Oct 24, 2007
Executives
Chuck Boehlke - Executive Vice President and Chief FinancialOfficer David Sandler - President and Chief Executive Officer Shelley Boxer - Vice President of Finance
Analysts
David Manthey - Robert W. Baird Dan Whang - Lehman Brothers Scott Graham - Bear Stearns Jeffrey Germanotta - William Blair Brent Rakers - Morgan Keegan Adam Uhlman - Cleveland Research Company Robert McCarthy - Banc of America Securities Yvonne Varano - Jeffries & Company
Operator
Good morning. My name is Mat and I’ll be your conferenceoperator.
At this time I would like to welcome everyone to the MSC IndustrialDirect Fourth Quarter Fiscal 2007 earnings conference call. All lines have beenplaced on mute to prevent any background noise.
After the speakers' remarks there will be aquestion-and-answer session (Operator Instructions). I would now like to turn the call over to Eric Boyriven ofFD.
Thank you. Sir, you may begin your conference.
Eric Boyriven
Thank you, and good morning, everyone. I would like towelcome you to the MSC Industrial Direct fiscal 2007 fourth quarter resultsconference call.
You should have received a copy of this morning's earningsannouncement. If you have not received a copy, please call our offices at212-850-5752, and a copy will be sent to you.
An online archive of thisbroadcast will be available within one hour of the conclusion of the call andwill be available for one week at www.mscdirect.com. Certain information pertaining to non-GAAP financialmeasures that may arise during this broadcast can also be found on the samewebsite in the investor relations section.
Let me take a minute to reference the Safe Harbor statementunder the Private Securities Litigation Reform Act of 1995. This call maycontain certain forward-looking statements that are subject to significantrisks and uncertainties including the future operating and financial performanceof the Company.
Though the Company believes that the expectations reflectedin its forward-looking statements are reasonable, they can give no assurancesthat such expectations or any of its forward-looking statements will prove tobe correct. Important risk factors that can cause actual results todiffer materially from those reflected in the Company's forward-lookingstatements are included in today's earnings release and in the Company'sfilings with the Securities and Exchange Commission.
In addition, the information contained in this conferencecall is accurate only on the date discussed. Investors should not assume thatthe statements made in this conference call remain operative at a later time.The Company undertakes no obligation to update any information discussed onthis call.
With that said, I'd like to introduce MSC IndustrialDirect's President and Chief Executive Officer, David Sandler. David, please goahead.
David Sandler
Thanks, Eric. Good morning, everyone, and thanks for joiningus today.
With me are Chuck Boehlke, Executive Vice President and CFO; andShelley Boxer, Vice President of Finance. I'll be providing some details on the quarter, marketconditions along with updates on J&L and our West Coast growth initiative.Chuck will provide details on the financial results, including our thoughts ongross margin, operating expenses and how we will handle J&L in our websitemetrics.
After my closing remarks, we will open the lines for questions. Fourth-quarter results were solid, given the mixed state ofthe economy.
We continue to be pleased with our progress on J&L and havesuccessfully executed on our fourth quarter plan to complete the integrationand absorption of the J&L back office and distribution centers. We're also making solid progress on our plan to train andacclimate the J&L sales force in selling MRO products and other MSC brandsto our J&L customer base.
We are beginning to see progress on thisinitiative. This is a process that will take time, and we expect that theresults will continue to build throughout the year.
We're pleased to have met or exceeded guidance on all keymetrics in our business. We continue to execute our business strategy, takeshare and grow.
We exceeded the upper end of our guidance for both sales andearnings, and operating margins were slightly better than forecast. Expense control as well as gross margin execution continuedto be outstanding.
Overall, I'm very pleased with MSC's performance in thefourth quarter. In general, the market is reasonably solid with pockets ofstrength and pockets of weakness.
Since our last call, we have generally heardan optimistic tone from our customers, although tempered by their concern overthe liquidity crunch, oil prices and the possibility of another slowdown oreven a recession. Customer order flows have remained steady.
The ISM remainsin positive territory, although the two most recent readings have moderatedversus the preceding four readings. While the ISM points to growth, there are other conflictingindicators at this point such as we durables orders and a weak-housing market.We have factored this market information into our guidance for Q1 along withour plans to continue to invest in future growth.
And Chuck will add some morecolor to this later on in his portion. We continue to execute on our plans to penetrate the Westernregion of the United States and are in the process of opening three new salesoffices, Seattle, Portland and Salt Lake City.
We believe that we're just beginning to take advantage ofthe huge sales opportunity that exists in the Western United States. Of course,we're continuing to grow our sales force in the balance of the United States aswell.
The MSC sales force grew to 814 at the end of Q4, and weexpect that the sales force will grow to about 840 associates by the end of Q1.Last quarter, we reported on the successful migration of J&L to MSC'scomputer systems. During the summer months we completed the absorption ofJ&L support functions into MSC.
