MSM - NYSE

Good day, and welcome to the MSC Industrial Supply Fiscal 2023 Fourth Quarter and Full Year Conference Call. [Operator Instructions] Please note today's event is being recorded. I would now like to turn the conference over to Ryan Mills, Head of Investor Relations. Please go ahead.

Thank you, and good morning, everyone. Welcome to our fourth quarter fiscal 2023 and full year earnings call. Erik Gershwind, our Chief Executive Officer; and Kristen Actis-Grande, our Chief Financial Officer, are both on the call with me today. 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 our Investor Relations web page. Let me reference our safe harbor statement, a summary of which is on Slide 2 of the accompanying presentation. 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. 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 our other SEC filings. In addition, during this call, we may refer to certain adjusted financial results, which are non-GAAP measures. Please refer to the GAAP versus non-GAAP reconciliations in our presentation or on our website, which contain the reconciliations of the adjusted financial measures to the most directly comparable GAAP measures. I now turn the call over to Erik.

Thank you, Ryan. Good morning, everyone, and thanks for joining us today. On today's call, I'll reflect on where we are by recapping our fiscal 2023 performance and our 3-year mission-critical achievements. I'll then pivot to where we're going by outlining the next chapter of MSC's mission-critical playbook. Finally, I'll provide color on the current environment and outlook. Kristen will then provide more specifics on our fiscal fourth quarter financial performance and our initial expectations for fiscal 2024. I'll wrap things up, and we'll open up the line for questions. Before I dig into our annual performance, I'd like to thank our shareholders for their continued support. Earlier this month, we announced the completion of our share reclassification agreement and elimination of our dual-class share structure. This was voted heavily in favor by our shareholders and makes MSC shares a more attractive investment as it broadens our scope of potential investors, enhances our corporate governance practices by limiting the Jacobson and Gershwind family's voting power, to 15% of shares outstanding, transitions us to a majority standard for any election of directors that is not a contested election and replaces the 2/3 voting rule for certain significant transactions with a simple majority voting standard. Additionally, we'll add another independent board member with the selection process getting underway in short order. Lastly, it remains our intention to offset dilution from the transaction and Kristen will discuss that later on in more detail. I'll now move on to our recent results. As you can see on Slide 4, we continued the trend of meaningfully outpacing the IP index in our fiscal fourth quarter. Average daily sales improved 9.3% year-over-year compared to flat growth for the IP index.

