MSC Industrial Direct Co., Inc. (MSM) Earnings Call Transcript & Summary

Well, good morning, everyone. Thanks for joining us here in Nashville for the Stephens Conference. I'm Tommy Moll, analyst here at Stephens. One of the companies I cover is MSC Industrial Direct. We're delighted to host them today, specifically 2 members of the management team. To my immediate left is CEO, Erik Gershwind. To his left is Ryan Mills, Head of Investor Relations. Erik and Ryan, good to see you both and thanks for coming.

Thanks for having us, Tommy. Great to be here.

So we've got about 45 minutes together. I have Q&A prepared for roughly half of that time. If you have a time-sensitive question during the first half, by all means shoot up a hand. Once we get to the back half of our time together, though, please, anyone and everyone, feel free to ask any question you have directly, we will foster a good back-and-forth dialogue today. But for -- I want to start with some very high-level questions. For those of you who may be new to the story, that's kind of how we've designed this conference. Sometimes you can pop in and get up the curve quickly with these firesides.

So let's just start very high level, Erik, with the spot buy to mission-critical evolution. These are terms that probably don't mean much to those who aren't in the weeds on distribution. But give us a sense of what that initiative looks like at the company years ago.

Sure. And good morning, everybody. Do you hear me okay? Good. Yes, I'm getting that. So yes, maybe what I'll do is just start at the beginning. So the company, MSC grew up as what Tommy referred to as a spot buy or long-tail supplier. In the industry, we were known as a catalog house. Of course, catalogs are not all that present anymore but the spirit behind it was that for industrial customers, MSC would play the role of keeping their plant running. The industrial supplies or MRO marketplace is very large and very fragmented. So you're talking about literally millions of SKUs that keep plants running, dispersed among thousands of suppliers. And oftentimes, these are low dollar value parts. So the customer, who are mostly, in our case, manufacturers have not historically spent a lot of time worried about them. And yet if one of these parts is not in stock, it can shut down a line. So the role for really the better part of 2 decades that MSC played was to be their backstop. We carried well in excess at the time of 1 million SKUs. Today, that number is up to 2.5 million SKUs. Most of them were stocked in 1 of 4 large, centralized warehouses or DCs that range in size between 700,000 and 1 million square feet, all located near UPS hubs. And basically, the gist of it was get product to customers next day with a seamless, wonderful customer service experience. And that was the crux of the business for a long time. Tommy referenced this pivot that we made, if you will, a transformation from being a catalog house to being something more. And that was coincident with my tenure as CEO. I grew up in this business. I'm 54. I've been in the business for basically 53 years. It was started by my grandfather but I took over as President in 2011, CEO in 2013. And bit by bit, we started to see changes happening in the industry. Certainly, one was the advent of the Internet or Google search, which made shopping for our customers much easier, much more transparent. We saw the entry of single channel online players like Amazon with declaring their intent to get into B2B. And that caused us to take a step back. And the other thing, Tommy, I would say we saw was our customer base. So 70% of our revenues are tied into manufacturing end markets in North America. And it began, I would say, after the global financial crisis of '08, '09, where bit by bit, there's been a drumbeat that persists to this day about the need for help in U.S. manufacturing, help in running their businesses better. That could mean help in finding productivity because most of our customers are under margin pressure. It could mean help in freeing up capital because they have limited working capital and want to grow. It could be help in getting products into their customers' hands faster. And so we saw this interesting opportunity to pivot what MSC did that for 2 decades, basically, our role ended when we would drop stuff off at our customers' loading dock. And we decided that we were going to play a bigger role and reach inside of our customers and actually help them on the plant floor to achieve all of those objectives I described. And so during my tenure, there was a really aggressive build-out of our product offering. So it was moving it from just carrying everything to -- we continue to carry everything but to focus and specialize on product categories that are either technical or high-touch in nature that would be needle moving for the customer's manufacturing process. It led to a build-out of inventory management services. So beyond just shipping into products, if you go to an MSC customer today, you'll find vending machines, you'll find vendor-managed inventory programs that are outsourced to us, so we help our customers manage their inventory better. You'll find technical experts. So we had an aggressive build-out, a network of well in excess of 150 technical experts. So these are people with deep roots in manufacturing and machining who could have done the job that the customer is doing and can help them find productivity opportunities. The last one I'll call out and then I'll stop talking is our In-Plant program. So we reached the point where we're actually placing MSC, our associates, as we call them, our employees full time inside of our larger customers' operations. These folks are playing a role anywhere from sourcing, procurement, put away, kitting, they'll do lean walks, they'll bring in technical experts. And this one has been of particular note because we feel like we're tapping into something. Nearly every one of our customers that we speak to, if you ask them, name your 2 biggest challenges or obstacles, access to qualified labor is always one of the 2. And this program seems to be tapping into that. So as of -- for instance, our In-Plant program went from more or less 1% of sales pre-COVID. We decided to hit the foot on the accelerator. It's now at 20% as of our most recent quarter and that's growing quarter-over-quarter. So in essence, I would say, Tommy, that's a summary of the pivot that we made.

