By Stephen D. Simpson, CFA
Sooner or later, every investor will find a company that challenges his or her beliefs on the proper trade-off between quality and value. For me, that company is MSC Industrial Direct (NYSE: MSM). This industrial supply company has posted excellent growth over the past decade and boasts full-cycle returns that many far larger companies in less cyclical businesses never approach. While this company has ample potential to grow its footprint and top line, as well as expand those margins even further, today's valuation seems already predicated on those assumptions.
Carving A Niche In A Huge Market
Figuring out MSC Industrial's market potential is no easy task; my first job on the Street was with an analyst team that covered this company and that was a constant struggle. A good estimate, though, is probably in the $140 billion neighborhood – suggesting that MSC has less than 2% share.
Like many industrial supply companies, MSC Industrial has chosen to focus and build around a particular niche – metalworking in this case. MSC believes that this segment is about $12 billion in size and nobody seems to dispute that it is the dominant supplier.
Old Assumptions Need Revisiting
It's odd how rules of thumb can persist well past a point of relevance and the industrial supply/MRO business is no exception. Here there is a long-standing impression that Fastenal (Nasdaq: FAST) is the growth story, Grainger (NYSE: GWW) is the established and somewhat defensive play, and MSC Industrial is the cyclical player. Certainly Fastenal has a great record of growth, but MSC Industrial is not exactly chopped liver either.
At the same time, there are definitely some differences in strategy here. All three companies have gone with the industrial vending machine concept to some extent (Fastenal the most, Grainger the least), and all three are willing to take a proactive role in helping customers manage their inventory needs. Beyond that, though, Fastenal is clearly focused on blanketing the country with stores, Grainger is looking more at global expansion, and MSC is committed to a store-light model that relies on next-day shipping services. Likewise, there are different market priorities between the companies – MSC with its metalworking, Fastenal with industrial fasteners, and Grainger with operations like spill control.
Rolling Up The Weak Sisters
As companies like MSC and Fastenal get larger, the operating environment for the numerous small competitive distributors gets harder and harder. MSC has been a serial acquirer for some time and that is not likely to change. In fact, in an environment where competition is getting more fierce and access to capital more costly for small players, MSC Industrial arguably will often find it cheaper to buy than build. The argument for further deals is pretty straightforward – it can add sales and broaden the company's market exposure while also offering up cost-cutting possibilities.
Still, this remains a very competitive industry. MSC is certainly not the largest player, and rivals like Applied Industrial Technologies (NYSE: AIT), WESCO (NYSE: WCC), Anixter (NYSE: AXE) and subsidiaries of larger companies like Genuine Parts (NYSE: GPC) and Schlumberger (NYSE: SLB) are all looking for their own growth. That's also not to ignore privately-held businesses like Graybar or HD Supply, nor emering companies likes Lawson (Nasdaq: LAWS) or Interline Brands (NYSE: IBI) that would like to replicate the success of the Fastenal/MSC/Grainger models.
A Squeeze Play?
One of the downsides to MSC Industrial is that the company cannot do much to influence its largest demand factor. This company's success is predicated on the health of the economy, particularly the manufacturing sector, and especially the small/medium-sized shop or company. While manufacturing activity seems to be rebounding in the U.S. (and there's talk of bringing back jobs that once went overseas) and MSC's core small/medium category hasn't recovered as strongly as the larger corporations, the fact is that MSC can do little to influence end-user demand.
It's also worth noting that while distribution can be lucrative, it is challenging. When suppliers like Kennametal (NYSE: KMT), Sandvik, or Illinois Tool Works (NYSE: ITW) increase prices (as they recently have), MSC has to try to pass them on. MSC recently hiked prices in its so-called Big Book by about 3% and there's always that risk that rivals will try to compete on price and force MSC to choose between margins and market share.
The Bottom Line
Even with fairly robust growth assumptions, it's tough to argue that MSC Industrial is a cheap stock. All I can offer in rebuttal is that I would rather own a great company's stock at full value than buy the cheaper stock of a lesser company. Great companies have a knack of surpassing expectations and outperforming over the long haul and they're not so easy to find that they should be discarded lightly. I think any new money needs to wait on these shares in the hopes of a pullback and longs probably need to accept the idea that holding today may be inviting some short-term pain even with the prospects of long-term gain.
Disclosure: I am long MSM.