year's reported EPS was $2.06 which included a one time tax benefit related to Tax Cuts and Jobs Act of roughly $0.72 Also included in last year's Q2 was the catch up of the lower tax rate on our year to date income. As noted in January, perhaps the simplest way to normalize EPS for tax benefits is to apply the current quarter's tax rate of 25.1% to fiscal 20 18 Q2. And if we did this, Q2's EPS was $0.01 below last year.
Turning to the balance sheet. So our DSO was 54 days, flat with fiscal 20 eighteen's Q2 and down roughly 4 days from our fiscal Q1 of 2019, which is broadly in line with our typical seasonal pattern. Our inventory increased during the quarter to $573,000,000 up $45,000,000 from Q1 as we continue to take advantage of calendar year end rebates opportunities, build safety stocks ahead of possible tariff related disruption and also to get ahead of impending supplier price increases. Total company inventory turns remained at 3.6x. With tariffs looking less likely, we have slowed purchasing and expect inventory levels to decline in our fiscal Q3.
Net cash provided by operating activities in Q2 was $22,000,000 versus $36,000,000 last year. Our capital expenditures in the 2nd quarter were $13,000,000 versus last year's unusually low $8,000,000 And after subtracting capital expenditures from net cash provided by operating activities, our free cash flow was $9,000,000 as compared to $28,000,000 in last year's Q2. We paid out $35,000,000 in ordinary dividends during the quarter and bought back 275,000 shares for $21,000,000 at an average price of $76.02 In last year's Q2, we paid out $33,000,000 in dividends and spent CAD18 1,000,000 on buybacks. Our total debt at the end of the second quarter was CAD593 1,000,000 comprised mainly of a CAD 281 1,000,000 balance on our credit facility and CAD 285 1,000,000 of long term fixed rate borrowing. Our leverage increased slightly to 1.2x as compared to 1x at both Q1 and last year's Q2.
So now let's move to our guidance for the Q3 of fiscal 2019, which you can see on Slide 4 and is shown with and without acquisitions. Please remember that Deco is in the base, while AIS and MSC Mexico are included in the total company deals. Please also note that Easter is later this year and this artificially inflates our March growth, but then suppresses our April growth rate. For the fiscal Q3, of course, the anticipated impact is awash. Overall, for Q3, we expect total company ADS to increase by approximately 5.5 percent to 7.5% versus the prior year period.
This includes 3% to 5% of organic growth and around 2 50 basis points from acquisitions. Note that AIS was acquired on April 30 last year, so 1 month of sales was included in last year's Q3 And MSC Mexico is now included for the full quarter. You can see on the website offsets that March's total average daily sales growth is estimated at 9.5 percent. We estimate that this includes about 3 50 basis points from the acquisitions with Mexico contributing about 100 basis points of that. We also estimate that the month was boosted by about 200 basis points from Easter falling into April this year.
As Eric mentioned, our fiscal March was softer than expected for most of the month with a nice rebound in our final week, which was the 1st week of calendar April. Our guidance forecast assumes daily sales rates above the 1st few softer weeks in March, but not at the levels we saw in the last week's rebound. Our Q3 reported gross margin is expected to be 42.7 percent, plus or minus 20 basis points. This is inclusive of a roughly 60 basis point negative impact from the acquisitions and roughly 30 of this comes from the New Mexican business. Our base business gross margin is expected to be 43.3%, up 20 points sequentially from the 2nd quarter and bucking the trend with a seasonal decline.
Year on year, our total company Q3 gross margin is expected to be down almost 90 points, with roughly 40 basis points due to acquisitions. On our last call, we flagged price realization as the key gross margin driver for the second half of the fiscal year. So far, price realization has been strong. However, higher purchase costs and mix are continuing gross margin headwinds as higher sales growth coming from vending and direct ships comes at gross margins below the company average, but they do contribute to our operating profit. Operating expenses are expected to be around R262 1,000,000, up R17 1,000,000 over last year's Q3, with AIS and MSC Mexico accounting for roughly $5,000,000 of this.
Variable expenses associated with higher base sales are expected to account for another roughly $3,000,000 And an additional roughly $2,000,000 comes from inflation net of productivity. And finally, our growth investments, including the higher field sales and service headcount, are expected to be up roughly $7,000,000 on the prior period. Recall that we added 35 sales and service associates in our fiscal 4th quarter, 34 in our fiscal 3rd quarter and 16 more in our fiscal 2nd quarter. We also added to our inventory management implementation team to support accelerated lending signings. Sequentially, our base business OpEx is expected to be flat after allowing for the roughly $5,000,000 of higher volume related variable expenses.
