Keysight Technologies Q3 2022 Earnings Call Transcript

Quartr
Provided by Quartr
October 13, 2022

There are 9 speakers on the call.

Operator

Greetings, and welcome to the Fastenal 20 22 Third Quarter Earnings Results Conference Call. At this time, all participants are in a listen only mode. A question and answer session will follow the formal presentation. As a reminder, this conference is being recorded. I would now like to turn the call over to Taylor Ranta of Fastenal Company.

Operator

Thank you. You may begin.

Speaker 1

Welcome to the Fastenal Company 2022 Third Quarter Earnings Conference Call. This call will be hosted by Dan Swarenich, our President and Chief Executive Officer and Holden Lewis, our Chief Financial Officer. The call will last for up to 1 hour and we'll start with a general overview of our quarterly results and operations with the remainder of the time being open for questions and answers. Today's conference call is a proprietary Fastenal presentation and is being recorded by Fastenal. No recording, reproduction, transmission or distribution of today's call is permitted without Fastenal's consent.

Speaker 1

The call is being audio simulcast on the Internet via the Fastenal Investor Relations homepage, investor. Fastenal.com. A replay of the webcast will be available on the website until December 1, 2022 at midnight Central Time. As a reminder, today's conference call may include statements regarding the company's future plans and prospects. These statements are based on our current expectations, and we undertake no duty to update them.

Speaker 1

It is important to note that the company's actual results may differ materially from those anticipated. Factors that could cause actual results to differ from anticipated results are contained in the company's latest earnings release and periodic filings with the Securities and Exchange Commission, and we encourage you to review those factors carefully. I would now like to turn the call over to Mr. Dan Portnus.

Speaker 2

Good morning, everybody, and thank you for joining us for our Q3 earnings call. We had a good quarter. When I look at the performance of the team, I'm proud to be a member of the Blue team. The 16% daily sales growth that we In the quarter, we were able to translate that into 19% operating profit growth. And ultimately, we are also able Translated into strong operating cash flow growth.

Speaker 2

We grew our cash flow 54% from the Q3 of 2021 to Q3 of 2022. And an expansion of our ability to generate operating cash relative to our level of earnings, we haven't been able To lay claim to that for over a year and a half, I believe you have to go back to prior to 2021 where you can see that. And it was really great execution throughout the organization and the fact that supply chains Have become a bit more stable and that doesn't mean they've become easier. It just means they've become more stable and You can rely on what you're seeing in your level of safety stock. It doesn't need to be quite as deep.

Speaker 2

As far as customer demand, that was stable throughout the quarter. Now September's 2.7 percent sequential growth versus August does lag the way we look at the historic pattern and History would say we should be up 3 3.4 percent. The real driver of that is if you look at the storms that hit the Southeastern United States, Hurricane, Ian. And late in the quarter and essentially pushed some business out of September and into October, The storms likely reduced our sequential DSR by about 0.5%. And so you can do the math on what it would be if that's added back in.

Speaker 2

But We see it as stable demand. And in the next bullet, touch on the fact that we are preparing for a softer 2023. So I thought I'd share some thoughts on what does that mean. Now first off, I remember back in the fall of 2015, I believe it was a Tuesday morning. Don't quote me on it.

Speaker 2

But the day before we'd had our Board meeting and I learned after that Board meeting that I'd been selected as the next President Seal will pass it on. And it was a pretty tough environment for not just the organization, but for industrial Entities in general. And the next day, I during the Q and A Section, I was probably a little more animated than I typically am and I commented on what I saw as the state of the economy and The next day, my wife informed me that I was on the front page of the Wall Street Journal without my mouth. So we're not in that kind of environment. We're not in something where I'm going to proclaim something, but we are preparing for a softer 2023.

Speaker 2

And a lot of that centers on 2 things. One is something that has nothing to do with 2023. If you've been on the call ahead an hour or 2 hours ago with our leadership around the planet, I talked I gave them the typical October talk and that is we are a seasonal business. And if you look at History, history says between September December, our daily sales typically drop off 12%, 13%. And I'm going back To the time before COVID and even before some of the tariff period, I'm going back to the 2017, 2016, 2018 numbers.

Speaker 2

And just looking at Sequential patterns, that should not be a surprise to anybody listening to this that a business that operates in Northern North America, a big chunk of revenue in North America, After you get past Canadian Thanksgiving and get to the U. S. Thanksgiving and get to Christmas, the business slows down, we're preparing ourselves for that. When we're talking about 2023, it's really about a lot of the numbers we're seeing. And again, they're not numbers that are Unique to our lens, I'm looking at industrial production and Holden will touch on some of that here later.

Speaker 2

But Looking at industrial production and what some of the forecasters are predicting. But the most important feedback that we focus on What are our regional and district leaders hearing from their customers as far as their confidence going into 2020 3. And I'll be honest with the group, that confidence isn't strong. It's not, hey, the sky is falling, but the confidence is very, very cautious And we're preparing for that type of environment. And that means that you're very thoughtful about where you invest.

Speaker 2

You're very thoughtful about not getting ahead of yourself. Now we've signed a lot of on sites this year and that gives us resiliency going to next year and I'll touch on that in a second. But what it means is you staff for the things you know, but you don't get ahead of yourself And that's the mindset we have going into 2023, whereas a year ago and 2 years ago, we were staffing for both. And it's just a bit of caution in the air. Last week, I was traveling in Europe, my first trip Human beings, even this human being is a social creature.

