Good morning, welcome to the MSC Reports Fiscal 2018 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 touch-tone phone. To withdraw your question, please press star then two. Please note, today's event is being recorded. I would now like to turn the conference over to John Chironna, Vice President of Investor Relations and Treasurer. Please go ahead, sir.
Thank you, Rocco, good morning to everyone. I'd like to welcome you to our fiscal 2018 first 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.
These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those anticipated by these statements. Information about these risks is noted in our earnings press release and the Risk Factors and the MD&A sections of our latest annual report on Form 10-K filed with the SEC, as well as in our other SEC filings. These forward-looking statements are based on our current expectations, 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.
Thank you, John. Good morning, everybody. Let me start by wishing you a happy New Year, thank you for joining us today. It's an exciting time as we begin calendar 2018. The environment remained solid in the first fiscal quarter, our own business developments reflected this momentum. Revenue growth of 12% on an average daily sales basis. Gross margins in line with expectations, driven by a second quarter of improved price realization and a continued pattern of sequential stability. Earnings per share up 9%, in line with our guidance. Looking forward, the environment offers the potential for an improved outlook on multiple fronts. There is growing certainty of inflation after several years of a weak pricing environment. Customer sentiment and industry indices remain positive, pointing to continued growth.
The recent tax reform is a significant tailwind, not only for our own earnings per share, but also potentially for our customers and the broader manufacturing economy. I'll touch on all of these as part of my discussion. Rustom will then provide additional detail on our financial results and share our second quarter 2018 guidance. I'll then conclude with some broader perspective, and we'll open up the call for questions. Let's begin now with a deeper look at the environment. Conditions held steady through the first fiscal quarter as the manufacturing environment remained firm. The most recent MBI readings continued to reflect expansion despite coming down from the high of 57.9 MBI reading back in October. November and December readings were 55.2 and 56.2, respectively.
The rolling 12-month average for the MBI to 55.8, which is meaningful, because an average above 50 points on a rolling 12-month basis to growth in metalworking end markets. Historically, on a four-month lag basis, our rolling 12-month sales have also had a high correlation to the MBI rolling 12-month average, so this also points to continued growth. Customer sentiment remained positive on both current and future opportunities. This is reflected in order volumes, backlogs, and sentiment on business conditions. We're also hearing a lot of positive sentiment about the potential impact of tax reform on the manufacturing environment going forward. While the timing and magnitude are obviously not well-defined as of yet, the new tax laws should create a stimulus for further manufacturing growth in the coming quarters.
From an end market perspective, aerospace, machinery, equipment and parts, as well as agriculture, were all areas of particular strength. As long as customer sentiment remains positive and the indices hold at current levels, which we expect, we should continue to see solid ADS numbers. Our Q1 organic growth rate was in the high single digits and consistent with the improved environment. Looking at the first month of our fiscal Q2, our estimated December organic growth of roughly 2.2% is an outlier from this trend. Last December and even into January, capital spending surged post-election. As a result, the drop in December average daily sales from November last year, it was the smallest that we've seen in well over a decade, down only 6% as compared to our historical average of about 12%. This year's December was down approximately 11%, more like a typical year.
It seems that the opposite dynamic was at play this year, with many customers holding back on capital-related purchases pending the outcome of tax reform. We saw the impact of this particularly in the machinery, equipment, and parts vertical, which went from high single-digit growth in our fiscal first quarter to flat in December. With tax reform now in place, we see the potential for an acceleration in capital-related spending during 2018. In addition to this dynamic, our fiscal December was impacted by two other factors. One, last week's snowstorms, as remember, the first week in January is part of our fiscal December. Generally, the first week in January is a bounce-back week following vacations. We did not see the typical lift due to the snowstorms in the Southeast and the Northeast this year.
2, government was atypically soft in December due to the delay in budget resolution, and in fact, contracted. Once the budget is finalized, we would expect to see spending resume and potentially pick up due to pent-up demand. Taking a look at our various customer types in our first quarter, growth rates were steady or improving across the board. As I mentioned on our last call, our CCSG customer growth had reached the double digits at the time, and the business finished the quarter with growth in the low teens. DECO growth was also well into the double digits. National accounts and core accounts maintained their growth rates of double digit and mid-single digits respectively, and government in Q1 lifted in the high single digits. Turning to e-commerce, we've now included DECO numbers in our calculations.
E-commerce was 59.8% of sales in the quarter, up from 59.6% a year ago, but down slightly from 60.4% last quarter, simply because no DECO sales were accounted for as coming through e-commerce. As I've said before, it's important to note that our e-commerce sales include all forms of automated selling. Product sales that go through our vendor-managed inventory solutions or our vending machines account for slightly less than half of e-commerce sales. In Q1, sales to vending customers contributed roughly 340 basis points to growth in the quarter. In the first quarter, our net total active salable SKU count declined slightly due to some pruning of non-performing SKUs at the start of the fiscal year. The total number remains above 1.5 million, and we still expect to add a net of roughly 65,000 SKUs in fiscal 2018.
We ended the fiscal first quarter with 2,337 field sales and service associates versus 2,370 last quarter. This is the result of the continued execution of our sales effectiveness programs aimed at expanding selling hours per seller. We expect sales and service headcount to bottom out over the next quarter and begin to increase over the next few quarters as we restart sales force expansion with sales effectiveness programs now fully in motion. Integration of the DECO acquisition is off to a strong start, and the business is performing quite well, with the top line growing well into the double digits. Execution remains strong as our focus remains on allowing the team to deliver high levels of service and to begin to take advantage of the MSC value basket and our expansive supplier relationship. The business has so far been everything we've expected.
