Good morning, ladies and gentlemen, and welcome to the MSC Industrial Direct Co. Fiscal 2019 first quarter results conference call. All participants will be in 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 telephone keypad. To withdraw from the question queue, please press star then two. Please note this event is being recorded. At this time, I would like to turn the conference over to John Chironna, Vice President of Investor Relations and Treasurer. Please go ahead, sir.
Thank you, Denise. Good morning, everyone. Welcome to our fiscal 2019 first quarter conference call. With me today are Erik Gershwind, our Chief Executive Officer, and Rustom Jilla, 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 plan, 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&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 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 Erik.
Thank you, John. Good morning, everybody. Happy New Year. Thank you for joining us this morning. To kick off this morning's call, I'll provide a brief overview of our fiscal first quarter results. I'll then offer specifics about the environment and our recent performance before turning it over to Rustom to review the details of the first quarter and to provide our second quarter guidance. I'll then wrap it up before we open up the line for questions. Our fiscal 2019 started with a slightly better than expected first quarter performance, which included sales growth above the midpoint of our guidance range, gross margins in line with our guidance range, and earnings per share $0.02 above the midpoint of guidance. Turning to the environment. Despite some of the recent headlines and choppiness in the financial markets, the U.S. industrial economy remains strong.
Sentiment indices like the MBI remain in positive territory, although down in recent months with readings of 57.7 in October and 54.7 in November. Adding the December reading of 53.4 brings the rolling 12-month average for the MBI to 57.7, which points to continued growth in metalworking end market. We continue to see this in customer order volumes and general industry sentiment. Although there is more uncertainty than there was six months ago. Tariffs and lower oil prices are two overhangs with the potential to create macro headwinds. Another area of uncertainty is the government, as we're now well into a shutdown with no apparent end in sight. Historically, a shutdown initially softens demand, although it does create some pent-up spending once a budget is approved and the shutdown ends.
With respect to tariffs, on our last call, we framed our own exposure as roughly 5% of our cost of goods sold, reflecting those goods that are directly and indirectly sourced from China and that have exposure to the tariffs. Since that time, things have played out pretty much as expected. We've seen the increases that we anticipated, and we've generally been successful in passing those tariff increases along as they arise. As a result, tariffs have not had a material impact on gross margins to date. Of course, we will, along with everybody else, watch and see what happens come March with respect to the potential step up to 25%. That's a good segue to the pricing environment.
Since our last call, as expected, we've seen significant activity from our suppliers in raising their list prices and expect more to come this month in January based on recent discussions. As a result, we anticipate implementing a meaningful price increase later this quarter and more specifically in the month of February. We decided to wait an extra month as compared to last year's mid-year increase in order to capture as many supplier moves as possible and so that we can begin notifying customers well in advance. Turning now to our revenue performance in the first fiscal quarter. Sales growth came in above the midpoint of our guidance range. Similar to last quarter's trends, core account growth continued to lift and was in the high single digits, as was national accounts. As anticipated, government saw a near double-digit decline.
As we mentioned on the last call, this is the result of a couple of contract losses. We expect government to remain a headwind to sales growth for the next couple of quarters, with our third quarter being the peak of that headwind. Sales to vending customers contributed roughly 280 basis points to growth. More encouraging is that we've accelerated our vending signings and implementations, which bodes well for future growth prospects. In fact, Q1 signings were up double digits sequentially and more considerably over prior year. In support of this growing funnel, and as part of our high touch strategy, we've staffed up our vending service organization and have now brought the entirety of the service function in-house. We are now at headcount levels that are needed for the remainder of the fiscal year to support the growth.
Finally, our net total active salable SKU count was approximately 1.7 million, up from last quarter by roughly 20,000 SKUs. Moving now to our recent sales force transformation. It is now behind us. We continue to see improvement in our underlying growth rates, particularly in core, where most of the changes were aimed. Our recruiting efforts continued to deliver strong results in a tight labor market for the second consecutive quarter. We added a net 34 field sales and service personnel in the quarter. We now expect to add roughly another 40 or so through the remainder of fiscal 2019. This, of course, could move up or down based upon the environment and based upon the performance that we're seeing. The new additions will take a few quarters before they fully ramp up to speed and start contributing meaningfully to our growth rate.
Finally, All Integrated Solutions continues to progress according to plan, delivering solid top-line growth in line with our expectations and beginning to make headway on cross-selling with MSC. We're encouraged by the nice start. I'll now turn things over to Rustom.
Thank you, Erik, good morning, everyone. Before getting into details, let me remind you that we had provided Q1 guidance for both our total company results and our base business. That's total company excluding the impact of the All Integrated Solutions acquisition. I'll talk to both sets of numbers. Our first quarter total average daily sales were $13.4 million, an increase of 8.2% versus the same quarter last year and above the 7.8% midpoint of our guidance. All Integrated Solutions contributed 230 basis points of growth, while base business growth was 5.9%, also above the 5.5% midpoint of our guidance. Our reported gross margin was 43% for the quarter, in line with the midpoint of our guidance range. This was down roughly 60 basis points from last year, with about half of the decline coming from All Integrated Solutions. In our base business, price contribution remained positive.
However, as expected, purchase costs continued to increase and mix remained a headwind. Our next price increase will help mitigate this, but given the February timing, we will see very little benefit in our fiscal 2019 second quarter. We continue to drive productivity in Q1, and even with higher growth investments, OpEx to sales at 30.7% was flat versus last year's Q1. Total OpEx was $255 million, up $19 million from last year's Q1, with about $5 million of this coming from All Integrated Solutions and roughly $5 million attributable to volume-related variable costs, such as pick, pack, ship, freight, commission. Another $5 million was growth investments, including additional field sales and service personnel, stepped-up marketing, the vending service initiative that Erik referred to earlier, and roughly $3 million of inflation net of productivity.
