MSC Industrial Direct

MSC Industrial Direct (MSM) is an 75-year old industrial distributor with a focus on metalworking and maintenance, repair, and operations (MRO)-related products and services.

It is primarily a US based company (>95% revenue), where it has 5 large distribution centers and 80 branch offices.

Since its IPO in 1995, it has grown top and bottom lines at 12%. Here is its fundamental performance since 2007.

Screenshot from 2017-08-26 16-45-19

Here is the performance of its stock price, annotated with some plausible narrative:

Screenshot from 2017-08-26 16-47-44.png

In 2017, it fell from a high of $105 to its current price in the $65-$70 range.

Alan Mecham had this to say about industrial distributors (emphasis mine):

… an industrial distributor, like MSM, has very low cap ex requirements but large working capital needs. What I have an affinity for are companies with staying power that I feel I understand well.

I like the hourglass model, where a distributor stands in the middle of fragmented markets. That model allows a well-managed distributor to enjoy strong bargaining power in both buying and selling while occupying a niche that’s valuable to customers and difficult for competitors to dislodge. I also like when there’s a high-touch service component that’s valued, which further fosters sticky customers.

So here we have a $4B market cap company with $2.9B in TTM sales, and $382M in EBIT, whose price has fallen ~40% from recent highs. It is probably worth a look.

The rest of the post follows a Q&A format. I raise questions that seem relevant, and try to address or counter them, as best as I can.

EBIT and sales have grown at 13% for 20 years. Is this extraordinary growth sustainable?

The MRO business in the US is fragmented. Not just the suppliers and the customers, but also the distributors.

The top 50 distributors account for less than 30% of the market. MSM is in the top 10. Currently, there are 145K companies like MSM in the US; most of them operate at a much smaller scale.

Management estimates that the total addressable market for MSM is $160B. With revenues of $2.9B, MSM has a market share of under 2%. There is plenty of room for consolidation. MSM could acquire or displace smaller companies. It is also small enough to get acquired itself.

If MSM continues to grow at 13% for another 20 years, its revenue would be ~33B. Over the time period, it is possible that the TAM would have increased further, making this scenario (brisk and steady growth) completely within the realm of possibility.

Industrial distributors like MSM have high gross margins near 45-50%. Are these sustainable?

MSM has boasted gross margins in the neighborhood of 45% since inception. That said, product cost is a tiny sliver of the total operating expenditure, which is instead dominated by the procurement and inventory operating costs. Thus, focusing on gross margins might be somewhat misleading.

Screenshot from 2017-08-26 17-17-36

If this is a big market with juicy margins, won’t Amazon Supply step in to defragment the market and eat their lunch?

Bezos is famous for saying, “your margin is my opportunity”, and even during these time of “peak Amazon”, I wouldn’t willingly compete against Bezos or Amazon.

But AMZN is not infallible. That I am willing to bet on.

Amazon’s entry into a large market with juicy margins, doesn’t mean incumbents are toast. Amazon tried to compete with Priceline in the online travel business before giving up. The Fire smartphone was a debacle – it couldn’t hold its own against the iPhone or Samsung. In these markets, it was Amazon that had to retreat.

In other domains, including groceries I suspect, AMZN will be a player – perhaps, even an important one – but it won’t suck the oxygen out of the room. 15 years ago people worried that Walmart would displace all the local and regional grocers, yet stores like Publix and Wegmans have continued to thrive.

You don’t want to fight Amazon (or yesteryear Walmart) only on price. When outmatched, like David against Goliath, the key is to play the game by different rules. For example, I happily go to my neighborhood Publix, even though there is a Walmart offering better prices at the same distance, because of three reasons: (i) The staff is familiar, and I feel my presence is acknowledged (low churn unlike Walmart), (ii) shopping is more pleasurable; the lighting, the produce; if I don’t find something I need there is someone close by happy to help, and (iii) I absolutely love their store branded (Greenwise) cereal.

There are some lessons here for industrial distributors like MSM, which runs a well-oiled call-center that fields customer queries. They might not be able to compete with AMZN in logistics, but so long as they play in a field where customer relationships are important, they will be resistant to AMZN attacks. Even if AMZN somehow makes deep inroads, MRO is not necessarily a winner-take-all business.

Also, who knows, at a $4B market cap, AMZN might even see MSM as an acquisition target. Of course, the Jacobson family who owns most of the voting power would have to bless any such merger.

ROIC has decreased from 20% in 2012 to 13% TTM. Operating margins have declined from 15-17% to 13%. EBIT has stagnated. Earnings have declined. Is the best behind?

MSM operates in a cyclical industry. Currently demand and pricing are soft, and yet MSM spews off cash throughout the cycle.

CEO Erik Gerstner once remarked:

Economic slowdowns are the times when MSC makes its greatest strides. These are the times when the local and regional distributors that make up 70% of our market suffer disproportionately. History tells us what will happen to local distributors if this downturn prolongs. Reducing their inventory leaves customer service vulnerable. Clamping down on receivables disrupts long-standing customer relationships. Laying off people creates hiring opportunities to acquire industry talent not typically available.

We are just starting to see the very early signs of these things occur in the marketplace. The pace will accelerate the longer these conditions hold. We are pleased with our share gain performance to date and would anticipate it to continue or even accelerate the longer these conditions last, and that will lead to disproportionate top-line growth when the environment does improve.

At some point, the cycle will turn. Perhaps, the infrastructure bill will be the first domino to fall. It might be something else. Whatever it is, it will cause the earnings numbers to explode. If tax-reform happens around that time (currently MSM pays 35% in taxes), any savings will flow to the bottomline, and lace the upside.

The company’s debt has increased significantly over the past few years. Isn’t that a cause for worry?

Debt is still only 1/3 of the total capital, and less than 2x EBIT. So debt-levels are very manageable. From a tax perspective taking on some more debt might be the smart thing to do.

By and large, management allocates capital well. Recently, they borrowed $365 million at 1.29% after tax to retire shares which yielded nearly 2.5% in dividends each year [S/O have declined by 10% over the past 10 years]. This would be smart, even if shares were fairly valued. However, if MSM is undervalued, this is even smarter.

So what is it worth?

It is always difficult to value a cyclical company at the bottom of the cycle. Especially, one that gains strength during a down cycle.

Based on history, assuming long enough holding periods, one would expect returns to mimic ROE: mid teens, say 15%.

A DCF with reasonable inputs yields $65-$75 as fair price for the equity. At its current price, it is in the lower range of my estimate.

figure_1However, my DCF anchors too much on the recent past and suppressed earnings, even when it tries not to. It doesn’t factor in the likely levered upswing, when the cycle turns. Both Credit Suisse and Morningstar have target prices in the low $90s. Those analysts probably know how to account for cyclicality better than me.

Over the past 5 years, MSM has traded between $55 and $105. The EV/EBITDA and P/E have ranged between 8.3-15, and 15-27, respectively. The current EV/EBITDA and P/E at 9.7 and 16.8, are at the lower end of the historic range. Unless you believe that the recent stagnation is a secular trend, and not a cyclical low, it would be prudent to bet on some reversion to the recent mean.

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