Yes. And one of the product categories that's consistent through the whole history there, Erik, is metalworking, which is the largest for you, not always the largest for your peers. So it's not as well understood, I think, by investors. So can you frame for us what kind of contribution it delivers to your overall revenue pie? And then just give us a sense of some of the value add and the compare and contrast in metalworking specifically versus other product categories that folks may be more familiar with.

Yes, Tommy, it's actually a good call out that I should have mentioned as part of the pivot. When we were listening to our customers, we looked inside of MSC and said, beyond logistics capability and a broad product offering, what else do we have to bring to the table? And so just by virtue of my grandfather growing up, selling cutting tools, we -- roughly 45% of our business today is what we call metalworking. So if you take the total North American market for the products we sell, MRO, industrial supplies, you're looking somewhere, depending upon the estimates, $220 billion to $250 billion. Of that, metalworking represents approaching -- north of $15 billion and approaching $20 billion of it. So metalworking, think primarily cutting tools, abrasive supplies that would finish anything that would help form, cut, shape metal, machine tool accessories and such. And what's really interesting about that product category for us, Tommy and that's really where our expertise comes in, is unlike some of the products we sell that are kind of in and around the plant floor, janitorial products or a power tool that's repairing something, cutting tools, you're actually influencing the final output. So they're really important to the customer. And we found that as our pivot. So we do think it's a big part of the moat. It's not the only moat but it's a big part of what we lean into. It's interesting. So we're sitting today, we're still at just touching 10% of the metalworking market. So it's still a very fragmented market. We still see plenty of room for growth here. And so it's a big part of our advantage that we want to keep pressing on.

Erik, you mentioned the company was started by your grandfather. So I want to give a quick sketch of the family history here and then give us the latest on the transition. So founded by your grandfather, you've been CEO, I think you said since 2013 officially. Recently, it was announced that you'll transition to an Executive Chairman role and you've named your successor CEO who is not a family member. So I've kind of hit on the themes there but give us what additional context do you think is important for folks who want to underwrite a potential investment idea here.

Yes. I think -- so a couple of things I'll say, the family ownership. So it's been -- it's 1941, the company was founded and it's -- through me, we've only had 4 CEOs in company history. So Martina McIsaac, who I've been grooming for the better part of 3 years now, will be the fifth. We've had one other nonfamily member in between me and my uncle Mitch, David Sandler, who groomed me as I've done with Martina. So I mean, it's a pretty unique culture. If you think about over 80 years, only 4 CEOs and 3 of the 4 of us are from the same family. You can imagine a couple of things. One is, I think the values and the culture inside the company, it's a very values-driven company as a result. And we've been an interesting blend because we certainly have all of the governance of your typical public company. If you look at our Board of Directors, we always say we fight above our weight. We've got Board members that -- feel fortunate to be surrounded by. But there is something different. Like when you walk the halls, it does feel a little bit different. I will say speaking of governance, we -- a couple of years ago now, we made the decision to collapse. So we had a dual share structure in which a 10:1 voting right for B shares that were held by the family. We made the decision to collapse that. And it was really about looking at sort of reading the tea leaves, looking at where the world was going, looking at good governance. And so we collapsed, the family today has a little over 20% of the economics of the company. Although as part of the agreement, we did cap our voting rights at 15%. So whatever difference there is, we vote pro rata. I think even with Martina coming on, I think if you went inside the company, most would tell you and dealt with customer supplier, it's a net competitive advantage for us, just in terms of, #1, a very long institutional memory, a strong sense of culture and values and the ability to think long term, which I think is paying off for us. In some of the pivots that we made, I think it would have been tough for me to do without the benefit of that -- the family influence.

Yes. One more personnel-related topic, and then we'll dig into the operating environment. But in terms of the CFO, where are you in the process -- the search process for a new CFO?

