Michael DeCata - President, CEO & Director Ronald Knutson - CFO, EVP, Controller & Treasurer.

Ryan Mills - KeyBanc Capital Markets Kevin Steinke - Barrington Research Associates David Hathaway - Far View Capital Management.

Good morning, ladies and gentlemen, and welcome to the Lawson Products Third Quarter 2018 Earnings Conference Call. This call will be hosted by Michael DeCata, Lawson Products' President and Chief Executive Officer, and Ron Knutson, Lawson Products' Chief Financial Officer. They will open the call with an overview of the third quarter results.

Then there will be time for questions and answers. This call is being audio simulcast on the internet via Lawson Products' Investor Relations page on the company's website, LawsonProducts.com. A replay of the webcast will be available on the website through November 30, 2018.

During this call, the company will be providing an update on the business, as well as covering relevant financial and operational information.

I'd like to point out that the statements on this call and in the press release contain forward-looking statements concerning goals, beliefs, expectations, strategies, plans, future operating results and underlying assumptions that are subject to risks and uncertainties that could cause actual results to differ materially from those described.

In addition, statements made during this call are based on the company's views as of today only. The company anticipates that the future developments may cause those views to change. Please consider the information presented in that light.

The company may at some point elect to update the forward-looking statements made today, but specifically disclaims any obligation to do so. And now, I'd like to turn our call over to Lawson Products' CEO, Mike DeCata. Thank you. You may begin..

Good morning, and thank you for joining the call. This morning, I will comment on the quarter and our overall progress. Ron Knudsen, our CFO, will provide more detailed review of our financial results and then we'll take your questions. Our third quarter performance was strong and represents a continuation of our solid first and second quarters.

We continue to successfully execute our three-part growth strategy of adding sales reps, increasing sales rep productivity, and pursuing a disciplined approach to acquisitions.

Beyond sales growth, earnings and leverage have performed as forecasted during our last call, and this quarter further demonstrates the inherent leverage and earning potential of our business under a wide variety of growth scenarios.

We achieved $7.3 million in adjusted EBITDA versus $5.4 million in the third quarter of 2017, and adjusted EBITDA growth continued to outpace revenue growth. So a really good quarter in both sales and earnings.

Also the fact that we were able to slightly increase our Lawson segment gross margin percent is further evidence that our customers recognize us as a critical partner in their success. Now, let's discuss some of the details. Total sales grew 17%. Our organic sales grew 4% and the Lawson segment achieved a 6.6% increase in sales rep productivity.

Despite facing challenging comps on a year-over-year basis, every market segment group, our strategic accounts increased 3% versus the third quarter of '17 and 12% year-to-date. Considering the 45% growth we achieved during 2017, we are extremely encouraged by the continued growth in this segment.

Our Canada automotive segment grew by 4.5% for the quarter. During the 2Q call, I mentioned that we work closely with one of our key customers to bring the cloud-based procure-to-pay suite called Coupa, and digital workflow online.

Our Microsoft team's knowledge-sharing platform was especially useful for our sales reps to answer technical software-related questions on behalf of the customer. Now that we've built the digital links to Coupa, it will be available to other large customers along with other digital platforms such as Arriba.

These tools greatly improve the efficiency of the procure-to-pay process for our customers and Lawson. Our Canadian business grew by 122% and 3.2% excluding Bolt Supply. As a reminder, we acquired Bolt Supply on October 1st of 2017. So its performance was not reflected in our 3Q 2017 results.

We are especially pleased with the growth and monthly trajectory of our government segment. We achieved 6.7% growth for the quarter, and the government segment has built momentum every month this year.

Over the past several years, we have shifted our government focus from predominantly federal Department of Defense business to a balance between federal, state and local business. For example, we recently won the State of Mississippi contract for consumable MRO. We also won an agreement called Co-Stars.

This is a cooperative purchasing agreement used by the state of Pennsylvania, and we've expanded our relationship with the Chicago Transit Authority. This diversification results in a more robust and resilient approach to our government segment.

During the third quarter, we added 59 new locations within existing strategic accounts, as part of our conversion process, and 238 new locations year-to-date. We also added several new strategic accounts this quarter. Several represent significant growth potential.

