I like MSC Industrial (NYSE:MSM), one of the largest industrial distributors in the country, but that doesn't mean I think it's worth paying any price to own. The shares have done pretty well since my last update, but then so have other distributors like Grainger (NYSE:GWW) and Fastenal (NASDAQ:FAST), as well as Kennametal (NYSE:KMT), a large manufacturer of metalworking tools and a significant MSC supplier. Some of this optimism makes sense as a reaction to the significant pessimism around industrial companies around the turn of the year, as well as the recent upward trends in the Purchasing Manager's Index and Metalworking Business Index.
Management didn't have a lot to say on the call that I considered encouraging, but I do believe that 2016 is still likely to be the low point for the company in terms of revenue performance, and management is doing well with margins. I still believe that MSC can deliver long-term growth of 5% on the top line and around 10% in FCF, but that means the shares are more or less fairly valued today.
A Decent Quarter In A Not-So-Decent Environment
MSC reported slightly more than a 3% decline in sales for the fiscal second quarter, very slightly below the average sell-side estimate and the midpoint of management's guidance after the first quarter. Manufacturing demand/sales continues to be weak (down 5.6% yoy after a 4.9% decline in the first quarter), and that's a clear headwind given that MSC is more manufacturing-centric than any of its peers. Non-manufacturing sales growth improved (up 2.6% this quarter versus 1.3% in the first quarter). E-commerce sales rose 1% over last year, and it sounds as those the CCSG business improved a bit.
Gross margin declined 30bp from last year (slightly better than expected), and there's still no real pricing power in the market. Operating income declined 7% and operating margin declined 40bp, but this was better than expected and MSC managed a two-cent beat versus the average estimate.
It's Tough Out There … And Management Isn't Offering Much To Encourage
Although the operating conditions for MSC don't seem to be getting worse, they aren't improving fast enough to inspire a great deal of confidence in a meaningful near-term growth rebound. Management's revenue guidance for the next quarter was about 1% lower than the prior average estimate and works out to a roughly 1.5% year-over-year decline.
MSC's daily sales wobbled from down 1.6% in December to down 5.5% in January and down 2.3% in February, but have taken another move down in March (down 4.8%). Looking at recent results from Grainger and Fastenal doesn't help much - Fastenal reported 3.3% growth in January sales and 2.6% sales growth in February, while Grainger reported a 2% improvement in January and a 2% decline in February.
Given the differences in their weightings toward metalworking tools (more than 10% of Grainger sales, but around 5% of Fastenal's), maybe these results help corroborate the idea that weak metalworking conditions are still the primary headwind for MSC. To that end, I'd also note that the U.S. Cutting Tool Institute's data have been pretty ugly, with a nearly 17% decline in January following a 5% decline in December. While the Metalworking Business Index has been improving (44 in December, 44.4 in January, 46.3 in February, and 49.7 in March), the trailing 12-month 45.9 is still weak and March's 49.7 means that the declines are still continuing albeit at a slower rate.
So, what irked me about management's comments? First, the company blamed Spring Break and aerospace for some of the weakness, but Spring Break comes every year and MSC has never before quantified a meaningful exposure to aerospace. I'd also note that the company saw its field rep count decline by 30 qoq, while the total number of associates declined by 62 - not exactly what you'd expect to see if management were preparing for growth right around the corner.
I'd also note that management said that it is exploring the purchase of the Atlanta distribution center. This DC is owned by the same family that controls the company. There are valid reasons for MSC to want to own this facility, but this is the sort of transaction that merits careful monitoring from a corporate governance/fairness standpoint.
On The Other Hand...
I don't believe it's all doom and gloom. Management announced a distribution agreement with Schneider (OTCPK:SBGSY) that will see the company add more than 50,000 electrical products to its offerings (a roughly 4% increase in SKUs). I believe that diversifying beyond metalworking tools is a must-do for MSC, and Schneider is a very good partner to do it with in electrical products. This does not mean that MSC is looking to challenge WESCO (NYSE:WCC) in any meaningful way (WESCO distributes over 1 million products, with about 40% to 50% of them classifiable as "electrical"), but it does expand the company's opportunities to grow share-of-wallet with existing customers.
I would also note that MSM is doing quite a bit better with expense control than it has in prior downturns. Given that downturns don't last forever, I think this leaves the company well-positioned for the eventual recovery in industrial demand. When that happens, MSC should benefit from both demand growth and some pricing power. How long "eventual" takes is still an open question, though, as manufacturing outside of aerospace and autos isn't all that great right now in the U.S..
The Story Remains Basically The Same
I did make a few adjustments to my model here and there (increasing my FCF estimate for 2016 on lower working capital, but lowering future FCF estimates to reflect a rebuilding of working capital when demand/volume recovers), but the net effect was no real change in my expectations.
I'm still looking for long-term revenue growth of around 5%, versus a trailing rate of over 9%, and a FCF growth rate of around 10% supported by a roughly one-point improvement in long-term FCF margin. That margin improvement would be driven by modest improvement in gross margin (less than one point over the trailing long-term average) and a gradual decline in SG&A spending that would support a return to high teens operating margins. I'm not expecting much net change in the company's net working capital needs relative to the scale of the business.
Discounted back, those cash flows still support a fair value around $70, but that's not so exciting given how the shares have performed recently. I'd also note that the company is experiencing a more extended period of sub-optimal ROICs than it has in past downturns, and I don't know that regaining a high teens or low 20%'s ROIC is realistic anymore. Still, a mid-teens ROIC is hardly something a company needs to apologize for, and I believe it reflects the quality of the business.
The Bottom Line
My biggest concern now about MSC is that the company is paddling hard just to hold its position against a negative current. With everyone fixated on costs these days, squeezing middlemen like MSC is an option that larger accounts are going to consider, and MSC remains very vulnerable to extended weakness in the manufacturing sector.
All of that said, I think it's important to remember that things often look horrible near the bottom of cyclical declines, just as they'll look awesome again at the peak of the recovery/expansion. I'm not eager to recommend purchasing MSC today given the valuation, but I'm content to continue holding absent any real sign that MSC is losing ground within its core markets and/or that the industrial distribution sector is really undergoing any sort of fundamental negative changes.
Disclosure: I am/we are long MSM.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.