So year on year, in percentage terms, we expect our total company 3rd quarter OpEx to sales ratio to be unchanged at 29.7% despite the higher growth investment spending. We expect the 3rd quarter's total company operating margin to be approximately 13% at the midpoint of guidance, a 90 basis point decline over last year's 13.9%. The driver is a roughly 90 basis point gross margin decline with roughly 40 of this coming from acquisitions. The additional sales and service headcount added since fiscal Q4 2018 also contributes, but the impact is minor. Assuming the midpoint of our total company Q3 operating margin guidance, we would remain in the lower left quadrant of our 2019 annual op margin framework through the 1st three quarters.
You might have noticed that we modified Slide 6 in our deck, and that's the operating margin framework, and this is including acquisitions. This is strictly to reflect Mexican acquisition, which dropped the GM ranges and the operating margins in each quadrant by 10 basis points. Before turning to taxes, I'd like to briefly cover incremental margins. In fiscal 2018, we delivered base incremental margins of over 22%. In fiscal 2019, we have taken a step back.
Our first half base business operating profit only grew slightly as the decline in gross margins cost us around $2,000,000 or 50 basis points of operating margin and we invested around about $11,000,000 for growth, mostly in field sales and service personnel. Q3 is expected to show a similar picture. Our gross margins will be sequentially higher because of the February price increase, but down year on year. And as Eric noted before, where OpEx is concerned, we intend to continue investing in field sales and service personnel through this fiscal year. Our full year 2019 incremental margin picture implied by our annual operating margin framework was already slightly below 20%.
Assuming the midpoint of our fiscal Q3 guidance for the total company, our 9 months year to date incremental margins will be only marginally positive. The primary driver of this is revenue growth. Sales have been softer than anticipated over the past couple of months and our guidance assumes that this will continue in our fiscal Q3. At the same time, our higher growth investments, namely sales and service, both operating expenses as a percentage of sales also slightly above what we had anticipated at this point in the year. As we look ahead, we remain confident that our investments will continue to yield payback and that we will achieve leverage on the step up in investment spending.
Now turning to our estimated FX rate for the 3rd quarter, it is 25.1%, in line with the first half of the year. Our guidance also assumes a weighted average diluted share count of roughly 55,400,000 shares. Our fiscal 3rd quarter EPS guidance range is $1.46 to $1.52 per share, with a midpoint of $1.49 This includes AIS and MSC Mexico, which together are expected to have a roughly breakeven impact on EPS. I'll now turn back to Erik.
Thank you, Rustom. Before closing, I'll provide some perspective on our performance and our path forward. Over the past few years, we've repositioned MSC from a spot buy supplier to a mission critical partner on manufacturing plant floors. This journey has included several important initiatives, migrating our product portfolio to technical and high touch product lines expanding our inventory management footprint through vending and BMI, creating a new value proposition, anchored in producing cost savings and productivity improvements for our customers and reengineering our sales force to support the new value proposition. As we entered this fiscal year, our plan called for improving revenue growth relative to the market, particularly in our core customers, moderating gross margin pressures through price realization and achieving operating expense leverage on our growth despite a step up in sales investments.
Halfway through the fiscal year, the biggest difference in financial results compared to our expectations comes from revenue growth. While starting out in the right direction, top line growth has not maintained momentum, at least not over the last 2 months. Whether the moderation that we've seen continues or it proves to be just a blip is still unclear. In either case, we like what we're seeing from our growth investments. We therefore remain focused on our growth plan and we are confident that it will deliver the anticipated benefits as we move forward.
We'll now open up the line for questions.
Thank Our first question comes from Evelyn Chow of Goldman Sachs. Please go ahead.
Good morning, Eric, Rustom, John.
Hi, Evelyn. How are you?
Doing well. Thanks. I just want to start on your fiscal 3Q growth guidance and the deceleration you embed. Helpful to hear a few of the things you posited, inventory destocking the national accounts, maybe some potential share shifts, your government contract headwinds peaking next quarter. It seems like April is a step in the right direction, but from what I gather, a lot of the headwinds you cite don't really seem like things that resolve in the short term.
So maybe Eric or Wissam, could you elaborate a bit on what you're seeing here? And also what factors could actually get better as you go through the fiscal year?
