Q3 2023 MSC Industrial Direct Co Inc Earnings Call

[music].

Good morning, and welcome to the MSC industrial supply fiscal 2023 third quarter conference call. All participants will be in listen only mode should you need assistance. Please signal a conference specialist by pressing Star then zero on your.

Telephone keypad.

After todays presentation, there will be an opportunity to ask questions to ask a question you May Press Star then one on your telephone keypad to withdraw your question. Please press Star then two.

Please note this event is being recorded.

I would now like to turn the conference over to Ryan Mills head of Investor Relations. Please go ahead.

Thank you and good morning, everyone I'm excited to have joined MSC, just last week and I look forward to getting to know each of you over the coming months.

Welcome to our third quarter fiscal 2023 earnings call Erik Gershwin, Our Chief Executive Officer, and Christi knock this 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 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.

Many of which is on slide two of the accompanying presentation or comments on this call as well as the supplemental information we're providing on the website contain forward looking statements within the meaning of the U S security laws.

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 are noted in our earnings press release and our other SEC filings. 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.

<unk> of the adjusted financial measures to the most directly comparable GAAP measures I'll now turn the call over to Eric.

Thank you Ryan.

Good morning, everybody and thanks for joining us today.

On today's call I'll begin with some perspective on our recent performance and our longer term outlook.

I'll then provide color on the current environment.

Christian will provide more specifics on our fiscal third quarter mission critical accomplishments, our financial performance and updated expectations for the balance of the fiscal year.

I'll, then wrap things up before we open up the line for questions.

Before I dig into our performance, though I'd like to discuss two topics.

The first is to welcome Bryan Mills, our new head of Investor Relations, who joined US earlier this month.

He brings several years of Investor relations and sell side experience, including the coverage of MFC and our peers.

We're thrilled to have Ryan on the MSC team as we continue striving to increase shareholder value.

The second topic is the recent agreement with the Jacobson and Gershwin family.

To eliminate the company's high voting class B shares.

The details of the agreement and the associated shareholder benefits.

Our outlined in the press release that we issued last week.

And more information will be provided in our proxy statement that will be filed with the SEC later on this summer.

At a high level, though we're confident that this will make M. S C a more attractive investment.

And broaden the scope of investors through several aspects.

Such as replacing the two thirds voting rule to approve mergers and asset sales and other significant transactions.

So instead of a simple majority of votes outstanding standard.

Limiting the family's voting to 15% of shares outstanding.

Adding a new independent director.

And exploring share repurchases to offset dilution from the transaction.

I'd also note that our families receipt of the premium in shares increases our economic ownership position.

And reinforces our belief in the long term outlook of this business.

The reclassification is subject to a number of closing conditions. Most importantly, the approval of the transaction by the company's shareholders.

We look forward to completing the process and successfully closing the transaction.

I'll now move onto our quarterly performance.

Ongoing share gains and successful execution of our mission critical initiatives.

Were the primary drivers behind our strong growth.

They resulted in fiscal third quarter sales growth of approximately 10%, despite one less selling day or nearly 12% on an average daily sales basis.

This continues the trend of outgrowing, the IP or industrial production index in excess of our long term target.

As a reminder, our five growth priorities include metalworking.

Solutions.

Digital.

Selling the portfolio.

And diversified end markets with an emphasis on the public sector.

Today I'll highlight a few of these.

Beginning with the public sector.

We've described for the past several quarters now and we see a building momentum in our public sector business.

And this quarter was particularly strong with public sector growth of more than 80% year over year.

That was driven by penetration of existing contracts.

Along with the addition of some significant wins.

In particular.

Approximately two thirds of the public sector growth this quarter than it had benefited from a large number.

Small capital purchases.

Our recent contract win.

While wins of this nature are below company average margins.

They provide near and long term benefits.

Starting with the near term.

These wins require modest investments in working capital and they bolster our cash flow.

And this allows us to accelerate investments in other areas too.

Further strengthen our market position and I'll touch on that momentarily.

Over the longer term.

We believe these wins improve our position for additional share gains and higher margin opportunities across the sector.

Which helps to diversify our business.

Looking forward.

We expect revenues from the recent contract win to continue in Q4.

And into fiscal 2024.

Be it at a lesser pace.

On the solutions front, we continue to achieve strong growth across our implant vending and vendor managed inventory offerings.

These high touch high retention solutions continued to grow double digits.

And we see plenty of runway for future share gains given the market size and.

And the customers appetite for value add solutions.

In fact, our fiscal third quarter represented our high watermark in terms of new implant signings.

That bodes well for continued sales growth in the future.

Moving to e-commerce.

We strengthened our position for future growth.