Our positive margin trends are being driven not only by strengthening in demand, but also multiple internal cost containment and productivity initiatives. Our Lawson gross margin percent was 60.9%, compared to 60.8% before the reclassification of expenses to costs of goods sold based on the new accounting standard.

This improvement reflects our sharp focus on distribution center productivity, transportation costs, operational improvements, and price actions. We're maintaining this focus in an environment of inflationary headwinds and supplier cost increases. Again, I'd like to thank our sales team, our operations folks, and especially our customers.

As we look back over the past five years, our quarterly GP percent has been between 59% and 61% for the MRO business. We believe our customers recognize the value of our services and our private-label product offering.

By providing intensive lost and managed inventory services, and visiting our 75,000 customers on average every 10 days, we are able to replenish their inventory and provide technical problem solving that customers depend on.

From an operational standpoint, our Alberta distribution center is working to optimize on-hand inventory to better serve its customers and accelerate growth in Western Canada. On October 22, we also opened a new Bolt Supply branch in Port Kells, a suburb of Vancouver.

This is the first Bolt branch that has been opened in 10 years, and will further enhance our footprint in British Columbia. We also moved our Winnipeg location to a larger facility. We've added several territory managers to the Bolt team this year, bringing the total to 27 at quarter-end.

Beyond facilities and supply chain, we continue to focus on improving productivity and managing our back-room costs. For example, we recently negotiated sourcing savings within IT that will provide significant ongoing savings. We also achieved significant cost avoidance in our benefits plans without negatively impacting employees' coverage or costs.

Our annual medical and dental costs have seen only minor cost increases over the past few years, which has benefited both Lawson and our employees. These are both examples of our goal of holding G&A costs essentially flat while growing sales. Turning to growth, we continue to work on our three-part growth strategy. Growing our sales team.

This quarter, we finished with 1,005 sales reps including the Bolt Supply. We will continue to focus on incrementally adding sales reps for the foreseeable future. We have also seen encouraging signs of improved sales rep retention. Increasing productivity.

This quarter Lawson sales reps achieved 6.6% improvement in the sales rep productivity versus third quarter 2017. We measured this as sales per rep, per day. We continue to enhance OrderPad, the order entry software that sales reps use. We also see continued adoption of Microsoft teams for just-in-time knowledge sharing between reps.

These are just two examples that are helping us drive sales rep productivity improvements. Growth through acquisition. On October 1st, we announced the acquisition of Screw Products of Dallas, Texas. Screw Products brings us valuable knowledge in the job shop and kitting arenas. We welcome Bill Marthens, the former owner of Screw Products.

Bill has a great track record of success, and we are confident that he and his team will thrive in the Lawson environment. We also have an active pipeline with a broad range of acquisition opportunities, but remain disciplined in our approach. From an operational perspective, we are pleased with our operation's supply chain metrics.

We continue to focus on distribution center productivity as measured by lines shipped per man hour worked. Year-to-date, we've achieved improvement of 6.7% on this metric while opening a new distribution center in Alberta. Looking forward, we feel very good about the remainder of 2018, and we are extremely well positioned heading into 2019.

Challenging comps will continue in the fourth quarter, but leverage will continue to expand in the fourth quarter as we drive sales through execution of our three-part growth strategy. Now, I'll turn the call over to Ron for more insight into the third quarter financial results..

first, Bolt Supply generated sales of 9.8 million in U.S. dollars for the quarter; second, actions we've taken to drive growth continue to deliver results as we realize positive sales growth in all of our segments for the quarter. We continue to convert new locations for our existing strategic relationships.

In addition, our talent development initiatives are yielding benefits to the organization as we improve the onboarding process of new reps, drive more accountability to the field management, provide sales reps with forums to support product and technical questions, invest in technology, and continue to reward our sales reps for growth.

As a result, sales per rep per day productivity continued to improve with an increase of 6.6% over the year-ago quarter. We ended the quarter with slightly less than 1,000 Lawson and Kent sales reps, plus 27 territory managers in the Bolt Supply business. Our focus remains on sales rep productivity and hiring.

The 4% organic Lawson sales increase was broad-based with all segments growing through the quarter. On an organic ADS basis, U.S. sales were up 4% while our Canada ADS excluding Bolt Supply were up 2% in local currency. From a sequential average daily sales basis, the Lawson segment July sales were $1.227 million.