Speaker 2

And there's a certain energy you get And a certain rapport you can get and a level of communication and intimacy you can get by meeting people in person. And it was a wonderful trip. I spent some time with our folks at what we call Ehub, which is our distribution facility up in the Netherlands. And most of our European leadership were there for that discussion. And then I traveled down to Northern Italy, primarily Lombardi area of Northern Italy and met with our team there.

Speaker 2

And what stands out is the last time I was Visited this group was in fall 2017. How the group has grown just to answer your numbers, but grown in talent And business acumen was really impressive. And despite all the stuff that's going on in Europe over the last 3 year actually the globe, but then more specifically Europe in the last 12 months. That business is 80% bigger than what it was in 20 And that's telling the story in U. S.

Speaker 2

Dollars. If I left it in local currency, it'd be closer to 90. And I think back to when I was there, which was 2 years earlier, we haven't tripled in size, but we're pretty close to it. And so it's really a powerful story about The marketplace around the planet has identified in Fastenal what is special about Fastenal over the years. And I'm glad to say that we're replicating that with our team in Europe.

Speaker 2

The one thing that is a positive despite what it looks like in the numbers, it's a positive. And that is The pre pandemic margin profile of the business has reemerged. And back in 2016 2017 2018 when we were really Telling the story of how we thought our growth was going to change in the future and those will be much more on-site driven. It changes the profile of your gross margin, But it also changes the profile of your operating expenses. And we felt over time that was a great trade off because ultimately It's about the level of profit and return you can generate and is this a faster way to grow and a better way to develop your talent and be special in the marketplace, we thought it was, but it was explaining how those dynamics would work.

Speaker 2

Mix driven lower gross margin did occur in the quarter. Strong expense leverage also occurred Very much in line with the story we were telling 5 years ago. And I'm pleased to say that after a period of time where our Operating margin was kind of stuck within 20 or 30 basis points of 20% for a number of years. Year to date, we've been able to break out of that and move it up to 21% or actually slightly better. So very pleased with that.

Speaker 2

And then finally, I touched on it earlier, really impressed. I'm a former CFO, so looking at our cash flow statement for the last couple of years, It was tough for Holden, it was tough for Dan too. And I'm really pleased to say when I look at the cash flow statement that for the first time in Quite a few quarters, 6, 7 quarters. I can look at the year over year numbers and say it's improving. Our cash flow is improving.

Speaker 2

And I believe it has staying power because I look at the things we're doing to create it, the environment that's allowing us to create it and the tools we're deploying to maintain it and We've never been in a better position to improve our ability to generate cash. Flipping to Page For the book book, on-site signings softened a little bit during the quarter, 86. So total active on-site is 1567, Up about 15% from a year ago. Our goal for the year of 375 to 400 remains intact. Given where we are and it's in the early part of October, we expect to be in the lower end of that range.

Speaker 2

FMI Technology, We signed 5,187 weighted devices, that's about 81 per day. A year ago, we signed 75. I'd be lying to you if I didn't say I'd like that number to be closer to 100 and at least starting with a 9, But we're getting good execution. What really stands out is the what's happening with that business from the Point of the revenue per device, how it's expanding nicely from what we've seen. The fast bin element of it, We're putting up really impressive numbers.

Speaker 2

One of the things I shared with our Board yesterday is If you look at that discrete number of signings per day, a couple of years ago, one of those signings It was a fast spin. Today it's 15. And so it's rapidly expanding throughout the organization and really impressed with the way our Teams in the field have embraced the technology and the way our customers like the technology too. You look at e commerce, Daily sales through excuse me, and our goal for the year of 21,000 to 23,000 Unit equivalents for FASTBEND and FASTBEND signings remains intact. Finally, daily sales for e commerce rose 50%.

Speaker 2

And e commerce is an interesting one because for years, I think back to when I stepped into this role, e commerce was about 5.5 percent of our sales. And it has been stuck there. That was stuck in purgatory. And because it wasn't how we went to market, We're a service organization. We're not a catalog standard organization or an e com company.

Speaker 2

We're a service we're a supply chain partner. And part of it was we had to Admit to ourselves that's what we are and that's a beautiful thing. And then how do we play those strengths. And so we've really, I believe, found a way to make this Part of our business, in the quarter, we hit $5,000,000 a day going through e commerce. And it wasn't too many years ago that we were starting out in that journey.

Speaker 2

So really impressed with the team. Then finally, our digital footprint. We've talked about that. It's really about widening the mode, illuminating supply chain for our customer In making supply chain more efficient for both ourselves and our customer, I'm pleased to say that we've grown that to 49.5 Percent of sales in the Q3 versus 43.7 a year ago. And we've talked about our Our goal to hit 52% of our sales were in through digital footprint sometime in 2022.

Speaker 2

That's still, our goal. In fact, in the month of September, We came in at 49.9%. So if you would excuse me a second, I'll just round it up and say 50% of our business is now the digital footprint, and we see that continue to grow as we move forward. The other piece, And this is touching back and I didn't touch on it with the e commerce a second ago is not just have our numbers improved, But one thing we always look at internally is our level of participation. In other words, how much is everybody doing, not just A few leaders in the organization.