Through an exclusive agreement with machining cloud, which was announced earlier this quarter.

This partnership brings a great deal of excitement to MFC.

This partnership brings a great deal of excitement to MFC.

To machining cloud and to the end user community.

It gets M. S C closer to the early stages of the manufacturing process would.

Which expands M S C. Its reach to new decision makers.

Such as engineers and programmers.

Who are key influencers in the procurement process.

The customer will benefit from M. A c's brand offering.

Which will save time and money when selecting the ideal tools needed for their jobs.

And while we're still in the integration process.

The end user community's excitement is building.

As visits to machining cloud side have increased significantly since announcement.

I'll now turn to the external environment.

As expected when we outlined our framework for the fiscal year.

Conditions have moderated as we moved through the quarters.

This is consistent with contractionary readings from the sentiment indices.

Such as the metalworking business index and.

Declining IP index readings.

We have seen some more softening across some areas of the business during the fiscal third quarter.

But the tone on the ground is one of leveling.

Rather than significant declines.

We're seeing stable volume and customer activity levels.

In addition.

We see favorable conditions in several end markets, such as automotive and aerospace.

On the pricing front.

Conditions have also moderated as expected.

We continued to achieve benefits from pricing.

But this is narrowed as we lap high pricing price increases in the prior year.

While higher product costs continue to work through our P&L.

I supply change of normalized customer.

Customers are increasing their focus on achieving competitive prices.

Just as we're doing with our suppliers.

Overall, we would describe the environment.

Both on the demand and the pricing fronts.

Right.

Regardless of the environment.

I remain confident about our prospects for continued growth.

In the near term.

As I described earlier.

Many of our growth drivers are just starting to hit their stride.

Our value proposition, which is anchored in our technical and high touch approach.

It's yielding customer wins at a higher rate than we've seen in the past.

Many of these wins are not close to full maturity or revenue run rate.

So we're not yet seeing the full benefits in our numbers.

This has given us confidence to accelerate strategic investments despite market uncertainty.

To further strengthen our position.

For example, we're accelerating investments in our ecommerce platform.

Including an advanced search and product discovery function.

We expect these enhancements to increase future growth.

Particularly with smaller customers and spot buys.

Looking beyond the near term.

There are several dynamics that we believe will benefit M. S C over the longer term.

First.

The re shoring trend continues.

We see an increased number of new plant construction projects that will drive incremental domestic manufacturing activity.

Second elongated production backlogs in commercial aerospace driven by increased post COVID-19 demand.

Provide a long runway of growth in that end market.

And third.

We see opportunities to further penetrate new higher growth end markets, such as medical and electric vehicles by leveraging our technical expertise.

Our new capabilities from recent acquisitions.

Moving on to productivity.

I'm also encouraged by the outlook for continued progress.

Which we believe will be driven by several factors.

First.

As I mentioned before.

Our mission critical program is transitioning to a continuous improvement mindset and initiatives.

Under the leadership of our C O L Martina mcisaac.

Kristin.

Second and related.

We'll continue evaluating our business for structural cost opportunities.

And lastly.

We're making nice progress on our category line reviews.

We're now winding down the first two waves of product categories.

And we're pleased with supplier responses.

In some cases.

We're getting cost reductions on the heels of market indices pulling back.

And in others, we're having exciting growth discussions.

For example, we.

We're seeing early success with consolidation of suppliers and Skus.

We're a broad assortment isn't as necessary through the eyes of our customer.

This approach will simplify our search find and buy experience.

Increased engagement and share gain with the select suppliers, who partner with us.

Streamline our D C operations.

And should also drive meaningful savings in fiscal 'twenty four.

In summary I'm.

I'm excited to see MFC, becoming the mission critical partner on the plant floor that we envision years ago.

We're gaining momentum on growth above the I P index.

We're translating that growth into profitability improvements.

I'll now turn things over to Kristin.

Thank you, Eric and good morning, everyone.

Please turn to slide five of our presentation, where you can see key metrics for the fiscal third quarter on a reported basis.

Slide six reflects the adjusted results, which will be my primary focus this morning.

Before I dive into the numbers as Eric mentioned public sector growth was very strong this quarter, primarily driven by our recent contract win related to small capital purchases.

Wins like these are dilutive to margins, but have strong cash flow attributes.

This is causing some compression in gross and operating margins during the back half of our first full year.

As a result, I will provide some color on the impact from related sales as I walk through our results and updated outlook.

Moving onto third quarter performance successful execution across our mission critical initiatives.

It resulted in ongoing share gains and strong cash generation.

Combined with a 4% contribution from bolt on acquisitions and more modest benefits from price due to actions taken in the prior year average daily sales improved 11, 7% year over year to 1.154 billion.