Yes, sure Evelyn. So I would say with respect to the deceleration in the growth rate and we're referring to, of course, the base business, really two things to talk about. One is that, what we did see softer conditions in February that continued into March. And what we've done with our guidance is assume that basically those conditions hold. In terms of color on that, I would say it was no one thing, a combination of a whole bunch of things, I mean some weather, particularly in February, I would say weather, destocking, which when I say on destocking hard to quantify, but a lot more anecdotal evidence than we've heard about in the past.
We saw some pockets of softness in automotive and oil and gas and a little bit of ripple effect from the government shutdown that occurred on some of our core customers who did government work. So that was the macro. I would say hard to say for sure, but a good chance that there's a case to be made that some of that lingers on and there's a case to be made that says some of that is temporary and doesn't. Reasonably encouraged to see the start of the calendar quarter, Q2 or 1st week in April bounce back. So I think that's what we'll see.
The second thing that I want to hit on is essentially what we're seeing, what you're hearing from me is despite the tick down in growth, a lot of confidence in what I'm seeing from our growth initiatives. And essentially what's happening is there is a lag between what we're seeing on the ground in terms of progress on initiatives and how that progress is translating into numbers. So during the prepared remarks, I commented on 2
of those, one being vending and
the other being business development or is referred to as hunting, in other words, new account generation. So just to put some color on new account generation, we're seeing I talked about the growth and the size of the team, but that is translating. So new account signings have doubled in recent months and these are signings per month and we're seeing a pipeline that continues to grow. And most of that progress is being driven by the core team of hunters that have been in place for a while. Nearly half the team is new, meaning have only been hired in the last year and haven't hit their stride yet.
So we expect that pipeline to keep growing. Again, still early, but we're seeing a lot of positive indicators there. So as we look out, let's put the macro to the side and who knows what happens there, we do see a couple of things in our control that should positively impact growth rates. So one is just the math of government lapping government over the next couple of quarters, which the headwinds abates and that's worth roughly a point. And then between bending and new business generation, as we talked about, we see again, you can never pinpoint timing precisely, but over the next couple of quarters, at least a point there.
So we do like what we're seeing on the ground and what's in our control.
Thanks, Eric. That's all really helpful. And then maybe just touching upon something you raised just now. As you've been folding new salespeople into your organization, have you gotten a better sense of when they become productive and when you feel like they get past that ramp phase and start to produce?
Yes, Evelyn, that's a really you want to go ahead, listen, take Go ahead. Sure. I
mean, it was the yes, Evelyn. Well, first of all, they're different, right? They're some of the hunters all the way from telesales hunters to the large enterprise hunters. But the early economics of these hunters, I mean that we're seeing that they're producing, as Eric said, significantly more revenue per head and that gross margin is lower than company average, but better than national accounts. And most importantly, it's still early, but the initiative is already breaking even from a P and L perspective overall.
Great. And then maybe just
One thing I'll highlight just to underscore Rustom's point about early signs being positive and just I have the benefit of being here since the old days. Relative to and it is early as Rustom said, but relative to the older model, the one size fits all model before all these changes, we are seeing for the base of sellers that have been here for a bit now, considerably higher revenue per head than what we saw under the old model. So very early, but encouraging.
Thanks, guys. And if I may, just sneaking one more in here on the fiscal 3Q margin. Rustom, I know you said it will probably stay in that lower left quadrant of the guide, I. E. Around 12.8%.
Just thinking about typical seasonality, I think your fiscal 3Q margins tend to be up quarter over quarter 100 to 200 bps, pricing should improve. So are you do you just think that particular quadrant looks especially good to you or are there other headwinds to margins that I'm not really thinking about?
No, I mean the fiscal I mean sequentially, I mean between Q2 to Q3, I mean there's normally a downward drift. So I mean this time it's actually bucked it, the base margins. And that's due to strong price realization. It's led to the normal seasonality that's with the price increases having gone through earlier and then going through and then reflecting, but also increased purchase costs. But also don't forget that Mexico pulls down our Q3 and this is going off the base.
Mexico pulls down our Q3 gross margin by roughly 30 basis points. Because remember, there's a theme for 1 month in the Q2. And were you talking about gross margins or were you focusing more on op margins?
I was looking more at the EBIT margins, Rustom.
Sorry. No, not to worry.
So look, I can give you that as well. I mean, the so the EBIT margins, I mean, and maybe I'll actually take it in terms of incrementals. I mean, we do expect incremental margins in the second half to be in the lower left quarter into the framework. And we expect slightly positive incrementals for the second half, but it's too early really to be definitive beyond Q3.
I appreciate the time today guys. Thank you.
Thank you, Evelyn.
Our next question comes from Robert Barry of Buckingham. Please go ahead.
Hey, guys. Good morning.
