Between ongoing worries about a short-cycle slowdown and management’s ability to execute on the latest self-improvement plan, I wasn’t bullish on MSC Industrial (MSM) shares back in July of 2021. Since then, the shares have lost about 10% of their value (partly offset by a good dividend), underperforming the S&P 500, the broader industrial sector, and other comps/peers like Fastenal (FAST), Kennametal (KMT), and Sandvik (OTCPK:SDVKY).
I do believe the valuation is getting more interesting, and the company does seem to be executing on its operational turnaround. Although I still have cycle-related sentiment concerns here (as well as ongoing concerns about management), I do think the opportunity is more appealing here now than it has been in some time.
If There’s A Slowdown, It’s Still Ahead
Since MSC reported fiscal first quarter results in late December, the overall outlook for industrial demand hasn’t worsened appreciably in my view. Almost every industrial company has continued to point to supply chain pressures and limited component availability, leading me to believe that production activity should remain robust through 2022 as company’s try to meet the demand that’s out there for machinery and machine components.
Looking at the monthly data reported by Fastenal, manufacturing sales have more or less stayed on track. For MSC’s fiscal first quarter, Fastenal’s manufacturing daily sales figures were up 20% (September), up 23% (October), and up 23% (November), with MSC itself reporting 9% overall organic growth in average daily sales and nearly 16% growth in its manufacturing business.
Since then, Fastenal has delivered two more monthly numbers (up 26% in December, up 21% in January), leading me to expect healthy ongoing industrial demand for MSC. Likewise, with other reports of comparable businesses. Kennametal’s fiscal second quarter results (reported in early February) were not uniformly good, but did point to healthy underlying demand across most non-auto industrial markets. Sandvik reported low double-digit growth in revenue and orders for its metalworking tools business, and Lincoln Electric (LECO) (a manufacturer of welding equipment and supplies) reported strong ongoing demand trends.
I can understand why the market would be concerned about how much incremental growth short-cycle markets can generate; companies are going all-out, but are limited by supply constraints, so growth isn’t really going to accelerate and comps are getting tougher. On the other hand, most companies are expecting supply chain pressures to ease later in the year, and I don’t see how that happens unless industrial demand for the metalworking/cutting tools provided by MSC stays strong.
Price / Cost And Ongoing Margin Challenges
MSC did report gross margin misses (versus average sell-side estimates) in the last two quarters, and I’m concerned that many analysts are still too bullish on gross margin leverage. I believe the market has simply changed in too many fundamental ways for MSC to generate significant gross margin leverage from here, particularly with more and more companies getting into the e-commerce space.
Even inflation, once a benefit to distributors like Fastenal and MSC, is no longer a clear positive. In times past, rising prices gave distributors pricing power, and indeed, one of the contributors to the general weakening trend in industrial distributor gross margins has been the lack of meaningful inflation for many years.
Now that inflation is here, though, that pricing power is being eroded by increased customer visibility on supplier pricing and increasingly competitive “real-time” pricing from other distributors. Said differently, in the past a company like MSC might be able to take a 100bp price increase from a supplier like Sandvik and leverage it into 150bp or 200bp of pricing power. Now, it seems tougher to get much incremental price at all.
With gross margin off the table, at least in my view, as a major forward driver, that puts even more emphasis on MSC’s “Mission Critical” operational improvement plan – a plan that includes above-market volume growth through enhanced service offerings (working with customers to understand their needs and select the right tools), expanded offerings (like fasteners), and expanded sales channels like on-site vending. Management is also working to take costs out of the system, and as of now at least, costs and headcount are below pre-pandemic levels.
I have some doubts about MSC’s ability to control costs while in an upturn, particularly with the increased focus on new products, new sales channels, and higher-touch service. Moreover, MSC has had many past self-improvement programs come up short. That said, the initial results from this plan have been better, and management hasn’t been afraid to upgrade its operating margin guidance.
I do expect strong demand in calendar 2022, and I’m now looking for double-digit revenue growth in this fiscal year. I am concerned about the slowdown that will follow, but that’s more from a sentiment standpoint than for the long-term consequences to the business.
Longer term, I expect MSC to grow revenue at around 3% on an adjusted basis, and that growth rate does include some expectation of share growth and growth above underlying industrial production. I’m still expecting long-term declines in gross margin, albeit with a fairly gentle trajectory – from 43.5% in FY’18, 42.6% in FY’19, and 42.1% in FY’20 to a bit below 42% this year, around 41.5% in FY’26, to just under 41% in FY’31. With improved operating cost leverage, though, my operating margin estimate is for 12.4% in FY’26 (after 11.5% in FY’20) and 13% in FY’21.
With those margin assumptions, as well as some revisions to my working capital and capex estimates, I’m looking for long-term FCF growth of around 4% annualized from pre-pandemic norms.
Between discounted cash flow and margin/return-driven EV/EBITDA, I see a fair value above $90 for MSC shares now, and a long-term total annualized return in the high single-digits.
The Bottom Line
Sentiment is not with short-cycle industrials right now, and there are certainly risks that industrial production doesn’t stay at these robust levels. The bigger risk I see, though, pertains to whether management can execute on its latest self-improvement plan. Early returns are encouraging, though, and with an improved outlook for 2021 and what I think has been a market-wide turn to “over-bearishness” on short-cycle names, this is a name worth more consideration now.