Good morning, and welcome to the MSC Industrial Direct Co. 2018 third quarter 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 0. 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 your question, please press star then two. Please note this event is being recorded. I would now like to turn the conference over to John Chironna, Vice President, Investor Relations and Treasurer. Please, Mr. Chironna, go ahead.
Thank you, Anita, and good morning to everyone. I'd like to welcome you to our fiscal 2018 third quarter conference call. In the room with me 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 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&A sections of our latest annual report on Form 10-K filed with the SEC, as well as in other SEC filings. These forward-looking statements are based on current expectations, and 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.
Thanks, John, good morning, everybody. Thank you for joining us today. I'll begin this call with an overall assessment of our third quarter performance, which is consistent with my assessment of last quarter. First, our strategy to position the company in highly defensible niches, as well as our execution on the buy and the sell side, continued to deliver gross margin stability. Second, our ongoing productivity efforts throughout the company resulted in strong incremental margins and operating margin expansion. Third, our focus on working capital delivered strong free cash flow generation. Finally, I'm pleased with the performance of our two recent acquisitions, Deco, which has begun producing earnings accretion ahead of schedule, and AIS, which is off to a nice start. All that said, like last quarter, our organic growth rate continues to fall short of my expectations.
Given the current environment, as I had said last quarter, I believe that we should be growing well into the high single digits, at present time, we are not. We know that this is mainly due to the impact of our sales effectiveness initiatives and the related lower sales headcount, we fully expect MSC to return to our more typical organic growth levels after a couple of quarters. My assessment is reflected through our third quarter numbers. Sales growth slightly above the lower end of our guidance range, gross margins at the midpoint of guidance, incremental margins of 28% on the base business, earnings per share $0.01 above the midpoint of guidance when factoring in the AIS dilution, which we had anticipated. Turning to the environment, manufacturing conditions generally remained solid.
MBI readings, while moderating from earlier highs, continue to reflect expansion with March and April at 59.5 and May at 58.6. Adding the June reading of 57.8, that brings the rolling 12-month average for the MBI to 57.6, pointing to continued growth in metalworking end markets. All of this is reflected in our customers' order volumes and the backlogs. Like many others, we're watching the tariff developments closely. We have not yet seen tariffs impacting customer demand, although they are now top of mind for both customers and suppliers and are beginning to impact manufacturing input costs. We're just beginning to see cost pass-throughs from some suppliers, as of now, it's still way too early to predict any longer-term implications. The pricing environment remains solid. We implemented a moderate price increase in late January and saw nice realization.
Price contribution, which had turned positive in our fiscal second quarter, stayed in positive territory in the third quarter as expected. Commodities, freight, and wages are all rising. To date, however, the number of our suppliers who have raised their list prices since our last increase in January is more limited than the inflationary pressures might suggest. This will, of course, impact the size of our pending price increase. That said, should these inflation pressures continue, we expect to see considerably more price increases from our suppliers to come, that would be reflected in our fiscal 2019 mid-year pricing actions. Turning to our performance in the quarter, sales growth was slightly above the bottom end of our guidance range. March comparatives were negatively impacted by the timing of the Easter holidays this year, while April then benefited.
Through most of April, we were on track to achieve the midpoint of our sales guidance range. We then saw some softening in May. For the quarter, our government business grew low single digits, but it dropped sequentially through the quarter. National accounts grew in the high single digits, while growth for core and CCSG were both in the mid-single-digit range. DECO maintained its strong double-digit growth pace and continues to exceed our expectations. I spent some time in Iowa two weeks ago with the DECO team and came away very excited about our continued prospects for growth. AIS had a small but positive impact on growth given the timing of the acquisition. Before going further, let me talk a bit more about AIS now. We have three primary filters when evaluating acquisition candidates: strategy, culture, and financial performance. AIS has passed each of those filters.
First, on strategy, AIS competes in the OEM fastener market, which is a technical and high-touch niche. AIS's sales team interacts directly with customers' engineers to design fasteners that go into the final product. They then deliver those fasteners through a hands-on vendor-managed inventory service. It's closely related on the plant floor to metalworking and our Class C parts, so it's a good complement to our existing business. In fact, many of our existing manufacturing customers have a need for these production fasteners, which creates an exciting cross-sell opportunity. Second, much like DECO, AIS has a strong culture whose values line up closely to ours, and that's a testament to CEO Jim Renz and his team.
Third, we look for acquisitions to be accretive by their second full year with us and to achieve a return on invested capital above our weighted average cost of capital in the third full year. We expect AIS to meet both of those financial hurdles. Turning to e-commerce, it was 60.6% of sales in the quarter, up slightly from the same quarter last year and from last quarter. The overall trend remains positive and consistent with e-commerce increasing moderately as a percentage of overall sales. As I've said before, it is important to note that our e-commerce sales include all forms of automated selling. For instance, product sales that go through our vendor-managed inventory solutions and our vending machines account for slightly less than half of our total e-commerce sales. Speaking of vending, in the third quarter, sales to vending customers contributed roughly 300 basis points to growth.
Rounding out the results of the third quarter, our total net active salable SKU count was just over 1.6 million, flat with last quarter. Given the success of our SKU expansion program, we are accelerating it during our fourth quarter. This will positively impact sales growth in fiscal 2019. As I mentioned earlier, our recent performance has been tracking below the levels that I would expect due to the impact of our sales effectiveness initiatives and the related lower sales headcount. For many years, we've operated with what could be described as a one-size-fits-all sales model. This worked for a long time, and we grew our top line nicely. As the market changed and the sales process became more technical and complex, we recognized the need to evolve our sales model.
