Good day, and welcome to the MSC Industrial Supply Fiscal 2022 Third Quarter Conference Call. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note today’s event is being recorded.

I would now like to turn the conference over to John Chironna, Vice President of Investor Relations and Treasurer. Please go ahead sir..

Thank you and good morning everyone. Erik Gershwind our Chief Executive Officer and Kristen Actis-Grande our Chief Financial Officer are both on the call with me today.

During today’s call, we will refer to various financial and management data in the presentation slide that accompany our comments as well as our operational statistics both of which can be found on our investor relations webpage.

Let me reference our Safe Harbor statement under the Private Securities Litigation Reform Act of 1995, a summary of which is on Slide 2 of the accompanying presentation. Our comments on this call as well as the supplemental information we are providing on the website contain forward-looking statements within the meaning of the U.S.

securities laws, including statements about the high inflationary environment and globally economic conditions on our operations, results of operations and financial conditions, expected future results, expected benefits from our investment and strategic plans and other initiatives and expected future growth and profitability.

These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those anticipated by these statements.

Information about these risks is noted in our earnings press release and the risk factors and the MD&A sections of our latest Annual Report on Form 10-K filed with the SEC as well as in other SEC filings. These risk factors include our comments on the high inflationary environments and global economic conditions.

These forward-looking statements are based on our current expectations and the company assumes no obligation to update these statements except as required by applicable law. Investors are cautioned not to place undue reliance on these forward-looking statements.

In addition, during this call, we may refer to certain adjusted financial results, which are non-GAAP measures. Please refer to the GAAP versus non-GAAP reconciliations in our presentation or on our website, which contain the reconciliations of the adjusted financial measures to the most directly comparable GAAP measures.

I’ll now turn the call over to Erik..

Thanks, John. Good morning and thank you for joining us today. I hope you remain safe and healthy. On today's call, I'll reflect on our recent performance, provide color on Q3 and also share our perspective on the current environment. Kristen will provide more specifics on our financial performance and outlook.

And I'll then wrap things up before we open up the line for questions. We're now three quarters of the way through fiscal 2022 and our drive to improve execution and financial performance is in full swing. Each passing quarter is another proof point of progress on our Mission Critical journey.

During our fiscal third quarter, we achieved revenue growth of roughly 500 basis points above the IP index. We demonstrated continued gross margin expansion both sequentially and year-over-year and we translated the growth into strong operating leverage.

Adjusted incremental margins for the quarter were just over 33% and adjusted operating margins expanded 200 basis points. Our fiscal third quarter represented the highest revenue in the history of our company and the lowest operating expense to sales ratio since fiscal 2013. While we're encouraged with progress, we are far from satisfied.

On the growth front, we're seeing historically high contribution from realized price in light of the inflationary environment. And so we still expect more growth above IP and we're focused on capturing it. On the profitability front, operating margins are improving but we strive for consistent margin expansion before we declare victory.

Turning now to our performance, I'll begin with revenue growth. We remain focused on the same five growth levers that have had our attention all year. And those are metalworking solutions, selling the portfolio, digital and customer diversification with an emphasis on the public sector.

Today, I'll highlight metalworking, selling the portfolio, and the public sector. Metalworking remains the cornerstone of our strategy. We use our expertise to bring productivity, and profit improvement to our customers. These efforts are driving customer satisfaction, new wins, and the strong price realization rates that we've been seeing.

A recent example underscores the power of our metalworking team. One of our experts recently consulted with a customer who produces machinery for the food processing and consumer goods industries. You recommended numerous process improvements to both their drilling and milling operations.

Those recommendations reduce cycle times in milling in the customers milling operations from nearly three minutes down to just 10 seconds per part. Similar improvements were made in their drilling operation, making cycle times from over two minutes down to just 15 seconds.

In total, this translated into increased capacity and reduced energy consumption yielding $700,000 in annual profit improvement for the customer. For MSC, this has resulted in a several fold increase in share of wallet.

In order to bolster our metalworking leadership, we acquired Engman-Taylor, a premier metalworking distributor headquartered in Wisconsin after the quarter end. We have long admired the company and are excited about the combination of our two businesses.

Engman-Taylor brings to MSC a deep bench of metalworking expertise, a great reputation with customers and suppliers, and a culture that aligns with ours. CEO Rick Star will continue running the Engman-Taylor business, and I'm thrilled to welcome him and the entire team to MSC.

Next, I'll touch on selling the portfolio, which is about cross selling additional product lines, most notably our C-Parts consumable offering of CCSG.

This business is particularly important because it solves a big challenge for our customers through an outsourced VMI model and at the same time, creates high degrees of loyalty and stickiness for MSC in a high margin category. We have sharpened our focus on this business and we're seeing performance improve as a result.

