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

Okay. Good morning, everyone. My name is Dave Manthey. I'm the senior industrial distribution research analyst for Baird. We have with us today management from MSC Industrial. MSC is a leading distributor of industrial products, including cutting tools, abrasives, measuring instruments, machine tool accessories, safety equipment fasteners and welding supplies that are used mainly for customers, MRO or maintenance, repair and operations requirements. The company sells approximately 1.7 million SKUs through a variety of online and traditional channels through 5 regional distribution centers and a number of customer fulfillment and customer care centers as well. The company serves approximately 440 -- I'm sorry, 400,000 customers throughout North America. So with us today to talk with us about MSC Industrial, we have President and CEO, Erik Gershwind; and John Chironna, who is the Vice President of IR and Treasurer. As many of you know, Erik joined the company in 1996 and held a variety of roles throughout the company, most recently VP and COO, until he was appointed President and CEO in 2013. And John has been with MSC in his role in the past 9 years with extensive prior experience, most notably at ABB. So with that, welcome guys. We'll -- to start out here, I will turn it over to management for an overview of the business. Erik is going to give us a brief introduction to level set everybody. And then I'll come back to moderate Q&A. If you in the audience have questions, you'll hear this a lot throughout the conference, please e-mail me directly, and I'll address those questions. My e-mail dmanthey@rwbaird com. So with that, Erik, take it away.

Thank you, Dave. Good morning. Nice to be with you virtually as we were saying, hopefully, next year in person. So I'll be brief, but I thought hitting the high points of the story and begin by saying, certainly, for those who have followed us, you know that we have been repositioning MSC over the past several years from what was a spot buyer as is often referred to a long tail supplier to a spot buy supplier, but more than that. Really moving towards becoming a mission critical partner as we refer to it on the plant floors of industrial America. Heavy focus on manufacturing, particularly durable manufacturing where we can leverage some of our core strengths, product strengths of metalworking. During the course of this repositioning, we've undergone really extensive change in a number of areas. We rethought our value proposition, reengineered our supply chain to move from being purely spot by to having a presence directly on our customers' plant floor, reshaped our sales force and updated our technology infrastructure to enable us to do this and take advantage of some of the digital capabilities. Internally, we rolled out a plan recently and actually publicly as well to translate all of this work that's gone on over the past several years into superior financial performance, and we called it mission-critical. And basically, there were 2 goals that we outlined. One was to accelerate market share gains and we indexed market share against industrial production or IP growth. And what we wanted to see was a spread of at least 400 basis points to build towards that by the time we reached our fiscal year 2023. And by the way, we have just begun our fiscal year 2022, we are September to August. The second goal was to bring returns on invested capital back into the high teens where the business had historically been. In fact, we believe there's runway well beyond that. But by 2023, we wanted to see ROIC get into the high teens. And that would be powered not only by leveraging growth, but also through a structural cost improvement plan that would yield at least 200 basis points of OpEx to sales improvement during the same time period. We are definitely -- I'm encouraged by the progress we're seeing. We are seeing the transformation pick up steam across a number of fronts. Starting with share gains we did during the course of fiscal our fiscal '21, we wanted to move from what had been essentially flat with IP to seeing a positive spread of at least 200 basis points by our fiscal fourth quarter. We were encouraged. We saw that spread build during the course of the year. We actually achieved roughly 500 basis points in the fiscal fourth quarter. So encouraged. We still think work to do and still lots of opportunity, but encouraged. At the same time, our end markets, while the recovery and demand is robust, no question demand was impacted by all of the supply chain, the labor disruption that's been all over the headlines. So sort of good news, bad news. The bad news near-term constraining growth. We think, long term, it's actually good news for a couple of reasons. One is the ability to further capture market share from local distributors that simply can't get products in a constrained environment, availability wins, we're seeing that. And the second thing is we actually think that this extends the potential recovery here well into 2022, some of these constraints now because most of our end markets, again, heavy manufacturing, we think the demand is good and the supply chain constraint could actually prolong the recovery. We're also seeing -- I'm encouraged by the execution of our growth initiatives. We've outlined several. We are seeing some proof points and progress, and improved execution. Our implant program is when we've talked about, it moved from 5% of sales to 7% of sales during the year. We expect that to get to 10% by 2023. Our vending program has returned to pre-COVID levels, obviously, during the pandemic, tough to get inside of customers, tough to install vending machines. That program is back to pre-COVID levels. We're investing heavily in digital technology. Our e-commerce business is growing nicely, and we're seeing e-commerce revenues as a percentage of totals at our high watermark. We expect to move past that, so encouraged there. Beyond sales on the gross margin front, we've now seen 2 years in a row of roughly flat gross margins, which in a pretty difficult competitively -- high competitive intensity industry, we feel good about. We think it's outperforming the marketplace and certainly what is sort of bucking general industry trends. We see a robust inflation runway right now and in front of us. And certainly, our plan now is to -- and our goal is to be roughly flat again for 3 years in a row. On the operating expense and productivity side, I mentioned our structural cost programs that 200 basis points in OpEx to sales improvement would be powered by $90 million to $100 million in cost takeout by fiscal 2023. We are actually ahead of plan for fiscal '21. And so we've made -- we've actually increased our long-range target to at least $100 million, so encouraged there. All of that, and then Dave, I'll turn it over you in a minute, translates into an operating margin framework for the year for our fiscal '22. That implies roughly 300 basis points of growth above IP. We took some assumptions on what we think IP will do, but that puts our top line somewhere mid- to high single digits, hopefully better, depending upon environment, but at least mid- to high single digits. And at those levels, we would expect to achieve 20% incremental margins, and that is while absorbing nearly $40 million of year-on-year cost when you combine outsized inflation that we're seeing, plus roughly $13 million of COVID-related costs. And particularly cost add-backs, costs that were taken out of the P&L during the pandemic that have come back online. So putting that together, we feel good about it. Certainly, we feel like we are just getting started here and want to see this kind of performance extend to '23 and beyond, but certainly encouraged by early proof points. And Dave, with that, I'll turn it back to you.

