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

Well, great. Good morning, everyone, and 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 at williamblair.com. With us today is Erik Gershwind, President and CEO. We also have John Chironna, Vice President, Investor Relations and Treasurer. By way of background, MSC is a leading North American distributor of metalworking and MRO products and services. It offers over 1.5 million SKUs, along with high-touch services that lower supply chain costs. We're going to skip the intro remarks and just dive right into the Q&A.

So Erik, first off, why don't you just give us a state of the union on the U.S. manufacturing economy and if supply chain disruptions are limiting faster expansion in your opinion.

Sure. Good morning. Good to see you, Ryan. Good to be here virtually. So starting with the macro, the -- look, I think the short answer is we're really excited about what we see for the future. And by future, I mean the coming quarters. Next 1 to 2 years, the trajectory seems really positive. Certainly, I think in the near term, we can expect to see some chop based on -- you mentioned really 2 big things going on right now in the near term that -- I heard somebody use the expression that you can't just turn the entire economy, put it to sleep for a year to 15 months, and wake it -- expect it to wake up perfectly chipper and right away that there's going to be a little bit of kinks to iron out, and we're seeing that. And I think along 2 dimensions. One is supply shortages, and two is labor shortages in spades. So yes, I think that could certainly put some chop and constrain things near term. Longer term, though, we are pretty excited about the trajectory for North American heavy industry and manufacturing. And the other thing is some of those things in some ways in our industry, because it's so fragmented, bad is good. And when I say bad, some of the things that are factors that will cause disruption and limit growth or whatever. They'll cause issues for us, but for the less well-capitalized distributors that make up 70% of our market, I think it's going to really inhibit them in terms of access to supply and access to people. So from our standpoint, there's actually further market share capture opportunity they create. So pretty exciting.

Yes. And then as a follow-up, in a post-COVID world, are you thinking differently about your business strategy? And then a related question, any secular changes emerging for U.S. manufacturing, whether it be more onshoring, more automation, 3D printing, anything you're seeing?

So I think, Ryan, for our business, and most of the viewers will probably recall that, look, MSC, over the past several years, has been through an extensive repositioning of the company from a spot buy supplier to a mission-critical partner, wide-scale changes through the business that impacted financial performance certainly while we went through. And we feel like we're coming out the other side, and we felt that way going into COVID, Ryan. So certainly, some of the progress you made in the early months was on hold. But basically, as COVID became the norm, what we realized is that -- and I would say our reaction to COVID has more been using it as a prompt to accelerate our strategy than it is to change the strategy. So the direction for us of moving technical, high-touch, closer to customers on the plant floor has only accelerated. And I think ways in which it's accelerated, an example would be digital. Technology, certainly, while our strategy relies heavily on people, it also relies on technology to improve the effectiveness and the efficiency of those people. Certainly, COVID has accelerated that. So we've used it as a prompt basically to make changes to footprints, changes to the way we work inside the company, rethinking interaction, but I would say all of that is accelerating strategy rather than changing it. So that's sort of inside the company. Outside the company in terms of macro trends, I think a couple that I'd point to, Ryan, one would be -- and we saw this dynamic after the global financial crisis of getting closer -- manufacturers getting their supply chains closer to their end markets, which means, in your words, reshoring. While it's early, and it's always -- it's hard to tell and parse out what's just words versus actions, it does seem like that's one. I certainly think the labor challenge is not going away anytime soon. And I think what that's prompted for many companies, including ourselves, is a heavier focus on automation to relieve some of those challenges. And what I would say is it brings -- there was a building manufacturing skills gap, in particular, a building crisis, if you will, in the country before COVID, that's only going to accelerate. And so for us, again, we think it helps actually accelerate our strategy because what we've tried to position MSC as, as an extension of our manufacturing customers, we're an extension of them. And in many ways, we think we can help relieve them of some of the skills gap constraints. But those are the ones that I think for the broader industry will accelerate.

