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

All right. Great. Good morning, everyone. Welcome to the MSC presentation. I'm Ryan Merkel from William Blair's research department. Before we begin, I need to remind you that a complete list of disclosures and conflicts of interest is available on our website. With us today is Erik Gershwind, President and CEO. We also have John Chironna, Vice President of Investor Relations and Treasurer. As many of you know, MSC is a leading distributor in North America of metalworking and MRO products and services. This company offers over 1.5 million products, along with high-touch solutions that are designed to lower supply chain cost for customers. So Erik, let me throw it to you for sort of 5 minutes or so of introductory remarks, maybe hit on the sales release from last night and then maybe hit on the business model and the strategy a little bit as well.

Yes. Sure, Ryan. And maybe where I'll start is just with where we've been over the past few months. Obviously, it's been quite an episode. I have been pleased overall with the way the company has responded during the COVID crisis. What I would say is, if I go back over the past quarter, the first few weeks were really about playing defense. And by playing defense, what I meant is ensuring the safety of our people, ensuring business continuity so that we could service customers, and we were deemed essential the whole time. And ensuring financial security of the company because at the time, we didn't know how severe the drops in revenues could be. So you saw us pull down the revolver as a for instance. As things stabilize during the course of the last 3 months, I would say the attention has turned from defense to offense. What I mean by offense is looking at opportunities for market share capture that inevitably come in downturns. And certainly, this is as severe as anything we've seen. And then hearing from the field that even relative to those who have been with us for a while, even relative to '08, '09, the local distributors that make up the 70% of our market are really struggling. So market share capture certainly presents itself with opportunities. You could see in the press release and from our last call another opportunity in terms of playing offense, if you will, would be the PPE, safety, janitorial products that were needed. We saw this big surge. And it was great because it was an opportunity to make up and offset a drop in the core business and also it makes you feel good because we're getting products into the hands of people on the front lines. And it really goes in keeping with our mantra of being mission-critical on the plant floor, helping keep businesses running. So between government and safety and janitorial, I think that's felt good. So again, attention moved from defense to offense. I would say where we're at now, again, I felt very good about how the team has executed. We moved to a work remote environment everywhere we could, which was pretty much everywhere other than our distribution centers, of course, where people were coming in every day. The attention is now turning. It's going to remain on playing offense. But also as things begin to settle out into somewhat of a new normal, kind of continue the march down the path of the repositioning of the company that we have been on. Most of that heavy lifting was behind us. And I would say 2 bodies of work that remain. One is finishing off the sales realignment, which we're pretty close on with our, I'd say, our new leader of sales, Eddie Martin, who's been with us a year. But we're close to finishing that work. And then the last body of work was around the cost realignment or the operating model realignment that we just started to touch on as we went into the COVID crisis, but picking up where we left off there and continuing that repositioning.

Great. All right. Thanks for that. So let me dive into some short-term questions first I'm getting from clients and then we'll bring this to some of the longer-term questions. So first off, what percent of your sales is safety and jan-san products? And can you give us the growth rate in May?

Yes, sure. John, do you want to jump in? Sure.

Yes. So Ryan, if you take safety, jan-san, PPE, all of that, they're somewhere pre-COVID in the 10% to 15% range. And obviously, it grew pretty dramatically in May, probably in the 150% or higher range growth. So that and given the rest of the business, it must have doubled in terms of as a percent of sales. But just keep in mind, that includes a surge in that business, right, which not guidance for future months, but there is going to be a drop-off to that and some level of maintaining that, but not at that surge level.

Okay. Yes. Okay. And then you still have a safety backlog of about $100 million. Is the supply of safety easing up such that you'll sell that backlog over the next 1, 2 months or could it be longer than that?

Go ahead, John.

