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MSC Industrial Direct Co Inc (NYSE:MSM)
Q3 2019 Earnings Call
Jul 10, 2019, 8:30 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning and welcome to the MSC Industrial Supply Company's Fiscal 2019 Third Quarter Earnings Results Conference Call. All participants will be in listen-only mode. (Operator Instructions) After today's presentation, there will be an opportunity to ask questions. (Operator Instructions) Please note this event is being recorded.

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

John Chironna -- Vice President of Investor Relations and Treasurer

Thank you, Anita, and good morning, everyone. Today, I'd like to welcome you to our fiscal 2019 third quarter conference call. With me in the room are Erik Gershwind, our Chief Executive Officer; and Rustom Jilla, our Chief Financial Officer. 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 US 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 expected benefits from recent acquisitions.

These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those anticipated by these statements. Information about these risks is noted in our earnings press release and the Risk Factors in the MD&A sections of our latest Annual Report on Form 10-K filed with the SEC, as well as in our other SEC filings. These forward-looking statements are based on our current expectations and the Company assumes no obligation to update these statements. Investors are cautioned not to place undue reliance on these forward-looking statements.

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

I'll now turn the call over to Erik.

Erik Gershwind -- Chief Executive Officer

Thanks, John. Good morning, and thanks everybody for joining us today. To kick off this morning's call, I'll provide a brief overview of our fiscal third quarter results. I'll then offer specifics about the environment and our recent performance and I'll discuss our plan moving forward before turning it over to Rustom to review the details of the third quarter and provide our fourth quarter guidance. I'll then wrap up before we open up the line for questions.

Our fiscal third quarter results were disappointing. Sales were below our expectations for the quarter, while gross margin was at the low end of our guidance range. Although, operating expenses were below anticipated levels, our earnings per share were below the low end of our guidance range. We'll dissect the reasons in detail this morning, and I'll share with you the actions that we are taking to address them.

First, I'll start with the environment. We've seen a step down in industrial demand since our fiscal April. On the last call with you, we described the softer than expected March with the rebound during the first week of calendar April, which was the last week of our fiscal March. As we said at the time, we weren't sure what to make of it.

As it turns out, the softness from March not only continued, but it has worsened since we last spoke. And we've seen this softness evidenced in discussions with customers and suppliers, along with data points coming from many sources, including manufacturing output numbers, distributor growth surveys and the sentiment indices. In April and May, the last two months of our third quarter, readings for the NBI were 53.6 and 51.6, respectively, and June was at 51.8. The rolling 12-month average for the NBI is now 54.7, while still reflective of growth, there is a continued deceleration.

With regards to the pricing environment, there continues to be an overhang of uncertainty, mostly due to tariffs and trade. In the fiscal third quarter, realization of our mid-year price increase continued to be positive. As we look forward, our plan is to take our late summer increase as we usually do, although it will likely be slightly later than last year to give ourselves more time to understand how the tariff situation is shaking out.

In terms of our performance within this environment, our core customers had growth rates in the low-single digits, while national account growth was mid-single digits. Both were slightly lower than expected, impacted by the softness that I just mentioned. As expected, government sales growth declined mid teens this quarter, weighing down our overall growth rate. You'll remember that our fiscal third quarter was expected to be the peak of the government headwind and while the headwind continues for another couple of quarters, it does begin to abate in this coming quarter.

Let me now step back and share my assessment of our performance along with an overview of our action plan moving forward. Clearly, the biggest difference between our actual results and our previous guidance has been a change in industrial conditions. And because of that softening environment, we've implemented a three-part action plan designed to achieve improvement in the following: one, field sales execution, particularly around new accounts implementation; two, profitability of our supplier programs; and three, expense control and productivity.

Part one, improved field sales execution and new account implementation. We are winning new accounts at a fast clip. However, revenue growth from our new account wins is taking too long to materialize as these new account wins have outpaced our expectations and hence our resource planning. I would have liked to have seen more contribution from these wins heading into our fiscal fourth quarter.

In response, we have focused, one of our top sales leaders on new account implementation and have allocated additional resources to keep up with the rate of new account signings. This is one of the key actions that we're taking to improve field sales execution. Overall, I continue to have strong conviction in our plan.

I should also note that any Eddie Martin, who we recently announced as our Senior Vice President of Sales, has hit the ground running and is playing a significant role in field sales execution improvements.

Action plan part two, improve the profitability of our supplier programs. We are working to deepen our relationships with our suppliers in a win-win fashion. Those that improve their programs and invest in MSC and our customers will be rewarded with focus and investment on our part. Suppliers that do not step up, will see moves away from them and toward their competitors, who choose to invest in our partnership.

Related to this, the softening demand conditions and reductions in commodities prices have led us to reassess product cost increases. Whether it's tariff related or otherwise, we are pushing back when we don't think an increase is justified for our customer. And when it comes to our own tariffs exposure on direct imports, we're also pushing back on our Chinese suppliers to offset tariff related increases.

Action plan part three, increase operating expense controls and improve productivity. And we're taking three steps to do so: first, curb hiring and clampdown on discretionary spending; second, ratchet up performance management and review resourcing needs department by department; and third, reengineer inefficient processes to drive productivity. It's a bit too early to quantify additional details right now, but we will do so as part of our fiscal 2020 framework on our next call.

I'll now turn things over to Rustom, before I come back with some concluding remarks.

Rustom Jilla -- executive vice president and chief financial officer

Thank you, Eric. Good morning, everyone. Before getting into the details, let me remind you that we provided Q3 guidance for both our total Company and our base business, which is our total Company excluding the impact of the AIS acquisition and the Mexico business.

Our third quarter, average daily sales were $13.6 million, an increase of 4.6% versus the same quarter last year and below the low end of our guidance range. AIS and MSC Mexico contributed 260 basis points of growth between them, slightly ahead of guidance. The entire shortfall, therefore, was in our base business, which had ADS growth of 2%. Eric has already covered the reasons, so, I'll move on to gross margin.