Speaker 2

So if I go back to 2018, 17% of our branches had more than 10% of their sales in e commerce. 2 years later in 2020, that number had grown to 25% of our branches had more than 10% of their sales in e commerce. I'm pleased to say in the Q3 of 2022, 52% of our branch and on-site locations excuse me, of our branch locations had over 10% of their revenue in e commerce. So this 18% that we hit in the Q3 isn't coming from a few. It's coming from a lot of activity throughout the organization, which means it's becoming part of our DNA.

Speaker 2

And that's how we found success in vending a decade ago, how we found success in On-site over the last 5, 6 years and what we're seeing in e commerce today. With that, I'll turn it over to Holden. Great. Thank you, Dan. I'll start on Slide 5.

Speaker 2

Total and daily sales increased 16% in the Q3 of 2022. Growth did decelerate by 200 basis points from Q2 of 2022 and September's DSR growth is below the historical norm. However, a lot of that was due to comparisons. Price contribution in the period was 110 basis points below the Q2, which we expected. Relative to the Q2 of 2022, we also saw difficult government comps that cost us about 20 basis points, foreign exchange cost us about 10 basis points and the impact of Hurricane Ian on our Atlantic coastal region cost us about 20 basis points as well as 50 basis points in September.

Speaker 2

At the same time, we experienced robust 22.6% daily growth in our manufacturing end market, 18.2% daily growth in our fastener product line and 20.8% growth in national accounts. Regional VP feedback had a more had a few more Pricing contributed 550 basis points to 5.80 basis points to growth in the Q3 of 2022, Moderating from the Q2 as we began to grow over the pricing actions that started in the Q3 of last year. While many commodity indexes have recently fallen from their peaks, Global supply chains are filled with product where costing reflects the higher commodities of a number of months ago. It will take several quarters for lower costed product to find its way point of use and we continue to see supplier letters seeking to recover these costs. These variables have supported stable product price levels in the marketplace.

Speaker 2

Overall, the Q3 of 2022 reflected stable demand, stable price levels, but tough comparisons. At this time, we don't have a reason to believe that those conditions will change in the Q4 of 2022. However, as always, our visibility into the future is limited and the uptick in caution that our regional VPs are receiving from their customers, while far from universal, is still notable and something we need to watch. Now to Slide 6. Operating margin in the Q3 of 2022 was 21%, up from 20.5% in the Q3 of 2021.

Speaker 2

Our incremental margin was 24.5%. Gross margin was 45.9% in the Q3 of 2022, down 40 basis points from Q3 of 2021. This quarter's results had a lot of moving pieces. The first piece I'll address is price cost, which relates specifically to fasteners and with a negative 30 basis point impact on the period. Over the past 15 months, the Blue team has done a remarkable job defending our profitability In an environment where fastener costs are rising as much as 30%.

Speaker 2

At this stage of the cycle, the marketplace is less receptive to further price increases even as higher cost Product is still being imported. As I indicated earlier, product pricing in the marketplace is stable and there are tenuous signs of product inflation easing. The timing of product flows suggest that while price cost may remain negative for a couple of quarters, the magnitude is likely to moderate going forward. The second piece impacting gross margin is a write down, this time of Nitrile gloves, which pulled gross margin down 20 basis points. This is very similar to the glove write down we had in the Q1 of 2021 Mask write down.

Speaker 2

Mask, sorry, mask write down that we had in the Q1 of 2021. In that, it derives from decisions that we made during the pandemic to support our customers. And with the stresses of the pandemic waning, the value of our inventory relative to the market became inflated. We believe this is a discrete event specific to the Q3. The 3rd piece is customer product mix, which was 40 basis points dilutive based mostly on relative growth from our national accounts and on-site customers, which I believe everyone understands is an anticipated byproduct of our growth strategies.

Speaker 2

These three impacts were partly offset by continued strong growth in Freight revenues of 30.6 percent, which is narrowing losses related to maintaining our captive fleet and leverage of organizational expenses as Higher volumes absorbed overhead. We achieved 110 basis points of operating expense leverage in the Q3 of 2022. The largest contributor to this leverage was occupancy expenses, which reflects our branch rationalization. We also achieved leverage over employee related costs due to primarily lower healthcare expenses and to a lesser degree moderating annual growth in total compensation expense. We also leveraged other operating Putting it all together, we reported Q3 2022 EPS of $0.50 up 17.4 percent from $0.42 in the Q3 of 2021.

Speaker 2

Turning to Slide 7. We generated $258,000,000 in operating cash in the Q3 of 2022 or approximately 91% of net income in the period. This still trails the conversion we might normally expect in the Q3, reflecting the ongoing impact of steps taken with working capital to support our customers. However, this was the first time in 6 quarters that our conversion has improved year over year. As product availability in our hubs has reached our goal, We have been able to slow our inventory build even as improvement in the supply chain has allowed us to slightly shorten domestic and import ordering cycles.