So we're right in the midst of it. So Martina, over the past 3 years, Martina joined us as Chief Operating Officer. We had not had one in the company since me actually before I was CEO and felt it was the right time. Martina got promoted over 1 year ago to President. And over the course of the 3 years, she's really put together a strong management team. And I would say that's a balance of some fresh thinking that she brought in from the outside, a couple of people recently in sales, in supply chain, along with giving opportunity to long-standing MSC people who understand the culture and the heritage. So it's been a nice blend. This, Tommy, is the last piece of the puzzle, is the CFO search. So we are -- our former CFO, Kristen Actis-Grande, left beginning of August. We are in the midst of a search. We do expect to go outside. So interest seems really good. I think about prior searches, it generally takes a couple of quarters to find Mister or Miss right. I will say we have a lot of confidence in the meantime in the team here. Greg Clark, our Interim CFO, has been Controller for a long time. The man to my left here, Ryan Mills does a terrific job with the investment community. So we feel like it's solid and we're right in the midst of the search. And that should really be the last piece of the puzzle to the team.

So let's dive in on the operating environment here. Erik, on your recent earnings call, you used terms like stable to describe demand. You talked about some pockets of improvement but really still highlighting an overhang from some of the uncertainty. Reflecting on a lot of the conversations I've had with investors, particularly before last earnings season, there was a lot of hope about short-cycle recovery. Basic elements of the thesis, including a rate cut, One Big Beautiful Bill, this idea that we're kind of due for it, just given how long PMI has been sub-50%. Are there any signs of life that you can point to about a recovery? Or does it feel like we may be sliding into a pretty slow end of calendar '25 here?

I would say we feel, Tommy, for the most part, that there's been some notable improvement. But I would call the improvement more stabilization than inflection upwards. So realize we're coming off of 70% of our business into manufacturing, 50% into heavy manufacturing. So think heavy machinery and equipment, ag type equipment, think metal fabrication, auto, aero. And other than aero, for the last 2 years, it's been brutal. I mean, really brutal. To your point, we look not only at PMI, there's another index that if you want to track us that's highly correlated, it's called MBI, the Metalworking Business Index. It's run by the Gartner Group, very similar to a PMI sentiment survey. That index, I think, Ryan, it is like 26, 27 months now and going of being negative. And I asked the team to -- say, can you go back and show me what happens with this kind of protracted negative reading and they said, we can't because it's never happened before. So this is unchartered water, and it's been a rough couple of years. I would say all of us had hopes. I think the way the tariffs played out, there's just an overhang of uncertainty. The rate cut is not that significant. But we have seen some stabilization. So I would describe it that for those who are on webcast, they won't be able to see this. But instead of just going like this down, it's been level. And when you've been down so long, it feels like up. It's -- we felt like in our business with our goals at a flat Industrial Production Index, we ought to be able to grow mid-single digits. And that's starting to come to fruition. Of course, we are getting the benefit of some price. I would say we still feel, Tommy, like there's -- it's been one thing after another. Obviously, the tariff situation, the government shutdown, the prolonged government shutdown for us, public sector is around 10% of company's revenues. And of course, there's a little bit of a ripple effect you get with those selling into the government, take a defense contractor. But -- so it's kind of been one thing after another. I think as we look out, we're cautious, I would say, cautiously optimistic that the worst is behind us and perhaps there's more upside than there is downside. I think for us, we're particularly encouraged because we actually have started to see, which I'm sure we'll touch on, important parts of our business inflect positively due to some of the work that we've done. So I think our feeling is, even if it's just a levelized leveling and a stabilization that we ought to be able to grow and it's starting to do so.

Yes. We will certainly address some of those trends you referenced. But first, just to stick on some of the high-level themes here. You mentioned pricing, Erik. What details can you share about the increases that you pushed through in June and September? What are you seeing in terms of supplier price notifications? And if you run all this together, would you characterize what you have seen lately as the kind of inflation that should, all things equal, be a tailwind to margins? Or is there some reason that, that might not be the case this time around?