The estimated cost savings are now beingrealized and are included in our guidance for Q1 results. We are in the process of optimizing the customer experienceto bring the best of MSC and J&L to all of our customers.
At this point I am unable to share details, due to competitivereasons. But we're confident that the result will be a service model that'seven better than the industry leading model that we currently have in place andwill help to drive growth well into the future.
I saw some of the results of the combination of MSC andJ&L during our recent customer visit in the Midwest. This customer has beena J&L customer for many years.
They have relied upon J&L for the bulkof their metalworking supplies and then they have enjoyed ongoing savings fromJ&L's value-added solutions. The field sales associate serving this account has continuedto bring value to them since our acquisition of J&L.
The customer's plantmanager sees the combination of our two companies as a very powerful one. The addition of MSC's huge SKU base, CMI/VMI tools andaccess to many more quality private-label and branded products to the J&Lpackage has positioned our Company to further penetrate this account.
The customer trusts us to solve their problems and reducetheir costs. In the last year our business with them has grown about 60%, andour expectation is to see continued strong growth as we install DMI in theirTool Crib and begin to introduce the complete range of MRO products into theirplant.
Once again, my customer visits have shown me how wellpositioned MSC is for the future. I would like to provide some guidance for Q1.
At this point,we think that sales will be in the range of $435 to $441 million and dilutedearnings per share will be in the range of $0.68 to $0.70. Thanks and I'll now turn the mic over to Chuck.
Chuck Boehlke
Thanks, David. Financial results for the fourth quarter offiscal 2007 were excellent.
As a reminder, the fourth quarter of this yearincluded an extra week as compared to last year. This happens every five yearsas we true up our fiscal year to the last weekend in August.
Gross margin came in at 46.1%, within our guidance range. Ithink that it's important to review the components which impact our grossmargin, as the environment this year will likely be a bit more challenging.
The drivers of gross margin are the following. Number one,customer mix, as we grow our margin account program more quickly than othercustomer segments, we experience a diluted effect on gross margin.
Number two, the degree of inflation has an impact on grossmargin. We think that this year's inflation effects will be mild, and it willsee less impact from pricing that we have seen in the past few years.
Number three, our aggressive buy-better programs, whichincludes focus on private brand, better structured growth programs with keybrands and our re-auction program for commodities have an accretive impact ongross margin. And number four, product mix.
As you know, some of ourproduct lines carry higher margin than others. We think we have a solid processfor forecasting and managing the major components of gross margin and a solidtrack record for delivering results.
As we noted we think that this year will be a bit morechallenging, and accordingly we think the gross margin for all of fiscal year’08 will be 46.2%, plus or minus 20 basis points. We continue to experienceongoing success in our efforts to manage our operating expenses.
Our headcount remains under control. We realized somebenefits in the health cost area, and J&L integration expenses weresomewhat less than expected in Q4.
We expect there would not be any J&Lintegration expenses in the future. MSC's consolidated operating margin in Q4 was 17% of sales,including J&L integration costs of $1.4 million and amortization ofintangibles related to J&L of $1.9 million.
Earnings per diluted shareexceeded the top of our guidance range by $0.02. Benefits from exceptional operating cost management accountfor much of this.
Our expectation wasfor Q4 operating margin expressed as a percentage of sales to decline slightlyfrom Q3, reflecting the higher levels of investment spending that began at theend of Q2 of ’07. We intend to continue to invest at these higher levels inareas such as our sales force throughout fiscal year ’08.
Even with thisinvestment our expectation is that operating margin in Q1 will increase from Q4levels as we increase productivity, generate leverage in the business andrealize the anticipated cost synergies and savings from J&L. Balance sheet metrics remain solid.
Annualized inventoryturns were 2.95%, and accounts receivable DSOs were 43 days. Consolidated freecash flow, which we define as cash provided from operations with capitalexpenditures, was $34.8 million in Q4 and $138.7 million for fiscal ’07.
Free cash flow has continued a high levels and in Q4 we paiddown $25 million of borrowings under our term loan and purchased $11.1 millionof our stock in the open market. For all of fiscal year ’07 we purchased $75.2million of our stock.
Capital expenditures were $5 million in Q4, inline with ourexpectations, and totaled $26.5 million for the year. Total CapEx for fiscal’08 is expected to be about the same.
Before turning the microphone back toDavid. I would like to make mention of our business metrics onmscdirect.com.
As promised, we have included J&L in the metrics for Q4. Wedid substantial amounts of work following systems conversion in May to getcomfortable with the data and to make certain judgments about what we should beincluding.
We decided to leave out the effect of the UK operation, asthat business is not operated in the same manner as the U.S. businesssimilarly, we have excluded the J&L call centers from the call centermetrics, as those metrics are not relevant to the J&L call centerexperience.
