simonkr
When I last wrote about MSC Industrial (NYSE:MSM) in the fall of 2023, my view on the company was balanced between commendable ongoing execution and my worse-than-consensus expectations for short-cycle manufacturing, and particularly among smaller manufacturers. Both of those drivers have continued to play out, leading to a lackluster share price performance since my last update, a couple of modest misses versus Street expectations, and lower sell-side estimate for the remainder of the year.
I believe at least some of the underperformance at MSC relative to other distributors like Fastenal (FAST) and W.W. Grainger (GWW) can be explained both by MSC’s greater reliance on manufacturing (metalworking tools in particular) and by MSC’s greater skew toward smaller companies – indeed, Fastenal’s sales performance among small customers hasn’t been much better, but Fastenal benefits from having a larger national accounts business service major manufacturers.
I do have some concerns that the economy could see a harder landing than the Street currently expects, and that would a definite risk to MSC’s business, but I nevertheless expect manufacturing activity to pick up later in 2024, and I believe MSC is well-positioned to benefit from ongoing growth in U.S. manufacturing. The shares aren’t a tremendous bargain, though, and that is another of my primary concerns at this point.
Looking Back At The Last Quarter
MSC Industrial’s fiscal second quarter, reported back at the end of March, saw another modest sales miss relative to expectations, but pretty solid margin performance. Guidance wasn’t particularly robust, as management acknowledged that the weaker than expected performance in the first half of the fiscal year makes it more likely that full-year results will be toward the lower end of the company’s guidance range.
Sales declined 3.6% on an organic average daily sales basis, with underlying volume down about 4.5%. National accounts generated a little more than 1% growth, while core account revenue (smaller manufacturers) declined almost 6%. While worse than the 3%-6% declines that Fastenal reported for the corresponding months in its non-national accounts business, I would say the performance is at least in the same ballpark.
What concerns me a little more is that overall U.S. cutting tool consumption was stronger than these results would suggest in both January (up 4.1%) and December (down 0.3%), with February numbers not yet available. This is a limited comparable data point, but I do think it does underline that smaller manufacturers, particularly those in the heavy manufacturing vertical, are seeing a more challenging environment.
Sales growth was not impressive in the last quarter (nor particularly good in the prior fiscal first quarter), but there were still some bright spots. Vending and on-site continue to be growth drivers, with the former up 6% (on 11% installed base growth) and the latter up 10% (on a 39% increase in the installed base).
I was also impressed with the margin performance relative to weaker-than-expected sales. Gross margin increased 30bp year over year (to 41.5%), beating expectations by 30bp, as the company continued to benefit from efficiency efforts like a comprehensive category lines review. Operating income declined 17%, a slight miss, with margin down 170bp to 10.5% but still slightly above sell-side expectations.
Limited Options To Fight The Cycle
Not ignoring the opportunity to continue growing the vending and on-site businesses, as well as the opportunity to continue to take share from sub-scale “mom and pop” distributors, there’s not too much that MSC Industrial can do right now to offset sluggish demand.
As I talked about in my recent article on Hurco (HURC), small manufacturers appear to be under a lot of stress right now, not only from a cyclical downturn in many markets, but also pressures like higher interest rates, higher wages, and the uncertainties that are pretty typical in a major election year.
I’m not expecting a banner year for auto production (a key demand driver for many smaller manufacturers), and I think heavy machinery is likewise going to remain pressured. Aerospace is now perhaps at risk given the ongoing challenges at Boeing (BA), and sub-markets like energy aren’t large enough to offset all of that. At a minimum, pay attention to the reports and guidance from companies like Dover (DOV), Illinois Tool Works (ITW), and Sandvik (SVDKY) in this upcoming earnings cycle, as they offer commentary on a range of manufacturing end-markets.
Turning back to the question of self-help, MSC has reviewed and adjusted its online pricing for its SKU base, keeping the company competitive on pricing. Management does expect some improvements in price/cost later this fiscal year and has been using internal efficiency efforts (including product line reviews and automation) to reduce costs.
Service is also an important and perhaps underrated part of the story. In recent years, the company has rolled out a range of service offerings designed to help customers identify the best tools and components for their tasks, and the company recently acquired the IP assets of Schmitz Manufacturing Research & Tech. From what I gather, this company specializes in consulting in areas like machining dynamics and mechanical vibration, and I can see this fitting into MSC’s overall service effort to help metalworking/machine tool customers optimize their own operations.
The Outlook
I was below-Street to start this fiscal year, and I’ve nevertheless still reduced my expectations a little further, with my FY’24 revenue number now about 4% lower (down 1.5% year over year, and a bit below the Street), and my FY’25 number about 4% lower as well (but up close to 5% year over year). On a more positive note, I’ve modestly increased my gross margin estimate as the company has done notably better than I expected given the revenue headwinds.
Long term, I’m still expecting MSC to grow revenue at a 3%-plus rate, as the company gains share in its still-fragmented core markets and benefits from the reshoring of manufacturing in the United States. I don’t believe it will be possible to maintain gross margins over time, but I believe SG&A and working capital efficiencies can largely offset this, and I’m not looking for meaningful changes to long-term free cash flow margins.
Between discounted cash flow and a margin/ROIC-driven EV/EBITDA approach, valuation on these shares falls into that “not great” bucket. Today’s price can support a mid-to-high single-digit long-term annualized return based on cash flow, while the EV/EBITDA approach gets me to around $105.
The Bottom Line
I went back and forth a lot on whether this stock should be labeled a “Buy” or a “Hold.” The valuation isn’t great, and I don’t necessarily believe the U.S. economy is out of the woods yet; I believe we’ll see short-cycle end-markets pick up later in 2024, but a harder landing is definitely possible. On the other hand, management has been executing well to its self-improvement plan, and I do see further room to gain share and benefit from increased U.S. manufacturing. Given that the shares are within 10% of the 52-week high and my concerns that expectations for industrials may be stretched. I lean more toward “Hold,” but absolutely acknowledge that a soft landing scenario would likely limit the downside from here.