So it's a 2-part answer. I think to date, what we've seen to date has actually surprised us to the negative and not been a margin tailwind. I think as we look forward, it's beginning to feel more like the kind of inflation cycle that would be a tailwind. And let me put more color on that. So when the tariff noise began after election early in the calendar year, we were really surprised at how slow the industry and by industry, as a distributor, price movement is typically triggered by what the manufacturers who are suppliers of what they do and no one was moving. And it really -- it took us by surprise because we were expecting a wave of inflation that didn't come. And what we were hearing was no one had enough conviction and confidence that the tariff environment would remain stable and we're afraid about having to move and pull back. So what happened was there came a period and it was right around our last earnings call, I thought we had a good fiscal fourth quarter but gross margin was a disappointment to the tune of 50 bps. And there was 10 or 20 basis points that were kind of noise and onetime items but 30 basis points was price cost performing worse than we expected. And for us, we're on an average costing system. So usually, early in an inflation cycle, we'll take price right away, the cost bleeds in and we see a benefit. So we got caught by surprises. A couple of things happened. One, it was like an avalanche. So for all of this time of not moving, suppliers moved in a hurry. And just to put some data to that, we went back and looked, we got in supplier cost increases in a 2-month period, it was right around our earnings call, the equivalent of nearly a year's worth of inflation post COVID, which was a robust time. It was crazy. The other thing that happened was, it became like a mad scramble. We typically have the ability to work and partner with our suppliers to say, "Hey, give us 30 days notice, give us 60 days notice, so we can buy ahead of it and plan." We were getting like 3 days' notice, 4 days' notice, like, hey, starting on Monday. So it was a bit of like a 100-year flood. And so what ended up happening was price cost flipped negative and really because we took more cost than we expected. I think if there's a good news story there, what I was most pleased about, I was concerned about when margins turned negative but pleased to see the outcome, we got price. So we got exactly what we thought we got for price. The lesson learned was we didn't take enough. And so what we did, we kind of -- we didn't knee-jerk. `We took it on the chin a little bit in August and September. And the reason we did that is we've developed a pretty good cadence with our customers about giving them time and felt like that's more important than a month's worth of margin drag is the integrity, the transparency and consistency. So what we mentioned on our October call is, end of September, early October, we took pricing moves. And those were intended really to catch up for what's happened. So what we expect, we gave a gross margin guide for -- our fiscal Q1 of September to November that was up 30 bps from Q4 but it was kind of like a tale of 2 quarters in that our month of September looked pretty lousy. It would look more like Q4 and we were expecting better performance after pricing in October, November. I will say one other point on pricing, Tommy, is we're beginning to -- I mentioned it's a 2-part answer, we're beginning to see the signs that would make this cycle look more like a typical inflation cycle. And what I mean by that, the tariff-driven increases have been really, really wonky. There's kind of been a knock-on effect here, which is the tariffs had led to commodities inflation in certain instances. So the one that's funny. We've been studying -- following tungsten forever in our business but it's starting to get mainstream headlines. But tungsten is the single biggest ingredient into carbide and carbide is the biggest material for cutting tools, our cutting tool assortment. And so that and tungsten prices and we've been talking to our suppliers about this up something like 90% year-on-year. So to the extent that sustains, what we would expect to happen is our suppliers raise their list prices. And that would look more like a normal cycle to us where we can get ahead of it, plan for it, buy into it and be able to see the kind of price/cost dynamic we expect.

Yes. So let's tick through some of the different types of customers and the initiatives you have to attack each type. So I've got core, national and public sector. We'll take them in that order. So on the core customer side, first of all, just to level set on the language. When you guys talk about core customer, what does that mean? And in terms of the substance here, why did the trends there diverge for a while from IP? And what were some of the corrective actions that you took?

