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

Hello, and thank you, everybody, for joining us. We're very happy to have MSC Industrial with us. We have CFO, Kristen Actis-Grande with us; and Head of IR, John Chironna with us. And so with that, the format is fireside Q&A. [Operator Instructions] Mario Cortellacci on my team will take those through the program.

So I'll kick it off with sort of the first question. Question would be sort of around MSC has talked about outgrowing their end markets, has talked about 400 bps of outperformance by fiscal 2023, high teens ROIC. Maybe update us on the progress there and the path to sort of getting to some of those metrics and sort of the big levers at your disposal to achieve those.

Sure. Yes. Thanks for the question, Hamzah. Thanks for having us, too. We appreciate the time. Yes, so as you mentioned, publicly stated goals, which are part of our mission-critical program. Sort of an incremental progress goal we've put out there is for the end of the fiscal 2021 year. We plan to exit our fiscal Q4 at 200 basis points over IP on the way to that 400 bps by the end of fiscal 2023. We're expecting Q4, which aligns to our fiscal Q4 IP to be around 7%. So we we're expecting to be slightly better than that 200 bps we've guided for fiscal Q4 exit. As you mentioned broadly, we've got 5 goals that we've communicated as part of Mission Critical on the growth side or 5 growth levers. Those are digital solutions, what we call selling the portfolio, metalworking and end market diversification, where we've put a big focus on government there initially. We also have a big operating expense reduction component of the Mission Critical program. And what we've communicated there is that we want to take out $90 million to $100 million of costs by the end of fiscal '23. Those are the 2 biggest levers that contribute to that ROIC improvement that we're targeting. We haven't specifically communicated anything around working capital, but I will throw out there that we think there are improvement opportunities, and we're going to start putting some focus on those in fiscal '22, and that would be kind of another lever to help with the ROIC improvement.

Got it. And as you think about inflation, historically, inflation has been good for distribution because of ability for passing on pricing. But again, obviously, there are some other dynamics in the marketplace around supply chain, et cetera, today as well. Maybe just talk about inflation today, how it's impacting your business, how you think about price cost? And if you want to talk about some of the supply chain issues as well, maybe that would be helpful, too.

Sure, sure. So certainly an interesting time, both from an inflation perspective and a supply chain perspective. I guess I'll comment quickly on the supply chain side, and then I'll pivot over to inflation and price cost. On the supply chain side, certainly been challenging time to get inventory in. We're experiencing a lot of the same issues that a lot of other companies are dealing with in terms of delays in receiving product, delays in the ports. Largely, while we're not immune from those challenges, we do see it as an opportunity for us relative to a lot of the local distributors. Our size and our buying power makes it a bit easier for us to get a hold of the inventory that we need. But obviously, a lot of active management happening there from our team. And then on the inflation side, there's certainly a lot of interdependency between the 2, supply chain and the inflation situation right now. It's really the most robust inflation cycle we've probably seen in over a decade. And like you said, we would consider inflation to largely be a good thing for us in the distribution business. If you think about the -- like the price/cost mix equation for MSC, one of the things that we talk a lot about is the mix headwind that the business has experienced for the last several years. So if you think about price/cost mix for MSC, there's usually about a 30 to 50 bp mix headwind that we have to overcome. And right now, that price/cost equation is helping us with that. So typically, in the beginning of an inflationary cycle like what we've seen in the last 6-ish, 9-ish months, we would expect to be flat to slightly favorable on price/cost. And then as that inflation cycle kind of comes to an end, that's when you would see us slip a little bit back the other way. And the cost tends to outpace the price and it has to do with how we do average costing inside of our business. But largely a good thing. We do expect to overcome those mix headwinds. And what we've said on the margin side is we anticipate being flat in our fiscal '21 versus '20, and we want to repeat that again in fiscal '22.

Great. And then as you guys think about headcount additions going forward, what are your plans there? And maybe just remind us how the sales force is structured today and how you are thinking about sales force execution. And as you know, the reason we ask is there's been quite a bit of change historically, I guess, in the business around sales force. So any thoughts there would be great as well.