All right. Thank you, Erik. So let's -- I'll use 1 of the analyst phrases here and say there's a lot to unpack here. So maybe we could talk about supply chain first. Could you talk about product availability, fill rates, any relevant issues in the competitive environment? You mentioned taking share because of this, but just some of the key points of the supply chain shortages today?

Yes, Dave. And I'll start by saying I've never seen anything like this in my career. The -- specifically, the product scarcity, so inability to get product, the combination of the raw materials, freight issues and labor issues for sure. And on top of that, COVID, which is still not done and manufacturer is still struggling with people out for COVID and contact tracing and such. Product availability, I've never seen a period where it's this difficult. I think for us, it's been net-net, a positive. So certainly, Dave, inside the company, we measure our service level or fill rate, basically, we'll look at first pass and second pass. And what I mean by that is you mentioned our 5 primary distribution hubs. The first cash measure would say, out of 100 times how many times does the home location have the item. So if a customer is sitting in Atlanta, Georgia, how many times does the Atlanta Distribution Center have it? That's first pass. And then the second pass is how often does that product sit in 1 of our 5 somewhere in the network? We've seen a sizable impact on first pass fill rate, less so on second pass fill rate. And -- but I think the real key point, Dave, is whatever we're seeing in a gap when we speak to our suppliers and our customers, it really pales in comparison to what local distributors, the way they're struggling to get product. They're seeing service levels that are a fraction of what ours are. You could certainly see by the numbers we're investing in inventory. We really do believe availability wins right now. So net-net, we feel like it's probably more of a help and a tailwind than a headwind, although inside the company, you could imagine our supply chain folks are not feeling so good every day when they see the numbers. But net-net, we think we managed it pretty well.

So the other issue that we're seeing today in supply chain, of course, is the logistics, and you mentioned the people side of things. And I'm just trying to gauge how you feel today about your logistics infrastructure, given that you do -- you outsourced hat effectively? You don't have to deal with hiring a bunch of drivers versus some of your competitors that may have to do that. But you do have to hire people to work in the warehouses and there's challenges there. So could you just break those 2 things down and talk about labor specifically?

Yes, sure. David, I think in general, I feel like our supply chain does set up pretty well for an environment like this for a couple of reasons. One thing -- noteworthy point is product selection, while we do some global sourcing, it's at 15% or less of our business. So the majority is U.S.-based, which -- don't get me wrong, there's plenty of challenges there, too, with our suppliers, but not to the same degree where we can at least avoid some of the port congestion. You are correct. I would say the biggest constraint right now, the biggest issue we face is labor, specifically labor in our distribution centers. You are correct. Again, I think we've done a fairly decent job navigating it. That said, it's coming at a higher cost. So if I think about pre-pandemic where starting wage rates were in our distribution centers and where they are now, it's quite a gap. That's part of that $40 million headwind that I was referencing. We've been pretty aggressive. And look, we think part of our appeal is our culture. And we do think, even at an hourly level, that helps. That said, we've got to be competitive in order to keep it higher and retain. So we have been aggressive about moving because, again, right now, we think availability wins, and we've got to have people. So that's part of that headwind.