Turning to gross margin, I continue to be pleased with our results. Gross margins remain stable as mix and competitive headwinds are being offset by increasing growth contributions from higher-margin areas like CCSG and improving price realization. Gross margin has been roughly flat for the past few quarters. Looking to the future, the outlook for gross margins is encouraging. Last quarter, we discussed the potential for price inflation due to rising commodities prices. We said at the time that we'd have a better feel for supplier price movement on this call, as the end of the calendar year generally gives us more visibility. In fact, we did see significantly more supplier price movement recently than we've seen in the past few years. This is a very good sign because, as you know, distributor pricing is triggered off of manufacturer list price movement.
As a result, we will be implementing a price increase later this quarter. For competitive reasons, we're not going to get into specific dates or amounts. Suffice it to say that it should be considerably larger than the mid-year increases of the past few years. Given the timing, the impact on our Q2 will be small but should build for the remainder of the fiscal year. I'll now turn things over to Rustom.
Thanks, Erik. Good morning, everyone. I'd first like to remind you that we will continue to break out DECO's impact as we report fiscal 2018. Let's turn to our fiscal first quarter in greater detail. Our average daily sales in the first quarter increased by 12% versus the same quarter last year, in line with guidance, with DECO contributing slightly more than expected. Our gross margin was 43.6% for the quarter, again in line with our guidance midpoint. Excluding DECO, our gross margin was 44.5%, slightly above our guidance midpoint and down from 45% in fiscal 2017's first quarter. Base business gross margins benefited from better price realization and higher CCSG sales. Our focus on operating expenses continued with OpEx to sales 110 basis points lower than last year. OpEx was $236 million. That's versus last year Q1's $218 million.
$6 million of the increase was due to DECO, $5 million to volume-related variable costs with higher sales, and the rest mostly to salary, bonus, and medical cost inflation. Excluding DECO, our OpEx to sales was 31.1%, 70 basis points better than last year and in line with our guidance. Excuse me. Our fiscal first quarter 2018 operating margin was 12.9%, or 13.4% excluding DECO. The latter was an improvement on the comparable 13.2% reported in the same quarter a year ago, as OpEx leverage more than offset lower gross margins. Our tax expense came in at 37.8%, lower than our guidance of 38.2%, with a favorable impact from share-based compensation accounting being the largest contributor to the lower rate. All of this resulted in earnings of $1.05, up 9% from last year's first quarter and in line with our guidance. Turning to our balance sheet.
Our DSO was roughly 57 days, up three days from Q4. Q1 typically includes timing headwinds as we near the calendar year-end. However, our DSO has risen over the last 12 months, mainly due to the higher mix of national account business. We do expect it to level off and of course, aim to improve it. Inventory turns remained relatively flat at 3.5 times from Q4 as inventories increased slightly along with higher sales. In the fiscal first quarter, we turned about 138% of our net income into cash flow from operations. Net cash provided by operating activities was $82 million, versus $76 million last year. Basically, this was due to the increase in net income. Our capital expenditures were just $9 million, and after subtracting capital expenditures from net cash provided by operating activities, our free cash flow was $73 million.
As I expect you've seen, last week we announced a 21% increase in our dividend to $0.58 per share. This was a direct consequence of the recently signed Tax Cuts and Jobs Act and follows our normally timed annual increase announced the previous quarter, which was 7%. Excuse me again. The new tax regime will have a strong positive impact on our EPS, and given our strong balance sheet, cash flow, and commitment to enhancing total shareholder returns, we believe that this dividend increase is an appropriate use of capital. I will come back to the earnings impact of tax reform shortly. We ended Q1 with $493 million in debt, mainly comprised of a $291 million balance on our revolving credit facility and $175 million of fixed rate debt.
We ended the quarter with $20 million in cash and cash equivalents and a leverage ratio of 1 times, down slightly from 1.1 times in Q4 of last year. Let's move to our guidance for the second quarter of fiscal 2018, which as you can see on slide four, is shown with and without DECO. We expect our Q2 ADS to increase by 8%-10% versus the prior year period. This includes 4%-6% organic growth and 400 basis points from DECO. December's preliminary organic growth rate was about 2%, but as Erik noted, December was a deviation from our recent high single-digit growth trend for several reasons. Forecasting the rest of Q2 is a bit more challenging than normal.
In addition to new variables such as the impact of the tax reform, the snowstorms last week reduced our visibility as they distorted the typical bounce back following the holidays. Our guidance assumes Jan/Feb growth of about 7% based on the assumption that we follow our typical Q1 to Q2 ADS sequential pattern. Hopefully, we'll see higher sales as our customers can expense their capital investments for tax purposes and the federal government budget resolution results, that results in greater spending. We are sticking for now with the typical historical trend for guidance. We expect the second quarter's gross margin to be 43.6% ± 20 basis points. That's the same as Q1 and down 110 basis points over last year, primarily due to the impact of DECO with some mix headwinds. Sequentially, we expect our base business gross margin to be relatively flat.