Today, a heavy premium is placed on solutions and documented cost savings for the customer, which is a positive development for us given our metalworking expertise. It requires making our sales model more effective, and we're doing so by differentiating between our customers and clustering our salespeople who serve those customers. As a result of these changes, we'll be positioned to better meet our customers' needs and should be able to grow our top line without the same percentage increases in headcount as were needed historically. That, of course, means leverage and productivity. We've been implementing these changes over the past year. As we did so, it did not make sense to hire salespeople, so sales headcount has come down by design. We did not want to bring in a lot of new sales talent only to change their position within the first few months of joining us.
There's no question that there's a connection between sales headcount and top-line growth over time. Of course, there also was and is some level of distraction for the current sales organization as we put these changes in place. Changes in assigning reps and accounts, and we are now beginning to recruit sales talent. Excluding AIS, our sales headcount was down very slightly by a handful of people from the second quarter to the third quarter. As I also mentioned on the last call, we do expect that number to grow moderately in this coming fourth quarter and then into the start of fiscal 2019. I'm encouraged by several early indicators that our new model will produce the results we expect. First, our pilot market is showing strong performance with growth rates that are in line with our high single-digit expectation.
Second, while mid-single-digit organic growth is not up to our standards in this environment, when coupled with mid-single-digit declines in organic sales headcount, we're seeing growth per salesperson in the double digits. Third, our leadership spends a lot of time in the field with our sales team. Feedback on the ground is positive that these changes, while not easy in the near term, are absolutely the right thing for our business and will lead to a more effective sales model. Of course, it takes time for our new associates to become productive, so we do not anticipate an immediate lift in sales. As I look past the next couple of quarters, I am very confident that these are the right changes and will deliver stronger growth levels more in line with our historic expectations. Now over to Rustom.
Thank you, Erik. Good morning, everyone. Before getting into details, let me remind you that we had provided Q3 guidance for both the base business, which excluded DECO and AIS, and also for our total company, which included DECO. AIS was acquired on April 30th and was not in our Q3 guidance. We owned AIS for just over a month in our Q3, and it generated sales of $6.7 million and a $400,000 operating profit before $1.8 million of transaction expenses and purchase accounting requirements pulled it into the red. Rather than talk to three sets of numbers, on slide four, we have provided you with our reported results as well as the impact of AIS so that you can see clearly how we performed versus guidance, which again, was provided before AIS was acquired.
We will still discuss our reported Q3 results. Let's do that now. Total average daily sales for the third quarter were $13 million, an increase of 11.4% versus the same quarter last year. DECO continued to generate double-digit growth, high teens, in fact. AIS's ADS growth was in the high single digits. Base business organic growth at 6.1% was just above the low end of our guidance range. Erik's already covered the key drivers. I will simply reinforce his comments by noting that our sales performance gap is isolated to the base U.S. business where the sales effectiveness changes are underway. Our reported gross margin was 43.6% for the quarter, in line with our guidance after taking into account the 20 basis point negative impact of AIS. The 70 basis point year-on-year reduction came entirely from our two acquisitions.
That negative mix effect was exacerbated by a $1.1 million AIS purchase accounting charge required to amortize the stepped-up value of acquired inventory. Excluding the acquisitions, our gross margin was 40 basis points higher than last year's Q3, which as you may recall, came in below our expectations at the time. Pricing and mix, along with higher supplier rebates, were the major drivers, more than offsetting product cost inflation. We continue to drive productivity with OpEx to sales declining 90 basis points from last year to 29.7%. Total OpEx was $246 million versus last year's $228 million, with about $7.5 million of the increase coming from the acquired businesses. This included $0.7 million of one-time AIS transaction costs. Our base business OpEx to sales was 30.2%, 40 basis points better than last year's Q3.
Of the $10 million year-on-year increase, roughly $5 million can be attributed to volume-related variable costs, such as pick, pack, ship, freight, and commissions, and $3 million to higher incentive accruals. Productivity and cost controls offset much of our investment spending and our general inflation increases, including fringe and merit. Our third quarter operating margin was 13.9%. It's worth noting that we absorbed $1.8 million of AIS acquisition costs and purchase accounting charges in this. This pulled our operating margin down by roughly 20 basis points. Our base business operating margin was 14.5%. This was an 80 basis point improvement on the comparable 13.7% reported in the same quarter a year ago as we achieved a higher gross margin and also leveraged our OpEx to deliver incremental margins at the high end of our long-term incremental margin range.
As you know, we aim to deliver 20%-30% incremental margins on an annual basis. The drivers of incremental margins are sales growth, gross margin movement, and OpEx leverage. Year to date, our base business gross margin is 44.6%, unchanged from fiscal 2017, while we have leveraged our OpEx with a 70 basis point improvement. After three quarters, we have delivered a 24% incremental margin on 6% organic growth. Of the recent Tax Cuts and Jobs Act impact, our total tax expense for the fiscal third quarter was 29.3%, slightly better than our guidance of 29.5%. This was mainly attributable to a higher benefit from share-based compensation. All of this resulted in reported earnings of $1.39 per share. A strong third quarter EPS performance from DECO more than offset the $0.02 of dilution from AIS, which was comprised of acquisition costs and purchase accounting charges.
