Q2 2022 MSC Industrial Direct Co Inc Earnings Call
Yes.
Good morning, and welcome to the MSC industrial supply.
'twenty two fiscal second quarter results conference call.
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I would now like to turn the conference over to John Corona, Vice President of Investor Relations and Treasurer. Please go ahead.
Thank you Andrea and good morning to everyone.
Erik Gershwin, our Chief Executive Officer, and Christian Axis ground, our Chief Financial Officer are both on the call with me today.
During today's call, we will refer to various financial and management data in the presentation slides that accompany our comments as well as our operational statistics, both of which can be found on our investor Relations webpage.
Let me reference our Safe Harbor statement under the private Securities Litigation Reform Act 1995, a summary of which is on slide two 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.
<unk> statements about the impact of COVID-19 on our business operations results of operations and financial condition expected future results and expected benefits from our investment and strategic plans and other initiatives. These forward looking statements involve risks and uncertainties that could cause actual results to differ materially from those.
<unk> 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 potential impact of COVID-19. 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 contains a reconciliation of the adjusted financial measures to the most directly comparable GAAP measures I'll now.
I'll turn the call over to Eric.
Thank you John good morning, and thanks for joining us today.
I hope that everyone remains safe and healthy.
As we crossed the halfway point of our fiscal 2022.
I'm excited by the growing momentum inside of our company.
To accelerate market share capture and improve profitability.
Each passing quarter is another proof point that the extensive repositioning of MFC.
Is now firmly taking hold.
As our performance improves.
We continue raising the bar on expectations across the organization.
And I'm pleased to see how our team is rising to the challenge.
With respect to market share capture.
We're sustaining growth rates that are at or above our long range target of gross at least 400 basis points above the industrial production index.
Our fiscal second quarter average daily sales growth rate of seven 9%.
Does not do justice to the momentum that we see developing.
This year included two sales days around the holidays.
It carried minimal sales.
Whereas last year, we were closed due to the timing of those days.
Therefore, the absolute sales growth rate of 11, 4%.
It was more indicative of underlying performance.
January got off to a very slow start as a result of widespread absenteeism due to the COVID-19 surge throughout the supply chain.
In fact, our gross rate in January actually started out negative.
We saw an inflection during the last two weeks of the month of January .
And we've sustained double digit growth rates since that point.
February was particularly strong at nearly 18%.
With a catch up from the soft January .
In March has continued our double digit growth pace.
You'll hear from Kristen that we now see double digit growth for fiscal 'twenty two.
Likely outcome.
In line with our strategy.
Growth is being fueled by the five growth levers that we've been describing for you.
And those are metalworking.
Solutions selling.
Selling the portfolio.
Digital investments.
And customer diversification with an emphasis on the public sector.
Within these five levers.
Today I'll highlight our implant program.
E Commerce metalworking.
In the public sector.
Implant continues its strong momentum and now represents approximately 9% of company sales.
We're tracking ahead of plan, which targeted 10% of total company sales by the end of fiscal 'twenty three.
Our recent investments in e-commerce .
We're also starting to pay dividends.
E Commerce reached 67% of total company sales.
150 basis points from prior year.
And 30 basis points from the prior quarter.
This is being driven largely by improvements to MFC direct dotcom.
Our technical metalworking expertise, including M. S email Max is particularly powerful in the current environment.
Our customers are experiencing rapid inflation.
Labor shortages and extended lead times and more.
As a result the.
The need for productivity on the plant floor is higher now than it's ever been.
And MSC is uniquely positioned to address these challenges.
As the largest national metalworking distributor.
Offering multiple brands.
A robust technical expertise.
And the ability to document cost savings and productivity improvements on a continuous basis.
A recent example demonstrates how our approach is helping customers find the needed productivity.
Our technical experts were brought into one of our aerospace customers.
To analyze their cutting tool consumption.
We were able to save the customer over $1.2 million on an annualized basis by.