We expect Q2 operating expenses to be about $239 million. That's up $11 million from last year's second quarter. DECO accounts for $7 million of this, with about $3.5 million due to variable expenses using our usual estimate of 10% for sales growth. The rest is mostly due to investment spending, medical cost inflation, and salary inflation. This represents a sequential OpEx increase from Q1 to Q2 of roughly $3 million. About two-thirds comes from fringe expenses, mostly the payroll tax reset that occurs every January, as well as higher medical costs as a new plan year commences. The remainder is from key investments and salary inflation. Excluding DECO, we expect that this will yield 100 basis point improvement year-over-year as the OpEx ratio goes from 32.4%-31.4%, midpoint, obviously.
We expect a Q2 operating margin of approximately 12.5% at the midpoint of guidance, up from last year's 12.3%, even after absorbing a roughly 50 basis point negative impact from DECO. Using our Q1 actual and our Q2 guidance midpoints operating margins, we derive an implied first half operating margin of roughly 13.2% and incremental margin of roughly 20%, excluding DECO. Given the seasonality that typically drives our second half operating margins higher, we're on track to remain within our annual framework. As promised, to the impact of the new Tax Cuts and Jobs Act. MSC's income is mostly from the U.S., and the corporate tax rate has gone from 35% to 21%, effective January 1, 2018.
As our fiscal year started earlier, we must prorate the impact of the rate change, and we estimate that fiscal 2018's full year combined federal and state effective tax rate will decline to around 29.5%. This compares to fiscal 2017's 37.1%. The accounting rules require us to show future fiscal 2018 quarters at the estimated full year rate. As our fiscal Q1 was already booked at 37.8%, by the end of Q2, we need to take the year-to-date tax rate down to 29.5%. Hence, for Q2, and Q2 only, we expect an effective tax rate of about 20%. Let me be very explicit that our fiscal third and fourth quarter tax rates will be at the full year's estimated 29.5%. Looking forward, we estimate that our fiscal 2019 combined federal and state effective tax rate should be around 25%.
In addition to the above, we expect to recognize a net one-time tax benefit in Q2 for the revaluation of net deferred tax liabilities, primarily related to the lower federal corporate tax rate, partially offset by the lower federal benefit for state taxes, and the change from a worldwide to a territorial tax system. These are all factored into our guidance. Given the magnitude of the tax changes to our EPS, we've added a slide five, to our presentation that spells out the drivers. Our Q2 tax rate of 20% includes between $0.01-$0.02 of EPS benefit from share-based compensation versus a $0.03 EPS benefit in last year's Q2. Also note that we expect our weighted average diluted share count to increase by roughly half a million shares from Q1 due to exercises and the impact of higher share price on dilution.
Our EPS guidance range for Q2 is $1.93-$2.03. That's wider than normal and reflects the following assumptions. A tax rate of about 20%, inclusive of the share-based benefit, some benefit, and the year-to-date tax rate catch-up, but before the net one-time benefit. This compares to 36.1% in fiscal 2017's Q2. We estimate this will add between $0.27-$0.29 to Q2 EPS. The net one-time beneficial impact of the revaluation of tax-related benefit balance sheet items is estimated to add between $0.66-$0.70 to EPS. Finally, without the positive impacts above of the Tax Cuts and Jobs Act that we've noted, it's an EPS range of $1-$1.04. I'll now turn back to Erik.
Thank you, Rustom. This is an exciting time for the company. Over the last several quarters, we've strengthened the performance of our business as the environment's improved. We've returned organic growth rates to the high single digits. We kept gross margins sequentially stable at roughly 44.5% in the face of intense competitive headwinds. We improved the productivity and expense structure of our business by bringing operating expenses as a percentage of sales down by 70 basis points in the last quarter on an organic basis. We've enhanced our value proposition by expanding our product and solution portfolios and by leveraging our metalworking and supply chain expertise to drive manufacturing efficiencies and cost savings for our customers. We've deployed capital carefully, returning nearly $1 billion to shareholders over the past three years. Now, we look ahead and see the potential for even better performance moving forward.
Tax reform should boost U.S. manufacturing further in the coming quarters, which should only serve to improve our growth rates. Price inflation is finally poised to materialize as commodities inflation is driving supplier list pricing higher. This should mean improvements to price realization and a gross margin tailwind that has not existed in the past few years. Our productivity efforts will allow us to sustain our expense leverage, creating the prospects for strong incremental margins. On top of this, the tax reform significantly enhances the earnings power of our business and allows for more return of capital to shareholders, as evidenced by our recent dividend increase. As we look forward, our team will remain heads down executing our plan, just as our associates have done so well over the past year. With this improving environment, we see an even brighter future for our company.
We'll now open up the line for questions.
Thank you. We will now begin the question and answer session. To ask a question, you may press star then one on your touch-tone phone. If you're using a speakerphone, we ask that you please pick up your handset before pressing the keys. To withdraw your question, please press star then two. Today's first question comes from Hamzah Mazari of Macquarie Capital. Please go ahead.
Good morning. Happy New Year. The first question is just on tax reform. The first part is: Is there any material difference between your cash tax rate and book taxes? Just trying to get a sense of, from a cash flow perspective, how much of a benefit is tax reform. Then secondly, what do you expect to do with the proceeds?
Thanks, and hi, Hamzah, and Happy New Year to you as well. The entire $0.66-$0.70 one-time benefit is completely non-cash, right? That's a balance sheet item. That's totally non-cash. Everything else is a cash benefit. It will flow through and reduce book taxes, cash taxes proportionately with book taxes. If you can do the math on a full year basis, where you simply take the difference out. Take the go forward to really help with the 25%, but you can also do the quarterly numbers. What we do with the proceeds is we continue to have the same capital allocation strategy that we have had before, right? That philosophy is unchanged. First, we keep investing in the business to also improve organic growth and drive greater efficiencies. We keep paying moderately ordinary dividends, moderately growing ordinary dividends.