After allowing for AIS's dilution, our actual EPS came in $0.01 higher than the midpoint of our guidance range. Last year's Q3 reported EPS was $1.09. A fairer comparison would be to exclude both the negative impact of AIS's acquisition costs and purchase accounting charges, as well as the benefits of the Tax Cuts and Jobs Act, and this would yield EPS growth of 14% versus the prior year period. Turning to the balance sheet. Our DSO was 56 days. Consistent with historical trends, this increased two days from the second quarter. DSO usually drops in our fiscal second quarter, then goes back up in the third. DSO has also trended higher in recent years due to national account growth. We will continue to focus on receivables with an aim to offset this customer mix headwind as much as possible.
Excluding roughly about $20 million of inventory from the AIS acquisition, our inventory declined slightly during the quarter. Base business turns remained sequentially flat at 3.5 times. Looking ahead to the fourth quarter, we expect inventory to increase as we protect against some longer lead times and also buy ahead of expected price increases. Net cash provided by operating activities in the third quarter was $112 million versus $62 million last year. The main drivers were working capital, which had an $11 million inflow this year versus the $22 million outflow last Q3. Cash income taxes paid were $7 million lower, and net income was $16 million higher. Our capital expenditures in the third quarter were $14 million, and after subtracting capital expenditures from net cash provided by operating activities, our free cash flow was $99 million as compared to $50 million in last year's fiscal third quarter.
Our free cash flow generation has been solid all year, with $199 million generated year-to-date versus $121 million last year. We ended the third quarter with $536 million in debt, comprised mainly of a $284 million balance on our revolving credit facility and $225 million of long-term fixed rate debt. We also ended the quarter with $40 million in cash and cash equivalents, and our leverage ratio remained at one times. Let's move to our guidance for the fourth quarter of fiscal 2018, which you can see on slide five and is shown with and without acquisition. Excuse me. We expect total company ADS to increase by 8.2%-10.2% versus the prior year period. This includes 3%-5% of organic growth and around 500 basis points from acquisitions.
Our preliminary base business ADS growth rate in June was 3.1%, and this was impacted by two primary factors. First, we had an extra selling day this June, which negatively impacted ADS. Absent the extra day, the June growth rate would be more comparable to July and August projections of roughly 5% ADS growth. The second year-over-year factor affecting June was government spending. In June, our government growth rate turned significantly negative as we did not see the typical uplift in daily sales. At this point, we're assuming some government spending pickup as we enter the last quarter of the government's fiscal year, but not as much as in prior years. Our fourth quarter total gross margin is expected to be 42.7%, ±20 basis points, with 100 of the 150 basis point year-over-year decline due to the acquisitions.
In Q4, we will complete the purchase accounting amortization of AIS's inventory step-up. This alone accounts for a non-recurring 40 of the 100 basis point headwind. Sequentially, Q4 total company gross margin is expected to be 90 points lower than in Q3. Roughly half is from AIS and the remainder from our base business, which is following the typical seasonal pattern in which gross margin drops largely due to product mix and the sale of more heavily discounted items. We often point out that there are quarterly swings in many line items and try to look at numbers on a full year basis. Gross margin is no exception. If Q4 comes in at the midpoint of guidance, our full year base business gross margin will be 10 to 20 points lower than the prior year.
Fourth quarter operating expenses are expected to be around $250 million, up $17 million from last year's fourth quarter. Acquisitions account for roughly $9 million of this. Year-over-year, total OPEX to sales is expected to improve 110 basis points to 29.9%. Variable expenses associated with our higher sales account for $4 million. The bonus accrual is expected to be $2 million higher than last year's Q4. The remainder comes mostly from investment spending, medical cost inflation, and salary inflation, partly offset by productivity. Excluding acquisitions, we expect our OPEX to sales ratio to improve in Q4 by roughly 70 basis points. Again, taking a full year perspective, if actual OPEX to sales ends up in line with our Q4 guidance, this ratio will have improved by approximately 70 basis points versus fiscal 2017's full year.
We expect the fourth quarter's operating margin to be approximately 12.8% at the midpoint of guidance, a 50 basis point decline over last year's Q3, due entirely to the impact of acquisitions. Base business operating margin is expected to be 13.7%, up 20 basis points from the prior Q4. At the midpoint of our Q4 operating margin guidance, excluding acquisitions, we expect to achieve an operating margin for the full year well within our operating margin framework for fiscal 2018, which you see on slide six. It would also mean that our annual incremental margin would be around 22% in fiscal 2018. Our estimated tax rate for the fourth quarter is 29.6%, consistent with what we said in January. Our guidance also assumes no significant change in our weighted average diluted share count from Q3. Our fiscal 2018 fourth quarter EPS guidance range is $1.24 to $1.30.
Note that this is after absorbing $0.03 of net dilution from AIS, which includes a $0.04 negative impact from the purchase accounting amortization of AIS's inventory step-up. I'll now turn it back to Erik.
Thank you, Rustom. I'll conclude with some brief additional remarks and then we'll move to Q&A. While I'm not pleased with the organic growth that we're delivering right now, considering the environment, I fully expect us to return to our more typical organic growth levels after a couple of quarters, and our team is intensely focused on this. As we do so, we'll benefit from the leverage inherent in this business and continue to achieve our long-term annual incremental margin target range. We'll also maintain our focus on growing areas that are technical and high touch, creating a deeper moat around the business. All of these are critical to our long-term success, and I am confident in our ability to deliver. Let's now open up the call for questions.
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. To withdraw your question, please press star then two. The first question today comes from Evelyn Chou with Goldman Sachs. Please go ahead.
