Good morning, and welcome to the MSC Industrial Supply Reports Fiscal 2017 First Quarter Results Conference Call. All participants will be in a listen-only mode. [Operator Instructions]. After today's presentation, there will be an opportunity to ask questions. [Operator Instructions]. Please note this 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..

Thank you, Drew and good morning everyone. Happy New Year. I'd like to welcome you to our fiscal 2017 first quarter conference call. In the room with me are Chief Executive Officer, Erik Gershwind and our Chief Financial Officer, Rustom Jilla.

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 in the MD&A sections of our latest Annual Report on Form 10-K filed with the SEC as well as in our other SEC filings. These forward-looking statements are based on our current expectations 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. And you may have noticed that we are now reporting average daily sales in our operational statistics on our website.

Also given that customer count and average transaction size have not changed much at all in more than eight quarters we will be reporting these metrics on an annual basis going forward. I'll now turn the call over to Erik..

Thank you, John and good morning everybody. Thanks for joining us today. I want to start by wishing everybody a happy 2017. I'll begin this morning's discussion by covering the environment which is showing potential signs of stabilizing. We’ve also seen increased optimism from our customers over the past couple of months.

I’ll then discuss recent business developments which were highlighted by the following; solid share gains and sales above the midpoint of our guidance for our first quarter, stable gross margins in line with expectations, strong execution resulting in operating expenses that came in slightly below our guidance, and as a result of all of this earnings per share above the top-end of our fiscal first quarter guidance range.

Rustom will then provide additional details on our first quarter financial results, and will also share our second quarter fiscal 2017 guidance, I’ll then conclude with some additional perspective on our performance. And we will then open up the line for questions. So let me begin with market conditions and our first quarter.

While conditions remain difficult throughout the quarter we did see a better than expected November as well as a return to growth in December, the start of our second quarter. The improvement in growth rate was across all of our customer types.

MDI readings that had risen above 48 back in August continued above the 48 level through October and then ticked up to 49.7 in November and 49.8 in December bringing the rolling 12 month average to 47.2. The most current readings imply essentially stable metal working end markets, and are a significant improvement over the trends of the past year.

Remember that December of last year was at a reading of 44. If the current levels hold this bodes well for our prospects given our historical four month lag to the rolling 12 month average of the MDI readings. It’s an interesting time right now in the industrial economy.

On the one hand at the present most customers continue to experience pretty low order volumes. However there is also a market improvement in optimism about what the future may bring.

This optimism is being driven by a couple of things, first there is an expectation that increases in infrastructure spending, lower corporate tax rates, and a more business friendly regulatory environment will provide a stimulus to the industrial economy.

And second, there does appear to be a leveling in manufacturing that’s occurring as evidenced by the MDI readings I just mentioned. Among other things oil prices have improved over the course of the year and there is greater confidence that energy related end markets are in better shape as a result.

Our most recent December sales trends which Rustom will talk about in more detail provides further evidence with increasing optimism among our customers. Part of the improvements in our growth rate came from a higher mix of capital related sales such as machinery, machine tool accessories, tool holders, and tooling package orders.

All of these tend to increase when customers are more optimistic about investing in their businesses. The lift in these categories which have lower gross margins as they are larger ticket purchases are pulling down the overall company gross margin in the second quarter.

Even so, the increase in spending on these categories is an encouraging sign and is generally followed by an increase in higher margin consumables in future quarters.

All of that said we caution that these are not yet sustained trends and increased optimism will need to translate into sustained increases in demand and order activity before we declare that the environment has turned. We are certainly more optimistic than even just a couple of months ago but we are not yet drawing firm conclusions.

I'll now turn to the pricing environment where it remained soft in the fiscal first quarter and continues to be so. Commodity prices are still fairly low relative to historical levels despite improving over the past year. While we have seen some supplier price increase activity, we characterize it as selective and not broad based.

That said any activity at all is more than we've seen over the past couple of years. If we continue to see increases we anticipate taking a very modest price increase sometime in the next month or two. Turning to our share gains, we remain pleased. Our growth rate against the markets within which we operate reflects that.

Average daily sales growth came in at minus 2.9% on a year-over-year basis more than half a point better than the midpoint of our guidance range.

These numbers remain better than the movements in metalworking manufacturing indices and the growth rates of local metalworking distributors based on our discussions with suppliers and other industry trade partners.

Should recent optimism translate into future increased demands we would expect to continue to outperform the end markets that we serve and hence see improvements to our growth rate. I will now look at our various customer types and I'll start with our government business which was basically flat year-over-year in the fiscal first quarter.

And this result was achieved in what was a very difficult spending environment within those customers. National Accounts had a low single-digit decline and was below the company average. This is a result of the ongoing drag from crackdowns in spending at many of our largest customers.

We continue to feel quite good about our position within these accounts and we should benefit as conditions turn. Overall our national accounts new business model remains quite strong. Turning to our core customers, they declined roughly in line with the company average for the quarter.

Now this is an improvement from where the core had been trending which was below company average and it's consistent with the notion that metalworking is experiencing some stabilization.

CCSG sales on the other hand slightly below the company average due to high end market exposure to natural resources and transportation which has not yet shown improvement. Now turning to e-commerce and vending, e-commerce reached 59.6% of sales for the first quarter up from 59.1% last quarter and 57% a year ago.

Sales to vending customers contributed roughly 60 basis points of growth in the first quarter. We also added approximately 10,000 net SKUs in the first quarter. This brings our total active salable SKU count to just over 1.5 million.