Our Q3 reported gross margin was 42.5%, 20 basis points below our guidance midpoint. The majority of this gap was due to base business customer mix, and slightly higher than expected purchase cost escalation. Our total Company gross margin was down roughly 110 basis points from last year, with about 40 basis points of this coming from AIS and MSC Mexico. Sequentially, our base business gross margin of 43.1% was flat with Q2, as the February price increase offset both mix headwinds and purchase cost escalation.

Total operating expenses, in Q3, they were $258 million, or approximately $4 million lower than the guidance midpoint, mainly due to actions taken to reduce discretionary spending and avoid planned cost increases, as well as to lower volume-related variable cost and a lower incentive accrual. We slowed our rate of hiring in Q3, tempering our headcount growth, which when combined with performance driven attrition, resulted in field, sales and service headcount reduction of 22 and an overall reduction of 31 heads from Q2. But note that we do expect to end Q4 with close to the Q2 level of field, sales and service associates.

Operating expenses were up $13 million from last year's Q3, about $5 million of this year-on-year increase came from the acquisitions, another roughly $2 million was attributable to volume-related variable costs such as pick, pack, ship and freight, and roughly $4 million came from higher field sales and service payroll costs, where head count is up 63 versus a year ago.

OpEx to sales at 29.8% was up 10 basis points from last year's Q3 and 10 basis points above the midpoint of the guidance, as our cost control actions helped, but did not fully offset the impact of lower than expected sales. Our fiscal third quarter reported operating margin was 12.8%, within, but at the low end of our guidance range. This was down roughly 110 basis points from the prior year, with roughly 10 basis points due to AIS and MSC Mexico.

Our base business operating margin was 13.2%, at the low end of our guidance range and down about 100 basis points from the same quarter a year ago. Lower gross margins and the ongoing impact of people and project investments made earlier in fiscal 2019, both contributed to the year-on-year decline.

Our total tax rate for the third quarter was 25%, slightly below guidance and lower than our fiscal 2018 Q3 effective tax rate of 29.3%. The year-on-year decrease was primarily due to the lower corporate tax rate resulting from the Tax Cuts and Jobs Act. So all of this resulted in reported earnings of $1.44 per share, $0.05 below our guidance midpoint. AIS and MSC Mexico combined had a $0.01 negative impact on reported EPS. Last year's reported EPS was $1.39.

Turning to the balance sheet, our DSO was 59 days, up three days from fiscal 2018's Q3, with national accounts continuing to be the main driver. Our inventory decreased during the quarter to $561 million, down $12 million from Q2. Total Company inventory turns were down slightly to 3.5 times from Q2. We have slowed purchasing and expect inventory levels to decline again in our fiscal fourth quarter, but by a lower amount.

Net cash provided by operating activities in the third quarter was $89 million versus $112 million last year. Our capital expenditures in Q3 were $13 million versus last year's $14 million, and after subtracting CapEx from net cash provided by operating activities, our free cash flow was $76 million as compared to a strong $99 million in last year's Q3. Note that we currently expect annual CapEx of $50 million to $55 million in fiscal 2019.

We paid out $35 billion in ordinary dividends during the quarter and did not buy back any shares on the outside market. In last year's Q3, we paid out $33 million in dividends and bought back $4 million in shares. As you saw this morning, we increased our quarterly dividend to $0.75 per share, a 19% increase. Based on fiscal 2019's expected EPS, this will result in a payout ratio of about 57%. Our strong balance sheet and high levels of free cash flow generation comfortably support this level. Eric will elaborate more on this in his closing.

Our total debt as of the end of the third quarter was $531 million, comprised of a $246 million balance on our credit facility and $285 million of long-term fixed rate borrowing. Cash and cash equivalents were $39 million and net debt was $492 million. So our leverage decreased to 1.0 as compared to 1.2 times at the end of Q2 and was flat with last year's Q3.

Now, let's move to our guidance for the fourth quarter of fiscal 2019, which you can see on slide 4, and is shown with and without acquisitions. Please remember that DECO is in the base, whereas both AIS and MSC Mexico are included in the total Company views. And note that when we get to fiscal 2020 guidance, we will move AIS into the base, but leave Mexico in the total Company view.

Overall, for Q4, we expect total Company ADS to increase by approximately 1.2% to 3.2% versus the prior year period. This includes a range of 0% to 2% of organic growth and around 120 basis points from acquisitions. As you see on the op stats in our website, June's total average daily sales growth is estimated at 3.7%. Note that this year's June had one fewer selling day as we closed on the Friday, following the July 4th holiday.

Our Q4 total Company gross margin is expected to be 41.8%, plus or minus 20 basis points. This is down 110 basis points year-over-year. Our base business gross margin is expected to be 42.3%, down 120 basis points from last year. While price realization has continued at expected levels, we anticipate higher purchase costs and sales mix to also continue as gross margin headwinds in the fourth quarter. Also, the higher sales growth coming from vending and direct ships comes in at gross margins below the Company average.

Gross margins for the base business are expected to be down 80 basis points sequentially from the third quarter. This is due to the normal seasonal Q4 decline, exacerbated by escalating product costs and a slight delay to annual price increase. Let me provide some additional context on gross margin.

Our gross margin formula is made up of three elements: price, cost and mix. In recent years we averaged a gross margin decline of 30 to 50 basis points. And if price and cost are neutral, we would still expect year-over-year gross margin deterioration from sales mix. The past two years have produced quite a different picture, primarily due to the timing of price/cost.

In fiscal 2018, we benefited from our price increases before the cost increases flowed through our P&L. As a result, the price/cost spread was positive and our base business gross margins were flat. This year, fiscal 2019, we are later in the price/cost cycle. While price realization has been positive, the gap between price and cost has turned negative as we are now bearing the full impact of escalating product costs from fiscal 2018. As such, at our Q4 guidance midpoint, fiscal 2019's base business gross margin would be down 80 basis points versus last fiscal year.

On top of the price/cost timing issue, the demand environment, though still positive, discernibly softened in Q3. We don't see this changing in the fourth quarter and are addressing the purchase cost side of the equation.