Sure. Yes. So sales additions, they're not -- we don't really specifically call that out as 1 of those 5 growth levers that I mentioned before, but that's absolutely a dynamic and a contributor to our planned growth. So 2 things that I would elaborate on there, Hamzah. The first is that some of the biggest changes we're making with the sales rules have been implemented kind of even pre pandemic, pre Mission Critical, and that's going from like a one-size-fits-all role to more differentiated hunters, farmers and complex account managers. And that's been good for us because it really lets each sale associate really focus on what it is that they do best. Now the challenging side is that pandemic has made it harder to fill those roles. It's slowing the hiring process down relative to what we would have preferred, but those roles are coming online. The second thing I would mention on headcount, we did a restructuring with our sales organization earlier this year that was part of the Mission Critical program. And so the second thing I would add there is we eliminated 110 noncustomer-facing roles, and we're planning to add back 135 customer-facing positions. So you've got kind of the dynamic of shifting how the sales roles are structured, what people focus on and then making that pivot away from the noncustomer-facing roles into putting more heads on the customer-facing side. And then I believe you asked about sales incentives as the last part of your question. So it does vary a little bit by role, but the hunter roles that I mentioned, you can think about them as having a higher percentage of variable comp because we really want them focused on bringing in new business, new customers. Farmers are a little bit less variable, but obviously, still have a large variable component of their overall compensation, and we do put a governor on gross margins for the variable incentive programs.

Got it. And then any color as to what your view is today? What you're seeing in the industrial cycle? Maybe any color you can provide on end markets, what's coming in better than expected? What's a little weaker? Any thoughts, that would be great as well.

Sure, sure. So for MSC, about half of our sales come from the sub indices of IP index, which are heavy machinery -- or excuse me, heavy manufacturing, I think, metalworking, fabricated metals, aero, auto, I think I'm missing, what, primary metals. So all 5 of those subcategories, if you look back at our fiscal Q3, we saw all of those kind of flip and start to grow above the overall IP index. And you saw the same dynamic happen in our MSC sales if you look at the non-janitorial and safety product. And then if you look longer term, what's happening with those end markets kind of through the pandemic, where we expect them to go looking forward, we think there's a lot of runway there. The one caution I would give, I kind of alluded to it in your opening question, Hamzah, is we did see June IP soften and came in lower than we were expecting. So I think given everything that's happening with the Delta variant, I think there's just some skittishness out there still, and we're keeping a careful eye to see how that affects our growth, how it affects the end markets.

Got it. And then just switching gears sort of to technology. I know you have a big sort of online presence and you use technology in vending as well, and maybe there's data analytics you're doing around pricing. Just maybe talk about, from a technology perspective, where is MSC, what's behind you, what's yet to come?

Sure. Yes. So digital is one of our big 5 growth levers of -- unsurprisingly, a very large technical or technology-oriented component of that. We've been investing really heavily into a lot of different types of technology in the business, really a big kind of overhaul of our technology stack. And it's sort of all aimed at focusing and improving the customer's digital experience with MSC. We've made investments into AI-based search, new user interfaces, kind of modernizing our commerce engine. And what we're trying to do there, first of all, go cloud-based, but then also allow for more modular improvements. And that really helps us to go faster and be a little bit more deliberate about what we're rolling out as well. We've made big investments into product information, so enhancing the technical content, providing a richer experience for the customer, making it easier for the customer to find things, so improved search capability. And what we're looking at there in terms of results, if you look at the e-commerce percent of revenues for MSC, we're looking to grow that, particularly the portion that comes from mscdirect.com. And then another one that you threw out there, I'll just make a couple of other references where we've made investments, are investing into advanced analytics initiatives and then also into improving pricing capability technology that improves pricing or a couple of other focus areas where the investment has been going.

Great. [Operator Instructions] I'm going to turn it to Mario to run through some of the questions. And then Mario, you can turn it back to me when you run out or in closing.

Got it. There are a few from the audience. First one being [ create your head write-downs ]. I guess recently, do you foresee any other write-downs within your business?