August was $1.226 million, and we had a strong finish in September at $1.302 million. In addition, from a Lawson segment standpoint, strategic account sales were up 3% over the year-ago quarter and represent approximately 16% of our MRO volume. We also realized growth of 6.7% in our government segment and nearly 5% growth in our Lawson core business.

In line with our expectations, reported gross margin for the quarter was 54.3%. Similar to prior quarters this year, gross margin was impacted by $3.4 million of service-related expenses that were reclassified into costs of goods sold in addition to lower Bolt Supply gross margin than the Lawson segment.

Prior to the expense reclassification and Bolt Supply, the organic Lawson segment gross margin was 60.9% compared to 60.8% in the year-ago quarter.

Despite the challenging inflationary environment, we've been able to maintain the Lawson gross margin percentage through effective pricing and operational efficiency initiatives in our product fulfillment process and low customer setup costs.

While we are seeing vendor cost increases, we've been able to proactively stay ahead of them from an overall margin perspective. Consistent with previous quarters, when we look at our pricing to the same customers for the same product from a year ago, our gross margins have not been compressed.

Selling, general and administrative expenses were $50.4 million for the third quarter compared to $44.9 million a year-ago quarter. Prior to moving a portion of selling expenses to gross margin as required under the new revenue recognition standard, ASC 606, total expenses were $53.8 million.

On a year-over-year basis, the increase was primarily driven by higher stock-based compensation of $5.3 million and the inclusion of Bolt Supply in the amount of $3 million.

Excluding these items, operating expenses were up 1.6% reflecting our focus on reducing total operating expenses as a percent of sales, and further leveraging our existing infrastructure.

On an organic Lawson basis, adjusted EBITDA leverage was approximately 37% for the quarter and in line with our expectations, reinforcing our previous guidance of 35% to 45% for the second half of the year. We expect increased EBITDA leverage in Q4, given continued sales growth and some non-recurring Q4 2017 expenses.

Operating loss was $2.3 million for the third quarter, primarily as a result of our stock-based compensation expense of $7.6 million driven by the increased stock price during the quarter.

Adjusted non-GAAP EBITDA, taking into account stock-based compensation, severance and acquisition costs, was $7.3 million for the quarter compared to adjusted EBITDA of $5.4 million a year-ago quarter. Of the $1.9 million increase in adjusted EBITDA, the Lawson segment contributed an additional $1.1 million with the remainder coming from Bolt Supply.

Net loss for the quarter was $816,000, or $0.09 per diluted share inclusive of the stock-based compensation expense of $7.6 million. Adjusted net income excluding stock-based compensation, acquisition costs and severance, was $5 million or $0.54 per diluted share. From a balance sheet perspective, we ended the quarter with $9.9 million of borrowings.

During the quarter our borrowing position net of cash decreased by $7.8 million as we drove earnings and efficiently managed our working capital. Capital expenditures for the quarter were $198,000.

We expect our capital expenditures for the full year of 2018 to be in the range of 42 million to $2.5 million compared to our prior range of between $2.5 million to $3 million. Let me now provide some commentary regarding the remainder of 2018.

In Q4 of 2017, we reported a 17.8% sales increase in average daily sales and a 6.1% growth in our organic Lawson business segment on a year-over-year basis. Despite these challenging sales comparisons, we remain optimistic regarding demand given our trends over the past few quarters, complemented by our internal initiatives to further drive growth.

Current economic indicators in our sector remain favorable. In addition, we expect to remain disciplined in our acquisition activity as evidenced by the recently announced Screw Products transaction. Second, we remain focused on improving rep productivity and adding to our sales force.

Third, we continue to monitor inflation trends and the potential impact of tariffs on our business. We will take the necessary actions to ensure that we stay ahead of increasing product costs. And finally, we will continue to leverage our existing infrastructure.

We expect our second half of 2018 Lawson segment leverage to now be at the high end of our previously communicated range of between 35% and 45%. I will now turn it over to the operator for questions..

[Operator Instructions]. Our first question here is from Steve Barger from KeyBanc Capital Markets..

This is Ryan on for Steve. If I look on a two-year stack basis for average daily sales on the legacy business, they're down about 100 basis points from 2Q.

Can you talk about sales during the quarter relative to your expectations, and were there any hurricane impacts or one-time headwinds?.

