MSC Industrial Direct Co., Inc. (MSM) Earnings Call Transcript & Summary

Good morning, everyone. This is Mike McGinn, Senior Analyst, Wells Fargo. I'd like to start off by thanking the MSC team, Erik and John for joining us this year. I believe this is their first year attending. And we're delighted to be hosting in our new socially safe virtual format. For those investors on the line and webcast, if you have any questions you haven't already submitted, you can e-mail me at [email protected], and I'll do my best to fit those in. But starting off and by way of introduction, MSC is a leading distributor of MRO manufacturing products but really traces their roots right back here to New York in the metalworking industry. The company is unique in that they operate an asset-light hub-and-spoke distribution center model with a highly trained sales force and call center staff and, of course, an online market presence. Aerospace, heavy machinery, transports and metals and mining are key end markets, along with some of their top suppliers, Kennametal, Sandvik and their own private label brands, which is somewhere north of 15% but less than 25%, I believe.

So with that as a backdrop and to kick it off, Erik, we're certainly in a different position than last year, when tariffs were all the rage, and the macro environment had deteriorated rapidly. However, MSC is in a unique position to help the economy turn back on and provide high-demand PPE products through this downturn. Can you help us walk through how the company has evolved over time from your core metalworking customer to today, where government is a decent-sized business for you?

Yes, sure. Good morning, Mike. And yes, thank you for having us. Our first time attending the Wells conference and obviously doing it virtually. So let me begin by just wishing everybody. I hope everybody is staying safe and healthy, and nice to speak to you by phone. So Mike, what I thought I would do, as you talked about the evolution of the company, is just step back a little bit and describe kind of the strategic moves. We've always taken strategy seriously inside the company. I think it's something we've done reasonably well. So take you through the evolution. As you said, the company's roots are here in New York essentially as a direct marketer of metalworking supplies into the Northeast and spent a lot of our years that way as a regional family business. And then from there, moved into a series of adjacencies in a staged, carefully thought out way in order to capitalize on the full North American $200 billion MRO marketplace. So if you think about the moves the company made from the time years ago, we were a direct marketer of metalworking supplies into the Northeast. We moved geographically from Northeast to national. We moved from strictly metalworking supplies, as you mentioned, a full-line MRO distributor, from direct marketing into field sales, from print into digital. Then back from broad-line distributor, where we still carry everything, but to becoming more technical and high touch, which has been the recent pivot that we've talked about. And then one that you've mentioned, the end markets from years ago, focusing pretty much exclusively on small machine shops in the Northeast. We've moved into broader manufacturing, broader industry, and industry generally being the 4 walls of an industrial plant. But you mentioned government. So when we look at adjacent end markets or product lines for that matter, there's a few attributes that we look for. We look for markets that have high entry barriers and therefore have a deep moat. Related, we look for markets in which we see the ability to make disproportionate returns over time. And then the third thing we look to do is we look inside the company at our core capabilities. And we want to make sure that we're leveraging our core, our know-how, our infrastructure. With those filters in mind, the government was actually a natural for us for a bunch of reasons as I just described. We got into the government business, it was nearly 2 decades ago. And within government, there's lots of areas to focus within government, lots of agencies, lots of entities. We have tended to focus where we can leverage our technical expertise, our metalworking strength. So for instance, think military bases would be a good example. And we've also looked to where we can leverage our broad assortment and our fulfillment, our next-day fulfillment model. And there's a bunch of areas in which that plays well. Government got as high as 10% of sales for the company. But as we've talked about over the last year or so, we stubbed our toe with a couple of execution issues and contracts that were lost. I'll tell you that we're back on track. We have a strong leader in place now for about 3 quarters, investment going into that business and a lot of momentum. So between the improvements we've made, lapping the 2 lost contracts this past quarter, we certainly -- we've been telegraphing that we see improvement coming. And the timing couldn't be better because given this recent crisis, obviously, that improvement has been coming in spades.