So these are pretty broad categories. And what we try to do for the public is, make it specific enough to be able to explain differences but simple enough to keep it simple, stupid. So core, national accounts, government, let me start with the other 2 are public sector. Public sector is pretty straightforward. I mentioned it's 10% of our revenues but those would be sales to any federal or state agency or organization, there, the 10% is broken up roughly 2/3 federal. So think military bases, for instance, and 1/3 state government. The second bucket, national accounts would be where we have a larger organization, typically has a centralized purchasing function and disparate kind of dispersed plants that would have large amounts of spend that function more like a corporate relationship where we're putting a contract in place as opposed to a one-off. That is about, Ryan, I'm 35-ish of revenues. So the balance, which is around 55% is what we call core. Core is a big bucket but it's made up primarily of manufacturing businesses and small- and medium-sized operations. So I'm overly simplifying here. But for the most part, our core customers will behave less like a large corporate that has a large purchasing team and contracts and more on a one-off basis. So the really important thing about core to note is that, #1, because as you can imagine, smaller customers, not as strong an ability to plan, these tend to be our highest margin customers. And #2, we have underperformed here, I'm going to say, for the better part of a decade. And I think the reason for that, there's probably one sort of structural industry issue, which is just smaller businesses have not fared as well as larger. But some of it is our own doing, which is that a lot of our resources and effort went into that mission-critical pivot I described. Those value-added services play really well for larger organizations who are thinking about total cost of ownership, who are willing to sit down and negotiate. For a smaller shop, first of all, they don't play as well. And second of all, they're not always as cost effective to introduce into the customer. And so there, what we were left with was a back to our catalog house value proposition that I would say was still fine but at one point, it was industry-leading. And if you don't move forward, others do and we needed to play some catch-up. And so this was actually -- I've been really encouraged to see but Martina came in and this is probably the biggest -- she's had a few big imprints on the company. But her diagnosis was, this is the economic engine of the business. We've got to get the core customer back and came up with basically a 4-part plan to do so. #1 was to realign our public-facing web pricing. So if you're a customer that logs on to our website and you don't have a negotiated discount, our pricing had drifted up, which was kind of similar with how the industry pricing structure worked. Add in, I mentioned earlier on an Amazon or some other single channel models and we looked out of whack. That was one. Two, we needed to upgrade our e-commerce experience, which was really good for the sophisticated large buyers, not as good and at one point was industry-leading, we needed to play catch up for the smaller customer. Three was marketing. And really, once -- our feeling was once our pricing was realigned and the web experience was back to industry-leading, we wanted to hit the foot on the accelerator with respect to marketing but in a different way from our legacy, which was mostly print, which in some, there's some great things about print but it tends to be costly, it's slow and it's not personalized. And so we built out a much more aggressive digital tech stack that allowed us to get more timely and more personalized and targeted in our marketing. And then the fourth leg of the stool around sort of reinvigorating the core customer was optimizing our seller coverage. So what Martina came in and diagnosed was we had a large concentration of our sales force focused on these big relationships where we're doing great, not enough coverage in the smaller guys. And so she took a look and brought in -- I know you referenced this on your note but sales is a science. I mean, Martina comes from an organization called Hilti that was really a selling machine. And she actually brought somebody in from Hilti recently, who seems terrific. And they're bringing a science-based approach to how you, #1, expand reach; #2, construct the portfolio of customers the right way; #3, look at compensation; and #4, look at the tools that are surrounding the salesperson. So all of these 4 bodies of work, long-winded way of saying, have come to fruition between basically we're early in our fiscal '26, the end of fiscal '24 with the big pieces in the middle of fiscal '25. So I think early this calendar year, February and March. And sure enough, we launched the website, we launched -- upgraded the website, the marketing. And bit by bit, we have begun to see the core customer improve. So that core customer was in decline in the first part of our fiscal '25 or about 1 year ago, hefty numbers, high single digits, low double digits. We saw a continued steady climb to the point where -- so Q4, again, is June through August, the company grew 2.7%. The core customer grew 4%. And we mentioned that we actually saw it continue to improve in September and October. So we think we're on the right track there, which opens up a lot of market share capture but also margin expansion for us.

And Erik, if you could compare and contrast the core value prop that you bring to the national account versus the core, I used core twice there to the core customer. But with national account, as you've referenced, it's more of a total cost of ownership type pitch. And there are all different ways, largely service-based that you can deliver a lower cost of ownership to the customer. In the core category, what would be the equivalent there? I mean, buying experience has to be part of it and you talked about some of the web experience there. But do a better job than I am right now of summarizing what is it you're attempting to construct to capture the core?

Yes. So it's a great question, Tommy, because some of the things I described like getting your pricing right in a web experience, table stakes. So what's been interesting is what we found along this journey is that even the small and medium-sized customers, they care about the same things. They're not as sophisticated in how they go about it but they care about making their business better, which means how do I take cost out? How do I increase throughput? And so what we've done is looked at how we deliver a similar kind of value that we do at the high end to a medium and even a smaller customer. And so I'll give you an example. We have a technical team that is an inbound technical team. So these are people who spent years or decades working in a machine shop and no longer wanted the grind of that and are now sitting in one of our call centers. We're opening up access to small shops to this group. And that changes the value proposition from just, hey, it's price and transact to these people, with FaceTime, I mean, they're actually able to help the customer save money and find productivity. So there's other examples like that, Tommy, that are kind of like the difference maker in the small and medium.

So national accounts, we've hit on several times. But maybe give us the latest and greatest on how you're bringing that total cost of ownership solution. The on-site location is part of it. But you've had some of these initiatives in place for some time. So where are you spending most of your time today on the national account side?

So for the national accounts, what I would say is the whole model is anchored in how do we improve customers' output, cost down or revenue up. So for our national accounts program, there's a regular cadence where we will sit, we'll go in early on, diagnose what we see happening and come back with a recommendation to the customer that will identify a total size of prize of what we think we can help them achieve in either revenue up or cost down. And it has to be in the customer's math. We will use that as our anchor. We call that a business needs analysis. That turns into a plan. And that's kind of our North Star with the customer. We will have a regular cadence depending upon the size of customer, monthly, quarterly of kind of rinse and repeat of looking at how we're doing against it. And then we deploy a whole number of tools on how we actually bring the savings to light. So obviously, we talked about In-Plants. We talked about our vending initiative, which is bringing shrinkage down and improving tool usage. Our technical team, so we also have people that will go in and walk plant floors and help customers identify opportunities to use a different tool, to use technology that we have that helps them run machines faster so they can save time and not have to invest in more capital. So it's a very rigorous process. And yes, that's been fueling our national account success.