Speaker 2

These factors should improve cash conversion rates in future periods. Year over year, accounts receivable was up 17% On strong customer demand and an increase in the mix of larger key account customers, which tend to have longer terms. Inventories rose 19.8%, continuing to reflect On an annual basis, strong customer demand, higher inflation and our hub inventory build. However, an improving supply chain and moderating inflation impact Contributed to a sequential improvement in our days on hand from 161 days in the Q2 of 2022 to 157 days in the Q3 of 2022. This continues to trend roughly 10 days below the pre pandemic level despite the challenges in the last 15 months, which reflects increasing and sustainable efficiencies in how we manage our inventories.

Speaker 2

Net capital spending was $44,000,000 in the Q3 of 2022, mostly flat with the Q3 of 2021. Year to date, net capital spending was $121,000,000 up 13% due mostly to increased spending for FMI hardware, Hub Automation and Upgrades and IT Equipment. We are reducing our 2022 net capital spending to a range of $170,000,000 to 190,000,000 down from $180,000,000 to $200,000,000 This reflects slightly lower FMI spending, slightly lower vehicle spending on continued availability issues and higher asset sales. We returned cash to shareholders in the quarter in the form of $178,000,000 in dividends and $95,000,000 in share buyback. From a liquidity standpoint, we finished the Q3 of 2022 with debt at 14.9% of total capital, up from 11% in the Q3 of 2021 and 13.7% in the Q2 of 2022.

Speaker 2

With that, operator, we'll turn it over to Q and A.

Operator

Thank you. We will now be conducting a question and answer Our first question has come from the line of David Massey with Baird. Please proceed with your questions.

Speaker 3

Good morning. Hi, Dan, Holden. How are you guys doing?

Speaker 2

Good morning, Dave. Good.

Speaker 3

Hey. So as you're thinking about gross margin into 2023, If pricing remains flat like you say it is right now, won't margins gross margins that is come under pressure as you cycle through rising cost Good sold because of your FIFO inventory method. And on Slide 5, you said the material prices have started to decline, while market prices remain I'm just trying to understand how you're thinking about gross margin here and where those lines intersect?

Speaker 2

So as you know, through most of this cycle, we've been Fairly flat from a price cost standpoint. And that reflected our ability to kind of match the cadence of our price increases with how we're seeing costs come through. As you pointed out, we have a long supply chain and we're at the point now where on one hand, Pricing levels are stable, but we're still seeing some product come through that was bought months ago that was at a higher cost in the marketplace That's impacting us and that's where the 30 basis point drag from price cost sort of evolved to in Q4. But what we're also seeing Is that and you look at the same indices we do, right? I mean, we're starting to see that material costs, things like steel Have come off from prior peaks.

Speaker 2

And what we're therefore seeing is as product is now getting on boats in Asia and it won't be here for months months, right. It won't flow through our supply chain. It takes time. You're starting to see that the inflation in those in that product Has begun to come off. In fact, if I think about September, September August cost levels of product that we're purchasing was fairly flat.

Speaker 2

The first time that's been true in a long time. We've been seeing sequential increases as things have flowed through. This is the first time that we've seen that number flatten out. And so I think that what that tells you is that we were a little bit shy of all of the cost In our pricing actions, we had that impact us in Q3. As that Less inflated or non inflated product begins to work through several quarters from now with price levels being where they are, that should all stabilize.

Speaker 2

We had a 30 basis point drag in Q3. I think in Q4, perhaps in Q1, there'll still be some of that, I don't expect it to get worse. I think it will be basically at or better than that level. And then by the time you get into the middle part of next year, we're going to see some of that product that It looks like it's moderating in terms of cost coming back into our system.

Speaker 3

All right, Holden. Thanks for the color. Appreciate it.

Speaker 2

Sure.

Operator

Thank you. Our next question comes from the line of Jake Levenson with Melius Research. Please proceed with your questions.

Speaker 4

Good morning, everyone.

Speaker 2

Good morning.

Speaker 4

Hi. Just on the non res construction side, I know you it seems like sales have slowed a little bit there and you made some cautious comments in the release. Just Curious, and I'm sure there's storm impacts in September there, but just curious what you're hearing from the field in terms of Friends in that market, if there are any particular regions or verticals that seem better for us?

Speaker 2

I think there could be a few things that are playing out in construction. One is, as you said, weather probably wasn't our friend as it relates For the most recent months, in certain parts of the southern markets. But I think there's a few other things playing out too. We tend to be a little bit later in the construction cycle as opposed to being early in the construction cycle because We don't really supply a lot of the high volume, high bulk, but very low margin type of product. We tend to come in as the project is proceeding And we sort of step in to sort of fill in spot buys that they might need for product or Supply sort of folks who are involved in the later stages of the project with their reflective vest and things of that nature.

Speaker 2

So I think that there is an element of timing. So as we get further away from the pandemic, and more projects that restarted coming out of it get deeper into it. I think that tends to favor us from a cycle timing standpoint. So there may be some elements of timing that's in there. I think the other element of it though is recall, we have altered our branch model in certain respects.

Speaker 2

And that branch model has used to be very much an open showroom for people to come and buy a lot of product. And in many respects, we've reduced the size of that showroom and tried to get a lot of that walk in business to go online. And in many cases that's been successful. Again, you see the e comm business is growing the way it is. A part of that is because of that.