Great. It's absolutely great color. I just moved -- part of that evolution, albeit somewhat unplanned in this new world, is you're now a company operating with a backlog, which is foreign territory for all of us familiar with distribution. Can you help us frame how you're managing in terms of procurement, pricing, delivery, maybe sales offsets to the industrial-centric portion of your businesses?

Yes, Mike. And you mentioned it's foreign territory for you following us. I'll tell you, I've been in the business now 20-something years. It's really foreign territory for me because given the assortment that we have and the next-day delivery and the 24-hour shipping, I'm not used to a backlog. So on the last earnings call, we talked about the difference between revenues and the order or bookings rate. And we never talk about that because usually they're tightly coupled given our fast shipping. But right now, we are definitely in different times. What I can tell you is that I've been really thrilled to see how our team has come together and really learned a new way of operating, as you talk about managing a backlog. And in particular, by team, what I mean is our supply chain folks, our category management, sales and even finance. The best example, certainly the most obvious example, would be in the PPE and janitorial space, where demand -- there's no problem finding demand, but supply is scarce. Most of the supply is overseas, hence leading to lead times and backlogs. And just the way our team is managing, navigating through really choppy waters, trying to get stuff out of China with 2, 3 times a day on calls, action plans around the clock, I've been really impressed. It's also, I think, helped that we've got a long history in China. We have our own office there. We have a couple of trading partners that we've been doing with for over 2 decades. So the trust is high, trust in our team is high. The fellow running our safety business has been running safety for over 2 decades. So it helps having experience there. But it's been an adjustment managing to a backlog. And overall, I've been very pleased with how we're managing through it.

Right. And a lot of distributors are out there, not just you, saying that sales -- or safety and sales in PPE can double as a percent of their business in the next few months. Is this just isolated to the next few months? Or is this something that you plan to expand your reach into longer term, safety, MRO, complementary manufacturing services?

Yes, Mike. It's a good question because it's something we're asking ourselves right now. And by the way, we probably say the same thing without getting too specific. It certainly wouldn't shock me if between from a product standpoint, safety janitorial skyrockets as a percentage of revenues and then government as well skyrockets as a percentage of revenues. As we look into the future, it does feel -- you and I were talking about this before we came on, that there's going to be a modified version of new normal for a while. The way we're sort of looking at the world is there's going to be a pre-vaccine world and a post-vaccine world. And in a pre-vaccine world, at minimum, so call that, who knows, but 12, 18 months, we think this category, safety and related categories, not just safety but janitorial, all types of products that are going to help our customers prepare to reopen for those who have closed and prepare to adhere to new rules around social distancing and safety and regulations that there is something here beyond just the near term. So the good news for us is, as I mentioned, like safety, it's not one of those categories that we're really known for, at least in Wall Street. But sort of under the radar, we've built a pretty big safety business outside of metalworking and the Class C business it's our next biggest category. It's been our fastest grower for a while. As I mentioned, we have a leader who's really well known in the industry and been with us a long time. We actually have built out quietly a network of safety technical specialists in the field, smaller than our metalworking team, for sure, but built out -- so we think there's a lot to build on here. But we do think there's likely something beyond just the immediate. The one caveat, Mike, is -- what we're not going to do is stray away from our core, our core obviously being metalworking. So I think where you can expect to see us focus with safety and related categories is into our current customer base, be it manufacturing or government.

Right. That makes sense. So correct me if I'm wrong, this transformation comes with some trade-offs, most notably mix, and you're certainly not alone in that camp. Can you walk us through maybe the trade-off between your highly profitable core and Class C customer in terms of gross margin, but maybe doing more with larger accounts and seeking that better operating leverage?

