MSM - MSC Industrial: Good Growth Prospects At An Attractive Valuation

Summary

• The company’s revenue should benefit from the healthy demand in aerospace, Oil & Gas end markets, pricing actions, market share gains, and M&As.
• The margins should benefit from the pricing actions, reduction in freight costs, and cost reduction initiatives.
• The stock is currently trading below its historical levels.

Investment Thesis

MSC Industrial Direct Co. (MSM) is experiencing healthy demand in manufacturing end markets such as aerospace, Oil & Gas, etc., which should benefit revenue growth in 2023. Additionally, the pricing actions taken by the company over the last few quarters should also help in revenue growth. During these weakening macroeconomic conditions, the company plans to gain market share through its strategic initiatives, which focus on solidifying its customer base, expanding its solutions business, diversifying its end markets, growing its e-commerce business, and leveraging its portfolio. Apart from organic growth, the company is also working on M&As to boost its revenue growth. I believe these positive actions should more than offset the weakness in the company's consumer-facing end markets which are getting impacted by rising inflation and interest rates.

On the margin front, the company should benefit from the pricing actions, reduction in purchase costs, operational efficiencies, and strategic initiatives. The stock is currently trading at 13.22x FY23 consensus EPS estimate of $6.08 and 13.00x FY24 consensus EPS estimate of $6.18, which is lower than its five-year average forward P/E of 15.28x. Given the good growth prospects and low valuation, I have a buy rating on the stock.

MSM's Q1 FY23 Earnings

Earlier this month, MSM reported better-than-expected Q1 FY23 financial results. The revenue in the quarter increased 13% Y/Y to $957.7 mn (vs. the consensus estimate of $947.68 mn). The adjusted EPS increased 18.4% Y/Y to $1.48 (vs. the consensus estimate of $1.46). The revenue growth was driven by higher price realization, increased sales volume, and acquisitions. The adjusted operating margin increased 90 bps Y/Y to 12.3% due to lower adjusted operating expenses as a percentage of revenue. This benefited the adjusted EPS growth in the quarter.

Revenue Outlook

In Q1 FY23, the company's revenue benefited from healthy demand in manufacturing end markets, pricing actions, and the acquisitions of Tower Fasteners and Engmen-Taylor. The manufacturing end markets, such as aerospace, are not yet back to their pre-COVID levels and are still recovering, whereas the oil and gas market is experiencing good demand since the Ukraine war. Recovery in these businesses is driving good sales growth and more than offsetting the weakness in the consumer-facing industries from rising interest rates and affordability.

While the broader macroeconomic environment is tough, MSM plans to gain market share during this downcycle by focusing on the below-mentioned initiatives:

• Solidifying customer base in the metalworking business through product innovations to elevate productivity and lower costs for its customers.

• Expanding its solutions business, which is driven by vending and in-plant programs. MSM's solutions business' capabilities have helped diversify its end markets, with the most recent wins coming from the medical manufacturing, packaging, and hospitality sectors. The company is continuing to invest in its vending solutions to streamline customer replenishment and trim its customers' inventories which should further help grow this business.

• Leveraging its portfolio strength to increase its wallet share through ancillary products, especially in the Class-C Consumable Group ('CCSG') business. The CCSG business provides services and solutions for consumable items such as fasteners, fittings, fuses, etc. which usually have higher margins.

• Growing its e-commerce business. The company is focusing on improving the customer experience on its website by enhancing product discovery and enhancing product data.

• Diversifying its customers and end markets with an emphasis on the public sector. The company has gained good traction in terms of winning projects at the state and federal levels in recent years and has won several contracts serving the U.S. Marines base over the last few years.

Looking forward, the company's revenue should continue to benefit in 2023 from the healthy demand in manufacturing end markets such as aerospace and Oil & Gas. Additionally, the pricing actions taken by the company over the last few quarters to offset inflationary costs should also benefit sales growth. The company has also gained market share and posted an above-market growth rate in the last five quarters. I believe this trend can continue going forward given the management initiatives discussed above. While the economy is slowing and some of the company's end markets are getting impacted by it, the strength in aerospace and Oil & Gas end markets, pricing actions, and market share gains should more than offset this weakness. Hence, I am optimistic about the company's organic growth prospects.

Apart from organic growth, the company is also focusing on growing through M&As. The company strengthened its OEM fastener distribution business through the acquisition of Tower Fasteners in August 2022. This helped the company broaden its end-market exposure and increase its geographic footprint in the high-touch Vendor Managed Inventory ('VMI') category. In January 2023, the company acquired Buckeye Industrial Supply and Tru-Edge Grinding Inc. Buckeye is an independent metalworking distributor, whereas Tru-Edge is a custom-tool manufacturer. The company plans to build on Buckeye's technical high-touch relationships and value-added services by offering access to its product portfolio. Tru-Edge will join MSC's existing regrinding business to support manufacturing customers in the Midwest. The company plans to continue its M&A activities in 2023, and its strong balance sheet with 1.3x net leverage (on a TTM basis) allows it to do M&As at attractive valuations during this downturn.

Management has guided for average daily sales to grow between 5% Y/Y and 9% Y/Y in FY23. FY23 is having six fewer working days compared to the previous year (258 working days in FY22 versus 252 in FY23). This translates into Y/Y sales growth between 2.5% and 6.4% using management's average daily sales guidance. The current consensus is at ~4.04% which I believe is reasonable.

Margin Outlook

The adjusted gross margin in Q1 FY23 was down 10 bps Y/Y to 41.5% due to headwinds from product cost increases and product mix. The adjusted operating margin improved by 90 bps Y/Y due to the 100 bps Y/Y improvement in adjusted operating expenses as a percentage of revenue, partially offset by the slightly lower gross margin.

Looking forward, the company is planning to take an additional price hike in FY23 as it has seen new cost increases from its suppliers in recent quarters. This should help offset the cost pressure and benefit the gross margin. The freight costs are also moderating which should further help gross margins.

Given the recessionary concerns, the company is prioritizing a reduction in purchase costs, streamlining operational efficiencies, changing its staffing levels, and reprioritizing investments. Back in 2020, management laid out a target of $100 mn in gross savings by the end of FY23. The company has already achieved $91 mn in savings till the end of Q1 FY23 (including $6 mn incremental gross savings in the first quarter). I believe MSM can easily surpass its cost reduction targets.

Overall, I am optimistic about the company's margin improvement prospects in FY23 and beyond given price increases, moderating freight costs, and the company's cost reduction initiatives.

Valuation & Conclusion

The stock is currently trading at 13.22x FY23 consensus EPS estimate of $6.08 and 13.00x FY24 consensus EPS estimate of $6.18, which is lower than its five-year average forward P/E of 15.28x. MSM's valuation is also at a significant discount to its peers W.W. Grainger ( GWW ) and Fastenal ( FAST ) which are trading at 18.73x and 25.20x FY23 consensus estimates, respectively. The company's revenue should benefit from the pricing actions, healthy demand in certain end markets, such as aerospace and oil & gas, strategic initiatives, and acquisitions. This should more than offset headwinds from a broader macroeconomic slowdown. The margins should also improve in FY23 and beyond due to the strategic cost-reduction initiatives, pricing actions, and moderating freight costs. Given the good growth prospects and low valuation, I have a buy rating on the stock.

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