Discipline the M&As next. Finally, we have the opportunity to return excess cash to our shareholders. No real difference to that.
Okay, great. Just a follow-up question. I'll turn it over. You recently obviously did the DECO deal, which is smaller than Barnes and J&L historically. Maybe if you could frame for investors any lessons learned from past M&A and how you're thinking about M&A maybe differently with DECO and on sort of a go-forward basis from an execution perspective. Thank you.
Hamzah, very good question. Let me start by saying that, and hopefully you picked up on this in the comments, that we're quite pleased with how DECO is performing. It's the first acquisition that we've done since the Barnes deal several years back, and it's going quite well. I think certainly, one of the reasons for that is we were able to acquire a really high-quality business. The second reason is that the business is right in our core, right in our sweet spot. The whole thesis for the deal has played out. As we look forward, certainly, it gives us confidence in our ability to integrate future acquisitions and to do them successfully. As Rustom pointed out, our philosophy on M&A, on capital allocation remains pretty much the same, which is it's going to be part of the arsenal.
We're actively looking, we're going to keep the same high bar that we've had before.
Great. Thank you.
Our next question comes from Matt Duncan of Stephens. Please go ahead.
Hey, good morning, guys. Happy New Year.
Hey, Matt. How are you?
Good, thanks, Erik. First question back to tax reform. You talked a little bit about how your customers may react to it. I know it's still early days, it's hard to know for sure at this point. I'm assuming you've had some high-level conversations with customers about how they plan to use the cash. What is your sense for how much of that may go to CapEx and increasing that expenditure? As you think about the annual increase in your revenues that could occur as a result of that, how much extra growth do you think you might be able to see for the next couple of years as customers sort of adjust for that?
Matt, I'll take it. Look, I think in general what we're hearing, obviously it's still very early, hard to put a number to it and hard to put numbers to what percent of this increased cash flow to our customers goes to investment. Suffice it to say, look, the early conversations, there's no question that this should be a stimulus. I would not yet pinpoint timing. As you heard in Rustom's comments about our guidance, we didn't assume a whole lot in our second quarter because we just don't know how fast this flows through. We did hear it. We certainly did hear that this increases the prospects for spending for growth for our customers moving forward. Just hard to pinpoint.
Look, as we look out beyond the next month or two and look out the next year, it's part of what gets us very excited.
On pricing, I certainly understand the desire to not be too very specific here, but I want to think about how this could help gross margin, because I know that's been front of mind for a lot of people. Historically, if I remember correctly, when you guys have done price increases, it's been more like 2%-4% than 1%. Recent price increases have obviously been very small. You're saying this one's going to be more normal. Let's not put a number on it, but assume that it is more normal. How does that help gross margin? Can you start to see gross margin increase again? Are the headwinds enough to keep that from happening, and this is just a nice way to cancel it out?
Yeah, Matt, so look, I think, and I appreciate your sensitivity. You can imagine, we wanted to make it clear that we will be taking a pricing action based on all of the list movement that's happened. We're encouraged by it. You are correct that the best way I characterize it is, yeah, relative to the midyears that we've seen in the last few years, much more meaningful than that. You are correct sort of sizing it. Look, here's what I'd say in terms of the gross margin outlook. If you look back over the past few quarters, we have been, as we pointed out, more or less, taking the DECO influence out, the underlying base business has been more or less stable and sequentially flat over the past few quarters, plus or minus.
If you look underneath that and you look at our pricing DECOmposition, you'll see that over the past couple of quarters, price realization has gotten better. It went from slightly negative to more or less flat. What I would say to you moving forward is, let's assume that-- and the tricky part, Matt, by the way, I'm going to caveat this by saying gross margin, there's only so many moving parts that at any point something else could change. If I look at the recent trends and assume nothing else changes, certainly if we see the kind of price realization on the midyear that I would expect to see and that we have seen in the summer increase, then certainly from here, is it possible that we could see gross margins lift? It is. That said, I'll couch it by saying, look, mix could move.
I'll give you a scenario, Matt. If we see a surge in capital-related spending, that could bring margin down and be a mix headwind. If we see a surge in government spending because of the pent-up demand of a slow-to-get-approved budget here, that could bring it down. I put these qualifiers in here because there's so many moving parts. If things stay the way they did, and we layer in pricing and good realization, I'd expect it to lift from here, yes.
Okay. I appreciate the answers, guys. Thank you.
Our next question today comes from Robert Barry of Susquehanna. Please go ahead.
Hey, guys. Good morning.
Hey, Rob. How are you?
Good, thanks. How are you? Happy New Year.
You too.
I just wanted to dig a little into the sales growth. It sounds like you're looking for 7% in Jan, Feb, after December at about 2.5%. Is it fair to assume that that gap, about four or five points, is roughly what the impact was in December of the storms, the government slowing, the customers holding back on capital purchases? Or do you have an estimate for what that impact was?
Rob, let me give you sort of a high level walk of what's happening in December to start. What you're seeing in December, and what I'll do is compare it to looking backwards, looking at what we've actually done, which is Q1, which was high single-digit growth rate, roughly over the quarter, 8%. Look, that's in line with what I would expect given the environment. Obviously, December is a significant drop off from that. For the most part, we expected some compression in December. I would say the compression and the growth was lower. The compression was more severe than we expected because of a couple of factors. If you wanted to do the walk, the biggest influence from Q1's number of 8 to the 2+ in December is the comp from last year, and I tried to describe it.