By recommending alternate tooling.
That yielded faster metal removal rates sure.
Order lead times and.
And increased productivity with a more cost effective tool.
These savings are allowing our customers to bring some of the outsourced production back in house.
Adding volume for our customer.
And leading to greater opportunities for M. S C.
Examples like these are happening regularly across our business.
And there are fueling new customer wins.
As well as greater wallet share at existing customers.
Finally on the growth front is the public sector.
Our team is performing well.
You may have seen that we were recently awarded a five year contract.
To service 10 U S Marine Corps bases across the Continental United States, Hawaii in Japan.
Implementation across the basis is underway and.
And we expect to see revenue build through the balance of fiscal 'twenty two.
And into fiscal 'twenty three.
Turning now to profitability improvements.
Our long range goal is to restore restore return on invested capital into the high teens by the end of fiscal 'twenty three.
And we said we would achieve this by leveraging growth.
By executing on gross margin initiatives.
And by delivering structural cost take out of at least 100 million Hell.
Helping to reduce opex as a percentage of sales.
By at least 200 basis points.
From our fiscal 2019 baseline.
I'm encouraged by progress on each of these fronts.
Let me start out with a few words about gross margin.
You'll recall that we were not pleased with our gross margin performance in our fiscal first quarter.
We began addressing it aggressively with countermeasures.
During the latter portion of Q1.
As part of those countermeasures and in response to the massive purchase cost inflation coming from our suppliers.
We implemented a significant price increase in late January .
Price realization, thus far has been strong.
And as a result Q2 gross margins came in at 42, 5%.
This gives us added confidence that we can keep gross margins flat or better.
For fiscal 'twenty two versus prior year.
We also generated strong operating expense leverage and reduced adjusted Opex as a percentage of sales by 80 basis points versus prior year.
This is largely the result of our mission critical initiative.
We delivered $6 million of savings in the second quarter.
And remain on track for $25 million and expected cost savings for the fiscal year.
And we remain on pace to achieve our goal of at least 100 million in total cost savings by the end of fiscal 'twenty three.
All of this is translating into improving adjusted returns on capital.
Which is well on its way into the high teens.
Turning now to the external landscape.
The story remains largely unchanged.
Strong underlying demand.
Tight supply chain constraints.
Even tighter labor constraints.
And rapid inflation.
All of this is evidenced in public indices, such as IP readings, which remain at mid single digit growth levels.
Sentiment surveys like the M B I.
And feedback from our customers.
With some very limited exceptions like automotive.
The order backlog and outlook for most customer segments remains robust.
Relative to last quarter headwinds from Covid have eased dramatically.
They reached a fever pitch during December and the first half of January .
But if subsided considerably as the virus has waned.
Like everyone will watch the developments with the latest variant of course.
Here at M. S C.
We reopened our customer support centers in Melville in Davidson with a hybrid work environment.
We've received positive feedback from our associates and our operations are running smoothly.
Angst related to Covid has been joined by broad based concerned related to the Russia, Ukraine situation.
Our direct exposure to the region with respect to sales and purchasing is insignificant.
The indirect impacts, though will likely play out in the form of further inflation.
And more supply chain disruption.
While these conditions create some challenges for us here at M. S C. They.
They also provide opportunities.
To take additional market share from the 70% of the distribution market, that's made up of local and regional distributors.
M, a c's broad and deep inventory.
Good better best brand assortment and our logistics capabilities.
To enable us to service our customers at high levels when many cannot.
We've used the recent market conditions to accelerate share capture.
And we'll continue doing so.
Chris will now take you through the details of our performance the financials for the quarter and our outlook.
<unk> includes a revised annual operating margin framework with a low double digit sales growth scenario kristian over to you.
Thank you Eric.
On slide four of our presentation, where you can see key metrics for the fiscal second quarter on a reported basis.