By the end of fiscal 2017 we expect to add roughly 75,000 to 85,000 net SKUs, an increase therefore of total active salable SKU count to about 1.6 million. With respect to our field sales and service teams we remained focused on expanding sales force capacity.

Meaning, selling hours in front of customers, and we’re doing so by executing on our various sales force effectiveness initiatives. We continue to optimize our field sales and service teams, and total headcount ended the first fiscal quarter at 2352 associates down slightly and in line with our expectations.

As I mentioned earlier, we maintained our focus on gross margin stabilization. Our gross margin was 45.0 for the first quarter in line with the midpoint of our guidance. And finally operating expenses were 218 million or about $10 million below last year and slightly better than our guidance.

I’ll now turn things over to Rustom to go through it in more detail..

Thank you, Erik. Good morning everyone. So let’s turn to our fiscal first quarter in greater detail. Our average daily sales in the first quarter declined by 2.9% versus last year with our sales to manufacturers being down 4.2%.

However, Q1 ADS was better than our guidance midpoint of minus 3.5% and also better sequentially as last year’s fourth quarter ADS was minus 3.6%. Our gross margin was 45% for the quarter in line with the midpoint of our guidance and down very slightly from the 45.1% delivered in fiscal 2016 first quarter.

As Erik noted the pricing environment remains soft but we’ve continued to offset this headwind with gross margin counter measures. We have also continued to tightly manage our operating expenses. Fiscal first quarter sales were approximately 4.4 million above the midpoint of guidance.

Nevertheless even after allowing for the increase in variable cost associated with this OPEX too came in below the guidance midpoint. OPEX was also around $10 million lower versus the fiscal first quarter of last year.

Now keep in mind that last year’s Q1 included about 5 million of unusually high medical expenses as we transitioned to a new medical plan at the end of calendar 2015. So after adjusting for this and for lower variable cost due to lower Q1 sales, our year-on-year OPEX reduction on an apples to apples basis was around 3 million.

Of course there are other puts and takes, lower amortization related to J&L acquisition and higher bonus accruals with the two largest and they roughly offset each other. I’d like to reiterate an important point also made on our last earnings call.

In fiscal 2016 on a comparable 52 week basis our sales declined by around 103 million and our gross margin declined by around 20 basis points. We nevertheless took out enough OPEX to maintain our OPEX to sales ratio and deliver a flat year-over-year operating margin of 13% the last year. So this focus on tightly managing costs will continue.

Our various productivity initiatives are allowing us to offset key investments, merit increases and other cost increases. However in fiscal 2017 as we discussed on our last call, we expect the roughly 40 basis points or $12 million step up in market driven incentive compensation versus fiscal 2016.

Our OPEX and consequently operating margin comparisons grew more challenging in Q3 and Q4. And although we have started fiscal 2017 ahead in terms of operating margin performance, our annual framework still holds.

Now back to Q1, operating margin was 13.2% better than the guidance midpoint of 12.8% due to higher sales, gross margin in line with expectations, and tightly controlled OPEX coming in slightly below midpoint despite as noted those variable expenses associated with higher sales.

Now compared to last year’s fiscal first quarter margin of 12.8% you also see a similar dynamic. So even with lower sales and the slightly lower gross margin this quarter we delivered a higher operating margin due to lower expenses which resulted in improved OPEX to sales ratio.

So this quarter’s results do illustrate the potential for significant leverage in our business model as the environment improves and the industrial economy returns to growth. Of course this leverage translates to our EPS as well. Our fiscal first quarter EPS was $0.95 that’s $0.03 above the midpoint and just above the high end of our guidance range.

Tax was at 38.2% but that was in line with our guidance and so roughly $0.02 of the upside in EPS that is versus the midpoint came from higher sales and roughly 1% came from lower OPEX.

Last year's Q1 EPS was $0.89 therefore even after adjusting for a roughly 5.5 cent benefit from the share buyback completed in August, our EPS was up slightly year-over-year despite lower sales. Turning to balance sheet, our DSO's were 52.5 days up roughly a day and half from last year's fiscal first quarter.

Our inventory turns at 3.3 were essentially flat with the prior quarter and our inventories increased by roughly $10 million over the quarter. As you may recollect we flagged an inventory increase of being the likely case on our last call. In Q2 inventories will likely be flat to slightly up so we remain well positioned for a possible upturn in sales.

We had another excellent quarter in terms of cash conversion turning 139% of our net income into cash flow from operations. Net cash provided by operating activities was 75 million in the fiscal first quarter versus 122 million last year.

The difference was mostly due to inventories and accounts receivables which were an 11 million use of cash in Q1 versus a 26 million source of cash in the prior year's Q1. Our capital expenditures were 12 million in the first quarter down 3 million from fiscal 2016's Q1. So our free cash flow i.e.

net cash from operating activities less CAPEX was 63 million versus 107 million in the prior year Q1. Our total fiscal 2017 CAPEX was expected to be around 60 million and we expect to -- and we continue to expect fiscal 2017's cash conversion to be about 100%.

We do not provide quarterly cash guidance and I would like to take this opportunity to remind everyone that Q2 was the quarter we typically make two cash payments versus none in Q1. This is simply a consequence of how the quarter is for the last September to August fiscal year.

At the end of the first quarter we had roughly 544 million in debt namely comprised of $166 million balance on our revolving credit facility, 175 million on our term loan, and 175 million of private placement debt.

We closed the quarter with 32 million in cash and cash equivalents and therefore this resulted in a leverage ratio of approximately 1.1 times. Now to our guidance for the second quarter of fiscal 2017 which you can see on slide four of our presentation. First please note the usual caveat that our visibility is limited.