Yes. I was going to say, it's definitely going to be longer than that because what you have to keep in mind, everyone needs to understand that in the backlog are things like blanket orders or open orders, right? So a customer could say, hey, I want $12 million of goods, PPE-type goods, but I want it over the next 12 months, $1 million each month. That's definitely included in there. And then there's an element of, I don't think it's not a huge number, but I would expect that some of these orders could get canceled because people were scrambling in the beginning of COVID, right, just trying to get whatever product they could get their hands on, as we were, by the way, trying to procure this stuff. So no, don't think of it as half of that getting billed out over the next month or 2. That would be way too aggressive.

Okay. Okay. And then non-safety, non-jan-san in May was down double digits, but it improved modestly from April. So is the weakness broad-based? Is it sort of concentrated in aero and auto? What can you tell us about that part of the business?

Yes, Ryan. And to be even more specific, and John, I think, will share just sort of directional color on what we saw. John gave you sort of the main numbers on the safety. And we sort of group safety and janitorial together because think about, for us, hand cleaners, sanitizers would fall into janitorial, but have that same characteristic of being a surge need during this time. For the rest of the business, Ryan, if you went back to the end of March and then through April, April, we were looking at sort of the core of the base business down 25%, 30% in that sort of range, which, to be honest, was consistent with what we were seeing in the way of customer shutdowns, particularly in the Midwest, particularly concentrated around auto. I would say, we saw it quite acutely. So what happened through May, May was more like mid-20s, which you can imagine the beginning of May being worse, the end of May being a little better. We called it modest improvement because certainly, you're seeing states begin to reopen, and the headlines are such that it seems like the country is back. What we're seeing is more, we called it modest because customers, look, what we're finding is customers are cautious. If they're opening up, they're coming back at 1 shift, not 3 shifts. They're very cautious about not buying a lot of supplies and burning off what they had pre-COVID because everybody is worried about a second surge in the virus. And Ryan, the other thing I would say is, to your point, metalworking markets right now, so as things come back, 1 shift is better than no shift. So to the extent customers open, that helps us. But certainly, you look at the underlying fundamentals right now in auto, in oil and gas and aero, as you mentioned, which aerospace had really been holding metalworking up for a while, it's changed dramatically. So look, the end markets are soft. Now again, going back to the share capture, I think that helps us in a lot of ways. While not a green shoot for the economy, I think it is sort of a green shoot for MSC, an ability to capture share from locals.

And then this is sort of a hard question to answer, but clients are asking me. Could sales be negative in August, September when the safety surge ends? I know you don't have a lot of visibility, but is there a chance for that based on what you see?

Could they be? They definitely could be negative. Yes, certainly could. I mean just think about, so think about the dynamic that we just talked about and where sales were coming out of May. And if you see sort of a gradual improvement, they definitely could be negative. Could they turn positive? Yes, they could also turn positive. But I would say, right now, with what we see, negative definitely could be in the cards depending upon how quickly things come back and what happens with the virus.

Okay. Another big question I'm getting is gross margin. Are safety gross margins similar to the company average? And then second question to that is, does the answer change if it's safety sales to government?