Slide five reflects the adjusted results, which will be my primary focus for this morning.
Our second quarter sales came in at 863 million as Eric mentioned, given the extra two days this year coming with minimal sales total sales growth of 11, 4% over the prior year period, it's more reflective of a real growth.
On an average daily sales basis Q2 growth was seven 9%.
Non safety and non janitorial product lines grew just over 10% on an 80 S basis and sales in safety and janitorial products declined roughly 3%.
Looking at Ats growth rates for ourselves by customer type government sales declined roughly 11% due to the difficult janitorial and safety caught.
This is a large improvement from Q1's decline of nearly 30% and we expect the comps to ease further in the back half of fiscal 2022.
National account growth with low double digit in core customers grew high single digit.
We're continuing to see strong execution and growth initiatives with vending and plant and MFC direct dot com, each growing roughly 100 basis points or more as a percent of total company sales versus the prior year.
As Eric mentioned, our fiscal Q2 gross margin was 42, 5% up 90 basis points sequentially from our first quarter and up 440 basis points from last year's fiscal Q2.
You May recall included in last year's Q2 gross margin with a 30 million PPE related write down exclude.
Excluding this write down our prior year Q2, adjusted gross margin was 42% 50 basis points below the current years quarter.
We're very pleased with this result, and we remain on track to hold the annual gross margin for fiscal year, 2022 flat or better in fiscal 2021.
Reported and adjusted operating expenses in the second quarter were 266 million or <unk> 38 per cent of failed.
Last year's reported operating expenses for $245 1 million and adjusted operating expenses were $244 four or 31, 6% of sales.
This represents an 80 basis point reduction in adjusted Opex itself.
It's worth noting that this includes an increase to our incentive compensation accrual this quarter.
On a year to date catch up that will not repeat.
We incurred approximately $3 1 million of restructuring and other costs in the quarter as compared to $21 6 million in the prior year quarter.
Last year's Q2 charges, primarily included operating lease impairment and other exit related costs associated with our move from physical sales branches to virtual customer care hub.
Our operating margin was 11, 3% compared to three 6% in the same period last year.
Excluding the restructuring and other costs in the P. P E related inventory write down in the prior year. Our adjusted operating margin was 11, 6% versus an adjusted 10, 4% in the prior year period, a 120 basis point improvement.
On the adjusted incremental margin front, our second quarter came in at just over 22% head of our initial fiscal 2022, though.
Earnings per share were $1 25, as compared to 32 cents in the same period prior year.
Adjusted for restructuring and other costs as well as the prior year's PPE related inventory write down adjusted earnings per share were $1 29 compared to adjusted earnings per share of the dollar three in the prior year period, an increase of 25%.
This is a result of our execution on all levels South performance gross margin and Opex leverage.
Turning to the balance sheet, you can see that as of the end of our fiscal second quarter, we were carrying $658 million of inventory up 35 million from Q1 balance of 623 million.
The inventory build just fairly typical with historical periods of high growth with the added element of ongoing supply chain disruptions.
Accounts receivable are authorizing as expected with the current sales growth as a result of this increased use of working capital our second quarter cash flow conversion or operating cash flow divided by net income was slightly negative.
Capital expenditures were 16 million in the second quarter.
Turning to slide seven you can see the uses of working capital also impacted our free cash flow, which came in slightly negative for the second quarter as compared to 4 million in the prior year quarter.
We do expect cash conversion to improve in the second half of fiscal 2022 and for the fiscal 2022 full year to come in at approximately 70 to 80 per cent roughly comparable with historical periods at southwest.
Our current expectation for strong sales growth for the year, continuing supply chain challenges and everything government contract win are all increasing our working capital and affecting our cash conversion for this year.
Our total debt at the end of the fiscal second quarter was 835 billion, which reflects a $72 million increase from our first quarter.
That's where the composition of our debt $285 million on our revolving credit facility about 200 million with under our uncommitted facilities.