This capital surge that we saw last year, last December really bucked the historic trend. There's a few points of growth. If you compare the difference to a historic average November to December versus last year, there's a few points there. On top of that, the weather certainly in the first week of January was nearly a point. The government certainly surprised us. The fact that there's been no budget resolution led to a contraction in spending. That's a little bit over a point of growth relative to where we had been tracking. Then one that's just a little harder to quantify, and it ties back to this capital spending issue, but I think is real, is we did hear anecdotally, and particularly from our smaller customers, sort of a wait-and-see mode as it related to any big purchases pending Tax Reform.
Whereas last year, we saw the opposite dynamic where there was a surge post-election. That's the walk. That's the story behind December. As Rustom pointed out, looking forward to January, February, look, this is always a tricky quarter for us because we're following a holiday. It's even trickier this year. We've got more variables because we lost some visibility with the snowstorms. Last week is usually an important indicator for us, and we lost some visibility. You've got the impact of Tax Reform. You've got the looming government budget. There's a whole bunch of factors making it tricky, basically what we did is we went back and we looked at history. We looked at sequential patterns from Q1 to Q2. What you're seeing for January, February is typical of a Q1 to Q2 sequential pattern
Got it. Super helpful. Can you remind us what % of the revenue for MSC you put in this capital purchase category?
Yeah. We talked about it last year. We didn't give a specific number. The reason is, Rob, it's a whole bunch of stuff. Obviously, we could give you a number. We have a number that would be straightforward, the machinery type big purchases, but there's a lot of items that go along with it that would be related to tooling up a manufacturing line that are not as clear cut. I don't have a percentage of sales to give you. Look, it's not a huge percentage of sales. What we saw last year is that it was a particularly large influence on the quarter, and I think the best thing I could point you to is last year, the November to December drop. Historic average, minus 12. This year, as a case in point, minus 11, so sort of more typical. Last year was minus six.
That'll give you a feel for how big the surge was.
Right. Great. Maybe just finally, just to follow up on the pricing comment. I don't mean to damp the enthusiasm about the pricing. I think it's great that it's starting to come through, but I'm curious about what kind of tailwind we could see, if the pricing you're putting through is happening concurrent with your own COGS inflation. It sounds like it's even happening slightly after the COGS inflation.
Yeah, Rob, you are correct. What I would tell you is that generally, if you look back at history, at times like this when there's inflation, we can tend to benefit more. We can actually create some expansion opportunity, through timing and through negotiations and such. It actually is an opportunity to create expansion, and particularly as we look at the back half of this fiscal.
Sorry, Rob, cutting in.
Yeah.
Remember that we're holding inventories, right, that we purchased at lower prices. We're holding a lot of inventory. That's one of our strengths, right? That goes through. Also, as John's probably communicated many times, it's average costing, the way we roll it through. It takes a while for the price increases to really begin to show up.
Fair enough. Thank you.
Our next question comes from Ryan Merkel of William Blair. Please go ahead.
Hey, thanks. Good morning, everyone.
Hey, Ryan.
Hey, Ryan.
I want to go back to this idea of pent-up demand in government, and I think you mentioned machinery. I guess two-part question. Can you quantify that for us? Secondly, when do you think that we might see that? Is there any sense of timing?
Yeah. Ryan, there's actually two factors. Rustom made the point that they're not. We're leaning on history here on our Q2 guide. What's not factored in is a major surge from tax reform, which could happen. We really don't have a good feel for timing on that one, to be perfectly honest, if and when customers start spending as a result of it. The second surge that is possible but not factored in would be if and when. Look, at some point, there will be resolution to a government budget. We don't have factored in a major surge. I'll tell you that based on history. I feel quite good about our market share position within the government. Nothing's changed there. Our competitive position is strong.
Generally, based on history, in times like this, the further the budget resolution gets pushed out, what ends up happening is spending actually generally doesn't go away. It just gets compressed into a shorter fiscal year, which makes the pop, the pent-up demand, as you call it, that much greater. Again, we don't know when it happens. We haven't factored it in. Look, that could also be meaningful.
We actually saw something, Ryan, like that happen about a year and a quarter ago, where you got that quick snap back, what Erik is describing. Like I said and Erik's repeated, we didn't factor anything into our guidance because frankly, we don't know if there'll be a budget resolution in the Jan-Feb sort of timeframe.
Right. Okay.
On that one, by the way, just to help you, if you wanted to try to quantify, we've shared government is roughly 10% of sales. We gave you the color in Q1, government grew high single digits. We told you in December it actually went negative. You could get a feel for the impact on growth rate there. Hypothetically, and look, it's not likely to happen in Q2, but at some point this fiscal year, if and when there's budget resolution, if and when there's a surge, that 10% of sales could go from what's now negative to being quite strongly positive.
Okay. Yeah, I got it. That's helpful. Thank you for that. Secondly, customer mix is starting to improve. Obviously, CCSG is doing quite well. The core is now, like you said, mid-single digits, so it's starting to improve. What do you think the core could do over the next couple of quarters? Would you expect that to start to get up into the high single digits, given the backdrop that we're talking about?