So we expect ADS growth to range from 0.5% to 2.5% positive. At the midpoint of that range average daily sales would be 11 million, this implies average daily sales of 11.4 million for the remainder of Q2 or basically flat with last year. Let me explain our estimated December sales growth of around 4.1%.

While we have seen a pickup in sales this comparison has benefited from the timing of the Christmas and New Year holidays which this year fell on Sunday versus last year when they fell on Friday. While it is difficult to exactly pinpoint the benefit, we estimate that this generated approximately 250 basis points of growth.

In addition to this holiday benefit we believe that most of December's remaining sales growth was due to our customers capital related purchases in anticipation of a lift in business activity. It could well be that we are being cautious when arriving at Q2 guidance.

But given that we have five successive quarters of ADS declines through Q1 averaging around 3.5% we would rather err on the side of caution. Turning to gross margin, we expect it to be 44.6% plus or minus 20 basis points in Q2 and that is down from the prior Q2's 45.1% and down about 40 basis points sequentially.

The primary driver's product mix including the capital related purchases Erik described earlier. Now we do not provide guidance beyond the current quarter but it's worth noting that we currently expect Q3 gross margin to be relatively stable unless capital related sales increases.

And obviously if that happens this will be a positive and would bode well for the manufacturing recovery. We expect Q2 operating expenses to be about 4 million lower than in the prior year despite the increase in average daily sales and our OPEX to sales ratio for the quarter should improve by around 100 basis points year-over-year.

As in Q1 this will be due to higher medical cost in the comparable period, lower amortization and payroll expenses offset partly by higher spending on the upgrade of our SAP core financial system and other key investments. Sequentially we expect an OPEX increase from Q1 to Q2 of roughly 6 million.

Around $1 million each is due to higher sales volume and key investments and around another 3 million comes from fringe expenses which are mostly the payroll tax reset that occurs every January as well as higher medical costs as a new plan year commences.

Now you may wonder why we didn’t see a similar sequential lift last year and this was because mostly last year’s Q1 had unusually large medical expenses as mentioned earlier and also sales declined from Q1 to Q2.

So as such we expect a second quarter operating margin of around 12.2% at the midpoints of guidance as we leverage positive sales growth to improve our last year’s Q2 operating margin of 11.8%. Finally our EPS guidance for the fiscal second quarter is a range $0.86 to $0.90 and this is due to the tax rate of 38.2%. I’ll now turn back to Erik..

Thank you, Rustom. For the past two years we’ve operated in the midst of a prolonged industrial recession, one of which is particularly acute in our primary end markets of metal working manufacturing. We executed well during this time outperforming the markets that we served.

But we also used this time to retool and refocus the company making MSC a better performing business. We stayed focused on providing our existing customers with exceptional service as well as creating new customer relationships. Many of our customers businesses have been depressed by the difficult environment.

And this has created the potential for a spring loaded effect when the industrial economy returns to stronger foot. We’ve enhanced our value proposition by investing in improved technical capabilities, inventory management solutions, and technology including e-commerce, digital capabilities, and analytics.

We forged new supplier relationships and enhanced existing ones to further our efforts to capture market share from the local and regional distributors that make up roughly 70% of the market that we serve. We worked hard with our suppliers to bring purchase cost down and stabilize gross margin in historically challenging pricing environment.

We leaned out the company with a heavy grass roots focus on productivity throughout the organization and that’s the testament of the hard work of all of our associates. We built on our already strong culture to become leaner, sharper, and more nimble.

We generated significant cash flow by carefully managing working capital and then we deployed that capital in ways that enhance shareholder returns such as the buyback that was done in August of last year. We did all of this in preparation for an eventual industrial recovery. And we are now seeing signs that a potential recovery could be coming.

If in fact it becomes a reality we will benefit from a tremendous earnings leverage story. If it does not we’ll stay focused on continuing to execute the playbook that I’ve outlined knowing that it will make that earnings leverage story even more compelling when the recovery eventually does arrive.

I'd once again like to thank our entire team for their hard work and their dedication and will now open up the line for questions..

[Operator Instructions]. The first question comes from Hamzah Mazari of Macquarie. Please go ahead..

Good morning, Happy New Year. Just a question on your margin framework. You guys did pretty strong margins, 13.3%, despite sales declining. Is the margin framework too conservative around your operating leverage? I know you mentioned incentive comp potentially being a headwind.

Just trying to think of how to think about the operating leverage, which seems to be coming in stronger relative to the go forward margin framework?.

Hamzah hi, it is Rustom for you and good morning and Happy New Year to you as well. So the short answer is no, we don't think it's too conservative. Look quite simply our framework is for the year and not for any one quarter. So we had seasonal swings in our quarterly operating margins in Q2.

For example the operating margin is typically much lower due to the holidays as well as the payroll tax resets, right for the new calendar year. Now last year we also reversed remember some of our H1 bonus accruals in the third quarter and that was based on updated forecast and deteriorating market conditions.

And last year's Q1 also had unusually high medical expenses. So, look I mean I could give you more detail on that and I can also talk about the incentive compensation step up which will impact more in the second half than the first half because of the reversals rate last year and when we flagged that.

But really I mean the real answer is that our operating margin framework is appropriate for the full year. But quarter-by-quarter it will bounce around. So hence we're out of the gates with a very strong start but the whole -- the full year framework holds..

Yeah, Hamzah, this is Erik I would highlight one thing that Rustom said there and we mentioned that on the last call which is the incentive comps for the year on the last call we said we had what we saw as a onetime meaning this year step up in incentive comp that would be 40 basis points of headwinds. That was for the year.