Yes. So mix, and particularly, Mike, I'll call out gross margin probably more so than op margin because what we found -- and we've done a bunch of studies on net profitability over the last few years and found that gross margin and net margin are not necessarily correlated. In a lot of cases, we have the same national account, for instance, where one sort of corporate relationship that could have the same pricing terms and you go to different sites and their profitability is very different. But the gross margin mix effect is real. And what I would say is there is kind of a short-term answer and a long-term answer. Let me start with the long-term answer. Look, no question that if you go back to that evolution I described earlier and you go to the historic core of the business, which was spot selling through direct mails, spot buy metalworking to small customers, that's like the highest margin business you could find anywhere in the industrial environment. And so certainly, over time, when you trace the adjacency moves that we've made, most of them are going to be gross margin dilutive. And so that's why -- and this is going back a decade or more. We've talked about a mix headwind for that reason. The flip side is a lot of these new revenue streams relative to the direct marketing or even digital marketing revenue streams come with some better attributes. They tend to be stickier, and what we mean by stickier is that they have higher retention rates. And when customers have higher retention rates, that leads to higher lifetime value. So as we look at it over time, as we leverage those relationships, take the same fixed cost that comes upfront to acquire the account. The longer you hold that account, the higher the lifetime value. So that would be a positive. But let me move to the near term for a second when it comes to mix because interestingly, the answer is not necessarily what you would think, because you would think core customers down, government customers up, that's a gross margin mix headwind. Metalworking products down; safety and janitorial products, which are not quite our core, up, that's a mix headwind. And while those are partially true, what I would say is there are so many moving parts right now in our business, Mike. And what we're finding is that there's other -- and I think we mentioned this on our last call, that gross margins have been -- we've been pleased with gross margin performance. One of the reasons is there's actually other mix effects that are helping us. So for instance, when our core customers' volume is down as it is, their production metalworking spend tends to be down. Their purchases of capital items like machinery are way down, and those tend to be coming at a lower gross margin. So that's actually a mix tailwind. So the punch line is, at least in the near term, there's a whole bunch of moving parts on mix, and we're not necessarily seeing it as a big headwind that I mentioned. We've been pleased with our gross margin performance of late.

Got it. And so we're talking about larger accounts, and you mentioned those stickier customer relationships. And the industry term is "capturing that spend relevance," which is, in my mind, simply code for national accounts. You made a couple of interesting moves here over the last few months that maybe have gone unnoticed. For example, you brought vending in-house. Can you tell us what that means in layman's terms, and what other services you have or you need to offer to attract these national accounts in this sticky business?

Yes. You picked up on an interesting move that did go under the radar. And maybe to step back for a second, I think the words we would use, kind of our substitute for spend relevance, is what we're referring to in our strategy as being mission critical, which means not just the size of the customer, meaning national account, but also the role we play in the customer, not just being a spot buy supplier, not just supplying MRO, but getting to what really matters in their production process. And we do that by not only bringing products but technical expertise. So we mentioned the network of metalworking specialists, digital capabilities, not just e-commerce, but e-procurement, where we hook into our customers' systems and operations. We're bringing cost-savings ideas and, of course, inventory management, vending and VMI, which you mentioned. So vending continues to become a bigger and bigger part of the equation. It's growing our presence on the plant floor. Over the years, we've made a bunch of improvements to that program. We put out a leader in place, probably about 3 years ago now, who was Chief Supply Chain Officer at a very large company. And we put him specifically over inventory management. And he's made a bunch of changes, and I would say both on effectiveness and efficiency. Effectiveness being how well are we executing the program and how are we doing in terms of customer satisfaction. He's made a bunch of changes to the way we go about servicing customers that have led to improved Net Promoter Scores, improved satisfaction. The other thing is efficiency is just saying how is the cost relative to the revenue. So one of the improvements that he's made, this is the one you mentioned, is bringing vending in-house was particularly when you think about we have this installed base of thousands upon thousands of machines out there. And these machines are like little computer systems and little operations that need servicing. In our early years, what we were finding is that our salespeople were getting dragged in to do vending maintenance and service. And we found that they were neither qualified to do it nor did we want them spending their time servicing vending machines and not selling. So we had ended up with some third-party relationships in maintaining some of those machines. It was generally -- that was an area that was actually pretty efficient for us. But what we found was that in the end, there's no substitute for our own people and culture coming through in terms of customer satisfaction. So what we have done, and it's sort of been buried within the growth in sales and service headcount, is part of the growth in service headcount in particular has been we've brought that function in-house. So now if you're a vending customer and there's an issue with a machine, replenishment or actually just with the technology itself, you're going to see our own person. And what we found is that while there's been a lift in headcount, we're seeing big leaps in customer satisfaction and actually efficiency.