Along those lines, could you just gave us a little context of how you've gone from a catalog company to providing all these additional value-added services? Structurally, how much higher should margins be given the value you're bringing to customers [indiscernible]?

So I would say, right now, we're sitting at high single digits EBIT or operating margin. And we see -- that has been a combination of some heavy investments in fixed costs that we've made, whether it's digital, our e-commerce upgrade and such, along with 2 years of contraction. We feel like there's a path back. I mean, what our stated goal is, at least mid-teens on the operating margin front. We haven't time bound that. A lot of that will be a function of the pace of revenue recovery. So for instance, our fiscal '26, as a kind of rule of thumb, we had shared that we expect a mid-single-digit revenue growth to produce around 20% incremental margins. We would expect, if I look out over the next 3 years, that would be in a flat environment. If either the environment inflects or our share capture picks up pace or we get more price than we're getting now, that revenue number should improve. If the revenue number improves, the incremental margin number should lift. And the incremental margin -- so the mid-teens operating margin target is really going to be fueled by a couple of things. #1 is revenue growth and leverage. #2 is going to be for the -- if I look back over the last 10, 15 years for us and most of our peers, there's been a gross margin headwind in the business of, call it, 30 to 50 basis points because the big customers grow faster than the small ones. We're kind of encouraged here that this could eat into that gap and stabilize gross margins if the core continues to outperform. The third lever is productivity. And Martina has really brought a, I would say, a sharper edge to productivity inside the company that would overlay on top of just leveraging a fixed cost base but actually eat into the cost base. So she's looking at -- there's a couple of big areas. Supply chain is one and we've highlighted some numbers that we're expecting to achieve in run rate basis right now. Seller optimization, I mentioned is another. And then she's got some things cooking on just general SG&A as well. So that would be our outlook.

And then can you talk to these value-added services? Is there a way to look at just what it's done for customer satisfaction scores or churn or however [indiscernible] to measure what these initiatives have done?

That's what you -- those are exactly the metrics. So if you're sitting in our boardroom, you'd hear a push and I'll be transitioning to being out of management, maybe I'll start giving this push. But hey, why aren't we charging for these services if they're so valuable? And there's elements where we can. The biggest levers we see to value creation are not a service fee. It's share capture and revenue growth, particularly for an existing account. If we get share of wallet, that's a very strong incremental margin and retention. So as a case in point, when we put in a vending machine, there's an expectation we have the customer will sign a letter of understanding. I mean it's not a legally binding document but saying, "Hey, in exchange for this, I will divert x amount of spend to you MSC from one of your competitors. And depending upon how big the machine is and how many machines, that number will vary. With In-Plants, so retention is another thing we look at. And if you looked at our retention rates for our core customer that doesn't have any sales relationship, they're going to be rather low and getting better but still low. If I go to the other end of the spectrum, an In-Plant, so we have 411-ish In-Plant locations that I could probably count on 1 hand the number that we've lost. They're extremely, extremely sticky.

Any other questions from the audience?

Well, let me take that 411, where were you 1 year or 2 years ago? Can that number be 1,000 [indiscernible] ?

Yes, north of that.

Yes, we were at 287 at the beginning of last fiscal year. Our 411 -- our In-Plant program count has been growing at a 20%, 25% year-over-year clip for quite some time. Vending has been growing at high single digit clip for quite some time as well.

And is every national account a potential [indiscernible]

I would say. Not every but a lot, a lot. So with the In-Plant program, different from a national account, the agreement is generally signed at the corporate level. The In-Plant decision is made at a site level because you're bringing the resources into the site. So we could have a national account that has 20 sites. It could have 2 or 3 In-Plants. There's typically a breakeven number of revenue that we need to justify putting somebody in there full time. Usually, it's a person and we're bringing vending machines in. So the cost becomes the cost of a person or people and then the depreciation on the vending machines that are in the plant. So it's a site by site. But let's put it this way. I mean, if we look out over time and the runway is in the thousands.

Do national accounts try [indiscernible] and then you've seen them roll them out, so most sites.

Yes.

Thanks for the questions. And anyone else that wants to shoot up a hand, please do. I've got more topics but certainly welcome anything from the audience. Yes.

A couple of questions. One is, it looks like about 60%, 70% is business related manufacturing [indiscernible]. There's an extended downturn [indiscernible].

