MSC Industrial Executing Better, And The Street Has Noticed (NYSE:MSM)

I’ve been highly critical of MSC Industrial (NYSE:MSM) management at times, but I have to acknowledge that this latest round of strategic initiatives – initiatives that include expanding and highlighting value-added services for customers, pursuing new channels, expanding the portfolio, and streamlining expenses – have not only been executed adroitly, but have produced real benefits. With that, the shares have continued to outperform Fastenal (FAST) since my last update (and over the past year), though Grainger (GWW) and Applied Industrial (AIT) have done better still.

I believe that 2023 is going to see MSC Industrial’s improving execution collide into a more challenging macro environment that will see weaker short-cycle operating conditions as well as improving supply conditions that reduce some of the value provided by top distributors like MSC and Fastenal. While MSC shares do look undervalued on mid-single-digit revenue growth and further margin leverage (as well as on margins and returns), holding an industrial supplier into a period where metrics like ISM and industrial production could decline is a riskier proposition.

Healthy Trends Close Out The Fiscal Year

While MSC Industrial’s revenue was basically in line with expectations, the company did once again outperform on margins, building more credibility for the company’s ongoing “Mission Critical” self-improvement program.

Revenue rose 23% as reported and 14% on a reported average daily sales basis, though underlying daily organic growth was more on the order of 11.5% – not all that bad relative to Fastenal, particularly as Fastenal has long been a faster-growing company than MSC. Government sales rebounded strongly (up 32%), and sales to national accounts were up at a high-teens rate, suggesting a still-healthy environment for larger manufacturing companies. Manufacturing sales rose more than 20%, trailing Fastenal a bit, but still keeping pace with the low-20%’s growth there (a surprisingly strong result to me).

Gross margin declined 10bp as reported (to 41.9%), but the company noted 60bp to 90bp of headwinds from channel/customer mix and M&A. Pricing contributed 600bp to top-line growth, suggesting solid mid-single-digit organic volume growth, and helped offset ongoing price increases from suppliers.

Operating income rose 43% on an adjusted basis, with margin improving almost two points to 13.6% and with an incremental margin of almost 22% – not far off the mid-20%’s incremental margin at Fastenal.

All told, full-year results were better than I’d expected on revenue (about 5% above my initial expectations a year ago), operating margin, and EBITDA, but short on free cash flow due to a higher-than-expected build on working capital.

Executing On New Sales Opportunities

I mention Fastenal frequently in reference to MSC not only because Fastenal has long been a darling within the industrial distribution space (with a valuation to match), but because there are some interesting trends here – MSC is following in Fastenal’s footsteps in prioritizing vending and on-site customer inventory management, as well as expanding into fasteners, while Fastenal has been investing more in e-commerce and expanding into metalworking tools.

MSC saw 21% growth in vending customer signings this quarter; that compares well to Fastenal’s 10% growth, but MSC doesn’t quantify its signings and I suspect Fastenal is far larger here, particularly given that vending is 15% of MSC sales now versus 37% of Fastenal sales. MSC also reported 42% growth in in-plant signs, with this business now more than 11% of sales. E-commerce sales are a large portion of MSC’s sales already (over 60%), but still outgrowing the overall growth rate, with 20% growth this quarter.

Looking ahead, I believe vending and on-site offerings will be increasingly important in distribution, and will further separate companies like MSC, Fastenal, and Grainger from smaller “mom-and-pop” distributors that can compete online, but can’t really offer the same on-premise services.

I also expect MSC to continue to emphasize value-added services to customers like tool selection and process review – offerings that help customers save money and operate more efficiently. With short-cycle demand likely to slow in 2023, suppliers that can offer margin-boosting ancillary services will be more valuable to industrial customers.

The Outlook

I do believe that the economy is going to slow, and that that is going to impact MSC’s business. To that end, management expects a slowdown as well, with an average daily sales growth forecast for the next year of 5% to 9%, with the high end assuming a flat economy. What’s more, with supply/product availability improving in most segments, I believe the product sourcing/availability advantages of companies like Fastenal and MSC won’t be quite as valuable in 2023, and customers may well do more price-shopping – again, this is a reason why on-premise efforts (vending, inventory management, consulting) can be valuable in making revenue stickier.

I also believe that MSC will likely look for more acquisition opportunities. The company has moved relatively slowly to expand its fastener distribution capabilities (as well as other industrial components), but I see more room to expand this, particularly as the company doesn’t have to make flashy large moves to build up these offerings.

Although I modestly trimmed my revenue growth rate for FY’23, the higher starting point (better FY’22 revenue) cancels that out. All told, my revenue outlook doesn’t really change much, and I’m looking for deceleration in FY’23 and FY’24. This could prove a little too bullish if a more serious correction/recession hits, but I’m also giving credit for growth initiatives like vending.

On the margin side, I was a little disappointed with management’s gross margin guide, but some of that is offset by further progress in improving SG&A efficiency. With that, my operating margins for the next couple of years don’t change much, and my EBITDA margins are in the mid-14%’s (basically steady with FY’22). My FCF estimate goes up a bit on my assumption that some of that working capital build up will roll off (as well as higher depreciation assumptions).

All told, I’m looking for long-term revenue growth of around 3%, consistent with my prior expectations. I expect FCF to grow closer to a 10% rate, though closer to the low-to-mid single-digits on a core basis (adjusted back to pre-COVID norms).

The Bottom Line

I expect weak sentiment around industrial stocks to remain, if not intensify from here, as I think evidence of a 2023 slowdown is going to accumulate in this last quarter of the year. Operationally, though, MSC is executing well and even if 2023 is a slower year, the company is better prepared for this slowdown than past cycles.

Between discounted cash flow and margin/return-driven EBITDA (using a forward multiple of 10.5x), I believe MSC shares are more than 10% undervalued today and priced for a long-term total annualized return in the high single-digits. That’s okay, but there are cheaper industrials out there (though with more short-cycle risk), and investors should be cautious about making a big move into an industrial distributor ahead of a potential slowdown.