Great. So that kind of leads me into my next question. You mentioned service, mission critical, digital integration, vending, VMI. Those are kind of what I would dub organic growth-oriented changes. But in terms of inorganic growth, you've also been a fairly active acquirer but not as much recently in the past, starting with J&L, Barnes, DECO, AIS and now Mexico. It seems like each business gave you a little different end market or regional exposure. And maybe Barnes, CCSG came with the highest expectations but also the most integration challenges. Can you walk us through, one, maybe what you've learned after multiple acquisitions? Two, what you think the biggest challenges or successes have been? And then lastly, three, how you expect future M&A to go with this higher hurdle rate that you've now publicly acknowledged?

Sure, Mike. So M&A -- and look, my first job at MSC 20-something years ago was actually -- we were acquiring local distributors, and I was responsible for building an integration process and team. So I've got a lot of scars and battle wounds when it comes to M&A over a couple of decades. So plenty to share. Here's what I'd say. I think the first -- the biggest lesson that I've learned, that we've learned, is that acquiring inside of your core business is much easier than acquiring outside of it. So particularly for MSC, we've done a lot of deals within metalworking. Nearly all of them have been successful. And some of them have different flavors. So you mentioned J&L. That was a big-platform metalworking deal, but it was still in our core of metalworking. We bought catalog businesses like Rutland Tool. And then we bought a bunch of branch-based metalworking businesses, the most recent one being DECO. I can tell you, even the branch-based ones, I know some on Wall Street don't love them because of the margin percentage dilution particularly on gross margin. Those businesses, every one of those acquisitions has been really strong. They've all met or exceeded their financial case, produced strong returns on capital. The most recent one in DECO, for instance, filled out a geographic hole for us in the Iowa sort of like the farm belt area. It's been a really good success. And I go back through the line the metalworking ones have. At the same time, I would say and just caveat it, that does not lead us to become -- that could beg the question, "Why don't you just -- if every one of your metalworking deals is successful, why not become more of a serial metalworking acquirer and roll up smaller distributors?" That's not where we're headed. We think one of the reasons we have been successful is that we're selective. So we're thinking carefully about not just acquiring any business but getting the best of the best and where there's a culture fit. So the flip side of the coin here, acquiring outside of our core business is harder. And I think the Barnes, CCSG acquisition is a case in point for that. I'm certainly happy we did that deal. It got us into a very important category that back to the criteria we look for high entry barriers, opportunity for returns. We're definitely better for it. But look, no question, the deal came with a longer curve, a lot of learnings and bumps and bruises because it's a new business. So I think moving forward, what I would say is, for now, the hurdle rate is higher across the board. It was pre-COVID. It certainly is now COVID. We're just being very careful about cash and where we deploy, looking for high return at low risk. But where we will acquire, I think point one would be within metalworking, we would absolutely -- a good business we would acquire. And then looking outside metalworking, outside of our core, what I would say is lessons learned: number one is there's got to be margin for error, knowing that you're going to make some mistakes when it's outside your core. The second thing I'll say on Barnes, CCSG is that business did not come with a strong leader by itself. We -- there was some great talent we got out of that business. But in terms of at the top, we put our own people in. And I think that works really well in metalworking, probably not as well going outside of our core. And so I'll contrast that, and then I'll wrap up, Mike, but contrast that with recently, we did a deal in joint venture style that was outside of our core business, and that's Mexico. That's been a home run. And I think the reason it's been a home run, despite being outside the core is that we got a great leader. The gentleman running that business has been with it for a long time, staying whether we trust him, and it's performing great.