Our base business OpEx to sales was also 30.7%, roughly flat with last year's Q1 and in line with our guidance as the higher investments offset the benefits of sales leverage. With sales coming in above our guidance and gross margins and OpEx to sales in line with guidance, the benefits of a stronger top line flowed through to our operating profit and our operating margin. Our reported fiscal first quarter operating margin was 12.4%, down roughly 50 basis points from the prior year, with approximately half of the decrease due to AIS. Our base business operating margin was 12.6%. That's down about 30 basis points from the same quarter a year ago, this was entirely due to lower gross margin as noted earlier, both of these were slightly better than guidance.
Our total tax expense on a percentage basis for the first quarter was 25.1%, slightly favorable as compared to guidance of 25.2%. All of this resulted in reported earnings of $1.33 per share, $0.02 above the midpoint of our guidance. AIS had no impact on reported EPS. Last year's reported EPS was $1.05. However, if we applied the lower tax rate of 25.1% to last year's Q1, the net tax benefit would have amounted to $12 million and added $0.21 to last year's Q1 EPS. Therefore, excluding this benefit, our Q1 EPS was up roughly 5% for the prior year's first quarter. Turning to the balance sheet. Our DSO was 58 days, up three days from our fiscal fourth quarter of 2018 and broadly in line with our typical seasonal pattern of collections flowing towards the end of the calendar year.
Our inventory also increased during the quarter to $528 million, up $9 million from Q4, as we continued to buy ahead of likely supplier price increases and also to take advantage of calendar year-end rebate opportunities. Total company inventory turns decreased slightly to 3.69. Looking ahead to the second quarter, we expect inventory to again increase as we protect against possible supply chain disruption and continue to buy ahead of further price increases. Should we see disruptions, our strong inventory position creates a competitive advantage for us, particularly versus the local distributors that make up the vast majority of the market. In addition, the increases are coming almost entirely from our faster-moving item classes, we do not envisage any difficulties burning them off when we decide to slow down our rate of purchasing.
Net cash provided by operating activities in the first quarter was $77 million, versus $82 million last year. Our capital expenditures in the first quarter were $10 million, after subtracting capital expenditures from net cash provided by operating activities, our free cash flow was $67 million, as compared to $73 million in last year's Q1. We paid out $35 million in ordinary dividends during the quarter and bought back 778,000 shares to $64 million at an average price of $81.71 per share during the quarter. Our total debt as at the end of the first quarter was $523 million, comprised mainly of a $210 million balance on our uncommitted revolving trade facility and $285 million of long-term fixed-rate borrowing. Our leverage remained at 1x, unchanged both sequentially and versus last Q1.
Now let's move to our guidance for the second quarter of fiscal 2019, which you can see on slide four and is shown with and without acquisitions. Please remember that DECO is now in the base in FY 2019, and it is only the AIS business that is included in acquisitions. Our fiscal second quarter, particularly December, includes a larger than typical negative holiday impact on total sales and operating profits. We see this when Christmas Eve and New Year's Eve fall on Mondays. This year we closed on Christmas Eve and New Year's Eve played out as expected with minimal sales. Through the first three weeks of December, growth was in the high single digits before turning negative for the last two weeks during the holidays. Overall, for Q2, we expect total company ADS to increase by 8%-10% versus the prior year period.
This includes a 5.5%-7.5% of organic growth range and another 250 basis points from AIS. You can see on the website offset that December's total average daily sales growth came in at 10.6%. That was boosted by one fewer selling day this year due to our closure on December 24th. Our guidance forecast assumes January and February ADS growth at about 8%, similar to where we've been running. When evaluating our Q2 ADS growth rate guidance in its entirety, it'd be fair to say that the higher ADS from one fewer selling day slightly outweighs the drag from holiday timing. Our Q2 reported gross margin is expected to be 42.8% ±20 basis points, and that's down 20 basis points sequentially and down 110 basis points year-over-year. Roughly 20 basis points of the year-over-year decline is due to AIS.
On our last call, I noted that supplier cost increases would be a headwind until we put through a mid-year price increase. As Erik noted, we'll be taking our increase in February so as to include as many of the January increases as possible. We do not expect a significant incremental price contribution while the supplier cost headwind worsens in our fiscal second quarter. While we expect our mid-year price increase to be meaningful, it would have much more of an impact on our fiscal third quarter gross margin than on our second quarter. A sequential decline due to is fairly typical in years where we don't have a mid-year price increase early in the quarter. Operating expenses are expected to be around $256 million, up $17 million over last year's second quarter, with AIS accounting for roughly $5 million of this.
Variable expenses associated with higher base business sales account for another roughly $4 million. Growth investments, including the higher field sales and service headcount, should be another roughly $6 million. Recall that we added 35 sales and service associates in our fiscal fourth quarter, as well as another 34 in our fiscal first quarter, and that we've added to our vending service team to support accelerated vending signing. The remainder comes from inflation net of productivity. After absorbing these costs, our expected OpEx to sales ratio in Q2 is 31.1%, flat with the prior year's Q2, and sequentially, our OpEx is expected to be up around $1 million after allowing for volume movement, and again, primarily attributable to growth investment spending. We expect the second quarter's total company operating margin to be approximately 11.7% at the midpoint of guidance, 110 basis point decline over last year's 12.8%.