Yeah. Ryan, I would. The reason I would is, it's interesting. So you're right, the core, which is associated with kind of our core base of manufacturing customers, is mid-single digits, as you said. What's interesting, when you get under the covers there and look at the verticals, most of the verticals that make up our core business are actually performing quite strongly. Quite strongly meaning either high single digits or low double digits. Machinery equipment is one, aerospace, automotive, agriculture, which is particularly in the Midwest, are all growing really strong. What we found is isolated pockets within the core that are not faring nearly as well, and in fact, are pulling us down. As we look at that, a couple of them are tied to very specific sectors that are off or regions of the country.
What gives me confidence is that the broad base here of core is actually up high single digits to low double digits, and you got a couple of isolated pockets that if something changes there or if we lap comps, all of a sudden the net gets very different.
Oh, that's helpful. Okay. Well, great. I'll pass it along. Thanks so much. Good luck.
Thank you.
Our next question comes from Luke Junk of Baird. Please go ahead.
Good morning, guys.
Hey, Luke. How are you?
I'm doing well, thanks. First question, Erik, just curious what customer conversations around price are like today as both demand and inflation have picked up. Just curious, are you finding them to be much different than prior periods with similar conditions, or is it similar, would you say?
Luke, two thoughts come to mind on customer conversations. Look, number 1 is there's no question that when customers are busier and have less time to shop, that price conversations are easier than when customers are slow, have time to shop. The equation changes from how do I save a dollar to how do I get products in the door that are going to help me get my products out the door to generate revenue. I think there is a connection there between environment and the price conversation. They're never easy, of course. I do think the environment influences it. The second thing I would say, and this is sort of more specific to MSC, is a lot of our conversation when it comes to price is about total cost of ownership and tried to make some comments over the last couple of years.
We've put a lot of focus on our value proposition, particularly in metalworking, where we have metalworking specialists that are in our customers, saving them hard cost and bringing their cost structure down. That helps a lot when it comes to price, what we're doing is sitting down as a total cost conversation and showing cost savings. It becomes easier to explain why price needs to go up in the low single digits, mid-single digits, why that would be the case.
Mm-hmm. Okay. Helpful. Second question for you, Erik. Just any additional color you can share on CCSG, maybe in terms of the work you've done on sales force integration or similar, which can speak to the staying power of the uptick in growth that we're seeing right now in the kind of low teens ranges you'd cited.
Luke, CCSG is one of the points in the business to which I point to say, what gives me confidence as I look forward. I do like what I'm seeing. We've been talking for probably more than a year about progress we were seeing sort of under the covers on that business, said we're going to reserve judgment until it shows up in the numbers. It is showing up in the numbers. I think, look, several factors as to why, it's been the initiatives, the work that we've done over the last few quarters on bringing the sales forces together and accelerating cross-selling in both directions. As I look out going forward, we have good momentum.
The sales teams are coming together nicely. We have a few internal initiatives in flight that are sort of hitting the beach, like waves hitting the beach over the next quarter or so that give me confidence that the growth we're seeing now can be sustained.
Supply chain driven ones as well, not just sales, Luke.
Okay. That's helpful, Rustom. Just a quick question, clarification, make sure I'm understanding it right. Just to be clear on the tax guidance going forward for the rate, we should be using 25% as a good number going forward, and that the 29.5 this year is just because of the partial year impact, is that right?
Absolutely. 25% is the number that we're estimating from fiscal 2019 onwards. You nailed it. I mean, 29.5 is the effect of the pro rata thing. What we got to do is basically get ourselves to an average of 29.5, plus there's a little bit of the share-based comp coming in in the first half as well with the thing I did. Your 29.5 for Q3 and Q4. That's exactly right.
Perfect. Thanks so much.
Our next question comes from Adam Uhlman of Cleveland Research. Please go ahead.
Hey, guys. Happy New Year.
Happy New Year to you, Adam. Good morning.
Hey, I was wondering if we could go back to the pricing discussion. I'm wondering if you're hearing about or seeing any signs that others in the industry might be using some of their tax savings as a competitive weapon to try to win over market share, that there could be some dislocation in the pricing environment as some of those savings start to flow through. Any signs of that at all?
Adam, I would tell you to date nothing, no signs at all of that. No.
Okay, got you. Related to that, it sounds as if you're going to be ramping up your investment in salespeople the back half of the year. I'm wondering if you could frame that for us, just what type of magnitude of growth we should be thinking about. It's still early days with the tax savings, but I'm wondering if you're pulling forward any longer-term capital plans that the company might have had for CapEx distributions under automation, et cetera. If you could just talk through your thinking on that would be helpful as well.
Let me take that one quickly, and then Erik can get into the pricing thing. We're so not capital intensive as a business, right? You think about our requirements, they're 2% of sales basically. The short answer is not really from our perspective, because we haven't had that much needed, and we have also been investing continuously in whatever will drive the business and move the needle and make us more productive and all that. Having said all of that, yeah, of course. If we were a manufacturer, same thing. If we were looking at something and we had for us it's small dollars, but let's say we had a $5 or $10 million investment that we are thinking about making, we would obviously have held that off until after January.
You basically get the TCJA benefits of the cash tax expensing coming straight away rather than over seven or eight years. Let Erik get to the substance, the big part of the question.
Yeah. Adam, on sales headcount, you're right to note it, what I would say is, what we're signaling here is really that over the next quarter or so. If you look back at sales and service headcount over the past year or so, it's come down slightly, sort of sequentially quarter by quarter. That's been the result, as we've pointed out, of some of the salesforce effectiveness initiatives that a few in particular, where it made sense for us to drop headcount a bit, integrating CCSG being one that's produced really good results. Look, we've been ratcheting up performance management is another. There's a couple of others. What we wanted to signal is with those now in flight, what we see is essentially a bottoming now of the number. Plus or minus.