You know, there were some hurricane impacts but not material. We sort of see this as normal variation, a little bit of movement between quarters, some one-off customer situations, not directly connected to us but impacting us nonetheless.

And so, the long and short of it is we just see this as normal variation, month-to-month and even quarter-to-quarter..

what is Lawson doing differently to maintain or even improve gross margins? And then to piggyback on that, is strategic accounts and government sales a mixed headwind for Lawson?.

Let me take the beginning of that, and then Ron can jump in as well. This is Mike. So there's a number of actions we're taking. We work hard on low-cost country sourcing which now includes Taiwan, India, and other places, Southeast Asia. So there's positive impacts there.

As well, we're working hard on distribution center productivity actions, freight savings, and a myriad of other activities. Lean Six Sigma continues to pay dividends for us as it relates to cost of goods sold and operating costs. So there are a broad range of actions.

Of course, when necessary, we do take pricing actions and the fact that our customers accept these pricing actions is further reinforcement of their understanding of our value proposition, the service-intensive nature of what we do for them, and the fact that because of the service we provide it enables them to run their equipment more productively and with a higher uptime of their equipment.

So while we really don't like raising prices, when we have to, customers are willing to work with us and they have accepted price increases when necessary..

Ryan, regarding the second half of your question on the strategic account headwinds, not too much for this quarter. But on a year-to-date basis, as Mike mentioned, our strategic accounts are up about 12%.

So they are putting a little bit of downward pressure on the percentage, but so far we've been able to offset that with the items that Mike spoke about and feel good about being able to keep that margin in that - in that 60-ish range, as we've indicated in the past.

We're monitoring all of our vendor activities from a cost perspective, whether or not it's inflationary or tariff-related. And we still feel comfortable that we can manage those overall gross margin percentages..

Okay.

And then tariffs are becoming an increasing focus, and sorry if I missed this in your prepared remarks, but do you have an idea of your percent of COGS sourced from China and the potential cost impacts? Also, are you exploring alternative sources?.

Yes. So Ryan, this is Ron. We are monitoring the potential impact on the tariffs very closely. What I would say is, is that we have limited exposure on the amount of the product that we're purchasing, and both on a direct as well as on an indirect basis from - from China.

So we haven't seen a significant impact so far, and again, we feel like we can still take the necessary actions given that limited exposure to stay within that 60-ish gross margin percentage range..

Okay. One last question for me, and then I'll hop back in the queue. Incremental contribution margins on the legacy business have been pretty strong now year-to-date. You're about to anniversary your Bolt Supply acquisition here some time in 4Q.

So just curious, how should we think about consolidated incremental contribution margins in 2019?.

So you're right. On the loss and kind of base organic segment side, we've been able to leverage for this quarter, 37% and the guidance that we provided is between 35% and 40% - 35% to 45% for this second half of the year. We still feel that we will end the second half of the year at the high end of that range.

There's a little bit less leverage that'll come through when you look at it on a consolidated basis. Typically the Bolt Supply organization operates at about a 10% EBITDA.

So on an overall basis it'll bring down the leverage a little bit, but we'll continue to report these numbers separately so that you have visibility to both the Bolt Supply results and - and the Lawson segment results..

Our next question is from Kevin Steinke from Barrington Research..

Hey, I wanted to follow up a little bit on the cost increase and pricing discussion there. As I understand it, typically pricing isn't even really a consideration or part of the discussion when you're dealing with your customers, again, you know, because you're - the parts that you are selling them are so critical.

And very low costs on a per piece basis.

So you know, given some of the inflationary pressures out there, I mean, have you heard anything at all? Any more pushback or discussion from customers about price, or is it just kind of continuing as-is where even if you do have to implement price, really, it's not even a consideration among customers given the strength of your value proposition?.

Kevin, this is Mike. I would say the latter. Again, because we integrate the product, 60% of which is private-label and they recognize, customers recognize the superior performance of that product wrapped around a lot of service.

And because we're there on an either every-week basis or every-other-week, averaging 10 days, across the customer base, the value add services that we provide are extraordinary. And those value-add services translate to machine uptime for our customers.

So they recognize by having us there so frequently and reliably, also technical problem solving, that we're able to give them more time utilization out of their equipment. And so they still recognize us as the lowest total cost provider. So the short answer is, it's just not a conversation.