The largest driver is, of course, the gross margin decline. About 20 basis points is due to AIS, with another 20 basis points coming from the more pronounced holiday timing in December. Finally, the additional sales and service headcounts added in fiscal Q4 2018 and fiscal Q1 2019 reduced operating margin by roughly another 20 basis points. Assuming the midpoint of our Q2 operating margin guidance, we would be at roughly 12% for the first half of fiscal 2019. This is below the bottom end of the range in the lower left quadrants of our 2019 annual operating margin framework. However, our second half operating margin on average have been about 100 basis points higher versus our first halves due to seasonality. We expect to do better in the second half this year and to be within the framework for the full year.
This is for a few reasons, including the lift from our meaningful mid-year price increase, continued traction on our sales programs, front-end loaded investments, and the fact that we lapped the AIS acquisition in May. Keep in mind that AIS is contributing sales in the first half of fiscal 2019 with minimal operating profit. Turning to our estimated tax rate for the second quarter, it is 25.1%, in line with the first quarter. Our guidance also assumes our weighted average diluted share count declines to roughly 55.3 million shares. Our fiscal 2019 second quarter EPS guidance range is $1.22-$1.28. Note that this includes AIS with a roughly breakeven impact on EPS.
Last year's Q2 reported EPS was $2.06, but this included a one-time tax benefit of $0.72 per share relating to the revaluation of the net deferred tax liabilities and an additional $0.30 impact related to applying the lower year-to-date tax rate in Q2 of last year, the period of adoption. As only part of the $0.30 applied to Q2 of last year, to facilitate an apples-to-apples comparison, we simply applied this year's Q2 expected tax rate of 25.1% to last year's Q2 pre-tax income, and as a result, at the midpoint of our guidance, our Q2 fiscal 2019 EPS would then be flat year on year. I'll now turn back to Erik.
Thank you, Rustom. As I've said before, technical expertise is an important element of our competitive advantage. One way that this manifests itself is in documented cost savings for our customers, which are particularly important now as we enter price increase discussion. A key reason that we've been able to sustain gross margins over the past few years in the face of a fiercely competitive environment is our ability to save our customers money by engineering productivity on the plant floor. I'll share a recent example that demonstrates this. Our metalworking specialists regularly conduct reviews of customer plant floors. During one such review for a customer on the West Coast, our specialist identified a drill that he felt was not the right choice.
It was not strong enough to efficiently cut the raw material being used, and as a result, the customer was running its machines too slowly in order to avoid breaking the tools, and different shifts were actually running their machines at different speeds. This resulted in extra costs tied up in machine time, labor, and even excess material. Our specialist recommended a different version of the cutting tool, one that had a special coating on it. It was a much higher piece price, in fact, 10 times higher than the drill that the customer was currently using. Fortunately for the customer, our specialist convinced them to run a test with the coated tooling, and that test produced compelling results. While the cost of cutting tools is generally somewhere between 3% and 5% of the total manufactured part, this one change drove annualized cost savings of over $200,000.
For example, cycle times were reduced by about three times, tool life more than quadrupled, and the number of parts produced per tool increased four times. Additionally, the customer was now able to standardize its speeds and feeds across shifts and increase machine availability by almost a full shift per day. All of this, by the way, is based on the customer's calculation. Based on this success, we're now working with this customer to replace the same tool in other sizes as well as other applications. These kinds of examples are routine among our metalworking group. Our team's expertise, combined with the broadest metalworking brand offering in the industry, allow us to bring a strong value proposition such as this to our customers each and every day. All of this is only possible due to our team's dedication to our customers and to our mission.
I thank you, and we'll now open up the lines for questions.
Thank you, sir. We will now begin the question-and-answer session. To ask a question, you may press star, then one on your telephone keypad. If you are using a speakerphone, please pick up your handset before pressing the keys.
If your question has been addressed and you would like to withdraw from the queue, you may do so by pressing star then two. Your first question will be from John Inch of Gordon Haskett. Please go ahead.
Thank you. Good morning, everyone.
Hey, John. How are you?
Good morning, guys. I'm fine, thanks. Happy New Year.
You too.
Erik, are there product categories where you're expecting it to be, say, easier to raise prices versus others? The corollary is, are there categories where the channel, because of, say, competition or whatever dynamic, it's just going to be more difficult to raise prices? If so, could you maybe give us some examples?
John, what I would say, I guess you're referring to the upcoming price increase.
Correct. Yep.
Generally what happens is, the size of the increase and then our success in realization, look, it's a function of a number of factors. One factor is what's happening with the key suppliers in that product line.
Another is what's happening with the raw materials that drive the costs. A third is, of course, our competitive position and the relative importance to the customer. All of those factor into the mix and drive how big the increase would be and how successful we are in realizing it. I'm going to be careful not to give too many specifics about the one upcoming, since it hasn't hit the market yet. Just as an example, looking back over the past couple of years, one of the things we've called out is we've had larger increases in our cutting tool business, primarily because the commodities, tungsten, steel, metals, have been up there more than they have in other categories, and that's driven more suppliers to raise prices and hence more of an increase for us.
That makes sense. It looks like Grainger is raising prices by maybe 3%, and I think your traditional mid-year is around one and change. Is that just based because we're obviously in a different dynamic, given the cost increases and supplier price increases? Is that kind of the magnitude of the overall increase we should be expecting, or how would you frame it?
Yeah. Correct. John, the words we used in the prepared remarks were meaningful, and the color I'd give on meaningful would be larger than the last few increases that we've taken.
Okay.
If you go back and look over the last several we've announced, we'd expect this to be a bit bigger.
Then maybe one.
That is based on the macro.