As Rustom mentioned the dynamic is such that virtually all of that 40 basis points headwind is going to happen in the second half of the year. So we have not yet seen that headwind so to Rustom's point we are thinking net-net still on track..

That's very helpful. And then some of your suppliers have talked about potentially using more of a distribution channel versus a direct channel.

And I'm just curious if that's something that you've seen already as a benefit to you guys or is that something yet to come? And is it at all material and how we should think about that?.

Yeah, Hamzah it is a good observation. I would say we are seeing a trend among some of our suppliers with many already do all or virtually all of their sales through distribution. I would say there is more of a trend of laid towards putting more of sales through distribution.

And I think the reason that's the case is because distribution is winning as a channel in the marketplace. So I think it's a response to what's happening with customers making choices about where they want to buy and that's through well performing distributors. What I would say is I think that it's still very early.

There are certain suppliers and very important suppliers to us that we're in discussions with about how we can help them in their efforts. But I would say still very, very early and you're not really seeing much of that in our numbers today..

With this last question I'll turn it over, maybe for Rustom. Could you maybe outline what the corporate tax reform benefit would be to you guys and what you plan to do with the cash? It seems like the cash tax rate is very similar to book tax, and you have obviously 97% U.S. exposure.

Just curious if you could outline what you think the benefit is and what you guys plan to do with the potential cash savings? Thanks..

Sure Hamzah. Look, I mean yes, our federal tax rate is pretty much we pay our full federal tax so any reduction whether it's 20% to 25% to 15% any reduction will be a positive for us, right. The ultimate EPS benefit to us and we definitely expect it will depend on what the offsets are and whether there are any offsets.

I mean that could be with foreign tariff, cross border taxes, interest, a whole bunch of different factors which might or might not come into play. So it's hard to quantify.

I mean since you did ask the question it was foreign tax related but I will sort of make the point on the -- on our cost of goods sold as well in there and that is that remember that about 12% to 15% of our cost of goods sold comes directly from outside the U.S. And we believe that -- and we believe, we don't have the exact number with the U.S.

purchases that are actually foreign source it's roughly about 40%. So remember many suppliers have multiple countries of origin and alternatives as we do also.

And in any case inflation is historically good for distributors but it's a bunch of different factors here that mean it's hard to quantify exactly how much of the benefit will flow through but we clearly are expecting a benefit. Now part B of your question is what will we do with that.

So I mean, look I mean in general we believe in steadily increasing our ongoing ordinary dividends. I mean we're very, very Erik and I have been very consistent in terms of communicating that. There's no reason to think that will change.

And we have also demonstrated over the years that if we do have excess cash flow over and above requirements, we are balanced and opportunistic in terms of capital management and if we do have excess cash at the end of the day that we can’t deploy in the business, that we can’t deploy you know for ordinary dividend increases, and if we don't have attractive M&A we are absolutely not averse to returning it by way of open market by banks or even tender type things.

So that’s a long answer but it is hopefully a comprehensive answer..

No, very helpful. I appreciate it, thank you..

The next question comes from Matt Duncan of Stephens. Please go ahead..

Hey, good morning guys. Happy New Year and nice job this quarter..

Thanks Matt, Happy New Year to you..

Thanks. So Erik I wanted to start on the average daily sales trends so, November you said was a little bit better than expected. You move to December and the growth got four or got six points better against a four point more difficult comparison and Rustom you talked a little bit about sort of what drove that higher December number.

Could you maybe talk about was there any improvement in that growth rate through the month of December, did you see maybe fewer plant shutdowns in 2016 than in 2015 just trying to get a sense for how much conservatism there could be in the expectation for flat next couple of months if some of this stuff does carry forward?.

Yeah Matt. So look no question when you hold back. We are seeing an improvement in the growth rate in the business, okay plain and simple because you're right you point to its start in November being better than expectations, December certainly better.

What we wanted to do though is give you a realistic picture that I would say in terms of December it was a pretty strong month across the Board obviously. So Rustom mentioned the 250ish basis points as a rough we estimate from the holiday affect.

So obviously we did get a lift in the end of the month but in general look we're seeing some firming up in the underlying business. So even if you back out the 250 basis points or so from the growth rate you still got about point and half for December. Now our belief there Matt is we did see a spike in what we call Capital related purchases.

So these -- it could be a machine. It could be a tool holder, it could be a tooling package, let's think of that like a start up kit of cutting tools when a customer purchases a machine. Or all of those things tend to imply optimism about the future obviously if they are investing in the business.

Our assumption right now and again Rustom mentioned limited visibility, we're sitting here very early in the month of January is that a lot of what we saw was end of the year buying because customers are more optimistic and that won’t continue in January and February. Which kind of gets us to more or less flatter January and February.

As Rustom said if we're wrong our guidance will -- the midpoint anyway would prove to be conservative. But we just don’t know, we sort of giving you our best, our best view of what we see right now..

Does that imply that the capital purchases did not carry over into the first 10 days of this month or is it just early to know?.

Well I would say a little earlier than that, it is too early to tell. You also realize our December went through Friday, so that would include early calendar January..

So we do have the numbers. Matt I was just going to add that look it’s because we had such difficulty and then because December is a little bit of an unusual month right, that is why we are being so to the best of our ability we're trying to provide you with an account of what it is between the holiday effect and the capital goods.

I mean, especially in our guidance I mean if we were, if ADS did happen to come in, it is 1% higher. You know that movement, that is about -- that is worth about $0.02 on the shares. You can see it now in our numbers. We are just trying to be very transparent as to how we -- as to what the basis is for the guidance..