No. No, we don't, unless there are any really unexpected or anomalous kind of market pricing changes with PPE. But we did take a big write-down in the second quarter on our PPE items, particularly disposal masks was the largest majority of that. And we feel that those are down to an appropriate level now. We do still have PPE inventory, of course, a lot of demand still from our customers, but no significant risk that we see in terms of the carrying value on that inventory.

Got it. The next question is, you mentioned complexity as a supply chain like many others out there, port delays, et cetera. Are these issues proving to be a governor on your ability to grow? And do they create incremental temporary or surprise costs that are hard to price ahead of? Are you able to pass those through in real time to your customers?

Yes. So I -- we haven't seen this really inhibiting growth. We had to be a lot more deliberate and purposeful about making sure we have inventory in on time, looking at how we get the inventory there, particularly in our A items and B items. In terms of passing on increased costs related to those constraints, we feel like, generally, we've been able to handle that with the price increases that we've taken. Probably the most challenging one has really just been on the increased costs of the freight containers or just container costs. That required us to change a few of our internal processes, but nothing major. Just trying to adapt and make sure we're picking up the most real-time information and making sure that we're thinking through all forms of increased costs when we take our price increases.

Understood. And then next one is on vending. Could you talk about your current vending initiative? And what are the opportunities there? And how does your offering differ from your competitors?

Sure, sure. So vending, I kind of -- I'll go ahead and take a liberty of broadening that to really all of our solutions portfolio, which we would consider to be vending, VMI and then our implant solutions. And that -- those 3 together about roughly 40% of our revenues. And I guess, for the sake of clarity, when we talk about vending revenues, what we're talking about is product that's actually sold through the vending machines, not necessarily all revenue that goes through a vending customer. So we are always looking at how we can add more value to the customer through our solutions offering. In general, we try to offer solutions to our customers because we think it's better for them and it's better for us. It allows us to deliver a better experience for the customer, increases their efficiency and their productivity. You can think about theft elimination, gives them useful data to help them run their business. And I guess one other thing I'll add since we're kind of talking about solutions broadly that we don't charge for those. We don't charge for vending machines, we don't charge for implant resources. What we're basically looking for is kind of an incremental commitment from the customer. But generally, in terms of like where we're going with vending, there's a few enhancements that we are planning to roll out that we'll probably talk about more on future earnings release calls. In terms of -- I think there was a part of the question, Mario, that was relative to competition, I think you mentioned. What I'll probably add there is just sort of some basic differences in the vending machines that we offer versus some of our customers. And then when you think about VMI technology, MSC tends to focus VMI more on kind of our strengths, which are the metalworking offering. So some of our VMI tech is more geared towards things that are related to supplying metalworking customers with the items that they most frequently need, which is something that makes us a little bit different in the solution space relative to our competition.

Kristen, I'll just add in on vending. Yes, just on vending. When the goods, the products are in the vending machines, they're not on consignment. I know some of our competitors, it's consignment goods. But when we ship it and it gets to the customer's location, they already own it. So just FYI.

Yes. Thanks. That's a good point, John. Yes.

Understood. And then just the last question from the queue and I'll turn it back up to Hamzah to kind of wrap it up or ask additional questions. Walk us through how many of your DCs are fully automated today, and whether that's an opportunity going forward. And maybe you can give us a sense for how -- what the ceiling is there? Is it fully -- is it at 100%, and whether your DC footprint is optimized today?

Sure. Yes. So starting with the automation question. All of our distribution centers have automation, some more than others, but they all do have some pretty sophisticated automation that we're leveraging in those operations. The -- in terms of whether or not we're looking to invest more, I'd say, absolutely. Particularly with the challenges in the labor market right now, it makes it even more compelling to be looking at how we can do more automation or even advancing or upgrading existing automation. There's a lot of technology evolution happening in that space. And I think MSC, one of the things we pride ourselves on is really being quick to adopt and leverage that tech inside of our distribution centers. So yes, we're always looking at that. And then, Mario, I think there's a part of your -- oh, footprint optimization on DCs, was that the last part?

That's correct.

