Description

MSC Industrial Direct Co., Inc (MSM: $92.92) – Short

Summary

The Trump rally caused a major short squeeze in MSM. The shares now trade at 23x run rate EPS and 13x EV/LTM EBITDA, yet revenues and EPS were down in FY 2016 (ending September 2016) and management gave guidance for continued declines in Q1 FY 2017 (ending December 2016). MSM has experienced 16 straight months of declining average daily sales and, with the recent strength in the USD, has little visibility on any improvement in its metalworking end market. The recent jump in its shares reflects a knee jerk reaction to Donald Trump’s election and his (potential) infrastructure upgrade plan. Shorting MSM offers an attractive risk/reward profile since if Trump follows through on his promise, a substantial improvement in MSM’s end market is already priced in. On the other hand, if history repeats and Trump, like most politicians, follows through on only a small fraction of what he has promised, MSM faces +50% downside risk to $40.          

Business Description

MSM is a North American distributor of metalworking and maintenance, repair and operations (“MRO”) products and services. MSM is #1 in the metalworking space, with 10% market share, and is significantly bigger than its next largest competitor. Its customers range from individual machine shops, to Fortune 100 manufacturing companies to government agencies. MSM operates in the U.S, Canada and the U.K. and offers +1 million SKUs through its website, mscdirect.com, as well as through its +4,500-page master catalog, known throughout the MRO industry as “The Big Book.” The company’s MRO products comprise of cutting tools, measuring instruments, tooling components, metalworking products, fasteners, raw materials, hand and power tools, electrical supplies, etc.

One of MSM’s competitive advantages is its next-day delivery in the U.S. for qualifying orders placed by 8 p.m. ET. MSM adds value to customers through 1) lower prices due to its private label products, 2) reducing customer inventory through just-in-time inventory management, and 3) production floor cost savings and productivity improvements through its team of metalworking experts (a value-added service). Manufacturing customers make up 76% of sales and non-manufacturing comprises 24%. The company's largest end market is the metalworking sector, for which the Metal Working Business Index (MBI) tracks business activity.  

Bear Thesis

MSM was carrying an 11 day short position when the world found out Donald Trump was going to get his chance to Make America Great Again. The squeeze took MSM from $72 to its current ~$93. The squeeze does have a rational explanation as Trump promised an infrastructure upgrade program which would, in combination with a corporate tax cut from 35% to 15%, turbo charge U.S. GDP growth to 4% from its current 2%. This best-case scenario, however, appears to be fully priced in now.  

MSM executed a modified Dutch tender in August 2016 and bought back ~8% of its shares outstanding at $72.50.  After adjusting for the 53-week year, the $4.01 in run rate EPS shown below reflects FY 2016 net income on the current (post buyback) FD share count (56.6 million). The stock trades at 23.2x run rate EPS and 13.2x EV/LTM EBITDA. The market is pricing in a substantial rate of future growth, which reflects a complete reversal in the decline rate of MSM’s end market.  

MSM Valuation

Growth in Average Daily Sales (ADS) at MSM turned negative in July 2015. As we approached July 2016, the bull case was that MSM faced easy comps and ADS would soon turn positive. That did not happen as the strong USD (which recently strengthened even further; see below) and low oil prices continued to depress end market demand in the metalworking sector.

Average Daily Sales (ADS) by Month

On MSM’s last earnings call (Q4 FY 2016), management offered little hope of a change in outlook for FY 2017:

“…we’re in such a short-cycle business, visibility is so limited, that for us to go out and project the year in terms of environment on either demand or pricing, to be honest with you, we’d be kidding ourselves.”

• CEO Erik Gershwind, Q4 FY 2016 earnings call

Adjusting for the 53rd week, revenues were down 3.5% in FY 2016. Management got very aggressive on costs and on an apples-to-apples basis operating expenses declined by 4.4%. The solid execution on expense controls and gross margin pressure countermeasures kept operating margin steady at 13.0%. EPS fell to $3.65 (52-week basis) in FY 2016 from $3.74 in FY 2015. As discussed above, since the Dutch tender for ~8% of the outstanding happened right at the end of FY 2016, taking FY 2016 52-week net income and dividing by current FD shares yields $4.01 in run rate EPS.

Management guided to an ADS decline of 2.5% - 4.5% in Q1 FY 2017 (October, the first month of the quarter was down 2.4% so guidance appears conservative) and EPS of $0.90 - $0.94 compared to reported EPS of $0.89 in Q1 FY 2015. The apparent growth in EPS is entirely explained by the fewer shares outstanding post the Dutch tender. Dividing Q1 FY 2015 net income of $55 million by current FD shares outstanding (56.6 million) yields EPS of $0.97, which should be seen as the true year-ago comp.

Management has been guiding conservatively and beating guidance (4 cent beat last quarter). I expect this trend to continue, but post the recent short squeeze (with a valuation now pricing in strong growth), I think the shares will decline even as the company “beats” low-balled guidance.  