Like 300 million with long term fixed rate borrowing and $50 million with short term fixed rate borrowing our cash and cash equivalents were 42 million, resulting in net debt of $794 million at the end of the quarter up from 700 million at the end of the first quarter.
Let me 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 eight our cumulative savings through fiscal 'twenty, 'twenty, one where 60 million and we also invested roughly 22 million over that same period.
Well your fiscal 2022, we expect additional gross savings of $25 million and additional investments of 15 million. We've made excellent progress towards this goal in the first half as we've achieved $16 million of gross savings and invested $11 million, we remain on target to hit at least $100 million of cost savings by fiscal 2023.
Before I turn it back to Erik let me share a few comments on the back half of the year. We're encouraged by the momentum building across all three lines of the P&L revenue growth gross margins and operating expense leverage.
Our current growth momentum creates the potential for a higher tier on our annual operating margin framework provided to you on slide nine you can see that we added a low double digit scenario in that growth range, we would achieve an annual adjusted operating margin between 12, 5% and 13, 1%.
So the current trends continue we would expect to move into that range.
At those levels of adjusted operating margin, our incremental margins will be around 25% in the back half of this year and north of the 20%. We originally envisioned for full year fiscal 2022.
And I'll now turn it back over to Eric.
Thank you Kristen.
We've now crossed the halfway point of fiscal 'twenty two.
And momentum is picking up steam.
With each passing quarter, our repositioning is taking hold.
We're accelerating market share capture.
Capitalizing on our ability to add value in a unique pricing environment in order to improve gross margins.
And we're generating operating leverage through our mission critical efforts.
As we look to the back half of the year.
We will continue raising the bar.
Targeting double digit sales growth.
Strong price realization.
And incremental margins in the mid twenties.
Before closing I'd.
I'd like to acknowledge the incredible efforts of our team.
They are the driving force behind our improved performance for all stakeholders.
All 6500 of US will remain restless until we achieve our mission to be the best industrial distributor in the world.
Thank you and we'll now open up the line for questions.
Yeah.
We will now begin the question and answer session.
I ask a question.
Star then one on your telephone keypad.
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<unk>. Your question. Please press Star then two.
At this time, we will pause momentarily to assemble our roster.
And our first question will come from Tommy Moll of Stephens. Please go ahead.
Good morning, and thanks for taking my questions. Good morning, John Good morning, Tommy.
Wanted to start off with the update you gave for the adjusted operating framework framework for the year with a low double digit yes scenario now now in place.
What were some of the factors that gave you the confidence to go ahead and add that to the outlook and specifically what I'm trying to understand is just.
How much was it progress towards some of the pricing realization versus where there were some changes in the markets, where you've got better visibility or greater confidence in how the year might shape up.
Yeah, Tammi I would say you have a couple of things going on first and foremost we're seeing it in the numbers.
So we're looking at actual performance and basically, especially if you take out you know, which we had a really strange first two weeks of January with Covid, but if you put that aside the underlying performance of the business justifies. It. So I think that's one we're actually seeing in the numbers number two.
The outlook remains robust and look I think it's been a strong outlook. It continues if if if anything to firm up but it looks as good as it did and then the third thing as you mentioned is is is price realization you know with this sort of level of pricing and inflation in the market. It certainly creates an additional tailwind you can see that on our growth deal.
Composition. So you know sitting here halfway into the year with those three factors, we feel like if if things continue as they've been running that's where we should land.
Thanks, Eric and just to follow up on some of the countermeasures you've taken around pricing last quarter, you gave us some anecdotal examples of what those might be so anything you could do to refresh us there just on contracting strategy or anything else would be helpful and I guess, a broader question, you've you've announced some.
These pricing initiatives.
In an inflationary environment, partly as a response to some of those pressures, but longer term a more nimble organization around pricing has got to be.
Good thing under any kind of circumstances and so.