Understood. Maybe just one more. Erik, what's your recession playbook? I realize things are good debatably today, we could be in a peaking time. It's not really clear. I'm just curious, what is your recession playbook? You must have talked about it as a management team. Do you stop the sales hiring? Do you look for other costs to cut? How does this all maybe even dovetail with sales effectiveness? Does that have to get modified in some manner, or does it actually still, do you think, let you return 2 to 300 basis points above the market, even in an economic downturn?
Yeah, John. One of the benefits of growing up in this business is I've seen the business perform, and I've been part of several cycles up and down. We certainly do have a playbook for a recession. What I'd tell you, one thing out of the gate is, as a management team, we've not spent much time talking about it because right now, from our standpoint, no sign of a recession. What we wanted to get across is looking at the industrial market today, things are robust. Things are very solid. What we did want to flag is a couple of yellow flags that are out there that are certainly caution signs that something could change. At this point, we don't see recession. Should that occur? Yeah, we would certainly move into a different operating mode.
We'd certainly look to clamp down on expenses and discretionary spending as we've done before. What I would say is our goal would be, as it always is, John, our gauge and our success measure on the growth side would be how are we performing relative to market, and our goal would be to outgrow the market. We would clamp down on discretionary spending, and then what we would do is take a very careful look at investment spending. There'd probably be some where we feel it would be responsible to modify and to reduce it. There'd be other things where we'd say if they were really important to our future, that we continue to plow through. Broad strokes, that's how I describe it.
Got it. Thanks very much. Appreciate it.
The next question will be from Robert Barry of Buckingham Research. Please go ahead.
Hey, guys. Good morning. Happy New Year.
Rob, how are you?
Good, thanks. Just want to start actually by clarifying the comments on the December ADS, the 10.6. How much was that number boosted by having one less selling day, that 10.6?
This is an estimate, obviously, coming to that, but it would have been north of 4%, if you look at that number. The 10.6 number would have dropped down to 4%.
Sorry, something just north of four?
Yeah, north of 4% in the month of December. In the quarter, the ADS boost-
Yeah
from one day would be about 1.5%.
Got it.
Rob,
Right
just to be clear, by the way, because you have a couple of moving parts with respect to what we refer to as holiday timing in the day. There's the math on simply closing Christmas Eve Day, which we did, because with it falling on a Monday, there's virtually no activity going on in the business community. Okay? There's the math of if you simply add back the extra day, what happens? That would bring the growth down. The second effect moves the other direction, which is that with Christmas and New Year's falling on Tuesdays, we see a more pronounced holiday drag. That actually takes the numbers down, which is why in the prepared remarks, Rustom tried to give some description of December as sort of a tale of two months. If you looked at the first three weeks, which was a true picture pre-holidays.
Business was up high single digits. It turns negative the last two weeks. That turning negative is a result of the holiday timing.
Right.
Is that clear?
On the days you weren't closed, you had some weaker open days.
Yeah. Specifically, we had several weekdays, the one that really dragged us down was we were closed Christmas Eve day. New Year's Eve day was really, really slow and counted as a full day in the numbers, and really, really slow.
Got it. Just looking at the revenue for 2Q, excluding the M&A, it looks like the growth is going to be down about a point and a half versus 1Q. Is that all on the lost selling day or something else going on with the underlying-
No. That's why Erik stepped in to explain the second half. I just explained the mechanical answer to it, right? No. If you adjusted for the actual lost sales by having the two holidays coming on Tuesdays and the Christmas Eve coming on the Mondays, right? The actual lost sales, and you pull that out, we felt that our number would be If you just looked at our base business number, we were talking about closer to 5.9%, 6%, pretty much the number that we had in Q1. That's the number, just a matter of how it comes out. The other thing to take account of is that the comparatives in last year were a little stronger in January, too, because we had post-tax, all the changes with taxes and everything. We thought we had at the time and talked about a stronger January last year.
That's, of course, incorporated into our number, and that's why it makes it seem kind of flat growth if you adjusted around the 6% number.
Got it. Just to close the loop, I guess then some of the data has been, I guess, a little less robust, the MBI, the ISM, et cetera. It sounds like you're still forecasting that the, I call it organic growth, ex the selling days and the M&A, is similar in 2Q versus 1Q.
I think Rustom described it exactly right, Rob, that basically when you net out the extra day, the timing effect of the holidays, the growth rate in Q2 for the base business looks pretty darn similar to Q1. I think that's a very fair description. Sort of the one point he's adding there is, what we do this quarter in particular is always a tricky guide because we have one quarter under our belt. It's December, and then we go into January and February. We modeled January and February. We'll normally look at to provide you with a guidance forecast, we look at our sequential historical patterns. How do November and the first part of December compare to January and February?
What we've modeled implicit in our guidance this year is slightly less of a sequential lift from November, first part of December into Jan, Feb this year, and the thinking there was we got an outsized lift last year. We think because of the tax change, we saw a bigger than normal lift. What we've modeled in is something closer to a normal lift this year.
Got it. All right, I'll pass it on. Thank you.
The next question will be from Hamzah Mazari of Macquarie Capital. Please go ahead.
Good morning. Happy New Year. My first question is just on pricing. It feels like some commodities have come off, oil, maybe some others. Maybe if you could talk about how quickly do commodity changes roll through in your price discussions? Then is there anything different in your customer base that just makes price cost a lot more competitive to get this cycle than prior cycles?
Hamza, what I would say regarding pricing is, look, you're right to call out that there are certain commodities that have come off of what was there. There was some really aggressive growth in commodities for a period of time, and there's some that have come off. I think overall, I would characterize the pricing environment as robust and as a good time for a pricing discussion. When you look at sort of the broad landscape of business, that would include tariffs, that would include freight, that would include wages, pressures that nearly every business is feeling now. I think the environment is actually quite good for pricing.
