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It has been a long time since I covered MSC Industrial Direct Co., Inc. (NYSE:MSM). In fact, it was 2017 when I believed that margin challenges at the time could just be a start of its woes.
The MRO distributor saw sales increase, but margin pressure was kicking in, as I feared the impact of stiff competition, certainly on non-value added products, with investor fearing the entrance and focus of Amazon.com (AMZN) on the MRO business.
While this entrance has only been very limited, MSC has seen margin pressure nonetheless. With growth being little inspiring in recent years, the company has regained some operating momentum again post the pandemic, as this observation, modest valuations and some shareholder-friendly moves create a more favorable risk-reward proposition.
A Recap
MSC Industrial is a distributor of MRO products, operating 80 branches which in their turn are supplied by 5 distribution centers back in 2017. These are very large individual businesses, with the company posting sales at nearly $3 billion per annum.
Consolidating half a million SKUs from some 3,000 suppliers make that MSC created a one-stop solution for its clients. The company has seen strong double-digit growth in the decades before, while posting operating margins in the low double-digits.
The company operated in a highly fragmented MRO market, the reason why names like MSC but also the likes of Fastenal (FAST) and W.W. Grainger (GWW) were consolidating, both organically and through M&A efforts. While this looked good, online competition was arriving, potentially disrupting the steep (gross) margins reported by these businesses.
Amidst the boom in the U.S. shale energy industry in 2014, shares of MSC peaked near the $100 mark, but fell to the $60 mark in 2015 amidst a stronger dollar and retreat in energy markets. This came as historical operating margins around 17-18% had fallen to 13-14% of sales, although that shares recovered to the $100 mark in 2017.
With the company trading at market multiples and employing relatively modest leverage, I failed to see the appeal, largely on the impact of lower potential margins of the business going forwards.
What Now?
Shares of MSC have been trading flattish since 2017, trading around the $75 mark pre-pandemic, as shares recovered to the $95 mark in 2021 amidst the recovery in the economy and the stock market. Shares have largely traded around the $75 mark in 2022, and recently rallied to the $100 mark, now trading a few dollars below this number.
Fast forwarding to October 2022, MSC reported its 2022 results. Revenues rose by a solid 13.8% to $3.69 billion and while this was decent, cumulative sales growth between 2017 and 2021 has been stuck to around 10%. Adjusted operating margins of 12.9% worked down to adjusted earnings of $6.15 per share and while margins improved 140 basis points on the year before, this is still down from 2017, the reason for my caution.
In January, the company posted a 12.9% increase in first quarter sales to $958 million as adjusted margins improved a point to 12.3%. This was followed by two bolt-on deals announced the same month, with the purchase of Buckeye and Tru-Edge adding a combined $28 million in sales, a truly bolt-on deal. Second quarter sales rose 12.2%, as margins were up 60 basis points to 12.2% of sales. More good news arrived in June, as the company reached a deal with the Jacobsen/Gershwind family to exchange high-vote stock and eliminate the dual class stock structure.
In June, MSC reported an 11.4% increase in third quarter sales, although that operating margins of 13.1% were actually down, in what generally is a seasonally strong quarter. At this pace the company is on track to post $4.0 billion in sales and earnings likely around $6.50 per share, although that the third quarter saw some margin pressure. This was driven by solid operating conditions, as well as market share gains, which have been a driver behind the topline sales growth.
Moreover, net debt of $406 million is rather modest, with EBITDA trending around $575 million here. This reveals that a business with less than 1 times leverage trades around 15 times earnings, quite frankly being rather non-demanding multiples, certainly as the top line performance is good but, of course, in generally an inflationary environment.
Moreover, it is the elimination of the dual class share structure which might ignite potential, or perhaps speculation on M&A action, as this remains a rather small business, with competition likely on the look-out for further consolidation candidates.
A Final Word
The reality is that MSC Industrial Direct Co., Inc. has been showing stronger growth than the overall industrial production index since the outbreak of the pandemic, indicating that the business has been outperforming peers driven by growth initiatives and pricing efforts. While net debt is very modest, it should be said that a part of the recent deleveraging has been the result of the securitization of accounts receivables in recent times.
Quite frankly I see better operating performance (although the third quarter was a bit weaker), on the back of an improved competitive position, lower debt and a gradual compression of valuation multiples. This makes me quite upbeat, certainly in combination with shareholder friendly moves (i.e., the elimination of the dual class structure), which makes me upbeat, and willing to buy on dips.
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