It could move around slightly by quarter, a bottoming, and I would describe it as, for now, a gradual tick back up as opposed to any sort of sharp ramp-up in sales force headcount. I think should we see something that's really working, that's really good, we could always modify that and increase the rate of additions. I would describe it as a bottoming for now and a modest tick back up for the remainder of the fiscal.
Thanks. That's helpful.
Erik-
Yeah.
Sorry, Adam Uhlman. One little comeback. Just one little thing to remember. You asked about our CapEx. I know you know this, just for benefit of others as well too. We have enough capacity to handle roughly $4 billion worth in sales. Between that and the office infrastructure and everything that we put into place for us, we're pretty well positioned. Sorry for cutting you off. You had another question, Erik Gershwind?
That's okay. I just wanted to follow up, Erik, on the pockets of weakness that you mentioned, if there's any consistency there or industry vertical trends. I noticed the Northeast slowed, maybe that's a big chunk of it. Are there vertical markets that you would call out?
Yeah. Adam, as I described before in, I think it was Ryan's question that when I look at our core customers, while the average is mid-single digits, what gets me encouraged as I look forward is a lot of the big meaty ones are up well more than that. We have isolated pockets that are way down. You're right to call out the Northeast. What I would say is the Northeast in particular is heavily weighted towards fabricated metals. Fabricated metals is a pretty broad vertical for us that includes a number of different areas, a couple of which are really off. I'll give you one as a for instance, is firearms, way down. Particularly prevalent in the Northeast. While not a huge percentage of business, it's way off, it's bringing the numbers down. That would be one I'd call out.
Okay, thanks.
Our next question today comes from Ryan Cieslak of Northcoast Research. Please go ahead.
Hey, good morning, guys.
Hey, Ryan, how are you?
Good. Thanks for taking my questions. Really quick, Erik, if you go back and you look at the supplier price increase announcements that you've seen in recent months, I'd just be curious to know how those have compared maybe to your expectations going into these announcements. Meaning, maybe back in the prior quarter, was it above, in line with your expectations? Any color around that would be helpful.
Yeah, Ryan, I would say when we spoke a quarter ago, I was sort of reserving judgment on the pricing because I knew that this was always the period, November, December, when we have a lot of the pricing discussions with suppliers. Look, our expectation was much like a lot of the research I saw, that there would be more activity. There absolutely was. I would say in terms of the frequency or the number of suppliers coming to us, it was about as expected. I would say in terms of the size, the typical increase was somewhere for most suppliers, low to mid-single digits. I would say also probably in line with expectations. What I would say, Ryan, there were a bunch of manufacturers that haven't moved yet. It's not like every one of our manufacturers.
Look, it's going to be a healthy increase, but there's some that are sort of playing a wait and see, I guess because it's early in the cycle, wait and see. I think for a lot of those, there's a chance of movement, particularly if they see their peers' pricing sticking in the market, that there could be more increases coming later in the year.
Okay. That's helpful. Just to follow up on that, if you go back and you look at history during strong pricing environments for you guys, and let's assume that's the case going forward, is the way to think about when you guys implement price increases, essentially the beginning of the year and the midyear? Or is there opportunity, again, depending on demand and the pricing environment, to actually see the frequency of price increases actually tick up from maybe what you've seen in the last several years or so.
Yeah. I would say the norm, Ryan, is certainly you'd have the summer, the late summer, what we used to refer to as the big book increase and this midyear. That's the norm. I would say there have been years in the past where if the inflation environment is hot, where we could do a third. What I would say to you, we're sitting here now in January, we're telling you that the increase is going to be sometime in Q2, so it's going to be January or February. That would certainly leave room, potentially. Just going back to my prior comment, what we would need to see is a lot more suppliers move.
We're mindful that we sort of have a rhythm with our customers. If there was some supplier movement, but not a lot, we'd probably be more inclined to wait and build that into the next summer increase. If, on the other hand, there were a lot of movement, we could certainly consider doing something in between.
Okay. That's helpful. Just my last question, then I'll turn it over. I know the mix impact from recent new SKUs added in recent years, I think was a negative for you guys in fiscal 2017. Can you just update in terms of where you are with maybe optimizing some of those SKUs and getting them into inventory and maybe just how to think about that mix headwind here in this most recent quarter, and how do we think about that going forward? Thanks.
Yeah, Ryan. Good point. Right, when we refer to mix headwinds, obviously, there's the customer side and the product side. What you're referring to is a lot of the products that we've been adding that are of the, to start at least, direct ship variety, what we've described as they're a gross margin, not a net margin, but a gross margin mix headwind. That does remain. Essentially, that headwind is part of the numbers. It remains. That program is a healthy, vibrant program. One thing you probably did pick up on is, the number of new SKUs, the number was actually slightly down this quarter. But for the year, total SKU additions are going to be net about 65,000.
What you're seeing is the number of net new SKUs coming down a bit, not surprising, as we've taken advantage of low-hanging fruit and big supplier additions. That said, the program still has plenty of runway, and that will continue to be one of the headwinds that's in the business. You're also right, the last point I'll make is what we typically do as we see these products selling and getting multiple hits, we will bring them into stock, so we're providing a great service experience for the customers. That does provide margin enhancement opportunity over time, but off of a low base. Net-net, it is still a mix, and it's a mix headwind that's in our numbers.