So yes, so let me touch on gross margin because I know John's been getting questions also on our release. What do you guys mean by solid gross margins? So maybe let me start there and then answer kind of the moving parts and what we're seeing in terms of mix. Our definition of what solid gross margin performance would be, I would say 2 things that we sort of set out as a bar for ourselves at the start of the fiscal year. One was, we put the op margin framework, which right now seems like ancient history. But when we set that, we've put, I think 42.0% was the number that was like sort of the Mason-Dixon line right the middle of that chart. And I think from our standpoint, particularly in this choppy environment, anything that would be at or above that number to us would be solid. The other thing we thought is we said, hey, as we move towards the back half of the year, we're making some improvements to our execution on pricing. We have the supplier actions that should kick in. We also felt like as the year went on, the year-on-year gross margin gap, which if you think back a few quarters ago had bulged to be 100 basis points or more, we felt like if we did our job, that gap should compress as the year goes on. Those would be sort of the 2 barometers for us that would say solid performance. In terms of, Ryan, where you're going is mix, and it's the right one. What I would say right now is, on the price side of this, so if there's 3 levers to gross margin, price, cost, mix, I'm pleased with what I'm seeing in terms of execution on the price side. I'm pleased with what I'm seeing on the cost side. It's going as expected. Mix in this environment is such a wildcard, and it's so volatile. What I would say is, in general, to answer your question specifically, in general, safety is not a big event in either direction relative to the average company gross margins for us. When safety is sold to the government, yes, it would tend to be consistent with most of our government sales, yes, that would be a headwind. The flip side is, Ryan, in this case, what's so unusual is, we have cases where in a given month, and I can't exactly predict what's coming, it's one of the reasons why guidance was so impossible, safety could be driven by a handful of SKUs. And so there's looking at the category in general and then there's, is there maybe 1, 2, 5, 10 SKUs that really drive a big piece of the growth? And if that happens, it could end up being a mix headwind or a mix tailwind literally depending upon the SKU, which is why I don't mean to be evasive, but it's hard to answer. So in general, safety is not sort of material either way, but it's down to a SKU-by-SKU determination.

And the only thing I would add, Ryan, I would also add in the point on national accounts, similar situation in terms of mix, right? So national account gross margins are typically lower than the company average as well.

Okay. One follow-up, Erik. What your peers are telling me is that they're having to source safety from nontraditional suppliers and the economics aren't quite as good. So between selling to government and health care and then not getting as good on terms, that's why the gross margins are lower. Do you guys have the same sourcing issue?

Got it. So what I would say, Ryan, look, this is an area where looking back, I've been pleased, really pleased with the execution of the team in terms of how sales and the category managers and the supply chain folks are all collaborating. Look, and I'm sure our peers have the same where we have people who've been in this business for 20-plus years and have really long-standing supply relationships, including overseas, which has helped a lot. It sort of moved us to the front of the line. So in general, I felt good about our sourcing. What I would say with sort of 2 caveats. One is, there have been cases where you mentioned the supply difficulty in getting product over to the States has been real. I think we fared better than most, but still real. So there were instances where we had to second source, for instance, and just do a fill-in for a customer where that could have been at like 0 margin. If it was an emergency basis, our approach is you do whatever it takes to fill the customer. So we did see some of that. We are seeing some of that. And then look, the other thing is, this market is moving so fast, Ryan. And when I say this market, specifically the PPE products. It's moving so fast that pricing could come -- what was a good price to buy at today may not be tomorrow. So it's again very volatile.

Yes, certainly not easy, that's for sure. Okay. Well, let me move to some longer-term questions. Erik, you touched on this a little bit, but just talk about the strategic shift, the high-touch solutions business. And the other part of that question is, does that mean you're moving away from the spot buy, which traditionally had been what MSC was sort of known?

Yes. Good question. So Ryan, look, I think what we've been talking about is a move from spot buy supplier to what we've been referring to this mantra of being mission-critical partner on the plant floor. And basically, what that means is that the role MSC plays inside of our customers has expanded. So we still, if you go to most of our good customers, and Ryan, I know you've spoken to several of them, you will still hear a lot of comments about reliability, about inventory, next-day delivery, keeping me running. That's kind of the legacy spot buy. We don't see moving away from that. We don't see ceding that market. In fact, what we find is where we're executing our strategy the best, we get a lot of that spot buy business. It's just kind of now that's not the only thing. And what that's being blended with is business that is more technical, think metalworking, where we have hundreds of reps who are on plant floors right now maybe, in part, virtually, but doing literally, with face time with customer, optimizing their tooling and their production process. It means the C part, the Class C business of being high-touch, kind of like an outsourced inventory management model for the customer. It means vending and VMI. It means some on-site, et cetera, et cetera. So I would say not ceding the spot buy. It generally will come along with the other stuff, but it's going to move more aggressively towards the new business.

What exactly is the mix, would you say, between high-touch solutions and spot buy today? Is that something you can sort of precisely determine or is that something that's a little hazy?