Growth has been pacing ahead of company average, with Q3 coming in the mid-teens. We view this as the early stages of our plan, and we expect momentum to build. Finally, on the growth front, I'll update on the public sector. While sales remain down in the quarter, I'm encouraged by progress.

During the course of Q3, we completed implementation across the entirety of Marine basis for the for 4PL contract. We've begun to see revenues build, and we're on pace with our initial expectations. Partially as a result of this, we saw the public sector inflect during the quarter.

March and April were slightly under 20% negative whereas May flipped to growth and we expect double digit growth in our fiscal fourth quarter. Turning to gross margin, I remain quite pleased with our performance. Following a strong output in our fiscal Q2, gross margins lifted sequentially another 40 basis points in Q3.

This is largely the result of the late January price increase and supplier rebate upside due to higher purchase volumes. Realization rates remain strong against the backdrop of severe inflation as our value proposition is resonating with customers during these extreme times.

Our customers are plagued with rapid inflation, labor shortages and extended lead times. The need for product availability and for tangible productivity gains are paramount. MSC is delivering on both fronts, as evidenced by the example I shared earlier.

I'll also mention that in response to continued supply or cost increases, we implemented a low single digit price increase towards the end of May. Finally, I'm particularly excited by our progress this quarter on operating profit improvement.

Thanks to our Mission Critical initiative and to the efforts of our entire team on expense control and productivity gains, we reduced the adjusted operating expense to sales ratio by 140 basis points and hence expanded adjusted operating margins by 200 basis points.

These efforts are pushing adjusted ROIC into the high teens and we are ahead of schedule with our original 2023 goal. Turning to the external landscape, where you are in interesting times indeed.

On the one hand, there are several yellow or red macro indicators, such as high inflation, rising interest rates, and on-going supply chain shortages and challenges. On the other hand, we are experiencing a more encouraging picture. Order levels, backlogs and overall activity remains strong.

Most segments of the industrial economy are still seeing robust demand patterns, as evidenced by the industrial production index.

That said, many of our customers are feeling the effects of extreme inflation in all lines of their income statement, along with the on-going labor and supply shortages resulting in the need for productivity and process improvement. Despite supply chain constraints easing gradually, we are nowhere near back to a normal environment.

And while all of this continues to put pressure on our customers, we are not seeing the evidence of an imminent recession that is suggested by the headlines. As a result, we remain in growth mode. In fact, we expect double digit organic average daily sales growth to continue in fiscal Q4, as evidenced by our June reading.

If, however, we were to see a change in environment at any point, we're prepared to adjust quickly. Through the pandemic, we've become more agile and we've improved our ability to course correct. In addition, our balance sheet remains strong.

And our cash generation will continue improving, leaving us well positioned to capitalize on any opportunities that would emerge. I'll now turn things over to Kristen..

Thank you Erik. I’ll begin on slide 4 of our presentation where you can see key metrics for the fiscal third quarter on a reported basis. Slide 5 reflects the adjusted results, which is where I'll focus most of my comments today. Our third quarter sales were up 10.7% versus the same quarter last year, and came in at $959 million.

Our non-safety and non-janitorial product lines grew nearly 13% and sales of safety and janitorial products improve sequentially to flat. Looking at growth rates for our sales by customer type, government sales declined nearly 10% due to the difficult janitorial and safety comps.

The comps have forgotten to ease and we do expect government sales to return to growth in Q4. National Account growth with high teens and core customers grew low double digits. Moving to more technical and solutions oriented business remains an integral part of our Mission Critical strategy.

Sales to customers with solutions now represent roughly 55% of the total company sales. Within that solutions umbrella, our in-plant program moved to nearly 10% of total company sales in Q3. You may recall that our goal was to reach 10% by the end of fiscal 2023, so progress is accelerating faster than anticipated.

The remaining approximately 45% of company sales to solutions customers are made up primarily of our vending and vendor managed inventory channels. As Erik mentioned, our gross margin for the fiscal third quarter was 42.9% up 40 basis points sequentially from our second quarter and up 60 basis points from last year's fiscal Q3.

Reported operating expenses in the third quarter were $271 million versus last year's reported operating expenses of $257 million. Adjusted for acquisition related costs, adjusted operating expenses were $271 million, or 28.3% of net sales versus last year adjusted operating expenses of $257 million, or 29.7% of net sales.

This represents a 140 basis point reduction in adjusted OpEx to sales year-over-year. We incurred approximately $3.3 million of restructuring and other costs in the quarter as compared to $1.3 million in the prior year quarter. Our reported operating margin was 14.3% compared to 14.8% in the same period last year.

As you may recall, included in last year's Q3 operating margin was a 20.8 million impairment loss recovery.