We were also very thorough in illuminating the overlap incustomers from the count of active customers. If one entity did only $1 inbusiness with a customer of the other entity, we only counted that customerone.
With a large increase in the number of active customers,it's clear that there's a huge opportunity in the J&L customer base. Thankyou, and now I'll turn it back over to David.
David Sandler
Thanks, Chuck. I'd like to thank all of our associates for alltheir efforts and the outstanding results, which they produced in fiscal year’07.
We set new records for sales, profits, profitability and cash flow. During the successful integration of our largest acquisitionever, the service experience to our customers never faltered and in factreached new heights.
We expanded our footprint in the West. Invested substantially in our future and continued todemonstrate the strength of our model in terms of share gain and in leverage.On behalf of all of our stakeholders, I offer a heart felt thank you, and welldone to all of our associates.
Thanks, everyone and now I'll open up the linefor questions.
Operator
(Operator Instructions) Your first question comes from the lineof David Manthey with Robert W. Baird.
David Manthey - Robert W. Baird
A couple questions on the tone of business. I was wonderingif you could talk about what you saw in the pace of business and the trajectoryin September and October versus what you saw in August.
It looks like things picked up, and I'm wondering if that'sjust comps or if there was some underlying strength there.
David Sandler
Hi, David. It’s David.
It’s very tough to certainlycharacterize the four weeks of August. It's one of the two very heavy vacationmonths.
So, I can't say that the tone, frankly, was meaningfully different fromour customers during that period versus what we are really seeing right now. So, in general, customers, based on the segment that theyare in generally have an optimistic tone.
The environment is reasonably solid.Again, that's depending on which customer you go into really depends on howthey are feeling. But the other thing going on here, obviously, is what ishappening more in the macro, and that's also in customers mind.
David Manthey - Robert W. Baird
Okay and then, could you remind us, as far as pricing in theBig Book, I think you had previously said you thought you would achieve 1%, andI don't remember that was for fiscal ’07 or what you expected for fiscal ’08.Could you talk about pricing in both years?
David Sandler
Sure. I'll talk about it, I guess, in the quarter, and I'llalso talk about the Big Book.
The Big Book was basically if you add items oneby one by one, basically we took a little over a 1% increase, 1%, 1.25% if so. And then in the quarter, the impact of pricing was roughly,of the 8% growth on an ADS basis, of that growth, roughly 2.3% came from thecumulative effect of pricing throughout the year.
David Manthey - Robert W. Baird
Okay and the 1% to 1.25% is for fiscal ’08?
David Sandler
It's for fiscal ’08, specifically what you saw for -- anincrease in September's Big Book.
David Manthey - Robert W. Baird
Got it. Okay.
And then final question on margins at J&Lgross margins. Could you remind me in terms of how those compare relative tocore MSC margins, is there any material difference?
Chuck Boehlke
David -- the business is integrated and the purchasing and soforth is being done, obviously, here that accommodate all customers that areaccounted buying from -- MSC, J&L or otherwise. We had realized and hadbaked into our forecast that there would be substantial margin improvement bothon the growth side and the operating side.
And we feel confident right now atpost integration, we have achieved all the savings we said we were going toachieve.
David Sandler
And David. Having said that, we do see that the marginsbetween J&L and MSC historically, J&L has been lower.
We have achieved,as Chuck said, many of the improvements that we expected. We don't characterizebeyond that.
But your point about them being different, they are different.
David Manthey - Robert W. Baird
All right. Okay.
Thanks very much guys.
David Sandler
Thanks Dave.
Operator
The next question comes from the line of Dan Whang withLehman Brothers.
Dan Whang - Lehman Brothers
Yes. Good morning.
First question was regarding some of thegeographic trends that you saw in the quarter. I think there is somestrengthening, particularly in the Northeast, and maybe a little bit ofsoftening in the Southeast.
Could you perhaps go through some of the driversbehind those regional trends?
David Sandler
Dan sure. Sure I can.
I guess throughout all of the regions,certainly one of the drivers is our concentration in manufacturing. You couldsee on our website stats that manufacturing was at a significantly lower growthrate than our non-manufacturing business.
But then, within manufacturing, the two major componentsthere are what we'll call heavy versus light manufacturing. We don't break itout, but it's certainly something that we watch very closely internally.
Heavy manufacturing is actually durable goods manufacturing,and generally we've seen that durable goods manufacturing has been far moreheavily hit in terms of softness than the broader manufacturing economy. Andwhere you're seeing concentrated pockets of durables throughout our region,you'll generally see that our region has been more or less affected in theirgrowth rates.
Having said that, for example, in the Northeast you willnoted that the growth rate there has actually picked up. And given that the Northeast is our mostheavily concentrated in manufacturing and specifically in durables, you maycome back to me and say, David, I don't understand what you just said.