What I would say is that with respect to commodities specifically, reductions in prices, typically like the same way it works on the way up, you'd have to see that for a sustained period of time before that would, I think, really impact our suppliers view in particular, who are the ones passing us the list price increases on a change in strategy.
Got it. Just on the government side, you had mentioned contract losses, I think previously. I believe most of your exposure is federal versus state, but anything in government that's going on in that segment? Are you pulling back on purpose? Aside from the shutdown, is there any competitive dynamic change in the government business which is causing you to lose share, ex the shutdown?
No, Hamza, no change in direction, really no change in the program or our focus on it. Really what you're seeing from us in government is a function of the two contracts I mentioned on the last call. At this point, it's just a matter of those working their way through the numbers and through our comps. Outside of that, though, it's an important area for us. We're focused on it. I can tell you, inside the team, there's a lot of work going on to try to recapture some of that lost share from those two contracts with other contract wins and opportunities. No change in approach.
Okay. Just last question, I'll turn it over. Maybe if you can frame for us how investors should think about sales force execution risk. What I mean by that is, we integrated Barnes. There were some issues around sales force transformation realignment. I think you just had a recent leadership change in sales as well. Now you're beginning to add headcount potentially late in the cycle. It's not a ton of headcount, but just any thoughts on sales force strategy for MSC and execution risk going forward? Thank you.
Hamza, very fair challenge and very fair point. What I tell you on the sales force front is I actually feel quite good about where we're at at the moment and encouraged by what I'm seeing. What I would say is execution risk was probably highest a year ago as we were going through the changes. We're really on the other side of the changes now. Dave leaving, with the way the timing worked out, really is not a concern. We have the plan. It's in place. The changes have been made. We have a playbook. We have a strong team. Look, we may be adding late in the cycle, but I like what I'm seeing.
Just some proof points there, Hamza, would be number one is, we had a pilot market that sort of predicted when we should start seeing improvements in some of the underlying pieces of the business, particularly in core, and the improvements to our growth rate happened just as predicted from the pilot. That's point 1. Point 2 is the core, which is really where the changes were aimed, is growing high single digits. It's been a while since that was growing high single digits. Didn't touch on it this time in the prepared remarks. We did last time. Our small accounts, our marketing program, which is connected to these changes, the small accounts growing double digits, the strength there continues.
The last proof point I'll call out as to why I'm encouraged and I think the prospects are good on the sales force side is we mentioned that the vending pipeline is growing. That's really a result of getting through the sales changes. With our sales force back and focused, more time in front of customers is leading to an increased demand for vending. Net-net, I'm encouraged. Obviously, it's still early, and I want to see us perform, and I'm by no means declaring victory here. I think in terms of risk-reward, I like the balance.
Great. Thank you very much.
The next question will be from Scott Graham of BMO Capital Markets. Please go ahead.
Hiya. Good morning. Can you hear me?
Yes. Loud and clear, Scott.
Great. Thank you, and happy New Year to you all.
You too.
I was hoping if we can maybe go a little bit down the rabbit hole here on the end markets. I know that you called the industrial environment robust, Erik, but obviously you've got a view on a lot of different end markets. Are there any out there that have either seen pretty meaningful slowdowns in growth in the last six months, perhaps even flipping to negative other than government that you would cite?
Right. Obviously government we hit on. I would say, Scott, generally strong. Again, there are yellow flags out there, right? There's some caution signs that things could change, but right now, strong. I think if I were to call out a couple, one, no surprise, oil and gas. I'm sure you'll remember from our last go around with oil prices that our direct exposure to oil is low single digits. The indirect exposure, obviously way bigger with all of the trickle-down. Certainly, we've seen our oil and gas-related customers soften, no question. That has not extended beyond direct oil and gas. In areas in Texas where last go around when prices really came down, where the softness really extended, we've not seen that at this point.
Oil and gas would be one. The other I'd call out automotive, more as leveling, I think, than acute softness, but those would be the two.
Got you. Thank you. I guess my follow-up question would be, again, on the pricing and not to beat this horse dead, but are you getting any pushback from customers? We've kind of heard in the channels a little bit that customers would prefer to see on certain commodity-related price increases, surcharges as opposed to list price increases. Are you getting pushback in that way? If so, in what pockets of your business?
Scott, no. To answer your question specifically, we are not getting pushback in that regard, and the proof point there is that when there was an increase that was a direct tariff-related increase, those have been passed along, and our success has actually been quite good. Customers have understood. Obviously, we give them specifics, we give them documentation, and they've understood. Our success there has been good. More broadly, I'll let you know next quarter how we do. Look, I would expect that for most of our customers-- Look, no one ever likes to talk about a price increase, but it's important. If we're doing our job as we were in this case with this West Coast customer where we're delivering value and we're bringing documented cost savings, it becomes a much easier discussion.
I guess I'll let you know next quarter, though, how we do.
Yeah. Erik, if I just may just tuck in sort of a question 2A here. Along those same lines, are your price increases in February going to contemplate the list 3 at 25% tariff? To that end, are your discussions with customers going to allow that to sort of stay? I know that's a hard question to ask, that second one, are you contemplating 25% tariff increase in your February price increases?
No, we're not. I think should that happen come March, that would then be sort of a new data point, and we have to assess from there, not.
Very good.
Even the tariff increases we have passed through to date, we have passed them through very successfully, Scott. They have been different, specific, and identified. The idea there with the customers, too, is say, "Look, this is a tariff increase," customers understand it, if the tariff is rolled back, we'd roll that back as well. That is kind of more the surcharge that you were referring to, that approach.
