Description

MSC is a leading distributor of MRO and industrial supplies that span everything from metalworking supplies such as cutting tools to other categories like safety, electrical, hand and power tools, etc. The company was founded in 1941 and founding family retains a significant stake in the company (through Class B voting shares), owning nearly

30% of the outstanding shares and grandson of the original founder is the current CEO.  Company generates ~$3Bn of revenue in a very fragmented industry estimated at $140Bn, with top 50 distributors having ~30% of the market.  The remaining 70% of the market is made up of small local players.

 ~70% of MSC’s revenues are concentrated in the manufacturing sector, with the biggest component coming from the metalworking and cutting tools sector (e.g. drill bits, saw blades, and the machines and tools that use them) - metalworking market is ~$12Bn, and MSCI is the largest player with a 10% share.  The remaining part of the business is focused on MRO products with key focus areas in safety, materials handling, paint and lightning. 

While distribution can be considered a commodity business with low barriers to entry and players acting as just “middlemen”, as seen by the fragmented nature of the market and populated by small local players, large scale players enjoy significant barriers to entry.  I would argue that the key customer value proposition for larger national distributors like MSC is that it holds the inventory so that customers do not have to, which frees up working capital for its clients, an important factor in cyclical businesses such as manufacturing.  In addition to offering balance sheet relief, MSC relies on product depth and breadth within the end markets where it focuses, product availability and fast, on-time delivery, and technical expertise.   MSC offers close to 1 million SKUs (industry average is ~15,000) sourced through over 3,000 suppliers.  MSC guarantees next day delivery on orders placed by 8 PM. In many cases it also competes on price, but can often do so more effectively than most competitors given its scale, which affords it better pricing with suppliers.  In addition to reducing product costs, MSC also focuses on reducing customer procurement costs.  Unlike other competitors, MSC does not rely on a physical network of stores – over 50% of sales are done online with the remaining via phone.  Management in the past pointed out that purchasing departments of customers typically spend about $100 per order on overhead costs for a manual order vs. $10 if the order was placed through MSC’s online site. 

Over the last decade, revenue has grown at an annualized rate of ~11%, of which ~9% has been organic and ~2% through M&A.  Given the manufacturing end-market it focuses on, there is clearly some cyclicality in the growth – for example, revenues were down 16% in 2009.  But larger players such as MSC take advantage of tough environments as its large scale allows it to sustain lower pricing environments and gain market share from small local players who are forced to close down.  And when the cycle recovers, large players usually benefit from significant operational leverage.  For example, MSC’s revenue increased by 14%/20% in 2010/2011 respectively, and operating margins expanded from sub-14% in 2009 to almost 18% in 2012.

Shares of MSC have sold-off ~30% since its high in mid-2014, primarily through a multiple contraction.  This has been mainly driven by a slow-down in top-line growth as well as a contraction in EBIT margins.  Growth in the past few quarter slowed down to low/mid-single digits driven specifically by a slowdown in the manufacturing sector which only grew 1.2% in the last quarter; although the non-manufacturing sector continues to grow at a healthy low double-digit rate.  Main drivers for the slowdown in the manufacturing sector have been the dislocation in the energy sector, softening export demand, and FX headwind from the strong USD.  While direct energy exposure is only ~3% of revenues, indirect exposure is higher as they have customer accounts located in the Midwest that service the energy sector.  Lack of commodity inflation has also resulted in a soft pricing environment.  In addition to a slowdown in top line growth, costs related to recent growth investments (digesting a $500MM 2013 acquisition and build-out of new distribution center) also contributed to a contraction of EBITDA margins from 18% in 2013 to sub-16% today, close to 2009 levels (high of ~19%) and operating margins of 16% in 2013 to ~13% today (high of ~17.5%). 

Clearly a normalization of the external demand environment is hard to predict, but management has done a good job of managing the environment by continuing to gain market share and driving productivity.  They have used their scale to increase purchasing efficiencies to offset effects of low pricing environment, as seen by the stability in gross margins.  Company has also taken a few measures to reduce costs.  This past quarter, their opex came in $5MM lower than what they guided earlier (off of a revenue base of $745MM for the quarter).  They managed to drive down freight costs, reduced the number of non-customer facing part-time workers, and cut discretionary spending.  The headwinds from their growth investment should also abate after this year.  As stated earlier, weaker macro environment will put disproportionate pressure on smaller players, which should benefit MSC, with its superior scale and balance sheet and strong cash flows. 

Looking at the valuation, assuming revenue growth of mid-single digits in the next few years with margins at today’s levels and current EBITDA multiple of ~9x results in ~$70/s.  Assuming a more normalized environment with growth rates in the high single digits, EBITDA margins going to ~17% given the significant operating leverage embedded in the business model and no re-rating in multiples results in a share price of ~$90 in 2018.  Distribution businesses trade between 10-15x EBITDA.  I would argue an organically growing company with low capital requirements, clean balance sheet with less than 1x of debt, and high ROIC should be trading at a higher multiple than that.   Assuming 11x EBITDA results in share price of over $110. 

Catalyst

- Stabilization in durable goods manufacturing industry

- Improved pricing and demand environment