The markets reacted to the fiscal cliff resolution last week with relief, but the dickering and delays had real consequences to companies. As one example, industrial distributor MSC Industrial (MSM) saw a very pronounced stagnation of business in its fiscal first quarter, and the Street was not happy to hear lower guidance from management. While I expect investors to approach this stock with caution until ISM numbers and reported growth improve, this remains a quality long-term name for investors to consider.
Off The Cliff
Many companies saw industrial demand taper off in the U.S. as 2012 went on, but the uncertainties around the presidential election and the fiscal cliff negotiations had a pronounced impact on MSC Industrial's business. Management characterized business in December as "near paralysis" with customers going "hand to mouth in MRO supplies" because of all of the uncertainties regarding taxes, government spending and likely GDP growth in 2013.
Revenue rose 6% for the quarter, which did at least meet the lower end of the company's prior range. That's a marked deceleration from recent quarters, but management believes they still outgrew the market for the quarter. Manufacturing-related growth came in better than 6%, while non-manufacturing sales were up just under 5%.
While MSC saw an increasingly tough demand environment, management once again did a strong job of controlling expenses. Gross margin dropped about 70 basis points from last year, but improved a similar amount on a sequential basis. Gross margins were compromised in part by dilution tied to ongoing expansion of the company's vending machine program. Operating income (adjusted) rose 7% this quarter, with operating margin improving both annually and sequentially. The incremental margin also improved notably - from 15% in the prior quarter to 21.6% in this quarter.
A Crystal Ball Full Of Mud Leads To A Lower Outlook
I have no doubt that these shares are selling off hard on this quarter due to the company's weak guidance. The midpoint of management's guidance is about 5% lower than the prior average estimate, with EPS down about 14% relative to the prior number.
I think a few details are important here. First, management said this guidance assumes no improvement in current conditions - even though ISM has gotten a little better lately and rail traffic data has been pretty solid (particularly in areas like vehicles). What's more, the company is going to continue to invest in vending (pressuring gross margin) and currently has no plans for a mid-year price increase, this last move alone apparently making up about half of the downward revision.
I think it's also worth noting that Sandy may have had an impact on performance and guidance. Management didn't talk about it much, but sales in the Northeast were down 1.6% this quarter - notably worse than trends everywhere else in the country.
Why Be Optimistic About MSC?
I believe there are a number of reasons investors can continue to expect better things from MSC Industrial in the coming years. For starters, the company is on board with the vending concept, a move that has proven lucrative for rival Fastenal (FAST), and this is a difficult product concept for small rivals to replicate. In fact, while overall business trends are so great today, the company is seeing vending sign-ups come in ahead of their own internal expectations.
The company also continues to invest in its e-commerce platform, and this produces more than 42% of the company's sales - perhaps blunting some of the incremental impact from Amazon's (AMZN) entry into MRO distribution.
But that's not all. The company is investing in private label products, giving customers a wider array of selection from higher-priced products from suppliers like Kennametal (KMT) down into value offerings. Here again, smaller players are going to struggle to compete with their own products.
It also sounds as though the company has no intention to stop its M&A program. As I've said before, the MRO/industrial distribution space is incredibly fragmented, with large companies like Grainger (GWW), Fastenal, Wesco (WCC) and Applied Industrial Technologies (AIT) making up less than a third of the market. Moreover, just as companies like Wesco and Anixter (AXE) have benefited from a focused market approach, MSC is far and away a dominant supplier in the $12 billion-plus metalworking market.
Last and not least, while I think the first quarter or two of calendar 2013 is going to be tough, I believe there are signs pointing to better overall conditions. Onshoring manufacturing is more of a long-term benefit for a company like MSC, but reports of improving conditions in the automobile supply chain, steel service centers, and so on would seem to be reasons for optimism about U.S. growth in 2013.
The Bottom Line
While I do believe MSC Industrial will see its revenue growth slow as the company gets larger, I believe mid-to-high single digit revenue growth is still in the cards over the long-term - driven by share growth in the MRO/distribution space and expansion into new markets/product categories (like fasteners, motors, material handling, etc.). Likewise, I think the company has ample scale to leverage its very healthy balance sheet towards more growth-generating M&A.
On the margin side, the company has a long history of holding up well through the ups and downs of the cycle, and I believe that expanding the sales base will ultimately allow the company to better leverage its expenses and assets and generate better free cash flow. Said differently, I think MSC can follow Fastenal into mid-teens free cash flow margins over time, and generate low double-digit free cash flow growth.
All in all, I believe these shares carry a fair value well into the $80s. While today's operating conditions are difficult, I believe they are even more difficult for smaller rivals and the company is poised to gain even more share. I wouldn't be surprised to see Wall Street take a wait-and-see attitude with these shares for the first half of 2013, but I continue to believe MSC Industrial is a good holding for exposure to American manufacturing and industrial activity.