Adjusted for restructuring and acquisition related costs as well as the prior year’s impairment loss recovery, adjusted operating margin was 14.6% as compared to adjusted operating margin of 12.6%, a 200 basis point improvement year-over-year.

And as Erik mentioned earlier, that resulted in an adjusted incremental margin for our third quarter of just over 33%. That puts us at a year-to-date incremental margin of 24%. So we feel confident we will exceed our original fiscal 2022 incremental margin goal of 20%.

Reported earnings per share were $1.78 as compared to $1.68 in the same prior year period. Adjusted for restructuring and acquisition related costs as well as the prior year’s impairment loss recovery, adjusted earnings per share were $1.82 as compared to adjusted earnings per share of $1.42 in the prior year period, an increase of 28%.

This is a result of our execution all levels of performance, gross margin and off OpEx leverage. Turning to the balance sheet, you can see that as of the end of the fiscal third quarter, we were carrying $680 million of inventory, up $22 million from Q2’s balance of $658 million.

The inventory build is consistent with our double digit revenue growth, the on-going supply chain disruptions and the continuing inflation. Accounts receivables are also rising with the current sales growth. As expected, we saw sequential improvement in our cash flow conversion for operating cash flow divided by net income.

These three cash conversion was 78% compared to slightly negative cash conversion last quarter, and 22% conversion for last year’s Q3. Our capital expenditures were $14 million in the third quarter.

Moving ahead to slide 7, you can see the uses of working capital also impacted our free cash flow, which came in at $64 million for the current quarter as compared to $3 million in the prior year quarter.

As discussed last quarter, we expect cash conversion to continue improving and we remain on track for the full year fiscal 2022 cash conversion to reach approximately 70% to 80%. Our total debt at the end of the fiscal third quarter was $790 million, reflecting a $45 million decrease from our second quarter.

As for the composition of our debt, roughly 56% was floating rate debt and the other 44% was fixed rate debt. Cash and cash equivalents were $29 million, resulting in net debt of $761 million at the end of the quarter, down from $794 million at the end of the second quarter. I will now provide an update on our Mission Critical productivity goals.

You may recall that our updated cost savings goal for fiscal 2023 is a minimum of $100 million versus our fiscal 2019 cost base. As you can see on slide 8, our cumulative savings through fiscal 2021 were $60 million, and we had invested roughly $22 million over that same period.

In our fiscal third quarter, we achieved additional savings of $4 million and invested another $2 million. That brings our year-to-date savings and investments to $20 million and $13 million respectively.

We fully expect to achieve $25 million in gross savings and reach $15 million of investments for fiscal 2022 and we remain on target to hit at least $100 million of gross cost savings by fiscal 2023. Before I turn it back to Erik, let me share a few comments on our fiscal fourth quarter expectations.

Keep in mind that this fiscal year includes a 53rd week, so there will be an extra five selling days in the quarter. That extra week of sales is expected to carry a roughly 20% OpEx to sales ratio. On an ADS basis, we expect to continue growing at a double digit pace for the quarter.

Sequentially, we anticipate gross margins will likely see the typical seasonal headwind, as the benefit of the latest price increase will more or less be offset by a lower rebate accrual and increased purchase costs.

We also expect to continue leveraging our strong growth such that incremental margins while not at the level of our Q3 should still be in the mid-20s. All of that should get us comfortably into the top tier of our fiscal 2022 annual operating margin framework, which you can see on slide 9.

Last point on Q4, the numbers I just referenced are on an organic basis excluding the impact of Engman-Taylor. Let me provide some color on Engman-Taylor.

With annual sales of roughly $60 million the business will be about 30 basis points diluted to our gross and operating margins in the fourth quarter, roughly neutral to EPS in fiscal 2022 and accretive to EPS thereafter. More importantly, it's expected to achieve an ROIC above our weighted average cost of capital in the first full year of operations.

One final area I'd like to discuss, as Erik mentioned, and we are all aware, many are concerned about the economy. First, let me reiterate that we currently do not see signs of a slowdown but if a slowdown were to occur we are well positioned to weather the storm.

Our balance sheet remains strong and as we've shown numerous times historically, when the economy slows, we generate strong cash flow and working capital becomes a source of funds. This enables us to strategically invest through the downturn.

In addition, through Mission Critical, we have already built momentum, removing structural costs from our business, and plan to continue doing so. Finally, our growth initiatives are still ramping, and should continue to fuel growth above the IP index under any economic scenario.

For all these reasons, we feel well positioned regardless of the environment. I'll now turn it back to Erik..

Thank you, Kristen. Our Company remains firmly in growth and execution mode. With each passing quarter, we are gaining traction. We look forward to closing the fiscal year strong with double digit top line growth, gross margin expansion and adjusted incremental margins in the mid-20s.