Hi, Rob.
Just to maybe clarify, were you able to quantify how much these factors impacted the quarter, the weather, the government shutdown impacts?
Rob, it is so tricky. So the short answer is no. I mean, what I would say though is what you saw from the base business, Rustom mentioned in the prepared remarks, we were off from the midpoint. So if we go February in particular, we were off from the midpoint of our guidance by about 40 basis points on the base business on the top line. That was the driver behind that were these factors that I saw and it was particularly in February, which quite frankly didn't surprise us all that much based on what we were seeing in terms of weather and other reports and surveys about February.
And what surprised us a bit is that it extended into March with the exception of that last week of our fiscal month. But tough to quantify other than to say that, that gap between the midpoint of our revenue range and where we landed would be the difference.
Got it. Got it.
So kind of marginal, I guess, is
the best estimate?
It's certainly look, nothing we saw we point to would indicate any sort of major step down here. And certainly that drives what we're hearing from customers, things did get off to a slower start for all of those reasons, but outlook generally remains pretty good. So nothing we're talking about here appears to be dramatic.
Got it. And it sounds like you put through the price increase, it went as expected. So on the base business, do you expect or does the gross margin forecast assume that you're net positive on price cost in 3Q?
So the answer is no. I mean, because we have a very strong positive contribution coming back from realization on our pricing, but we also have a long lag coming through in our costs as we've explained before. And so think about our last quarter, the last quarter of fiscal 2018, when we got pricing earlier than the costs coming through, we saw the positive benefit of that. Because we have an average costing system, because we buy ahead, because we defer increases, all the rest of that, it takes a while for costs to come catching up with us. And so we are seeing that.
I mean, we are seeing that in our numbers. And for instance, in the first half, Robert, I mean, most of the P and L impact was from calendar 2018 cost increases, the cost that we saw coming through.
And just to tag on to what Rustom saying, if you're looking, Rob, to say where is the pricing benefit, take a look, the answer to
that Rustom sort of hit this
in his remarks that essentially we bought what has been if you look over our last few years what you'd see is margin absent any action will tick down Q2 to Q3, it ticked up. That's basically price.
Got it. I mean, do you think in 4Q,
you'll be neutral? Or is there a
line of sight to being at least
neutral on price
core say so many moving parts. The one thing I'd say just the caution there would be generally if we follow a seasonal pattern as we do most years, you'll see Q4 generally will drop from Q3 primarily due to seasonality. That would be the typical pattern, but obviously we'll give more color next call.
Got it. I guess just lastly, I wanted to follow-up on the comments about all these sales efforts adding about a point to growth. I think a few quarters ago you talked about the kind of sales realignment causing you guys to underperform the market by maybe it was 200 or 300 basis points and as you kind of ramp the sales people that you could close that gap. And I don't know if that's taking longer, if I'm not remembering it correctly, but now it sounds like you're only talking about all the efforts adding a point to growth versus where we are now. So could you just clarify that, please?
Yes, absolutely, Ross. So in terms of gauging progress, first thing I'd say is take a look. I think it's important to isolate government in the story here because we've been pretty transparent about a couple of contract losses and government changes we've been making. But when pulling out government, if you look at our core business, which is where most of the changes were aimed, Q1, Q2, even into March, which granted March was held by Easter, the core business is up high single digits. Okay.
So part of the changes, part of the benefits are being seen in the performance of the core. The core is outperforming the company average right now. The comment about the point was related specifically to one aspect of these changes, which is the new business generation. So from where we sit today, first of all, realize that our Q3 guide is contemplating some unexpected softness continuing. That may or may not continue.
But regardless of the environment, what I'm isolating is the new business generation we anticipate adding and what I said was at least a point and then build it. So realize the way this works, Ravi, we've hired a lot of hunters. As you heard, the numbers went from a handful up to 100. And it takes roughly what we found is it takes a hunter somewhere 3 to 6 months to sort of build their funnel and be able to start hitting their stride. As they do each month that goes by, they are we are seeing new account signings add.
These new account signings are going to layer on top of each other. And so what I was describing in the point was looking out over a couple of quarters getting at least a point. I absolutely expect if we continue to execute as the early signs indicate we will that build because these account signings layer on top of each other.
Got it. All right. Thank you.
Our next question comes from Scott Graham of BMO Capital Markets. Please go ahead.
Hi. Good morning all.
Good morning, Scott. Thanks, Rich.
I was wondering, I know Eric you commented that the more moderating sales in manufacturing in particular in February March that in fact you saw a little bit of a snapback in early April that the moderation was broad based. I'm wondering was the snapback similarly broad based?