Okay, that's all very, very helpful and Rustom you made a comment about gross margin potentially stable into the third quarter, you are saying stable year-over-year or stable with the 44.6 for the 2Q..

It is the latter..

The later, okay and that assuming that you do see a pick continued, I guess that is assuming a continued pickup in capital goods then which would then be followed by the higher margin stop.

So we would see a gross margin improvement down the line, I guess is the way for us to think about that?.

Obviously you see more of the consumer who's going through you'd begin to see the benefits over there. And you know we really can't provide Q3 guidance so we are just trying to provide some color that we're not suddenly seeing something that would call you know -- obtain a sequential drop, that is all we are trying to provide color on..

And I think the one thing I'd add about the capital related purchases, look it is an encouraging data point sure. So even if we're right about Q2 I mean in January and February, it tends to -- we haven't seen this dynamic in several years where historically we were in a normalized growth environment.

We tend to see a dip in gross margin in the underlying business in the second quarter and certainly in December because of end of year buying and capital purchases. We haven't recently because there's not been optimism. So January and February not withstanding what we do view it as an encouraging data point..

Okay and the last thing to show quick on pricing Erik can you talk a little bit more about what's going on there. I mean I think everyone's expecting that we might see some inflation show up.

It sounds like you haven’t really seen the supplier price increases key up here, but the comment that you might be doing a price increase in a month or two implies to me that you think that may happen.

So what are you hearing and seeing out there on that front?.

Yeah, good question. Matt I would say right now we are seeing some activity but the word that was used was selective and not broad based. So we have seen some suppliers come forth with increases to the calendar year not a ton. Now that may change as time goes on here. Certainly if things firm up, I would expect more to come down the road.

So my comment on a price increase and what I call a very modest price increase. It is more reflective of what we've seen to date which would be sporadic. So some activity which is better, you know we like to use what is pretty tough and virtually nothing. But not that I would consider to be broad based.

So you can expect whatever we do in pricing at this point anyway would be pretty modest..

Okay, thanks guys, appreciate the answers..

The next question comes from Robert McCarthy of Stifel. Please go ahead..

Good morning everyone. Happy New Year..

Happy New Year Rob..

You know I guess the first question would be maybe you just talk about -- I mean your average daily sales rate is kind of hovering in the 11 million range or thereabouts. I mean you have seen sort of pricing in the beginnings of what you kind of talked about here for kind of an industrial short cycle recovery fueled by this optimism.

What do you think could be the outside bound of what that daily sales rate could be over the next twelve to eighteen months?.

Rob, I wish I knew. I mean we can hardly give you the other balance of the quarter. Here is what I would tell you is that you can generally track some of what I can tell you is what we measure and what I feel like we can control and feel pretty certain about it, how are we doing relative to the environment that we're in.

And what we're seeing now is an environment that appears to be certainly had signs of stabilizing. Now what we look to do is outperform the market in any given level.

If you believe in a strong recovery and you believe that the manufacturing markets and in particular the metalworking manufacturing markets were to grow at a meaningful rate you could see growth rates for the company in double-digits based on our gap. But of course that would require that the economy really firm up.

On the other hand if things are really continue to muddle along, and December was just a bit of a onetime Spike, well over time based on all the indices we're looking at we would expect to grow but not nearly at those rates. So for us what we can control is how fast we outpace the market.

Certainly if the market comes back and you look at our historical numbers there, nothing from our standpoint has changed that would lead us to believe normalized growth environment of the company historically has grown mid to high single-digits. And in a stronger sort of recovery case the company is growing double-digits.

No reason to think that couldn’t be the case but we just had such limited visibility.

And in terms of the border adjustability tax and other issues I mean do you think you're going to have to kind of revisit your 10-Q in terms of highlighting the risks, I mean because there is I mean, you can talk about in short at this point in terms of what the risks are.

But do you have the Republican tax plan out there, do you do have some detail around how these offsets could kind of play out and so do you think you have to address in a forth rate manner what it would mean if we saw border adjustability tax world?.

I mean here is our challenge. I mean it's really early. I mean what is -- what's going to be the new tax floor. I mean they are different proposed by the different proposals out there between as far as we can tell the incoming administration, Congress, or the rest of it.

It's just too early but yes, I mean your broader philosophical point I mean as soon as these things sort of firm up I mean absolutely we would -- once they firm up we can then figure out what the impact is and once you figure out what the impact is and what the implications are of course we will communicate them..

And then I guess to get down from the 30,000 foot level to something a little more ticky tacky, it looks like your depreciation expense year-over-year came down modestly but couple million in the context of that, could you and I think it was did you have some asset sales and the balls of CAPEX last year but could you talk about what drove the lower DNA in the quarter versus last year?.

Sure that's mostly the A part of that. That's the G&A amortization that I was talking about which we also mentioned back last year. And that's what it is mostly about. I mean our full year depreciation is in the ball park of around 65 million..

65 million?.

DNA..

I will leave it there..

Thank you Rob..

The next question comes from Ryan Merkel of William Blair. Please go ahead..

Hey, good morning everyone..

Hey Ryan..

So first of all just want to put a little more context around the cap goods left.

How much of this category up year-over-year if you have the number and then when was the last time you saw the cap goods perking up at all, my guess it’s been maybe two years but maybe that would be helpful to put some context to it?.

You know Ryan to answer the last question first it’s actually been more than two years, it is at least three years because the last two years there's been really low confidence among our customer base. It has been at least three years since we've seen anything resembling this, that’s the first thing I would say.