I want to thank our entire team for their dedication and their hard work. And we'll now open up the line for questions..

Thank you This first question comes from Tommy Moll with Stephens. Please go ahead..

Good morning, and thanks for taking my questions..

Hey, Tommy, good morning.

How are you?.

Doing well, thanks. I had planned to ask if you had seen any sign of a slowdown in the business. But now having Erik and Kristen on the record that you're not I will instead of asking a third time, I'll go a different direction.

And ask have you seen anything change? So compared to last quarter, when we had this conversation, have any of your end markets gotten better or worse? Has the patience with customers changed at all you highlighted Erik, some patient fatigue? Maybe that's a little bit different.

Anything that's changed would be helpful?.

Tommy, I would say that, for the most part, most of the factors you just referenced. So demand, outlook, inflation, the shortages, the lead times are fairly similar to last quarter. I think in some ways, the changes that these headwinds that our customers and suppliers are feeling continue.

And I think what that's doing is just sharpening the focus on need for productivity, and need for help on our customers. There is a drumbeat for sure that, hey, that we understand, price increases, they're coming fast and furious from every line of the P&L. We need help offsetting them with productivity.

And we need help offsetting the labor shortages we're facing, which have not abated either. And they're still, despite some of the headlines on supply chains, easing, there's still real shortages and lead time delays, so we need product.

So I think all of those are playing well into our favor because we can deliver on some of those things for customers. But I think it's more or less a lot of the same things that are just kind of sharpening this need for the customer..

Following up on Mission Critical, you're ahead of plan currently. So if we, if we think this through as it continues to evolve, do you end up with a more run rate repeatable kind of operating framework? I mean, Mission Critical was a very specific plan for a very specific starting point.

But do we evolve into a more -- process in years, and if the answer is yes, in -- any of the contours? Is there a implied incremental that you end up in, hypothetically, if you have an operating -- production growth low single digits in a given year? Is there a rough range from why?.

Yes, I'll break it down a few parts. I think first part of your question on Mission Critical. So we've got the official sort of originally stated Mission Critical goals ending in fiscal 2023.

I mean that's the guidance that we gave back in, the kind of the beginning of this journey where we're going to deliver greater, greater than $100 million cost savings.

So absolutely on track to meet and exceed that target so you can kind of assume at least $15 million more of savings in 2023, to kind of bring us across the finish line for the originally stated Mission Critical goals. But, then to your point it's not really going to end in 2023.

What Mission Critical is ultimately about is kind of changing the culture, changing the mind-set in the company to generate continuous productivity, how much productivity I think you can ask, but how to think about that in the context of a framework.

I'd say a lot of it has to do with how much we think we need to offset in terms of what's coming out of from an inflationary perspective. And also, how much do we want to be able to invest every year. So no specific guidance at this point beyond 2022, we'll give a little more color in our fiscal 2023 framework that will come up next quarter.

And at that point, hopefully, we'll have a little bit more of an understanding of what might be coming at us from a macroeconomic perspective.

But generally, we feel really well poised for next year, we're on track for all the Mission Critical targets, not just the cost now targets, so feel very confident about continuing to grow at least 400 basis points above IT. We feel very good about delivering the OpEx savings and we're already on track and ahead of schedule on the ROIC improvement.

So feeling very good about where we are to close out 2022. And right now feeling, feeling optimistic about 2023..

Stay tuned, and I'll turn it back for now..

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

Hey, good morning, everyone. Nice quarter..

Hey Ryan, good morning..

So my first question was on inflation.

I'm curious do you think prices are starting to peak here or is that not clear yet?.

Ryan, I would say not clear yet. Certainly today we continue to see, we mentioned in the prepared remarks that we took an increase as recently as late May in response to what we're seeing from suppliers.

So I would say we have not yet seen a slowdown in the rate and pace of increases coming from our suppliers, which Ryan, as you know, is sort of, for us the leading indicator, and I think that's because this inflation wave is driven beyond just commodities.

It's driven by so many other factors, oil and fuel wage rates and what's going on, there's multiple variables here. So so far, no slowdown..

That's kind of what I thought you'd say.

And then turn into gross margin, how much did price cost health gross margin in the quarter? The increase here at 60 bps?.

Yes. So year-over-year, the way to think about the margin improvement of 60 bps is that attribute about half of it to favorable price offsetting purchase cost inflation in any mix headwind and then about the other half, from increased vendor rebates..

Got it.

So I'm just trying to get a sense for this year, how much price cost is helping your gross margin? Could you help us there? And should we view that as one time because COGS will eventually catch up, so it might be a little give back as we look out at 2023? Is that the right framework?.