That's a great run down. The other big question I'm getting, and we're hearing this from some other distributors is that heavy manufacturing is slowing -- is recovering a bit slower than light manufacturing. So the question, Erik, is what percent of your sales roughly, direct and indirect, would be tied to oil and gas, aero, auto, some longer cycle end markets? And then how are you thinking about the recovery timing in those markets?

Yes. I -- Ryan, I would agree with the sentiment. And I think had you asked me -- first of all, I wouldn't have expected a rebound this quickly like anybody, but I probably would have expected some of heavy manufacturing to come back sooner. I think you're right. And the more we've digested it, the more actually excited we are because, in some ways, what it can do is really, for our purposes, prolong our cycle and our recovery period. And we had a lot of stuff going on in the micro inside the company that will -- should fuel the share gains we're looking for. But on top of that, if the cycle extends -- particularly, you think about aerospace, which is probably a '22, '23 event for real recovery, it could extend the run for the company. So I think in many ways, it actually has me encouraged. In terms of percentages, our top 5, and you mentioned 3 of them, oil and gas, automotive, aero, we've got primary metals, metal fabrication, which are machine shop, job shops. Those 5 end markets make up close to 50% of our revenues. We have some others that would fall within what we call durable -- what we consider durable manufacturing, but it's a big chunk of our sales. And so again, I think the benefit would be we could see extended recovery as we look out to '22, '23.

Got it. Okay. Let's shift gears a little bit. Let's talk about Mission Critical. I know you've given some details on what that is, but just talk about why you're confident in being able to achieve the gross cost takeout, which I think is $90 million to $100 million by the end of 2023.

Right. So you've got the target right. And basically, the reasoning behind it, and I'll give you an answer to why I'm confident, but it was really twofold. One was we've really -- as I said, we pivoted the company to play a different role for our customers. And what that meant was that inside the business, a lot of the -- whether it's footprint or operating model and business processes were geared towards one type of business. It needed to flex to another kind of business, being closer to the customer. Our supply chain moving from the 4 walls of our DC onto our customers' plant floor. So we felt we needed to reengineer the business, everything from our footprint to our business process, et cetera. And that's been one impetus. And then the other was realizing that, look, we have aggressive share gain targets, and we want to reaccelerate to sort of back to the legacy of this business as a growth business, which we were away from for a few years during the changes. And so we wanted to be able to fund that growth out of our pockets, not the shareholders' pockets, if you will, meaning structural cost takeout. So those were the 2 reasons. I am confident in the $90 million to $100 million. I guess I'll give you a couple of reasons why. One is I'm seeing a track record now. So there is momentum building. If you think that $90 million to $100 million was set off of our fiscal 2019 operating expense base because that was when we kicked into gear right before COVID. And if I look and strip out the temporary cost savings from COVID and just say what was structural changes, we achieved about $20 million of structural change, cost takeout in fiscal '20. We targeted another $25 million in fiscal '21, which would leave us $45 million to $55 million for '22 and '23. And right now -- so we hit our number in '20. We're on pace to exceed the $25 million in '21. So I'm seeing the track record, number one. Number two is the pipeline of projects beyond what's currently in flight, and some of these are longer-term sort of things that take time, as you can -- the recent changes we made with the sales model were a big one. Some other things in the works, it will take time, but I can see a pipeline. And then the third thing that gives me confidence, Ryan, is I would say culturally, and this has been part of the Mission Critical initiative, if you will, the company is getting better at implementing and adapting to change and doing it faster. And the case in point to me was the sales changes we made this go around with the move to the virtual customer care hubs. If I compare that to the early changes we made to the sales model where, quite frankly, we took too long, I think. We moved through this much faster. And I think as a result, it's been digested better, and it's like we move past it. So I'm seeing the pace of change pick up, which also gives me confidence.

Yes. That's great. So shift gears here to talk about inflation, and we were talking about this a little bit before we got on the call here. We may be entering a period of sustained inflation, which we haven't seen for a long time. And to put some numbers of that, I think MSC will have raised prices 3x in the past 12 months here in August. So the question is, could this be material to gross margins? How does it help? Or is it more of a gentle tailwind, Erik, if we get sort of sustained price inflation? How do we think about it?

