The North American MRO market is ripe for consolidation and MSC Industrial (NYSE:MSM) has made it clear that it intends to be one of the consolidators. On Friday morning MSC Industrial announced a large transaction - an agreement to buy the North American distribution business of Barnes (NYSE:B). This deal will not only add incremental revenue to MSC Industrial, but it also adds entire new lines of product distribution and customer categories.
The Deal To Be
Assuming that the deal goes through as planned, MSC Industrial will acquire the Barnes Distribution North America (BDNA) business of Barnes for $550 million in cash. MSC Industrial will pay for the deal with cash on hand and a credit facility/term loan that it later intends to refinance long term. All told, about $400 million of the purchase price will likely be borrowed at a long-term interest rate below 3%.
MSC Industrial expects the deal to close in its fiscal Q3, likely March or April of 2013. Due to the structure of the deal, the company expects to recognize about $100 million in tax benefits, substantially reducing the long-term effective cost of the transaction.
What MSC Industrial Is Buying
In buying BDNA, MSC Industrial is buying its way both into the Class C MRO market and several new sizable addressable end markets.
The MRO market (that is maintenance, repair, and operations) is a large, highly fragmented market that includes myriad items that companies need to operate - everything from welding equipment to fasteners to tools to hydraulic components to janitorial supplies. The market is generally split into three silos - Class A, Class B, and Class C - on the basis of unit prices. Class A MRO supplies typically cost more than $250 per unit, while Class B supplies cost $10 to $250 per unit, and Class C is $10 and below per unit. Of course, it's never that simple. Major MRO suppliers like Grainger (NYSE:GWW) and MSC sell across Class A, B, and C, while Fastenal (NASDAQ:FAST) tends to focus on Class B and C. BDNA, is almost exclusively focused on Class C.
By product, fasteners are more than 25% of the mix at BDNA, putting MSC Industrial into a large, new product category (MSC is traditionally strong in metalworking) and into closer competition with Fastenal and Lawson (NASDAQ:LAWS). BDNA also sells significant amounts of hydraulic components, industrial maintenance equipment, electrical components and so on (including fittings, fuses, hoses, and so on).
Expanding its presence in Class C would arguably be reason enough to do a deal like this, but there's even more potential here. In buying BDNA and bringing its 800 sales reps into the fold, MSC Industrial is also significantly expanding its addressable markets. I estimate that BDNA gets more than 30% of its sales from the transportation vertical (including railroads) - an area where MSC has had little presence. Likewise, BDNA will introduce MSC to the natural resources market (where it may compete more with DXP (NASDAQ:DXPE) and extend/expand its exposure to government buyers).
In buying BDNA, MSC is also extending its reach into Canada - something that management has mentioned as a long-term goal for the pre-deal company.
Can The Businesses Mesh Together Well?
MSC Industrial has built itself on its non-store asset-light model - providing customers with thick catalogs (and more recently, extensive online information) and rapid (often next-day) delivery. Like Grainger and Fastenal, MSC has also gotten into the industrial vending business in a significant way.
The BDNA business is different. First, BDNA is a top player in "vendor managed inventory" - a system whereby companies like BDNA basically manage customers' storerooms and handle the inventory and ordering for them. Risk is shared between the two parties, and it has proven to be an effective way of managing inventory for items that are too numerous and trivial to make close tracking economically viable.
Certainly there are risks in combining these "chocolate meets peanut butter" approaches. MSC Industrial has a good history of integrating deals, though, and I like the odds that management will find the right blend - basically expanding into vendor managed inventory with existing MSC vending customers and bringing vending into BDNA's VMI clients.
Likewise, I see significant potential synergy between the two customer bases. MSC Industrial does not currently sell much in the way of fasteners, hydraulics, and fittings to its metalworking customers, and likewise BDNA has not been selling much in the way of tools or metalworking components to its Class C customers. Bringing those two together, and perhaps displacing rivals like Fastenal or Lawson, or the numerous sub-1% share companies in the MRO market, could be powerful.
Running The Numbers
MSC management was somewhat circumspect on its conference call, not being able to divulge what is still proprietary and sensitive information about Barnes. That said, using historical data from Barnes I think a few broad conclusions are possible.
First, the business brings about $300 million in revenue, against a trailing run-rate of $2.4 billion at MSC. BDNA has higher gross margins than MSC, likely on the order of the low-to-high 50% margins at Fastenal and Lawson versus the mid-40% at MSC. BDNA falls down on operating efficiency, though.
While MSC management wouldn't go into detail, data from Barnes suggests an operating margin in the neighborhood of 8% to 9%, almost half that of MSC. Management sounded pretty optimistic about improving this over time; while BDNA's business is more labor-intensive than MSC's (800 sales reps versus 1,150 for MSC), it sounds like there is more than a little fat in the overhead structure. If so, MSC will quickly cut it.
On first blush, it looks like MSC paid about 1.8x sales and about 13x to 18x EBITDA, a pretty pricey deal for a company with single-digit revenue growth. Keep in mind, though, that sometimes the sum is greater than the parts and adding BDNA's customers could significantly improve MSC's long-term growth. What's more, Barnes has been looking to slim down and focus around its manufacturing and aerospace businesses for some time, so I wouldn't assume that the company has sent the best and brightest to run BDNA, nor allocated all the capital it might want to fund its growth.
Remember, too, that MSC is getting substantial tax benefits from the deal and expects to drive upwards of $20 million in annual synergies (eliminating redundant overhead, improving purchasing, etc.). Factoring in the tax benefits, the deal multiples appear to shrink to about 1.5x sales and 10x to 15x EBTIDA - not a bargain (unless you're comparing it to Fastenal, which I wouldn't do), but not a bad price if MSC can avail itself of those new products, customers, and end markets.
The Bottom Line
For a little while now, MSC Industrial's management has been looking to expand into new MRO product categories like fasteners and expand into new end markets like transportation, not to mention expand the business north and south from the U.S. With this deal, MSC has done all of that in one fell swoop. This also happens to be a good deal for Barnes, as it gives the company over half a billion dollars in cash and an abundantly fair multiple for a business it didn't really want to keep.
I'm not doing handsprings about the deal price, but MSC has a knack for doing deals that look kind of pricey initially (J&L, a deal with Kennametal (NYSE:KMT)) and really pay off down the line. With this deal potentially adding more than 1% to long-term free cash flow growth, fair value on MSC Industrial moves into the $90s.
Disclosure: I am 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.