Speaker 2

But at the same time, a lot of construction business tends to walk in the front door. And I wouldn't be surprised if our shift to focusing on Larger key accounts, which includes, by the way, larger construction accounts, I wouldn't be surprised if Some of the walk in business we might normally have entertained in our branches isn't as prevalent in our model today as it was then. And so I think those are probably the variables that are The other one would be the fact that and this isn't unique to this quarter or this year, But over a number of years, we've reduced physical number of locations and that has a place too. But that doesn't have a lot of relevancy to seeing right now in the patterns.

Speaker 4

Okay. That's helpful. I think that's it for me today. Good luck, guys.

Speaker 2

Thank you. Thanks.

Operator

Thank you. Our next question has come from the line of Chris Dankert with Loop Capital Markets. Please proceed with your questions.

Speaker 5

Hey, morning guys. Thanks for taking the question.

Speaker 2

Holden, we've talked about this

Speaker 5

in the past. I guess given the very high sales growth and kind of the necessary Preoccupation with finding and sourcing alternative products and repricing, as some of that starts to moderate, does that mean we can refocus More on on sites and kind of help drive some of these kind of more organic growth initiatives. And was that part of the productivity

Speaker 2

The stability in the supply chain Remove an incredible distraction to the entire organization, because if we don't have product If either we don't have product on the shelf in our distribution centers or we're having difficulty locating product, The fallback for everything is our branch and On-site. They are the first line to the customer. And if a customer needs something, they will find it. But the thing is, from a time standpoint, it takes them more time to source and locate Then it takes to push a button on your computer and request it from your distribution center. So the energy loss is there And that energy is coming back.

Speaker 2

And so that puts us in a position where we can grow the business. We can grow our intensity And we don't and we can leverage the payroll side better because you don't need to add people as fast because all of a sudden That burden time is disappearing from your day. And again, this is for folks at the branch and the on-site. And It does provide Parral a less tension environment too. Yes, I don't think that you can underestimate the amount of energy that has been diverted over the last 15 months Towards conversations with customers about raising prices, right, as opposed to conversations about increasing what we can do for them, Right.

Speaker 2

And how we can solve an additional or incremental levels of challenges that our customers may have. As all of that normalizes, I think that our conversations will shift from Playing defense to playing offense to even greater degree than it has been. And I think that that's useful and I think that is going to help on the productivity side. And If we weren't doing the things that we were doing to prioritize digital footprint, to rethink Kind of the structure of our physical footprint and how we prioritize our time, I think that we would have been much more challenged than we turned out to be.

Speaker 5

Thank you both so much for the color.

Operator

Sure. Thank you. Our next questions come from the line of Tommy Moll with Stephens. Please proceed with your questions.

Speaker 6

Good morning and thanks for taking my questions.

Speaker 2

Good morning. Good morning.

Speaker 6

We appreciate the insight you gave from your RVPs in terms of some of the cautious comments that you've picked up there. And I was curious if we could maybe go one level deeper. To what extent does that caution apply to the manufacturing end markets? Or are you picking up anything different there versus Construction and maybe some of the others tied to consumer that have been weak even earlier this year. Appreciate it.

Speaker 2

Yes, I think that the elements of manufacturing That faces capital spending or commodity markets being stronger than manufacturers that are touching consumer markets. That dynamic has persisted to some degree for the last two quarters and it existed in September as well. So that still is a thing That hasn't changed. But I think that the feedback that we're getting from the RVPs and again, it's not universal. There Some RVPs that said no, things are really still good, right?

Speaker 2

So I'm taking sort of a holistic consensual view from some 20 plus individuals And not all of them are seeing weakening markets, but I am seeing a few more comments from a few more people. And it's not about specific markets, it's just about the mindset And the outlook of the customers, generally speaking, has gone from, look, I'm just trying to get this massive backlog work through Yes, my backlog is pretty good, but I'm a little bit concerned about the orders, right? And so I can't relate it to specific markets. It's been true in the consumer side. The fact that it's ticking up, I assume, means that there's been some change in the customer sentiment on some level.

Speaker 2

And that's probably a little bit more broad than simply the consumer side of things. But again, I want to emphasize and again, we don't have a lot of visibility. It's not universal. I mean, we're not facing a sales force and a customer set that is that has seen a major inflection. It's just the tone of some of the conversations have taken on a little bit more of a cautious tone.

Speaker 6

That's helpful. Thanks, Holden. To a more strategic question around Onsites, Are we through most of the access issues that you faced at the peak of the pandemic where you can now get the access you need to have those conversations? And then to the extent you are and that we do enter into a recession that spilled over into the industrial economy, should that accelerate Decision making around on sites, does it put a hold on a lot of those decisions or no impact really?

Speaker 2

To the extent your business is in the Americas or in Europe, access is completely there. To the extent your business is in Asia, particularly China, part of Asia, it's Very, very restricted. Fortunately for us, 99% of our revenue is in the areas that access is really good. As far as history has shown When you're really busy, sometimes decision processes slow down a little bit because you just don't have the time The change from a strategy standpoint, you don't time to change that and that can hurt the on-site. A little bit weaker environment Probably helps our ability because we're bringing at the end of the day, our on-site model is about a more efficient model for supply chain.

