MSC Industrial Lagging Despite On-Target Performance

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.

 

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MSC Industrial Lagging Despite On-Target Performance

MSC Industrial Executing Better, And The Street Has Noticed

I’ve been highly critical of MSC Industrial (NYSE:MSM) management at times, but I have to acknowledge that this latest round of strategic initiatives – initiatives that include expanding and highlighting value-added services for customers, pursuing new channels, expanding the portfolio, and streamlining expenses – have not only been executed adroitly, but have produced real benefits. With that, the shares have continued to outperform Fastenal (FAST) since my last update (and over the past year), though Grainger (GWW) and Applied Industrial (AIT) have done better still.

I believe that 2023 is going to see MSC Industrial’s improving execution collide into a more challenging macro environment that will see weaker short-cycle operating conditions as well as improving supply conditions that reduce some of the value provided by top distributors like MSC and Fastenal. While MSC shares do look undervalued on mid-single-digit revenue growth and further margin leverage (as well as on margins and returns), holding an industrial supplier into a period where metrics like ISM and industrial production could decline is a riskier proposition.

 

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MSC Industrial Executing Better, And The Street Has Noticed

 

MSC Industrial Logs Another Very Good Margin Result, But Cycle/Economy Fears Are Front And Center

MSC Industrial (NYSE:MSM) management appears to be making real progress on multiple self-improvement initiatives – something I’ve been skeptical/critical of for some time – but that progress is coming at a time when investors have become considerably more cautious about economically-sensitive names (and stocks in general). While the shares may not be benefiting in the short term from the company’s progress, and I do think cycle/economic risk is relevant, an improved long-term margin profile would certainly be a net positive.

MSC shares are down about 15% since my last update in April, slightly outperforming the average industrial stock, and the shares have likewise outperformed the industrial sector since I went positive in late February (outperforming by around 700bp); the shares have likewise modestly outperformed the S&P 500. Although I think there’s still more room for growth from the company’s industrial customer base, and a lot of bullishness has come out of the industrial space, I do think there are opportunities to shop around in the current market environment.

 

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MSC Industrial Logs Another Very Good Margin Result, But Cycle/Economy Fears Are Front And Center

Manufacturing And Self-Help Come Through For MSC Industrial

I've been skeptical about MSC Industrial's (NYSE:MSM) latest self-help initiatives, but management is providing the best rebuttal possible - good execution. I can, and will, quibble that sales growth should be higher given the underlying strength in manufacturing, but the company is definitely doing better on margins, and that helped drive better fiscal second quarter results - a set of results that should also bode well for the broader multi-industrial space in the upcoming calendar first quarter earnings cycle.

I flipped from neutral to positive on these shares in late February, in part due to valuation/sentiment, and in the short time since, the shares are up about 10% - roughly doubling the performance of the underlying industrial sector. With some positive adjustments to my margin assumptions, I still see around 10% to 20% near-term undervaluation, with longer-term total return potential in the high single-digits.

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Manufacturing And Self-Help Come Through For MSC Industrial

MSC Industrial Leveraged To Robust Industrial Activity And Self-Improvement

 

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.

 

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MSC Industrial Leveraged To Robust Industrial Activity And Self-Improvement

Business Is Improving For MSC Industrial, But The Street Isn't So Impressed

 

One of the frustrating realities of the market for many investors is that stocks can often move in anticipation of underlying shifts in the fundamentals - the "buy the rumor, sell the news" saying that investors will hear from time to time. In the case of shorter-cycle companies/stocks like MSC Industrial (MSM), industrial end-demand is indeed improving nicely, but the shares have underperformed as the market is starting to look past the short-cycle recovery story.

As I've said in the past, the cycle is going to do what the cycle is going to do, and I believe more of MSC Industrial's performance potential rests on management's ability to execute on new programs meant to increase share, drive sales growth, and improve margins. Given the many and varied disappointments of the past, some skepticism is still in order, though recent results have looked a little better.

I would say that MSC Industrial is still more of a hold today. I don't think the cycle has run its course, and I don't think the shares are overpriced, but I also don't have a lot of confidence in a bull story that rests on management execution given past execution issues. The dividend yield isn't bad, though, so investors looking for income-generating options in the manufacturing sector may find this name a little more attractive.

 

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Business Is Improving For MSC Industrial, But The Street Isn't So Impressed

MSC Industrial's Markets Are Returning To Growth, But Follow-Through Is Essential

 

As some early recovery stories have flattened out, MSC Industrial (MSM) shares haven’t done much in the last three months – they’ve outperformed other industrial distributors like Fastenal (FAST) and Grainger (GWW), and mostly kept pace with the S&P 500, but they have lagged the broader industrial space.