What can you talk to us a.
Talk to in terms of cultural shifts in the organization incentive structures that may have changed around the sales force all aimed at some of these near term goals on on price costs, but maybe with some long term benefit to the organization more broadly.
Tommy your spot on in fact, a lot of the work you know obviously look theres a list that came.
From a sizable price increase but we started and we called this out on the last call. We started gaining traction before the January move so there's more going on than just raising prices.
There is a big effort underway you referred to it as being more nimble more agile building our muscle.
In our sales organization around how to talk to customers about price.
And that is clearly, resulting in better realization rates and as you suggest for US. This is something that is agile as or more important when inflation settles down and it's sort of back to normal as it is right now when it's you know relatively easy to explain a price increase I think the other thing I'd call out tiny that's helping us a lot I'd mentioned it in the prepared remarks.
Which is the work we're doing with our customers to take cost out of their business. You know every customer right now understands when you come to them and talk about the need for a price increase everyone gets it.
However, our customers are getting squeezed and they did call out the cry for help is greater now than ever for saying look if you're going to come in with a price increase helped me offset it and you know our technical experts. So that's really where they're spending their time now inside of the plants of our customers figuring out how to offset the pricing and I think.
That's really resonating and helping us improve realizations.
Thanks, Eric I appreciate it and I'll turn it back.
Our next question comes from Hamzah <unk> Macquarie of Jefferies. Please go ahead.
Hi, This is Mario <unk> filling in for Hamzah could you just remind us how much of your business is levered to OEM production and then along with that maybe just comment on what Youre hearing from your customer base or what they're saying around supply chain issues. Do you think that's been a governor at all on.
On your organic growth.
Mario Good morning. So so first off look I think the best sort of way to think about our business as you can see on the op stats sort of manufacturing as a percentage of total company.
That that's sort of your best proxy look we we are within manufacturing we tend to be heavily levered towards manufacturers that are cutting removing metal working with metal.
That's that's sort of the guts of our business I would say a resounding, yes, Mario that the supply chain constraints. You know there is a lot of talk in the headlines that they're easing I will tell you on the ground.
It's not happening quickly and we don't see it going away anytime soon it is absolutely constraining growth. So there is you know I guess good news bad news from our perspective. The good news is there is pent up business here and that the demand is stronger than the numbers are showing because of limited supply no question and that's across the board from our customer.
<unk>, our own issues with lead times and our suppliers. So I think the answer is yes, and look to be honest, we don't see the supply chain. We're leaving are the bottlenecks were leaving overnight certainly know you compound that with the Russia, Ukraine situation, but again I think the good news story there, yes, there was some pent up demand not getting filled right now.
Got it and then just for my follow up.
Maybe I missed it in the prepared remarks, but I guess, what kind of growth are you specifically seeing within vending I think I think the comment was more or less around that being now 1% or it grew 1% or a 100 bips as part of your mix, but did you provide an actual growth rate around that and then could you also just remind us how big.
That market or how big that addressable market is for you guys.
Yeah, Mario that number we had cited in the script with roofing vending grow as a percentage of revenue of about 100 basis points over prior year and.
Ours are bending total addressable market.
Or do you want to take that yeah, I think look I would say Mario we've not publicly sized it specifically, but I would say if if you've taken a I I would put it beyond vending and put the umbrella around services.
Isn't there some inventory management services, specifically, if you umbrella all of the concepts in which MFC is on the plant floor that would be vending via my and our implant program, where we directly have a presence that is somewhere around half the business today and we certainly think if you look moving forward and think about the growth algorithm for the company.
At least that if not more than half of the growth is likely to come from those you know those areas as part of the puzzle that being vending V M I <unk> and and implant.
Great. Thank you.
Our next question comes from Michael Mcginn of Wells Fargo. Please go ahead.
Thanks going back to your National account progress, that's the momentum with the federal and the military.
