Description

Company Overview

Founded in 1941 by Mitchell Jacobson, MSC Industrial is a leading industrial distributor servicing the MRO industry in North America. Historically the company has focused on metalworking (~50% of revenue) but have gradually diversified into fasteners, safety & janitorial, plumbing, materials handling, power transmission supplies and other product lines. The company sells about 2 million SKUs across all 50 states, Canada, and Mexico. Nearly half of sales are into heavy manufacturing and about 20% are in light manufacturing.

The company started as a catalog business and has retained its roots as it has transitioned to e-commerce. It currently operates a dozen fulfillment centers, most in the US, providing it the ability to offer next day delivery on 99% of orders, provided the order is made before 8pm Eastern. It does operate about 100 branch offices, however these are sales and service offices and do not hold inventory.

Investment Thesis

MSC Industrial is a leader in a fragmented industry requiring increasingly complex solutions where size and sophistication are critical. Regional and local

distributors can’t compete with larger distributors that have national scale. The industry has seen GDP type growth for years but will benefit from on-shoring

trends and growing US manufacturing. We believe the company will increase market share due to industry position and sophistication with a long runway. Mission

Critical target for cost efficiencies is producing results. This should help with improving margins.

Source: MSC Industrial Investor Presentation

The stock has underperformed in recent years due to macro issues and competitive threats. On the macro level, the energy industry created a headwind to suppliers, tariffs impacted their supply chains, and then Covid impacted both customer demand and supply chains. Further, the stock is suffering from the shadow of Amazon, which entered the industrial supply space in 2012.

We believe these issues are overstated or declining, but sentiment remains dour and now offers an opportunity to buy a high-quality company with a strong balance sheet and some increasing growth trading at a compelling valuation.

Source:Gurufocus

Sources of Quality

Industry Structure – The industrial distribution industry benefits from both a fragmented supplier and customer base. MSC sources from over 3,000 suppliers and sells to over 700,000 customers. As a result, there is limited negotiating power on either side. Competitively speaking, the industry is also fragmented with over 140,000 competitors, differentiated by product line, geography and end market. Currently the top 50 distributors account for less than 30% of market sales. Amazon’s entrance into the space has altered this dynamic although the impact appears to be more in generic, commodity categories such as janitorial supplies.

Niche Market Focus – A niche market focus can create a competitive advantage when the customers value domain expertise and/or product breadth. MSC carries an inventory of 1.9 million SKU’s, 500,000 specific to metalworking, and possesses a technical service capability that allows them to help identify solutions to customers’ technical problems. Within industrial supply, fasteners and metalworking best exhibit these characteristics and are a significant reason for their superior gross margins.

Cost/Value Relationship to Customer – A typical order is roughly $300 as these are low-cost products such as replacement drill bits or saw blades. However, they are often essential to the customer’s production line. The last thing a customer wants is an assembly line shut down because they ran out of drill bits. As such, service creates customer loyalty and a price umbrella. All else equal, there is limited upside by switching vendors but significant risk if the new vendor fails to deliver.

Evidence of Quality

Profitability

The company has historically generated strong profitability with gross margins generally in the mid 40’s and operating margins in the mid-teens. I believe this reflects the value-added nature of their products and service. The recent margin declines are concerning. However, at this point it is difficult to delineate how much of the decline is due to transitory macro factors, product mix changes, and competitive factors. Most likely it is a combination of all three.

Cash Flow Generation

The business requires little cap ex to grow as their distribution facilities have adequate capacity to meet anticipated demand.

The company has a history of returning capital to shareholders currently sporting a dividend yield of 3.6%. In addition, they paid a special dividend of $195 million paid out in December of 2020. Management has indicated their cash priorities are to invest in organic growth, pay dividends, opportunistic M&A, and special dividends.

Returns on Investment

ROE is over 25% (highest level since 2008) in TTM while ROA double digits. Long-term, I believe the economics of the business support a return on equity of 20%-25%.

Recent Events

The industrial supply industry has faced a relentless stream of bad news over the last 10 years. The energy industry had been a significant purchaser of supplies and the subsequent decline in oil prices hurt demand. Amazon’s entrance into the market has put pressure on participants, particularly in less differentiated products. The tariffs affected supplier prices that, in light of the prior two issues, participants were less able to pass on than in prior years. Finally, like many companies, Covid was and continues to be a serious disruption to both end markets and suppliers.

Specific to MSC, I believe Amazon’s entrance has most significantly affected its business in adjacent product categories. While less directly affecting the core metal working business, this has impaired the overall growth opportunity as a core part of their growth strategy over the last decade has been to expand in adjacent product markets.

Catalysts

From a macro perspective, a general improvement to manufacturing both cyclical and secular could do wonders for the company. In recent years analysts have speculated there could be a movement to onshoring brought on by a desire to reduce supply chain risk. Regardless, any alleviation of the recent headwinds would be a tremendous help to the business. Below you can see the relationship between organic revenue growth and industrial production.

Although macro has a notable impact on short-term results, long-term results will still be determined by management’s ability to growth the business while protecting its competitive position, thereby protecting profitability. With that in mind, management has initiated several measures with the goal of generating long-term revenue growth 400bp above industrial production (~3% annually) and returning operating margins to the mid to high teens. These initiatives are as follows:

·         Expand IT Solutions

o   Currently 60% of revenue is via e-commerce with the rest coming from customer service, sales reps, and even fax. There is an opportunity to convert these customers, leading to a more profitable sale.

o   Redesigned their user interface to improve the user experience.

o   Better analytics to identify customer solutions.