Today's last question comes from Robert McCarthy of Stifel. Please go ahead.
Good morning, everyone. Thank you for fitting me in. I'm sure John Chironna is wearing black for the terrible event occurred a couple of days ago. My condolences.
Rob, he did have the benefit of the semifinal game in which they came all the way back.
That's true.
Well, you are a short-cycle business. You had a couple of days of euphoria before reality set in.
It was pleasant hanging out with John on Tuesday. Thank you for fitting me in, Rob.
No, I'm sure that'll be taken out of my flesh in short order. In any event, the Hollywood Squares is over. Thanks for taking the time. Sounds like a good call overall. Some concerns around December. I think I'm going to go back to the kind of the pricing questions overall. Is there any part of your SKU base that you're kind of monitoring to think about the competitive dynamics that we've seen around price transparency and some of the broader line distributors that are out there? Could you talk about perhaps the portion of your business that you're just watching to see maybe if the bears are right about some of the stagflation from the standpoint of pricing comes through, but these are commodity products with a high degree of price transparency, and you're not able to get price. How do you assess that risk?
You just can't ignore the risk. The risk is there. There's large parts of your business in terms of the SKUs, which you're very insulated from or actually very tied to material inflation in a very direct material way, and also metalworking given the technical specification. How do we think about that risk? If there is some credence to the bears argument around pricing transparency, could it just be for 5% of your SKUs, 10% of your SKUs? How do we think about that in the context of what should be a very positive good news story in terms of material inflation and pricing?
Rob, look, I think it is a good news story. I think just what I'd start out by saying is take a look back over the last year, stable gross margins. Over the last two quarters, relatively flat price realization without the benefit of inflation. You layer inflation on top of that. I do think it's certainly a net positive. To answer your question, we monitor everything. We monitor by product type, we'll monitor by customer type, and we'll look carefully at we look back at our last price increase, while modest, the summer price increase, and we measure realization, and we'll look at it across a number of dimensions. And what I tell you is we generally feel good about it. Is there some risk over time? Of course.
What I would tell you, Rob, with respect to transparency, I think it's been there. It's been there for a number of years. I think it is a headwind. We've talked about competitive intensity rising. I think it's there for sure, but I think it's a net positive. As we look, I will tell you, as we look over the last couple of quarters, particularly post price increase, look at realization, look at what's happening. I don't see anything that gives me pause for major concern.
Let me cut in there as well, Rob. Hey, Rob. We've been running a data mining, predictive analytics sort of effort and tool for the last couple of years. We've talked about it when we've been traveling together, right? We look all the time at our profitability by customer, our profitability by product line, by product, all the rest of that. It's a very ongoing focused area. No, Rob, I haven't seen any particular product group that deep sells and shows any signs of what you were alluding to.
Okay. Thanks for that. The last question, probably the last question for the call is, you've talked a lot about capital allocation. Obviously, I think you answered the questions around CapEx and capacity utilization of your existing plant and volumes. Could you talk about relative priorities for capital allocation overall in this new environment of tax reform? Is there a possibility, I mean, in the years past, you have done special dividends. Is that a possibility? How do you think about entertaining that, the mechanisms of doing that? Anything around capital allocation, just to close the circle.
Well, Rob, you're right. You know us very well. What we did use back in August of 2016, instead of a special dividend, we went towards using a Dutch auction tender, which effectively achieved pretty much the same thing of offering our owners the ability to tender back and receive the cash. At the end of the day, it left us with the benefits of a lower share count and the EPS benefits and all the rest that come with it. The really short answer is that at the end, the reply to the earlier question I said at the very end of it's returning cash to our shareholders, right? You have the ordinary dividends, you have the steady growth and all the rest of it. Then we'll do that. We are very focused on total shareholder returns.
We're not driven to, luckily, we're not driven that we have to get out there and return everything. At the same time, we think that if we end up in a situation where we have a ton of quote-unquote "surplus cash," and we don't have good discipline, accretive acquisition opportunities, then clearly we return cash to our shareholders. You probably also noticed that we had increased the buyback authorization by 2 million shares. That doesn't mean we'll go out and go buy back 2 billion more shares tomorrow or anything like that. It just means we now have an authorization that in total is at 2.8 million. Erik, you want to add anything there?
No, I think, Rob, I think Rustom hit it. I think we're going to take, as he said earlier on, the same approach to capital allocation. We're fortunate to have more net cash coming in, the same approach, which is invest in the organic business, fund a steady ordinary dividend growth within a reasonable payout ratio range, look for good acquisitions, look for buyback opportunities, and if we have excess cash, we'll return it to shareholders. You mentioned one vehicle of a special dividend. Rustom talked about another, a Dutch auction tender. That's really the how, the idea is we're going to deploy cash smartly in the business, and if there's excess left over, we'll find a smart way to return it.
Happy New Year. Best wishes for the quarter.
Happy healthy. Thank you.
Thank you.
This concludes the question and answer session. I'd like to turn the conference back over to management for any closing remarks.
Thank you, Rocco, and thank you everyone for joining us today. Our next earnings date is set for April 10th, 2018. We'll be at a number of institutional conferences over the coming months, as well as doing some road shows. We look forward to speaking with you then over the coming months. Thank you.
Thank you, sir. Today's conference has now concluded, and we thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day.