Based on your explanation, it should be down. Well, theother thing that we talked about is that, while we don't publicly discuss whatcustomer segments are up and down, the Northeast specifically has a couple ofsegments within durable goods manufacturing that are, frankly, very hot rightnow and we are taking advantage of the growth.
Dan Whang - Lehman Brothers
Switching over to the J&L, you're making great progressthere. Some of the backroom DC-related integration efforts are complete,focusing on cross selling.
In terms of potential use of free cash that'sgenerated and how another acquisition might play in, could you just commentaround that? If the right opportunity came along at the right price,would you consider another acquisition of something as sizable as J&L, orwould it be more kind of a bolt-on?
David Sandler
Dan, David again. We, in our strategic process, first ofall, I guess the short answer is we absolutely would consider an acquisition,either smaller an acquisition the size of J&L or frankly perhaps even onelarger.
The way that we'd make that decision is that, as we look atour strategic plan of the next five years, the acquisition candidate would haveto meet a very high bar, as did J&L, in terms of putting the business bothin a better strategic position and in driving our results over the next fiveyears, better than if we had not made the acquisition.
Dan Whang - Lehman Brothers
Great. I’ll let someone else have a chance.
Thank you verymuch.
David Sandler
Thanks Dan.
Chuck Boehlke
Thanks Dan.
Operator
The next questioncomes from the line of Scott Graham, Bear Stearns.
Scott Graham - Bear Stearns
Yes sir. Good morning.
We have several questions for you.The inventory number. I know that was run up a little bit because of theintegration of J&L, because of the warehouse stuff and the need to maintainservice rates.
When can we see that number start to come down?
Chuck Boehlke
Scott this is Chuck. I think you'll see for the short-termthat we have been very cautious with protecting fill rates for customers andhave actually used some of that inventory and increased it, actually, to helpprotect fill rates and make sure that we absolutely ensure the serviceexperience is the absolute best for the customer.
I think it will be towards the latter part of the year whenyou actually see us start to significantly hope we make progress on thatinventory number. Right now, as you can see from the cash flow and the balancesheet, there has been an inventory build, and we certainly think over time thatnumber will be coming down.
But I would not say it's imminent in the next monthor two.
Scott Graham - Bear Stearns
But it shouldn't go up higher?
Chuck Boehlke
Again, we're looking at fill rates and balancing thosedecisions. I don't want to sit here in an absolute vacuum and say that it's notgoing to be up any higher.
But for sure, over time, it will definitely the turnshould improve and we should be making progress in taking that number down.
Scott Graham - Bear Stearns
That’s fine. Thank you.
Okay on the national accounts, couldyou tell us what that contributed?
David Sandler
Scott, David. For competitive reasons, that's not a segmentor statistic that we break out.
Certainly, we measure it internally, but itisn't one that we talk about.
Chuck Boehlke
I think you maybe talking percent of growth.
David Sandler
Percent of growth. I can give you those…
Scott Graham - Bear Stearns
Yeah
Chuck Boehlke
It's a large number, a large accounts. Large accountsaccounted for 43% in the growth.
David talked about pricing before, that wasroughly 29% in the growth, and pure volume was about 28% of the growth when youlook at those numbers on an average daily sales basis.
Scott Graham - Bear Stearns
Okay great. And share repurchases in the quarter, I saw,were about $11 million.
What's left? And is there a new authorization,potentially, being sought by you guys with the Board?
Shelley Boxer
Scott, this is Shelley. There are still 2.5 million sharesleft on the authorization, so there's plenty of run room there.
If we were togo back to the Board, I don't think we would meet with any resistance. Scott,did you ask anything else?
Scott Graham - Bear Stearns
I do have one more. On the J&L savings, how will thatroll through gross margin versus operating expenses, do you anticipate?
Chuck Boehlke
That's split about 50-50. I'll give you some numbers for therecent quarter in the full year.
In Q4 alone, there was about $5 million ofsynergies that we expected to see out of J&L. That was split pretty much50-50 between gross margin and operating expense.
For all of 2007 including the $5 million for Q4, there wasroughly $10 million worth of synergies in there. Again, that was split roughly50-50.
As you know, we have commented publicly that we expected to achieve 20,and you should certainly see the full $20 million in fiscal year '08. We weighted a little bit more, about 60% OpEx, 40% margin,the difference being, rolling forward, the integration savings and back officesavings that we have experience in Q4 obviously will be annualized, and we willhave the full year benefit of all 12 months of those savings.
And I thinkthat's why the OpEx portion ramps up a little bit higher.
Scott Graham - Bear Stearns
That’s very helpful. Thanks you.
Operator
And next question comes from the line of Jeffrey Germanottawith William Blair.
Jeffrey Germanotta - William Blair
I am Jeff. Good Morning.
Chuck Boehlke
Hi, Jeff. You there?
