By any reasonable standards, MSC Industrial (MSM) had a fine quarter. Unfortunately, valuation and expectations have climbed to a level where the standards aren't necessarily reasonable, and shareholders may have to buckle up and prepare for more volatile performance in the stock.
Growth Continues, But Where's The Leverage?
The manufacturing sector of the U.S. economy continues to rebound and grow, and that's showing up in MSC's revenue. Revenue grew more than 16% this quarter and the company continues to post double-digit organic growth as well. While non-manufacturing sales picked up (up 9% this quarter versus 4% growth in the last quarter), manufacturing growth also remained strong at more than 19%. Website sales grew 26% this quarter and now make up about one-third of sales.
The company did not do as well when it came to driving ongoing profit leverage. Gross margin (46.1%) dropped 70 basis points from last year and 10 basis points from the prior quarter, reversing what had been a good run of improvements. Operating income rose about 20% and though operating margin improved from last year's level, it did come in below both average sell-side expectations and the prior quarter.
Does Management Need To Talk Itself Up More?
MSC Industrial has a long record of quiet excellence; delivering not only double-digit free cash flow growth over the past decade, but also establishing itself as the largest supplier in metalworking supplies by a large margin.
Despite that record, MSC Industrial doesn't necessarily get its due. Much is made of the company's cyclicality, but it really isn't any more cyclical than Fastenal (FAST) or Grainger (GWW). Likewise, although Fastenal is often praised as the growth play in industrial supply/distribution, Fastenal has only barely outgrown MSC by most metrics over the past decade.
At the same time, MSC Industrial has developed a best-in-class e-commerce platform, joined its two largest rivals in the industrial vending space, and actively pursued accretive acquisitions. What's more, the company is shifting to more efficient product sourcing and expanding its presence in markets like fasteners and power tools. Last and not least, while much is made of Grainger's overseas growth potential (and the European MRO market is probably one-third larger than the U.S. market), MSC's expansion into Mexico and Canada should offer very capital-efficient profit growth potential as the company will not need to completely replicate its logistics infrastructure.
Still Tied To Manufacturing … And That's A Good Thing Today
While MSC still has numerous avenues to growth (including the incremental acquisitions of smaller specialized distributors), it's ultimately still a manufacturing story. ISM's Purchasing Managers Index has been showing lower readings on a year-on-year basis, but the readings have consistently stayed above 50 (indicating expansion) and that has almost always been supportive for MSC's growth and share price in the past.
The question for MSC Industrial today, then, is not so much about the state of the addressable market as it is about its ongoing internal leverage improvements. While productivity measures like sales force and call center efficiency have been holding up, it does seem like cost inflation is still a factor and the company has to deliver better margins to support the story.
The Bottom Line
I have never been especially shy about my admiration for the management team here, nor for the company's long-run potential as a consolidator in the industry. That said, even I acknowledge that today's valuation is demanding (even if Fastenal's valuation is even more so) and the company is going to have to start shoring up the Street's confidence in regards to its expansion and leverage opportunities to enjoy even higher multiples.
I do believe that the company can continue to deliver double-digit free cash flow growth, and MSC may be one of those relatively rare companies where growth accelerates as the company gets larger. Even with that expectation, though, fair value is still in the low $80s and MSC Industrial shares are no particular bargain today. While I do prefer to hang on to fairly-valued good companies, and I'm in no hurry to sell MSC Industrial shares, there are definitely better bargains out there in industrial/manufacturing stocks.
Disclosure: I am long MSM.