The second point, I don't have the numbers off hand but I can tell you it’s something that it was a noticeable and unexpected uptick across really all of those categories that I mentioned. So the machinery, the machine tool accessories I think like the tool holders and then also the tooling packages pretty evenly dispersed across all of those.

It was a pretty healthy unexpected lift that drove a good part of the sequential downdraft in gross margin but obviously very encouraging about what that could mean..

About 1.5% of December is ADS growth. So if you do the math that’s in the 3 million to 4 million range. Again with these numbers and with the holidays they are estimates, Ryan which is always hard to exactly quantify..

It is encouraging it is, it's just one module. You know I think we shall be cognizant of that but it is definitely encouraging. So then your peers had a soft November and you beat my model.

I'm just wondering if maybe how to answer but do you think this is more about your metalworking exposure and just coming off a deep trough or do you think share gains are picking up steam..

Look I would say, we have been pretty consistent in a couple of things one is we have felt over time pretty good about our share gain performance. And I think that continues. I feel like we’re executing well and I think we've also been pretty consistent in that. We don't make too much of one month, even two months.

This is the same way if we have one or two bad months I would tell you we don't get too alarmed. One or two good months look I think you're right I think on a relative basis November and December appeared to be pretty good pretty good months. We don't make too much and we don't celebrate.

I mean so when I would say talk to me in a quarter if we continue outperforming in the season, outperforming peer etc by more than we would have expected, I think then there could be something there and I think you're right. I think the two candidates would be improved.

Share gains and or improved metalworking, stabilization, rebound recovery whatever you call. But I think it is too early for us to form a judgment..

Okay and just lastly going back to gross margin in Matt's question, I recall last quarter you were talking about or thinking about a flat gross margin for this year and now just based on Q-Q guide and the early 3Q thoughts, it looks like gross margins could be down twenty beds call it.

Now I think just to be clear is the change here primarily just the increase in capital goods mix?.

Yes, actually so, first of all our framework for the year did contemplate modest gross margin deterioration throughout the year. And that's consistent with our usual seasonal patterns and absent the meaningful price increase which as we said we weren’t really counting on as we started the year.

So, absolutely our current Q2 midpoint guidance of 44.6 is slightly lower than we had anticipated at that time. And that is due to December's product mix including the capital related sales. Okay so that's what you're seeing. And at this point we don't think it's a good significant departure from our annual framework..

Okay, okay, and in terms of fun, if core customers came back and there are higher margin I recall and if you get a little bit, you get some price increase that would obviously maybe push you back towards flattish maybe in a litter better. Right, okay very good, thank you..

The next question comes from Adam Uhlman of Cleveland Research. Please go ahead..

Hi, guys, good morning..

Good morning Adam..

Good, congrats on getting back to growth.

I was wondering if we could start maybe earlier in the prepared remarks you had talked a little bit about oil and gas but could you talk about what you're seeing in those, into that geography of the country and the oil patch and what you are hearing from those customers, has that kind of lead this rebound in the capital equipment related sales, could you dig into that please..

Yeah sure Adam and I'll start even more broadly just sort of with an end market view and then I'll take hit your point on oil and gas. And just one thing I would say that, I wouldn't yet call this and December looks like a rebound but I think in general we're calling -- we see this to date as more of a stabilization.

And look if the December trades really continued and we are wrong about January and February and things continue at this rate you'll probably hear us talking differently on the next call. But for now I think what we're seeing is more stabilization. This stabilization has been pretty broad based Adam.

So across most of our core customer types that we referred to was our typical core customer types of the machine and equipment folks, primary metals, metal fabrication. All of those are seeing an improvement over the last couple of months.

I think some of that is driven by oil and gas, no question Adam because we've said the indirect effect on all these job shops. And again what we're hearing is more stabilization than it is a strong rebound even with oil and gas. Things have stabilized a bit based on oil prices. Maybe the potential to improve but the word I would use is more stable..

Okay, got you, thank you.

And then disprove regarding more of the medium term, maybe longer term could you talk through scenarios where you had started to add more aggressively sales headcount would you need to see mid to high single-digit growth to add people rather than trying to get additional selling hours into the preexisting force and then maybe some of the vendors lie but if you could just talk about this ski broke that you had mentioned earlier is that more towards new categories this year as there is further penetration of existing ones? Thanks..

Yeah to two really good questions. So our sales force, right, when you picked up on for a while now headcount has been more of a stable and in fact now slightly down. And lot of this Adam, is in response to the environment.

So clearly big picture if I look long term here, medium term as you call long-term sales force expansion remains an important component of the company's plan. What we found though is number one in response to the environment we're taking a hard look at productivity before we spend money.

And number two is the real driver of growth of share gain of customer satisfaction is how many hours do our sales people get in front of their customers.

And so, what you're seeing from us now is really in response to seeing some of our sales force effectiveness programs gain traction that are allowing us to get more selling time without adding to headcount.

So those are things such as better using technology and that's using technology to help our sales people be more effective and help them grow customer relationships. It is using technology to help free up their time for more backlog from administrative tasks.

Sales force affecting this includes much better work and cross selling between MSC and CCSG which is improving seller productivity. So there's a number of levers that we're looking at and we like what we're seeing. So yeah, certainly if the economy improves or should say when the economy improves over time we are envisioning sales headcount, I do.

What I would also tell you though is some of that will be a function how fast that grows will be a function of how good we feel about some of these productivity measures. So to the extent we think we can continue generating increased selling hours without rapidly adding to headcount we'll do it.