Well, it's encouraging that you mentioned your ability to grow, your ability to layer on, hopefully, 20% contribution margins while absorbing some of those incremental costs and while bringing some of the other variable components of your cost structure back online. And it's a strange period right now. But as we think about the next 3 to 5 years, let's say. And I know that's hard to do with the chaos that's happening. But if it's a relatively normal environment, should we think about MSC Industrial as a -- as you're talking about here near-term sort of 300 to 400 basis points of outgrowth relative to the industrial end markets, 20% type contribution margins over that stretch of time. Is that how we should be thinking about the growth and profit algorithm at the company?

Dave, I would say, yes, that's a reasonable expectation. And obviously, we've been through a period of underperformance here as we made a lot of changes inside the company. We're coming out of those now. We are starting to see some proof points. So look, I would expect -- the short answer is yes that if the company performs at -- we had said 400 basis points or more by fiscal '23, that's fully my expectation, Dave. So if you look at a normalized environment over long periods of time, and we grow 400-plus basis points above IP, that should put us approaching the high single-digit organic revenue range. We've been there before as a company. It's still a highly fragmented market, no reason that shouldn't be achievable. At those sorts of levels, a couple of things happen. One is we do generate some nice OpEx to sales leverage. And then at the same time, we've really sort of made a focus of the company to take structural cost out on top of that. So the short answer is, yes, that is a reasonable expectation.

Well, that's a really good segue. The next thing I wanted to ask you about was it is 1 thing to get operational leverage, you get volume, you're able to lever a lot of your fixed costs and drive those contribution margins. But given some of the pressures that we just talked about on the other side, I think it's also important to get more efficient and drive technology to get those levels of efficiency. Could you talk about how MSC is applying technology today to improve the productivity of the business overall?

Yes. And Dave, just going back to the algorithm for a second. If you think about it, one of the things we've talked about is over time, there probably is a modest gross margin headwind in the business. Right now, we've been at this point. There is a mix element to the business that will bring gross margins down 30, 50 bps a year if price and costs are flat. And we've been in this last 2 years. We've been pretty pleased that we've offset the mix headwinds with positive price cost. We're early stage inflation cycle. We'd like to see that happen again this year. But over time, we think we need to start taking structural costs that we have. It's been through a number of ways and definitely technology is at the heart. I would say, Dave, there's a few sort of -- a few platforms in which -- in the way we're thinking about technology. One is digital and digital commerce. So if I think about just the efficiency of -- on the growth side of the business of our e-commerce channel, the efficiency and sales force productivity we gained by using a CRM like Salesforce.com that's integrated with the website, that would be one. Sort of related is how we handle inbound and customer care. So the moves we made through the pandemic with the branch network moving to this virtual care network could not have been done were it not for the smartphone system that was integrated with the CRM that was done in years leading up to that because basically what we're able to do is in an MSA, create a local field, create a local team and just do it by phone instead of them sitting in the same room. So effectively, that is technology. That's the second. The third one I'd bring up is automation. And I think this one, Dave, will play a bigger and bigger role for the company moving forward. But automation has been at the heart of what we've done in our distribution centers. In the last couple of years, we've put some bigger bets down on artificial intelligence backed robotics that's starting to show payback. And we think the payback only improves with the outlook on the labor front. So I think you'll see us invest heavily there in warehouse and personnel automation. And then the fourth one, I would say, sort of the fourth bucket in the technology sector would be end-to-end process improvements, Dave. So if I think about just the value streams of order to cash, procure to pay inside the company, a lot of this is legacy, not just systems but business process that hasn't changed. And that's an area that Kristen, in fact, is taking the lead on with our transformation office to look end-to-end and no question, technology is going to be at the heart of how we make those business processes more efficient.