Yes. And the only caveat is snapback. I wanted to it's all what we saw was a week. And granted it was an important week we felt because it was the start of a calendar quarter. So if the destocking hypothesis had held, we felt it was an important week, but only a week.
To answer your question, yes, it was broad based. So very much the way the softness was sort of broad based, what came back was broad based.
Got it. Rustom, I was hoping that you could maybe shed a little light on your thinking around Q3 free cash flow. Obviously, this quarter was impacted by some of the working capital build that you've talked about here. Does the lack of sort of pre purchasing as well as the sales allow you to have should Q3 be a really strong free cash flow quarter up year over year and all that?
Yes. Scott, and the answer is yes. We do expect the Q3 to be significantly better than the Q2.
And working capital would be a source of funds in the 3rd quarter?
But inventory for sure would go down. We expect inventory to go down. I mean as sales grow and we continue, I mean I'm not sure if receivables will be a source of funds. They're not going to be an aberrationally high use of funds, but they're not going to distribute a source. So the driver is going to come from and also remember in the Q2, we pay we have the way it works, we have 2 tax payments that happens every single year.
So that alone sort of gives us a ton of cash.
Yes, fair. Thanks. And my last question is, you guys are kind of for the last couple of years just give us sort of this price mix net of discounts within your supplementary data supplemental data. What I'm wondering is it's been positive now for 5 straight quarters. One of your competitors started, I guess, a little over a year ago to kind of say what they estimate mix is each quarter.
Essentially, they wake up in the morning and they have certain negative mixes, a certain range of basis points. Is that something that you guys might be prepared to talk about what you sort of your wake up in the morning negative mix, whether it's large customers, vending, other e commerce. Is that something you could maybe give us a little bit more detail on?
Got it. So I think a fair point. And look, we have pointed to ongoing that there is a mix element to the gross margin equation, a negative mix element. You're right. We haven't specifically called it.
Let us take it back and chew on it. Part of the reason by the way when you see our decomposition, you're right, what you see is price mix together. And look, the fundamental reason is in a business with 1,000,000 plus SKUs, several 100,000 customers, there's a lot of permutations getting at price realization. There's multiple ways we look at it. It's in many cases very hard because a lot of our customers are not buying the same items every quarter, every year.
They're random purchases, it's very hard to disaggregate mix from price, which is why we why you see them together. Let us see if there's something we can do to give you some more point you in the right direction.
That would be great.
That's all I had. Thank you all.
Our next question comes from Hamzah Mazari of Macquarie. Please go ahead.
Hey, good morning. My question is largely around operating leverage for the company. It feels like post the Barnes deal that took longer to integrate. We had a sales force strategy shift and now it feels like some of these growth investments are just late in the cycle. Do you think longer term the company can get up leverage in a slowing macro?
Meaning, do you think that the share gain in a slowdown given these growth investments will materialize? Or are we just we just have to wait for the next cycle to see these growth investments pay off?
So hi, Hamzah. So maybe I'll take that and take it in terms of incremental margins and maybe bring the conversation back to that. So we've talked about increment achieving a 20% plus annual incremental margins. And we said to do that, we need a mid to high single digit organic revenue growth, flat or modest erosion in gross margin and OpEx productivity offsetting inflation, okay. So right now, we're seeing greater than modest gross margin erosion.
Our stepped up growth investments are not yet producing payback. I mean, you heard me mention that on the business development people, we've come to breakeven, but we're at that point. So as a result, we're going to be well below the 20% level this fiscal year. But looking beyond, I mean, our current growth investments will abate and then it comes down to gross margin erosion. If gross margin erosion remains at current levels, we need low double digit sales growth to get it and we go from there.
And probably the only other point to mention is OpEx productivity. I didn't cover that. But if you saw the last two quarters, we talked about it. I mean, on a $3,000,000,000 plus business, I mean, if you look at the our productivity has offset in Q2 and in the projections for Q3, all but a couple of $1,000,000 of inflation. So we continue to focus on that too.
Does that give you enough of Yes, no.
That's helpful. I was just wondering, are these growth investments just coming too late in the cycle? Or do you think structurally these investments just take longer to pay off than some of the investments maybe you've made in the past cycles?
Hamzah, I mean, from our perspective, when we look at growth investments, really we try to do it in a cycle agnostic sort of way and say, are these good return on investments? Are we going to get high payback from the investments over cycles because it's very hard to run the business throttling up, throttling back. Now certainly, at the margin, we can temper based on environment. But we look at over a cycle saying, are these investments going to produce payback? We're confident in these investments.