In the “buy the rumor, sell the news” world of Wall Street, it’s worth asking whether there will be enough momentum in the industrial recovery to keep driving positive sentiment here. While some analysts do seem to believe the U.S. is on the cusp of some sort of “super-cycle” recovery, that strikes me as a new version on the old “it’s different this time” theme.

Instead, I think the real key for MSC Industrial now is executing on what management has positioned as a transformative management restructuring (Mission Critical) meant to resolidify the company’s position in metalworking, expand into complementary adjacent markets, and drive better margins from a restructured expense base.

It sounds great in theory, but I’ve almost lost count of the number of management plans that were supposed to drive these benefits and didn’t, whether that was due to the plan being wrong or the execution being poor. Maybe we really are on the cusp of an unusually strong recovery cycle, and maybe MSC will get it right this time, but I’m not inclined to press my luck.

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MSC Industrial's Markets Are Returning To Growth, But Follow-Through Is Essential

Business Activity Is Slowly Improving, But MSC Industrial Has Yet To See The Big Turn In Demand

Industrials certainly haven’t been suffering going into the new year, with the sector up about 20% in the last two months of 2020 alone as investors reposition for a cyclical recovery buoyed in part by COVID-19 vaccinations. MSC Industrial (MSM) has gone along for the ride, slightly outperforming the sector since my last update, as stocks sensitive to industrial production (including names like Kennametal (KMT), Parker-Hannifin (PH), and Sandvik (OTCPK:SDVKY)) have also been performing quite well. 

While skeptical about management’s ability to deliver on its latest self-improvement program (largely a collection of reheats and repackaged goals from past unsuccessful efforts), I did see some relative value in the stock in that last write-up. With the outperformance since then, I’m not as excited about the relative value opportunity, and while I do think there could be more room for cyclicals to run on recovery hopes, management execution will become an increasingly significant part of the story as 2021 develops.

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Business Activity Is Slowly Improving, But MSC Industrial Has Yet To See The Big Turn In Demand

MSC Industrial Does A Little Better On Margins, But End-Market Pressures Remain

Another quarter is in the books, and really not that much has changed at MSC Industrial (MSM). Management once again did a little better on margins, but end-market conditions remain challenging and MSC continues to underperform companies like Fastenal (FAST) in the manufacturing vertical (though this is an apples-to-oranges comparison). And once again management is looking to sell the Street on a “it’ll be different next time” strategic plan that is supposed to deliver above-market revenue growth and improving margins – something investors have heard several times in the past only to see the company under-execute and under-perform.

Valuation is where things get tricky. I’m looking for long-term revenue growth of around 3.5% and even lower free cash flow growth, as I don’t believe management will execute fully on this new plan and I believe the core distribution operations will see ongoing margin pressure. On the other hand, MSC is leveraged to a still-nascent recovery in manufacturing and those expectations still support a long-term total annualized return of around 9% to 10% a year. MSC Industrial management has a long way to go to re-earn the benefit of the doubt, but I can see some trading appeal here.

 

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MSC Industrial Does A Little Better On Margins, But End-Market Pressures Remain

MSC Industrial Holding Up A Little Better Than Expected

The going remains tough for MSC Industrial (MSM) (“MSC”), and management’s ability to get going remains very much a point of debate. While the U.S. economy has likely seen the bottom for this sudden downcycle, significant uncertainty remains as to the shape of the eventual recovery. More concerning to me than the short-term outlook is management’s multiyear track record of missing their own sales growth and margin targets, though the last couple of quarters have been better than expected.

When I last wrote on MSC Industrial after fiscal second quarter earnings, I thought the shares looked modestly undervalued amid considerably uncertainty. The shares have since modestly outperformed the larger industrial sector, though lagging peer/rival Fastenal (FAST) by a wide margin and delivering a more mixed performance relative to Grainger (GWW). At this point, I view MSC as more fairly-valued to slightly undervalued, with near-term upside likely tied to the shape of the recovery (and the market’s on-again/off-again enthusiasm for industrial stocks), while the long-term performance outlook remains tied to management’s ability to successfully execute its latest transformational strategy – a development that can, in my opinion, be very fairly called a “show me story” given past failures.