Hi. Good morning, Erik, Rustom, John.
Hey, Evelyn.
Thank you. Maybe just starting out on the Salesforce effectiveness initiative. Helpful to understand your expectation that that will resolve in a couple of quarters. Is it about reacquiring lapsed customers? Is it about expanding share of wallet at those customers? Is it more about driving new business? How do you kind of think about the drivers of the headwind you're seeing in organic sales today? To that point, what kind of metrics are you looking at to understand the path to recovery?
Yeah, Evelyn. It's an excellent question, and I think what it helps tee up is a very important distinction of what's happening in the business right now, because it's really sort of like a tale of two cities. When we look at our existing base of business, meaning business with existing customers, I give us strong grades. We're growing nicely. Where the largest delta is from our historic growth rate is new business generation. I guess it shouldn't be surprising given the Salesforce decline that that's where the biggest toll is. The biggest part of the plan right now as we move through these changes is getting the sales headcount back, and it's directed specifically at new business generation, which is where we see the gap relative to historic performance.
Thanks, Erik. Then maybe a more granular question, just thinking about the gross margin line. I think if you look at gross margins ex the acquisitions, in 3Q they actually expanded year-over-year. In 4Q, it looks like the guidance on a core basis implies a decline year-over-year. Would just be interested in understanding the dynamic there.
Sure. Let me take that, Evelyn. The primary driver of the 4Q sequential drop is a normal seasonal pattern that we see due to sales of lower margin summer products. We don't expect the erosion to continue, particularly given our planned summer 2018 price increase. Also, if you're looking year on year, another reason why we don't think 4Q is the start of a trend or anything was that last year there was an unusual pattern with 3Q dropping and 4Q rising. Of course, finally, taking the longer-term view, which we always say, we focus on more than a quarter.
All right. Thanks, guys. I'll get back in queue.
The next question comes from Ryan Merkel with William Blair. Please go ahead.
Hey, thanks. Good morning, everyone.
Hey, Ryan.
First question I had, if I adjust June organic growth for the days and maybe a little bit for the government, that would get you to 5%-6% organic. This implies that the lack of hiring and the distractions are impacting results by about 300 basis points to get you back to high single digits. Is that the right read, Erik?
Yeah, Ryan, I think you got it right. As we look at it, obviously the print on the organic growth rate in the Q4 guide is down from Q3. As I assess the performance, it's very similar assessment. Rustom outlined that, look, in reality, when you account for the extra day last year, just to be clear, July 4th fell on a Tuesday. We were closed that Monday. Just the day differential, the one-day differential takes the 3.1 back to roughly five, which is where the July, August implicit is. The second change, you're exactly right, is government where historically what happens, and just to be clear, it's not so much that ADS has fallen that we're not getting the lift that we normally get due to year-end spend. We've got a lot of intelligence on the ground in government.
From everything we're reading, this is not share loss, this is lack of year-end spending to date. In normalizing for those two things, yeah, correct. Q4 looks a lot like Q3, which looked a lot like Q2. To be clear, those are still under our expectations, and I think you're right in terms of the kind of gap to historical expectation of somewhere in the 200-300 basis points is right on.
Okay. 200-300 basis points is what we need to make up, and you said it was a couple of quarters, and I think you need to hire the sales folks, and then it takes two quarters or so for them to get productive. Should we be thinking about sales recovery back to normal in the second half of fiscal 2019?
I think, look, absent any other changes, I would say that's a reasonable assumption. The reason I say a couple of quarters is you're correct, Ryan, that it takes a few quarters for a new hire to get fully up to speed. We are mindful that we've moved through a lot of changes. There's some distraction that should be behind us, so we should get some benefit from that sooner, with the sales benefit of the incremental heads being a little further out. Net, yeah. About right.
Okay. Lastly, I want to clarify the comments about historical incremental margins, even while you hire these sales folks. I think that means 20% or 30% incremental margins. I want to clarify, you think that you can do that in 2019, even while you're adding these heads? Then once the heads become productive, would you expect that that would help the incremental margins? Again, in the back half, maybe biased up.
Hi, Ryan. Let me take that. Yes, we do expect, regardless of this investment, our long-term annual incremental target range of 20% to 30%, we expect to be able to deliver that. The second part of your question, as the salespeople become more productive and all the rest of it, you get the contribution from it, I think that will still keep us in that 20% to 30% range. We're not saying we're going out of it either.
I do think, Ryan, I think the point is right, that if we looked first half of the year, back half of the year, yeah. If you ask me right now, we're not giving, we've got another quarter before we'll give an annual framework that one would think the performance should get better as the year goes on if you look out past a couple of quarters. The biggest driver there, Ryan, being the growth rate. Obviously, to the extent the growth rate is higher, that's going to move us further up in the incremental margin range.
Right. That's kind of what I was thinking. All right. Thanks a lot. Appreciate it. I'll pass it on.
You got it.
The next question comes from Scott Graham with BMO Capital Markets. Please go ahead.
Hey, good morning.
Hi, Scott.
Hi, Scott.
I have two questions. The first one is simply, I know that we're trying to improve effectiveness of sales and trying to tune them into the more market-specific focus, solutions, end markets, the whole thing. I guess what I'm wondering is, sales were kind of going along okay, and why are we maybe kind of doubling down, or however you would want to put it, Erik, right now at the height of where sales growth in short cycle is? It just seems like you'd kind of want to let it ride for a while before we do anything that could potentially be disruptive. Why the timing?