Moving now to operating expenses, they are expected to be around $258 million, up $6 million from last year's fourth quarter, with the base business accounting for about $4 million of this. As you know, we added sales and service headcount over the course of the year, and total payroll and payroll related costs accounted for about $3 million of the year-over-year increase.

You might expect a sequential decrease in operating expenses in Q4 rather than sequentially flat operating expenses. There are three reasons why OpEx is flat sequentially. First, most of the actions taken in the last two to three months were to a wide planned headcounts and cost increases rather than to reduce costs. To be clear, we will take cost reduction actions in the coming months and the savings will kick in more meaningfully in fiscal 2020.

Second, we had a roughly $1 million incentive compensation accrual reversal in Q3. And third, we are expecting depreciation cost to rise sequentially, driven primarily by the strong growth in vending signings this year.

We expect the fourth quarter's total Company operating margin to be approximately 11.2% at the midpoint of guidance, a 170 basis point decline over last year's 12.9%. The year-on-year drivers are the roughly 110 basis point gross margin decline, and a roughly 50 basis point operating expense expansion, due to our growth in investments and the acquisitions. Assuming the midpoint of our total Company Q4 operating margin guidance, we would fall below the lower left quadrant of our 2019 annual operating margin framework for the full year.

Before turning to taxes, I'll say a word on base business incremental margins. While we delivered a solid fiscal 2018, we will have taken a significant step back in fiscal 2019. Assuming the midpoint of our fourth quarter guidance, we expect operating profits to decline roughly $20 million on approximately $90 million of additional sales. This is, of course, unacceptable and we are taking actions to improve our performance.

Turning to our estimated tax rates for the fourth quarter, it is 24.1%, slightly lower than our year-to-date tax rate of 25.1%. This is due to the typical release of state tax reserves that occurs in our fiscal Q4.

Finally, our Q4 EPS guidance range is $1.21 to $1.27, with a midpoint of $1.24. This includes AIS and MSC Mexico, which together should be EPS neutral in Q4. Our guidance also assumes a weighted average diluted share count of roughly 55.3 million shares.

I'll now turn it back to Eric.

Erik Gershwind -- Chief Executive Officer

Thank you, Rustom. As I shared earlier, we're taking actions aimed at improving sales and gross margin and lowering expenses. You've heard some of the details today. But in summary, we are focused internally on improving execution. And this also means that any M&A activity that we may consider over the near term will have higher hurdle rates, particularly as valuations remain historically high.

You also saw that we are adjusting our capital allocation philosophy to return more capital to our shareholders via the quarterly dividend. As Rustom said, we have a strong balance sheet and generate high levels of free cash flow. This dividend leaves us with a comfortable payout ratio and this would be true even if things soften further.

Reflecting on the fiscal year thus far, we're disappointed with our performance and more importantly, we are taking action to address this. With that said, I don't want the progress that we're making in some critical areas lost on all of this. We are winning new accounts and doing so at a very strong pace. Our vending implementations are growing more rapidly than they have in a long time.

We are deepening our commitment to our valued supplier partners at a time when our shared goals are more important than ever. And our team of associates is working to deliver on our action plan. I thank each of them for taking it on with urgency and commitment, as we continue our journey from a spot buy distributor to a mission critical partner on the plant floor.

We'll now open up the lines for questions.

Questions and Answers:

Operator

Thank you. We will now begin the question-and-answer session. (Operator Instructions) The first question today comes from Robert Barry with Buckingham Research. Mr. Barry, please go ahead.

Robert Barry -- Buckingham -- Analyst

Hey, guys. Good morning.

Erik Gershwind -- Chief Executive Officer

Rob, good morning.

Robert Barry -- Buckingham -- Analyst

Actually, before my question, I just wanted a housekeeping item clarification on the ADS results, estimate for how much do you think Easter impacted April and how much does having one less selling day benefit June ADS?

Rustom Jilla -- executive vice president and chief financial officer

So, the April impact washed out, I mean, so we didn't -- in the quarter as we looked at it. The ADS impact of the one less selling day in June, if you do it purely mathematically, right, would not be quite the way to do it, Robert, because effectively the last -- if I just disclose what the number was on Friday. I mean we had like just a little bit over a $1 million in sales. So when you -- if we didn't have that $1 million and didn't have that day, it would have really a negligible impact on the overall number.

Robert Barry -- Buckingham -- Analyst

I see. So, it's pretty minimal.

Rustom Jilla -- executive vice president and chief financial officer

Erik, do you want add anything.

Erik Gershwind -- Chief Executive Officer

No. You got it.

Robert Barry -- Buckingham -- Analyst

Sorry.

Erik Gershwind -- Chief Executive Officer

You can keep going. If there is another question.

Robert Barry -- Buckingham -- Analyst

Okay. I'll follow up afterwards. So on the price/cost impact to gross margin, what was that impact in 3Q in the quarter?

Rustom Jilla -- executive vice president and chief financial officer

So, the price mix impact -- we haven't disclosed the price/cost impact specifically like that, but the price mix impact that we had was roughly around 60 basis points.

Robert Barry -- Buckingham -- Analyst

Right. (Multiple Speakers) the price/cost positive turned negative, so, I was curious how much of --

Erik Gershwind -- Chief Executive Officer

Yeah, Rob. So a little bit on gross margin. So essentially what happened was, as Rustom described, we came in on the bottom end of our gross margin range. So effectively, 20 basis points off the midpoint and what he highlighted is, there are two drivers behind that in the base business: one being purchase cost slightly higher than expected, the escalation; and then, two being customer mix. He also put some context on price/cost in terms of, essentially, what happens in our business, when we take price, we get it right away. When we take a cost increase, it bleeds into our P&L slowly. And what we were describing in the prepared remarks was how this fiscal year price/cost has turned negative as we're bearing the full brunt of the cost increases taken over this year and last year.

Robert Barry -- Buckingham -- Analyst

Got it. And I guess just lastly, curious about what the outlook is there for that price/cost equation getting back to at least neutral? I mean, is there a line of sight to that happening? Because it seems actually like maybe the inflation, at least, from tariffs might continue to rise, especially, if you're seeing more coming through from third-party vendors.