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MSC Industrial Holding Up A Little Better Than Expected

MSC Industrial's Earnings Bring Some Relief, But Uncertainty Remains The Primary Takeaway

MSC Industrial (MSM) is now effectively one of the first industrial stocks to report in an earnings cycle, and MSC's Wednesday report on its fiscal second quarter (calendar first quarter) brought some relief, but also a reminder of the exceptional uncertainty that companies are operating within at the moment. Sales held up about as well as expected, but management declined to provide guidance given fast-changing end-market dynamics and wider timing spreads between orders and shipments.

This year (calendar 2020) is going to be a tougher one than I was expecting, but I don't think COVID-19 is going to materially change the long-term trajectory of the business. The bigger issues for MSC management revolve around whether their plans to reaccelerate growth (to 300bp or more above market) and recapture above-industry incremental margins can bear fruit. I remain skeptical, but I do acknowledge that today's share price offers a decent prospective return for a stock where sentiment has shifted to a more conservative "show me" stance.

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MSC Industrial's Earnings Bring Some Relief, But Uncertainty Remains The Primary Takeaway

MSC Industrial Muddling Through A Tough Environment, But Margins Remain A Key Concern

I've not been particularly gentle in my assessments of MSC Industrial (MSM) management over the years, as I think the company has been slow to react to the changing realities of the distribution sector, and when it has reacted, it hasn't done so particularly well (I can't remember which sales strategy we're on now…). It's even more frustrating to see that in the context of underperformance relative to Grainger (GWW) and Fastenal (FAST) and the changes/adaptations those companies have been making.

My chief concern remains the margins, particularly with management acknowledging that its latest strategy, shifting from a focus on spot-buy to deeper managed inventory relationships with customers, will lead to lower gross margins. Less pressing, but still relevant, is whether the U.S. industrial economy will, in fact, see that second-half rebound that the Street has been counting on. For now, I see MSC shares priced to generate a total annualized return in the mid-to-high single digits, including a roughly 4% yield without the special dividend, and it's not a particularly compelling name beyond its higher-than-average dividend.

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MSC Industrial Muddling Through A Tough Environment, But Margins Remain A Key Concern

MSC Industrial Executes Decently Against Lowered Expectations

MSC Industrial's (MSM) management to close out its fiscal 2019 on a relatively okay note, with the company beating expectations at the core operating income line despite mounting end-market headwinds. MSC Industrial isn't doing as well on gross margin as Fastenal (FAST), and I'll talk about this later, but management is at least explicitly targeting margin improvement efforts in fiscal 2020 at both the gross margin and operating margin lines.

It's tough for an industrial distributor to make great strides during an industrial downturn, but the good ones often pick up market share during these times. I haven't been impressed with MSC Industrial's management in recent years, and this downturn would be a good time for it to pick it up and improve execution. Here in the mid-$70s, valuation is more challenging and the management really needs to execute on sustained margin improvement to justify a substantially higher price on a DCF basis, though an EV/EBITDA approach is substantially more forgiving.

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MSC Industrial Executes Decently Against Lowered Expectations

MSC Industrial Offering Weaker Execution On Lower Expectations

As an investor, I err to the side of being too patient with under-performing companies with good underlying businesses and that has been the case with MSC Industrial (MSM). I wasn't impressed with the company's performance last quarter and the near-term prospects for the industrial sector, and the shares are down another 10% or so since then.

Although management is taking a few modest positive steps and the dividend yield is pretty good, I remain concerned that the company doesn't really have a strategy for driving better performance in a world where customers have increasing price transparency and where the internet is eroding the company's historical competitive advantages. Valuation is not demanding now, but I consider this a future source of funds now given the ongoing issues with management execution.

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MSC Industrial Offering Weaker Execution On Lower Expectations

Fastenal's Execution Remains Beyond Fault, But The Valuation And Macro Picture Are More Debatable

With investors feeling noticeably better about industrials over the last three months (the Industrial Select Sector SPDR (XLI) is up about 14%), I'm not altogether surprised that the shares of Fastenal (FAST) are up even more, though the 26% move is still exceptional. When industrials do well, Fastenal almost always does well, and at least, some investors certainly seem to be counting on a stronger second half in that sector.

I remain more cautious. I'm more cautious on the macro outlook for the U.S. economy going into this quarter, though I'd be more than happy to be proven wrong by strong beat-and-raise reports from the sector. I'm also cautious on what looks like a "take no prisoners" valuation that leaves no room for company-specific or more generalized headwinds for Fastenal, even though I do believe there are still growth opportunities in place that can drive above-sector mid-single-digit long-term revenue growth.

