I’ve been waiting for MSC Industrial (MSM) to show some meaningful signs of internal momentum for some time… and the wait just keeps going on. While management continues to tell a story of becoming a more integrated, mission-critical partner for customers and points to future benefits from pricing actions and sales force restructuring, the fact remains that this company has established a worrisome trend of underperformance and excuse-making.
I do still own MSC and I do still believe the shares are undervalued, but I now regard this position as a future source of funds if/when a better idea presents itself, and I’m not especially comfortable holding the shares in an underperforming manufacturing distributor going into what I believe is a slowdown.
Coming Up Short In The March Quarter
MSC reported 7% revenue growth in the February quarter (the company’s fiscal second quarter), with organic growth of a little over 6% (6.1%). Revenue missed sell-side expectations by about 1%, and the company came in about a half-point short of its own organic revenue growth target.
Management noted a slowdown in the auto sector (impacting its AIS business more significantly), and that really doesn’t surprise me given the commentary from companies like Sandvik (OTCPK:SDVKY) and Stanley Black & Decker (SWK) during their fourth-quarter reports. Likewise, I don’t consider the impact of weaker demand in oil/gas and government-related business to be altogether surprising. With the Metalworking Business Index easing off (although still in positive territory), pressure on MSC’s volume is consistent with past trends in the business.
Gross margin declined 120 bps as reported and 80 bps on an adjusted basis, though this wasn’t a big disappointment. Likewise with operating income which declined 2%, and with operating margin that declined 110 bps yoy on a reported basis. All told, MSC ended up missing by about $0.02, which to be fair is not a “crisis level” of underperformance by any stretch.
Weak Guidance A Little More Troubling
What disturbed me more about the quarter was the weak guidance. Management’s mid-point for fiscal third-quarter EPS was 7.5% below the prior average sell-side estimate, and the organic top-line growth expectation has shrunk to 4%. At the same time, the expectation for gross margin wasn’t quite what I’d hoped to hear.
To be sure, my expectations for volume-driven revenue growth for the next few quarters was not all that strong relative to expectations. As I said, I’m more bearish than many sell-siders on growth prospects for the U.S. in the second half of 2019, as I think slowdowns in areas like auto are spreading into other sectors like the nebulous “general industrial/manufacturing” that makes up a meaningful part of MSC’s customer base.
Still, with a 2%-3% price hike in February, the underlying volume growth implication isn’t so encouraging, and I’m concerned that operating leverage assumptions once again seem too high. To be sure, I’m also concerned about Fastenal (FAST) and W.W. Grainger (GWW), though Fastenal had a better recent quarter relative to expectations and in absolute terms with gross margin and revenue growth.
The bull thesis for MSC really does rely on the company shifting away from being “just another distributor” for its customers to a more value-added, more integrated “partner” to its customers. I’m skeptical, in part because while MSC does indeed have a strong presence in an area of distribution that requires more expertise and customer service (metalworking), and that shields it from more price-based competition from the likes of Amazon (AMZN), there still are other competitors (including a Berkshire Hathaway (BRK.A) (NYSE:BRK.B) subsidiary) with similar business plans and past efforts to realign the business to generate more growth and better margins have come up short.
My key concern on MSC remains that differentiating itself from the crowd in distribution is going to get harder and harder, and it will be more difficult for the company to generate growth and margins meaningfully above the norm. The company’s decision to expand into Mexico makes a great deal of sense to me, but I think it will be some time before this can really move the needle on growth. At the same time, the company’s track record with M&A hasn’t been very strong in recent years, so it seems more and more to me that the company will have to find its answers internally.
I’ve trimmed my growth expectations slightly, with my long-term revenue growth outlook now slightly below 4%. I’ve also trimmed back my long-term FCF growth expectations (by about half a point on a long-term basis), with a lower gross margin as the primary driver. While there is room for MSC to outperform my expectations, particularly on operating expenses and net working capital efficiency, I consider those “show me” stories now. With these changes, my DCF and EBITDA-based fair value estimates decline from the mid-$80s to mid-$90s to the low-to-mid-$80s.
The Bottom Line
I do still see some value in these shares, but that value has to be weighed against a management that has been long on excuses and promises of future improvement and rather shorter in delivering the goods. I believe time is running out (in terms of a “benefit of the doubt” valuation multiple) for management to show the expected improvements, and slowing macro trends don’t help, so I would be cautious about committing to a large new position here until there’s more evidence of an upward inflection.
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.