And at the point of which we think we need to add headcount to generate more selling hours we'll do that as well. So big picture and the punch line is sales force expansion still important but in the meantime we think we have a number of things to increase selling capacity without adding headcount. Your other question was about SKU growth.

So we have been -- so our number for 2017 by the way was around 75,000 to 85,000 for the year slightly down from the last couple of years but still pretty healthy cliff. For the most part Adam I would say the strategy is a little bit above. So we have some product line extension. We have some product line fill in.

We have some new supplier additions and that makes up the bulk of where we're adding the SKUs. I think if you looked back last year we had a particularly large year in terms of SKU additions.

The primary driver there was we had a couple of really large supplier additions that had a lot of SKUs that drove that whereas this year it's not as much high profile new supplier as it is drilling and extensions..

Great. Thank you very much for the color..

Thanks Adam..

The next question comes from David Manthey of Baird. Please go ahead.

Hi, thank you. Happy New Year guys. So as it relates to the operating margin framework. I believe you said you contemplated 20 or 30 basis points of gross margin degradation in the framework at the beginning of the year.

Did your framework also assume a midyear price increase or would that be over and above what was in the assumption?.

There was a very small price increase contemplated in that, really not particularly material..

Okay..

So David I think I know where you're going. What we're outlining now about consistent with the framework, less in the framework more than the framework.

And I would say you've heard it will happen over the next month or two, the reason being the supplier price increase activity that has not been that broad based we want to get a little more feel for how much is coming in before we quantify it. We refer to it is as very much.

What I would say is there is probably from a pricing standpoint not downside to what's in the framework. At this point what we would contemplate is either consistent with the framework and depending upon how the next month or two goes, maybe a little more but I would caution that it’s still too early to say..

And it stays David within the -- if you think about our framework I mean the -- it was a minus 1% to 0% on the slightly negative side and the 0% to plus 1% on the slightly positive right in terms of the guidance that we provided. So everything we're talking about is very much within the within those..

Okay and as it relates to your ability to get price in the coming year you've got one big competitor out there that’s lowering prices on a large swath of their customers and you've got just general secular pressure and relatively slow growth.

I mean even if growth picks up a bit here, how are you navigating the environment, are you seeing any price declines generally from competitors out there or you are going to navigate this effectively?.

Yes David, I would say look, I would say pricing and I referred to the pricing environment remains seriously competitive as competitive as it's been.

But look I would say the primary driver here is consistent with what we've seen which is the distributors that make up the bulk of the market, the roughly 70% of the local distributors are really, really under pressure right now David. And when they get under pressure price becomes one of their primary lever.

So that is front and center, we're seeing it. Of course there's other competitive movement going on. I would still tell you that the primary driver of the pricing environment is the local distributors.

Look that said what I would tell you was that if we implemented a midyear price increase first of all it would be in response to visible manufacturers moving their best prices. And second of all we would only do it if we felt that we could get a realization from it and that it would be well justified with our customers.

And then the last thing I say we feel like in a lot of cases with our good customers we're bringing a heck of a lot of value to them where we're helping them take cost out of their manufacturing operations through technical capabilities, inventory management, etc, etc and we think it's justified.

And in many cases even our customers feel it's justified based on the cost we're taking out of their business..

Got it, okay. Last question I think when you're near the end of the call it is required to ask the acquisition question.

So, what does your pipeline look like, what is your appetite to do deals today?.

So I will take that. I mean there's no change in our M&A outlook. We remain active in building our pipeline as we do have a pipeline and we are keeping on building and assessing where, different stages starting with different things but we actively looking for opportunities but they have to be the right fit.

And we're talking there about strategic fit most of all, cultural, ease of integration, and last but absolutely not least not over paying. And the good news is that with 1.1% leverage we have plenty of financial capability..

Got it, alright thanks very much guys..

The next question comes from John Inch of Deutsche Bank. Please go ahead..

Yes, thank you, good morning everyone.

Hey Rustom your comment around the 40% of profits that you sell that have sort of been imported content do you thing that's, I'm sorry, was it 40%, and then there's 12% to 15% or does the 40% include the 12% to 15% directly imported?.

It is the latter John. It's roughly 40% to start with and that would include the 12% to 15% of direct imports that we've talked about in the past. I mean it hasn't been as relevant to talk about it it's way beyond in the past.

But this is, remember that many of these suppliers that we buy from have multiple countries of origin and multiple sources from which they supply to us. So now we are trying to quantify more but that's what it is 40..

Yeah, the 40 makes more sense than 40 plus 12 to 15, so that I can come up with, I just want to make sure I heard that right.

The growing J&L amortization, so this is going to be kind of a 12 million benefit for the year I'm assuming, right?.

I think, it was posted about 8, right. I will come back with the exact number. I think it was 8..

Okay, I guess my question is if it's -- I want to go back to the framework that you presented last quarter. So we think that you know the top margins are going to decline 40 to 60 basis points but if we're starting and we've got lower general amortizations, so call that maybe 30 plus basis points.

And then I think Erik you implied that the headcount, was going to sort of remain at these levels if you see more of a pickup then you're going to pick it up. What's accounting for which is kind of bullish because I would have thought that your headcount might have actually been rising it bodes for your cost structure.

So, what is the carrying for the difference again in terms of down still call it 50 basis points at the midpoint and you seem to have these tailwinds and not having to hire people and then you've got this J&L, again just reminding what is the bridging just at a very high level?.

So John, we talked about the J&L amortization last time when we did the fourth Q call because we start from the benefits coming in then and various tons of puts and takes in the air.