Thank you, Erik, and good morning, everyone. Please turn to Slide 9, where you can see key metrics for the fiscal fourth quarter on both a reported and adjusted basis. Before I dive into our results for the quarter, public sector growth was again particularly strong this quarter. This was partially due to greater-than-expected small capital purchase orders from the contract win discussed during our third quarter call, that fall below normal public sector margins. Digging into the details of our fourth quarter performance, momentum across growth initiatives resulted in continued share gains and strong cash generation. Fiscal fourth quarter sales of $1.035 billion improved 1.3% year-over-year. Our year-over-year improvement was driven by continued volume growth, more modest pricing benefits as we lap prior year actions and a 150 basis point benefit from acquisitions, partially offset by five fewer selling days. On an average daily basis, we experienced year-over-year growth of 9.3% and outpace to the Industrial Production Index by approximately 900 basis points, continuing the trend of significant above-market growth. By customer type, on a year-over-year average daily sales basis, public sector sales increased over 60% while national accounts and core customers improved mid-single digits and low single digits, respectively. Looking at our sales through the lens of our mission-critical growth drivers, we continued making strong progress. In metalworking, we continued seeing growth driven by our ability to provide customers outsized savings and value through our best-in-class technical expertise, product breadth and service levels. These competitive differentiators, combined with our 150-plus metalworking experts, places at the spindle with customers and has us well positioned to further penetrate high-growth end markets and address customer needs associated with the skilled labor shortage in North American manufacturing. Within our vending and implant offerings, we continue capturing share and experiencing favorable levels of growth. In vending, Q4 average daily sales improved slightly more than 9% year-over-year and represented roughly 16% of total company net sales, in line with the prior year. Implant signings remained strong at a rate modestly below last quarter's high watermark and sales improved approximately 13% year-over-year. As a percentage of total company net sales, implant revenue represented 13%, an improvement of roughly 110 basis points year-over-year. It's worth noting that both of these solutions would have accounted for a higher portion of total company net sales excluding the outsized public sector growth. In e-commerce, we experienced mid-single-digit growth year-over-year. Sequentially, related sales improved slightly to 61% of total company revenue, but was down year-over-year largely due to the outsized public sector growth that transacts through different channels. Looking forward, we expect improvement in our e-commerce sales particularly through mscdirect.com as we start rolling out enhanced capabilities, including improved search and navigation functions. Across our other two initiatives, we continued making strong progress in selling the portfolio to increase share of wallet, which is primarily our Class C consumables, ADS growth was in the low teens. Progress on our diversification initiative also continued with public sector growth in excess of 60%, representing 13% of sales, which is an improvement of 500 basis points year-over-year. It's worth mentioning that even excluding the small capital purchases, public sector growth was north of 20%. Lastly, and as Erik mentioned, we successfully completed the first chapter of our mission-critical programs. However, we expect to maintain this momentum in fiscal 2024 and beyond. Looking ahead, this will help us mitigate impacts from the temporary market challenges we currently face that I'll speak to you later on. Moving on to profitability for the quarter. Our gross margin of 40.5% was down 140 basis points year-over-year. The year-over-year decline was largely driven by a 130 basis point mix headwind primarily due to the specific products sold in association with the previously discussed public sector contract win, which was below typical public sector margins. Looking forward, we don't expect these lower margin sales to have a meaningful impact in fiscal '24. As expected, price/cost was a larger drag on margins this quarter driven by the combination of more modest pricing benefits and higher cost inventories working through the P&L. However, this was completely offset by combined benefits of other items such as rebates and other cost of goods sold adjustments. Reported operating expenses in the quarter were approximately $299 million and up $9 million year-over-year. On an adjusted basis, operating expenses were approximately $289 million, a slight decrease of $0.5 million. This represents a decline in adjusted operating expense as a percentage of revenue of 40 basis points year-over-year to 27.9% of sales. The reduction in adjusted operating expense was primarily due to one less selling week year-over-year. Excluding the difference in business days, adjusted operating expenses would have increased year-over-year. This increase was primarily driven by variable selling expenses tied to higher volume, labor costs, digital investment and increased health care costs, which remain at the elevated level we experienced in fiscal Q3. This was partially offset by lower freight expense as well as mission-critical savings of approximately $3 million bringing total programming savings to $102 million, slightly above our stated 3-year target. Reported operating margin was 11.4% compared to 14.1% in the prior year period. On an adjusted basis, operating margin of 12.6% was in line with expectations and declined 100 basis points compared to the prior year. The year-over-year decline was primarily driven by the 140 basis point reduction in gross margins with a partial offset from the 40 basis point improvement in adjusted operating expenses as a percent of sales. We reported GAAP earnings per share of $1.56 compared to $1.86 in the prior year period. On an adjusted basis, EPS was $1.64 versus $1.79 in the prior year. Turning to Slide 10 to review our balance sheet and cash flow performance. We continue to maintain a