And I would say so far, while I understand all of us would like it to happen faster, no question. Relative to past growth investments that we've made, I'm not necessarily saying that it's going to take that much longer. I think we all the signs point towards improved growth. So the only last comment I'd make is they right now I understand your point about late in the cycle, but just to be clear, nothing we're seeing indicates that the macro is going way down. It may be moderating, but even in a moderate economy, there is an opportunity for us as these investments yield payback to improve our growth rates and produce the kind of growth rates that you're used to seeing from us.
That's very helpful. And just a follow-up, I'll turn it over. I may have missed this, but did Easter have any impact in sort of the 1st week of April pickup that you're seeing or it's just it didn't really have an impact?
Easter helped our March number our estimated March numbers by a couple of 100 basis points. They will get wiped out completely in April. So by the time we finish the quarter, net 0.
Got it. Thank you.
Our next question comes from John Inch of Gordon Haskett. Please go ahead.
Thank you. Good morning, everybody. Hi, John. Hi, John.
Good morning, guys. Hi. So I want to start with the gross margin guidance for the Q3. I guess we've got AIS in Mexico kind of 40, 50 basis points. The core, right, the 42.7 shows sort of no benefit from the sequential volume improvement.
So I'm assuming this is the Rustom what you've talked about the gross margin degradation, but we've got price I guess with 80 basis points of realization should be a lot more this quarter. What's the is there anything else you can comment on with respect to why there's not better gross margin leverage given the volumes and
the price increases? Sure, so the 42.7 is the total, right, which includes all the if you looked at if you looked at our base number without even AIS, so you're comparing complete apples to apples solids, I mean, that number is still up 20 basis points. And so we're seeing sequential rise coming through. It's fundamentally the same thing that we that I tried
to explain earlier, which is that the
price increases are going through, right? But you're having the lag effect of costs coming through and that's coming, right, with that. And then finally, there is, of course, a mixed element when we do more vending and things that they come through at a lower gross margin for sure. I mean, vending is about minus 40 basis points compared to the year. It's pulled us down about minus 40 basis points a quarter, pretty consistent with what we've seen.
And then finally, as you said, there's the 60 basis points also coming from
the 2
acquisitions. John, the only thing I'll
add to Rustom's comments is paint books, so if you go sequentially and what I would suggest you do is put Mexico to the side and I say that because Mexico was in one period and really essentially not in the other. And if you compare Q2 to Q3 plus 20, if you take a look at our last few years and look at what without a meaningful price because we really haven't had a meaningful midyear price increase in the past few years and look at the gross margin performance over those from Q2 to Q3. And when you compare this year those, you'll see a pretty sizable difference. That's effectively pricing. That's cost.
Okay. So the core growth in March, I think ex Easter and acquisitions was about 4%, but you talked about core I'm sorry, the organic growth, but the core account growth was high single digit. That almost sounded as if it was holding up throughout. So was it the large accounts that stepped down if you were to parse that out? Or was it the drag from government got even worse just because you've talked about the core stuff still being pretty resilient.
What actually happened ex those other moving parts?
John, so you're talking about specifically March?
Yes, yes. That seems to be the
kind of the big month here. So to be clear, I want to make sure I'm transparent. So core was high single digits in March. That was relative to the 6 for the company. You have to take off and that's inclusive of the Easter effect, okay?
So we're estimating the Easter effect at about 200 basis points, which brings the 6 down to an effective 4, it would bring core down also.
Okay, got it.
But also government, as we have indicated, was going to be down double digits for the quarter and March is the 1st month of the quarter. So yes, government took a step down from the Q2 levels.
Right. With 3Q being the worst inflection, do you think there was any kind of considering you guys were raising prices, do you think there was any kind of pull forward? If you go back to the fiscal Q2 as you look at sort of the trends within your accounts, Eric, that maybe have accounted for part of the step down versus the broader economy or maybe disruption from your sales force initiatives or something that's more idiosyncratic to MSC?
John, it's a good question. Generally with price increases, given the percentage of one of our customers, if you look at the stuff we supply industrial MRO supplies as a percentage of their total spend, it's not that big. It's not the kind of thing where they'd be buying in advance because it's just not that big dollars. What is possible because we did hear some destocking, as I said anecdotes, tough to quantify. But more anecdotes than we've heard in recent quarters is more of a macro buying, I guess, because of tariffs or whatever late in calendar 2018.