Let me make take you maybe Q3 to Q4 and kind of cap how to think about fiscal 2022. So if you're, if you're thinking about sequential gross margin, from Q3 to Q4, the first thing I tell you is you've got to account for the seasonal mix headwind that we typically see at this time of year. And that has to do with the product mix of summer goods.

So think about 50 to 60 basis points roughly, of headwind from that dynamic. Then you've got pricing, which we do expect to remain positive, we'll get a little bit of boost from that small May increase that we took. But then you have offsetting that increased purchase cost inflation, and a decrease sequentially and vendor rebates.

And so that's kind of the organic Q3 to Q4 changes. And then on top of that, I would layer in a headwind from Engman-Taylor, about 30 basis points approximately..

Okay….

Then for 2023 I’d say too early right now to guide Ryan. I mean, like Erik just commented, we don't know what's going on with inflation yet. And really, of all the variables that we're looking at to understand how fiscal 2023 might shake out price cost is definitely one of the biggest ones.

And much of that is contingent on what happens with the timing of the inflation cycle..

Okay, now, that all makes sense, and I was I was really just trying to get a sense my feeling is, price has helped the business but not maybe as much as we've seen in the past.

So is that the right it's been sort of a modest boost? Not something that was overly impactful to gross margins?.

Well, I think organically if you think about being able to improve margins, fiscal 2022 versus fiscal 2021 so we're going a few years now actually with keeping flat or slightly up margins. And that is a change in trajectory from what we've seen the business do in the last several years.

And to be able to do that, it basically means we're getting enough of a favorable spread from price cost that it offsets that mix headwind that we've kind of been seen in the business steadily over the past several years as some of our growth initiatives, which are margin headwinds as those continue to grow.

So we're off, we're getting enough price cost, but it's covering that mix headwind. So in that regard, I would say, we do feel really good about the price contribution in the business. I don't know how far back you'd have to go to really see price maybe doing better than that.

I don't know if Erik wants that at any context, from the, kind of era before I got here. But we're, we're really pleased with the price cost outcome..

I think the only other thing I'd add, Ryan is there, this time around there is look obviously, we're benefiting from a macro environment, the inflation that's out of our control. But I would say relative to past cycles, there is more work going on in the company to control our destiny.

So, we've talked about there's a big pricing initiative inside the company to sort of build up the muscle in our sales organization on how to have that discussion with customers and how to sell through price so that even if, at some point inflation is going to slow.

How do we still make sure we're extracting value because we are delivering the goods for the customer in terms of productivity and product availability, so that's one initiative.

CCSG, we mentioned in the prepared remarks, it's getting amped up focus under Kim and team in the field, that is a margin accretive piece of our business, that we're starting to see momentum. There's focus going on private brands, inside the company and moving the mix of business there. So there were things on the self-help front.

I think, probably more so than I would have said during the past pricing cycle, Ryan..

Very helpful. Thank you. I’ll pass it on..

And our next question today comes from David Manthey of Baird. Please go ahead..

Thank you. Good morning, everyone. I was wondering if you could give us some insight into your thinking, as you're developing the fiscal 2023 framework, potentially, I know you're not going to give us details.

But is the plan regardless of what you see, out in the market, you'll have a category for sales declines? Or will you just base the buckets on how you're budgeting and then adjust later if conditions change like you did with the upside this year?.

Yes and I should say, I think it's high, we're not high….

No, that's Dave..

It’s Dave..

Dave, it didn’t sound like you..

Yes, it’s me sorry..

So fiscal 2023 framework Dave, a couple of thoughts. We're obviously going to be modeling a lot of scenarios. There's a lot of uncertainty out there right now. We talked a little bit about, what happens with the inflationary cycle, and price costs being one of the biggest factors that could move the needle for us in 2023.

But generally, we're trying to understand, what is going to happen with the industrial production index, what is being representative of what we would say, is market growth, and then what's our ability to gain share and take price on top of that. So that's, that's like some of the really big buckets that we're modeling and thinking through.

And we have a lot of momentum heading into 2023 that we feel really good about allowing us to capture share, regardless of what happens to the market. So we're very focused on controlling our own destiny and delivering that at least 400 basis points of growth above IP, regardless of what the IP index actually does.

And obviously, if we were to head into a down scenario, some of our ability to continue expanding margin gets a little bit harder than if we get some favorable IP growth.

But generally, again, very optimistic right now with what we see the momentum in the business, and definitely committing to hitting those Mission Critical goals for 2023 regardless of the circumstances..

Okay, so it sounds like you're you'll base the buckets on some outlook for IP and then adjust from there is sort of the view..

Yes, yes. Big building blocks IP is a benchmark for market.

What do we think is going to happen on price cost, share gain, and then productivity and inflation?.