Yes. Good question, Ryan. So look, I think it is one of the fundamental big issues and big opportunities for us because you're right, we were saying the last time there had been sustained inflation was really in the 2000s, leading up to the financial crisis of '08, '09. And we've had little fits and starts, but it hasn't been sustained since. If you think about our gross margin equation, there's basically 3 levers: price, cost, mix. And we've been pretty transparent about the fact that if you look at mix alone, basically, the legacy of the business of selling spot buys is very high gross margin. And most of the adjacency moves that we've made since, most of the other growth vectors, not all, but most are lower gross margin, not higher gross margin. So we have CCSG that's higher gross margin, e-commerce, private brand, there's a few, but then you have our metalworking production volume, our vending business, our national accounts, our government. So most of our growth drivers are lower margin. That headwind, if you will, from mix is going to be somewhere in the 30 to 50 basis point range on a year-over-year basis. So if you look -- take the other 2 levers of price and cost, in the past number of years, those have, not on a year-by-year basis necessarily, but over time, more or less been a wash. And so what you're left with is if you look over our last few years, somewhere in the 30 to 50 basis point kind of average of gross margin erosion. And by the way, interesting, when we talk to other businesses and see other companies in our space, we actually think we fared reasonably well on that dimension, but that's been what it is. I think the opportunity would be if price cost -- if the inflation cycle sustains, the way -- I think important to understand, the way the distributor -- at least for us, the economics work is when there's a price increase that's generally prompted by an inflationary factor in the environment, commodities, scarce resources, the things we're talking about, which will lead our suppliers to raise their list prices across the industry, which will then lead distributors to pass along price. When that happens, MSC generally will take price right away and capture a timing benefit because with costs -- first of all, we'll try to negotiate and delay the cost increase. But even if we didn't, we're on an average costing system. So it bleeds in gradually. And early stages of an inflation cycle, there tends to be a price cost tailwind. So that's the dynamic. And the challenge is in a late-stage inflation cycle, we sort of -- we don't get the price and we're still left with the cost in our P&L, and it becomes a headwind, what hasn't happened, and this was your point, is sustained inflation where we continue taking pricing and stay ahead of it. If that happens, depending upon how successful we are, we think price cost can turn positive and then eat into the 30 to 50 basis point annual headwind. How much it eats in will be a function, I think -- how intensely competitive are the dynamics? So how much price can we get? And then two, how effective have we been at price realization and execution? And if I look back and compare us to the old days of the 2000s, I would say on the one hand, competitive intensity, transparency, et cetera, is greater than it was back then, makes it more difficult. On the other hand, I think our capabilities and our execution are significantly improved from back then in terms of using science, using analytics, having a group of quantitative pricing folks and I think having some more rigor and muscle in the sales force to be able to implement price. So how those shake out is to be seen, but I think the opportunity is price cost turns positive and eats into mix.

Yes. Yes, that's a great rundown. And yes, you do have to execute both on passing along the price to customers, but also you have to negotiate with suppliers. So certainly, it's hard to be precise, but certainly, it could be a tailwind, and we'll just have to see how it plays out. So let's transition to talk about sales force, which really -- that's the heart of a distributor model, a heart of MSC. You've had a big transition there. You've said that you're happy with results. Are there any metrics that you can provide? Or are you winning more customer accounts that we can't see? Just talk about how that's going and why you're confident that the new strategy is the right strategy.