Erik Gershwind -- Chief Executive Officer

Yeah Rob, really good question is, where does it go from here as it relates to gross margin and price/cost. Here's what I would say, on the pricing side -- so, right now, absent -- if we did nothing else and just trended things out, price/cost would likely stay negative in '20. However, an important -- however, two things could change. One is pricing and as I mentioned, we're going to be taking a summer increase. We would expect to see solid levels of realization as we did in the mid-year.

And you raise a fair point that should -- still for us too early to say what's going to happen with tariffs, but should that stimulate inflation, there could be more coming on price. I think the second important thing that we talked about this morning was the fact that we're taking aggressive actions on the buy side with our supplier community in a number of different forms. Still a little early to quantify exactly how much of the embedded costs that eats into and we'll certainly follow-up on the next call with the 2020 outlook.

Robert Barry -- Buckingham -- Analyst

Got it. All right. Thank you.

Operator

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

Ryan Merkel -- William Blair -- Analyst

Hey. Thanks. Good morning, everyone.

Erik Gershwind -- Chief Executive Officer

Hi, Ryan.

Ryan Merkel -- William Blair -- Analyst

So first off, can you provide a little bit more context around the organic slow down in daily sales, was it broad based or did certain end market drive the bulk of weakness?

Erik Gershwind -- Chief Executive Officer

Ryan, so what I would say is two comments. One is, we saw some real pockets of weakness. A few that I would call out. Automotive, it's probably not going to be a surprise to you. Automotive, oil and gas and then the Midwest was hit pretty hard with agriculture certainly. Pockets of strength. Aerospace continues to remain strong. That said, what I would say, outside of the pockets of weakness, we did through most of our customer base see a change through the quarter. And I would characterize the change as more uncertainty and shorter backlogs, along with some softening in export demand and concerns about more softening in export demand. So that's how I characterize it.

Ryan Merkel -- William Blair -- Analyst

Okay. And that's kind of what I expected. And then as a follow-up, the 1% organic ADS guide for 4Q, it looks like this assumes a little bit of further market slowdown, but not that much, right, because you're going from basically 2% run rate to a 1% in 4Q. Is that the right way to think about it?

Erik Gershwind -- Chief Executive Officer

Yeah. I think that's right. I mean if you look at the June numbers that Rustom mentioned, so the 3.7% is inclusive of a bit of acquisitive growth. I think without that we're somewhere in the 2.5% range, slightly benefited by the one fewer selling day. And then, you're right, Ryan, if you do the math and you did the forecast for July and August, it would be less than that. So yes, what we have assumed is a modestly softer July and August than what we saw in June.

Ryan Merkel -- William Blair -- Analyst

Okay. And then, just lastly and I'll turn it over. You mentioned that the price environment is more uncertain. Can you just expand upon what you mean by this and are there any implications for the P&L that we should think about based on that comment?

Erik Gershwind -- Chief Executive Officer

In terms of what I mean, it's really, Ryan, what we were referring to is the tariff and trade situation. Unlike the last round of tariff increases in 2018, which were smaller in size and more telegraphed, people saw them coming, this was larger in size and was not telegraphed and was a bit more of a surprise, so the uncertainty Ryan is really about what happens with our supplier community, and how much of that attempts (ph) to get passed through. And I think more importantly, what happens with the customer base, the end markets and how much of that makes its way through and gets accepted. So I think it's just the overhang of tariff and trade is what I would describe.

I mean I think in terms of the impact on the numbers, Ryan, look you're seeing it acutely in our fourth quarter, our fiscal fourth quarter guide with gross margin and what you are also hearing is, we're taking action. So, I would highlight, we did choose to push back the price increase a little bit, which obviously cost us a little bit of gross margin in Q4. We did that, so we get a little more line of sight into the tariff situation with customers and suppliers. And then, as we mentioned a couple of times here, we're moving aggressively with suppliers.

Ryan Merkel -- William Blair -- Analyst

Makes sense. Okay. I'll pass it on. Thanks.

Operator

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

David Manthey -- Baird -- Analyst

Thanks. Good morning, everyone.

Erik Gershwind -- Chief Executive Officer

Hi, David.

David Manthey -- Baird -- Analyst

So thinking about the action plan here, step one, Eric, you said you're gaining customers, but not ramping them quickly enough. And it's been years since you've given us any insight on active customer data. I'm wondering if just in the spirit of that part of the action plan, can you give us a spot update on the number of active customers today and what that is year-over-year?

Erik Gershwind -- Chief Executive Officer

Dave, I actually do not have the number handy to be perfectly honest with you. So we'll have to follow up. John is making a note for a follow-up. What I will -- the color I'll add there Dave is, relative to my time in the business, the new account wins we're seeing now and this is based on the changes that we've made in the sales force to put more focus on the hunter population, we are definitely seeing a greater rate of new wins than I've seen in a long time, maybe ever in the business. What we called out is quite frankly the rate and pace of the new account wins was a bit faster than we projected. And as a result, we need to play some catch-up on implementation and that's what we called out as action plan part one, is we're investing, we're reallocating resources as needed to get the wins in because what you heard from me is, I'd like to see the new wins translate into revenue faster.

David Manthey -- Baird -- Analyst

Okay. And the number two part of the plan here is better realization from supplier programs. I'm wondering, are these conversations you've already had or are those yet to happen? And what about this is going to be different? Vendor management is a key ongoing function of any distributor. I'm wondering what do you plan to do differently than you've been doing over the past several years there?

Erik Gershwind -- Chief Executive Officer

Yeah. Dave, really good question. So what I would tell you is, the bulk of the conversations have already occurred, so it's a bit early to provide results and outcomes, because as you can imagine, it's not a one-time conversation. There is ongoing dialog and we're still sorting through it, but most of the conversations have occurred. I would say that, what's different is, a heavier emphasis this time around on providing growth investment -- two-way growth investment, and sales and marketing programs that we would commit to to those suppliers that step forward to give them heavy degrees of focus inside of MSC and in a way that would be stepped up from what we've done in the past.