Jeffrey Germanotta - William Blair
I'd like to explore some of the levers to the incomestatement for a bit. If we look back over the last several years, a lot of theearnings growth has been gross margin derived.
It sounds like, or maybe Imisunderstand, that it will be less gross margin derived going forward and moredependent on sales volume and yet further harvesting SG&A synergies out ofthe J&L acquisition. Is that correct?
And if so, can we talk about some ofthose levers a little bit?
David Sandler
Jeff, that's absolutely correct. As you heard, we gaveguidance that we thought the margin, for all practical purposes, would be plusor minus were it is about right now, given the less fertile pricing environmentthat we anticipate next year, which as you know, has generally been good interms of expansion of gross margin.
That being said, the operating margins are improvingyear-over-year. We would expect them to continue to improve with some of theproductivity plans we have in place, the full-year realization of the J&Lsavings I just mentioned.
I think a key element to consider, though, as you cansee from the headcount increase in terms of investing for sales, is thatthere's a higher level of OpEx associated with those investments. Our fourth quarter hiring was at, from an absolute number offolks brought on broad with us was our highest quarter, and obviously that OpExis reading through the P&L in Q1 and beyond.
And we’ll continue to investat those higher levels. So operating margins would continue to improve, butthey would be at a much smaller pace then perhaps, you seen in the past,partially because we're aggressively investing for sales growth for the future.
Jeffrey Germanotta - William Blair
And can you talk a little bit about productivity of yourcore sales base and then the productivity you expect out of the incrementalhires?
David Sandler
Jeff, we've talked a lot about the information that we makepublic, and we know that it's very tough for you to get underneath the classes,which is something that we measure, to really understand productivity.Certainly, we're seeing continued productivity improvements of our collectiveteam. I will tell you that in this environment we don't get as muchproductivity as we like, although the improvements certainly continue.
And as we've always talked about from our new members of theteam, new associates, it does take time to ramp up. So and you see the effectson our P&L of heavy investment spending.
They are dilutive. They are dilutivein the short-term, but as time goes on they become accretive and criticallyimportant to driving growth and also critically important to drivingprofitability in the business.
But near-term, certainly, they have a dilutiveeffect.
Jeffrey Germanotta - William Blair
And then last question, are you publicly talking about anytargets for your incremental operating profit margin, as you have from time totime in the past?
David Sandler
Jeff, we are not – I what we publicly talk about is the factthat we have achieved, we have used our read-through tools to achieve thelevels of profitability that we are right now, which is in the high teens. Andfrom here, our plan is to incrementally continue to expand our operatingmargin, frankly, albeit at a much more moderate pace than what you have seen usdo over the last few years.
Chuck Boehlke
I think it is fair to say that, though. From the guidancethat we have just given, at least for the first quarter, we have given salesguidance; we have given you gross margin guidance.
It's not real hard to figureout that the operating margins are definitely expanding in Q1, even with thishigher level of investment spending. Certainly over, it's a much higher level of investmentspending in the P&L for Q1 versus Q4, and despite that the operatingmargins continue to expand without any incremental help, if you will, from thegross margin line.
So yes, there's still plenty of leverage left in thebusiness, and margins continue to expand.
David Sandler
Just I guess last point, to double back on gross margin.Certainly, what we have characterized and tried to help provide some guidanceon is what we see for this fiscal year. Obviously, that's as far out as wewould be comfortable going with our gross margin.
But remember that we'reinvesting in many programs that will have a long-term effect on improving ourmargins, and that's certainly part of our long-term focus.
Jeffrey Germanotta - William Blair
Thank you very much.
David Sandler
Thanks you very much.
Operator
(Operator Instructions) Your next comes from the line ofBrent Rakers with Morgan Keegan.
Brent Rakers - Morgan Keegan
Good Morning. I think just a point, first, of clarificationon an earlier comments you guys made.
In talking about the synergies atJ&L, I believe you referred to a $10 million number in Q4. Does that assumethat the run rate was $2.5 million at quarter in Q4 and ramps immediately to$4.5 million starting in the next quarter?
Or how should we look at that?
Chuck Boehlke
Brent, this is Chuck. Let me clarify if I was unclear.
Forall of fiscal year 2007, there were $10 million worth of J&L savings bakedin the number, $5 million of which occurred in the fourth quarter. So there hadbeen some build throughout the year.
For example, the executive costs thatwe've shared previously, they were out for the entire year in fiscal year ‘07,and there's no ramp on that. In ‘08 that was baked in the entire year for ’07as well as being the same number for ’08.
The full year ’08 is the realizationof the entire $20 million worth of savings that we committed to, that we sharedwith everybody in the past, when we did the acquisition. So what you have, really, going forward into ‘08 and it prettymuch is linear in terms of $5 million a quarter to make the $20 million, isbasically the savings achieved in the fourth quarter, post integration, whichis a big driver behind many of the incremental savings, is now complete; youwill get the full-year impact of that quarter-by-quarter, pretty much straightline for fiscal-year ‘08 versus the way we experienced it in fiscal-year ’07,which was a small build because of the executive cost and then a big chunkdropping, in Q4, given that the integration was complete.