Yes, Ryan. So the way we think about it -- and you're right, we've been through a lot of changes, and there'll always be tweaks and refinements. But what I would tell you is, for the most part, we're through the heavy lifting, the disruptive changes within the sales force. The way we think about it is in terms of an output measure and input measures. So an output measure is the result, and that's what we've gone on the huck for publicly that I would expect our shareholders and our analysts like you to hold us accountable to, which is market share capture. And there's lots of metrics we can use. We've looked at lots over time. We have -- we pinned it on IP because we thought we did a lot of regression analysis. It was fairly correlated, and it's also an output measure. It's clear, and it's a good proxy for our end markets. And so the output measure is how wide is our gap above IP. And when we set the goal, look, we were coming from a place, quite frankly, where we were at or below IP and have said we want to get to, by fiscal '23, at least 400 basis points above IP, which would -- the 400 basis points kind of would approximate historical averages for us putting the last few years of disruption to aside. Hopefully, we do better. That's certainly internally, you can imagine, if we set a -- we rally to do better, but 400 basis points. And then what we said is from where we are today to get to that goal, it's not going to happen overnight, but let's put some markers in place for the public to measure us against. And the first marker we said is, all right, we want to exit our fiscal '21. So our fourth quarter will be -- we're in it now, June, July, August. We want to exit at, at least 200 basis points above our growth rate, at least 200 basis points above IP. We chose Q4 for a couple of reasons. One is it gave us a little bit of time to improve execution, get some investments in place. And the second reason was we realized our fiscal third quarter that we'll report on in a few weeks had a lot of noise in it because of the PPE surge last year. So it sort of distorted things. But we thought Q4 would be clean, and it would give us time. So that was -- those are on the output side. On the input side, basically, what we do, Ryan, and we have a lot of metrics we look at internally, but we have outlined publicly 5 growth levers, if you will. And those 5, to remind the audience, are metalworking solutions. And by solutions, we mean inventory management, so vending and VMI, and our implant program, which is actually putting our MSC team directly inside of customers. Three is selling our portfolio, and that basically means 2 things. It means cross-selling CCSG, the consumables through our vendor-managed inventory program, and it means improved sales of our strategic suppliers. So we have a handful of suppliers we've earmarked as who've invested heavily in the company are really important, and we want to see outsized growth with those. Four is digital. And for now, that's primarily e-commerce. And five would be diversified end markets. And for now, we've earmarked government is the place to start. Those are the 5. And for each of the 5 -- so one of the things we've put in place over the past few years is a CRM that's fed by a lot of analytics. And Eddie and our sales leadership team are driving much stronger compliance with using the CRM. And so we have funnel, conversion rate and win rate -- annualized win rate data for each of those 5, and those are the input measures we're looking at on a monthly basis to see how we're doing. What I would tell you is, Ryan, there, I'm generally -- I'm encouraged. I wouldn't say it's too early to say pleased because we've got aggressive growth targets. I'm encouraged. Most are moving in the right direction. I would say things like solutions, in particular, so vending, VMI and implant were slow to get going because of COVID and access to plants. Those are -- in the past 90 days, have really ramped up. So we're seeing improvement there. Metalworking has been quite strong, and generally, progress along each of the 5.

Great. Perfect. Why don't we move to MillMax? And look, Erik, I know it's early, but for me and others I speak with, MillMax feels like it could really be a disruptive service. So what have you seen so far? And how long do you think it will be before you can provide us with revenues tying to MillMax?