Yes. I mean, it is. It's always been one of those things of, what is a spot buy. It's tricky. I mean, I think in some of our recent work over the last year or 2, we've sort of honed in on a couple of definitions. And basically, we'll look at the frequency that a SKU is purchased by a given customer. And say, if a SKU is bought onetime, 2 times a year by a customer, that is akin to a spot buy. And if it's bought more than that and it's recurring, it would be more like the new revenue. And definitely, what we're seeing, so if you go back like a decade ago, the vast majority of the business would fall into the spot buy. Over a 5-year span, what's interesting is what we saw is, so the lines are starting to cross. I mean, and you can see some proof points of that in terms of our inventory management solutions as a percentage of sales and some of these metrics. Interestingly, over the past 5 years, and this is the point about not ceding the business, the spot buy business is up. It's not like it's down. It's actually up. It's just up, and I want to say, depending upon the slice of time, Ryan, up like low single-digit CAGR, but it's not like it was down. But definitely what we saw was the recurring revenue growing faster. And so as a percentage of sales, it's moving. And look, I expect that to continue to happen.

And then the next logical question is, as you mix towards high-touch solutions, which is a little more recurring, right, with probably more production tooling, VMI, what happens to the margin profile, both gross margins and then EBIT margins longer term?

Yes. So look, I think that, I mean, if I think about the formula for getting the company back to EBIT margin expansion, to me, is where this all -- that is the bottom line as the company has seen EBIT margins drop. And I think in part because of some investments, in part because of the move to the new business and the mixing down. And look, in part because I think that we need to execute better. How do we get to EBIT margin expansion? Basically, the formula we still see is, gross margin year-on-year erosion, I would call it relatively modest or moderate erosion. I don't think we should be looking at 100 basis points. To me, modest moderate would be 50 basis points or less per year. And if the company does its job and we re-establish, sort of we get back to normalized economy and call it with industrial production somewhere in the 2% to 3% range over time. And the company does its job of its typical gap above IP of 300 to 400 basis points. At those levels, OpEx as a percentage to sales should at least offset gross margin erosion. That gets you to flat or better at, call it, mid-single digit. And then there's sort of 2 levers for op margin expansion. One is what you've always heard from us which was, as growth moves from mid-single digit to high single digit, we get more leverage. And then the second one, which I think is the newer one, is the structural cost work that's been going on. We've been calling it operating model realignment, Ryan, really because what we found over the past few years and looked at the whole operating model of MSC, the supply chain, the IT systems, the business rules were geared around a spot buy supplier, very high service, high gross margin, higher cost, and applying that to the newer business has been yielding part of the issue. So that was the impetus for some of the work we've been doing. So with the work we've been doing, we've been talking about a road map over, call it, 2 to 3 years to be able to actually implement all this work, but we saw a couple of hundred basis points in OpEx to sales improvement, and that would be independent of growth. So that would sort of overlay what our usual formula would be.

Okay. Thanks for that. And then you hit on the transition to the new sales roles a little bit earlier. I think this is mostly done. But what have you seen? Have you seen green shoots? Are you happy with it? You obviously talked about signing up a lot of new accounts. Are you feeling good about that transition and are you set up for future growth and all of that stuff?