·         Embedded customer Initiatives

o   Vending machines on site to manage inventory. These are a lower cost solution to the customer and create a switching cost.

o   Specialists actively working with customers to identify cost savings. MSC has documented examples where customers could alter their purchase to a lower cost solution.

o   Embedded infrastructure should improve customer retention via switching costs and relationships.

·         Expand Solutions

o   They would like to expand the size of their serviceable market via new product offerings.

o   The company expanded its fastener offering during the last decade via acquisition.

o   The effort should expand share of wallet with existing customers and open opportunities with new customers.

·         Restructured Sales Effort

o   Redefined the role from generalist to three distinct roles: “hunters”, “farmers”, and complex account managers.

o   Specialization should drive organic revenue growth via both greater capture with existing customers and new customer acquisition.

o   Expanding the salesforce – Have added over 100 salespeople in the last 2 years.

·         SG&A Rationalization

o   From a cost perspective, beginning in 2019, they started implementing cost savings within SG&A with the goal to improve operating margins by 200bps.

o   Consolidating branch offices and management roles.

o   Although management can point to direct cost savings, margin improvements have been overwhelmed by revenue declines and diseconomies of scale.

More broadly, I believe this business is capable of operating with SG&A closer to 25% of revenue, suggesting ample opportunity to resize the business. In fact, Fastenal and Grainger have transitioned to more efficient SG&A, each shrinking SG&A from roughly 30% of revenue to under 25% in the last decade.

Valuation 

Historical Value

At 11.5x EBITDA, the shares are attractively valued. Although, this is in range of its historical average, it fails to incorporate the re-rating many companies experienced following the reduction in corporate tax rates.

 Source: Gurufocus

Relative Value

MSC trades at a steep discount to Fastenal and a modest discount to Grainger, the two most common comparisons. Fastenal is arguably more insulated from Amazon and has a reputation as “best in class” so a premium is warranted even if the amount is debatable. Grainger’s premium is arguably less warranted given I believe they are most exposed to Amazon. Across the board, the relationship between multiples and EBIT margin is fairly tight, and I believe margin growth at MSC will translate to multiple expansion. MSC has the most manufacturing exposure of those three companies.

Source: Gurufocus

Discounted Cash Flow Analysis

I valued the company using management’s revenue growth and margin expansion assumptions. Based on those assumptions, I calculate the value of the equity to be a $150 per share, a significant premium to the current share price. This translates to an EV/EBITDA of 16x, which intuitively seems more appropriate for the company.

Timeliness

MSC has lagged the market and its main competitors for years. This trend has recently changed.

Risks

Management

The company is run by Erik Gershwind, CEO and Kristen Actis-Grande, CFO. Erik was named CEO in 2013 and is the grandson of the company’s founder. Kristen was named CFO in August of 2020. Prior to MSC, she spent 17 years at Ingersoll Rand, but this is her first time as a CFO. At 50 and 40 years of age respectively, I am a little concerned that they may not have the experience to navigate the challenges in a way necessary to deliver shareholder value. Additionally, on a heuristic level, third generation family members do not have great track records for creating value.

A bigger and more tangible concern is the share class structure. The company has a dual class share structure where the family owns the B shares which have 10 votes to every vote of the A shares. Including both A shares and B shares, the extended Jacobson family controls roughly 82% of the votes with Mitchell Jacobson accounting for 42% alone. The ownership structure nullifies any potential interest from activist investors and limits interest in taking the company private as the family would likely require a premium above the norm. 

Amazon

Historically, Amazon has typically created the most disruption where they gain the most leverage from their existing assets. However, the further the move from that base, they typically experience less success. For example, the Kindle leveraged their knowledge of consumer habits and their relations with publishers. But that IT experience gained from the Kindle did not translate to the Amazon phone. In grocery, they were successful in competing in dry goods but that did not translate to same day delivery, and ultimately, they had to acquire Whole Foods.

Specific to industrial supply, I believe they have natural leverage in generic product lines and ones requiring lower service levels such as janitorial supplies or basic safety equipment. They already have the platform to deliver these goods and the nature of low-end industrial supplies is not much different than retail, which they long served.

I believe the gap from their current platform to MSC’s is beyond their capability, particularly metalworking. Should they choose to expand here they would most likely need to acquire a direct competitor, which I do not expect them to do. However, should this assessment be incorrect, it could develop into a material threat to MSC’s core business and undermine the assumptions made about MSC’s competitive advantage.

Strategic Initiatives

Management’s move to further embed the company into their customer’s operations comes with notable risks. First, the additional efforts could be decretive to profitability and returns on investment. Second, moving from point-of-sale service to embedded solutions creates an operational risk as it is a fundamentally different way of servicing the customer. Finally, specializing the sales roles fundamentally alters the nature of the roles and their interaction with the customer. Executing such changes is a difficult exercise that can lead to turnover or a lapse sales and service for the customer.

Catalyst

·         Industrial Production remains strong

·         Better than expected earnings

·         Market share gains

·         Mission Critical delivers cost savings