Manufacturing And Self-Help Come Through For MSC Industrial (NYSE:MSM)

I’ve been skeptical about MSC Industrial‘s (NYSE:MSM) latest self-help initiatives, but management is providing the best rebuttal possible – good execution. I can, and will, quibble that sales growth should be higher given the underlying strength in manufacturing, but the company is definitely doing better on margins, and that helped drive better fiscal second quarter results – a set of results that should also bode well for the broader multi-industrial space in the upcoming calendar first quarter earnings cycle.

I flipped from neutral to positive on these shares in late February, in part due to valuation/sentiment, and in the short time since, the shares are up about 10% – roughly doubling the performance of the underlying industrial sector. With some positive adjustments to my margin assumptions, I still see around 10% to 20% near-term undervaluation, with longer-term total return potential in the high single-digits.

A Solid Set Of Results

MSC comfortably beat expectations this quarter, with most of the upside coming from the margin side.

Revenue rose 11%, or 8% on an average daily sales basis, beating expectations by about 1%. Manufacturing sales were up 13% (or around 9% on an ADS basis), with safety/janitorial sales down 3%. Sales to national accounts (typically larger corporations) rose by a low double-digit percentage, while core sales (typically smaller manufacturing companies) rose at a high single-digit rate.

Gross margin improved 50bp on an adjusted basis, beating expectations by a half a point. Price/cost benefited from pricing actions taken earlier in the year (price added more than 400bp to sales growth), as well as other countermeasures and ongoing mix improvement.

Adjusted operating income rose 25%, with margin up 125bp to 11.6%, beating expectations by almost 40bp and driving around $0.04/share of upside. Incremental margin for the quarter was over 22%.

Now For The Quibbling…

MSC saw a definite impact from the Omicron wave, with December sales up 2% (after 12% growth in November) and January sales up 5%, before February rebounded with an 18% growth number. Preliminary results for March showed 13% growth.

MSC actually outgrew Fastenal (FAST) on a daily sales basis in February (18% to 16.5%), but Fastenal posted significantly better sales growth in December and January, and I’d note that manufacturing sales were above 20% in all three months, and above 25% in two of those months.

Moreover, just about every manufacturing company that has commented on its business over the last couple of months (sell-side conferences, analyst/investor days, et al) has said that their facilities are going all-out to keep up with orders and deliver on their backlogs – or at least to the extent that their supply chain allows. Given that, I don’t think it’s totally unfair to wonder why MSC didn’t see even more growth leverage from this underlying surge in manufacturing activity.

Management did point to ongoing growth in in-plant solutions (vending and vendor-managed inventory) with both growing about 100bp as a percentage, but the total still below 10% of overall sales. While MSC was a pioneer in moving industrial distribution online, they have been lagging Fastenal and Grainger (GWW) in these channels, with both of those companies pointing to vending and VMI as meaningful growth drivers in recent years.

Building (Or Re-Building) Credibility A Quarter At A Time

MSC could certainly use more quarters like this, and a pick up in sales momentum would be welcome too. The “Mission Critical” initiatives do appear to be succeeding where cost-cutting and margins are involved, but I would like to see more progress on the sales growth initiatives.

Management mentioned an example on its call of its MillMax services saving an aerospace customer over $1M in tool costs, but I want to see more evidence of share gains, particularly with the Gardner Metalworking Index at 60.6 in February, 59.1 in January, and 58.3 in December (numbers above 50 indicate growth). Likewise, on a two-year comp, fiscal second quarter manufacturing sales were up 4% annualized – not a bad number, but not a great one either.

The Outlook

Management raised the high end of its guidance range for both revenue (from “mid-single-digits to high single-digits” to “mid-single-digits to low double-digits”) and operating margin (from 11.7% to 12.6% to 11.7% to 13.1%).

For my part, I’ve modestly tweaked my revenue number (up less than 1%), raised my GPM estimate by about 15bp, and adjusted operating expenses such that my operating margin estimate moves up 25bp. On the negative side, I’m assuming more working capital build this year as the company takes on inventory to serve its customers. This does have a slightly negative impact on my FCF estimate, but I think this is a sound move for the long term – companies like Fastenal, Grainger, and MSC should use their balance sheets to ensure supplies for customers; it’s one of their important strategic/competitive advantages over smaller players.

My long-term numbers don’t change all that much, as I’m still looking for around 3% to 4% long-term revenue growth (against a trailing growth rate of 3.6% that was boosted by M&A) and around 4% FCF growth relative to pre-pandemic norms.

Both my discounted cash flow-based valuation and EV/EBITDA-based valuation move higher, with the small improvements in my margin assumptions driving a slightly higher EBITDA multiple (12.25x versus 12x) and EBITDA estimate. Using that 12.5x on my 12-month EBITDA estimate, I get a fair value of just over $100. My DCF-based fair value estimate is lower than that, but still above today’s price and suggestive of long-term total annualized potential returns in the high single-digits.

The Bottom Line

MSC should still be positively leveraged to strong underlying industrial activity, healthy (if not strong) pricing, and further efforts on margin self-improvement. That’s enough to keep me positive today, and if management can continue to execute on its self-help plans, particularly on the market share/sales growth plans, there could be more upside here beyond just the shorter-cycle leverage that is likely to start waning next year.