David Sandler
And don't forget, we won't have those integration costs thatwe had in order to do the work, but we will continue to reflect theamortization of the intangibles into the P&L.
Brent Rakers - Morgan Keegan
So basically, you extrapolate the Q4 rate into next year;you essentially realize those savings in Q4. But now, going forward, you losethe integration expense?
David Sandler
Correct, which was roughly $6 million or so, $0.06 a share,throughout the entire fiscal- year 2007.
Brent Rakers - Morgan Keegan
I wanted to just follow-up briefly on the gross marginadjustments or flat kind of numbers year over year for 2008. Should we alsoincorporate an impact on operating costs from not extrapolating gross marginmaybe 30, 40, 50 basis points higher?
Is there an impact on compensationexpense, for example, of having more flattish gross margin?
Chuck Boehlke
No. The plan and the way we compensate folks, contemplated agross margin in that range of 46.2.
And just to be clear, there's plenty ofgood things going on in gross margin. Had we not been doing anything or wouldwe not do anything just for, as I mentioned before, customer mix in the largeraccounts growing quicker than the core that would serve to drive margins down.We have buy-better programs and other initiatives to mitigate that.
What we don't feel we have in 2008 anywhere near thestrength we had in prior years, was this pricing environment that allows us toimprove and expand gross margins based on what we saw in our ability to takeprice increases and pass them along. That's the major driver, one of the moresignificant drivers in the maintenance of the margin.
But that aside, had nothing been going on, on cost down,margins by their own mix would have generally be dropping. That has not beenthe case.
Brent Rakers - Morgan Keegan
And then last question. Just maybe a clean-up question.Looking through the cash-flow statement, is there anything going on with baddebt expense in the quarter?
David Sandler
No. Higher volumes, if you look at our sales growth in Q4,clearly, it was a little bit less than it was early on in the year, and webasically not had any kind of real bad experiences.
We obviously, when you integratea system, the customers that are left over from the integration from J&L.There's a piece of, cleanup that has to take place there. But that's a smallpiece and one-time and behind us now.
Brent Rakers - Morgan Keegan
But you do agree it was up on a year-over-year basis fairlysignificantly? So that's a one-time cleanup related to the systems, internally?
David Sandler
I think some of it systems related. I think some of it isvolume related.
Our sales were a good bit higher. I think there's still a pieceof receivables in there we provided for, that were made into the last severalhundred thousand dollars of open receivables from the old J&L system isgoing to be difficult to go back and collect, but I would not read into thatthat we've got an ongoing change in credit quality or receivables managementgoing forward.
Brent Rakers - Morgan Keegan
Okay. Thank you.
David Sandler
Thanks Brent.
Operator
Your next question comes from the line of Adam Uhlman with ClevelandResearch.
Adam Uhlman - Cleveland Research Company
Hi, good morning. A question for you on the guidance, firstof all, on the sales growth guidance of 8% to 10% for the quarter, for thefirst two months of the quarter, you're already running at the high-end of thatrange at 10%.
How should we be thinking about, are you nervous about thesales progression going into November? I guess, the comps are a little bit moredifficult, but I guess, first of all, you're already running at the top end ofthe range.
Why the cautious comments there?
David Sandler
Great question, Adam. The reason for is that the one datapoint that none of us have yet other than, certainly, in the forecast tocomplete our guidance for the quarter specifically is November.
Two thingsgoing on in November that are worth noting. First of all, we had a comp, lastyear we had a pretty significant one-time government order that we're factoringin that won't reoccur this November.
The other than going on is that, in November, the way thatthe Thanksgiving Day holiday falls, typically what we find is that thefollowing week after Thanksgiving, the beginning of the week is generally a bitmore sluggish as customers get back with a full belly of turkey. What is happening is that the way that it falls this year isthat, that second week following Thanksgiving actually falls in this quarter,whereas last year that week fell in December; so a mismatch of quarters.
Adam Uhlman - Cleveland Research Company
Okay, thanks then. It’s very helpful.
And then, switchingback to the gross margin guidance again, not to belabor this point. But, Chuck,you had outlined four different drivers to gross margin, customer inflation,better-buy programs and product mix.
Keeping the gross margin flat this year,should we assume that those are, the customer mix is the biggest headwind, andinflation is the second-biggest headwind to the performance in 2008?
David Sandler
For 2008, now, what we've said is that the pricing environmentis very different for 2008. I think if you want to isolate all those factorsare moving pieces of the margin calculation.