Speaker 2

And there's a noted cost advantage from the standpoint of When we're in there, we have the tools to provide the supply chain in a way the customer can. So I think generally speaking, average or a slower environment is probably a little bit Yes. One thing to bear in mind, we just answered a question related to how we have to spend what is a limited amount of energy, right? And How we're looking forward to shifting from spending a lot of energy on playing defense to be able to put a lot of energy into playing offense. And it's really very similar in our customer set, right?

Speaker 2

I mean, If you have a fairly stable environment, it's not that difficult to predict and plan and Take on an implementation process that can be fairly involved as you're getting these things set up. If you're in an environment that's Cascading frankly, either cascading lower or cascading higher. And your energy in an organization is being spent on managing And those significant changes, then your ability to spend a lot of energy on an implementation process becomes a challenge. So I would probably suggest that There's a great case to be made for Onsites, when people are trying to be cost conscious and working capital conscious. And that Certainly is the case in a downturn, but it's going to it would depend on the magnitude of what you're talking about.

Speaker 2

I would say in a Modest downturn. We probably are in a better position to be able to sell what we do. If you have dramatic growth or dramatic Downturns, I think that our customers' energy can be moved into other things.

Speaker 6

All very helpful. I appreciate the time and I'll turn it back.

Speaker 2

Thanks. Thank you. Thank you. Our next question has

Operator

come from the line of Chris Snyder with UBS. Please proceed with your questions.

Speaker 3

Thank you. So I understand the commentary that the fastener price cost drag will narrow over the next Few quarters as lower unit cost flow through the P and L. But I guess my question is, how should we think about fastener price into our revenue forecast for next year? Is the expectation that price will hold or that price will go down, but maybe not to the same level as the cost deflation you're expecting?

Speaker 2

As you know, we have, like 55%, 60% of our business today is national accounts. And those are contract pieces of business. Many of those contracts have terms and conditions in it, which when Raw material costs go up, we can adjust and when they come down, we need to adjust as well. So as we get to the point where our Costs are beginning to reflect less inflation and that sort of thing, then I would fully expect that there are going to be customers That we are going to have to make good on contractual terms. And so I think you would see pricing decline in those circumstances.

Speaker 2

Now bear in mind, of course, that even within contract relationships or spot buys and things like that, that aren't going to be as reactive to the contract terms. And of course, we do have a significant amount of business that isn't necessarily contract, that may not be as responsive either. And I think there certainly will be cases. I think our responsibility is to make sure that we reduce price as we see our costs coming down. That will be our goal, and then have the same conversations with our customers that we had on the way up.

Speaker 3

No, we really appreciate all that color. And then, Holden, to prior commentary you made about, I think you said unit costs, so the price, I guess you guys are paying from the producers, flattened out in August September, really for the first time since the pandemic. I guess my question is that is there fasteners down and everything else is still kind of inching higher? Or is it kind of really across the board Cost refining. I'd just ask again, it just feels like fasteners are on a bit different of a cost kind of trajectory.

Speaker 2

Yes. There's not a meaningful difference at this stage of the game, whether it be fasteners There's not a meaningful delta between those things. And bear something in mind. I think that we're at a point where we're seeing a little bit of a change in the market, but it's very early in. We actually are still when I talk about how the boats are still filled with Products that are fairly expensive from price levels that existed months ago, we're still receiving letters from suppliers that are asking for price increases on certain products Because of that FIFO effect on their own supply chains, right?

Speaker 2

So let's it's an exciting change, I suppose, but We have to see some string of these trends before we can start thinking about what actions need to be taken. Part of it, Chris, stems from what was the ultimate cause of the inflation. If you think Of the product and I'll speak to fasteners, but I think would be true to anything. There is a cost Of the underlying steel. There is a cost of the energy to convert that underlying steel to the finished product.

Speaker 2

As you know, that cost of that energy has only gone up and that's not coming down. The next piece is the cost of the human capital, the human resources to be involved And that endeavor of converting it, transporting it, of running it through distribution, That has appreciated as well and that's not coming down. Once a cost element there increases, it has incredible sticking power. The third one is the physical cost of moving it. That cost has moderated.

Speaker 2

I mean, it had gone ridiculously high. It has moderated. And but I don't see that coming back. And so if you look at those 4 pieces, there's really one of the 4 that you can see some that you can Just looking at it mechanically and see, yes, there's opportunity for that in the future. But the cost of the energy, the cost of the people and the cost to move it, Those are what they are, and they really don't deflate per se.

Operator

Yes. No, really appreciate that.

Speaker 3

And that was kind of really the genesis of the question on fasteners. So it just feels like if you look at those cost buckets, the one that is Deflating the most is metal, which fasteners are more exposed to them than the other product line. So I really appreciate all that color.

Operator

Thank you. Our next question comes from the line of Ken Newman with KeyBanc Capital Markets. Please proceed with your question.

Speaker 7

Hey, good morning guys.

Speaker 2

Good morning.

Speaker 7

So I just had a follow-up question on the non res side of the I appreciate that the operating strategy for that business may be a bit different versus prior cycles. But Is it fair to assume that the 500 call it, 565 basis points of price that you took in the quarter, Is that equally weighted across all your sort of end markets? I guess I'm ultimately trying to get to whether volumes in non res were down, Call it 4% or 5% or September or is that not really a fair assessment?

Speaker 2

Yes. And I guess the frank answer is I don't know the answer to that question. We haven't broken down price cost elements by end market. So I just don't have a good answer for you. But there's nothing that would lead us out intuitively to say there'd be a difference.

