Good morning, and welcome to the MSC Industrial Direct Second Quarter 2014 Financial Results Conference Call. (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 sir.
John Chironna – Vice President, Investor Relations and Treasurer
Thank you, Denise, and good morning to everyone. I’d like to welcome you to our fiscal 2014 second quarter conference call. An online archive of this broadcast will be available 1 hour after the conclusion of the call, and for 1 month on the investor relations homepage at www.investor.mscdirect.com.
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, including the BDNA acquisition and expectations regarding future revenue and margin growth.
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 the earnings press release and the risk factors in the MD&A sections of our latest annual report on Form 10-K 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 will refer to certain adjusted financial results, which are non-GAAP measures. Please refer to the tables attached to the press release and the GAAP versus non-GAAP reconciliations on our presentation, which contain the reconciliation of the adjusted financial measures to the most directly comparable GAAP measures.
I’ll now turn the call over to our Chief Executive Officer, Erik Gershwind. Go ahead Erik.
Erik Gershwind – President and Chief Executive Officer
Thanks, John. Good morning everyone and thank you for joining us today. Also in the room with us is Jeff Kaczka, our CFO.
I will start by saying that I am pleased with our execution and our overall performance during the first half of our fiscal 2014. As I usually do, on today’s call, I will discuss the current environment where we continue to see positive signs, our recent developments where despite weather-related disruptions we produced solid results in Q2 and progress with our infrastructure and our growth initiatives, including the BDNA integration which continue to go well.
Jeff will focus on our financial results and provide our fiscal third quarter guidance. And I will then conclude with an update of our full year expectations which have not changed since our last call. And finally we will open up lines for Q&A.
I will now start with the environment. Market conditions continued to improve despite some temporary weather-related hiccups in January and February. When we spoke on our last call in January, we’d just come off the holiday season and had seen the first winter storm impact our fiscal second quarter. Those weather-related disruptions continued through January and into February and did in fact impact our growth rates.
Nonetheless, the weather eventually did improve and the environment returned to the levels that we saw in November and the first half of December. In recent months, the ISM readings have come down from the high 50s to its low to mid-50s range. At the same time Metalworking Business Index which had been negative for quite a while has improved with the last reading in the mid-50s at 55.9.
For the first time in a while, those two measures have converged to a similar range. In fact, for the past two months, the MBI has actually been higher than the ISM. We are finally reaching a time when those macro indicators are generally consistent with what we are seeing and hearing from our customers.
The manufacturing environment, particularly the metalworking sector, has improved considerably from where it had been during the last year and a half. We’ve moved past the contraction that we were seeing during our fiscal 2013, and are now in what we would characterize as moderate growth environment. Customers are reporting slightly more confidence and are seeing steady order flows and backlogs.
To be clear, with some exceptions we would not characterize the current climate as high growth as growth customers remain appropriately cautious with their spending and their capital investments.
Another noteworthy change in the environment was the improved federal government spending climate. That improvement along with passing the anniversary of sequestration is contributing to strong growth which I will talk about in a minute.
So to summarize, we see our core business and metalworking manufacturing improving at a measured pace and we see considerable improvement in the government sector. When put together, these contribute to a positive outlook for the environment in the second half of our fiscal year.
I’ll now turn it to our recent results. Despite the weather-related disruptions, the improvements to the underlying operating environment along with our continued share gains allowed us to post organic growth of just under 4% for the quarter on an ADS basis. After the slow start in December and January due to holiday timing and the poor weather, our organic growth rates improved from the 2% to 3% range to the mid-6% range for February. As I mentioned earlier, the government sector performed well to end our fiscal second quarter and to start out our fiscal third quarter posting double digit growth rates in February and March.
Our national accounts program has also continued to perform well with growth rates well above the company average. This is testament to our customer focused approach. I had the opportunity last month to attend [Ribbon Live] the largest and highest profile conference for supply chain and procurement executives across North America.
I came away from the show feeling stronger than ever about the value that MSC is delivering for our customers. Our solutions, whether that’s technical expertise, inventory management or e-commerce, are helping companies gain visibility and control over their MRO spend. Since the second quarter ended on March 1, we closed the fiscal month of March on April 5. Keep in mind that our fiscal month of March did not include the Easter holiday this year but did last year.
With that in mind, we posted organic ADS growth of just a shed under 10% for the month. The Easter holiday timing will reverse itself in April which is also factored into our Q3 revenue guidance.
I’ll now turn to the execution of our fiscal 2014 plan and update you on our infrastructure and growth initiatives along with BDNA integration.