Okay. So to that one, I would say, yes, look, we made a choice that we're going to lever into manufacturing and heavy manufacturing because we think our competitive advantage is strong. And we think the long-term end markets for the most part, are sound. That the growth outlook is good. I think if you want to understand what would happen in a heavy downturn, the last 2 years are evidence of that. So it does make us a bit more cyclical. The last 2 years, heavy manufacturing has been really soft. We saw negative revenues. Our thesis is that if we look over long periods of time, we are in, #1, manufacturing for the most part, as I said, we feel good about the long-term outlook. #2, the distribution market is so fragmented. So the top -- of the $200-plus billion in North America, the top 50 distributors have around 35% of the market. So you're talking about a lot of regional and local distributors that when things get soft, they struggle. And interestingly, if there's a strong recovery or a snapback, they actually struggle even more because in our business, a snapback means working capital and they don't have lines of credit to fund inventory build-out to extend receivables. So our premise over time is that, yes, we're going to be a bit more cyclical but it gives us an opportunity to widen the lead in downturns. The other thing I'd say is we are spending time. I don't see us straying away from manufacturing but looking more carefully in our manufacturing portfolio to say, what are some of the fastest-growing end markets. So I mean, aerospace is an obvious one where it's been strong and the backlog is a decade plus and that's an area where we actually have increased our concentration. There's a couple of others we have our eye on.

I'd also add that we're probably better positioned for a downturn than we were in this past one due to the seller effectiveness and optimization works we've done last quarter. Selling heads were down about 100 year-over-year -- quarter-over-quarter and about 60 year-over-year. Customer touches were up low double digits year-over-year. So we're being more effective and efficient with our sellers, too. And then if you think about the enhancements to the website as well, there is a mix benefit there from sales on the website. So I'd say we're better positioned to attack a downturn if it does occur.

Then one more question on -- it looks like you have -- correct me if I'm wrong, about 18% in In-Plant long back. If you look ahead like, let's say, 3 years, 5 years, where do you see that, that still increase?

Yes, we think it increases. It's -- the rate limiter on In-Plant as a percentage of total will be how our core customer fares because if we're able to grow -- the In-Plant will not make sense for most of our core customers because they're simply not big enough and there's not enough spend. I am hopeful that we can keep that rate down, not because In-Plant doesn't grow but because the core customer grows faster. I would say if you looked at our count, so we're at 411, as I said, I mean, that number in a few years should be well into the thousands, like we don't see a runway there. The interesting thing about In-Plants, so that's -- it's 20% today. If you look at the economics on an In-Plant, the gross margin on an In-Plant will be several hundred basis points lower than our core customer. And that's because bigger customer, better ability to negotiate, one. And two, we're penetrating deeper and deeper into the customer, which tends to mean lower margins. But what we do see on an operating margin basis, particularly by the time you get to year 3 and I can describe why, at or above company average and certainly at or above our target. So if we want to get to mid-teens operating margins over time, In-Plant is not a barrier to that when you get to year 3 because what happens is we put the person, we put the vending machines, all the costs goes in upfront, the revenue, it generally takes a good 2 years before you hit kind of like a steady state.

And then so you trade-off between your gross margins and maybe long-term operating margins?

Yes, yes, because it's a higher degree of fixed cost than the rest of our business. And we actually experienced that in the last 2 years with the softness that Ryan refers to as a coiled spring effect that our In-Plant Program. So if you look this last quarter, count was up -- In-Plant count was up 20-something percent. Revenues were up 10%. So on a per In-Plant basis, revenues were actually down. Now part of that is because we're signing newer accounts that have a lower average spend with us but also part of it is you take -- we have some really good In-Plant accounts in the heavy truck sector, which is just getting [ killed ].

How much does it cost for an In-Plant at a , let's say on average [indiscernible]?

So depending upon the size of the site, it could be between 1 and 3 people.

1 and 3 people and the CapEx associated?

And then depending upon vending machines, 10, 20 vending machines and then our average.

What I'd say is to -- when a In-Plant gets to about $2.5 million in sales, it's closer to company average op margin to give you a little bit of perspective there. The revenue through that In-Plant program, to Erik's point, we have the -- pretty much the maximum share of wallet we could have. The revenues from the In-Plant programs match whatever the production rates are. So if we see a customer go from 2 shifts to 1, that In-Plant program is really going to fuel that because consumption rates are lower.

So it's the same machine going in different places. The -- I'm just looking at scalability. I mean do you have to custom [indiscernible]

Our customs would be more on the vending machines because they're more catered towards metalworking. You can't have like a pop vending machine because if you drop that cutting tool, you're going to chip it. So I'd say we're differentiated on the vending side because it's more catered towards metalworking.