Congrats on the win there so squaring the numbers to my knowledge I thought federal was maybe high single digit percent of cells and defense, maybe closer to mid single digit. So I just wanted to get your perspective on those numbers and whether these new contracts or somebody singles and doubles, but maybe at the building blocks for other wins you have in the pipeline with the.
Recent defense budget negotiations.
Yeah, Mike So what we've shared if you take government in total that's federal plus state and it's moved around a lot, particularly through the last two years during the pandemic, but tends to run high single digits.
As a percent of total company sales the split we've been calling out is two thirds of that is federal and one third of that a state now that also moves around quarter to quarter, but overtime, that's sort of been the breakout.
Yeah, I was a couple of things I'd say about the public sector group for US number one is yeah. We're pretty encouraged by recent wins, we talked about one here, which look we're proud to be able to service the Marine Corps, particularly at a time like now there has been other wins not quite as large in and not quite as high profile, but other wins.
Fueling our confidence there. So we are seeing momentum really pick up with our execution on public sector. So you know moving forward would it be possible to see that number of total government business in the federal move up as a percentage of sales like likely yes, we would and that'll probably happen might gradually.
These things tend to Theres, a whole implementation timeline and it should begin scaling over the next quarter or two but yeah. It would be likely the government could tick up as a percentage of sales as a result of the wins.
Yeah.
Great I appreciate the color and then.
Maybe an update on capital allocation it looks like your cash flow was fully burdened or overly burdened with a double regular dividend payment this quarter balance sheet in good shape I mean, how do you think about capital allocation with shares at these levels.
Yeah.
Yeah, Mike, Let me add I'll add a little color on working capital and then Eric do you want to jump in on any of the other aspects of capital allocation go for it that I think Mike just specific to the working capital utilization, we're expecting some recovery there but.
You know, we're not being a overly skimpy with how we're thinking about inventory right. Now we are kind of flexing the balance sheet, there strategically making sure. We're building a buffer where we can service our customers and so I don't anticipate our inventory freeing up as a use of cash anytime soon.
And then accounts receivable pleased with how that has just been growing in relation to sales. There are definitely some things that we're looking at them through the lens of mission critical that are going to help us on working capital, but I would say that a lot of those are kind of just coming online I think there's some opportunity for them to help us with cash flow in the second half <unk>.
Currently picking up steam into 'twenty, three and so that's sort of the working capital angle I talk around capital allocation I think.
With respect to M&A.
Now, we're always looking at potential interesting bolt on acquisitions, we've seen some.
Acceleration in those areas, probably I don't know what's in the last year or so I would say.
Eric do you want to add anything on capital allocation I think by and large you know Christian you had working capital and our philosophy on capital allocation remains pretty consistent.
So we're focused look priority sort of one a one b our organic reinvestment, we like what we're seeing with the organic returns right. Now so we're going to continue fueling nose continued steady growth in the ordinary dividend and then you know we feel very comfortable with where our leverage ratio is now and look what we'll as you know we'll look at things.
On a risk adjusted return I think the one thing to call out yeah, there the M&A funnel that sort of the the the the rate and pace of discussions probably has heated up over the last.
Several quarters, but you know if we do anything on the M&A front will be sticking to our knitting in that that means metalworking. It means class C.
Our OEM fasteners, something that bolt on to an existing platform.
Okay.
Alright, I appreciate the time I'll pass it along.
The next question comes from Ryan Merkel of William Blair. Please go ahead.
Thanks, Good morning, everyone and nice quarter, Hey, Ryan Good morning. Thank you. So my my first question is on operating leverage which you know had a strong result, this quarter and obviously the guide is for a step up and really my question. Eric is how confident can we be that this is a structural step up have you seen enough from mission critical it.
This point.
Yeah, Ryan I do think we're comfortable that there's a definite structural element of the improvement were gosh I guess about halfway through mission critical at this point.