healthy balance sheet with net debt of approximately $404 million, representing 0.72x EBITDA. We have a strong liquidity position with $50 million of cash on hand and approximately $550 million currently available on our revolving credit facility. Looking forward, our balance sheet strength and cash flow generation strongly support both our capital allocation strategy and near-term intentions to offset dilution from the share reclassification, which I will speak to you momentarily. Additionally, we had strong operating cash flow generation during the quarter of 152% and 204% for the full year, well above our greater than 100% target. Capital expenditures totaled $28 million during the quarter and approximately $92 million for the full year. Together, this resulted in strong free cash flow generation of approximately $607 million for the full year, an increase of over $420 million year-over-year. Moving to our capital allocation priorities on Slide 11. Our decision to deprioritize special dividends creates significant room for strategic optionality. Looking forward, this will likely be geared towards organic investment both on M&A opportunities and further deployment to shareholders. As it relates to the ordinary dividend, we will target modest and consistent increases as seen by the recent 5% increase. As I previously mentioned, share repurchases will remain in the pecking order of our capital allocation strategy. Given our intentions to offset dilution from the share reclassification. We detailed our expectations for buybacks in fiscal '24 for modeling purposes on Slide 12. The dilution of shares from the reclassification was approximately $1.9 million. We repurchased approximately 645,000 shares during the fourth quarter and an additional 205,000 in the current quarter as of October 13, leaving approximately 1.1 million shares remaining to fully offset dilution. As a reminder, we expect to repurchase the remaining shares by fiscal '24 year-end. Looking forward, after completing this buyback initiative, we will have approximately 2.4 million shares remaining on our current authorization. And at a minimum, we will look to offset annual stock-based compensation dilution. Now moving to our initial fiscal 2024 outlook on Slide 13, we expect average daily sales to improve approximately 2.5% at the midpoint with a range of flat to up 5%. This includes an approximately 160 basis point year-over-year headwind from nonrepeating public sector sales. Underlying assumptions within our sales outlook include more normalized pricing benefits year-over-year. As it relates to the current market challenges, our outlook assumes the IP index remains roughly flat, consistent with recent readings and that headwinds related to the UAW strike will begin to alleviate in early fiscal 2Q or before calendar year-end. Lastly, as a reminder, we have the same amount of business days year-over-year throughout the fiscal year. Within the sales outlook, we expect adjusted operating margins to be in the range of 12% to 12.8% or down 60 to up 20 basis points year-over-year. This reflects lower volume and more challenging price cost expectations in the first half of the fiscal year. However, for the full year, we expect to offset a good portion of these negative factors through category line review savings, other gross margin countermeasures and a roughly 50 basis point gross margin mix benefit from non-repeating public sector sales. The combined effect of these items are expected to result in gross margin for the full year being flat to slightly down year-over-year. Depreciation and amortization costs are expected to fall in the range of $85 million to $95 million, with the increase representing a margin headwind of 30 to 50 basis points year-over-year. This largely reflects the investments made in technologies and digital capabilities as well as continued growth in vending. Other underlying assumptions include an interest and other expense of $40 million to $50 million CapEx, including implementation cost for cloud computing arrangements of $120 million to $130 million, and a tax rate between 25% and 25.5%. Additionally, we expect strong operating cash flow generation to continue in fiscal 2024 and to be greater than 125% of net income. I will now provide some additional detail on our expectations for the first quarter and quarterly cadence throughout the fiscal year. With respect to revenues on a sequential basis, we historically experienced low single-digit improvements in our 1Q ADS rate compared to 4Q, which isn't expected to be the case in fiscal '24. This is primarily due to the previously discussed market challenges as well as an approximately $30 million headwind related to non-repeating public sector small capital purchases. As a result of these factors, we expect average daily sales in the first quarter to be down sequentially in the low single-digit range and up slightly year-over-year. Looking beyond the first quarter, we expect to slightly outpace historical sequential patterns in 2Q with stronger sequential performance in the second half. Under this scenario, we assume the previously discussed market challenges begin alleviating in early 2Q. With respect to gross margin, we expect the first quarter to tick up sequentially because of the removal of the public sector large order noise. That said, the first and second fiscal quarters are likely our most challenging due to negative price cost. As we move through the year, that gap should ease due to the cycling of our inventory and the benefits of category line reviews and other gross margin countermeasures. Finally, with respect to operating expenses, Q1 will see a sequential step-up in D&A and incentive compensation expense. That sequential step-up will not repeat itself to nearly the same degree in the following quarters of fiscal '24. Additionally, our profitability as the year progresses, will be supported by the swift actions Erik previously outlined in response to the soft start to the fiscal year. This will come in the form of clamping down on discretionary spending, taking a hard look at key expense areas like freight and other productivity initiatives and executing on several gross margin actions, including the category line reviews. With that, I will turn the call back over to Erik for closing remarks before we open the line for Q&A.