Yes. Very good. Thank you.
The next question will be from Stephen Volkmann of Jefferies. Please go ahead.
Hi. Good morning, guys. Maybe just a couple of quick follow-ups from me, if I could. I want to understand sort of the cadence of the investment in OpEx, and I guess that's mostly sort of sales force additions. It sounds like it'll be similar in the second quarter than it was in the first quarter, and then does it basically go away in the second half?
When you talk investments, we've built up. We've added heads in sales and service. We've added in the vending service, which includes insourcing over there. We've added some people in the CFCs so as to do the demand. That shows up in pick, pack, and ship. The headcount cost increases that we put in are layered in, obviously, and some of them would have occurred partly through the quarter, clearly and on average, when you hire through the quarter, and so you'll see a higher amount of costs coming into Q2, right? That is layered in. For the most part, except for the additional sort of small field, moderate really, for a company of our size, sales and service hiring that Erik flagged, for the most part, there wouldn't be any other big sort of surge after that we're talking about.
That's kind of reflected. A little bit of that will occur in Q2 and some over Q3 and Q4. In the second half, you'd get much more of a positive impact coming through because by that point, a lot of the people, the sales transformation is way in history. The additional ads have been occurring, and people have had time to build up and, in fact, as we've talked for a little while, we didn't expect to see the benefit from the sales headcount really showing up until second half, right? Now we'll see that beginning to flow through. Ditto for all the vending implementation stuff as we brought in people and there's implementations and they roll. Does that kind of cover what you're looking for?
Yeah. Right. That's exactly it. Thank you for that. Next one, just switching to the government business. I know you had the couple of contracts that you lost, but are you also seeing any significant impact of the shutdown, or are the customer-specific sort of sites that you serve still open and working?
So far, Stephen, shutdown impact would be, and early to tell, hard to tell discreetly because most of it occurred during the holidays when it's hard to tell with the numbers anyway. They're so funky during those holiday weeks. So far, from what we can see and our intelligence on the ground, impact is very minimal. Because of where the shutdown is directed and versus where a lot of our spend is, impact appears to be minimal so far.
Okay. Understood. Thanks. Then just my final quick one. Rustom, you mentioned in your comments some additional inventory build around potential supply chain disruptions, and I wonder if you can just give us a little more color on what you think might happen in terms of supply chain disruption.
Just being cautious. If the 25% tariff increases go through in March, we'd like to have more of those products on the right side of U.S. Customs before that occurs. This is deliberate, and that's all there is to it. Not that we're being told of any supply chain disruptions or anything like that. We do have a strong balance sheet, and we're willing to leverage it when need be. The point I made, I'll repeat it again, I talked about it earlier. The stuff that we are buying is inventory in the categories that moves very fast. If, for instance, these tariff increases don't occur, okay, and then there's resolution, then yeah, we'll tune down our buying and burn it off fairly quickly.
Understood. Thank you very much.
Thank you.
The next question will be from David Manthey of Baird. Please go ahead.
Hi, good morning, guys. Happy New Year.
Hey, Happy New Year, Dave.
First off, looking at contribution margins here, clearly they've been below your expectations, and I think the second quarter implies a negative result. Thinking about the second half of your fiscal year, when you look at the operating framework, it would imply clearly an improvement there, even as much as 20% with pull-through margins closer to 50-plus. Rustom, in your comments, you mentioned price, sales force effectiveness, front-end loaded investments, and acquisition contribution as factors that you hope to get leverage on in the back half. Is there any way that you can quantify those factors to give us some clarity or comfort on the outlook?
Yeah. Look, it's just a normal sort of sequence on average. We look at the last four years, just the normal average, there's like 100 basis point difference between the operating margin in H1 and in H2, right? No reason why we shouldn't, at a minimum, see that. You add to that all these others, the size and timing of the price increase, the AIS, only two months of AIS compared to six. The full effect in there. The holiday impact, don't forget that. That's probably about 20 basis points. By that, again, I'm getting away from the ADS that we talked about earlier. It's just the absolute loss of sales that we would have by having those two Monday, Christmas Eve and New Year's Eve. Absolutely. The others, you talked about it. That's why.
That's what gives us confidence that we'll be in the framework.
Dave, I think a little tricky. Rustom mentioned the holiday impact was about 20 basis points in Q2, of a drag in Q2. Some of these others are hard, particularly with pricing. We're going to wait and see how we do when we roll it out. Growth will be a function of how strong the growth is in the back half of the year, how much leverage. It's tough to quantify other than to say, if we looked at the four-year average of 100 basis point lift, H2 to H1, there's several tailwinds here that say to us, if we execute properly and nothing major changes in the environment, could push it considerably higher.
Okay. Thanks, Erik. Second, when you think about the sales force effectiveness efforts, how would you expect them to most manifest themselves in the second half results? What financial metrics are you watching that you think will reflect the benefits the most?
That's a good question, Dave. Look, over time, there's going to be metrics like sales force productivity. What I would tell you is, given that we've just started, we hadn't added sales heads in a while because of all the changes we were making. We just started in the fourth quarter. That takes a little bit of time. Obviously, internally, you can imagine we measure the new people 10 ways till Sunday. In terms of seeing that evidence itself for you, it's going to take a little time. Look, I think the biggest proof points that I'm going to be looking for that I think are tangible for you are going to be core growth rate, are going to be national accounts growth rate.
