By Stephen D. Simpson, CFA
There are certainly plenty of valid economic indicators that say conditions today are not strong – whether its high unemployment, stagnant wage growth, poor housing prices, or low interest rates. At the same time, it's not all bleak. Plenty of industrial companies have continued to post robust earnings and indicators like ISM and rail traffic have been modestly positive. It's interesting, then, is that an industrial supply company like MSC Industrial Direct (NYSE: MSM) is enjoying some of the best operating performance of its corporate history against a such a mixed backdrop.
A Solid Start To The Year
MSC Industrial posted first-quarter results that met the midpoint on revenue, but showed a little bit extra on the bottom line. Revenue grew more than 15% this quarter, with a recent acquisition chipping in about 2.5% growth (meaning organic growth was just under 13%). Sales to manufacturing customers were even stronger, growing almost 20% and making up nearly three-quarters of sales. Sales growth to non-manufacturing customers was less impressive, up just about 4%, as expected declines in sales to government buyers weighed on results.
Consistently improving profitability has long been part of the MSC story and this quarter was no different. Gross margin improved 20 basis points despite 55bp of dilution from an acquisition. Likewise, operating income rose more than 25% and operating margin expanded nearly 60 basis points despite a 40bp headwind. Incremental margins were 27%, with acquisition dilution dinging this number by 500 basis points.
Still Early Days In The Growth Story
MSC Industrial has been a very good growth story for a long while now, but management expects even more. While the quarterly conference call included a doze-inducing trip down memory lane, there were some definite nuggets along the way.
For starters, the company is targeting a whopping $10 billion in sales in the reasonably foreseeable future. The company is hoping to achieve this with a multi-prong strategy. Part of the strategy involves an ongoing migration away from being just a facilitator of spot buys to being a more fundamental part of customer supply sourcing.
MSC is also looking to expand its presence in product categories like fasteners, power tools, and material handling products – threatening, perhaps, to move a bit more into the kitchens of rivals like Fastenal (Nasdaq: FAST), Applied Industrial Technologies (NYSE: AIT), HD Supply, and perhaps even Home Depot (NYSE: HD) to some small extent.
MSC is also looking to expand beyond metalworking (which it already has) and target new end-markets, especially under-penetrated aspects of the manufacturing sector that may allow the company to capture more revenue from existing customers (great for margins).
Last and not least, the company is also talking about eventual international expansion. This is a page out of Grainger's (NYSE: GWW) book and there's definitely opportunity not only in mature markets like Canada, but nearby emerging markets like Mexico as well.
How MSC Is Stacking Up
Based on this quarter, MSC Industrial continues to look like a share-gainer in the MRO/industrial supply space. The company is growing well relative to the much-larger Grainger; Grainger reported monthly U.S. sales growth of 9%, 9%, and 7% for the same months covered by MSC's recent quarter. While that pales a bit next to Fastenal's 22% growth in the September quarter, MSC's growth isn't dependent on that more capital-intensive store-based growth model.
It would have been nice if management had offered more commentary on volume during the prepared remarks. For instance, while the company did announce a general 3% price increase in its latest Big Book (its master catalog), surely there are some discrepancies in pricing and some impact to sales from mix shift.
The Bottom Line
Some may read into MSC Industrial's announcement that performance is at a record high the threat that margins have peaked. Surely incremental operating margins are likely to come in a little from here, but the company still has levers to pull to drive better margins – not the least of which is the integration of the large ATS acquisition that diluted results this quarter. Moreover, there are plenty of acquisitions left to make in this industry and those hold the potential of long-term operating leverage.
Giving a slight bump to expected free cash flow on the basis of this quarter doesn't change valuation too dramatically, nor does it make MSC Industrial stock a screaming bargain. Still, the company is a share-gainer and a proven quality growth name and I see no reason to leave today.