Yes. Okay. Great.

And then, as it relates to Mission Critical and some of these cost savings, in a recent general investor deck, you cited that you still have 26 branch locations, and I'm wondering, does that number gravitate to zero over time? And if not, could you talk about why if so, could you talk about the timeframe and then if the savings from those closures is included in your Mission Critical targets?.

Yes. So Dave, the 26 now is we feel pretty good about that number, we would imagine that stay stable. Obviously, we did a lot of big work around the branch restructuring last year, which took out many of our branches, the ones that are left behind are really supporting some of the different kinds of businesses within MSC.

And we feel like 26 is the right number, so not contemplating any more savings from any kind of material branch restructuring or branch closures..

Perfect. All right. Thank you..

And our next question today comes from Chris Dankert at Loop Capital. Please go ahead..

Hey Morgan, thanks for taking the question. I guess you mentioned there's on-going lead time extension supply chain issues kind of continuing a pace here.

I guess, how do we translate that for MSC, kind of what's the fill rate today looks like versus that near 98% level we were seeing kind of pre pandemic?.

Yes, Chris so what I would say is, there's definitely still supply chain issues, we're seeing a difference in our compared to sort of pre-COVID fill rates, but the difference for us is very marginal. Whereas compared to the local distributors, it's it's a really wide gap between pre-pandemic and now.

So we actually feel in some ways, like on a relative basis, the advantage has grown. Although yes, when we look at our flow rate, and our service metrics are, as you could see, the difference, we're still not back, we're up from where we were at the lows a few quarters ago. But still not back to pre-pandemic.

I will point out one nuance, which is we look at it a couple of different ways, what we call, first pass and second pass. So first pass would be is the product located in the location that's closest to the customer. And there we see a pretty sizable difference.

The second metric would be second pass, which is do we have the item anywhere in our network. And for that second pass measure, the difference is very marginal. And this has been the case through COVID. So while there's some freight expense to be borne by moving things around, we're generally more often than not able to deliver for the customer..

Got it. And that's certainly been such an issue, which I -- having product on hand in terms of market share convergence so glad to hear that that kind of continues to recover we're not quite there yet.

And just kind of a point of clarification, I didn't see it in the deck, in plant growth in the quarter; I assume that's still kind of 9% of total sales. We're still seeing, near 70% growth in that that business today..

It's approaching 10% of sales actually this quarter..

Oh, perfect. Thanks so much guys, really appreciate the color..

Yes, no problem..

And our next question today comes from Hamzah Mazari with Jefferies. Please go ahead..

Hi, this is Hans Hoffman filling in Hamzah Mazari. I know you guys touched on it a bit in your prepared remarks.

But could you just talk about what you're seeing in metalworking markets from a growth perspective? And then just maybe talk about some of the competitive dynamics there?.

Yes, sure. So in terms of end markets, the general comment I would say is, we're seeing pretty much broad base strength across most of the verticals that are metalworking related. Certainly, you can imagine with oil and gas, oil prices being high, that area of the business is doing a lot better than it was years ago.

Auto and aero are certainly on their way back and growing. And we still feel like there's plenty of room in both of those general machining strong, so environment is good. And then in terms of competitive, dynamic, your metalworking, it's a lot like the rest of the industrial supplies in the MRO market space, which is that it's highly fragmented.

So you think about it across this is now beyond metalworking. But across the entire industrial landscape, the top 50 distributors have roughly 30% share. The metalworking would sort of be an analog to that. And so it's fragmented.

And there's a lot of market share to be had from local and regional distributors that aren't faring quite as well right now..

That's helpful.

And I know you guys, you mentioned the Engman-Taylor acquisition, but could you just talk about your M&A pipeline going forward? And if you're seeing any changes to private company valuations, and then how you're thinking about capital allocation going forward?.

Yes, sure. So on the M&A front, I would say in terms of our outlook, and we've been pretty consistent for a while now, which is that, particularly as it relates to anything really big, and really sort of outside of our core business the bar would have to be really high that we are focused on a pipeline within our core business here.

And we have a couple of things that we consider to be in our core. The one change I call out is it does feel like the pipeline and the degree of conversations are more robust. I think there's probably a lot of private owners just thinking about life, about the future of the business, etcetera. So I think the pipeline is pretty robust.

Again, they would be over the more or less of a smaller variety inside of our core, I mean, Engman-Taylor is a great example. It's a great team -- in an MSA, where we'd like to see more penetration, they've been a leading competitor for a long time, the values line up between Rick and MSC.

So a great example of what we would hope to find and continue to build on.

In terms of capital allocation, look, we're sitting now, at about one and a half times leverage, which is a very comfortable place to be, particularly as Kristen had mentioned, we would expect to start to see cash generation, really picking up as working capital kind of stabilizes.