Our co-headquarters in Davidson, North Carolina has been complete for a couple of quarters and the incremental annual operating expense is now fully in our run rate. We have over 200 associates located in Davidson and we will begin receiving the related incentives in calendar 2015. Construction on our fifth customer fulfillment center in Columbus, Ohio remains on schedule to begin shipping by the fall of this calendar year. As expected, the operating expense impact will continue to grow in the back half of fiscal 2014 and into 2015 as we staff the facility with inventory and staff it in preparation for opening.
Our project to relocate our primary data center is going quite well and we expect to complete the migration towards the end of our fiscal third quarter or early in our fourth quarter.
Now for our growth initiatives which continue adding to our share gains. The vending program added roughly 4 points to our revenue growth in the second quarter. Vending signings remained strong and we view this as a function of the program’s value along with our customers’ ongoing need to find ways to streamline their supply chain.
Excluding BDNA, ecommerce reached 46.8% of sales for the second quarter as compared to 43.1% a year ago and 46% last quarter. This reflects our customers’ increasing interest in conducting business online as part of an integrated solution that includes vending, VMI and other forms of automated sales. As a result, ecommerce remains an important part of our growth investment program.
Salesforce expansion is on track to add between 5% and 7% to our field sales headcount for the year. We had 32 sales associates in our second quarter putting us at 40 for the first half and well on our way to hitting our annual target. While it’s still early, we are encouraged by the initial performance of our recent hires.
And finally, SKU expansion. After adding more than 40,000 in the first fiscal quarter, we added another 35,000 SKUs to our web offering in the second quarter and now have approximately 760,000 available on MSCDirect.com. We remain on track to add roughly 150,000 SKUs for the year and the newly added SKUs ensure the growth contributions from this program will grow over time.
I will now turn to BDNA. While revenue growth turned positive in our fiscal first quarter, the second quarter saw a drag from weather, currency and market weakness in Canada. As a result, overall BDNA revenues were slightly below prior year. We did, however, see the very early stages of cross-selling and we remain quite encouraged by new account signings. As I have said before, we continue to take a measured approach to capture revenue synergies. As our primary focus for now remains on operations integration, achieving cost synergies and setting the customer service foundation for growth. I anticipate that our cross-selling efforts will increase in the coming quarters. For example, we’ve begun introducing MSC Big Book offering to the BDNA sales force in pilot mode. We expect to ramp that up over the next few months as we learn from the pilots.
Regarding the integration plan, we closed another two distribution centers in the quarter bringing the total closures to three. We are also on track to close the Cleveland headquarters and move our associates to our new Davidson location by September of 2014. Overall we remain on track to achieve our targeted cost synergy run rate of $15 million to $20 million by the end of fiscal 2015 and to achieve our $0.15 to $0.20 accretion range for this year.
As each month passes, our confidence about the further of this business continues to grow. In line with our original plans, we began ramping up investments for future BDNA growth and started adding sales force headcount. This will begin to show in the form of sequential increases in operating expenses and we are confident that these expenses will yield payback in form of improving growth rates and earnings in the quarters to come.
I will now turn things over to Jeff to discuss the financial results in greater detail and provide our third quarter guidance.
Jeffrey Kaczka – Chief Financial Officer, Executive Vice President
Thanks, Erik and good morning everyone. Overall we are encouraged by the underlying sales trend improvement in our business. In our fiscal second quarter, despite weather-related disruptions and coming in at the low end of our guidance on sales, we delivered the high-end of our earnings-per-share guidance. And I am also pleased to say that our infrastructure and growth initiatives are progressing according to plan.
Let’s get into the second quarter results in more detail. As I have done over the past year, I will speak in terms of our reported results and our adjusted results which reflect the exclusion of non-recurring costs.
Our reported sales growth on an average daily sales basis was 16.3% compared to the same period last year. This includes the full quarter of BDNA sales. Excluding BDNA, our base business organic sales growth on an average daily sales basis was roughly 4%. The growth rate benefited from the improvement in our government business as well as from customers within our vending program which contributed roughly 4 points of growth.
With regards to gross margin, we posted 46.4% for the quarter, above the mid-point of our guidance of 46%. We’re very pleased with this but I should point out that a key driver behind the gross margin outperformance included a lower than expected inventory reserve requirement and favorable rebate adjustments, which should not necessarily be expected in future quarters.
Our reported EPS for the quarter was $0.79 or $0.87 on an adjusted basis which excludes nonrecurring cost of $0.04 for BDNA integration, about $0.03 for executive separation costs and roughly $0.01 for relocation costs associated with Davidson. The $0.87 was at the high end of our guidance of $0.83 to $0.87 and reflects the bottom-line impact of higher gross margin as well as our management of operating expenses.
Finally, the tax provision came in at 38.5%, slightly above our 38.2% guidance.
