Up about 7% since my last update, MSC Industrial (NYSE:MSM) has managed to continue outperforming the broader industrial space, but has fallen short of faster-growing and less manufacturing-sensitive peers like Fastenal (FAST) and Grainger (GWW). Revenue has continued to grow in excess of underlying industrial production, while margins have been mixed as the company has continued to see pressure on gross margin while executing on operating margin improvement initiatives.
I like the company’s decision to set a more fair exchange ratio for the conversion of insider-held Class B shares, and I do see further scope for strategic initiatives to generate better results. That said, I continue to expect a second-half slowdown in MSC’s core markets and between discounted cash flow and a margin/return-driven EV/EBITDA approach, I believe the shares are only modestly undervalued today without a more aggressive shift in strategy.
Mixed, But Generally Okay, Results For Fiscal Q3
All told, MSC’s fiscal third quarter results were good, but not great, with some decent underlying volume trends offset by additional margin challenges. On the operational side, I do still see some opportunities (and risks) with the company’s strategic direction.
Revenue rose about 10% as reported, or a little less than 8% on an organic average daily sales basis, beating expectations by more than 3%. Growth was driven in large part by a new public sector win (sales were basically inline excluding this), with price/mix up about 3.5% and volume up more than 4% (or close to four points ahead of underlying industrial production).
By business, in-plant sales decelerated from the 19% growth in the prior quarter to 13%, while vendor-managed inventory business growth slowed a bit to “low double-digits” and vending decelerated from mid-teens growth to around 10% growth. Stripping these out, the core legacy business appeared to shrink at a high single-digit rate, which leads me to some concern about a further slowdown in manufacturing and the company’s strategic choices (more on these later).
Gross margin declined 220bp year over year and 60bp qoq, missing by 90bp. A lot of this was driven by that new large public sector win, a win that included a lot of lower-margin capital equipment, and margins likely would have been closer to inline otherwise. Operating income declined 1% on an adjusted basis, with margin down 150bp to 13.1%, missing by 60bp. Despite higher healthcare costs and some ongoing investments in digital/e-comm capabilities, the company’s overall strategy of offsetting gross margin pressure with operating efficiency efforts does still seem to be producing results.
Deceleration Is Coming, But How Much Is Unknown
I’ve been calling for weaker second-half results in the industrial sector (manufacturing in particular) since last year, and I continue to believe in that call. How weak “weaker” will be remains to be seen, but activity is definitely slowing and banks are pulling back on lending (in response to credit risk management needs and to maintain/improve liquidity).
Growth in average daily sales did accelerate month after month through the third quarter (from about 8% in March to almost 18% in May), but June looks to be decelerating to around 7% to 8%. Looking at Fastenal’s results, average daily sales slowed from +8.4% in April to +5.6% in May, with manufacturing sales growth slowing from 13% to a little under 10% and fastener sales growth moved from 1.2% in April to a 0.6% contraction in May.
I do expect further sales deceleration from here, with revenue growth likely down year over year in the next quarter. I do still expect growth in FY’24, though (over 3%), with reacceleration in FY’25.
Strategic Optionality
MSC management has done a lot of good things in recent years with respect to strategic marketing, sales, and expense initiatives. I’ve been highly critical of management in the past for rolling out numerous new efforts and failing to execute on them, but this time actually has been different. To that end, on-site efforts like in-plant, vendor-managed inventory (or VMI), and vending have all been successful (growing well above the overall corporate average), as have the company’s efforts to generate more public sector business.
While that’s been happening, the legacy core business has been underperforming. I believe price is an important issue here – while MSC does focus on offering the lowest total cost of doing business (including value-added services like Millmax, which can optimize tool selection on an application/job basis), a lot of small businesses look only at posted prices and MSC is pretty much never the low-cost option.
Management has talked about strategic moves like reviewing category/product lines and investing more in its digital/e-comm capabilities, and those are worthwhile initiatives. Still, I think MSC should consider taking a page out of Grainger’s book circa 2017 and look at a comprehensive re-think of pricing in its legacy core business. MSC’s customer base tends to be loyal and have specialized needs (small-to-mid-sized machine shops), but they also tend to be cost-conscious, and I think this is a case where pricing losses could be offset by volumes (as has been the case for Grainger).
A Fairer Deal For Shareholders
Shortly prior to the earnings announcement, management announced that the board had accepted a revised offer to exchange insider-owned Class B shares for Class A shares. I reviewed this back in early February, and my conclusion at the time was that the initial offer was unfairly generous to the insiders and that a more fair deal would be in the 1.2x to 1.25x range (versus the original proposal of 1.35x). The deal is now happening at 1.225x, or right in the middle of what I thought was reasonable based upon comparable transactions.
The company also announced other changes to its governance process. While the inside owners (the Gershwind and Jacobson families) will still own about 21% of shares, they will limit their voting to 15% of shares outstanding (voting the remainder with whatever unaffiliated investors opt). The company is also adding a new independent board member and changing to majority voting (versus two-thirds voting) for significant transactions.
Last and not least, the board will look to offset the dilution of the share exchange with share repurchases.
I’m on board with all of this. Some investors may still resent the 22.5% premium that insiders are getting, but it just wasn’t realistic to think they’d collapse the dual-class structure without some incentive.
The Outlook
MSC has done a little better than I’d expected on a year-to-date basis, and I’ve adjusted my expectations accordingly. My revenue estimate is a bit higher (about 2.5%) and my margin estimate is a bit lower, though I do expect slightly higher operating margins in FY’24 and FY’25 on the basis of improving operating efficiency. I also expect higher near-term FCF on the basis of working capital releases, but my long-term expectations haven’t changed much (still looking for long-term FCF margins around 9% versus a long-term trailing average around 8%).
I think the shares are priced for a high single-digit annualized total return based on discounted free cash flow, and I get a fair value of a little over $100 on the basis of EV/EBITDA (a 10.5x forward multiple). I do see some risk/vulnerability to a sharper manufacturing downturn, but I’d note that early-cycle names tend to move early, and I think the Street may well look past a relatively brief and modest downturn in manufacturing activity.
The Bottom Line
Between the share price performance and my assessment of fair value, MSC Industrial looks more like a marginal buy call than before – somewhere between a “buy” and a “hold”. I lean more positively because I believe management is making better strategic decisions, and I still see room for additional positive steps. That said, it’s not a “can’t-miss” valuation, so investors should certainly shop around.
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