Got you, Scott. Really sort of two questions embedded there. One, why do it? Two is why do it now? In terms of the why do it, look, I think you're right. Historically, the model produced pretty good rates of organic top-line growth. If you look back over a number of years, we weren't getting commensurate leverage on that. The model was losing productivity and effectiveness for a lot of the reasons I mentioned, changes that happened outside of the company, changes in the market. We are very confident that these changes are the right changes, and this is the right model for the future to deliver the top line and get more leverage out of it so that we don't have to add at the same rate we added historically. That's the why. Why now?
Look, the answer is, and obviously with hindsight, sort of you never know when you go into something, but I will tell you, we take a long-term perspective on the business. The answer is, if we felt, and we did feel, that this was the right thing to do, it sort of didn't matter whether it was high in the cycle, low in the cycle. We're taking a long-term perspective, and from our standpoint, if it's the right thing, the sooner to get it in, the sooner we'll get the benefit and we come out the other side, and the better for the shareholder over the long run. That's really the answer on why now.
Understood. Thank you. That I kind of fashioned as one question, but I see how you looked at it as two. My other question was, what percentage-
Scott, I wasn't trying to give you your question. Sorry.
No, that's fine. What % of your supplier cost, let's just say your inventory input, is sourced out of China? Could you tell us that?
Look, we've shared that the direct percentage of sales that are coming directly from Asia, meaning not through a lot of the products we sell are branded manufacturers who may produce around the world. Those branded manufacturers represent the vast majority of our purchases. For what we source directly is relatively small. Call it under 20%, in that range in terms of total impact. I guess if where you're going is with respect to tariffs, the other thing I'll say is we have a lot. That would be global. We have a lot of sourcing flexibility within that, where our sources will come from various parts around the world.
Right. Wouldn't that, because you're kind of tuned to the way you are right now, would that lead to higher input costs for you?
Look, I think certainly, no question that the discussion of looming tariffs has the potential to raise input costs. As I've mentioned, we are beginning, and just beginning, to see that now. Two things. One is, that should lead to pricing opportunity. Historically, when costs go up, we are able to at least recover those costs in the way of pricing.
Right.
The second thing I'd say is that, Scott, we're pretty well positioned. One of the ways we market our product offering is a good, better, best offering. If you go to most of our categories, you'll see branded manufacturers. You may see something that's sourced overseas. You're likely to also see an alternative, particularly in our bread and butter of metalworking, that would be a Made in USA product. That gives us a lot of flexibility. To the extent we see over time, real cost pressure, we have the ability to move, both from a sourcing and a marketing standpoint for our customers to domestic product.
Scott, just one tiny add to that. Just like we have opportunities to adjust sourcing, our suppliers, for the most part, have facilities all over the world, and they will also be moving around their sourcing and looking at the implications of the tariffs when these things finalize.
Comprehensive answer. Thanks, guys.
Thank you, Scott.
The next question comes from Robert McCarthy with Stifel. Please go ahead.
Good morning, everyone.
Hey, Rob.
Hey, Rob.
Yeah. A couple questions that are not meant to be bracing. Just prepare yourself. I guess the first question is, it's kind of to Scott's point, and I think Ryan's. You can go through this sales reorg and come out the other side and capture share, but you are a short cycle business. The question becomes, is there a risk here you could miss kind of the fat of the upcycle here, right? As we go into next year, that you've just structurally lost 300 basis points of sales going forward, right? What can you do to combat that?
Kind of part and parcel of that, do you think you have to train the sales force, or do you think you've trained, or do you have the initiatives in place that you're going to train the sales force to get price in this environment and exploit price in this environment? Because that's a key part of maintaining organic growth.
Yeah, Rob. Like with Scott's answer, I'll parse that into two. Let me hit price first. The answer is, yeah. We've been spending a lot of time and effort over the last couple of years to build up our capability around pricing. I think the first sort of proof point that we had of some of that work coming to fruition was the mid-year price increase, where we saw what I would consider to be pretty nice realization on a mid-year increase. The metric you can see is price contribution turning positive in Q2, getting a little more positive in Q3. I would fully expect that when it comes time for the next increase, I would expect strong realization rates, particularly given the environment right now and the headlines around inflation.
I do think that is a real opportunity, and I fully expect that we capture good realization. Go ahead, sorry.
Was that me or is Rustom going to add on?
Okay. I thought you were trying to get in, Rob.
Yeah.
I'll hit your point on sales.
Yeah.
I think your question was around the timing of these initiatives, doing it at the peak cycle and missing out on some of the upside. Look, as I mentioned to Scott Graham, we take a long-term view on this, Rob, and we fully believe this is the right plan, and so we're going to do it and get it in as fast as possible. I guess the answer is, yeah. One of the downsides here is we probably are missing out on some of the upside of the upmarket. Here's the flip side, is the sooner we get it in place, should the market come back, we're going to be better positioned to outperform. If the market continues to be strong, we should be better positioned to outperform. From our standpoint, the sooner it gets in and the sooner we outperform, the sooner we recapture.
One other thing, Rob, I want to circle back to the point I made to Evelyn Chou's question, which is around what's happening in the business. Very different picture right now when you look at existing base of business where the performance has been good. Where we're missing out is on new business generation, no question. Look, the nice thing about that, Rob, new business can be generated in virtually any environment.