Part of what we've done here is also free up some of the national account sellers and should translate into improved signings, more signings that layer into growth there over time. Then I think things like vending, which to be honest, was sort of an offshoot that we didn't necessarily anticipate coming out of the sales force changes, seeing the acceleration in vending. What you'll see there over time, if we execute properly, is you'll see the growth contribution from vending as these signings and implementations layer in. We should see improved growth contribution there over time. Those are the metrics for now. I think over time, as the sales head count, as people settle in, we'll be looking at productivity measures.
Internally, because we don't do a one-size-fits-all approach to our sales anymore, right? That was the whole sales transformation. Internally, we look at the different categories of salespeople that we're hiring, all the way from inside sales to hunters and things. We look at whether they're achieving their plans in terms of revenue growth and new account signing.
Great. Thanks for the color, guys.
Thank you, Dave.
The next question will be from Adam Uhlman of Cleveland Research. Please go ahead.
Hi, good morning, everyone, and Happy New Year.
Happy New Year, Adam.
Hey, can we go back to the timing of the February increase? Could you maybe just expand a little bit more on why the price increase was delayed from January into February? Was it a function of the absolute number of price increases that you were seeing from suppliers, or did the magnitude catch you off guard relative to maybe what you were hearing several months ago? I guess I'm just trying to better understand, was there an issue of just updating your price file in a timely manner that led to the delay of the price increase versus what you did last year?
Adam, absolutely. I'll hit this. Yeah, it's pretty simple, which is, look, when we go out with price increases, we try as best we can to minimize the number of times that we hit our customers with increases. Okay? Look, there are times in a real inflationary period where we could be taking pricing up three, four times a year. Usually, let's put tariffs to a side because Rustom described that's a very specific instance. Usually our cycle is two times a year, around the summer and around early in the calendar year. What we were seeing was late in the calendar year into January, meaning into this month, a significant number of list increases from our suppliers. Look, that's what we've been hoping for for a while. I think it came to fruition as we expected.
For us, the trade was to, by waiting an extra month, what it allowed us to do was capture more increases coming in January and go to our customers one time as opposed to missing out on that opportunity. That's pretty much it.
Okay. Gotcha. Thanks. That's helpful. Back to the gross margin on the quarter, I guess mix was mentioned as being a negative, but at the same time, the discussion was that core customer growth was up high single digits and small customers were up double digits. Was this a product mix headwind that we experienced, and how do you think about that for the rest of the year?
It's also mixed within categories. For example, national accounts, we've had some of our lower gross margin accounts in national accounts that we have either won or renewed, have lower gross margins relatively, have been growing faster. That's a negative mix in national accounts. Look at vending. Erik made the point about vending is one of our sort of strong positives in terms of revenue growth. Vending does come through at a lower gross margin.
Adam,
Oh, sorry.
You're right to call out, and we saw the same thing. In the numbers, mix is a pretty broad umbrella. Underneath our mix bucket, there's 10 or 12 moving parts that we're looking at. You are calling out two that within the mix bucket would be tailwinds. Core growing faster, government growing slower. What Rustom called out is a couple of others that offset that being the national accounts mix and vending being two in particular.
Now having gone into a little bit of detail, if I take it up to very top level, if we have our disaggregation, our stats. I mean, the price/mix in this quarter was about 80 basis points. It was about 50 in Q4. The price/mix from that perspective has actually been a positive too. There's different ways to look at this, a business with as many products and customers as we have.
Okay. Thank you.
The next question will be from Ryan Merkel of William Blair. Please go ahead.
Hey, thanks. Good morning. Thanks for fitting me in.
Hey, Ryan.
Hey, Ryan.
I want to start with gross margin for the year. Erik, how likely would you say that we're going to be in that gross margin expansion part of the framework?
Look, Ryan, a lot of this is going to hinge on our price realization. Obviously, sort of stating the obvious. It's a little early. We put that framework out there, and as you know, what we did kind of the middle of that line this year was basically the Q1 jump-off point, right? The sort of the plus or minus range was around 43.0, 43.1. Let's take a look at the first half. If we hit the midpoint of guidance in Q2 is 42.8, we hit 43, that averages to roughly around 42.9. We're sort of right underneath the line. Close, but underneath the line. Obviously, I'm going to state the obvious one more time, to get above the middle of the line, we'd have to be north of 43 and north of where we were Q1, Q2.
On the one hand, costs are going to keep going up, on the other hand, look, we have a meaningful price increase that's coming late in Q2, a lot of it is going to hinge on how we do in realization. I hate to punt on you, Ryan, I think we'll have a better feel with a quarter under our belts to see how realization goes.
Yep. I get it. Understood. All right, on price cost, I may have missed it, what was the headwind there for the current quarter for the 2Q guide?
In price/mix, it's actually a tailwind, if you look at the numbers. In our disaggregation, we have about an 80 basis point improvement. I was making the point that it was actually better compared to last sequentially, the quarter before that, Q4. Right? The point on cost was that because of our average costing system and the way things work and the lag effect of cost feeding into our system, we have a steady increase in cost going on each month, right? Whereas our price increases occur, as you know, every six months. After the price increase that we put through last year in the summer, right? The next point in time at which our prices go up is February, once it goes through the-
Ryan, take it real simple. From Q1 to Q2, you look at the decomposition of growth and that price mix thing, which is our best proxy on price, was plus 70 basis points. Our models would assume that given pricing, our next increase comes late in Q2, not much changes on the price front in Q2, and yet costs go up, and those two things, the net of those are resulting in what you see, which is a 20 basis point sequential decline.
Yeah, I'm really asking about price cost just to quantify, sort of see the progression. My understanding was in the current quarter, it was going to be about a 10 basis point headwind. Seems to me it's actually going to be a little bit bigger in 2Q because you pushed back the price increase, but then presumably you could be positive in the second half.