If you want to isolate one that'ssignificantly different than what we've seen in the last, really, 12 quarters,almost, it's that we don't right now perceive the pricing opportunity that wesaw in the past. Mild inflation has been absolutely good for us in terms ofhelping us to improve the gross margin.
You've seen the steady climb over the last 12 quarters. Wedon't see that pricing environment being there right now, and that's the reasonfor the guidance of the margin or one of the major reasons, if not the biggest,for why gross margin may stay in the area it is right now.
Adam Uhlman - Cleveland Research Company
Okay. Great.
And then the last clean-up question here. Wewere talking about inventory levels earlier.
Could you talk about what yourworking capital targets are for the year? Where would you like to getinventories to by the end of the year?
David Sandler
We didn't specifically talk about inventories and targets.But, much like this year, I would tell you that our expectation is to turn asignificant piece of our net income into cash flow from operations and provide,last year it was in the neighborhood of 95% of the income, net income that wegenerated flowed through in cash. I think that's the metric that we're lookingis the conversion of cash without specifically giving you exact data points forwhere we'll be on inventory and receivables and so forth.
Adam Uhlman - Cleveland Research Company
But a similar conversion ratio that…
David Sandler
Similar to last year, yes.
Adam Uhlman - Cleveland Research Company
Thanks.
David Sandler
Thanks, Adam.
Operator
Your next question comes from the line of Robert McCarthywith Banc of America.
Robert McCarthy - Banc of AmericaSecurities
Good morning everyone. So, can I just drill down a second?
Ithink you talked about in the Northeast some clients really seeing some prettynice growth there. Were those clients levered to a pretty active export marketin terms of demand for the growth of their goods abroad?
Do you have any kindof insight into that?
David Sandler
To be honest, I wouldn't want to characterize, probably fortwo reasons. One is that I don't want to tip my hand more than I have on whatthose segments might be.
The other is that there's only so much informationthat we really have on our customer base and any specific customer. Certainly, a lot of the larger multinationals are, some arehaving a lot of success based on the weak dollar and what's happening with theexporting environment.
I probably wouldn't want to go further than that.
Robert McCarthy - Banc of AmericaSecurities
Understood. Then, just obviously we could be at the tippingpoint here in the US economy.
I think you've adequately highlighted some of therisks surrounding that. Could you perhaps articulate what your rainy daystrategy would be in that case, when we would start to hear about it and how itwould maybe alter some of your spending patterns, some of your emphasis oninvestment and your pecking order in terms of capital allocation?
David Sandler
Bob, I'm not going to give you an exact pecking order. I willtell you that we've had a process in place, call it our rainy day strategy, forsome time.
Part of it depends on whether it's a rainy day or whether themonsoons are here for a protracted period of time, as to how we would kind ofturn the dials on our business. Certainly, we've got the ability to turn down a bit, basedon the timing of some of our hiring, some of our investment hiring, some of oursales programs like direct-mail, the degree of which we are investing in ourbusiness, the degree of the level of investment hiring and all.
We try and gauge all of that, and we've got those dials toturn, which we do turn in the spirit of, frankly, balancing what we see,achieving short-term profitability coupled with the appropriate balance oflong-term growth. And so those dials get turned, depending on what we'reseeing coming around the corner.
I think we've got unless something reallydramatic occurred like what we saw many years ago after 9-11, I think we areable to turn those dials so that we can certainly maintain our operatingmargins and also maintain what we target, which is earnings growth in excess ofsignificantly, actually, in excess of our revenue growth.
Robert McCarthy - Banc of AmericaSecurities
Have you seen any, basically, retrenchment in terms ofinvestment by competitors or any kind of smaller competitors in terms ofinventory service, etcetera, that would lead you to believe that we areentering a slower patch?
David Sandler
I'd rather not characterize anything that we're seeing,certainly, from some of our larger competitors. Smaller competitors are alwaysscrappy in a more difficult environment.
They generally only have one weaponthat's not so, they've usually got two weapons. But the primary is pricing, theother is the depths of their relationship.
I guess the only other kind of indicator and that's prettytypical of what we would see in an environment like this. I guess the onlyother is that we've been extraordinarily successful in attracting newcandidates to MSC.
We are, I guess, a pretty exciting place in industrialdistribution, and so it has been really fertile ground for us to attract newcandidates, and new members to our team. I think that's also indicative of theenvironment being at a place where you can really count on the level of servicethat's going to be consistently and reliably delivered to a customer and havinga value basket that, frankly, we think can't be beat.
Robert McCarthy - Banc of AmericaSecurities
Understood. I’ll leave it there.
David Sandler
Thank Bob.
Operator
Your next question comes from the line Yvonne Varano withJefferies.
Yvonne Varano - Jeffries & Company
Thanks. I know J&L UK is a small part of the business,but can you just comment on what you're seeing in the markets over there, whatthe plans might be for that business going forward?
David Sandler
Yvonne, it’s David. How are you doing?