Okay. One last question. Talk about customer experience and how the larger customers, they know how to go through your system but then you revamped the stuff. What kinds of general things did you all do other than website redesign? Did you have to go change the back end, invest in the back end? I mean, can you talk about the...

Most of the customer experience improvements have been what I'll call either front end or technology foundation. If you're thinking back end, like our service level, our fill rates to customer, our product offering, our delivery model is good. And we track Net Promoter Scores every week. So we see we're really good at getting product to customers. The biggest thing was the experience. And if a customer -- if you're a customer and you call one of our -- what we call our customer care associates, you're going to get -- this goes back to the culture and the family field, pretty great experience and you get people who will jump over backwards to delight a customer and do whatever it takes. There's that kind of mentality. Our e-commerce experience, it wasn't good enough. It didn't match what we did offline. So I would say the easiest -- what we did first is we upgraded the tech platform and we modernize the stack just to make it much simpler, cleaner and that work is done.

So what's in more than upgrading [indiscernible], I mean, other than how it looks?

We had -- so it's -- I mean, it's -- #1, it's actually reevaluating the technology platform rather than looking at one monolithic platform, we broke it into pieces, which is a more modern modular way to go. Two is search. That's really the holy grail, if you will, when there's this many SKUs, the ability to find stuff fast. And so that actually leads me -- so we upgraded our search model and the way we present products. The other thing we're doing now that is, still got a ways to go, I would say, is content, the build-out of data and content. And I think what's exciting is that this is an area where technology, I mean, in particular, AI opens up so many avenues to build content faster because you could have the greatest search engine in the world but if the data behind the search engine is not robust enough, organized properly, it will be tough to find. I think there's still an unlock for us there. So I would say our e-commerce experience is the biggest thing about the customer experience upgrade. I would call us good now. I would say we were mediocre. I think we're good but we need to be great and we're not great yet.

And in this last fiscal quarter, web average daily sales turned positive for the first time in quite a while. We're seeing improvement in the conversion rates, average order size and the direct traffic. And then we also streamlined our checkout experience, too. And what we saw is within the first 0 to 5 minutes, somebody adding an item to their cart improved year-over-year for the first time in a while. So that's telling us, one, it's -- our search is working; and two, the checkout experience is working as well.

Erik, you mentioned AI, and that's the theme I want to end on today. Where are you in that journey? What are any examples you can share where you've deployed the technology internally?

We're very early stages. Let me start by saying, Tommy, I don't know that there's a better industry that's ripe for AI than distribution because we just -- we talked about millions of SKUs, thousands of suppliers, hundreds of thousands of customers, so all these permutations. So we think it's going to change the company and the industry in very fundamental ways. So I mean, we're in the very beginning stages. But we've taken a few steps and we've got a pretty robust road map right now. So the first thing we did is, we brought somebody and this was during COVID. So this was before generative AI actually. But we brought somebody to our Board of Directors who had lived in the AI early-stage venture space for 15 years. So she was in it well before generative AI because we wanted to have somebody with a network and a knowledge of working base on our Board. So the second thing we've done is we plugged somebody out of our company who she's really strong engineering and data science background. She's in Melville, where I'm located. She's really smart and eager and she's getting a lot of support from our Board and she's got a team. And basically, that team is chartered to build the road map along 3 vectors, if you will but look at every possible use case and catalog and prioritize for customer experience, revenue generation and productivity. And then we have like a game board, if you will, on what we've prioritized. In most cases, I mean, there's some obvious things that we're doing with whether it's Copilot or the real basic stuff. But in most cases, we're trying to be humble enough to say we don't need to go build this stuff. There's people way smarter than us that are building new things every day. And so we're trying to partner with companies outside of us who are in that ecosystem. So I mean, I'll give you a couple of examples. One is cross-selling and upselling. We've been partnering with somebody for a few years. But when a customer calls into us or visits our website, we are serving up highly relevant recommendations or -- and the numbers, we had tried this on our own before using AI and the numbers are just leaps and bounds ahead. We're -- marketing. So we've been talking about some of the success in our core customer was driven by -- and I'll just be careful for competitive reasons, the marketing efforts. We mentioned we're stepping up investment where it's working, AI-driven marketing, which is getting more personalized and more targeted and more real time is the big one. And then on the productivity front, you can imagine it's probably not that dissimilar to many of our peers looking at rote repetitive functions where there's cost-down opportunities. So all are in flight now.

I want to thank everyone for your attention and interest in MSC. And again, I want to thank Erik and Ryan for their time and insight. We appreciate it.

Thank you.

Thanks, everybody.