Thank you, Kristen. Fiscal '23 was a monumental year for MSC as we strengthened our corporate governance, successfully closed the first chapter of our mission-critical journey and surpassed $4 billion in annual sales for the first time in company history. I'd like to thank our entire team for their hard work in making this possible. Looking ahead, we will leverage the muscle memory gain from the past three years to further strengthen MSC's performance. Regardless of the macro environment as we enter fiscal '24, we will remain focused on harnessing our momentum, adding new levers of growth and productivity initiatives and executing what is in our control. Thank you again to our entire team, and we'll now open up the line for questions.

[Operator Instructions] First question comes from David Manthey with Baird. Please go ahead.

Good morning, everyone.

Good morning, Dave.

Yes. Thanks for the color on margin progression as we look year-to-year. But I'm hoping you can bridge us a little more clearly from fiscal '23 to '24 gross margin. We're starting at 41 even. You said 50 basis points due to the non-repeating public sector contract win. I think the last time we did a line review of something like 50 basis points. So, I'm thinking you probably, are getting 100 basis points of good guys there on the gross margin. What are the 100 or more basis points, of offset that leads you to believe gross margin will be flat, to down next year?

Yes. So you've got the tailwind on the purifiers right, Dave. That's definitely one piece of it. And then the second thing I'd point out is on the category line reviews, I'm not sure I'd go quite as high as the range that you gave. But there is a reasonable expectation, of course, that's helping to offset some of the price cost headwind, that we've been experiencing and we'll continue to experience. So if you're starting at 40.5, let's just say you build that up to 41 as a kind of revised starting point for simplicity. I think then you could expect let's just say, somewhere between maybe 50 to 70 on the category line review benefit, and then your headwind would be in your price cost spread, and that would get you back down to roughly flattish. Now we alluded to kind of the countermeasures in the script that Erik was talking to. So obviously, there's a lot of things we're doing within gross margin, both in terms of transactional price cost, but also trying to affect other things in the kind of the other cost of goods sold accounts via countermeasures, but that that's kind of the color I'd give you, on kind of simple building blocks, to get back to the roughly flattish guidance on the GM rate.

Shouldn't the - you're starting from 40.5, but shouldn't we start from 41.0 if we're adding back the 50 basis points for the government business?

Yes. Yes, that's what I did. So go from 40.5 million then put back on 50 bps for the government business, so that would take you to 41.0. And then depending on how you want to assume category line reviews go, I think we've communicated that we hope to do at least as good as in prior reviews. So that would be about $20 million I'd say, obviously, we're hoping to do better than that. So, depending on how you want to layer that in, I would put in 50 to 70 on category line reviews, if I'm kind of being conservative, that would get you up to 41.5 to 41.7 million. And then to drop you back down to 41 flat, that's where your price cost headwind comes in.

Okay. All right. We can follow-up on that. And then on the overall sales growth outlook here, including the 400 basis points of share gain, if you take out the unusual government sales and acquisitions, it still seems like you're assuming industrial recession in most cases here. So first question is, is that the case? Are you looking at flatness to down in terms of IP for '24 as a base case? And then second, Erik, you mentioned a bounce back in auto-related sales following a period of slowness. Is your assumption in the second quarter of fiscal '24?

Yes, Dave. So on the revenue front, what I'd say is - basically what we're assuming, and I think Kristen alluded to this in going through the framework, is a roughly flat IP through the year. The reason revenues are where there are is you have two things. One is, as you mentioned, it's about a 150 basis point headwind for non-recurring public sector orders. So if you take the midpoint of our guidance at 250. There's another 150 basis points or so for non-recurring orders. The other thing I'd say is it's also in recognition, Dave, we're coming out of the gate slow - slower than we otherwise would have, because of the UAW situation. And in the prepared remarks, we talked about low single-digits in terms of points to growth impact. So September and October, we're a little more than halfway through here. But September, we have under our belt at half of October are going to be lower than the midpoint. So that is factoring into our equation. In terms of bounce back, that is not factored in. So what we are assuming is that the UAW situation releases itself, before the end of the calendar year. And that things restore to more of a neutral, or flat IP situation, it does not account, for any big bounce back that certainly could happen.

Got it. Thank you very much.

Thanks, Dave.

And our next question today comes from Steve Volkmann with Jefferies. Please go ahead.

Hi. Good morning, everybody. Erik, you talked about the deceleration in September and October. It sounded to me like maybe half of that was due to UAW issues and the other half was sort of more general. Any more color you can give us on sort of the non-UAW drivers?