Yes. So I am feeling good about the progress. I won't be happy until the growth gap restores to market. And look, over the last couple of months, it's so hard right now to gauge how we're faring because the numbers are so wacky. A little bit of green shoots in terms of the last couple of months, I think, executing, I think, outgrowing market. But the fundamental shift, Ryan, was saying, all right, to sell the old value proposition of being a spot buy supplier, it was pretty simple. The newer one is more nuanced and it's more complicated. So what we did essentially is go from a one-size-fits-all seller where one seller would handle any type of account coming in to a little more segmented. And basically, it's 3 roles: hunter, farmer, complex account manager. We had a year ago a transition in sales leadership. So Eddie Martin came in with 20-plus years. I would describe Eddie's experience as much as anything else as almost like a chief commercial officer sort of profile as opposed to just the head of sales, a little more analytical, data-driven. And basically, his conclusion, he took a few months to spend time in the field, look at data, speak to customers. And his conclusion was, the strategy is right, implementation or execution needed to be improved. And specifically, what he found with data was he said, hey, let me show you why I believe we are over-allocated to farmers and under-allocated to hunters, and that's sort of why we're not seeing lift in growth that we ought to see. So what Eddie did, and this was pre-COVID, is we made some moves. You may remember headcount came down in sales, there was 1 or 2 quarters, was down pretty substantially. That was a reduction in the farmer population. And that was to be offset by hiring in the hunters. The hiring has slowed over the last few months because of COVID. We will pick that up. But the green shoot that I would point to, Ryan, is the performance of the existing hunter group this year has been really strong. Up until COVID, well ahead of plan, it's since come back as measured by revenues. But in terms of new account wins, not just the funnel, but the win percentage, the close rate, seeing real progress. So feel good about the hunters. The other thing I'd comment on, Ryan, where I've seen a change under Eddie's watch has been, a few quarters ago, we said, oops, good progress on the wins, and then we had this logjam at implementation. Eddie has since brought in a really strong VP of sales operations, who he had worked with previously at GE. And this gentleman is just bringing a different level of rigor, I would say, and intensity to how we execute the deals. So that issue is now clearly in the rearview mirror. So in general, feeling very good about progress. But ultimately, I won't be happy until I see sustained growth gap.

And then a question I'm sort of asking everyone is, in a post-COVID world, what do you see as the opportunities for MSC specifically or just your industry? And safety is obviously one.

Yes. The biggest, Ryan, so there's probably a few ways I'd answer the question. I do see real opportunity for MSC to forge ahead. The single biggest would be the share capture opportunity from local distributors. So just to remind those on this who don't know the industry that well, it's just remarkably fragmented that the top 50 players still have only 30% share. So 70% of the market is made up of local and regionals. And I was on a call last week with one of our best regional sales managers, who's been with us for a couple of decades and led the country in growth coming out of '08, '09, really took advantage. And he said to me that the opportunity that he's seeing now is bigger than it was in '08, '09, which really struck me that distributors -- I mean, it's unfortunate that it's happening this way. But those who are strapped for cash, the sort of same old story in a time like this, it's very difficult to hang on to inventory, credit terms, and hence, customers, salespeople, et cetera. So I think that's going to be one. And particularly, post-COVID and with soft metalworking end markets, the absolute numbers may not be so good. I think the share capture opportunity goes up. That would be one. Certainly, you reference the second, which is safety and related. We have an initiative inside the company now to build upon some of this early success and really create a pandemic category, not just products, but value-added services build on. We actually quietly, over the years, have built up a network of safety specialists in the field. We want to build upon that, provide them more training, some more people. And value-added services, like offering help to our customers on how to think about reopening, how to think about laying out their facilities, we have a lot of supply chain folks who are doing that inside our company, and we think we can help. So as John said, the big surge may be gone, but if I look out in a -- the way we're looking at the future, Ryan, is kind of in 2 phases, pre-vaccine and post-vaccine. And who knows how long that pre-vaccine phase lasts, that there is going to be an elevated need and heightened demand. So we see opportunity there as well.

And then what about e-com? That's another one where people are saying that's sort of seeing a surge. Are you seeing that in some of your numbers? And...

Yes. Actually, I neglected it. You're right. That's a third area that I should have mentioned is digital. No question that, look, as the new normal settles in, we absolutely still see a role for our field sales force either going to visit customers again or even doing it virtually, as we're finding we're able to add value virtually. That said, you're right, thank you for prompting me that no question that digital, the importance of digital is going to really matter. And we actually think we're well set up for kind of a post-COVID world between a strong e-commerce platform. We're actually going to be doubling down investment into e-commerce as we speak, doing some revamping there. And the centralized logistics model that we have, we think, is also advantageous where it's a few new centers that can ship next day. We think it's helpful. So we think the supply chain and the digital certainly would be a third area of opportunity there.