Yes. So what I would say is I think the answer is, yes, I think it does have -- it is early. It does have the potential to be really disruptive. The results with customers have been really good. So when we take the technology -- and it's interesting because the technology -- this concept of a tool that you literally just tap a machine and you read the vibrations back and get -- that's been around for a couple of decades. It's been how it's been refined between us and Oak Ridge National Labs, and the data we're bringing to it and some of the science and history we have that is improving the technology. It's -- like when we take our best metalworking folks who think that they could go in and do this on their own and then we arm them with MillMax, we are seeing game-changing productivity for customers. So we have a lot of early success stories. I would tell you it is still early. Like with a technology like this, we got to get it fully adopted in our sales force. Even our metalworking specialists have to fully adopt it. And then with our customers, where it's put in place, it's working. And for now, what I would say is the best metric -- we're using this -- the way we're measuring progress is twofold. One is how many MillMax installations and how many wins, which is still lighter than I'd like to see it. It's still early. But the second thing is what's happening with metalworking market share capture, and that number is really encouraging. And I think you're not yet seeing that. And so what we do is we measure literally by MSA, by account, new wins, where it's been a new customer and it would generally come -- typically, those customers come from a local distributor that had served the business for a while, and MillMax to us is a tool to help pry those relationships away by bringing productivity there, if I benchmark like the annualized win rate. And we're not yet seeing that in the numbers because we're first sort of getting volumes back with these customers -- and I size it in proportion to the total company size well ahead of any other downturn that we had in terms of the success of metalworking. So I think a little early to break out MillMax, but yes, I do think it has the potential to be disruptive. And then the other thing I would say is we are -- we have sort of an innovation engine team inside the company working on what's beyond -- life beyond MillMax. So how do we improve it and then how do we bring more value-add to the table for our customers.

Yes. That was actually -- my second question is, is MillMax a one-and-done test or service? Or will customers want to test and retest?

Yes. The answer is, for the most part, Ryan, they're going to want to test and retest. And the reason is, for most of our customers, their operations are not static. They're constantly changing. And if you take a job shop, for instance, they're getting new work all the time. Every time there's a new part being created or a new material being cut, it's a new application. And so if it were static, and it was the same job every week, every month, maybe, maybe not, but that's not been the case. So we do see repeat usage. The other thing I'd say is even just beyond MillMax, and I mentioned innovations to come, but a lot of what we're seeing opportunity with is we have sort of 3 unique assets in metalworking that I think make up our moat and that can facilitate continued innovation. So one is our technical people in the field. Two is the product portfolio, and the fact that we carry kind of the full complement of brands really matters because now when we come with a customer, and we -- we can be really objective in helping them find productivity. And then the third element is data. And by data, what I mean is we have the benefit of -- over a decade, of capturing all the -- or we have hundreds of metalworking specialists who've been in the field running tests, and we've been logging those results. And so we have data. And for the first time now with AI and some of our partnerships, like we're able to actually do something with the data and make intelligent recommendations for the customer. So I think those 3 things together will kind of keep fueling it.

It's really exciting. Looking forward to hearing more about it as time goes on. So I want to step back to a high-level question that me and others have been asking for a while now. And bear with me, it's a little long. But the heart of the question is, is digitization good for industrial distributors? Or is it more of a neutral? And the reason I ask is back to what you said earlier about the business model shift, you've moved away from the high-margin spot buy business because I think it's been impacted by price transparency. But at the same time, the shift to e-commerce is helping you because you're offering it in a way that your competitors cannot given your scale. So how do we think about digitization impact on your business?

I actually think you -- in that question, you gave a great assessment. I -- the first thing I'd say, Ryan, is I think digitization is generally good for the economy and good for industrial customers. I'll start there. Because I think like what we're seeing inside of our business, real changes, real advantages that otherwise we never could have gotten. For distributors, I think there are headwinds and -- I think you're right. I think, look, no question that the business has gotten -- the competitive intensity has grown. And part of that is transparency that just didn't exist 2 decades ago. That's real. At the same time, I think distributors, the well-capitalized ones that are taking advantage of technology can become better-run companies. And so whether that's how we're pricing, how we're bringing technical recommendations like MillMax, certainly, the wedge created for the local distributor because of e-commerce investments, like you mentioned, is only going to grow. So I think it's a little bit of a case of the haves and the have-nots. I think -- unfortunately, I think we're in the haves. But if you take -- not just us, but if you take the well-capitalized distributors with the talent and the investment capabilities to take advantage, I think it's a net positive. I think for distributors that can't fully take advantage, it's probably a net negative.

Yes. Yes. I think you answered it the way I was thinking about it. It almost feels like there's a bit of a transition period here where it initially sort of hurt, but now you're using that and the digital actually make yourself stronger. And I think we see that over the next 10 years. So that leads me to my next question, and you hit on it a little bit, but I remember coming out of the financial crisis, MSC took a ton of market share. Do you think you're going to do that again coming out of this crisis?

I -- look, I sure hope so. I would tell you that we've geared the company around it. We're investing into it. Our sales force is laser-focused right now. So being through the changes on share capture. As I said, I like what I'm seeing in terms of the input metrics, and I think the opportunity is there in spades. When I speak to some of our folks on the ground, our sales managers who've been with us for a while, some of our top performers who were there in '08, '09, what I'm hearing is that the share capture opportunity is actually greater than it was back then. And the other thing I would say is that when I look back to '08, '09, the -- as great as the opportunity was in the depths of the recession, it actually grows during a rebound because what happens -- and look, you could see it from our numbers in the last quarter, cash flow, working capital becomes a real constraint. And we're in a fortunate position of having plenty of free cash, but adding inventory, receivables extend, and so particularly when there's a snapback, smaller distributors that are capital constrained really start to fall down. So I actually think as this -- as time goes on here, we're going to see more. But short answer is, yes, I do. I do see at least as good an opportunity to capture share.

Okay. Good. Question from the audience here, just given the labor shortages and your goal to hire more outside salespeople, how is that going? Are you able to hire as much as you want?

We have been able to hire. We have not been able to hire as much as we want. There's no question -- and by the way, that extends beyond even our outside sales force. I mean you just -- right now, you go to hourly associates in our warehouses where we never had trouble, we're having trouble. So we've got a lot of people working a lot of overtime. We're doing a lot of creative things just to receive in product, as simple as that. That certainly does extend. And I think, yes, you'll see the trajectory of our additions will probably be slower than what we initially -- it's real. I mean it's definitely real.

I expect you'd say that because we're hearing that from everybody.

Yes.

So in the last 2 minutes here, Erik, and kind of a tough question, but I want to ask it because I want to get a sense of why things didn't go as well in the last couple of years because then we can sort of identify what we need to watch to understand that MSC sort of fixed things, and it's coming out the other side stronger. So financial performance, your stock valuation isn't where you want it. What was the key 1 or 2 issues? Was it really the sales force? Or were there other investments that you made that you didn't see the returns that you expected?

So I think yes and yes. I would say sort of the headline, Ryan, is going through an extensive repositioning of the company, almost a reinvention of what we stand for, particularly doing it in the public eye is hard. There was a lot of change. And I think a lot of what we went through was the disruption and the distraction of an extensive change. I felt we needed to do it. I really did to secure kind of the next decade, deepen the moat for the company, but it was a lot of change. I think, in particular, you mentioned -- you went right to it, the heartbeat of a distributor is the sales force, and the changes were wide sweeping -- widespread across the company. But when you change the sales force -- and again, we had to, to sell the new more technical mission-critical value proposition, you are tinkering with the heartbeat. And I think that it probably took longer than I would have liked. And part of the learning was moved through change faster, and it was disruptive. So -- and I think what happened was that's sort of fundamentally why the growth slowed. And I think what happened was that had a compounding effect on -- there were a few, if you look back in time, fixed cost investments that we made -- whether it was the acquisition of Barnes, which is now CCSG; investments into infrastructure like Columbus that did not get leverage. The investments we made did not generate the returns that we wanted, and I think sort of root cause back was disruptive change that led to growth slowdown. Look, I think a couple of things. We're through -- because you can imagine, we've done inside the company a lot of sole searching. I think we are through most of the disruptive changes. At the same time, we've also had the mantra that change will never stop completely, and I think the other thing is making the company stronger, more adept at dealing with change. That's come from practice. It's come from organizational changes. It's come from leadership changes. But I think that's the other thing we realized is moving through change faster and being more adept at it.

Great. Well, we're out of time. Thanks for the conversation, Erik. Really exciting, I think, for the next couple of years for you in MSC. And thanks, everyone, for joining today. We appreciate it. We'll talk to you soon.

Thanks for hosting us.

Thanks, Ryan.