Yes, Steve, certainly, I'll take a shot here and then Kristen can chime in to fill in any dots here. But certainly, if you look and you go Q4 to September, the Q4 and even August, growth number, it's certainly a big drop. I think one thing just to sort of walk you growth rate from where we were tracking Q4 to Q1, you have a couple of things going on. So one, certainly, the non-repeating public sector orders were about three points of that. So that brings you down to about 6%. There is a bit of a timing on the lapping of an acquisition, it's 0.5 point or so. But basically, you're looking at somewhere in the 5%, 5.5% range without those factors down to what's in the 13% range for September and something similar, to what we're projecting for October. Of that, what we were saying is in the low single-digit range, you could add back for UAW. So yes, I think you're back of the envelope on saying, about the sequential step down about half and half, is a reasonable ballpark, meaning half related to UAW and then certainly a little bit of softening, which isn't surprising to us, given what's going on at all of the macro indices.

Right. And just any sort of end markets or themes to call out in terms of that slowing non-UAW slowing? Is that what....

I would - I'm sorry to interrupt you, but I would call it general slowing. The real interesting thing here is it's hard to find a bright line between what's auto related and what's not. And what I mean by that is we have some direct auto exposure. The bigger issue for MSC, of course, is what would be coded as a machine shop, a fab shop, a lot of - there's a portion of their business that is auto related. So there's tentacles to the strike that extend, beyond just the direct SIC codes, if you'd look at auto. But more broadly, I would say general softening. You certainly do have some pockets of strength still like aerospace, of course, but more general softening, again, I think, consistent with what we've been tracking with the IP and the sentiment readings.

Got it. Okay. Thanks. And then just a quick follow-up. Kristen, are you assuming that gross price is positive in '24?

Yes, gross price will be positive in '24, Steve. I'd assume about one to two points of growth from price in '24.

Okay. Thank you.

You're welcome.

Thank you. And our next question today comes from Tommy Moll with Stephens Inc. Please go ahead.

Good morning. And thanks for taking my question.

Good morning, Tom.

Good morning, Tommy.

One follow-up on the '24 discussion we've been having. Kristen, I think I heard you say in terms of volumes, you expect them lower. I think that was a first half comment, but I just want to make sure, that we've got the right time frame there?

Yes, you heard that right, Tommy. Lower in the first half, of course, Q1, we kind of talked about here with what's going on with the UAW and the general industrial softening, and then the expectation that UAW alleviates in early Q2. So what I would - how I would think about kind of what changes first half to second half then is UAW headwind goes away. And then we also have, as we talked about in the prepared remarks. Two key things coming online that drive growth in the second half. One is some changes that we're making around our pricing strategy. And then the second is, of course, the changes we're making to the e-commerce platform, and both of those are intended to really reenergize the growth rate in the core customer space, which has been lagging the growth rate we've seen for the broader company overall. So that is - that, along with just the change in the macro piece drive sequential improvement in the second half. We've got a bunch of other growth initiatives that we're working on. I'd say there's a runway on the large account wins that we've had in the past year, particularly in the second half of '23 that provide upside through a year. But those are a few things that, I would point to that create the inflection first half to second half that we're expecting.

That's helpful. Thank you. I also wanted to follow-up on auto. If you have these numbers, it would be great, if you could provide them, just what you estimate your direct and indirect exposures are just in terms of percent of revenue? And just any more anecdotes you can give, where you may be able to discern it. It's more just general customer caution. So maybe not directly "strike impacted", but more just a sentiment headwind in that ecosystem that you've seen manifest? Thank you.

Yes. Sure, Tommy. So to answer your first question, direct exposure, roughly in the range of 10%, maybe a little bit under 10%. Indirect exposure, as I mentioned, tough to get our arms around specifically, but - certainly, it would take that number up considerably when we were referring to kind of MSC's bread and butter of machine shops, fab shops and job shops. So that's in terms of the first part. In terms of the color I'd provide. We stay pretty close to the ground with our sales force. And we're getting regular reports and some of the reports are temporary halts in production, which would be sort of a more direct example of what we're talking about due to a strike either at a customer or a customer of a customer. And then the other is, as you said, there are customers who are further down in the chain in the auto supply chain, who are expressly more caution, and are just clamping down on spending. And we have examples of that, where some of our vending customers that's basically buy only what you need. And so, we're seeing a lot of the - almost like what we described in the MSC world of clamping down on discretionary spending, we're seeing the same thing at a lot of our customers.