Well, to that point, the problem is investors shoot first and ask questions later, you're going to see that today, right? The messaging is basically, listen, we have a gestation period of the sales force, the cycle remains strong, pricing remains strong. Kind of full speed ahead, we'll catch up here. The bear case would suggest a couple things. Number one. You can comment as to that. Maybe it isn't all your fault. Maybe we are starting to see a relative deceleration. Number two, on new business opportunities specifically, that does come down to the fact that is your offering really competitive, right? Is there a pricing dynamic that perhaps has to be taken into account to get new business? That gets to the core of kind of the Amazon Google transparency argument, right?
How would you respond to those two critiques of how you're operating in this environment?
Yeah, Rob, I think on the new business side, really, it's a direct correlation to not having the people in place to be able to do the new business. Really where most of our hiring is directed right now, to be even more transparent, is new business development, i.e., hunters. That is the impediment right now, is just getting the people in place to do the new business development. Your other question, I'm sorry, was around?
Well, just around the fact that you basically saying the cycle remains strong, trends remain strong, MBI remains strong. It's more a question of your execution. You're not concerned about a second derivative deceleration in the cycle at this point.
Rob, I couch it with our view is always very near term. Given our delivery cycle is 24 hours, we're a short lead time business. From what we see today and our discussions with customers, things remain pretty good. Look, we mentioned there is a little bit of a specter, kind of a looming question around the impact of tariffs that at this point I would say is more psychological and related to input costs than it would be to demand. Look, to be fair, that's out there. I think that's a risk. Right at this moment, I think demand still remains quite solid.
Just one last one. The price increases we would expect to see, really the realization is really going to be a fiscal 2019 event at this point, right? In terms of the timing. Anything you can talk about fiscal 4Q in terms of realization of price increases?
Yeah. The pricing, our typical big book pricing will be later this summer. You are correct. Look, it will be driven off of market increases of what we are seeing from suppliers. It'll be later in the summer. You are correct. A greater impact in Q1 than in Q4. That's correct.
I'll leave it there. Thanks for your time.
Thank you, Rob.
The next question comes from Hamza Mazari with Jefferies. Please go ahead.
Good morning. Thank you. The first question was just on pricing. Erik, you mentioned that the number of suppliers raising list price since January is more limited relative to sort of inflationary pressures. Is there anything structural in the space whereby suppliers are raising price, demand is good, we're seeing inflation, but distributors cannot get price? Is there anything we should read into that or any color around pricing, just longer term structural? I know you talked about fiscal Q1 versus fiscal Q4. Just a deeper question on pricing.
Hamza, at this point, I would say no. What we're seeing is not structural. My answer would be different, I believe, if the dynamic we saw was that our manufacturers were passing along a lot of increases, list increases, and distributors could not get them through. I think we'd have a different situation on our hands. To date, the proof, at least for us, has been pretty good. As I mentioned, when we did the mid-year price increase, realization was good. Pricing turned positive. The issue has been more one that the manufacturing community, so our suppliers have not moved at the rate and pace one would expect given the inflation headline, which I think is a different story than the structural one you're describing. In discussions with most of our suppliers, the biggest theme that comes back is capacity utilization.
At this point, they don't want to do anything to risk getting capacity utilization up. I will tell you that our discussions with most also lead one to conclude that if the cost pressures we're seeing now sustain, and not just tariffs, but we're talking commodities and wages and freight, there's going to come a point where there's more increases coming from manufacturers. That would trigger more increases coming from distributors, certainly coming from us. To date, my expectation would be that realization is good, particularly in this environment. I think the structural question would be a different story if we weren't getting price.
Hamza, I'll just throw out one factoid on that again, just to repeat. Look at our three quarters of year to date gross margin performance. We're actually in line with last year. That is a better nine months than certainly most anything I can think of in the last few years. Just something to think about when you're questioning on the structural issues.
Right. No, that makes sense. I guess the second question is, aside from sort of DECO and AIS, the last time you guys did a deal was Barnes five years ago. Could you maybe touch on, and a lot of questions on sales force effectiveness, how much of the M&A strategy is sort of levered to just buying headcount, whereby some of these salespeople are already pretty productive? Can you accelerate some of the sales force effectiveness issues by just doing more deals?
The answer is that the acquisition strategy is really motivated by the three criteria that we laid out in the prepared remarks. Specifically, first and foremost, the strategy is about bolstering technical and high-touch niches. That's metalworking, that's the Class C parts. In this case, with AIS, we found kind of a third growth leg in the OEM fasteners. That's the real motivation, more so than headcount. Now, I will tell you that what comes along with both of those businesses is an exceptionally strong technical and capable sales force. The driver has been about the technical high touch niche, and then of course, obviously culture and financial performance are on the same level of importance.
Okay, great. Just a clarification. I'll turn it over. Just on the tariff question, I guess you mentioned it's not material impact to you directly. How much of your COGS is sort of sourced from China? You said less than 20%, I guess? Or just clarifying that. Thank you.
Well under.
The direct is well under the 20% number. Just remember that a lot of our major suppliers have facilities all over the world, and they change around their countries of origin. If you run the report for Q1 and the report for Q2, you might very well find similar products having changes in country of origin anyway.
Okay, great. Thank you.
The next question comes from Adam Uhlman with Cleveland Research. Please go ahead.
Hi. Good morning, everyone.
Hey, Adam.
Hey, I was wondering, Erik, if we could move back to Hamza's question on the number of suppliers raising prices here. I guess, I'm curious what your view is as to how much inflation we should start to expect to see over the next year. What would be your starting point of the catalog list price increase, as we all start to think about your fiscal 2019 pricing framework and that discussion? Also how much you might have to put in for that mid-year increase to catch up to what you think might be the new run rate. Just any kind of color you can give us on that.