David Manthey -- Baird -- Analyst

Okay. And then, finally, Eric, more of a strategic question here. As you make this drive to become a mission critical partner on the shop floor, do you feel that today you have the people, tools, technology and products and services in order to do that? And if so, I'm wondering why hasn't the uptake been faster? If not, what do you need to get there?

Erik Gershwind -- Chief Executive Officer

Yeah. Really good question. I would say, Dave, so let me start out by saying, my conviction in the plan is high. My conviction in the team -- our management team in particular is high. So look, that said, there have been considerable changes in the sales organization in particular. We mentioned Eddie coming on board and beyond Eddie, really largely a new sales leadership team around Eddie, with several other members of the team. But my conviction in the team and the plan is high.

So to your question about why the traction being slower, and I think, it's fair to say, look, I want to be clear, on the one hand, I'm excited and encouraged about the new account wins, on the other hand, I want to be clear, I'm disappointed with the results we're producing and I'm disappointed in how fast the new accounts are materializing into revenues. You heard us making some adjustments. We'll continue to make adjustments as needed until we get it right, but for me, the headline is, conviction in plan and team are high.

David Manthey -- Baird -- Analyst

All right. Thanks, Erik.

Operator

Next question comes from John Inch of Gordon Haskett. Please go ahead.

Rustom Jilla -- executive vice president and chief financial officer

Thank you. Good morning, everybody.

Erik Gershwind -- Chief Executive Officer

Good morning, John.

John Inch -- Gordon Haskett -- Analyst

Morning, guys. Hey, Erik. Is part of the issue that suppliers have been raising their list three prices (ph) , but that the market in terms of your peers are lagging. Is that part of what's going on here? I'm just wondering if you could comment a little bit in terms of what suppliers are doing with respect to list three and what you're seeing competitively in the market with respect to list three?

Erik Gershwind -- Chief Executive Officer

With respect to list three on the tariff situation, John?

John Inch -- Gordon Haskett -- Analyst

Yes, correct. The 25 --

Erik Gershwind -- Chief Executive Officer

Yeah. I mean, to be honest, with respect to the latest round of tariffs, still very early. So, I would say, too early to comment. And that's part of what we described as the overhang and uncertainty. What I would say is, the last round of tariffs, John, late 2018, most certainly triggered a greater incidence of list price increases from suppliers. So far, and again, I think that's part of the reason why we're waiting and seeing, there has not been significant amount of movement, I think in part because this was a surprise to many,

John Inch -- Gordon Haskett -- Analyst

Do you think it has anything, Erik, to do with maybe there is a threshold of greater sensitivity given the uncertainty in the economy that all of a sudden there is just not going to be quite the ability or perhaps greater resistance to push through some of these increases? And I'm just curious how you think that may be ultimately nets out for MSC? Are you comfortable that the cost will ultimately be offset? I mean you're obviously taking these the supplier adjustments. I'm just curious how you're thinking, are we reaching a bit of a threshold here in terms of how much customers are willing to accept?

Erik Gershwind -- Chief Executive Officer

John, it's a good point. I would say, any time -- this is largely cyclical and what we're seeing is no question a change in the demand environment and many times there is a correlation between how the demand environment goes and how the pricing environment goes. So softer conditions on the demand side will lead customers to be scrutinous of price and certainly will lead local distributors that make up the bulk of the market to get more aggressive. I think that's real, and I think that's why you're seeing us pull out our playbook on the buy side, absolutely.

John Inch -- Gordon Haskett -- Analyst

No. It makes sense.

Rustom Jilla -- executive vice president and chief financial officer

Sorry, John. Just to add. You also are seeing, as Erik alluded to, with the demand weakening and everything too, you're all seeing inflation in general and in commodities also beginning to come down. So it could very well have been --

John Inch -- Gordon Haskett -- Analyst

By way guys, how is metalworking in general responding to the demand? Obviously, a huge metal working data point, right. How is metalworking in general? Ex the NBI, how is the channel for suppliers, customers, competitors, how are they responding to these fluctuating tariff price changes and demand softening, what are you seeing there?

Erik Gershwind -- Chief Executive Officer

I would say, in general, John, what we're hearing from -- look the bulk of our customers are going to be broad based metalworking, is we're seeing uncertainty. There is more uncertainty, there is less confidence, since there was (ph) -- as I mentioned, the backlogs are shorter and an impact on the export demand.

John Inch -- Gordon Haskett -- Analyst

That makes sense. I guess lastly, Erik. You guys, MSC, have been on a multi-year ramp with respect to SKUs and expanding the big book and the product offering. I'm kind of assuming that this supplier initiatives are going to result in some actual supplier rationalization. Where would you anticipate -- like, what would you anticipate coming out of this in terms of maybe your supplier count? Do you have a thought process in terms of how much it may decline? And in turn, what would you anticipate for an SKU product offering in totality going forward?

Erik Gershwind -- Chief Executive Officer

Yeah. John, another good question. The SKU effort has been successful and actually it's been an important part of the strategy to make sure that when a customer comes to us, they can't get anything that they need that's industrial related. So I don't see that changing and I don't see the SKU count changing dramatically. To be honest, the supplier count may or may not change dramatically, John. Really, what we're talking about here is, where we put focus, effort and investment. So it may not necessarily mean that the -- it could, it will really depend, it'll be circumstance and product line specific. In some cases, it may mean some pruning or rationalization of suppliers, but in other cases, it may just be about where we put focus, sales focus and marketing focus in particular.

John Inch -- Gordon Haskett -- Analyst

And when do you think this is finished, or most of the bulk of the work on supplier is over, is it going to be six months, is it a bit of a longer process or how should we think about it?

Erik Gershwind -- Chief Executive Officer

I would expect by our next call, we'll have a pretty good feel for what we can expect to see in terms of results and what moves we will be making.

John Inch -- Gordon Haskett -- Analyst

Perfect. Thanks, Eric. Appreciate it.

Operator

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

Adam Uhlman -- Cleveland Research -- Analyst

Hey. Good morning, everyone.