Thank you. I appreciate it. I'll turn it back.

And our next question today comes from Ken Newman at KeyBanc. Please go ahead.

Hi, good morning, guys.

Good morning, Ken.

Good morning, ken.

Good morning. Touch back on to the UAW stuff a little bit more here. Obviously, you're assuming that strike alleviate by the end of the calendar year. I'm just curious just how much visibility do you have there in terms of what gives you comfort in making that assumption? And obviously, the range in the guidance is a bit wide for this coming year. So at the lower end, what are you kind of assuming in terms of a potential impact, if that strike lasts a little bit longer than you anticipated?

Well, Ken, what I'd say is you could see, I mean, we're tracking towards the lower end of the range through September and our estimate for October, right? So that gives you a feel for, if this were to continue, what would have to be the case for the lower end. We're kind of in it now. And look, we had to make some assumptions. Our visibility is somewhat narrow, as you limited like all of us. As you suggested, that's why the range is slightly larger. But look, I think the punchline is if this were extended, you're seeing what it's doing now. But certainly, to the extent this alleviates itself at some point, there is a lift to come. And then as we were talking with Dave earlier, if there were a bounce in response, more of a lift. And obviously, in the meantime, all the while Ken, we're focused on share capture. And so, I was encouraged while we can only control so much, I was encouraged right out of the gates in September, despite the lower growth our sales team's execution was strong. So vending signings up over 50%. VMI signing is up over 25%. Those are the things that Kristen mentioned sort of a build in back half some of the initiatives coming online. In addition to some of the bigger programs, just better execution in a tough environment, when local distributors are vulnerable, gives us confidence, because all of those signings will lead to new agreements, which lead to revenue as we move along the fiscal.

Right. No, that makes sense. I guess, for my follow-up, kind of following up on that. I mean, you did increase the CapEx here, for some of these digital investments. I think Kristen, you mentioned a decent amount of that going towards cloud computing. Can you just quantify how much of that is contemplated in the new CapEx guide? And when do you expect to see those benefits start to monetize through the income statement?

Yes, Ken. Happy to talk about that. So it is contemplated in the CapEx range that we gave. I would assume around $35 million of that roughly going to the digital core initiative that we talked about. And maybe let me put a little bit more color around that, than we kind of went into in the prepared remarks. But we really see this as being key to ongoing productivity generation and the ability to scale profitable growth once it goes live. So this is not a full-scale ERP system. Just to be clear, like we've kind of implemented parts of this along the way over the years. So, our finance systems done already, PIM, web pricing, we're not putting warehouse management and scope for this. And then a little bit - I guess a little bit more color on this, too. We brought in a new CDIO last year, John Hill. He's led several of these implementations before, and he's got a dedicated team that's taken us through this. So it ends up being about $35 million this year. I think a similar amount then in '25 with the program coming online towards the end of '25. I'd expect some productivity benefits to start trickling in a little bit earlier that, just related to kind of the business process reengineering on order to cash and procure to pay, which is really what the system is targeting. So maybe some small productivity generation in '25, but then material impact the P&L post '25. And of course, that's when the depreciation would start to hit as well.

Understood. Thanks.

You're welcome.

And our next question today comes from Ryan Merkel with William Blair. Please go ahead.

Thanks. Good morning. Two questions, first of.

Good morning.

Hi, good morning.

Hi Ryan.

Just on UAW, the impact of down low single-digits, how did you quantify that? Was that the 10% direct down sort of 20%, 25% or are you including sort of the indirect impact in there as well?

Yes. We're including the indirect impact in there, Ryan. So what we've tried to look at was - the change that we've been seeing in the IP end markets in auto, transportation, primary metals and fabricated metals. And as Erik mentioned, we've got some direct exposure in auto. So when we look at that one that's probably a little bit cleaner to track, although there's even some things that map in there, which aren't sort of perfect representations of our business. But primary metals and fabricated metals, would be where we would look to try to gauge the impact that, may be happening in the other spaces through like the job shops and the machine shops. So, we're basically looking at like what normal sequential trends, would look like for our sales in those spaces. And then we're looking at what the IP indices are doing to kind of triangulate against that low single-digit number that we gave.

Okay. Am I in the right ballpark where sort of all auto is down maybe 20%?

I think that would be roughly in line with what we were seeing when we did the analysis, yes.

Okay. Okay. That's helpful. And then just back to gross margins in the walk, just high level, it sounds like first half will be down year-over-year in second half up year-over-year. Is that roughly correct? And the reason being in the second half, you get benefits from the line review and then you've lapped the price cost headwind right in 3Q?

Yes. Maybe let me give it sequentially, Ryan, because you got the noise from the public sector contract win in the second half. So, what I would think about if you're starting with Q4 as the jump-off point on the 40.5, you're going to move up slightly sequentially into Q1. I'd expect a small inflection again in Q2 and then Q2 into Q3 with the second half being roughly level. That might be a little bit of an easier way to think about it, because there is a lot of noise in the year-over-year comps. Hopefully, that makes sense.

Yes, it does. Okay. I appreciate it. Thanks.

Welcome.

And our next question today comes from Chris Dankert with Luke Capital. Please go ahead.

Hi. Good morning. Thanks for taking the questions.

Hi Chris.

I guess, on the digital launch mace.com kind of revamp here, just any additional detail on timing? Should we still expect that before calendar year-end? And then maybe just any kind of contribution to sales growth, we should be kind of assuming in the guidance there?

Chris, so the - basically, the e-commerce improvements and the heavy lifting on this is done. So Kristen mentioned in the D&A, the impact of the P&L, the good news is the work is done. The rollout will be occurring really over the next quarter or so. So customers will begin to - that's when the customers will begin seeing an impact. We're pretty encouraged. What I would say is, it's factored in to our guidance for basically what Kristen described coming out of the gates here were slow. We expect some sequential build in part, because of this UAW situation at some point, of course, normalizing, but in part, because of the initiatives, and that's a piece of it. I think what we expect to happen with e-commerce, is it's not going to be a light switch. This will build over time. It is one of the things though that gives us confidence beyond this year, looking at kind of with a three-year lens, a multiyear lens. What gets us excited as we look back to the prior three-year chapter and we achieved our growth targets, or we exceeded the growth over IP without really getting the engine of our core customer growing, we think this is a big piece to it. So, I don't think it will be a light switch, but I do think we're going to start seeing benefits, beyond the next quarter.

Got it. Thank you. That's very helpful. And then maybe just to put a fine point on the cost front. Again, it seems like we're moving away from an absolute cost of dollars coming out of the business, that $100 million that we had in the last mission-critical program. Should we now just kind of keep our eyes on hitting that $20 million - or the 20% incremental margin and think about that, as kind of the target for continuous improvement going forward?

Yes. Chris, longer term, I would say that's a fair way to think about it '24 is going to be a bit challenging on hitting 20% incrementals, because of what's happening on price cost and margins and then what's happening in terms of fixed cost and OpEx step-up. So longer term, yes, I would agree with that. And then the way I would think about productivity within the year though, and maybe this sort of just helps the kind of OpEx sequencing also. As we mentioned in the prepared remarks, there'll be a step-up in Q1 on OpEx costs related to D&A and incentive compensation. I would also factor in the sequential volume change and how we gave that. But so you - based on what we're targeting for Q1, if you infer like a midpoint on what's happened in September and October. You stepped down based on volume-related costs and OpEx. That would be offset by the step-up in D&A and incentive compensation expense. And then I would think about OpEx dollar sequencing through the year as basically being roughly flat with the exception of your volume fluctuations. So basically, what that means is we're leveraging productivity, to cover things like our merit increase, fund some of the investments. And then just to kind of size what that's worth, our merit is typically around $20 million alone each year.

Got it. That's all very, very helpful. Thanks so much and best of luck in the New Year.

Thanks, Chris.

Thanks, Chris.

Thank you. And our final question today comes from Patrick Baumann with JPMorgan. Please go ahead.

Hi. Good morning. Thanks for taking my questions.

Good morning.

Hi, how is it going? First one, I guess, just a quick cleanup from the quarter. I think you said, Kristen, something about rebates and COGS adjustments offsetting price cost in the fourth quarter. What is that exactly?

Yes. So, we saw favorability in Q4, Chris, related to both vendor rebates and customer rebates. And then the other item that we had in there was around - so we've been doing a lot of work. I think we've alluded to it on previous calls in terms of countermeasures on working capital and kind of composition of inventory, and some of that work started to yield the benefit in Q4 in terms of requiring a lower inventory provision than we've been seeing. So that was the other thing that benefited us in Q4. And those items combined allowed us to offset, the price cost headwind. So it was a meaningful contribution, and we talk about countermeasures for fiscal '24. That's the type of stuff that we're looking to as well.

What - can you quantify what that was in terms of basis points that offset?

Yes. So, if you look at Q4, we had about 130 basis points of impact tied to the public sector contract. And then price cost was down 120 basis points, and it was totally offset by the improvements in those other cost of goods sold areas.

Super helpful. Thanks for the color. And then my follow-up, maybe for Erik, is if you could give us some more color on the pricing strategy, the changes you're making for that for the core customer like what it entails? And after you're done with this, how should we think about gross margin for this group? Can it remain above the company average by the same spread it is today? And can you remind us how much higher the gross margin is for core customer versus, what you booked for large customers. I recall in the past, a number given in the range of like 500 to 700 basis points. But that might have been a couple of years ago, so I just wanted to confirm? Thanks.

Yes, Pat, sure. So maybe I'll touch on the strategy. Kristen can follow-up just on the growth differential, but I'll give you the punchline. So, what we're doing here and look, our pricing strategy has always been around a list price as a jump-off point to get to a net price for our customer. We feel very good about our pricing. And first, I'd say our value proposition is a high price value prop. And don't intend on changing that. We bring a lot of value in the way of technical expertise to our customers. We do command a premium relative to the traditional distributor that's warranted and that's not changing. What isn't a change, is as we look in any case where we're touching a customer consistently, with a salesperson and a relationship, our pricing is competitive. What we have found, and I think we've alluded to this before that there's cases where we're not touching a customer as regularly with a salesperson. It may be a direct marketing relationship, and there are times where our pricing is not competitive. And with that - certainly, it's not competitive without jumping through some hoops on discounting. And so, what we're looking to do, is identify and isolate those cases. Both in terms of SKUs and customers and make adjustments, so that we're presenting out of the gate a more competitive price. The work is - basically, this will be going out. The work most of the heavy lifting, again, is done. It will be coming in flight in the next one to two quarters. And basically, we feel we're doing this as we've modeled out with minimal, if any, margin dilution. Because of the way, we've structured this and the idea is just bringing a better price to the customer out of the gate. Our feeling is absolutely that along with the web improvements, this will reenergize the core customer. And you are correct, we absolutely feel that post this adjustment, the core customer gross margin will still be healthily above company average and certainly, well above the growth drivers that have been driving most of the growth. So your estimate is certainly not out of the ballpark in terms of basis points. But that's one of the reasons, we're excited as we move past. Kristen talked about some of the challenges in the first couple of quarters, you get past the first couple of quarters of '24 into the back half into '25. This gets to be a pretty exciting picture.

Yes. So it's a good range that you gave. And the other thing I'll just - I'll add a little color on what Erik said too, in terms of profitability of sort of the - kind of customers we're talking about here, it's also lower cost to serve. So really benefits the P&L in a couple of places.

So if you - just to follow-up to that, I guess that's embedded in the 1% to 2% price you mentioned earlier for the year. If you reduce the price for this group of customers in select instances, how do you maintain the same gross margin spread that, that group had in the past?

Yes, it will be plus or minus, Patrick. And the answer is that, in a lot of cases, it's going to be - there's a lot of discounting that occurs when the list is high and we're not competitive out of the gate. There's a lot of discounting and oftentimes inefficient discounting that happens. So while this is going on, there's pretty tight controls around discounting disciplines, because we're bringing a better price to the customer right out of the gate. And most of our modeling suggests that, that will offset one another.

Understood. Okay. Great, thanks. I appreciate….

Oh, I think we lost you Patrick, but thank you.

Ladies and gentlemen, this concludes our question-and-answer session. I'd like to turn the conference back over to Ryan Mills for any closing remarks.

Thank you for your time and interest this morning. As a reminder, our fiscal 2024 first quarter earnings call date is set for January 9, and we look forward to seeing you in person at the Baird & Stephens conferences in November. Thank you for joining us today. Goodbye.