We've been executing on projects really across the South Bay operations kind of the core G&A function of the business and really quite pleased with what we've seen there and the ability to sustain those savings I definitely think we get some help in the second half from the growth rate of course, we're seeing favorable pricing.
That supports improved leverage.
But at the end of the day, if we think back to our commitments around mission critical it's even greater than $100 million of cost out really happy with how that's been going and the ability to sustain that progress.
Yeah.
Got it that's great to hear and then secondly on gross margin I guess, a two parter. What are you hearing from suppliers might you see another price increase here sooner than later and and then also typically in an inflationary environment you'd you'd see inventory profits right you're using your balance sheet or are we going to see some benefit from that in the second half this year.
Yeah and on the first part of your question Ryan and I, you know, we're definitely still seeing movement on inflation from vendors I'd say.
We'll react to that if needed in terms of what the timing or amount of that would look like that will all be dependent on what we see coming from our vendors our supplier base.
But you know obviously inflation remains a big concern in the business and then the second part of that question on our inventory just to clarify are you, saying will we see a reduction in inventory or sort of a continued increase in inventory because of the supply chain challenges just want to clarify your question.
Yeah, no more that you'd see a gross margin left because you've got inventory at a lower cost and you had a price increase in the market right. If I go I go back and look at 2011, when we had in place every environment right M. A c's, putting up 30% plus incremental margins with gross margin help I'm just wondering if that's going to help second half this year, if something's changed.
Yeah. So we're we've done a little bit on strategic purchasing them all I had.
Cost increases, but not a significant amount and if you're thinking about how to about margins for the second half of the year, what I what I'd share is obviously in second quarter. We took the price increase in late January which was mid to high single digits that largely benefit in February we had some progress before that as Eric alluded to around the countermeasure.
So I'd expect that gross margin for the third quarter, and probably a slight sequential improvement as we get the full quarter of price realization, but what's also happening that mitigates. Some of that is because of the way our Clos curve works on the average cost for the.
The increased costs coming in and I'd say for fourth quarter, you can probably expect a sequential decline that look somewhat in line with what our historical Q3 to Q4 sequential gross margin decrease would look like and so there there's a lot of moving parts there in gross margin.
Of course, we're looking at what's happening with supplier rebates to them, but the biggest drivers influencing second half gross margins are by far the impact of that January increase and then that continued role on the P&L or the cost increases through the average cost you nothing.
Ryan the one other thing I'd add is look I think you're seeing right now if youre thinking back to prioritize the benefit of using the balance sheet. If you will of taking price ahead of cost you're seeing it now so I mean, we're seeing positive price costs now. So if you think about the key elements of our growth and what's driving growth right now some of those still mix us down it sounds like those have gone up.
If you think about implant inventing we are getting benefit from price costs. Okay.
Very helpful. Thanks for the color pass it on.
Yeah.
The next question comes from Chris Dankert of Loop capital. Please go ahead.
Hey, good morning, Thanks for taking my question I guess looking at the.
People associate stats here looked pretty static compared to what we saw last quarter I guess any comment is labor availability an issue here or is this more of a strategic hey, we're happy with where the head count that and were you know actively not adding just any any comments on labor and kind of where we're at here yeah, Chris I mean, so our goal for the year was growth somewhere in the low single digits.
Range four four field sales head count so I mean in general we're tracking there. If you combine Q1 Q2, but if you asked me as Q2 had been affected by labor the tight labor markets. The answer would be yes, ideally we'd be a little bit ahead of that in the low single digit range. So we still feel like we'll be on track for the year low single digit range, but.
Hard not to be affected right now by by the tight labor markets for sure.
Got it makes sense. Thanks for the color there and then again if I remember correctly, we were kind of rolling out some new robotics at Harrisburg in Ala Carte and any comment on kind of how those upgrades or new investments are going.
Yeah, well, we're we're really pleased with that and how those projects have come online and I I think I couldn't be more appreciative of having them given what is happening with the labor environment. We're.