Yeah, sure, Adam Uhlman. A couple of points on pricing that I'll make. One is, we are going to take, and just to be clear, we are going to do an increase. We'll do it later in the summer. It'll be our normal big book cycle. Just to be clear, it's not like we're not taking an increase. It will be market-based, meaning we will take all suppliers that have moved since the January mid-year, we will pass those along. Nothing here should indicate that we're lagging behind, that there's more cost coming through than we are passing along in price. What I would tell you in terms of sizing is, the point I wanted to get across was that the size of that increase isn't commensurate to when you're reading the headlines now around tariffs and freight and wages.
You would think that we would be back in the glory days of like 3%-4% price increases across the board from manufacturers. That's not the case right now. If you're asking me to kind of hypothesize about looking out past the summer, it's hard to imagine that the current cost pressures could sustain a whole lot longer before manufacturers have to move much more significantly. If that's the case, we would plan to be ahead of it, as we normally are, meaning we'll pass along market price increases. We should have a timing lag of benefit, a price cost benefit when that happens. Look, generally our rhythm is to do that for us, our mid-year is somewhere would be early calendar 2019. All subject to change. Depending upon just how hot things got, we could always go sooner if we needed to.
That's sort of how I would look at things.
Okay. Then, Rustom, could you remind us all what the normal seasonality is for the first quarter gross margin performance relative to the fourth quarters that up or down and ballpark kind of a number. Then within that, is there any carryover inventory step-up expense that we need to keep in mind with AIS, or are we all done with that next quarter?
Sure. third quarter to fourth quarter, right? If I heard you correctly.
I think Adam, Q4 to Q1.
Hold. I can do that.
generally.
Yeah, in general it is. I mean, it almost always is, looking at that from Q1 going up, right? The AIS, there's about 40 basis points coming solely from finishing the amortization of the inventory step up, the usual thing. That's all in Q4, which means it's gone and in Q1 there's no longer a headwind there. On the total business also, there's also another loss of headwind, to use that phrase, because we acquired DECO in July of a year ago. DECO will wash in this fourth quarter when you look at it. Once you go into Q1, that's no longer a negative comp. When you think about the acquisitions pulling us down this year, it no longer becomes of effect in Q1.
Adam, this is John. The only other thing I'll add is that, if you look back historically, you need to kind of figure out, okay, when did they take the big book, right? If the big book came at the end of the Q4, you're likely to get more of a kick in the Q1. Sometimes it comes into Q1, you don't get as much. You get
If it comes earlier in the Q4, some of that price increases in the Q4, you don't get as much of a lift sequentially. That's something to consider as you look back at the historic trend over the last 10 years.
I think summary would be fair to say that the general pattern here is Q3 to Q4 goes down, Q4 to Q1 goes up.
Yeah. Yes.
Thank you.
The next question comes from David Manthey with Robert W. Baird. Please go ahead.
Thank you. Good morning, guys.
Hey, David.
First of all, on the growth guidance. 4% for the fourth quarter, as you mentioned, Erik, below your expectations relative to a strong market, but also down from the 6% core this quarter. I'm just wondering a couple things. First, as you look forward, you're certainly not anticipating that the market is changing, getting weaker or anything like that, would be my first question. Second is, are you already starting to see some of the benefits from the sales force effectiveness? Again, if so, if that's happening and you're seeing some benefit, it would seem to be incongruous here with the growth rate moderating. Can you just help us understand that outlook?
Yeah, sure. Dave, let me just also walk you from Q3 to Q4 a little bit, because you're right, the guide is down roughly 200 basis points. Again, you've got over the quarter, roughly 100 basis points of that is the difference in the days with the July 4th holiday last week. The other 100 basis points or so, government has taken, from a growth rate standpoint, a sharp turn negative because of the lack of year-end surge so far. Okay? Those are the two factors on the step down. What I would say is the difference is not market based. I would also say with respect to sales effectiveness, we are seeing success in the pilot, which is not large enough of a sample size to move the needle for the company.
I'd also tell you, look, there's other green shoots that we're certainly seeing, but they're not big enough to move the needle for the company.
Okay. That's helpful. Thank you. Second, as it relates to the sequential change in your field associates, if you exclude AIS from that, what was the change from last quarter in the field sales force?
We are down a handful of people. Literally, like a handful of people, Dave.
Okay.
Ex AIS.
Yeah. Last quarter, I think you said.
Almost flat
You expect it to be up this quarter. I know we're hearing from a lot of folks, it's just a struggle to find good people and at the right price. Is there a reason why it didn't uptick this quarter other than just some minor timing issues, or are you having a harder time finding good people?
No. Look, nothing big to read into. Certainly, it's a hot labor market, Dave. No question there, nothing to read into in terms of the size and the quality of the funnel. Some of it is timing and a hot labor market. We're not lowering our standards for the kind of people we want. We're making sure we get the right people. I'd also tell you, look, inside the company, there's a heavy focus right now on performance management as well. You're looking at the base, the drop's a little bit for performance management. As I look to this quarter, Q4, I do expect the number to be up.
All right. Thanks very much.
Thank you.
The next question comes from Ryan Cieslak with Northcoast Research. Please go ahead.
Hey, guys. Good morning.
Hey, Ryan.