As we've said, we'vedone a lot of work through the spring and through the summer on systemsmigration, getting the backend fully assimilated. The team is very focused onnow beginning to train, assimilate and grow our business.
Frankly, one of the core drivers, we said, is taking the MSCproduct line and, in particular, our MRO line and beginning to penetrate theJ&L customer base. That's really the primary focus.
Some teams have been fully trained. Other teams that drivegrowth are in varying stages of being trained.
That's a current focus, and it'ssomething that will occur, really, throughout all of 2008. And we think that once we're fully assimilated and trained,the growth, which is relatively small now but growing, will grow throughout allof 2008 and contribute in a much more meaningful way in fiscal 2009.
Yvonne Varano - Jeffries & Company
Do you see J&L UK, though, as a platform to continue tomake acquisitions?
David Sandler
Certainly, we're not ready to comment on what we see for theUK. We will tell you that the business very well could be a platform.
They'vegot a great team. We've really got a nice little infrastructure over there.
The market, as we are learning and continue to learn, seemsto be very fragmented and we think may in fact be a platform, certainly, to theUK and maybe even beyond, into Europe. It's a bit premature.
Certainly, it's not what our currentfocus is, although certainly the focus of the terrific UK team and justcontinuing to execute their plan and grow their business. But the bottom lineis we do think that it's a really good opportunity for us, long-term, in thefuture.
Yvonne Varano - Jeffries & Company
And what are you currently seeing in the UK in terms of theoverall market?
David Sandler
Actually, their economy has been pretty good. But we don'tbreakout or characterize the growth rates that we're achieving over there otherthan to say that we're very pleased with the results.
Yvonne Varano - Jeffries & Company
Great. Thanks very much.
David Sandler
Thanks a lot.
Operator
Your next question comes from the line of Adam Uhlman withCleveland Research.
Adam Uhlman - Cleveland Research Company
I had a couple of questions regarding the supplemental dataon the website. First of all, the Web sales category, it looks like you addedJ&L and income to the numbers.
What was the growth for only mscdirect.com,on a comparable basis?
David Sandler
I'm looking at them, and do you have the, show if you havehere.
Shelley Boxer
Yes. We're not going to break that out anymore.
The Websites do have different value statements on them. They're all being processedtogether.
There is a lot of crossover buying going on now between J&Lcustomers and MSC customers, frankly, both ways. And that's great for us, so that statistic starts to looseany real meaning.
So we're looking at the things together. That's the way we'regoing to report it from now on out.
David Sandler
Great, so that $115 million in a quarter, actually on anannualized run rate. I don't know if it shows there, but we are now at justunder 26% of our business and that growth with the three sites on anapples-to-apples is actually about 29%, 28.8%, so, very strong growth and avery meaningful contributor in the business.
Adam Uhlman - Cleveland Research Company
Okay. Great, thanks that’s helpful.
And then you typicallyprovide a forecast of what you are thinking about direct-mail shipments pieces,either for the first quarter or out a couple of quarters. How should we thinkabout that in the first quarter and the few?
David Sandler
I'm actually looking to see if …
Shelley Boxer
It's not on the website. In the past, we have includedinformation about the rest of the year on an estimated basis.
We'll put it upagain probably at the end of the first quarter. I don't think you're looking atanything in the first quarter that's substantially different than where we havebeen going.
David Sandler
And Adam we will get that projection re-posted. You areright; we typically do that.
Adam Uhlman - Cleveland Research Company
Okay. Great, thanks.
And then the last question, I had foryou is that, it looks like you had included the J&L numbers into theaverage transaction size as well. Was that dilutive to your average transactionsize or accretive?
How should we think about the underlying progression of theaverage order size?
David Sandler
Adams, it's now all blended in, but I will tell you that isdilutive to our average order size, which means that obviously, since we grew,there are other factors within MSC and some of our large customer programs thatdrove it higher, given the fact that the J&L, when we blended in wasdilutive to it.
Adam Uhlman - Cleveland Research Company
You’ve been running like 6% to 8% year-over-year growth andaverage transaction size for most of the year. Do you think, on a comparablebasis, we're still in that same range?
Or how would you think about that on anapples-to-apples basis?
David Sandler
I think I'm not going to characterize breaking it outbetween the two, because again, it's one of the reasons that we have been verycareful to not break it out is because the accuracy of breaking out thosemetrics, we don't want to go there.
Adam Uhlman - Cleveland Research Company
Okay. Great, thanks.
David Sandler
Thank you.
Operator
There are no further questions at this time. I would nowlike to turn the call back over to management for any closing remarks.
David Sandler
Okay. Well, thank you, Matthew, and thank you all for yourtime and your interest today and we look forward to speaking to you nextquarter.
Bye-bye.
Operator
This concludes today's MSC conference call. You may nowdisconnect.