Yes. So that's definitely something we're taking a look at. You saw us do a big move on footprint earlier in 2 spaces with our headquarters locations. So we're selling our Melville, New York, headquarters and downsizing that space. And then we made a big change with our branch footprint earlier this year. So I would say, yes, always looking and evaluating, nothing specific in mind at this point as far as changes go.

Good. That's all we have from the queue. I'll turn it back over to Hamzah.

Thanks, Mario. I think if we could also just touch on capital allocation and how you guys are thinking about return of cash. You flagged organic growth investments. Maybe also just touch on M&A as you think about capital allocation going forward.

Yes. Yes, happy to. So no -- largely no real change in our capital allocation philosophy. I mean I think where you've seen us go first, if you look historically at MSC's free cash flow utilization, organic growth, ordinary dividends. And then after that, we're really always looking at what's the best and highest use of a dollar, what gets you the highest risk-adjusted return. What you've seen us do even just in the last year some M&A, special dividends and some share buybacks. So we're always looking at a variety of uses of that cash. The -- on the M&A side, we have a pretty robust pipeline of potential M&A that we maintain. I think where you're most likely to see us go on M&A, Hamzah, is like local distributors that offer maybe a certain geographic strength or have a certain expertise in a particular area. I'll point out the Hertz deal that we completed recently is a really good example of that. So relatively small in the grand scheme of things, but adds some great technical expertise for us in the aero end market. And also from a geographic perspective, a good complement to MSC's existing business.

Got you. I guess the other question would just be around freight. Could you just talk about how your freight works? I guess most of your business is parcel, but maybe use LTL and ocean to just to get a sense of how investors should think about that as well.

Sure. Sure. So the majority of our freight dollars are with small parcel, and we are locked into a contract there that goes through -- that -- like it's renegotiated in '23. So we're relatively protected in terms of the increase that we'll see in '22 on that portion of our freight spend. And then we do obviously leverage LTL also, which is the minority of our freight dollars and freight lines that we ship. We'll see some more inflation pressure there in '22, but the good news for us is that's definitely less of our spend. So we're feeling pretty good about freight exposure given how crazy things are in the market right now.

Got it. And just going back to something you said sort of in the beginning around working capital. Maybe just walk us through where the opportunity there is. Is it more on the AR side, the AP side or inventory or all of the above? And how you think about where your free cash flow conversion sits today, and ideally where you think it could go long term?

Sure. So on the working capital side, I would say, AR is where we see the biggest opportunity. I think there are definitely opportunities within AP and within inventory. I mean anything on inventory, you'd see us be very cautious and very deliberate. I mean we -- that's our biggest asset. It's our biggest way to protect our customers, service our customers, so you won't see anything drastic around inventory. But a lot of opportunity in AR, a lot of opportunity in AP. On the free cash flow conversion side, expecting to end our fiscal '21 around 80% conversion. We haven't done the full planning yet for '22, but would probably expect to see that increase. We can provide some more guidance on that. When we go out with our framework for next year, we'll guide more on free cash flow as well.

Got you. I think we only have a minute or so remaining. So is there anything in closing, Kristen or John, that we didn't ask that you think is important to touch on or that you wanted to mention in closing on the MSC story?

No. I don't think so, Hamzah. I think just in general, we're really excited with the Mission Critical progress. We think there's largely a good macro backdrop here for us. Obviously, not without challenges, but we see a long runway on recovery still, and we feel like we're in really good shape to capitalize on that. So a lot of runway left in Mission Critical, but we're pleased with our progress so far and really happy with the work that the teams are doing.

Hamzah, I would just add that, I think fiscal '21 was probably the heaviest lifting year, if you will, in terms of Mission Critical taking cost out, also reinvestment. And I would just remind the audience that next year in fiscal '22 and fiscal '23, we're targeting to get back to 20%-plus incrementals, which obviously implies operating margin expansion.

Yes. Great point, John. Yes.

Got it. That's extremely helpful. Thank you both for joining us. Any follow-ups, please reach out to the MSC team or the Jefferies team. Happy to help, and good luck with the rest of the week. Thank you so much.

Thank you. Thanks, Hamzah and Mario.

Thank you, Hamzah.

Thank you. Take care.