We're seeing nice productivity driven by those projects and of course always looking at what additional investments, we could make support automation and more broadly in those facilities and in our other facilities.
Got it thanks, so much and congrats on a nice quarter here guys. Thanks, Greg.
The next question comes from Ken Newman of Keybanc capital markets. Please go ahead.
Hey, good morning, guys. Thanks for taking the question.
Morning.
Morning.
Just wanted to circle back to some of the operating leverage questions are asked earlier.
Can you just kind of think of it in a different way if we think about the mission critical savings coming through do.
Do you think you can start to drive operating margin higher than 12%. If revenue comes in at mid single digit in the future.
Yeah, Nick mid mid single digit revenue growth.
And can you keep your question was can we drive operating margins higher than 12% on mid single digit growth.
Yeah in the future right.
Yeah, I understand it the same work for 'twenty two.
Yeah. So looking looking ahead like really pass this year I think that would be the hope would be we'd be it can be what would be that we can be above the 12 about a mid single digit growth.
Scenario, if we're if we're thinking about this year, specifically with the annual operating margin framework and the mid single digit growth scenario.
The path to about 12 in fiscal 'twenty twos mid single digit growth scenario just to clarify.
Understood Yeah.
And then you know just kind of switching over.
Curious if you could just provide some color on how you view the sales momentum between manufacturing and non manufacturing as we enter into the second half.
Obviously, we're going to be starting to lap tougher comps in the government business next quarter with some tougher comps on the manufacturing side. So any idea how we should think about the run rate growth beginning in the third quarter for those two customer segments.
Yeah look I I I I I think in general can you know from well first of all from a sequential average daily sales basis, we should see things. We we would expect to see things build yeah, you're right. The comps are going to play around for sure with a percentage of sales and what grows faster so like particularly as you get past Q3 and some of them.
Public sector stuff kicked in some of the new wins kick in and you lap the comps it would.
Certainly expect that for an example by Q4 to have really strong growth. So on a relative basis that probably picks up but yeah as of now pretty much. Our our outlook is positive on pretty much. All of you know, we we called out automotive being an exception.
For obvious reasons, but the outlook is pretty positive across the board right now.
Yep.
If you don't mind I'll ask just one more and I'll get back in line, but I'm curious if you just remind us how much freight expenses represent as a percentage of sales and how much of those costs. Do you think are able youre able to contractually passed through.
Obviously, you've gotten pretty good realization on price and I'm, just trying to get a better sense of what's embedded in the margin guidance from what's been a pretty volatile fuel environment. Most recently.
Yeah.
Great out percent of sales is about 4% a little more than 4%.
We are actually pretty pleased with how we've been managing that considering what's been happening in the inflationary environment around free.
We are we're pretty well protected with our small parcel contract <unk> seen a bit more inflation on our L. T L. A.
Contracts and definitely not immune from some of the surcharges that I'm sure you're hearing a lot about in the market but.
Generally navigating that well and haven't seen a huge change in our freight per cent of cells given everything that's been happening in the environment, maybe maybe a little bit more risk coming in here in the second half.
We're hearing of course, a lot of chatter from our carriers fuel.
Fuel prices are absolutely impacting them, so I'm expecting a bit more pressure here in second half and potentially you know even into 2023, depending on how long this last but.
Generally are feeling pretty good about how our freight expense, it's been playing out to date.
Thanks for the color.
This concludes our question and answer session I would like to turn the conference back over to John Corona for any closing remarks.
Thank you Andrea before we end the call a quick reminder, that our fiscal 'twenty two third quarter earnings date is now set for June 29 2022.
We plan to attend a few investor conferences before then so we look forward to seeing you in person and.
And we'd like to thank you for joining us today have a good one.
The conference has now concluded. Thank you for attending today's presentation and you may now disconnect.
Hmm.
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Okay.
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