Strong Growth Returns for MSC Industrial but Operating Environment Remains Challenging

Business Strategy and Outlook

MSC has become one of the largest industrial distributors in U.S., and it is especially well known in the metalworking industry, wherein the firm enjoys approximately 10% market share.While MSC’s sales declined in 2020 (negative 5%) and sales growth was anemic in 2021 (2%) amid the global pandemic, over the longer term, but as per Morningstar analyst perspective it is expected that mid-single-digit growth prospects for the company driven by a return to healthier end-market demand and market share gains from smaller local and regional distributors.

Because MSC has national scale and a robust portfolio of products and value-added inventory management services, it is well positioned to capitalize on the growing trend of manufacturers consolidating spending with large distributors. Although national accounts can generate lower gross profit margins, they can also generate higher volume, which MSC can leverage to improve operating margins. MSC’s focus on providing inventory management solutions has helped the firm expand customer wallet share over the years, and we expect that trend to continue.

MSC has proved to be a consistent free cash flow generator throughout the business cycle, and in our view, it has allocated its free cash flow in a balanced, shareholder-friendly manner. We expect MSC to continue to use its excess cash to increase its regular dividend and repurchase shares. The company also occasionally pays special dividends, most recently in fiscal 2021 ($3.50 per share) and 2020 ($5.00 per share).

Strong Growth Returns for MSC Industrial but Operating Environment Remains Challenging

MSC Industrial Direct enjoyed strong year-over-year revenue growth during its fiscal first quarter ended Nov. 27. Sales increased nearly 10% as the company executed on its growth initiatives and end market demand improved (industrial production has expanded at a steady pace for much of 2021). In terms of the growth initiatives, MSC saw notable growth during the quarter from its industrial vending and in-plant initiatives as well as from its e-commerce platform (MSCDirect.com).

While MSC’s first-quarter revenue growth was encouraging (and caused us to increase our full-year fiscal 2022 revenue growth projection to 8% from 6.5% previously), supply chain challenges and inflationary headwinds persist. CEO Erik Gershwind said the company is seeing little evidence of easing supply chain bottlenecks, labor shortages are severe, and inflation is the most extreme he can recall. Yet, despite these challenges, MSC managed to expand adjusted operating margin 30 basis points year over year 11.3%. Management was disappointed with its gross margin, which contracted 30 basis points year over year (to 41.6%) as the firm’s price/cost dynamic had not been as favorable as management would have liked (price/cost was slightly positive during the quarter). However, MSC realized nice leverage on its operating expenses (7.5% growth compared with 10% top-line growth). MSC intends to increase prices by more than 2% in fiscal 2022 to improve gross margin, and management is still targeting about a 42% gross margin (unchanged year over year), which we think is achievable.

Morningstar analyst have increased fair value estimate about 2% to $87 per share due to our stronger revenue growth outlook and the time value of money.

Financial Strength

MSC has historically operated with a very conservative balance sheet, and it has only significantly flexed its balance sheet for large acquisitions (2006 and 2013) and large share buybacks (MSC spent $384 million to repurchase 5.3 million shares in 2016) a handful of times. At the end of its fiscal first-quarter 2022, MSC had an outstanding debt balance of $763 million. MSC’s earnings provide the firm with substantial headroom to service its debt obligations. During fiscal 2021, MSC incurred about $15 million of interest expense and generated $441 million of adjusted EBITDA, which equates to a comfortable interest coverage ratio of about 30 times. MSC has a proven ability to generate free cash flow throughout the cycle. It has generated positive free cash flow every year since 2001, and the firm’s free cash flow generation tends to spike during downturns due to reduced working capital requirements. This dynamic played out in 2020 with free cash flow increasing 26% despite sales declining 5%. Given the firm’s relatively conservative balance sheet and consistent free cash flow generation, it is believed that MSC’s financial health is satisfactory.

Bulls Say

As end-market demand improves, MSC could return to mid- to high-single-digit sales growth and highteens return on invested capital.
MSC’s national scale and focus on value-added inventory management services should help the firm take market share from smaller regional and local distributors.
MSC generates consistent free cash flow and runs a shareholder-friendly capital-allocation strategy. The company should continue to utilize its free cash flow to increase its regular dividend, repurchase shares, and occasionally pay special dividends.

Company Profile

MSC Industrial Direct is a value-added industrial distributor with a focus on metalworking and maintenance, repair, and operations products and services. The company offers 1.9 million products through its distribution network which has 11 fulfillment centers. Although MSC has a presence in Canada, Mexico, and the United Kingdom, it primarily operates in the United States. In fiscal 2021, 94% of the firm’s $3.2 billion of sales was generated in the U.S.

(Source: Morningstar)

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