Speaker 2

I mean, Fasteners made of the same steel, whether you're selling it into a construction application or manufacturing application, same underlying raw material, right? Right. But whether or not the pricing behavior in those two markets are the same or different, I just don't have a good answer for you on that.

Speaker 7

Okay. And then for my follow-up here, the On-site and the FMI growth looks pretty solid in the quarter. As you kind of think about pass down cycles and elevated levels of uncertainty, is there a change in how you think about the rate of deceleration In the macro, whether it's PMI or year over year industrial production versus the rate of change in on-site signings, Is that different from prior cycles you think because the value prop is different or would you expect kind of similar versus past cycles?

Speaker 2

Well, if you think about it historically, we could look at our established business and our business that was coming from new Branch openings, I'm going back 15, 20 years, I'll make this comment. So you had this constant wave of pushing, but we still sell into a cyclical end market. And so where you have a meaningful presence in a market, you get headwind and it's how much of that headwind is offset by Things you're doing. And On-site is a cousin to branch openings from the standpoint of I feel better about 2023, the fact that we've signed a whole bunch of Onsites in the 1st month, 9 months of this year. Because the customer activity at our existing branches, at our existing on sites It's going to be impacted by the economic cycle.

Speaker 2

That's just the reality. If we have a customer that's spending $10,000 with us and it goes to $11,000 it goes to $11,000 if it goes 9, it goes to 9. So it's how many new customers, how many expanded relationships are you adding. And I think a lot of comfort in the fact that we have a lot of pent up growth market share gains In our hopper right now because of all those on sites we signed and because of the vending in the FMI devices that we've signed, It gives you incredible ability to take market share. And when we're looking at it internally, we always look at it from the standpoint, okay, here's our growth.

Speaker 2

How much is the market giving to us and how much are we taking? And the number you focus on Is how much are you taking and what are you doing to take? And then the number that's how much is being given, that's what you use to pull levers to manage your business. Because those are things that impact you. The other is things you impact.

Speaker 2

I hope that's helpful. And I might if you think about our value prop hasn't changed that much, right? It's always been about getting really well trained people close to the customer and empowering to make great decisions to solve customer issues. And that has been the proposition. That remains the proposition.

Speaker 2

The only thing that's changed is the tools we have at our disposal to Achieve that, have gotten better and more sophisticated in advance. But the value proposition, I don't think has changed. But one thing that does excite me is, As you do go on-site, as you do put in those bins, not only is there a greater ability to add value through data that I think becomes Even more important when people are looking for how to become more efficient themselves, but it also ensures that we always have a reason to be there. That On-site might be down 20% because of the market, but we're still there every day And we're looking for other opportunities to expand our ability to gain more business. And when we're primarily branch driven, We would have to gain entrance to it.

Speaker 2

And there might be people that are saying, no, we don't have time right now, we're managing this. And now we're there every day, filling those bins that have That are part of the digital footprint and the vending machines and even on-site. I think that that's going to make our ability to gain market share resilient regardless of cycle. Well, you think to that end, do you think about when we're going through the pandemic, there's a number of reasons why we found success. 1, We just have a team that's really good at finding stuff and are really, really focused on quality.

Speaker 2

And so people could buy stuff They knew it was what it was and they could trust that they were going to get it. But because of our vending footprint, because of all the bin stocks we do, because of all those things that we've been doing For years, to Holden's point about access granted, we were getting into customer's facilities. One of the reasons we closed the front door of all of our branches, We didn't want to be the weak link. If this customer is shutting down access to their building, they're letting us in, well, our building becomes an extension of theirs and we shut down And so it puts us in a unique spot of we still get to come in and get engaged as opposed to being an Internet connection away or a phone call away.

Speaker 7

Very helpful color. Appreciate it.

Speaker 2

Thanks.

Operator

Thank you. Our next question has come from the line of Nigel Coe with Wolfe Research. Please proceed with your questions.

Speaker 8

Thanks. Good morning and hope all is well. At the risk of beating a dead horse here,

Speaker 2

I do want to go back

Speaker 8

to the non res Because that's a topic of interest for a lot of investors here. And I guess the fact that manufacturing is benefiting from the FMI And depending on sites and all that, whereas you clearly say that Non res is much more around stores. So I think the bifurcation makes sense. But is there anything unusual happening in that non res category in terms of, I don't know, projects getting delayed or Moving to the right, I don't know, customers buying less, anything unusual you call out there over and above what you just described?

Speaker 2

I don't think so. But again, I mean given some of the things that I described being perhaps a little bit later in the cycle in terms of where we hit our sweet spot Construction, some of the changes are made. I'm just not sure we're a great proxy for the overall non res market trends, right? But when I query the RVPs, nothing particularly special has come out of the discussion around non res for us.

Speaker 8

Okay. No, that's very clear. I just want to make sure that was the case. And then when you say preparing for a softer 2023 into the back half of the year perhaps, What does that actually mean? I understand maybe not hiring for growth, but are you actively in the process of managing down inventories, Managing sort of discretionary costs, are we in that phase yet?

Speaker 8

And any comments you have on 4Q gross margins, Holden, would be appreciated.