Actually, again, you mentioned a doubling down on the e-com. What does that mean exactly? I know one of your peers is spending a lot of time on merchandising, right, making sure that people can find exactly what they need very, very fast.

I would say similar, Ryan. So it's going to be pretty all-encompassing. We'll be looking at the technology platform. We'll be looking at how we present products. We'll be looking at how we market the products. So not just the website, but digital marketing. What we found with e-commerce over the year is, once you start hearing that your website is good and you get good customer feedback, it's time to reinvest because the gap never lasts for that long. You got to keep reinvesting. So I would say it's pretty all-encompassing, technology, merchandising and marketing.

Okay. I mentioned this in my opening remarks, but the goal of your business model is to reduce supply chain costs for your customers. Can you just explain how that's different than an Amazon or a Zoro?

Sure. So I think there's an element. If you mention Amazon and Zoro, I would say that's closer akin to the historic legacy MSC business as a spot buy supplier. And there are some really important ways that a spot buy supplier, the ones you mentioned and I think MSC as well, can take costs out for a customer. So the simplest way to think about it is, every time a customer needs to cut a purchase order for products, that comes with a cost. And if you can consolidate as a customer your shopping experience into one supplier, there's a lot of economies that come with that. And I think that's been the historic way in which MSC lowered cost. I think the difference with MSC now in the new strategy is going beyond just sort of process and soft cost savings into tangible hard cost for the customer. And by hard tangible costs, I don't necessarily mean price. I mean, we studied for most of our manufacturers, the overwhelming majority of their cost comes in 2 buckets: labor and materials. And what we found is the way to really move the needle for the customer, therefore, is to find ways that they can save labor and save materials. To do that, it's beyond just consolidating orders. There, you have to actually be on the plant floor with them, finding ways to improve their production process. So that could be recommending new tooling. That could be recommending a different material that they're cutting. It could be recommending running their machines at a different speed than they're used to. That's tough to do without technical expertise. I think that's where kind of the new strategy where we've moved towards and why we're moving the needle faster on cost savings for the customer.

Right.

Ryan, I would add into that, even at the simplest level, if you spoke to some customers, calling them, calling us, very different experience in terms of the support levels and the knowledge base that they're going to receive when they call MSC on different -- whether it's cutting tools or other products, the customer experience is going to be very different, I think.

Right. Okay. In sort of the 1, 2 minutes we have left, I get a lot of questions about the metalworking market. Is it still attractive? More competition has come in from several players. You're still the #1 player. But has competition made it a little bit harder for you today than maybe 10 years ago?

I would say, look, I think, Ryan, the answer is, I think business every year gets harder everywhere you look, and I'd be crazy to tell you otherwise. Competitors get smarter. Customers get smart. Business is not easy, and it's never a layup. There's constantly folks trying to get in, no question. I would say, though, as it relates to metalworking, $15 billion market, right now, really soft, but all signs are that it keeps growing. We have a leadership position with still plenty of runway, still very fragmented. And I think in terms of a national platform with technical expertise, I think there's still a big gap. I don't take it for granted. I mean, to me, it still means we're investing like crazy in metalworking. If there's a protracted downturn, Ryan, we'll still look to hire metalworking talent, for instance. We're coming out with a couple of new, I think, innovative technologies that are going to help customers. So we have to keep our foot on the accelerator. And I respect some of the folks coming in, and I do think that they're really good competitors, and that's why certainly it gets tougher, but I think the relative gap is still wide. And as long as we don't take that for granted and we keep reinvesting in it, I think we're okay.

That makes sense. Okay. We're out of time. Appreciate it. Thanks so much. We'll talk to everybody soon.

Thank you, Ryan.

Thank you, Ryan. Take care.

Take care.