On the last call management guided to margin pressure in FY 2017 from customer mix (higher-margin small customers are getting hit the hardest in this downturn) and incentive compensation returning to 100% from 50% in FY 2016. Management guided to a lower operating margin in FY 2017 under all scenarios except a best-case scenario (12.2% worst-case, 12.6%-12.7% moderate case, 13.3% best-case).

Consensus for FY 2017 is $3.87 (2.6% EPS growth; P/E = 24.0x) implying continued declines versus the FY 2016 run rate of $4.01.  Consensus for FY 2018 is $4.19 (8.3% EPS growth; P/E = 22.2x).

Metalworking Business Index (MBI)

From MSM’s 10-K:

“Through statistical analysis, we have found the strongest correlation between our customers’ activity and the Metalworking Business Index (“MBI”). The MBI measures the economic activity of the metalworking industry, focusing only on durable goods manufacturing.” Readings above 50 indicate expansion and values below 50 indicate contraction.

The MBI fell below 50 in July 2012 and, except for a brief spike above 50 from mid-2014 to early-2015, has remained in contraction mode. The most recent reading, for November 2016, was 49.7.  

On the last call, management talked about how best to view this index:

“MBI readings have ticked up over the last two months posting over 48 for both August and September. While these levels still denote contraction in metalworking end markets, the readings are nonetheless a significant improvement over the trends of the past year. If they sustain, it would bode well for our future prospects and indicate a potential leveling in the metalworking industry. That said, for now we remain cautious. Keep in mind that the rolling 12-month average, which on a 4-month lag is most highly correlated with our sales, is only reading 45.7. And that reading is indicative of significant contraction for metalworking end markets as things remain quite soft despite the potential for a leveling on the horizon. With some exceptions like aerospace, customers continue to see low volumes, backlogs and quoting activity. Visibility is extremely low with some customers taking a wait-and-see approach as is typically the case in a presidential election year.”

• CEO Erik Gershwind, Q4 FY 2016 earnings call

The #1 macro factor suppressing U.S. metalworking activity is the strong USD. #2 would be low oil prices which impact a sub-segment of the overall end market. The price of oil is relatively flat from where it was at the beginning of 2016, but the USD has recently broken out to new highs against a basket of other currencies (as measured by the DXY), with a strong move in the last 3 months. The last MBI reading (49.7) measured November sentiment, which was bolstered by Trump’s election win. I would bet that when subsequent readings come out, based on what the USD has just done, the MBI will fall back down toward 45.  

U.S. Dollar Index (DXY), Last 3 Years

Risks

• MSM has meaningful leverage to a turn in its end market. On the last call, management guided to a 30% incremental operating margin on the next $100 million in revenues (~3.5% revenue growth), translating to $0.33 in EPS after-tax. Management however stated that beyond the first $100 million in revenues, incremental margins would be lower as the company needs to invest in growth. However, I believe MSM’s leverage to a turn is fully priced in. If FY 2017 revenues grow by +12% (I’m not sure anything could realistically make this happen) resulting in an extra $1.00 a share falling to the bottom line, MSM trades at 18.5x that implied $5.01 in EPS.  

• MSM is under-levered at 1.3x net debt/EBITDA. The Company could launch another Dutch tender, or take on incremental debt to pay out a special dividend as it has done in the past.

• Because MSM’s revenues are currently shrinking, working capital has been a source of cash and FCF has exceeded net income. In FY 2016, when revenues declined by 3.5%, adjusting for the 53rd week and on the current shares outstanding (post Dutch tender), MSM generated FCF of $5.42 vs. EPS of $4.01. FCF was 135% of net income. In FY 2015 however, when revenues grew by 4.4%, FCF was 86% of net income. If MSM continues shrinking, its FCF will continue to exceed net income.  

Catalyst

• For whatever reason, Trump does not execute on his infrastructure upgrade/corporate tax cut plan.  

• The current downturn in the metalworking end market is secular, not cyclical. The QE and record-low-interest-rate-fueled economic recovery merely pulled forward future demand.

“Much of what central banks do consists of making things happen today that otherwise would happen sometime in the future. It’s not clear that the effects are long-lasting or anything more than an acceleration of events within the confines of a zero-sum game.”

- Howard Marks, May 26, 2016

• Stanley Druckenmiller once said that he's never seen a major currency move last for less than 2 years. If USD strength proves to be one of those major currency moves, which began in mid-2014, what we've been recently experiencing has been a consolidation phase before the next leg of the up move. The DXY recent broke out above 100. The Fed is expected to raise interest rates next month (two Fed Governors wanted to move at the Nov. 2 meeting). The Fed has repeatedly expressed a desire to remove emergency interest rates, albeit cautiously. Higher rates, all else equal, lead to a stronger currency. If the USD continues to strengthen, it will put added pressure on MSM’s end market.

• MSM management has done a great job of cutting expenses and minimizing the damage to the company’s bottom line. However, aggressive cost cutting is not a sustainable strategy. In FY 2016, management received 50% of targeted incentive compensation. To retain talent, you can’t penalize people for end market weakness. Incentive comp is expected to return to 100% in FY 2017 assuming management meets targets within its control, resulting in operating margin pressure.