Elevator Pitch:

MSC Industrial Direct (MSM) is the fourth largest industrial distributor in the US with significant room to grow market share in a highly fragmented industry. Today Mr. market is offering us shares at a 20% discount to the 10-year NTM PE, 18x, while the company is under-earning with EBIT margins over 10% below the 10-year average, 15%, and 25% below the prior 2 peaks (~17.5%). Their industrial end markets (~70% of revenues) are recovering strongly from the recent oil price decline led recession, and their recently completed salesforce realignment should accelerate revenue growth into the high-single digit range. Given the high incremental margins of 20-30% MSM should return to earning their 10-year average EBIT margin of ~15% by FY2020 (which begins in under 5 quarters) leading to EPS nearing $8 per share. Assuming only the average multiple over the past 10 years, (18x), MSM would trade at $144 per share at the end of August 2019, over 60% upside in under a year.

Additional upside comes from their 2.7% dividend and the potential for increased capital return given the company’s strong FCF through the cycle and underleveraged balance sheet of less than 1x ND/EBITDA on current depressed profitability. To put current depressed margins into perspective the 13.1% EBIT margin generated in FY17 is 60 basis points lower than what it was in FY09, the depths of the financial crisis.

Follow-on Commentary:

MSC Industrial Direct is a distributor of metalworking and MRO (maintenance, repair, and operations) products and services. The company has an over 75-year history in this business and works with a broad range of customers from governments to heavy manufacturing. In fiscal year 2017, the company generated 68% of revenues from manufacturing clients (~50% heavy industry ~15% light industry) and 32% of revenues from non-manufacturing end markets. [1] The company’s core segment, manufacturing, is down from 76% of the business in FY13, reflecting the recent industrial recession.[2] In fact, the company saw manufacturing revenue declines of nearly $200mm from FY2013 to FY2017 ($2.1bn to $1.9bn). As the economy bounces back, the company should regain this revenue and more leading to significant incremental margins. Adding to the potential for margin expansion, in FY15 the company opened a new distribution center in Columbus Ohio to support their next leg of their growth. This represented $56mm of capex for the DC alone and an additional

The company has a core competency in providing metalworking products (cutting tools, etc.) and with nearly 100 metalworking specialists on staff.[3] We spoke with Grainger management about competing with MSC in the metalworking space and they commented that while they did own a metal working business they were not aggressively looking to grow it. This is a major change in tone from the 2015 acquisition of WFS limited (said metalworking business) when Grainger called out metalworking as a growth opportunity. This anecdote highlights the defensibility of MSM’s core business. Metalworking is estimated to represent ~45% of company revenues.[4]

The North American Industrial Distribution industry is extremely fragmented with estimated to be over $150bn in revenues spread among >150,000 suppliers.[5] MSM, is the fourth largest player and has just 2% share. W.W. Grainger is the largest with ~6% market share. The business is highly cash generative, and relationship driven which has historically allowed smaller players to compete. However, another major factor in the survival of the smaller players has been the tax benefits of being an LLC or an S-corp versus a C-corp. The recent tax cut not only improved FCF conversion of the businesses, but it also somewhat leveled the playing field with the mom and pops that were avoiding the double taxation effects of being a c-corp. While the playing field is still not completely level, the family car is still going the business pre-tax, this could help the large players gain share long-term should they choose to lower prices in response to the tax benefit. That said, I do not expect the larger players such as MSM to lower prices. In fact, MSM and GWW are talking about small price increases in the coming months to offset inflation and freight. As such, I believe MSM’s 25%+ pre-tax ROIC is safe, and their ROE is likely to approach 30%.

MSC Industrial Direct 2007-2017

FAQ’s

·         What about Amazon risk?

o   In FY17 60.8% of MSC’s revenue was generated through ‘eCommerce’[6] and other innovation supported channels. As such, MSC is already providing the ease and convenience that exists from an Amazon. Over 99% of their orders achieve same day fulfillment rate, and orders completed before 8pm (except for Class C products) all have next-day delivery nationwide as an option.[7]

o   The company had 2,370 Field and Service associates at year-end FY17, and 1,007 In-bound sales representatives standing by to help customers with questions. In addition depending on the size of the customer they will have a direct sales rep who covers their account providing value add service to save their customers money,

o   In FY17 29% of MSM SKUs are private label or exclusive to MSM helping save customers money and deepen their competitive advantage.