Erik Gershwind -- Chief Executive Officer

Hi, Adam.

Adam Uhlman -- Cleveland Research -- Analyst

I was wondering if we could go back to the cost control efforts, and in particular what you're looking to do with head count. It sounds like most of the efforts here are focused on attrition and you're hiring rates and not layoffs or the like. But I'm trying to understand beyond that, what other levers you are pulling here in the medium term? You mentioned that there is more under way here in the fourth quarter, but assuming that flat demand environment persists for the next six months or year, or whatever, what do you think your underlying rate of expense growth shakes out at?

Erik Gershwind -- Chief Executive Officer

Adam, I'll take at least the first part of the question and talk to you a little bit about what we're doing and what you're seeing from us here and what Rustom and I described. What you can expect to see is, number one, more aggressive performance management. You can expect to see number two, a greater focus on productivity than we've had in the past. Look, I'll mention that over the past few years, we have made moves at times to align specific departments and make changes with the needs of the business. You're going to see us step up those efforts. As a result of those things, certainly with the picture that we see now for the demand environment, you will likely see head count levels come down during fiscal 2020.

Rustom Jilla -- executive vice president and chief financial officer

Yeah. And Adam. I mean, yes, just to elaborate on that. I mean it's more than simply attrition. I mean we are looking at, yes, we are looking at curbing hiring and clamping down on discretionary spending, but the ratcheting up on performance management and reviewing resourcing needs department by department is something that we will be doing more intensively than we've done. We have taken our OpEx down a couple of hundred basis points. So, I mean this is now going up to another level, but also reengineering inefficient processes to drive productivity. That's something else that we will be taking up to another level. And we will provide some further details as part of our fiscal '20 framework when we come back and talk next quarter.

Adam Uhlman -- Cleveland Research -- Analyst

Okay. And then, just a clarification on vending. It sounds like the signings have been ramping for some time. I missed what the sales growth contribution was this quarter, if you could repeat that for me. But I guess I'm just wondering how that looks now for maybe the second half of the year, should we be expecting an acceleration in the sales contribution, or is the weak manufacturing environment going to mute that?

Rustom Jilla -- executive vice president and chief financial officer

Vending is still contributing quite solidly in terms of the numbers. It probably contributed about 1.4% or something of our sales growth in this quarter. I expect vending to continue to contribute in terms of revenue. It's an area of focus. It's something that we're doing, and something that we've invested in. And along with vending, just one thing to remind you of is that, yes, it comes at lower gross margins. So contribution margins do vary greatly by account, but one of the things is, over the years, all the insights we've gained through our net profitability analysis have led to reductions in cost to serve and so we continue working on that. And vending's profitability also typically improves as the account matures. (Technical Difficulty) Does that helps?

Adam Uhlman -- Cleveland Research -- Analyst

Yeah. Thank you.

Operator

The next question comes from Chris Dankert of Longbow Research. Please go ahead.

Christopher Dankert -- Longbow Research -- Analyst

Good morning, guys. Thanks for taking my question. I guess if we could circle back to government. We're looking for that (inaudible) peaked this quarter mid teens. You said that it does trickle as we get into the fourth quarter and fiscal '20. Can you help us size what that headwind is moving forward? It's lower than mid-teens, that's a pretty wide range, I guess.

Erik Gershwind -- Chief Executive Officer

Yeah. So look, I mean the headwind we talked about mid-teens. If you think about the third quarter and its peak, mid-teens. And government is 7%ish of our business -- 7% to 8% of our business. So you do the math there, Chris, and that is a point headwind to the growth rate right now. Looking ahead to Q4, we still have government negative, but less negative. And it will be certainly -- I believe by the back half, so Q1 will still be slightly negative. As we move Q2 back half of the year, the headwind completely dissipates, which means that it's no longer negative. And if the work that's being done now in the program and I should add, by the way, I think there is some very good work going on in the government program right now, I expect that piece of our business to restore to growth. But that gives you a feel for the headwind and how long it lasts.

Christopher Dankert -- Longbow Research -- Analyst

Actually thank you. That's very helpful. And then we've talked a lot about the hunters and their impact. I guess is the goal near-term still to get them to add about 100 basis points? I mean I believe they're hitting that maturation rate. Just any color on what your expectation is for the actual sales growth contribution from them nearer term?

Erik Gershwind -- Chief Executive Officer

Yeah. So, Chris, you remember from the last call, I had talked about, what I saw from them in the next quarter or two. I think I described that at least a 100 basis points in growth contribution. Absolutely, nothing has changed in terms of what I see as the size of the contribution from hunters. Our confidence is growing, the payback looks strong. What has happened is quite frankly -- I mean, so this is good news, bad news. The good news is, it does appear that the value proposition is working because the new wins coming in are greater than expected. The bad news is, it's more than we planned for and as a result, the revenues are slower to materialize,. But in terms of size of the price, absolutely nothing has changed.

Christopher Dankert -- Longbow Research -- Analyst

Got it. Just the last thing from me. I was thinking about pricing, obviously, you guys waited a little bit longer than usual on the mid-year increase, tough to get the full realization, may be waiting a little bit longer on the late summer increase I guess. Is there an opportunity to revisit some of these price negotiations on a more quarterly basis rather than the biannual given tariffs have changed the landscape a bit?

Erik Gershwind -- Chief Executive Officer

So, Chris, one of the interesting -- I haven't thought about it. You're right, that's two increases in a row. And one of the things that we've done and I think we've put a strong pricing discipline in place in the Company and one of our findings is that, we'd rather wait a little bit and be really well prepared when we go and when we sit in front of a customer and talk about pricing and why the increase is justified. And so what we've found if it's buying ourselves a little extra time, the results have been really good in terms of the kind of realization rates that we're seeing, particularly if I look back at this last midyear. And so, I think as much as anything else that's part of our improved pricing discipline and practice.

In terms of the frequency and cadence, look, what we try to do, Chris, as much as we can is, we know price is a sensitive subject for our customers and keep the cadence to some sort of regular time intervals and where it's not too often that we're introducing price changes. We would rather go once or twice and have a meaningful discussion, than go all the time and continuing or kind of sort of opening up that wound.

