By Stephen D. Simpson
It's generally a good idea to keep up with the bear story on your holdings, if only to formulate a list of red flags to watch for or potentially under-appreciated aspects of the story that may drive the shares higher. In the case of MSC Industrial (NYSE:MSM), there has been a fairly constant skepticism about the reproducibility of the company's growth – sure, they've grown this far, but they will find it increasingly difficult to go further. And yet, the company keeps doing precisely that.
Rebounding Manufacturing Showing Up In Higher Sales
Whether you want to look at rail traffic data or dive into the particulars of the Institute of Supply Management's regular reports, it is clear that manufacturing has been rebounding in the United States. That is good for an industrial supplier like MSC Industrial. Better still, that rebound seems to be broadening out and spreading into the small/medium-sized business sector – a key market for the company.
With that backdrop, the company favorably surprised the Street with 22% revenue growth in the fiscal second quarter. At $483 million, revenue surpassed even the highest published analyst estimate.
Better yet, profitability improved disproportionately. Gross margin ticked up about 150 basis points, while operating income jumped almost 62% and operating margin grew by more than 400 basis points. That is very solid incremental operating margin – one of the metrics that bears watch closely here – and certainly a big part of the reason that MSM handily surpassed even the high-end EPS estimate ($0.78 reported versus a high estimate of $0.72 and an average estimate of $0.70).
Better Results Are Still To Come
With a strong earnings report in hand, management at MSC raised its guidance by a fairly healthy amount. Keep in mind, too, that this is a fairly conservative management team with a history of under-promise/over-deliver behavior.
Looking around the industry, there are reasons for confidence if not optimism. Larger supply rival Grainger (NYSE:GWW) offers monthly sales reports, and daily sales in February grew 11% (or 9% on an organic basis). Likewise, companies like Applied Industrial Technologies (NYSE:AIT), WESCO (NYSE:WCC), and Fastenal (NASDAQ:FAST) have been seeing not only good demand, but growing demand and their numbers have been heading higher as well.
True, some of this may well be a byproduct of picking up demand from smaller suppliers that have gone out of business during the recession. That said, industrial activity is picking up and manufacturing companies are not only spending on equipment but start to hire workers again. Moreover, a look at other industrial suppliers like Hurco (NASDAQ:HURC) and Lincoln Electric (NASDAQ:LECO) and it seems that this is more than just the byproduct of picking up after failed competitors.
Can MSC Industrial Continue To Grow?
Frankly, that is the biggest question for MSC Industrial right now. On one hand, the company's dividend and buyback policy, including a recent special dividend, would seem to suggest that the bears are right – the company has limited future growth prospects, so it's returning cash to shareholders.
That may be too hasty and fundamentally inaccurate, though.
First, MSC Industrial and its rivals like Grainger and Fastenal compete in an extremely fragmented market. There is still ample opportunity to acquire share through competitive gains and acquisitions. Second, while much is made of the hollowing-out of the U.S. industrial base, there's more manufacturing activity here than many people realize and not only can MSC deepen its penetration into manufacturing, but it can also broaden its business base into new markets as well.
More significant is the fact that MSC Industrial just may not need as much capital to grow as some people think. MSC Industrial does not operate stores like Fastenal or Grainger, favoring instead a direct next-day mail delivery model. So while it undoubtedly takes some sales effort and some working capital to expand the catalog (another growth opportunity, by the way) and convince potential customers to use them, there's no need to sink large amounts of money into buildings.
On a similar line of thinking, there are also more opportunities for MSC to drive costs out of its own systems – including more e-commerce and more automation in its fulfillment centers. All of that reduces the capital needs of the business.
Oh, and keep in mind one other fact – MSC is for all intents and purposes a U.S.-centric company right now. Expansion into markets like Canada or Mexico won't be easy as flipping a switch, but they are potential sources of growth down the line.
A Tough Choice With A Great Company
Longs in MSC Industrial shares have a bit of a dilemma right now. Much as I may like this company, I cannot pretend that the shares offer any bargain today. Even allowing that the company regains peak cash flow production and grows from there, the market is largely already on to this story.
Much as it may call my credibility as a value investor into question, I'm nevertheless hanging on to these shares. While I certainly would love to find a great company trading at a significant discount, I'm not opposed to holding a great company trading at fair value, implicitly betting that the company will continue to grow well and build shareholder value that will lead to market-beating performance over time. Still, with the momentum in the business today, maybe even a bull like me is still under-selling the potential of this company and this stock.