So we think we have plenty of dry powder here, we're going to stay pretty disciplined, first priorities for us, our organic reinvestment into the business to the extent, we like what we see in terms of the return prospects. And of late, our confidence is really building based on the performance.

Closely, close second would be the ordinary dividend, and then from there, we look at M&A, we'll look at return of cash to shareholders, i.e. buyback on a risk adjusted basis. And the only other comment I'll make is we are mindful of rising interest rates.

So from our standpoint, in a high interest rate environment it doesn't change anything other than that the hurdle, the hurdle rate effectively goes up if we're going to deploy cash..

Got it. Thanks. I'll turn it back over now..

Thank you. And our next question today comes from Ken Newman at KeyBanc Capital Markets. Please go ahead..

Hey, good morning, guys..

Good morning, Ken..

Hi. So first question, Erik, I appreciate the comments about the macro uncertainty and your ability to adjust quickly if the environment changes. We talked a little bit about, I think there's an earlier question about what structural incremental margins could look like, just given all the work you've done in Mission Critical.

But I'm also curious if you have a viewpoint on what structural decrementals could look like relative to past down cycles..

Ken, I can take that one. So at this point, we're not even modeling a scenario where we need to worry about decrementals for next year. If things were to really erode before we give the framework for 2023, we would provide some guidance on that. But right now, it's not something that we're even looking at..

But I guess to the point, though, you would expect that even in a downturn, an eventual downturn in the cycle, you'd expect those decrementals to be better than what you've experienced in the past, right? Just given on a structural cost out over the last two or three years..

Yes, absolutely. Yes, I think that's where we'll really see a benefit from all the Mission Critical work that's been done over the last couple of years already in terms of structural cost takeout. We're at $85 million roughly at the end of -- as of the end of this year approximately. That will certainly help us.

And then Erik also mentioned before, just a lot of things that we're doing differently inside the business now that are going to allow us to weather that storm differently than MSC has in the past.

So I think a big one that we're really excited about Erik brought up earlier, but just the work we've been doing around capability development in the field, things that benefit our ability to add value to the customer kind of regardless of what the macro environment is.

That would definitely make a down cycle look quite different for us than it has in the past..

Is there any way that you can maybe just provide just a little bit more color as to maybe give us a framework of if decrementals were making up a number here in the 20%, is it more of like a mid-teen type of range? Or is that you're still kind of doing work on that?.

We'll give you a look at that next quarter..

Okay. And then for my follow-up here, I know inflation is still a very real impact on the market today. And obviously, you're already putting in some price increases to address that here. I do think we've seen some pullback in raw material costs for some key materials though, like steel and copper.

Just any color on how you think about decisions on inventory? And how do you think about the potential price cost normalization when inflation does roll?.

Ken, look at some point, inflation -- obviously, we track commodities very carefully. And that is part of the buying formulas. We look our buyers are tracking commodities and indexes.

What I will say is, as I mentioned earlier, relative to prior cycles there's other factors beyond just the commodities that are influencing our suppliers raising prices for now. Look, at some point, no question, the music will stop. And the inflation cycle, that could be next quarter, it could be next year, it could be in three years, five years.

We have no idea. At some point, that will stop. And certainly, price cost will come under more pressure than it is now.

And look, I think it's why one of the comments we made earlier was we're focused on initiatives in our control, that even in an environment where we're not capturing as much in price, that we have the ability to offset more pressure on price cost through our own initiatives. And I mentioned a few of those earlier..

Understood. Appreciate the time..

And our next question today comes from Pat Baumann at JPMorgan. Please go ahead..

Good morning, Erik. Good morning, Kristen. Congrats on the strong quarter..

Good morning..

Hey, Pat. Good morning. Thank you..

Hey. How are you doing, Erik? Just a first question is on price. When you look in the fourth quarter, I think you said you put through late May increase.

I'm just curious what do you expect that price contribution to be to sales? Will it be up from the 6% you just put up in the third quarter given that increase? And then as you look into next year, what's the carryover now based on kind of what you've announced? And then I'm sorry, this is kind of a little bit of a long question, just along those lines, as you think about next year, is there some bucket of your product offering that could see pricing move down to that last question if commodities deflate from here? Or is all of that price you put through considered by you to be kind of sticky such that you wouldn't give any of that back in that scenario? Sorry for the long question..

Good. Good. It’s okay, so it's like an ABC, so let me start off with the -- we'll go near term, how about -- so near term, your first question, Pat, was about Q4. Look so you could do the math on. And what we show in the Op stats, we give you a sense of price.