That compares favorably to the IP index, which grew just 30 basis points year over year during the quarter.

By customer type on a year over year average daily sales basis public sector sales increased over 80%, while national accounts as well as core and other customers grew in the mid single digit range.

Despite the sequential step down in national accounts growth since last quarter. When you feel good about our prospects for ongoing growth based upon new customer wins.

Looking at ourselves through the lens of our mission critical growth drivers, we continue to make strong progress.

Eric mentioned, the five growth initiatives earlier, I will run through each of them briefly.

And metalworking, our ability to improve customer productivity levels through our best in class technical expertise.

Brad and service level continues to drive competitive differentiation.

This places us at the spend all with our customers, where we play a critical role in helping them optimize production and increased productivity.

Additionally, as our manufacturing customers face and Adrian and shrinking skilled labor workforce.

Our value proposition is more important than ever.

Looking ahead, our competitive strengths position us well to take share and further penetrate high growth end markets.

We continue to capture share with our vending and implant solutions.

Vending machine Ats continued to grow up 10% year over year.

And represents 15, 3% of total company sales compared to 15, 5% in the prior year.

In plant signings remained strong in Q3 and sales grew 13% year over year, representing 13% of total sales.

An improvement of 40 basis points sequentially.

It's worth noting that the vending and in plant percentage of total sales would have been higher without the impact of the strong public sector performance as much of the growth among those customers did not transact through our solutions.

And E Commerce, which includes all aspects of MLC digital engagement, we continue to experience solid growth.

As a percent of total sales e-commerce sales declined year over year to 60%, but would have increased over prior years, 62% if not for public sector gross about transacting through different channels.

Looking ahead, we are positioning ourselves to capture additional digital and small customer growth with a portion of our accelerated investments being focused on strengthening our digital capabilities as Eric mentioned.

We continue to successfully execute across our other two initiatives.

And selling the portfolio to increase share of wallet vendor managed inventory, which is primarily our class C consumables experienced a D. S. Roes in the low double digit range.

Progress on our diversification initiative continues with public sector growth in excess of 80% as I previously mentioned.

Our gross margin for the quarter with 47%.

Yeah, roughly 220 basis points compared to the prior year.

The year over year decline was driven by a 160 basis point headwind.

Primarily attributable to the recent contract win discussed previously and two customer mix related to public sector growth.

Acquisitions drove another 40 basis points of headwind.

The remaining 20 basis points reflects more modest pricing benefits from prior year actions and higher cost inventory working through the P&L.

Sequentially without the impact of the public sector contract gross margin improved nicely as expected.

Yeah.

Reported operating expenses in the quarter were approximately 292 million.

271 million in the prior year quarter.

On an adjusted basis operating expenses were approximately 290 million and declined 80 basis points year over year to 27, 5% of total sales.

In dollar terms the increase was primarily driven by variable selling expenses tied to higher volume labor costs.

I heard unexpected health care costs, and accelerated digital investments to drive revenue growth.

With respect to health care costs, we are self insured and this past quarter, we experienced roughly 2 million more in claims than we had been running.

This is primarily a result of our associates undergoing increased elective procedures, which we believe reflects the foreign demand.

These increases were partially offset by mission critical related savings.

<unk> 4 million in the quarter.

This brings fiscal year to date savings to 14 million in total cumulative savings to 99 million positioning us to exceed our target of 100 million by fiscal year end.

Reported operating margin was 12, 8% compared to 14, 3% in the prior year period.

On an adjusted basis.

Operating margin of 13, 1% declined approximately 150 basis points compared to the prior year.

The year over year decline was driven by lower gross margin with a partial offset from decreased operating expenses as a percent of cells.

We reported GAAP earnings per share of $1 69, compared to $1 78 in the prior year period.

On an adjusted basis EPS was $1 74 versus $1 82 in the prior year.

Turning to slide seven to review, our balance sheet and cash flow. We continue to maintain a healthy balance sheet with net debt of approximately 406 million and a net leverage ratio of approximately 0.7 times at quarter end.

Our liquidity position remains strong with cash on hand of 58 million and nearly all of our 600 million revolving credit facility is available.

Additionally, we made progress on inventory levels, which ended the quarter at 727 million down 20 million from Q2 levels.

Strong operating cash flow conversion during the quarter of 158%.

And 104% fiscal year to date.

Has us well on track to achieve the 100% target for the fiscal year.

Capital expenditures of approximately 24 million during the quarter resulted in third quarter free cash flow of $127 million up nearly 100% year over year.

Our solid balance sheet and cash generation to support our capital allocation strategy, including our desire to offset dilution from the reclassification of class B shares.

We will continue to focus capital on creating value for shareholders by reinvesting into the business.

Shareholder returns in the form of ordinary dividends and share buybacks as well as pursuing high return tuck in acquisitions.

As a reminder, we have $4 4 million shares remaining on our current repurchase authorization.

Now, let's turn to our updated fiscal year 2023 outlook on slide 10.

Given strong sales performance fiscal year to date, we are raising our annual average daily sales growth guidance to a range of 10% to 11%.

This compares favorably to the prior range of 5% to 9%.

As a reminder, we have five fewer selling days year over year in the fourth quarter.

We now expect adjusted operating margin to be around 12, 7% for the full year.

Our updated outlook includes two factors that were not part of our original outlook.

First the margin dilution related to the in your acquisition of Buckeye supply into edge.

Second the impact of the outsized public sector growth in the second half.

Lastly, we continue to expect strong cash generation for the full year with operating cash flow conversion above 100% in fiscal 'twenty three.

And with that I will turn it back to Eric for closing remarks.

Thank you Christian.

We are nearing the end of our three year mission critical program.

And I'm pleased to see how our team has performed.

We remain on track to meet or exceed all goals, we outlined nearly three years ago.

As we look to the future.

We view the next quarter or not as the end of the journey.

But rather as the first base camp.

Along our mark to fulfill our mission.

A being the best industrial distributor in the world as measured by all four of our stakeholders.

I, Thank all of our associates for all their hard work.

And I'll now open up the line for questions.

We will now begin the question and answer session.

To ask a question you May press Star then one on your telephone keypad.

If youre using a speakerphone please pick up your handset before pressing the keys.

If at any time. Your question has been addressed and you would like to withdraw your question. Please press Star then two.

At this time, we will pause momentarily to assemble our roster.

The first question comes from David Manthey with Baird.

Please go ahead.

Thank you and good morning, everybody.

Hey, Dave Good morning.

So first question on the new business.

Business you talk about this as a contract win but then you said, it's a large number of small capital purchases. If you could give us details on what that means.

And then any concrete numbers you can give us in terms of revenues I think Christian based on what you said I'm thinking maybe its 20 million bucks in the current quarter, but.

What does that look like in the fourth quarter, and then kind of run rate at 24, if you can help us there.

Hey, James.

I'll take the first part Kristen I'll answer that yeah.

You got it so just so a little more color David I'll I'll put the caveat that we're going to be a.

A little bit nondescript here. This is as you could imagine competitively sensitive in terms of the contract win itself.

But just to put some more color on it by a contract win what we mean is there there is an ongoing relationship with an entity here as opposed to just a one and done or a one time order.

Inclusive in the contract, though where a number of specific items that we described as small capital purchases and what I mean by a small capital purchase is something akin to a small machine as opposed to a consumable and the reason that's relevant is those the capital purchases capital like purchases tend to come.

With lower gross margins than consumables to so.

So what youre going to see is you saw a pretty big healthy clip of that in the third quarter I'm infringing a little bit on Kristen as part of the question, you'll see some more in the fourth quarter probably at around CAD.

Somewhere around half of what we saw in the third quarter and then there'll be some continuation into.

Fiscal 'twenty four I think you know a couple of points Dave on the benefits here, obviously, there's an immediate revenue impact on the machines. There is also higher margin business that follows along it consumable type of business. It follows along and then I think most importantly, what I see happening with the public sector team as we're using these.

Tract wins to establish a relationship.

With customers or entities that we may have not had a big relationship with before and that creates the opportunity for creating an ongoing permanent revenue stream with more general MRO product.

And then.

To your question about sizing it that way.

So just thinking about you referred to.

The.

Our bulk sector broadly.

Revenue for Q3.

323 in Q3, 22, I would take about two thirds of that and a trip to the win that Eric.

And then you can you can apply similar project, we mentioned in the prepared remarks about 160 basis point gross margin headwind from mix.

Similar two thirds logic for that just trying to size gross margin.

And then.

And in terms of how that trends.

The orders do come with a lower cost.

But the normal variable opex right on that.

Yeah, maybe cash or so to that.

So the number you come up with on the topline that'll kind of frame for you what happened in the third quarter with the noise from that went out of the picture.

A simpler way to saying it.

The impact.

That went out in any way to frame it in the margin.

And what have you.

Yeah.

One.

Unanticipated items to health care.

Mark.

For the fourth quarter, I would think about the impact being about half the size.

Yeah.

Okay.

That's helpful. Thank you and just along the same lines here of the operating income and the change in guidance just a couple of thoughts there.

If I take the midpoint of the new guide rooms, and compare it to the midpoint of your old guidance. It looks like operating income dollars are up just slightly.

And.

As you said it if you assume a low margin.

The government business that would tell me that expectations underlying.

That that means government win would be roughly the same and I'm just checking because Eric when you talked about the leveling I'm not sure. If that was your expectation 90 days ago or if that's gotten worse from what you thought I'm just trying to.

Gauge, what the expectations and the underlying business base.

Based on the guidance you gave excluding this government with.

Yes, Dave Good question look I would say that essentially or the underlying business. Our outlook is unchanged is the punch line. If you go back even beyond 90 days days ago, David from the start of the year when we outlined the framework.

Even though we saw IP coming down are the sentiment indices et cetera. You know, we said look we projected growth rates to moderate it doesn't mean that anything is dropping it's just that the growth rates will moderate between the leveling in the environment, the lapping higher comps lapping pricing and and that's what's playing out so no real surprises.

Okay.

Question on the guidance you or your thought on it like if you think about the midpoint of what we had indicated.

Do you have for the second quarter, if the change is really two things.

Think about moving from the midpoint to the approximately 7% roughly the impact of the public sector, Mick Twentyish basis points, and then the increased health care costs, which was about 10 basis points.

Okay. Thank you very much.

Youre welcome.

The next question comes from Tommy Moll with Stephens. Please go ahead.

Good morning, and thanks for taking my questions Hey, Tommy Tommy.

I want to start on price cost.

<unk> addressed it a bit but any more context, you can provide there on where you sit today.

And based on what you know now how about how that should unfold over the next few quarters would be helpful. Thank you.

Sure. So let me start on the prepared remarks, you mentioned about a 20 basis point gross margin headwind from price cost.

So we're still positive in price cost on a dollar basis, but it was a headwind to gross margin in the third quarter and then we would expect that headwind to grow in the fourth quarter.

It worked out for them the decelerating benefit of price.

But I think we mentioned last quarter that peaked in Q2.

I think a peak sort of implied you come down right away.

Oh on the cost inflation, that's rolling off the balance sheet.

24, well size the more when we get to the next quarter, but probably unsurprisingly that pressure continues particularly in the first half.

About 24, as we continue to unwind those higher product costs off the balance sheet.

More to come on in 'twenty four.

Color on Q3, and Q4 a bit more.

Thank you that's helpful and then maybe one for Eric here on the <unk>.

The reclassification of the agreement.

In terms of timing there Eric do you have.

Any sense for when the shareholder vote.

Or and I'm presuming it passes.

How long it would be until you change.

Effective and if I could make this a two parter hopefully that's not too greedy, but I was just curious drove a very high level of capital allocation strategy perspective.

We imagine there may be a change resulting from the reclassification or should we think of this more.

Okay.

Yes.

Tommy I'll I'll take that one I'm going to answer the first part of your question I might ask you to just repeat the second part we are having a little bit of trouble hearing you at the end, but let.

Let me start on the timing part of your question. So next.

With the submit it as for the F. D. C. That's followed by the proxy.

Clark surface to late summer and a reasonable ballpark for the proxy to be issued and then if everything goes. According to plan you can expect that probably in the fall is a reasonable expectation on timing.

And then assuming that that is approved by shareholders. The reclassification of close a few days after that.

Just can you could you just clarify the second part of your question I think I want to make sure I caught that right.

Yes, Thank you and apologies for the noise Oh My my question was regarding the rig the reclassification and the extent to which it may have an impact on capital allocation and door business strategy at the company or if we should think of those as for the most part distinct issues.

Gotcha.

Yeah, I'd say think of them as distinct issues or maybe another way of saying that is that we if we.

Are able to move forward with the share repurchase and offset the dilution of about 2 million which were.

We're working through that now.

We would absolutely be able to accommodate that and not compromise.

Capital allocation priorities, we've got plenty of room.

In terms of available funding we're.

We're doing some different scenario planning now, but we don't see anything that would.

Prevents us from committing to the capital allocation priorities, we've outlined previously.

And Tommy the only color I'll add is I think Kristen I answered the capital allocation portion of our business strategy look we feel really good about the direction of the company I mentioned in prepared remarks that the family.

If this goes through would receive the premium in the form of shares which is a sign of the confidence in the strategy that we have so I think you can feel good that we're going to continue forging ahead on the direction that we've been on.

Great. Thank you and I'll turn it back.

The next question comes from Stephen Volkmann with Jefferies.

Please go ahead.

Hi, good morning folks.

I'm going to go into actions.

Good morning go back to the price cost kind of question and I'm curious how this sort of plays through a Christian you mentioned maybe.

Pricing is still a little higher I think you said in the first half of 'twenty. Four is this a situation where you have sort of deliveries that are coming in containers that are coming in but we're sort of at higher rates and that we sort of just have to work through that and then we would expect the costs to come down after that.

Or.

Is it that the costs are.

Sort of unlikely to come down.

And in that that's sort of a new higher level that will have to live with.

Yeah, I can take that.

So the way I would think about it you've got you've got kind of two parts that are irrelevant, if you're thinking about price cost like for Q4, but then into 'twenty four and the first part of it is what's really already sitting on the balance sheet. So because it's the average costing method.

Been absorbing higher priced items onto the balance sheet.

Sherri period began in there the.

The impact of that rolls off onto the P&L, depending on how fast the items. So what the inventory turns are et cetera. So there's a big portion of it is really about how quickly the impact of whats on the balance sheet hits the P&L.

That's a little bit easier for us to size model now because it is in there. We know we know what it is we can make some assumptions about the timing of the impact, but then the second thing that complicates estimating 24.

The impact of additional cost increases that may come online.

Our suppliers and how we would choose to respond to those right. So that's where it gets a bit complex, especially as you start thinking later into 'twenty four.

Yes.

One other color I'll add here is just having been in the business for a long time over two decades. Now. This is what we're going through now is very typical of any inflation cycle early stages of the cycle. When we take price, we get it right away and the costs because of our average costing system will work its way through the P&L, whereas later in the cycle because they are worth.

And the way it was largely timing and is very typical of other cycles.

Understood. Thanks, and then Eric I think in past calls you've been kind enough to give us your sense of sort of the cadence of business.

As the quarter progressed, you know how it was may how does June feel and anything to call out there.

Yeah, I think Steve I, you know the words that we used in the.

In the prepared remarks of leveling.

Probably the most appropriate I mean, certainly look we've seen a moderation no surprise there given IP of moderation from where we were six nine months ago, but not not a big change.

Interestingly, if you look at our numbers.

The one thing that is the biggest change from Q2 to Q3 was there was a step down in international accounts growth rate and I have to tell you the feeling on the ground there.

Robbie the best it's been.

In a long time and you know sometimes it's what's tough to tease out there is how much of that is macro meaning how our customers are doing and how much of that is micro because I know our team is feeling good about a number of recent wins that haven't yet hit the numbers. So it's hard to tease that out but in general we're not feeling like things are falling off you know a lot of this what we're seeing is the.

Growth rate in June certainly is going to be less than it was in Q3, but we're lapping an acquisition, we're lapping higher comps that there's you know sequentially not a ton of change.

Great I appreciate it.

<unk>.

The next question comes from Patrick Baumann with Jpmorgan. Please go ahead.

Hi, Good morning, Eric Good morning, Christian Thanks for taking my questions. Good morning, Scott.

Good morning.

Just first wanted to clarify on the public sector win.

So you said two thirds of the 80% growth.

In that customer group is from from I guess those capital purchases.

So I calculate that to be close to $40 million.

And and then if I were to line up your prior expectations on gross margins, which I think were to kind of improve.

Quarter on quarter by by like 30 to 40 basis points.

It kind of suggests this revenue came in at.

15% to 20% gross margin all else equal, but but then youre, saying only two thirds of the 160 year over year gross margin compression is from that public sector win.

Can you just help kind of tie that altogether like I am I am I way off on my 15 years to 20% or is there. Some other part of the business, that's a little bit below where you thought it would be.

So youre a little high.

No.

In Europe , a little bit higher on the gross margin impact.

Maybe the simplest way to put it you mentioned the guidance. We gave previously on gross margin improving 30 to 40 basis points sequentially. If you take out the impact of the contract win that is exactly what happened.

Okay right right right.

Oh I see.

Think my math is pretty close to that okay.

If I move on to the next question, if I may kind of various adjustments related to the growth Youre seeing in the mission mission critical programs, you know vending BMI.

And also the government business growth.

If I back into kind of sales for the rest of the business that we're down maybe high single digit.

35% of sales that is kind of nonpublic non.

Non solution subset of customers.

Can you just addressed you mentioned strategic investments Youre, making focused on the website.

In terms of driving better results in that subset and then any other initiatives maybe to reinvigorate growth in that bucket of business.

Any color you can give on any of that stuff would be helpful.

Yeah, Pat sure So look I think.

A few years back we made a pivot and the pivot was to enhance the value proposition to become higher touch in more technical on our customers' plant floors in a lot of the programs that you were talking about are aimed at just doing that and we're really encouraged because we're winning there and you know I think what were you referring to and I don't know I didn't follow.

All the numbers and I feel like I can't confirm or deny exactly the numbers, but directionally. Yeah. We're we're touching customers with the new value proposition, we're growing at much higher rates than where we're not so you asked about where we're not touching customers. What are we doing we mentioned digital investments. So there's a couple of kind of.