Turning to the balance sheet, our DSOs were 45 days, basically unchanged from last year’s Q2. And we’re pleased that our inventory turns continued to improve to 3.52 from the previous quarter level of 3.46. While we did utilize our new inventory forecasting tools to reduce inventory levels over the past couple quarters, we do expect to return to normalized levels to support the anticipated growth as well as stock the new Columbus distribution center.
From a cash flow perspective, we continue to generate significant levels of cash as evidenced by our operating cash flow of $47 million. In addition, we paid out over $20 million in dividends and incurred total capital expenditures and infrastructure investments of $25 million.
CapEx was in line with our plan and our expectation for total year CapEx of slightly over $100 million remains on target.
As of the end of the second quarter we had $312 million in debt, mostly comprised of $244 million outstanding on our term loan and $40 million balance on our revolving credit facility. We closed the quarter with $45 million in cash and cash equivalents and since then have paid down $35 million of our revolver. Our current cash balance now stands at $38 million.
Now let me turn to our guidance for fiscal third quarter of 2014. I would point out that April 22 is the anniversary of our BDNA acquisition date. Consistent with last quarter, our guidance will exclude the nonrecurring BDNA integration costs and any remaining relocation costs associated with our Davidson facility. We expect total revenues, including BDNA to be between $720 million and $732 million, up 14.1% from the prior year at the midpoint.
We’re particularly pleased with the expected organic ADS growth in the base business of about 8%. The midpoint of our guidance range assumes that April and May continue the underlying organic growth rates seen in March.
Keep in mind that March this year did not have the Easter holiday impact that it did in the prior year. Therefore March this year was an easier comp while April will be a tougher comp with Easter falling mid-month. We expect gross margin to be in the range of 46.0% plus or minus 20 basis points which is down slightly from our fiscal second quarter. This reflects the positive impact of our strategic gross margin initiatives, the partial quarter BDNA mix and our modest mid-year price increase. This is expected to be offset by the mixed impact of strong growth in government and national accounts.
We expect adjusted operating expenses will increase at the midpoint of guidance by roughly $10.5 million versus the fiscal second quarter. The increase breaks out as follows: roughly two-thirds of the increase is the variable expense required to support the sequential increase of about $65 million in revenues. The rest relates primarily to the investments and infrastructure initiatives in the base business, including Columbus, sales force expansion, vending and more, plus some increase in investments into BDNA.
This increased spending will drive our future growth and remains on target with the plans we communicated last October. Our sales force expansion included about 40 hires through the first half of the year, also distribution center hiring to support the Columbus CFC and BDNA integration was up roughly 175 associates in the first half.
So the midpoint of our guidance implies an adjusted operating margin of approximately 14.7%, well within our fiscal 2014 annual framework of 14% to 15%.
Finally, our adjusted EPS guidance is $1.03 to $1.07 reflecting the current market environment and our increased spending on infrastructure and growth initiatives. It also assumes a tax rate of 38.0%.
Our earnings guidance, of course, includes BDNA operating results and excludes $0.03 in integration costs associated with the acquisition. Also, the BDNA business is expected to be accretive by about $0.04 in the third quarter.
So in summary, we were able to overcome the weather-related disruptions and achieved the top end of our EPS guidance for the second quarter despite coming in at the low end of our sales guidance. That reflects both the lift in gross margin and our ongoing expense management. We are also encouraged with some of the external indicators like the Metalworking Business Index and how we’ve started the fiscal third quarter in March.
And our investment programs are going according to plan and that along with improving demand will provide us growing leverage into the future.
Thanks and I will turn it back to Erik.
Erik Gershwind – President and Chief Executive Officer
Thank you, Jeff. Before we open things up for questions, I will summarize for you where we stand mid-way through our fiscal year. For the first half of fiscal 2014, we are on track with the annual framework that we laid out at the start of the year. We achieved mid-single-digit organic sales growth and adjusted operating margin of 14.3% and that includes by the way the fiscal second quarter which we indicated would be our low point for the year in terms of adjusted operating margins.
Accordingly, at organic revenue growth rates in the mid-single digits, which at this point appear quite reasonable, we expect full year 2014 adjusted operating margins to be within our range of 14% to 15%. As I look beyond FY14, I remain very excited about the story that’s building within our company.
We are setting the foundation within infrastructure to support a much bigger company. We are executing on share gain initiatives to fuel topline growth. We are putting in place a new growth platform in the form of BDNA with Class C products and solutions. And most importantly, we continue to relentlessly focus on adding more value for our customers. All of that is the formula for an exciting earnings growth story in the years to come.
I would like to thank our entire team for their hard work and dedication and executing on this plan and I’ll now open up the lines for questions.