Christopher Dankert -- Longbow Research -- Analyst

Yeah,. It makes sense. Always tough to have that discussion. Thanks very much. That makes sense.

Erik Gershwind -- Chief Executive Officer

Thank you, Chris.

Operator

The next question comes from Justin Bergner with G.research. Please go ahead.

Justin Bergner -- G.research -- Analyst

Thank you for taking my questions.

Erik Gershwind -- Chief Executive Officer

Good morning, Justin.

Justin Bergner -- G.research -- Analyst

I was curious as to what parts of I guess the sales disappointment in Q3 and in the Q4 guide you would attribute to Company-specific challenges versus end markets? Because it seems like what you're seeing in the Company specific side is that you're getting more account wins than you're expecting, but slower conversion to revenue, which would be an offset. Is there anything else that you would attribute to Company specific factors versus end market factors?

Erik Gershwind -- Chief Executive Officer

Justin, so two points I'd make. One is, the biggest change -- if you looked at the third quarter, our actual sales number to the guidance, the biggest delta there was change in environment that we didn't see. Where I was disappointed is not -- obviously, we can't control the environment. What I would have liked to have seen was the new account wins begin to materialize into revenues faster, therefore, buffering some of that market downturn, but really you hit on the two key factors that are the headlines of the story.

Justin Bergner -- G.research -- Analyst

Okay. That's good. And then on the margin side, is there anything that's happening outside of sort of list three and the surprise impact of that on price/cost? Is there anything else that is material that's affecting the gross margin trajectory versus your expectations, be it increasing mix headwinds or other factors?

Erik Gershwind -- Chief Executive Officer

No, I would say no other major change inside or outside of the Company in terms of environment. I think you hit on the key overhang in the environment with the tariffs and trade. I think there is nothing else I'd call out.

Justin Bergner -- G.research -- Analyst

Okay. Thank you for taking my questions.

Operator

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

Patrick Baumann -- JPMorgan -- Analyst

Hey guys. Thanks for taking my call. Just had a couple of questions. Maybe just to start, could you provide an update on the competitive intensity that you're seeing in the current environment? And maybe just broadly from this perspective, how do you see this, if it is a barrier to pricing versus historical inflationary cycles?

Erik Gershwind -- Chief Executive Officer

Patrick, I would say, competitive intensity is high. And it would be typical of what I've seen in past cycles, certainly, that as demand conditions soften -- I think important to remember 70% of the market is made up of local and regional distributors and those distributors, when things get tight, will hang on to business and will certainly use price as a weapon and a lever to retain accounts. So we're seeing competitive intensity as high. And I would specifically call out the local distributors as to where the ratcheting up has come from primarily.

Patrick Baumann -- JPMorgan -- Analyst

Got it. And then on the tariffs, can you just remind us once again of the exposure as a percentage of your COGS for list three and then list four, just the direct exposure?

Rustom Jilla -- executive vice president and chief financial officer

I mean the original exposure, I mean remember, what we buy from China is about 5%. I mean that is a fairly small number coming through, and we are by the way, going back to our suppliers in China as well and specifically going to them and as they go on for list three and then the higher 25%, and going back and looking for alternative sources and working with them to be more efficient and not just pass through those numbers, what Erik talked about as well.

Patrick Baumann -- JPMorgan -- Analyst

And so it's just 5% of COGS and the recent increase to 25% that has yet to hit your P&L, correct?

Rustom Jilla -- executive vice president and chief financial officer

Yes. I mean that the recent increases are coming into P&L, as well the tariffs. And it would basically double it, isn't it, when you look at the further exposure, if all of it came through again. And that's why I've made the point that we not really necessarily seeing all if it come through yet.

Patrick Baumann -- JPMorgan -- Analyst

So, the 5% will become 10% you are saying?

Erik Gershwind -- Chief Executive Officer

Yes. So, Pat, just to explain. I think what we've described was, 10% is the total universe of what comes from China, what our direct impact -- our direct sourcing is. The 5% is roughly what was covered by the first few lists that we had. What Rustom is describing is, if everything else were covered by list three and four, there is a remaining 5% of potential exposure.

Rustom Jilla -- executive vice president and chief financial officer

Potentially taking us up to 10%, yes.

Patrick Baumann -- JPMorgan -- Analyst

Got it. And the move on list three from 10% to 25% percent that will start to be felt in your P&L in the 4th quarter and next year, that's not yet in the numbers, correct?

Rustom Jilla -- executive vice president and chief financial officer

Correct. Also depending on it, those 25% come through, that's the point I am trying to make.

Patrick Baumann -- JPMorgan -- Analyst

Yes. But you're assuming it does come through in your guidance, correct?

Erik Gershwind -- Chief Executive Officer

Look, minimal in Q4. Because of the way we buy and the time lag for overseas sourcing, it wouldn't be in our numbers right now. I think Rustom is hitting an important point. If we were to take a tariff related increase, one would not see that in our numbers now. It would be next fiscal year. As I talked about, we are pushing back rather hard on anything that's tariff related.

Patrick Baumann -- JPMorgan -- Analyst

Understood. And maybe just a different question. The top line environment is slowing, obviously, but we're not yet declining. I'm just curious if you could provide some perspective on how we should be thinking about decremental margins if we do in fact see a lower top line, I don't know 5% or something, if the environment could turn for the worse, and your top line goes down mid-single digits or so, what's a reasonable range on decrementals? I mean I look in '09. And I think you guys did 30% to 40% or something like that. Just curious if you can provide some perspective on that?

Rustom Jilla -- executive vice president and chief financial officer

So, you're really going into fiscal '20's guidance and we try to avoid giving that guidance. We try to avoid giving more than a quarter's guidance ahead, but maybe I can take another angle at it and say in fiscal '20 and just say, sales remain in low single digits, right. I mean we can still -- our target would still be to grow earnings and that would depend upon price realization, the supplier actions that Erik talked about and the cost down actions which are being undertaken and others that are being contemplated. And we'll share much more of this on our next call.

Patrick Baumann -- JPMorgan -- Analyst

Yeah, I was just thinking hypothetically, if we had a recessionary environment, what kind of decremental margins would the Company target?

Erik Gershwind -- Chief Executive Officer

So, Patrick, the reason it's tricky to answer at the moment is, Rustom just hit on three variables that we'll have a better feel for quantifying next quarter than we do right now. So one being even if things get softer, how does price realization hold up, does it hold up as it did in the mid-year. Two is, quantifying the benefits of the supplier actions we're taking. And three is, quantifying the benefits of the cost down actions that are under way. And right now, we don't have those quantified. We will next quarter. So without those, it would be an incomplete answer.

Patrick Baumann -- JPMorgan -- Analyst

Understood. Okay. And then, last one for me. Just the performance and recent acquisitions. Just curious, was there any change to the hurdle rate due to results from these deals? Just wanted an update on, you've done a bunch of deals over the last couple of years. I'm just curious if you give an update on performance of those?

Erik Gershwind -- Chief Executive Officer

Yeah. So, Patrick, let me just answer the second piece first, which is, the hurdle rate is a function of two things, it's a function of what we're seeing on valuations, one. And two is, look, the Company is focused on improving our performance. And you heard, we are internally focused right now. So those are the two drivers behind the higher hurdle rate. In terms of the acquisitions in flight now, really not much to report. The only news I would report is that, what drove the $0.01 in negative in Q3 was really around the AIS acquisition. And that is really focused on automotive. The business is solid, but we have seen a stark change, that business is heavily exposed to automotive in the Midwest and we saw a stark change in performance driven by automotive.

Patrick Baumann -- JPMorgan -- Analyst

And that's just the environment as opposed to share loss.

Erik Gershwind -- Chief Executive Officer

Yeah. And particularly, that's an OEM fastener business. So it's pretty easy to determine share loss or not. And we go in that business account-by-account. So the answer is, yes, it's environment.

Patrick Baumann -- JPMorgan -- Analyst

What is the auto as a percentage of AIS?

Erik Gershwind -- Chief Executive Officer

You know what, I don't have the number handy. One of their primary locations is right in Michigan, which is virtually all auto, but we could get back to you with the number.

Patrick Baumann -- JPMorgan -- Analyst

Okay. Thanks a lot guys. I'll follow-up. I appreciate the time

Operator

The last question today comes from Barry Haimes with Sage Asset Management. Please go ahead.

Barry Haimes -- Sage Asset Management -- Analyst

Thanks so much and thanks for the info today. So I had just quick question on the hunter situation, where you're getting more accounts, but not quite as much volume upfront as you had hoped. So it sounds like that net is a slight negative and I wanted to hopefully get a little color on the extent -- overall sales were below expectation. How much was from that factor versus just sales from existing customers? That's one question.

And then, secondly, I was hoping you could talk a little bit about what you see in terms of inventories out there, both your own, but more importantly, customer inventories. Are they in line, are they a little bit heavy still from what you hear as you speak with customers? Thank you.

Erik Gershwind -- Chief Executive Officer

Yeah. So, Barry. What I would say is, for the quarter, the biggest change if you're reconciling what happened in the third quarter revenues to guidance as I mentioned earlier, the biggest change is environment. So the slower revenues coming from the new accounts was a factor. And as I told you, I was disappointed that it didn't buffer the downturn. But environment was the biggest factor and that would -- of course, when the environment softens, what happens is, sales from existing customers go down, that was the primary factor. Secondary would be materialization of revenues from new account wins.

Rustom Jilla -- executive vice president and chief financial officer

But I think I picked up in your question, you were also checking on the economics of the program in this. So, I just want to cut in and point out that, no, I mean actually the initiative is already covering its cost. The economics are strong. I mean, basically with these accounts, as they do come, they provide significantly more revenue per head than our old sales model. And using all the cost to serve insights that we've been learning over the past few years, we focus on making them profitable as well. So right now, from a P&L perspective at the bottom line, I mean there's no net negative coming from that. Erik answered that (Technical Difficulty)

Barry Haimes -- Sage Asset Management -- Analyst

Thanks. And just the inventory question?

Erik Gershwind -- Chief Executive Officer

Yeah, I would say on inventories, I mean, you see our inventory is coming down a bit, but more broadly, I think that's reflective of what's happening in the channel, manufacturer, distributor, end user. And I guess not surprising, given softening conditions, uncertainty, et cetera, I think what you're seeing from us is reflective of what's happening in the market and I think if you spoke to others, you'd find inventory levels coming down.

Barry Haimes -- Sage Asset Management -- Analyst

And any feel for, is that another quarter, another couple of quarters to rightsize?

Erik Gershwind -- Chief Executive Officer

I'm not sure. And I'm not sure because I don't know. You'd have to tell me what happens in the environment, whether things are kind of at a level now and they stabilize would be one answer. Whereas, if they were to pick up or if they were to fall further, I'd give you a different answer on inventories.

Barry Haimes -- Sage Asset Management -- Analyst

Fair enough. Thanks very much.

Operator

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

John Chironna -- Vice President of Investor Relations and Treasurer

Thanks, Anita, and thank you everyone for joining us today. Our next earnings date is now set for October 24th, 2019. And we look forward to speaking with you over the coming months. Have a good rest of the day.

Operator

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

Duration: 64 minutes

Call participants:

John Chironna -- Vice President of Investor Relations and Treasurer

Erik Gershwind -- Chief Executive Officer

Rustom Jilla -- executive vice president and chief financial officer

Robert Barry -- Buckingham -- Analyst

Ryan Merkel -- William Blair -- Analyst

David Manthey -- Baird -- Analyst

John Inch -- Gordon Haskett -- Analyst

Adam Uhlman -- Cleveland Research -- Analyst

Christopher Dankert -- Longbow Research -- Analyst

Justin Bergner -- G.research -- Analyst

Patrick Baumann -- JPMorgan -- Analyst

Barry Haimes -- Sage Asset Management -- Analyst

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