Pillars to our digital investments one is e-commerce for sure.

And Theres a lot of work going on right now and we've always felt like we had a strong ecommerce program, but we also have always felt that you'd never stand still and we're gonna be enhancing our platform we are enhancing our product discovery.

So work to make the transaction with them, that's even better that's one two would be digital partnerships.

That extend the reach of MFC and allow us to bring our high touch and technical value proposition to a larger and larger audience of customers. So you know certainly in the past we've talked about no Max which has become a key ingredient now when our value proposition, we mentioned macheting clouds, so extending the reach of MFC through digital partnerships would be the.

Second pillar both of those are key areas, where we've been investing and intend to drive growth in the smaller customers.

Understood.

Any thought just to follow on to that to any tweak and approach to the list price plus discount approach that you you continue to have.

Yeah look I mean, we we we always evaluate whether you're talking about pricing look there's always a tradeoff to be had between pricing and volume.

And we've designed the value proposition that is high value add higher cost because it's high touch and more technical and you know we believe appropriately that we should charge for that value and we do and we focus on customers that are looking for a total cost.

Ownership reduction and not just going to price shop. So I would say in general that's our approach is the pricing. We go with is commensurate with the value that we bring to customers I'd also say that anywhere we're touching customers and those higher touch models, where price competitively. So I think what you're referencing is for customers either who are new to M. S.

C or who don't have one of these programs in place, yes, there were times, where our prices are gonna look high we evaluated all the time I think you could expect to see us tweak, but I would say when I say tweak taking more surgical approaches as opposed to anything massive and broad brushed at one time.

Understood. Thanks, a lot for the color best of luck.

Thanks Pat.

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

Hey, good morning, everyone.

Hey, Ryan.

Yeah.

So I wanted to ask on gross margin just just high level just given it sounds like there's some puts and takes so sort of over the next three to four quarters could you talk about the high level of tailwind and then the high level headwinds. It sounds like net net you typically talk about gross margins mix being down like 30% to 50.

You bet it sounds like it might be in that range, maybe a little worse correct me if I didn't hear that right.

I think Brian you were talking about like the kind of typical way leave aside the margin mix headwind from that that's different.

Right through through the areas, where we have more to tell once like a public sector growth solution.

Are you referring to right.

Right and it sounds like with the public sector when the price costs. It just feels like there's a little more incremental pressures wanted to make sure I understood. The puts and takes high level. Just the next couple of quarters for modeling purposes, Yeah, Yeah. So yeah, you're spot on that.

That mix impact was definitely exacerbated in the third quarter.

Public sector in general tends to be a margin headwind for us, but then because of the nature of a good portion of that public sector growth in Q3 coming from that large contract win.

Lower gross margins and yes, absolutely.

Absolutely would be higher than we would normally affect caffeine.

In Q4, so there will be a similar dynamic but on a on a lower amount of revenue for the fourth quarter, probably about half the size of what you saw in Q3.

And then we I think we touched on this earlier, but there's a lot of moving parts in Q4. So the other thing on margin I would just reiterate is you have decelerating price benefit.

Not all day relatively flattish to Q3, such that the price cost headwinds on gross margin, it's worse than the 20 basis points that we saw in Q3.

And then the only need 24, it's a little hard to say, we'll put more color on that next quarter.

That's kind of how the Pos roll off and what that inflationary period looks like it's reasonable to think that the first half is going to be tougher on margins in the second half.

Got it Chris and the one other thing I'd I'd wait you weigh in with his just Ryan So Kristine summarized it perfectly to other potential tailwind that christine's point, we got a size all of this before giving a 24 outlook would be the category of line reviews, which will so of price cost is negative and worse in the first half and second half category line review.

You shouldn't get into that and second is some benefit from freight as that moves through our P&L. So putting that all those are kind of the puts and takes and then you know by next quarter, we'll put it together for you.

Perfect. Okay, and then just high level back on the macro conditions have moderated and we can all see the IP is down slightly now.

What are you hearing from customers in terms of the drivers is that Destocking is at higher interest rates is causing people to tighten up a bit our small and medium customers a little bit slower.

Any end market color you would throw in there I'm just trying to you know.

Figure out what what are the drivers here of sort of this moderating conditions.

Yeah, Ryan So I you know look I would say, it's definitely not a surprise to your point given given the industries I think things are actually held up.

Pretty well considering what the headlines in the industry show, we you know as we probe into it I would say first of all.

The leveling the moderation the pockets of softer. It's this is not across the board because.