I mean it's the forget the beard, the obvious one is the variable costs and that is the picking, packing, and shipping labor that does come in as well even increases all that we take out as well decreases. I mean there's commissions, there is faith. But there is the key investments.

I mean we've talked about telephony which is one of our big, big investments which is helping us. We've talked about the SAP core financials but there is other investments that the company has continued to make.

I mean the bigger point over there and yes the compensation increases and all the risks are in there but the point we made last time and which probably take this up this question is an opportunity reiterate this time is that we are targeting a culture and a discipline that looks for productivity to offset pretty much all of these things.

And yes, there will be some puts and takes and we call them out like J&L and then showed here you got this indent, that is a benefit of sales window or headwind. But the end of the day in FY'17, the only thing that we said we were not planning on offsetting was the increase in the bonus.

And that would -- and that's what you saw flew through the numbers..

So John let me just, let me try to answer it as well. The big headline behind the headwind for 2017 with the bonus step up. The bonus step up is pretty much -- as I said pretty much exclusively backend loaded. So if your question is, hey wait a second you're getting a tailwind from J&L amortization.

You're correct and what I would tell you is take a look at our Q1 results and take a look at our Q2 guidance and you'll see without the headwind from bonus what we're producing. So our Q2 guidance implies 100 basis points or so reduction in the OPEX as a percentage of sales on 1.5% sales growth. I think that's pretty healthy..

Yes, no it absolutely is there. You actually said the bonus is going to be skewed to the second half. So just conceptually I think you said last quarter the bonus is going to account for the kind of the lion share of the 40 to 60 headwind. I think you just kind of confirm that.

[Indiscernible] and then you got the bonus and that's the lion's share of that, does that then imply that in the second half margins because it's 40 to 60 for the year or call it I don't know, let's say 40 from the bonus does that imply margins in the second half fall under a lot more pressure maybe go down to sort of 70 to 80 type of thing to the bonus?.

Without quantifying that's a definite headwind John. But remember when we say it is Q2 towards the second half, it is not that we're accruing a different amount this year. It’s pretty even this year as we envisage our accruals right. It's just that last year’s comparative we spend more in the first half and we provided less in the second half.

That's why you see the impact being skewed more towards the H2..

Okay, got it and then just lastly if we do see this recovery continue to percolate and let's say it's not the double digit but I think those sort of back to the mid to high single-digits which seems completely realistic and expected.

How do you guys think of the initial 30% that you talked about last quarter, the variable contribution, is that mid to higher single-digit run rate like X compare just kind of if we could get back to that, is that enough to drive 30 or was the 30 predicated that we talked about last quarter on a much more substantive recovery kind of in the low double-digits that you alluded to before Erik?.

No, and the point we were making on that and which we will repeat again is that our first hundred million of revenue growth, right and we’re looking at that.

Now obviously where margins can move around a little bit up or down but broadly of our first 100 million in revenue growth we -- we asked to have an incremental labor and commissions and freight and all the rest of that. We believe that $30 million or 30% is what we take down to the bottom line, to the operating profit line..

John I think to your point. We don't need a dramatic recovery. Your point is how fast that hundred million comes does impact the incremental.

Sure, the 100 million took a year to come you're right because in a very slow growth came it would be more challenging and the faster the 100 million comes the higher the incremental but to answer your -- I think if we had the 100 million in something like what you described, a scenario you described we would expect that?.

And it sounds. Like then it's not a function so much of contribution leverage as it is maybe filling up excess capacity. So in other words companies historically if your volume grows faster you see much more rapid incremental.

And I realize you're distributing on the manufacturers so it sounds to me like it's a function of 100 million which is a fairly specific number as a function of I'm assuming incrementally filling up like the new Columbus DC, etc, etc.

Is that a reasonable assumption?.

Actually it helps but I think fundamentally its operating discipline and a culture that says that look we're not going to increase our costs just because our revenue goes up.

And that's been really impressive. Thank you very much appreciate it..

Thanks John..

And the last question will come from Ryan Cieslak of KeyBanc Capital Markets. Please go ahead..

Thanks for squeezing me in guys, Happy New Year..

Hey Ryan..

A lot of questions asked. I won't keep this long but know Erik I'd be curious to know when you think about the potential price increase you might put through here in the coming months, how does that compare to maybe what you guys have done the last several years.

I mean this is the first type of price increase broadly speaking for you guys, is the magnitude greater, just in the context of what the last couple years have presented maybe talk a little bit around that..

Yeah Ryan. It would be specifically around the midyear you're referring to it would be more than the last couple of years less than historical average..

Okay great. And then just a follow up talking and thinking about the capital expenditures that you are spending that you saw here in the last couple months and the possibility of consumables following that Erik.

You know historically when would you typically see that, is that a couple of quarter lag when you finally start to see inflection in the consumables or purchases or just how do we think about that going forward as well?.

Yes Ryan, good question. I think that’s about right. If you think about somebody, a customer that says they're going to buy a new machine to expand capacity by the time they get the machine and install it and then they buy a tooling package with it which if you think about it, it is like a startup kit of the consumable that go through it.

So they got to get the machine in which may take some time to get in and install, get it up and running and then burn through the first through the tooling package. I think that's a reasonable assumption of a couple quarters..

Okay, great. Thanks guys. I appreciate it..

Thank you, Ryan..

This concludes our question-and-answer session. I would like to turn the conference back over to John Chironna for any closing remarks..

Thanks again everyone for joining us today. Our next earnings date is set for April 13, 2017 and we certainly look forward to speaking with you over the coming weeks and months. Thanks again..

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect..