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

Good afternoon, everyone. Before we get started, if you are a member of the press or media, please disconnect at this time. This is a restricted line. Any unauthorized party in this meeting or any unauthorized use of the information communicated in this meeting is subject to prosecution to the fullest extent of the law. Any unauthorized person, including the media who is on the line at this time, please disconnect. Please note, today's call is being recorded.

Good morning, everyone. This is Mike McGinn, Senior Analyst, Wells Fargo Industrials. 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. Without further ado, delighted to have MSC Industrial, Kristen, CFO; and John Treasurer, IR. The company is a leading distributor of MRO and manufacturing products with roots tracing right back here to New York in the metalworking industry. The company is unique in that they offer an asset-light hub-and-spoke distribution model with a highly trained sales force and call center staff and, of course, an online market presence. Aerospace, machinery, transports and metals and mining are key verticals to name a few. Along with some of their top suppliers, Kennametal, Sandvik and their own private label brands, which are somewhere north of 10%, I believe. So John, this is your second go around at the conference and Kristen, your first, and I'd like to start there.

Kristen, you bring in an extensive background stemming from your time at Ingersoll, and I'd like to catch up on the transition process, what initially attracted you to MSC and what the ramp process was like or how it's going?

Sure. And first of all, thanks for having us, Mike. We appreciate it. It's an interesting time to change companies and COVID. First of all, I hope I'm not doing anything like that ever again, just a unique time to ramp up. But maybe I'll start by what drew me to MSC and then talk a bit more about the transition and the ramp. So I did spend 17 years with Ingersoll Rand prior to jumping over here. And I'll say the first thing is that the distribution industry has always been interesting to me in the 2 divisions that I led finance for over at IR, we were both the manufacturer and had a company-owned distribution arm. So it was always interesting to me, contrasting our company-owned distribution to independent distribution, and the independent distributors always had a slightly different perspective on how they approach the customer. They had the ability to focus solely on the customer and prioritize the customer because they weren't also manufacturing the product. So it was intriguing to me to move into distribution and really see things from the perspective of what I would have then referred to as an independent. The second thing is after spending that much time in one company, I wasn't looking to move for just anything. It had to be the right opportunity, the right company and MSC met the mark really in 2 ways. I mean the first is the transformation that the company is going through, the Mission Critical initiative, made it a really compelling time to come on board. And then what Erik was looking for in a CFO was a good fit with my background, and I really like the people that I met at MSC and the culture and values felt very consistent with what I was used to coming from IR, which is important to me. So those are kind of the 3 angles that I would say, made MSC the choice. In terms of transition and ramp up, I'm about, I guess, almost -- like right, the 9-month mark, I guess. And I've done a pretty ambitious virtual ramp up, a lot of things. And I'm definitely over the steepest part of the learning here, really focusing on driving changes and improvements now. But I do hope to do a real life in-person ramp up starting here soon. I want to go physically out in the distribution center, I want to talk to our customers, spend time with our sellers. I don't do well behind the desk. I much, much prefer to be in the field. I think it helps me to be more effective in my job. So looking forward to being able to do that soon.

Yes. And you mentioned it's switching gears from the distributor -- from the OEM to the distributor, different model, working off of backlog before MSC more quick turn, book and ship from the nuts and bolts like day-to-day finance stuff that we don't see. What was the biggest transition in terms of maybe your forecasting or your management style? And do you have to become more digital focused? Any color there?

Yes. Those are both 2 great things you called out. So yes, the forecasting absolutely different relative to what I'm used to. When you have a backlog, you have a longer cycle component of your business or at least a partial loan or cycle component. Here, it's very much the day-to-day, even hour to hour in terms of what we're booking. So it does change how we think about forecasting. It requires a lot more flexibility, agility. We do a lot more scenario planning as a result. And then just the other thing that's quite different is the sheer amount of data and transactions. So even though I have background with company-owned distribution, the nature of MSC's business, the number of suppliers, we have the number of customers, the number of SKUs, it's incredible amount of data we put off every day. And it's really interesting to see how we use that and what we can do to help with some of the things that are a bit more challenging like the forecasting. And the digital is another great one, very, very important here. And important from a finance perspective to be building digital competency and always figuring out what tools we should be leveraging that help make us more efficient and productive just from a functional perspective.

Right. And so you mentioned Mission Critical in your opening remarks as a reason for joining the company. It's certainly getting a lot of attention here. You've had some early success in the initial stages. But I think the sticking point for maybe some investors on the fence is how is this different than some of the sales force restructurings, hunter roles, share gain, footprint expansion with the new DC and some acquisitions? And then maybe even going further back, the transition from catalogs to more digital. Is this the culmination of a missing piece? Or can you just walk us through the process of what you saw?

Sure, sure. So I would definitely say those initiatives you mentioned are a component of this. They absolutely have influenced how we got to this point and how Mission Critical was shaped. I think what's a bit different is Mission Critical, we're really trying to focus on what is it that would do well, what's core to MSC's business, and how do we leverage those things as growth pillars that add more value to our customer. So yes, definitely has been a journey and that those things have influenced what we're doing today and how we got here. I think the other thing that makes Mission Critical different from previous things we've done at MSC is we're making sure to fund that growth through cost reduction. Like there's equal focus on Mission Critical with growth and equal focus on cost out. And the cost out is really intended to do think to do 2 things. One, it's driving the profit improvements we're committing to. But two, it's funding all the investments for the growth as well.

Got it. So another interesting wrinkle to the story that doesn't get much attention is MillMax, some interesting history here with the Department of Defense and also an interesting service opportunity. Can you discuss the service you're providing, how it feeds into your sales network? And then maybe is it pricing as a stand-alone tool but -- or the share gain opportunity with increased customer touch points and starting the conversation with that MRO spend and the ability to capture that?

Sure. Yes, let me jump in maybe with just a little background on Millmax. So essentially, it's a tool that we developed, partnered with Oakridge Labs. And it's literally like a little hammer that you can tap on a -- it's using 1 million applications. So you literally kind of tap it on the machine. And within 15 minutes, it spits out a ton of data about that operation essentially. So what our metalworking experts will do is we'll go in and say, okay, based on what the data is telling me, I see an opportunity for you to improve your productivity to gain increased capacity on the machine. It really allows us to partner and demonstrate that expertise, but to also do it in a way that's pretty unique relative to what else is out there in the market. And then because we're a distributor, we've got this really broad offering of metalworking tools that we can then say, all right, based on what we understand about your operation, these would be the best tools for you to use based on the analysis that I see. And to your question about kind of how it's priced, we don't price MillMax individually. What we'll do is basically a number of taps for the customer and in exchange for that, we have the customer commit to incremental share of wallet with MSC. And that could be in metalworking or it could be in some MRO product categories. We don't put requirements around that. But it's really a way for us to demonstrate that expertise, deepen the mode, increase share of wallet with the customer.

Okay. So sticking with the customer touchpoint focus. Last quarter, you mentioned the consolidation of some facilities, and there were some concerns with how the team would remain engaged with the customer to retain that intimacy factor. Can you talk to how customer touchpoints are trending as the economy is reopening and what that means for your core customer mix versus the PPPE heavy weighted mix that we saw on the last cycle?

Sure. So this is referring to the virtual customer care move that MSC made, we announced it back in December. And basically, with that, we shut down just over 70 of our physical sales branches. And there's a few things I'll give some background on that will probably help make it easier to understand how we're doing this without impacting the customer. The first thing I'll say is we -- these sales branches that we shut down have never been big inventory stocking locations. So it's not like we had customers coming in there to pick up inventory, we weren't shipping inventory out of those locations. It was really a physical space for the sellers in the market. But ideally, we don't want our sellers in that building we want them out with the customer. So the idea for this had actually started before COVID and had been enabled to buy some technology changes we've made, things like being able to roll costs, for example, pretty basic change, but really relevant to what we ended up doing. And COVID came along, and then we basically got like a 9-month proof point for this idea and making sure we could do this and not impact the experience with the customer because we do pride ourselves on having an interim relationship with the customer, being well connected to them, understanding their priorities. And we were able to prove that doesn't have to change because we're not physically sitting in the office. And in fact, we can supplement that because now we have the ability behind whoever it is they have that local relationship with, we've got this national infrastructure that's behind that local person to support the customer. So in a way, we've been able to take it to the next level. Maybe, Mike, the last thing to add on that is part of the announcement. We also did some restructuring with the sales organization. And there were about 110 roles that I would say were minimally customer-facing that we took out of the organization, and we're using that to fund about 130 roles that will go back in that are more closely connected to the customer, driving sales for the business.

Okay. So time this all together, should investors be thinking that the cost opportunity to fund came out, was somewhat front-end loaded? Or is this a continuous improvement type of situation. Can you walk us through the timing of some of these events and how that feeds into funding your future growth?

Sure. And Mike, are you thinking like broadly mission-critical or the customer care move specifically?

Broadly in terms of the sense of continuous improvement and then with what kind of -- how much of a bucket was the customer care consolidation sites? What was that in that total cost savings bucket for you? How much...

So definitely front-loaded on the cost side, like mission-critical work for cost-out initiatives actually kicked off in '19, late '19, and we were able to take $20 million out in '20, and we're on track to slightly exceed our goal for '21 of $25 million. So the cost worked definitely front-loaded because we did want to make sure that we were driving the growth programs with the cost savings and not burdening the bottom line with that investment. So yes, weighted more towards cost out in the beginning and the growth initiatives, too, take longer to ramp-up, which I'm sure is not surprising. The cost things we can -- the cost projects, you can get our DUCs in our own move pretty quickly on those. Specific to the customer care hubs, the fiscal '21 impact was about $6-ish million and then annualized, we expect about $17 million to $19 million of savings on that.

Okay. Great. Thank you for that color. So I guess switching gears here to more of an economic theme. It always seems like the window is pretty narrow for distribution. We came out of an energy driven industrial recession, got a nice recovery in a rig, and then hit with some tariffs and a recession thereafter. So with greener pastures on the horizon, can you discuss the opportunity to achieve your 20% incremental margin target? And how much is internal broad drivers versus externally macro driven? And then what would it take to get you back to maybe like a 25% to 30% asset level that you saw before the industrial recession in 2014, 2015 time frame?

Sure. So definitely, assuming there's some macroeconomic improvement in there that helps lift us in '22 and '23, but we are also committing to share gain on top of that. The commitment for fiscal '21 is to exit at 200 bps over IP. And then by the end of '23, 400 bps over IP. So really what we're banking on in that model to get us to the incremental 20% margin is mid- to high single-digit growth. And the cost takeout for Mission Critical is going to continue to be in the ballpark of like $25 ish million in the next 2 years. So that's all contemplated in the model that gets us to the greater than 20% incrementals. We will put out a framework for '22 as we get closer to the end of '21. What could add upside on top of that, like to push us more to the 25% to 30% range, I'd say one of the bigger unknown variables is what happens with the gross margin rate. And historically, MSC has seen pressure on margin rate, seeing an erosion of about 30 to 50 bps a year, if you kind of look back over the last like 5-ish years of our history, there's a large component of that, which is mix driven. The reason I always caution mix impact on margin is particularly because of the growth initiatives or the growth levers we put out there with Mission Critical, depending on the rate at which they ramp up and come online. Some of those initiatives are margin headwinds and some are margin tailwinds. So of the five pillars, metalworking is one. And if metalworking was to wildly take off relative to the other ones, that's a margin headwind for us. Government is another example, the margin headwind. So we're a bit cautious here right now because a lot of those initiatives are really ramping up and dependent on the degree to which they accelerate over the Mission Critical time horizon, that would have an impact on margin.

So Kristen, if I can add in. Yes. If the gross margin headwind is something lower than the typical 30 to 50 we've seen over the last 5 years, that would lead to potential upside in the incremental, I would say, yes.

Yes. Understood. I appreciate it. I think investors will appreciate that comment. So going back to the recession in COVID. In the end, I think you had a total of $35 million in inventory write down, but really who's counting, right? And you were able to sell-through some of that product when other companies may have been hurting. What was the total merchandise value of the product relative to the industry inventory issues? And are you fully accrued for? Or do you think that that'll be worked through or appropriately rewarded over time from your -- from some of your larger customers?

Yes, sure. So the inventory write-down you're referring to is the disposal math right down we took in the second quarter, it was about $30 million. But unfortunately, we did have the glove impairment in the first quarter, which was also sizable at $27 million. On the glove impairment, we're optimistic we can recover a portion of that. But as we touched on in earnings, we kind of like need to let the legal process work there. The PPE one is interesting on the disposal maps. So crazy lessons in supply and demand dynamics there and the market pricing on disposal maps just like sell off a cliff, late summer in the fall. And ultimately, what resulted in the write-down is the fact that we were carrying that cost or have procured it at a higher level than it was now worth. So that's like how you think about what got you to the $30 million. More broadly, what I would say is we -- obviously, we don't like that that happened. We've done a lot of deep dive in on kind of what we learned from that and how do we digest that and use it to make us better in the future. But I think one thing that we do pride ourselves on is that we were able to take care of our customers during the pandemic. And there was a lot of inventory shortages at the time. We worked really hard to make sure that our customers could stay face. They could keep their operations up and running. And we do feel very confident that, that effort that will be rewarded through loyalty and through retention over time. I will be okay if I don't ever see anything like that again, in my career, that rapid supply demand shift in the market fall off. I will be definitely okay with that. But we did learn permit. We are using it to make MSC of better company.

Yes. That really feeds into my next question. Long term, are there any verticals that are customer types that stand out, you sold more PPE to them during the pandemic, and that becomes a larger portion of your business going forward on a structural secular basis thinking maybe governments pretty sizable for you?

Yes. Government is absolutely the best example of that, Mike. That's an area where we've been focusing really heavily even before COVID but COVID amplified those efforts, and it's an area where in the 5 Mission Critical growth levers, we've committed to end market diversification with a really heavy focus on keeping and growing the presence in government that we've been able to establish right now. So that is definitely the best example. And as a result, it's one of the things we often talk about when we're articulating Mission Critical growth levers.

Okay. I want to go back back to the business model and some things that are probably going unnoticed, little tweaks you're making, bringing vending services in-house and expanding your footprint in JV -- in Mexico with the JV. Can you talk about the progress of maybe growth and margin benefits of those changes? And any other future opportunities or low-hanging fruit like that?

Sure, sure. So maybe starting with vending. We did bring that in-house. And what we've seen from that is it's really allowed us to be more responsive to the customer. It's given us more control over how we leverage it to add value to the customer and more confidence in offering it to the customer. Implant's actually really similar to that. That's something we've had for a long time, but we're being much more purposeful about making sure that we're offering it to the customer and articulating the benefit that can bring to them. And for us, on the flip side, what we get in return there is retention, stickiness with that customer. So that's why it's important to us in addition to the fact that it's important to our customer. The Mexico JV has worked out really well for us. That business is doing nicely. We've got a great team down there. And the -- I think you mentioned margin and your question. One thing I will say is that so vending implant, Mexico, those things do tend to be margin headwinds. So kind of going back to those comments I made about margin mix impact as we look forward, that's kind of another good example of how we have to balance out the growth and ideally look for upside opportunity on margin mix as these things play out. But definitely a mix of headwinds and tailwinds in terms of initiatives.

Certainly. So those are good examples of what, I guess, I would call, organic growth oriented. But in terms of inorganic acquisitive growth, historically, MSC has been a fairly active acquirer J&L, Barnes, DECO, AIS, but not so much recently. Kristen, from your perspective, what makes a good acquisition candidate? And do you foresee any changes for the playbook in terms of onboarding process, et cetera? Any color there would be great.

Sure. So it's an interesting time to be thinking about M&A. I'd say in terms of what makes a good candidate, we are always looking very carefully at bolt-on acquisition opportunities. We feel those are pretty easy for us to ingest once we find the right fit. And one of the most important things, and Erik would tell you this, too, that we look at when we're talking to companies, is the strength of the leadership of that company and making sure that the values are consistent with MSC. Those are some of the hardest things to change once you acquire a company. So if we have the right fit there already, it makes it much more likely that we'll see the success we want from that deal afterwards. So while we haven't been super acquisitive, I'd say we have a good list of targets that we're always looking at. It's not just in our core area, which, obviously, metalworking fasteners, we're always looking at those kinds of deals. We do keep half step to one step adjacencies on the list, although probably a bit less likely. But it should be interesting to see what happens with M&A through the end of the year, particularly with some of the proposed tax changes on the table.

Certainly. So a question I think is on everyone's mind is pricing and inflation. Can you talk to your recent price actions and whether they are margin neutral? Positive? I know some people think about it as a dollars perspective. How are you looking at it? And any other kind of variances in customer reorder points that you think are indicative of a resupply, a restock? Any comments on that...

Sure. So generally, price/cost spread is favorable for us. And there's obviously a lot of inflation out there in the market right now. We tend to see that as a good thing because it allows us to take price, which we've been able to pretty effectively do over our history. The thing that tends to offset that positivity has been the mix headwinds, and we really have to overcome that before you can get the benefit of margin expansion from the price cost spread. And we talked about some of the things that created that headwind already, like government, networking mix, for example. But generally, I'd say we're pretty enthusiastic about the dynamics around price right now. We even know that's coming on the back of some pretty significant inflation, managing that closely, and we think it's a good thing for MSC overall, and we've got a lot of momentum rolling into the back half of the year here.

Right. Right. Good to hear. More of a longer-term question from my end is additive manufacturing and 3D printing, autos and aerospace have been pretty big markets for you historically. And while you're further down the supply chain, the Tier 1, 2, three suppliers, have you seen any shift in technology for high throughput manufactured products and prototyping type of applications leaking into the supply chain?

Yes, it's an interesting question. So short answer at this point, no, we haven't seen a material impact on the business at this point. Definitely something we're keeping an eye on. I'd say, more near term, what we're focused on is headwinds to our customers in terms of shortage of skilled labor, for example. That's a headwind for them, potentially a tailwind for us because it plays right into our competitive advantage of being able to bring that SEC expertise to the customer. It gives us a chance to help them be more productive. It gives them the opportunity to really rely less on skilled labor that's hard to find right now. So definitely longer term, keeping an eye on some of those innovations, some of that tech that could be disruptive, but not seeing it right now and really trying to capitalize on things that the customers are definitely feeling in the moment that MSC can help with.

Okay. Going back to the gross margin conversation, it seems like the smaller core customer has a little bit more inflection left in this cycle. So when you think about that runway in terms of rebates, the core customer, how much is your business kind of national account annual renewal versus that core that could potentially kind of level set those margins for you?

So meaning in terms of the mix of customers, which one could be potentially headwind or which one would be a tailwind?

As a percent of sales.

As a percent of sales. Yes. I'd say, if you look at kind of the op statistics we published, national accounts has been underperforming core right now. So as things come back online, that would be a margin headwind for us, but we see a lot of runway in general across all of the segments right now. We really haven't hit an inflection point of any significance right now. If you think about MSC's growth and the macro recovery overall. So yes, some of them we're keeping an eye on and not something we're really concerned about. And John, do you want to add anything on that, go right ahead?

Yes. Just in terms of relevance to overall sales, right? So national accounts are about 1/3 of our sales and core customers are somewhere around 40% or so. CCSG is another 15% or so. CCSG, if it grows better, would be a tailwind to gross margins and core would also be a tailwind.

Yes. Thanks, John.

All right. So lastly from me before we end things. I'm just going to simply lob this up to you guys. What do you think investors who are on the fence need to know or maybe misunderstand about the company?

Yes, great question. So we've been on a long transformation journey here. We talked a little bit about it at the beginning some of the initiatives we had in play earlier, where we are now with mission critical. All those things are important to getting us to where we are now. And we really feel very optimistic that we're poised to recover growth, recover profitability. We've got macro dynamics that are in our favor. We're optimistic about price costs, we're optimistic about what's happening with inflation, most importantly, optimistic about how we're serving our customers and the value that we can bring to them even beyond where we are today. So culmination of a lot of things. But if we execute on Mission Critical, we feel like the groundwork is late, and we just need to focus on keeping our head down, delivering our Mission Critical, and the growth will be there.

Okay. I appreciate all the answers, the color and the commentary. I think we're out of time. I'd like to thank everyone on the line and the MSC team.

Thank you.

Thank you, Mike.