Because you'll have pockets, where things are softer I mean oil and gas would be one example, and then you have pockets where things are booming aerospace is doing well automotive is doing well medical is doing well. So this is not across the board at all.

We didn't see you it's always hard to gauge destocking, but we didn't we didn't see a ton of Destocking I think it was part of there's no question that higher interest rates I'm, having some impact.

But you know overall, Ryan I mean moderating is the word I'd use as opposed to anything that would.

We don't see signs of like things falling off a cliff I don't know if that's helpful color.

No. It is I I appreciate it I'll pass it on thanks.

The next question comes from Ken Newman with Keybanc capital markets. Please go ahead.

Hi, This is Katie pleasure on for Ken today.

Okay.

Hi, Good morning, So I know you guys really aren't ready to give any full year 'twenty four guidance, yet, but I'm wondering just high level.

We can talk about EBIT margins for next year, So if you're able to keep sales up low to mid single digits, just given some of these mix impacts from price cost headwinds.

Can operating margin be up or flat in fiscal 'twenty four.

Yeah, Katy I'll take that so yeah.

Definitely still too early to definitively answer the question the price cost pieces, a big driver, we've got to get our arms around and then as Eric mentioned.

We're really aggressively moving onto line reviews are sizing the sizing other productivity opportunities that we have been looking at the horizon for Windows would come online. So that there are a lot of moving parts, what I, what I would say higher level. If you zoom out we're still targeting 20% incrementals over a cycle.

And more to come on the specifics of the 24, we're really trying to get our arms around those moving pieces.

We are planning to model the sequencing for the year.

Okay, Yeah that makes sense.

And then on the going back to them.

A question here on the public sector is that typically a headwinds.

Price just trying to get a sense of like without the impact from that win wood prices have been up more than three 5% in the quarter.

I know, it's probably maybe a little bit higher acuity like it the way I would say, we think about public sector.

Impact on gross margin, it's a little bit lower generally than the core so like when we talk about the big growth initiatives that are margin headwind public sector is definitely one of them because the average gross margin like you know taken up one went out like on in general public sector margins are below the average of the rest of the business that we want to call that.

On the gross margin.

Yes.

Okay, great. Thank you.

Okay.

Our last question today comes from Chris Dankert with loop capital. Please go ahead.

Hey, good morning, Thanks for taking the questions.

I guess, Eric or you'd mentioned, you know medical and E V. That's some pretty exciting opportunities going forward here I guess, maybe if you could touch on just what does customer engagement look like there today I mean can these be like much more meaningful markets quickly or is it something that we're getting are really see moving the needle felt like five years out.

Chris look I I would say, both I think you're starting to see the impact of the medical certainly we're seeing the impact now.

And you know E D.

I would say we are beginning to see a bold right now with the infrastructure for the electric vehicles and the hybrid vehicles builds out and by infrastructure and I've, just been charging but batteries et cetera.

I think we are beginning to see.

Benefit now.

Say the other one that we called out Christmas Aerospace that we think has no pun intended a long runway with the kind of backlog that we've seen there. So all of those I think we're beginning to see benefit now, but we would expect good things to come through the next quarters and years.

And by the way one other point I'd make Chris is as we mentioned machining clouds of partnerships like that so.

I talked about the reason behind the partnerships is to extend our reach and bring our value proposition to more customers. We do try to line up and partner with customers with with partnerships.

Entities that are going to bring us closer to those end markets those higher more sophisticated end markets and machine and cloud would be a great example of that.

Perfect. Thanks, so much let Eric and then I.

I guess on implant growth has been really strong there any update or comment on just kind of where you see that as a percent of sales from the dot plot for growth there going forward.

Yeah.

So we you know it's been it's been growing at a nice clip I mean look we would say if you look at the total addressable market.

For customers with an implant and we'll look at it by size and complexity of customer Kristen. This is going you know if you. If you go out five years 10 years this should be a P.

Pretty healthy chunk of our national accounts business that ends up with whether it's full implant or the full suite of solutions. It makes so much sense and you know we're seeing the benefit for MFC is obviously the penetration the growth and the high retention rate.

But it's a real win for the customer.

Especially especially as the labor market remains challenged the skills gap remains customers are putting a premium on being able to essentially outsource lower value add function. So they could focus on the core operations, which is manufacturing. So you know I would tell you that over the long run a good chunk of National accounts order end up with an implant.

If not the slowest.

The suite of services.

Got it thanks, a lot for the color there.

Okay.

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

Thank you for your time and interest this morning as a reminder, our fiscal 2023 fourth quarter earnings date is set for October .

And we look forward to seeing you in person at Investor conferences or on the road in the coming months. Thank you for joining us today.

Good luck.

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

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Yeah.

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