MSM - MSC Industrial Outperforming An Increasingly Challenging Market

2023-10-27 15:13:02 ET

Summary

• Margins were softer in FQ4, including a somewhat disappointing lack of additional SG&A leverage, but overall performance for the quarter and fiscal year was good.
• MSC Industrial has shown impressive volume growth and share gains in its metalworking tools distribution business, with impressive outperformance relative to benchmarks like industrial production.
• The company's management is establishing credibility in driving persistent share gains and improving long-term margins; investments into digital capabilities and further expansion of vending/on-site efforts should drive more growth.
• MSC isn't as cheap as I'd like, particularly will elevated demand and gross margin risk in FY'24, but the overall bull argument is still sound.

Writing about MSC Industrial (MSM) after third-quarter earnings, I was skeptical of this metalworking tools and supplies distributor being able to significantly outgrow increasingly stressed short-cycle industrial markets. To their credit, management came through again, and this time with an all the more impressive volume beat relative to sluggish industrial production and metalworking tool consumption indicators. While margins were softer, the overall performance for the quarter and FY'23 was good.

Since my last update , the shares have outperformed not only the broader industrial space (by close to 10%) but also fellow distributors Fastenal ( FAST ) and W.W. Grainger ( GWW ), as well as suppliers like Kennametal ( KMT ) and Sandvik (SVDKY) (SDVKF). Lower margin and higher capex are a drag on next year's outlook, but I do think management is establishing more credibility when it comes to driving persistent share gains and then leveraging that improved scale into better long-term margins.

I wouldn't call the shares a screaming bargain today, and I see greater odds of negative revisions next year versus positive ones, but I still see enough undervaluation in the shares and positive internal execution versus targets to remain positive for the time being.

Mixed Results, But Impressive Volumes

MSC closed its fiscal year in pretty good form, with surprising volume leverage and share gains in the business. Margins weren't the best, and this remains an area of challenge, but all in all, it was a mixed but good quarter.

Revenue rose about 1% as reported, beating by 3%, but organic growth on an average daily basis came in at a strong +7.6%. With price up a little less than 3%, volume was up nearly 5% - a rather good result next to not only flattish IP over the period and sub-50 metalworking index readings (suggesting market shrinkage) but also low single-digit volume growth at Fastenal.

Looking at customer breakouts, national customers (generally larger companies/corporations) grew mid-single-digits (versus high single-digits at Fastenal), core customers (generally small shops) grew low single-digits (versus a 2% decline at Fastenal), and government sales grew more than 60%. The company's Class C business grew low-teens, and both vending (up 9%) and implant (their name for on-site vendor-managed inventory) grew 13% versus 13% vending growth at Fastenal and low double-digit growth from Fastenal's OnSite.

Gross margin declined 140bp year over year and 20bp quarter over quarter, though, and that was a half-point worse than expected in a quarter where Fastenal kept gross margin steady and outperformed by 40bp. Operating income declined 6%, with the margin down a point to 12.6% and 50bp below expectations. I was modestly disappointed that the company didn't squeeze more SG&A leverage out of its self-improvement efforts - for several quarters the company managed a little outperformance here.

It's Not Getting Any Easier Out There

I expected a second-half slowdown in industrial markets in 2023, and that's starting to become more apparent in various numbers. Industrial production has been bobbing around flat for a while now, PMI is still below 50 (though just barely in September, at 49.8), and Fastenal has been reporting decelerating momentum in its monthly manufacturing sales reports.

For MSC, the June-August period was robust, with 9%-10% average daily sales growth against double-digit comps in the prior year, but business hit a wall in September (up 1.3%) and the struggles have continued in October (up 1.5%), though the comps here are not easy (13.4% and 13.9%, respectively).

Management attributed about half of the recent deceleration to the UAW strikes, and the continuation/expansion of these strikes is a definite threat for the near future. The remainder, though, seems like a more general industrial slowdown that is consistent with the commentary from a lot of industrial companies - it looks increasingly likely that the U.S. will side-step a recession, but after a period of destocking, it looks like demand is holding steady at a low level, and industrial production will likely bump along close to flat until later in 2024.

Given management's ongoing target of +400bp outperformance to industrial production and fading price benefits into 2024, the guidance of 0% to 5% average daily sales growth in FY'24 would fit that outlook.

Margin pressures are also going to be an issue, with the company seeing more challenging price/cost dynamics in the first half of 2024 and some pressures from further product line revisions.

Changes For The Better

The plan that management is executing today has produced real results. The company has been showing demonstrable and sustained volume-based share growth (not consistently at +400bp, but consistently positive) and has likewise been delivering on operating efficiency targets - SG&A as a percentage of revenue has improved from 30.7% in FY'21 (and 31%+ for FY'14-FY'17) to 28.7%, and I don't think the plan has necessarily maxed out yet.

Part of management's guidance for FY'24 was a significant bump in capital spending ($120M-$130M), with the incremental year-over-year difference explained by a large digital initiative that will improve the company's marketing, sourcing, and inventory management capabilities. I've gone on about this at some length in relation to Rexel (RXEEY) and the benefits that this French electrical products distributor has seen from significant digital infrastructure investments, and I don't see why MSC can't garner some of the same benefits.

I also think the company's efforts in vending and on-site VMI may be going a little underappreciated. While there are upfront costs to these installations (including net working capital), they lead to stickier customer relationships and facilitate increased cross-selling and share of wallet. They also highlight MSC's capabilities against smaller rivals - while you can get a grinding wheel or annular cutter from numerous vendors (and quite possibly at a cheaper one-off price), MSC can offer a combined value and service proposition that small distributors just can't duplicate.

The Outlook

Macro risk is one of the biggest risks I see with MSC now, followed by growing concerns as to how much gas is left in the tank with respect to SG&A efficiency improvements. As I've said many times in relation to distributors, gross margin leverage is hard to come by and I don't see this situation ever reversing on a long-term basis. Perhaps efforts like improved digital infrastructure can drive some incremental improvement, but price transparency/visibility is extremely high and pricing power is all but impossible to maintain (though vending and on-site offer more opportunities…).

While a lot of moving parts in my model have changed, the net outcome hasn't changed much. I'm still looking for long-term revenue growth of around 3%, operating margins in the 12%'s, EBITDA margins in the 14%'s, and ROICs moving into the low 20%'s. I'm also still expecting FCF margins to improve too, and stay in, the 8%'s on a long-term weighted-average basis, driving high single-digit adjusted FCF growth.

Discounting those cash flows back still gives me a decent total annualized prospective return (around 8%) - not great, but certainly not the worst among industrials. Using my margin and return-driven EV/EBITDA approach, I think 11.25x forward EBITDA is fair, supporting a fair value of close to $110.

The Bottom Line

With the risk to macro demand and margins, I can't say that those fair values make MSC compelling, but I also don't dismiss the idea that management can still drive internal improvements over the long term (including harnessing/leveraging those digitalization investments). All in all, I think this is more of a "good hold" than a clear-cut buy, but I still lean largely positive.

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