That's possible. I don't know. I don't think it would be sort of like idiosyncratic MSC specific on price increase, don't think so. Nor do I think by the way that there was any sort of price connection between pricing and volume. We look at that pretty carefully as part of our price realization and saw no difference between where prices were raised and they weren't in terms of units.
Got it. A couple more quick ones. Rustom, the 30 basis points from Mexico, is that kind of one time based on step up of inventory and amortization? And then Eric, how are you thinking about maybe firepower to do a larger deal? It was announced that Cayman is exploring a sale.
That would be a very large deal, but I'm just curious about your own thought process now that you opened Mexico, AIF seems to be under your belt. What are you thinking going forward?
Sure. I'll let Rustom Mohit. Right.
So I'll go first. So not a major inventory step up over there. But yes, in the go forward quarters, we'd expect Mexico to be roughly closer to 20 basis points of downward.
Eric? Yes. And John, to your question on M and A, I mean, I'll even take it up a notch on capital allocation. Our approach pretty much the same, this idea that we refer to inside the company of think like an owner, which means spend the next dollar of free cash flow where we see the highest risk adjusted return. I would say a couple of things of note right now, 2 factors and certainly we have a robust M and A funnel, no question, but two factors I'd point out.
Number 1, we're seeing valuations as being pretty high right now, pretty robust. And number 2, look, you've heard we've got a bunch on our plate. We're heavily focused on our organic growth investments and seeing the early signs of progress translate into results and that's where we're putting most of our focus. So certainly M and A there's always a
Our next question comes from David Manthey of Baird. Please go ahead.
Hi guys. Thanks for fitting me in. First off, could you give us your specific definition of what a core customer is? And approximately what percentage of your sales are to core customers today?
Yes, it's very fair, David. So I'll give you a definition by subtraction here, which is a sense I mean the cleanest definition is if it's not national accounts and it's not government, we're referring to it here as core. But what it gets at and as a percentage of revenues, look, it's over, we've given you national accounts, we've given you government. So look, it's over half the company sales. And it is reflective when you look at what makes that up of it could be anything from small, medium to even some large, but our sweet spot of manufacturing customers.
That is where you see that most strongly.
Okay. And the remainder, I guess, beyond end market would primarily be a transactional type customer. Is that fair? Sorry, not following, Dave. Well, rather than having a national account relationship, some sort of a vending solution, integrated supply, VMI, sort of what you would consider not in that core group would be more of a simple relationship with MFC, maybe more transactional in nature.
Is that correct?
I see your point, Dave. So what I would say is within that core bucket, there are different types of relationships. So even within core, even for a customer that's not a national account, there may be a very formal relationship in place with a program a la national accounts, just not at the size and scale of national accounts. There may be something that's a program, but a little simpler, an inventory management solution that's in there or it may be a small customer where the relationship is through telesales or even through our direct marketing Okay.
Thank
Okay. Thank you. And then last question in terms of your strategy to target that non core customer. I think you've clearly outlined with sales force effectiveness, how you're going after the core. But I'm not sure I'm clear on how you're targeting the rest of the customer group in terms of that transactional customer, your sort of web pricing, catalog pricing.
Just give us any kind of color, Eric, on the strategy that you have for the rest of the business that's not really focused in this sales force effectiveness initiative?
Absolutely, Dave. So we have within that core bucket are many customers who don't have a formal relationship with the salesperson. They go through what we refer to as a direct marketing channel. And what we've done interestingly as part of the sales transformation efforts is we've taken pieces of it, not the sales force, but pieces of particularly around the value proposition and we've applied it to those small customers who are doing business with us through the web, through marketing campaigns, through inbound call centers. And what we've done and it's actually translated, Dave, and it's one of the things we didn't talk about today, but have over the last couple of quarters is seeing considerable pickup in the growth rate in that small direct marketing channel.
We've moved it from being a more transactional relationship to focusing more on some of the value add, ways to help with cost savings and just doing it without a person.
All right. Thanks, Eric.
Great.
Our next question is from Adam Uhlman of Cleveland Research. Please go ahead.
Hey, guys. Good morning. Hi, Adam.
Thanks for squeezing me in here. I was wondering if you could just step back and talk about the Mexico business, maybe you could give some more insights on what your plan is over the next year or 2, some specifics about
the size
of the business and kind of margin profile, customer profile would be helpful.
Sure, Adam. So look, I think the core the essence of the strategy here was twofold. 1, reinforce the core business and by core business what I'm talking about here is the business in the U. S. Many of our customers be it a national account or otherwise have plans or contemplating a plant in Mexico.