Speaker 2

So Nigel, as far as the we're always in the phase of managing down costs. We're always in the phase of looking at everything and rationalizing everything every day. And that just keeps us agile and fresh. What it means is sometimes it's reminding everybody. We've been through You think over the last 4 or 5 years, you had we were impacted very directly by all the tariffs Few years ago, we along with everybody else on the planet was impacted by COVID.

Speaker 2

We along with everybody else on the planet We're impacted by supply chains being just snarled up. The only Benefit we had was we're better at un snarling that than anybody else. And part of that we were willing to do just with hard work. Some of that we are willing to do because we just know a lot of manufacturers, a lot of potential suppliers. And part of it we were willing to do because we were willing to use our balance sheet.

Speaker 2

You think back to the spring of 2020, I remember some of the POs we were cutting for masks. I sleep really well at night. There were a few nights where I'm kind of like, oh my And as we went forward, if it's taken an extra 30 or 60 days To get product in, all of a sudden we're adding $250,000,000 of inventory because that's just mathematically what it takes Because at the end of the day, we have a covenant with our customer. We are their supply chain partner and they'll get it from us and they trust us to do that. Now We've been in the process for some months of looking at that and saying, okay, we now can rely on supply chains in a way we couldn't 6, 9, 12 months ago.

Speaker 2

So we can start dialing that safety stock down. What you're seeing in cash flow this quarter It's just the outcome of that. And so we aren't squeezing the balance sheet and squeezing inventory because of what we're thinking for 2023. We're removing layers of safety stock that we had added over the last few years and we're slowly removing you close a bunch of locations You changed your inventory layout. We had a lot of inventory that was positioned around the company Because we had a front room that we slowly are working our way out of.

Speaker 2

And those two things is what gives me confidence on our ability to generate cash flow. The idea of preparing for 2023 is reminding everybody, you know what, this isn't the time we're giving raises. This isn't the time where we're adding things that are discretionary. This is the time where we're saying to our field personnel, we have Close to 300 on sites we've signed. We need to staff those.

Speaker 2

We have locations that are growing. We need to staff those. Our headcount Became disproportionately out of kilter during the last 3 years because our recruiting model, A big chunk of what the way we recruit is we go into 2 year technical colleges and 4 year state colleges. And we say to young people, come join us, Work 15, 20 hours a week. Let's get to know each other so that when they graduate, they might decide that industrial distribution is right for them and we might decide they're right for us.

Speaker 2

And that's how we add people. We still haven't corrected that mix. And so we're going to be adding people in the field, but it's going to be disproportionate to Part time and folks, the staff are on-site. And part of when you're looking at a year like 2023 could be based on the Tone out there. You just remind people to what we're about.

Speaker 2

And with regards to Q4, I'll just give you a sense of sort of how I see the moving pieces. Product and customer mix is

Speaker 8

going to continue to be

Speaker 2

a drag. Is it the same 40 bps as it was in Q3 or is it 50 bps or Whatever that will be determined by the relative growth of national account versus non national account, the relative growth of the fasteners versus non fasteners. But I don't necessarily expect that to I don't expect that 40 basis points to be less. It could be slightly more. I don't expect the write down, of course.

Speaker 2

I don't expect price cost to get worse. It could get a little bit better, Frankly, than what we saw in the Q3, from a seasonal standpoint, it's not unusual for The Q4 to be 30 bps lower than the Q3, and I think that that's reasonable. And I think there'll be a little bit of a challenge On the organizational expenses, we had in some areas we had some difficult comps are going to come up against in Q4. So Run all that math together, I think normally you'd expect seasonality to play through for about 30 bps. And I I think when you get all those pluses and minuses all blended together, it probably comes in down 20, down 40 kind of range.

Speaker 2

We're about 2 minutes through the hour. So I'll just share a couple of closing thoughts. One is, Holden talked Briefly hear about Q4 and but also about some of the expense components that are fixed or that are variable. We're in a position where a lot more of our expenses are variable than we've ever been in for the last 50 plus years of our existence. And that couldn't be more true than what we see today.

Speaker 2

If you take a step back, go read our proxy and you'll see how People and Fastenal are paid. There's a lot of incentive comp at the branch level, at the support level, at the distribution level Throughout the organization, a piece of that's related to sales and gross profit growth, a piece of that's related to expense management, a piece of that is related Earnings growth. It's no secret that for the year, we'll have pretty good earnings growth. And if you think a A big chunk of folks are paid off that earnings growth. I think and I'll put a shout out to Dave Manthey.

Speaker 2

He coined this phrase, I think 15, 18 years ago about the shock absorbers In the Fastenal expense model, those shock absorbers, they're fully flexed right now. And what that means is, Unfortunately, as an employee, it means you'll probably get some contraction in pay and I'm an employee, so that's unfortunate. The fortunate is he had a pretty good 2022, But it puts us in a position to invest to grow the business in the future without cutting any muscle. There are some things that just naturally contract if earnings growth contracts. So it puts us in a great position To do the thing that we've been proven for decades, we can do quite well and that's take market share.

Speaker 2

Thanks everybody. Have a good day. Thank you.

Operator

Thank you. This does conclude today's teleconference. We appreciate your participation. You may disconnect your lines at this time. Enjoy the rest of

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Earnings Conference Call
Keysight Technologies Q3 2022
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