o   Level of Concern: Low

·         Will MSM have to cut prices like Grainger?

o   Grainger had been losing market share in the small and medium customer market for the better part of the last decade. They pushed through with a price cut as they said small tests that COO (now CEO) DG Macpherson had executed showed a positive overall improvement. MSM’s CFO has informed us that they consistently test lower prices and the volume response has not been sufficient.

o   That said in FY16 and FY17 the company did see growth from large customers and national accounts but declines at small customers. However, this has reversed in 1H18 giving us confidence that while their list price mechanism is likely a bit outdated they are not as overpriced as Grainger. In addition, the price cut has worked out tremendously for GWW as such I would almost welcome pricing action on the side of MSM in order to set the business up for potentially accelerated growth going forward.

o   The company has stated that only 5% of purchases are off contract

o   Level of Concern: Low/Medium

·         Trade War/Macro Fears

o   About 50-55% of the companies, COGS are in some way related to OUS manufacturing. In addition, their largest supplier accounts for only 6% of revenues and they can source from many different countries and regions, as such, they should be able to handle these issues in the medium term through better sourcing. In the short-term they should be able to take price which has historically been very good for them as it can lead to expanding gross profit dollars, leveraging operating costs.[8]

o   A trade war however would be undeniably bad for MSM given they benefit most from rising metalworking demand, and more generally a strong economy. The positive is that having come through an industrial recession already MSM’s margins are depressed, as noted current EBIT margins are below those in FY09, and the current multiple on those depressed earnings of ~14x does not imply significant future growth or margin expansion limiting downside if a worst case scenario comes to fruition.

o   That said if a trade war breaks out, and the economy does poorly industrial distributors have typically outperformed the S&P given their product offerings are fairly recurring in nature, and the companies end up harvest working capital by reducing inventories and collecting on receivables.

o   Level of Concern: Low/Medium

·          

 Notes/Primary Source Data

We offer next-day delivery nationwide for qualifying orders placed by 8 p.m. Eastern Time (excluding Class C category products).

We have a dedicated team of nearly 100 metalworking specialists, who work with customers to improve their manufacturing processes and efficiency, as well as a technical support team that provides assistance to our sales teams and customers via phone and email.

The most recent MSC catalog issued in September 2017 merchandises approximately 500,000 core metalworking  and MRO products, which are included in the SKU totals above. Approximately 29% of these SKUs are MSC exclusive  brands.

A significant number of our products are carried in stock. Approximately 77% of sales are fulfilled from our 12  customer fulfillment centers and 93 branch offices.

We have experienced the highest correlation between our  sales trends and the MBI by using the rolling 12-month MBI average on a four-month lag.

Issues with the business

·         In FY17 annual report stopped disclosing number of active customers. this had gone flat in the past year with growth slowing dramatically in the past few years. this is a poor sign and likely indicates a decline (why top sharing if it is a good metric)

o   The company has seen rev declines at non-large customers and revenue accounts for the past few years.

§  “Of the total increase in net sales, sales to our  government and national account programs (“Large Account Customers”) increased by approximately $27.4 million and  sales other than to our Large Account Customers decreased by approximately $3.2 million.” FY2017 Annual Report FY17 vs. FY16

§  “Of the total decrease in net sales, sales other than to our Large Account Customers decreased by approximately $72.2 million, partially offset by an increase in sales to our Large Account Customers of approximately $25.3 million.” FY2017 Annual Report FY16 vs. FY17

o   This has been hurting margins –

§  Gross profit margin was 45.0% in fiscal 2016 as compared to 45.2% in fiscal 2015. The decline was primarily a result of changes in pricing and customer mix.

§  Gross profit margin was 44.5% in fiscal 2017 as compared to 45.0% in fiscal 2016. The decline was primarily a result of changes in pricing and customer and product mix.

o   As of yet the company has been able to make up for this by growing sales with their large customers. However, they will not come at the same gross margin, or EBIT margin.

§  GWW had this same issue and they had to cut prices.

·         Foreign Sourcing/Tarrifs?

o   about 12% to 15% of our cost of goods sold comes directly from outside the U.S., and we believe, we don’t have the exact numbers, that with U.S. purchases that are actually foreign sourced, it’s roughly about 40%. 1Q2018 MSM Earnings Call