Erik, I want to go back just really quick and peel back the onion a little bit about what's going on with sales versus maybe your expectation at this point. I get that the sales force is coming down, which I think that has been the expectation, but it sounds like maybe the disruption from that has been greater than what you expected. Is that the case? If it is, ultimately, what can you do to address that near term? Is this going to take, like you said, a little bit of time to get things worked out and normalized as it relates to how operationally the sales force is going to market and working under this new strategy?
Yeah, Ryan, look, there's no question there is some distraction. I would say most of that distraction, most of it is behind us. A lot of the heavy lifting has occurred over the last few quarters. That is a piece of the story in addition to the headcount coming down. I think in terms of what we can do, I can tell you that inside the company, there is no wavering and we are heads down and we're executing like crazy, and to move through it as fast as we can, and we are almost through it, and it's now sort of rebuilding headcount. From our standpoint, the mitigating actions are about getting headcount back up, which is going to be focused on new business development, and it's just executing our plan and folks getting comfortable in new roles. We are heads down inside the company.
Okay. Then going back just to the market commentary, I get that year-over-year, things are still good and underlying demand is still positive. Are you also saying that you're actually seeing, when you strip out maybe some of the noise with what you're doing with the sales force, are you actually seeing ongoing acceleration in demand, or have we hit a point where maybe things have flatlined a little bit? I just wanted to get your perspective on maybe the sequential trends in underlying demand as it relates to what you would expect this time of year.
Yeah, we would not characterize it as acceleration now. There is leveling, certainly, but it's leveled at a robust Very solid demand perspective, but level, not accelerated.
Yes.
My last one is just, you had talked about on the prepared remarks about SKU expansion going forward into next year, and that might benefit the top line. I know in the past you guys have talked about, at least in the near term, that some of these new SKUs that come online that could impact the mix negatively and gross margins. Should we be thinking about it that way as it relates to maybe what this new SKU expansion can do for gross margins? How do we balance that from the top-line impact versus maybe the gross margin impact? Thanks.
Ryan, that's actually a good catch. I will tell you, it's been a very successful program. We saw opportunity to round out some lines, do some extensions, and accelerate the program. You're actually seeing most of the costs of that in our Q4 numbers. From a productivity standpoint, we're pleased that we're offsetting some investment spending with productivity in the fourth quarter. The benefit will build during the course of the year. Just to ballpark, if by the back half of the fiscal year, we could be looking at a point of contribution from our SKU program. You are correct. The historic profile of the SKUs, these SKUs that we add are lower gross margin. I will tell you the net margins on them, which we are heavily focused on as a company right now, are very strong. This could be slight.
Look, I call it slight because in the big picture, it's not going to be a major needle mover. Very slight headwind on the gross margin line, but should be a nice top-line contributor and bottom-line contributor.
Thanks, guys.
The last question today comes from Patrick Baumann with JPMorgan. Please go ahead.
Just to clarify, do you still see the big book prices this summer up more than the 1%-2% that you did at the mid-year in January? Or will you have to wait until the next mid-year at this point to see some acceleration there? Sounds like the latter. I just wanted to clarify.
Pat, I would actually say, look, and it hasn't come yet, but if you're asking me, somewhere in that range would be a likely range, 1%-2% for the increase later this summer. Again, that would be based on sort of what we're seeing in the market. That's an average across all of our SKUs, by the way. We're going to have SKUs, certain lines and SKUs will be up well more, some don't move. But as an average across the whole business, 1%-2% would be reasonable. Look, the mid-year, again, should these inflation pressures continue, hard to imagine suppliers absorb them and that they don't start moving more aggressively on price. The likely timing for that would be beginning of calendar 2019. But of course, depending upon how hot things get, we could always go sooner.
Is there a lot of flexibility to do things in between? For example, if tariffs were put in place kind of in between those periods, what's your flexibility to move between the mid-year and the big book?
There's a lot of flexibility.
On the sales force initiative and its impact on the top line, just wondering if you could flesh out what gives you confidence that the volume weakness is sales force related and not a pricing problem on the new business front?
Well, to be honest, Pat, where we do have people going after new business, we're generally pretty successful at it. That's what gives me the confidence. The issue is not that we can't win new business, it's that we don't have enough people doing it, is the answer.
Got it. Just lastly, just looking where the stock is this morning. Curious if you could update us on kind of your thinking on buyback, and you had a big authorization earlier this year you put in place, I think, and hasn't been a ton of movement on that. I'm just wondering how the management kind of thinks of the capital allocation alternatives.
Pat, I'll take that. Look, we always take a balanced, opportunistic approach to allocating capital, right? To enhance shareholder returns. I'll just repeat, it's organic investment, steadily growing dividends. That's what we do with it. After that, depending on the amount of extra cash that we have, based on what we think we're going to be doing, it's M&A and buybacks. It's returning cash to shareholders, which you could do in various forms of buybacks. You could even do special dividends. There's enough avenues to do things. Remember, it also depends on whether you have acquisition opportunities that you see out there that might be interesting in the near term. It's a bunch of different factors. Again, as always, we kind of stay with the longer-term view on these things, Pat.
Okay, great. Makes sense. Thanks a lot, and good luck, guys.
Thank you.
Thank you, Pat.
This concludes our question and answer session. I would now like to turn the conference back over to John Chironna for any closing remarks.
Thanks, Anita, and thank you everyone for joining us today. Our next earnings date is set for October 30th, 2018, and we certainly look forward to seeing and speaking with you over the coming months. Take care.
This conference has now concluded. Thank you for attending today's presentation. You may now disconnect.