Industrial stocks have held up rather well over the last three months, with investors apparently more confident that the risks to 2023 are priced in now and that the Fed’s efforts to stomp out inflation won’t lead to significant demand destruction. Despite that generally healthy backdrop, MSC Industrial (NYSE:MSM) and other industrial distributors have lagged the industrial sector since my last update, with MSM shares selling off more noticeably in response to fiscal first quarter earnings that weren’t really all that bad.
I do still see risk in the short-cycle industrial outlook, but metalworking-heavy sectors like aerospace, autos, and energy should be healthy, and heavy machinery is likely to hold up at least through the first half of the year. What’s more, the company continues to execute on growth strategies like in-plant sales, vendor-managed inventory, and diversification beyond metalworking. Weaker price and margin leverage remain risks, but MSC Industrial’s valuation is not demanding at this point.
Mixed Results To Start The Fiscal Year
MSC Industrial’s fiscal first quarter results weren’t bad relative to sell-side expectations, but there wasn’t much upside in core earnings and if anything management commentary would seem to point a bit more towards the lower end of guidance ranges now. In a market that needs reassurance about the outlook for industrial end-markets, I don’t think this was enough to get the job done (and the stock price reaction would seem to suggest the same).
Revenue rose about 13% year over year as reported (down 6% sequentially), or closer to 10% on an organic average daily sales basis. MSC saw strong growth with its government business (up over 20%) and its national accounts (up low-teens), while the core business was up high single-digits. Relative to sell-side expectations, MSC beat by 1%
Gross margin declined 10bp yoy and 40bp qoq to 41.5%, missing by 20bp. Operating income rose 23%, with margin up 100bp to 12.3% (down 130bp qoq), missing by less than 20bp. While quarterly free cash flow is not all that predictive, I would note that net working capital has remained relatively high.
Growth Drivers Coming Through, But End-Markets Are Getting More Challenging
MSC’s growth initiatives continue to perform well, and this is important not only to driving bottom line profit and free cash flow growth, but also rebuilding management credibility with investors after many false starts and failed self-improvement initiatives.
In-plant sales improved more than 20% from the year-ago period and were up somewhere in the low single-digits from the prior quarter (against a 6% sequential sales decline), with sales growing to 12% of total revenue. Vending and vendor-managed inventory both growth at a mid-teens rate, while e-commerce remains a growth driver (up 16%) despite the fact that MSC was a first-mover in e-commerce many years ago.
Execution on those growth initiatives is a clear positive, but the operating environment is getting more challenging. Average daily sales rose 13%-14% in September and October (versus 15% growth at Fastenal (FAST), and 19%-21.5% growth at Fastenal’s manufacturing customers) before slowing to 11% in November (versus 11% growth at Fastenal, with 15% growth at manufacturing customers). Management said preliminary results for December showed 9% growth, with the company seeing some impact from weather and the timing of the holiday season.
Manufacturing PMI has been weakening, with a 48.4 reading in December after 49.0 in November, and MSC has historically been pretty sensitive to short-cycle manufacturing trends (underperforming when PMI is declining). I do see a more challenging outlook for the company in 2023, but I would note that important end-markets like aerospace and energy should be strong throughout the year, autos should be fairly healthy, and heavy machinery (trucks, off-road equipment, et al) should be strong through at least midyear.
Beyond this, I’m concerned about the potential impact of inventory destocking and supply chain normalization. Leading distributors like MSC, Fastenal, and Grainger (GWW) benefited from a difficult supply environment as customers relied on them to source components they couldn’t get elsewhere (and paid up for it). As sourcing challenges ease, some of that leverage should erode.
Still, pricing was up 660bp in the quarter, and management expects another 400bp in FY’23, implying volume growth of around 1% to 5%. I’d suggest interested readers should monitor the guidance and outlook commentary from major industrials through this reporting cycle, as I think volume growth in the mid-single-digits could be challenging without share gains.
I’ve made some fine-tuning adjustments to my model (items like net working capital, capex, and so on), but nothing all that significant in terms of core drivers. My FY’23 revenue number is a bit below the sell-side average ($3.825B versus $3.84B), but more inline for FY’24, and I’m still looking for around 3% long-term growth. While the potential to do better is there, I want to see more in terms of expanding beyond the core metalworking business (and customer base).
My operating margin estimate for FY’23 is a bit below the average (and management guidance) at 12.4%, and likewise more or less in line for FY’24. Long term, I’m still expecting modest gross margin erosion and slight operating margin improvement, as I think management’s margin-improvement efforts will be necessary simply to stay put given ongoing competitive challenges. I’m expecting long-term free cash flow margins to average out in the high single-digits, driving high single-digit to low double-digit FCF growth.
Discounted free cash flow supports a prospective total annualized return in the high single-digits (8% to 9%), while a margin/return-driven EV/EBITDA approach supports a forward multiple of 10.5x and a fair value around $90.
The Bottom Line
Being positive/bullish on MSC during a period of contracting manufacturing PMI is a risky proposition given historical trends, and I do see a risk of a sharper decline in end-user demand and more pressures on margins if revenue does come up short. That said, I can’t and won’t ignore the evidence of progress on revenue growth and margin improvement initiatives, and I think the risk/reward balance here is still positive for longer-term investors.