They recognize the value add, and price is just rarely a conversation at all. Even our large strategic account customers, where we have longer-term agreements, readily work with us to accommodate any cost increases that we have to incur.

So even on a more structured basis, customers are really collaborative partners with us and they recognize that relationship. It's a really gratifying situation..

Okay, great. Yeah, thanks for confirming that that continues to be the case. And it doesn't sound like it from your prepared comments, and we talked a little bit about tariffs here in terms of, you know, the cost side.

But there's been some chatter in the media lately about maybe the manufacturing environment becoming a bit more challenged due to the tariff situation, and inflation area environment, and stronger dollar.

But I mean, our - are you seeing anything from your customers that would indicate maybe they're becoming a little more cautious in terms of their business prospects of you know, are the indicators continuing to be positive across the board as you - I think you noted?.

Yes. I think the short answer, Kevin - this is Mike - is we haven't seen any change. If anything, we see a continued strength in some of the things we look at. Time utilization for the construction equipment industry. We look at over-the-road trucking miles.

We aren't seeing pullback in - you know, when we start seeing customers go from three-shift operation to a two-shift operation, all of those sort of our indicators of caution or pullback. We aren't seeing any of that. So it's steady state, but steady state at a very good place or a very good rate of growth..

Okay, great. Ron, you mentioned that you expect leverage I guess in the fourth quarter to be at the high end of that 35% to 45% targeted range.

Can you just go over the rationale for why you expect it to be at the high end?.

Sure. Really, what my comments were that we expect the second half of the year to be at that high end of the range. So with the third quarter coming in at 37%, you can kind of do the math on that. We feel good about where we're at going into the fourth quarter, a couple reasons.

One is we've seen, for the month of October, we've seen a good start for the first three weeks of the month. The other piece that I would say is that we did have some expenses in the fourth quarter of 2017 that we know are just not going to be recurring.

So we do get a lift on that here on a comparison basis against the - like on a quarter-over-quarter basis.

So I think the combination of the sales that we're seeing so far, conversations we're having with our customers, the gross margins that we've talked about that we have a historical track record of being able to maintain, as well as knowing that some of the operating expenses are not recurring, we feel good about the fourth quarter..

Okay. All right, makes sense. I think lastly here, I wanted to ask about the Screw Products acquisition. As you noted, it gives you some knowledge in the kitting and jobs shop space.

So can you just maybe just refresh us on the differentiation, or the similarities and differences of that space, relative to your typical VMI model, and now that you've made an acquisition in that space does that knowledge potentially open up other acquisitions in that space in the future?.

Yes. So when we think about what we call job shop, there is a space between what we normally do, which is MRO, repairing one machine at a time and once you fix it you're not likely to see that machine broken again for a while.

At the other end of the spectrum is somebody who was servicing an assembly line, you know, an automotive manufacturer, or a large tractor manufacturer. Somebody who's running an assembly line.

In between those two tend to be a huge universe of smaller manufacturing companies producing limited quantities of things, or in some cases retrofitting items, and in fact what Screw Products brings us is knowledge in that space. That in-between space.

As it turns out, one of the acquisitions we made in Western Canada a couple years ago, a percentage of what they did was in this space as well. Theirs was more focused on the trucking industry with rivets and all the infrastructure that goes with rebuilding and rebuilding tractor-trailers.

So, there are also services like plating or minimal kitting, or some modest pre-assembly, building a bill of materials for customers. So it's this in-between space and there are in fact a number of what we would call traditional Lawson customers that operate in this.

Now, we've never used this language before, but there are situations where stuff is coming back from the field. The fleet of maybe fracking equipment, or that kind, and we're seeing the same stuff over and over and over again. It's not a pristine assembly line, and yet it's not a one-off fix. It's the in-between gray area.

The excitement here is that this opens up a very significant opportunity for us in servicing - let me say - smaller manufacturers that don't have the purchasing infrastructure, the sub-assembly infrastructure, to get them the best service that they need. And we think this opens up a real opportunity for us.

And candidly, further extends stuff we've been doing on the edges for quite a while. There's tremendous potential here, and we're really excited about this..

Our next question is from Brad Hathaway from Far View Capital Management..