And we always call it price mix because it's tough to decouple the two all the time, but it's in that growth decomposition. And in our Q3, I think it was in the five, five and a half percent something like that range. Where does it go for Q4? It's hard to predict precisely because mix does play into it.

This is sort of a living organism here and things change. But that being said, all else being equal, sure yes, we took -- so the increase we took in late May was low single digit. So it's not like it was huge.

But yes, if realization does what we think it should do, one would expect the price contribution in Q4 to be all else being equal, slightly higher than it was in Q3. That's right. So I think that was the first part of your question. The second part is the carryover. I think the way to think about that is we will get a part of the year.

So for the larger increase we took in January, we are going to get that for the first sort of carry over the first part of fiscal 2023. And then for the late May increase, we will get a carryover for roughly three-quarters of fiscal 2023.

And then of course, the other contribution would be any additional price increases that happen, which will be a function of what we see between now and September or, quite frankly, through the course of fiscal 2023. I think that was the second one. The third one was about deflation. And certainly, commodities are going to come down.

I will say, Pat, and you never say never, right? But if I look back over the course of my history in this industry, because the finished goods, the parts that we sell, the raw materials generally are a relatively small percentage of the finished product.

We have not really seen cases where deflation leads to mass price reductions, which is to say, generally, pricing is sticky. I think what certainly would happen is if prices commodities come down, the prospect of further price increases goes away. But it would be unlikely.

And certainly, it would be a break in pattern from the past to see prices in mass come down..

Understood. That's helpful color. Thanks for accommodating all of those questions. I have one follow-up and then this one is on gross margin. I guess what surprised you in the quarter? It just seemed to me like sales were kind of in line with how you thought they would play out in the quarter.

So I guess I'm curious why did volume rebates come in as it well, maybe you had -- maybe that was planned to be where it was. I guess that's the question.

What surprised you? Because you call out price cost, you call volume rebates, but I feel like the gross margin was better sequentially than maybe internally or maybe externally people thought maybe internally as well. Just curious what surprised you.

And then I think you said at one point recently, you saw enough momentum that gross margins could be flat next year. I may have that wrong. If I'm wrong, just tell me you never said that.

If I'm right, I guess, I'm just curious, is that still the case?.

So Pat, I can take the first part. I sort of start, and then I'll turn it over to Kristen. That's good. I think what surprises, look, I think if you go back, we were thinking at the time last quarter, we were coming off of a strong sequential lift from Q1 to Q2. We felt good about that.

And we felt like, hey, gross margin should be up a little bit from Q2 to Q3, but not a lot. So I would say you are correct. The 40 bps was a little more, probably a little more than we expected. I'd say two things. One is, look, I mentioned we have this initiative in the field on pricing to improve realization. The results have been quite good.

So I think that's one. And then two is, yes, look, we did a heavy amount of purchasing. That resulted in outsized rebates. And to some degree, we expected it, but we probably did even a little bit better there, is the two things I'd call out. And then the other point was about 2023.

Kristen, do you want to jump in?.

Sure. Yes. I don't believe we've commented on that specifically, Pat. I think we're looking at a variety of potential outcomes for margin next year. And obviously, the length of the inflation cycle would be a really big driver of the guidance we would provide for gross margins next year.

But I'd say, given what we know of for 2023, it would be a very good outcome if we were able to hold margins flat. There's certainly a set of conditions under which that could happen. But that would be a really good outcome for us for next year, I would say.

And we'll give some more guidance on some ranges and kind of what would affect that on the margin side when we head into the outlook for next year.

But -- and your comment was specifically on gross margins to be clear, right, Pat?.

Yes, you got it. That's exactly right, yes.

That's what your answer was in response to, right?.

Yes. Just checking. As I finished talking, I was like I got to make sure that was a gross margin question. Yes, that was gross margin answer..

Great. Great. And I mean I have one little modeling one, too. Just on the fourth quarter, you said OpEx to sales on that extra week is 20%.

What do you expect the extra week to carry for absolute sales contribution related to the extra week?.

Yes. Just roughly, whatever you're modeling for Q4 is whatever five days is worth. I just -- that's the easiest way doing it, then to supply 20% OpEx on that typical gross margins..

Perfect. Thanks so much. Appreciate the time..

No problem..

Thanks, Pat..

And ladies and gentlemen, this concludes our question-and-answer session. I'd like to turn the conference back over to John Chironna for any closing remarks..

Thank you, Rocco. Before we end the call, a quick reminder that our fiscal 2022 fourth quarter earnings date is now set for October 20, 2022. We plan to attend several investor conferences and perhaps a few road shows before then. So we look forward to seeing you in person. Thanks for joining us today..

Thank you. This concludes today’s conference call. We thank you all for attending today’s presentation. You may now disconnect your lines and have a wonderful day..