4 Takeaways From MSC Industrial's Earnings Announcement

Summary

• MSC Industrial clocked in robust top line gains.
• Unfavorable changes in inventory and accounts receivable put a dent in free cash flow.
• Expansion in operating expenses was a little excessive contributing to net income decline.

On Jan. 7, metalworking and maintenance and repair distributor MSC Industrial Supply (NYSE: NYSE:MSM) came out with its Q1 FY 2015 earnings announcement. The company reported solid revenue expansion vs. the same time last year. However, there are some concerns investors need to weigh. Let's take a look to see what is going on with this company.

Revenue increased

In the most recent quarter, MSC Industrial saw its revenue increase 7.8% vs. the same time last year. An improved economy as well as market share gains from the company contributed to the expansion of revenue. This means the company is seeing some improvement in demand for its products and that it's gaining headway over its competitors. Improving demand is always a good sign for the long-term investor.

Net income and free cash flow declined

However, MSC Industrial's quarterly net income declined 3% vs. the same time last year as an excessive increase in operating expenses ate into operating income. Operating income also declined 3% vs. the same time last year which contributed to the overall contraction in net income.

Free cash flow declined 52% year-over-year. Unfavorable changes in operating assets and liabilities, especially inventory and accounts receivable, contributed heavily to this decline. MSC Industrial also increased its capital expenditures 7% putting a bigger dent in its free cash flow. Hopefully, the negative impact from inventory will subside throughout the year as demand improves. Also, free cash flow should improve as customers pay their bills.

Balance sheet is ok

MSC Industrial sits on an ok balance sheet. Its $46.7 million in cash equates to a mere 4% of stockholder's equity. I prefer to see companies maintain a cash balance greater or equal to 20% of stockholder's equity to help get them through rough times.

Long-term debt creates interest cost which chokes out profitability and cash flow. With that said, MSC Industrial maintains a reasonable level of long-term debt. Its $234 million in long-term debt equates to 19% of stockholder's equity. I like to see that figure at 50% or less.

Dividends

The best way to gauge dividend sustainability is to see how much a company pays out in dividends compared to its free cash flow. While MSC Industrial paid a one-time special dividend its normal dividend payment amounted to 55% in the most recent quarter. I like to see companies pay out 50% or less of their free cash flow in dividends and retain the rest for reinvestment back into the business. MSC Industrial's dividend to free cash flow amounted to 41% in FY 2014 meaning that its dividend payout ratio is reasonable on a full year basis. Currently, the company pays its shareholders $1.60 per share per year and yields 2% annually.

Looking ahead

MSC Industrial currently trades at a P/E ratio of 20 vs. 19 for the S&P 500, according to Morningstar, making it slightly overvalued. I would like to see the company's free cash flow situation improve before buying the stock. Hopefully, demand will continue to improve over the long-term boosting fundamentals and subsequently its stock price. Right now investors should stay away from this company.

Analyst’s Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.