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Fastenal's Execution Remains Beyond Fault, But The Valuation And Macro Picture Are More Debatable

Standing Up For MSC Industrial Getting Harder And Harder

I’ve been waiting for MSC Industrial (MSM) to show some meaningful signs of internal momentum for some time… and the wait just keeps going on. While management continues to tell a story of becoming a more integrated, mission-critical partner for customers and points to future benefits from pricing actions and sales force restructuring, the fact remains that this company has established a worrisome trend of underperformance and excuse-making.

I do still own MSC and I do still believe the shares are undervalued, but I now regard this position as a future source of funds if/when a better idea presents itself, and I’m not especially comfortable holding the shares in an underperforming manufacturing distributor going into what I believe is a slowdown.

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Standing Up For MSC Industrial Getting Harder And Harder

Grainger Looks For A Soft Landing As Industrial Headwinds Build

It was a very mixed year for Grainger (GWW) in 2018, as the company did well in the first half as the company reaped the benefits of a significant pricing adjustment, but the shares significantly underperformed rivals like Fastenal (FAST) and MSC Industrial (MSM) in the second half as worries mounted about the durability of the U.S. economic cycle, whether Grainger had meaningful levers to drive growth beyond price, and whether the company could drive margin leverage.

Unfortunately, fourth quarter results don’t offer easy answers. Grainger’s guidance for 2019 looks quite rational insofar as expecting modest market growth and little price leverage, but expectations of almost 4% relative outperformance in sales could be too bullish. Grainger’s profitability is solid, but I believe distributors are going to have a more challenging time in 2019 and it’s hard to get really excited about these shares.

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Grainger Looks For A Soft Landing As Industrial Headwinds Build

Fastenal Pitting Operational Excellence Against A More Challenging Macro

Long a margin leader in the industrial MRO distribution space, not to mention a growth leader, Fastenal (FAST) has been reporting incremental margins north of 20% coupled with double-digit sales growth. A downturn in manufacturing PMI doesn’t bode as well for near-term revenue growth, and tariffs could still challenge the price/cost balance in 2019, though the company still has some opportunities with pricing and operational efficiency moves.

Fastenal’s margin superiority has never translated into significant free cash flow superiority over peers like MSC Industrial (MSM) or Grainger (GWW), but the shares have never been held back by DCF-based valuation. Strong margins and ROIC should support a forward EBITDA multiple a little above 14x, but that doesn’t leave much upside from here unless Fastenal can drive some outperformance on margins and/or revenue.

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Fastenal Pitting Operational Excellence Against A More Challenging Macro

MSC Industrial Has To Offer More Than Lackluster Growth And No Margin Leverage

MSC Industrial (MSM) has continued to test the patience of its shareholders, as the company’s shares have continued to lag not only the broader industrial sector since the company’s fiscal fourth quarter earnings report, but also fellow distributors like Fastenal (FAST) and Grainger (GWW). I believe the primary issue is a familiar and long-standing one – not only is MSC lagging in terms of organic growth, it’s not showing the hoped-for margin leverage that has been a centerpiece of many bull theses. On top of that, MSC’s exposure to manufacturing is a potential vulnerability has uncertainties build ahead of the upcoming wave of guidance from industrial companies with their calendar fourth quarter reports.

I believe MSC Industrial can be better than this, which is a large part of why I continue to own the shares, but “can” and “will” are not synonyms, and investors have to consider the risk that between internal missteps and a changing competitive environment, MSC will never live up to its growth and margin potential. The shares do appear undervalued on both a DCF and margin-driven EV/EBITDA basis, though, and I believe the potential returns are worthwhile if the company truly does, at last, have its ducks in a row.

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MSC Industrial Has To Offer More Than Lackluster Growth And No Margin Leverage

MSC Industrial Looking To A Restructured Sales Effort To Drive Better Results

As I've discussed (and lamented) on more than one occasion, MSC Industrial's (MSM) track record over the past couple of years has not been up to snuff, with the company underperforming other distributors like Fastenal (FAST) and Grainger (GWW) in both operational and stock performance terms. Although MSC's fiscal fourth-quarter results weren't all that great, expectations had ratcheted down going into the quarter, and it looks as though a long and surprisingly disruptive sales force restructuring/retraining process should start leading to better results in the coming quarters.

Valuation on these shares is mixed, and I don't think they're a screaming bargain, though I can support an argument that the company's profitability and return on capital (and assets) justify a price into the mid-to-high $90s. The biggest issue for the stock, though, is whether MSC can start delivering better organic sales growth and drive some of the long-awaited incremental operating leverage that investors have been waiting on for some time now.

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MSC Industrial Looking To A Restructured Sales Effort To Drive Better Results