And being able to present ourselves here, we now have Canadian presence through the CCSG business. This gives us a footprint to present ourselves to those customers as a North American supplier. We think that's important. The second piece is to the strategy is that Mexico over time we still see as a growth market for manufacturing And it's an opportunity to have a direct presence to a growing manufacturing market. It's something that we've had our eye on for a while.
And really it was about waiting until we found the right partner, which we did. Size of the business is small. As we said, it's immaterial. But really, this is about a foothold and a foundation for growth.
Okay, got you.
And then just from a high level,
from a high level, as
I think about
kind of price versus cost going forward, is it a fair assumption that the company is going to be maybe pushing more on trying to reduce the growth in product costs or should we expect maybe a pull forward of the catalog increase earlier in the year to offset this lag of product costs? I understand the mechanics of how it moves through your P and L, but which one of those do you think you're looking greater at? Is it trying to reduce your cost growth? Or do
you think you have
to pull forward that price increase you normally do in Labor Day?
Adam, I would say yes and yes. We're looking at price and cost. It's a silly answer, but it's sort of the truth. I would say on look on the cost front, yes, there is going to be some focus on particularly if conditions moderate. Yes, there's going to be a focus inside the company.
We have a meeting coming up with some key suppliers and that's going to be part of an ongoing dialogue. Yes. So we will step up our focus on purchase cost particularly as things soften. So you will see that from us. In terms of pricing, I'd say it's too early to tell.
I mean, that's usually that's decision, Adam, we'll make based on market conditions and customer willing to accept as opposed to just the numbers. So I would say TBD on the pricing.
Got you. Thank you.
Our next question is from Sam Darkatsh of Raymond James. Please go ahead.
Good morning, Eric, Rustom, John, how are you? Hey, Sam. A couple of quick questions. First, the total ecom platform sales were about what 6.5% year on year, which is real similar to your ADS organically excluding acquisitions. And that's the first time in recent memory that total platform sales haven't been a growth driver.
I'm trying to reconcile that with the fact that obviously vending was still a significant driver to organic growth and vending is included within totalecom platform sales. So I'm trying to reconcile with that and then also why it wasn't a driver this quarter.
So Sam, the one caveat and let us take a look at the numbers, but I do know that a lot of times that e comm as a percentage of total could be influenced by acquisitions. Yes, exactly. That's exactly right, Eric. So Sam, those acquisitions are coming in that they're in the denominator, but they're 0 e com. So that's why you're not seeing the same growth that you've seen historically.
Right. But I'm comparing the e comm sales to your ADS excluding acquisitions. I would think that's an apples to apples comparison, isn't it?
Then I'll have to double check that, but I'm not sure. I'd like
to see how you do that, but okay.
Okay. Let's assume it's the case though. If so, 2 things I would caution. 1 is realized vending, you are correct, vending is growing. We're actually excited to see it really taking off this year.
The growth the kind of growth we're seeing this year in signings of the over 50% growth is not yet making its way to the numbers. I think that's a really important point. Another one of those examples of kind of sort of seeing it on the ground and not translating into numbers yet. So the second thing about vending is they realize when we sell vending to a customer, only a portion of those sales will run through the vending machine. We see a lot of pickup in sales for things outside of the machine that may or may not be electronic.
Last question for me. The share repo activity was a little bit lower this quarter versus the prior couple of quarters, despite the fact that the stock and the valuation was lower than in prior quarters. Was that because of your internal visibility with the Mexican deal? Or is that has to do with the slowing trends you saw in February March? What was the reasoning behind the share repo activity moderating?
Well, if you look at the last 3 fiscal years, right, through 'eighteen, right, just sticking with the fiscal years, we've done $515,000,000 worth of buybacks And then we had some pretty sort of pretty decent buybacks in Q1. And then the smaller numbers you pointed out in Q2. So yes, we continue to buy back shares. I mean, no, there's nothing specific. I mean, Eric kind of said talked about this earlier.
So I'll just repeat very quickly. We are balanced and opportunistic. We continue with this. We're very we focus fundamentally on our organic investment and then on steadily growing our ordinary dividends. And we're not really driven.
We don't have a target per se that says we'll go out and buy back shares, buy X or something like that because we're also quite willing to just build up cash. And so it's just a function of how it's played out there.
This concludes our question and answer session. I would like to turn the conference back over to John Corona for any closing remarks.
I'd like to thank everyone for joining us today. Our next earnings date for the Q3 is set for July 10, 2019. We'll be out on the road and at various conferences over the coming quarter. So we look forward to speaking with you over the coming months. Thank you.