Congrats on another strong quarter; good to see the flow-through on the EBITDA line.

I was just wondering if you could give any more color on kind of the acquisition pipeline that you see out there, and how you're seeing that?.

You know, basically unchanged as far as process. It's a nice pipeline, a broad spectrum of sizes from small to large. You know, candidly we are a little more focused on the larger ones than this most recent one, but the reason we did this recent one was for strategic reasons. We value this knowledge that this team has.

And that will still be predominantly the driver of what we're attracted to. We continue to have conversations with a broad range of companies that we would like to combine with them, acquire them, and the more of this that we do, the more that we're recognized in the marketplace as - I often refer to as a serial acquirer.

But most important, our culture, the integrity of our process, the commitments we make to the company being acquired and then holding ourselves accountable to fulfill those commitments; all of these things are building a reputation for us in the marketplace, and it really revolves around our culture and what's going to happen after the acquisition happens.

So, while we're feeling great about it, again, we'd love to be doing larger ones. But the common denominator here is a disciplined, systematic and methodical approach to attracting the right combinations and then springboarding from there.

By the way, we mentioned recently with Bolt, that we've just opened a branch in Port Kells, a suburb of Vancouver. It's about a 12,000 square-foot branch. We've invested in an upgraded facility in Winnipeg, about 50% larger than the previous facility we had in Winnipeg. And we've invested in territory managers at Bolt.

That's our plan with, once the acquisition is done, is how do you sort of springboard it into something much bigger? And that's been sort of the common theme in everything we've done, and everything we will do in the future..

[Operator Instructions]. Our next question is from Steve Barger from KeyBanc Capital markets..

Just a couple more from me. Solid rep count in the quarter. I think they were up 10 sequentially. I know in the past you said modest increase.

Should we assume a low-double-digit run rate going forward, or do you think maybe a 5 to 10 run rate would be more realistic?.

You know, Ryan, this is Mike. It's a little hard to model that way. We're looking for the best people. There'll be quarters when it - you know, it moves ahead more than that. Be some when it doesn't.

You know, the common denominator is really not driving ourselves to the number, but rather, attracting the best candidates, making sure that they get onboarded correctly, opening up markets, retaining customers when sales reps either retire or leave for some reason.

So you know, I would say it's going to be a little spikey like it has been for the last kind of five years. But I think you're going to see a continuous incremental increase over multiple quarters and over multiple years to come. We are not going to run out of untapped territories.

We're not going to run out of customers anytime for a very, very long time. And operationally the better we do, the more we attract customers. The conversion process with strategic accounts is an example of that. So you know, we will continue to add sales reps..

Okay, and then one last question for me, sorry if I missed it in your prepared remarks.

Could you give a little bit of color on October trends, and then just a perspective on your end market performance?.

Yes, Ryan, this is Ron. So the October trends that we're seeing so far really are pretty consistent with the overall increase that we saw in the third quarter versus a year ago. So, relative to - I'd leverage comments on the fourth quarter, feel pretty good about where we're at.

Now, in the fourth quarter, keep in mind that there are only 61 selling days and we had 63 selling days in the third quarter. So we're - which, you know, so we're up against that as we move into the fourth quarter.

And typically, a little bit more seasonal sales - or I should say, a little bit more seasonal exposure as we move into the month of December..

Thank you. This concludes the question-and-answer session. I'd like to turn the floor back over to Mr. DeCata for any closing comments..

Thank you. Thank you, Matt. So, thank you very much for joining the call this morning. We continue to demonstrate consistently solid results, reinforcing the strength of our execution and strong value proposition with our customers. We had a great quarter, and we're excited about it.

As a result, our adjusted EBITDA growth is exceeding the pace of our revenue growth. Supporting these trends is the company's continuous focus on productivity improvement.

Finally, our opportunity for growth is expanding through potential acquisition activity, increasing share of [indiscernible] with existing customers, the addition of new customers, and the expansion in such areas as government which we mentioned a moment ago. This has resulted in solid leverage and improved EBITDA.

Lastly, our culture and our teammates are committed to extraordinary customer service. Thank you again for joining the call this morning and we look forward to speaking to you again for the fourth quarter call in February. Have a great day..

This concludes today's teleconference. You may disconnect your lines at this time. Thank you again for your participation..