Yes. I hear you. I think investors will -- and certainly in this environment, appreciate that high hurdle. You've been hearing a lot lately, "Cash is king," I guess. Moving to the other side of the spectrum, I have to ask because it gets asked of me a lot, quite frankly. Are you a willing seller if approached with the right offer?

Yes. Right. So that's the other side of the coin. Look, Mike, I see a great path for the company. I see a great future for the company. We've been through the wringer the last few years in repositioning MSC, a lot of hard work that resulted in some underperformance in the numbers. I feel like we have it at a really good place right now. So for that reason, it's not something that crosses my mind all that often. That said, look, I have a fiduciary responsibility as CEO of the company, as a shareholder to maximize shareholder value. So certainly, look, if an offer came in, I'd entertain it. I'd bring it to the Board like any CEO would do, and it would get its full attention. But right now, given kind of how far we've come and the relative valuation of the company, I see a lot of opportunity for us on our own at the moment.

Yes. I appreciate it. That was a tough question. So shifting gears to the current environment. The challenge, I think, every investor has is what parts of the economy lag and what parts return to normalcy. Can you talk about maybe the regional variances you're seeing or product trends and whether you see another gap lowering manufacturing as things like oil, autos and aerospace take a little longer? Or any incremental color you may have there.

Yes. And Mike, you hit the ones that, in terms of the macro, are top of mind for me. And not surprisingly, the softness by end market correlates to where we're seeing it regionally. So for instance, we've seen the highest concentration of shutdowns in the Midwest all tied to automotive. And it was like clockwork, going back to mid-March, when the Big 3 announced their shutdown schedule. It was like dominoes for our core customers, who -- many of whom are tiers down the supply chain for auto in the Midwest. Aerospace, certainly between what had happened with Boeing and now COVID softening oil and gas, no question. The one thing I'd say is, look, we estimate about 25% of our customers had shut down. We are gradually, not surprisingly, beginning to hear of customers coming back online. So I think that's a slow process. We're not expecting any sort of big boom. But at the moment anyway, we're also not seeing something that would suggest another major step down. I do think you're right, though, that some of these end markets are going to be fairly weak. I mean oil and gas certainly could be for a while. But nothing that would indicate a major step down from where we are now. And then look, the flip side, what we're trying to do, Mike, is focus on customers and end markets who are busy. And I mentioned government being an obvious one, sort of a poster child, getting a whole lot of attention from us that can offset some of the softness in the quarter.

Right. Yes. I understand it's wildly influx right now, very uncertain end market environments. But maybe just can you talk about what your margin playbook would look like, V-shaped versus maybe a U-shaped recovery? It seems like right now, most companies are fighting through with discretionary spend, T&E, bonus deferrals and the like. But what else do you see as maybe left in your back pocket to cap decrementals [ if need be ]?