You got it right.
Correct? Okay.
Yes, you got it right. Price cost actually worsens a bit in Q2 for that reason, that we don't get a lot more in price and we have costs going up, and then again, costs will go up again in Q3, Ryan, right? If we had no pricing, price cost would turn more negative. If we get good realization on the price increase, I'd expect a much better result.
Right. Okay, just lastly, and this is a question I get from investors, but you have these national account contracts where typically there's a six-month price window for you to pass along price. How are you navigating that? Is that a headwind, and is there any offset?
Look, so it depends, and without Ryan getting too sensitive information with a lot of our commercial contracts, but there's different ways that each contract and each customer, there's different terms. It's not a one size fits all on the national accounts is what I would say to start. Look, historically, what we've seen for mid-years is that there are cases where timing prevents us from getting all of the price day one. In virtually all of our contracts, there are set periods for pricing discussions. Look, we expect, given what's gone on, when those times arise, we expect to get pricing through based on what's happening to cost, all the documentation we have, and then what we're doing for customers in terms of cost savings. Our expectation is that we get the pricing through when allowed for by contract, and that varies.
Got it. Very good. Thank you.
The final question this morning will be from Ryan Cieslak of Northcoast Research. Please go ahead.
Thanks for fitting me in here. I hate to go back and continue to focus on pricing, I just want to make sure I understand what you're saying, Erik. Obviously, demand seems like there's a potential for it to slow here in the market going forward. Commodity costs have rolled over a little bit. What gives you the confidence that the realization, because ultimately that seems like that's the linchpin here. If you could see the type of realization that you want to see, that's going to benefit, obviously, the markets going forward. What gives you the confidence that you can sustain at least the type of realization you saw this past year versus actually seeing maybe less realization just because the environment's starting to slow a little bit?
Ryan, good question. Look, I'd point to a couple things. One is the backdrop. While commodities have softened again, go back to a lot of, for many businesses, one of the large inputs. The tariffs have been significant, wage inflation's significant, freight inflation has been significant. There is a backdrop of costs going up, one. Two, when we bring a price increase to our customers, it's supported with a lot of detail and backup, meaning that we're not just taking pricing up for the sake of taking pricing up. It's where we can point to our suppliers having passed along list price increases. I think it's justified, and we show documentation. Three, going back to value proposition. Look, we invest a ton of time and money in effort into helping engineer savings for the customer.
Generally, with most of our customers, in most cases, there's a win-win relationship and an understanding that we're entitled to get paid if we're in fact bringing the value and documenting the value. If we're not, shame on us, but I think in most cases we are, and with most customer relationships, it's win-win. Those are the things that would give me confidence. Again, Ryan, to be determined. We'll see how we do with the pricing under our belt, but those are the reasons I would have confidence in seeing solid realization levels.
Okay. Just to go back to the comment being made about the back half of the year margin trends being significantly higher. It seems like there's a lot of pieces that can drive that. If you assume that the market and demand stays stable, it doesn't get better, doesn't get worse from here, are you saying that you can actually get towards the higher end of your incremental margin outlook that you've typically given, which I think has been like 20 to low 20s to high 20% type of range? Is that what you're trying to say, or are you saying actually even better than that just based on all the different moving dynamics?
No, we're really saying that in the second half of the year, most of the conversation that occurred earlier was all around operating margin and the difference in the operating margin between the expected H1 and the likely H2. I don't want to use the term expected because it's too early to call for it, right? That was what more of the discussion was about in terms of that. In terms of the incremental margins, incremental margin is a factor of many things. Gross margin is one of them, operating expenses is the other, revenue growth, all the rest of it. We're not saying that we would be coming in at the high end of our 20%.
Yeah, Ryan. A couple of points to make just to ground us. One is if you take that annual framework and you look at the midpoint of that annual framework, it implied incremental margins actually slightly below our long-term 20% range at the midpoint. As you got high up in the high quadrants, you get up north of 20, but the midpoint was to begin with. The second thing is, look, just to be grounded in reality, let's assume we hit the midpoint of Q2. I think Dave Manthey mentioned it early, incrementals in the second quarter were negative. If you look at the average, we're like low single digits incremental margins for the first half of the year. That makes getting to 20%, which is the long-term range, and absolutely still our belief longer term where we could be.
For this year, that would mean we'd have to do something like close to 40% incrementals in the back half.
That's it.
Realistically, that's unlikely. What we were trying to get across, though, is that the back half of the year, as Rustom said, should be considerably better. That was the point.
Looking past step 19, there's no reason we shouldn't be back to the 20%-30% range for incremental.
Okay. Just the last one, I'll get off the line here. Any update on the timing of hiring a new sales lead? I know it's still early, I just wanted to see if you have just an initial thought directionally of when a decision might be made. Thanks.
Yeah, Ryan, what I would say there is search is underway. We have a very strong interim leader in the place. Search in place in the interim, search is underway. One of those things that's tough to give you an exact timeframe, obviously a top priority for me, we're going to move quickly, we're going to make darn sure it's the right person and not let a timeline get in the way of finding the right person. In process.
Okay. Thanks, guys.
Ladies and gentlemen, this will conclude the question and answer session. I would like to hand the conference back over to John Chironna for closing comments.
Thank you, Denise, and thank you everyone for joining us today. Our next earnings date is set for April 10th, 2019. We'll be attending a number of conferences and field trips over the coming quarter, so we look forward to seeing you and speaking with you over the coming months. Take care.
Thank you. Ladies and gentlemen, the conference has concluded. Thank you for attending today's presentation. At this time, you may disconnect your lines.