So I'll talk decrementals. By the way, one other point, Mike, before we leave the end market view that I think is relevant for the long term, not so much in the next few months. And that's the fact that we're hearing a growing sentiment about onshore that the COVID -- everything going on in the supply chain, the COVID crisis, there was sort of a move to onshore a few years ago. We're hearing the drumbeat louder for bringing manufacturing back to the States. So I think that as a long-term prospect is very promising. With respect to decrementals, let me get to your question. So what we talked about on the last call -- and to be honest, look, I think what we described was probably on the call. The framework we gave would have been more what you call U-shaped than V-shaped. Because in a V-shaped recovery, if things come back fast, one thing I've learned about our business is that either up or down, fast changes result in massive moves in incrementals because there's just not a lot of time to add in costs, to take out costs. But in a U-shaped, what we had talked about was decremental margins somewhere in the low 20s to low 30s. And I'll say that was using revenue sensitivities that were pretty healthy drops down that we hadn't been seeing to date. In terms of the actions that we're taking to achieve those, what I would say is we're taking -- certainly, we're taking temporary measures like most companies are doing. So that would be clamp down on CapEx, discretionary spends, compensation, travel and the like. We also are -- and we've talked about -- I think there's probably 2 other points I would make that add into this decremental picture. One is that over the last couple of calls, we've talked about structural cost opportunities that we see independent of volume levels. We've been moving ahead on that. We talked about seeing a couple of hundred basis points of OpEx to sales reductions. To be honest, the program will probably move a little slower than contemplated due to this crisis but still some opportunities for moving ahead on now. And certainly, over time, we see that picture clearly. And it's just a matter of having the time to focus on it. In some cases, some of the things involve travel that we can't do today but are waiting for us. And then the last factor on decrementals that I'll highlight is gross margin. It's sort of an unsung hero when it comes to gross margins in that if we can keep gross margins stable and strong, that helps the picture a lot. Whereas if gross margins drop, the decrementals will get worse. So as I mentioned, as of now, we've been seeing relative strength or stability in gross margins. If that holds, that helps the decremental picture. And that's probably the biggest factor in what would move us one way or another between the low 20s and the low 30s.

Okay. I'll try to sneak a couple more in here. Many investors like MSC for its stable free cash flow, and that's consistent with a lot of distribution models. But you're specifically that hub-and-spoke asset-light. I think your free cash flow stands out. And you're currently in a transition with an interim CFO, but can you help us frame what does the ideal capital allocation policy look like in a normalized environment? And does that maybe morph slightly if there's a change in perspective from an outside candidate?

So look, I would say that we've always maintained our own philosophy, I think, a fairly unique philosophy in terms of capital allocation. I do not see that changing based on whomever we select as CFO. And the reason I say that is, to me, being aligned philosophically, capital allocation is one of the most important priorities for a CEO, let alone a CFO. So I take capital allocation seriously. And I would struggle if the CEO that came in did not share the same view of the world that I did. So that will be a criteria in which we look to hire. It won't be something that will influence our thinking because our thinking has lasted over 2 decades. But I would say, if I had to describe the philosophy, is basically think like an owner and deploy money like it's our own because it is our own. In this case, it's -- I'm aligned with our shareholders. I'm a large shareholder, and that's how I view it. So what that means is that we try to avoid setting formulas. You see some companies saying 1/3 of the cash will go here, 1/3 to buy back, 1/3 to M&A. We don't think about the world that way because instead, the way we think about the world, if you're going to think about it as an owner is, "Where can I deploy the next dollar to its highest and best risk-adjusted use?" And that is the philosophy. So what does that mean? It usually begins with reinvestment into the organic business. That for us is as long as we believe in the business, and we do, that's usually as long as there's good projects, the lowest risk avenue to produce returns. From there, we're committed to consistent growth of our ordinary dividend. You've certainly seen us make moves recently between an increase in payout ratio. With stock prices coming down, the yield is obviously well up, but at a payout ratio that's very manageable and we think is part of what creates a compelling investment opportunity. And then from there, I mean we're in a position where, knock on wood and even in situations like this, cash flow is strong. So we'll typically have excess cash and then we have a choice. Do we deploy that to M&A? You heard us talk about M&A at a higher bar. We're not averse to hanging on to cash for a while. Particularly in times like this, it's not bad to have cash. And then over time, we'd return the cash if we don't have a better use either internally or through M&A. And then in terms of how we return it, we've been all over the gamut and over kind of balance over periods of time, even though not balanced in any one moment from whether it's increasing ordinary dividend, special dividends, buybacks, tender offer, et cetera. But that's the philosophy, is deploy the next dollar like it's our own.

Okay. So with that and in the essence of time, I believe that's a wrap. And again, I'd like to thank Erik and John and the investors on the line.

Mike, thank you very much.