Perfect transition again here, Erik. I was going to ask about Kristen. And broadly, I mean, just in terms of -- it seems like you've got the -- you feel like you have a really good team on the field right now. And we spoke with Kristen a couple of months ago. And what struck me about that conversation was she is coming from a place where she said she's used to more structured business operating systems and value stream mapping and things of that nature. And it sounded like those are huge opportunities if she's able to formulate those and make those happen within the company. Could you talk about how that's going, how much latitude you're giving her to sort of bring those best practices to MSC?

Yes, Dave, it's a great -- it's a really timely question. The short answer here is, look, I'm thrilled that -- Kristen is a year in -- a year plus in and I couldn't be happier. I wanted to bring somebody in that was a CFO with an operating bent and the background at IR, I gave her that. She's been terrific. I would say, she's really picking up steam in terms of -- so she's got basically free license in terms of the 2 areas you mentioned, the value stream work. So a change we made there is the transformation work that's gone on, the structural cost work now rolls up, the transformation office rolls up under Kristen. So she's going to have direct responsibility for the value stream work. And the second one, you mentioned it is building sort of like a more of an operating system akin to what she came out of in terms -- to tighten up execution. It's been an area that I think we have been okay, but just okay, and this is an area where I'm really going to lean and have been leaning on Kristen. I'm starting to see more and more changes happen just in terms of -- I mean, basic things in terms of how we measure the frequency, how we measure countermeasures and kind of just the operating cadence of the team. She's really got the ball there.

Okay. And related is Kim Shacklett who is now taking over the sales operation. And it sounded like at the time you implied that there was sort of a ground, the predecessor had laid the groundwork, and then Kim was going to take this and move to the next level with our relationships and her experience in the industry. Could you talk a little bit about where we go from here and what changes are necessary from the point we are today over the next 1 to 3 years under Kim's leadership?

Yes, Dave, look, and what I would say is, yes, Eddie did a really nice job for us laying a foundation and putting a plan in place, putting a playbook in place for how we improve sales execution, how we stay focused on just a few things. Some of the changes made during the pandemic on his watch were great. The nice thing is Kim is so well respected in the company and the industry. If Kim were here, she would tell you, she doesn't see any major shifts to the playbook. So it's not like there's going to be any sort of redo. We think the playbook is pretty good as is. I'm sure there will be a couple of little fine-tuning tweaks, but nothing major. This is more about now driving execution of it and rallying the team in a way there are probably not many other people inside the company could do other than Kim.

Okay. One of the things -- the time just flies here, it's amazing, we can do this for an hour. But I want to make sure we fit this in because it seems like it's a topic that a lot of folks are asking about is ESG. And I don't know that we've had the conversation. So maybe, Erik, if you could tell us how the company views ESG, if there's any initiatives ongoing that we should be aware of?

Yes. I mean -- so Dave, the answer is, it's important and becoming more important to us, to our customers, to our shareholders, to our stakeholders. And what's interesting is when I think about sort of the core tenets of ESG and what it really stands for, caring for environment, for diversity and inclusion. These are things that are like -- when my grandfather founded the company, those values were at the heart of why he founded the business. So I think at its core, the company is very well positioned for a good ESG strategy because it's who we are. I do think that what you're going to see from us, and it started, John's built a social responsibility, a corporate social responsibility website, which is kind of step 1 of just being able to tell our story a little better from what we're already doing. And then you'll see -- I do expect you're going to see more robust actions from us, Dave. So they're sort of like step 1 is just telling our story better because we do think there's a lot there. In areas like D&I, we have a lot going on in the company in that regard that we can better tell. And then I think there's things that we're actually going to take and advance the ball. I will tell you, Dave, I think one of the things that's exciting to me is -- and we hadn't thought about this angle until recently, until ESG's rise in importance is the role we play in helping manufacturers either shrink their footprint or grow their business without increasing their footprint. I think there's really something to build on there, whether it's MillMax or just the work that our metalworking tech people are doing, to the extent they're making U.S. manufacturing more efficient, there's real significant environmental implications that we're just scratching the surface on. So -- there's a lot more to come. I think step one, as you've started seeing us tell the story better and then it's going to be about building action behind it.

Okay. You mentioned earlier some figures around your implants presence in vending. And I think you've said that you hope to double your implant presence over the next 3 years. Maybe if you can just talk about where you are in that journey and where ultimately we're going. I think it's very important as a company to get closer to the customer to sort of circumvent this pricing and the transactional type business, which, of course, you have some of that. But can you just talk about what those targets are, where you're moving to ultimately?

Yes, Dave. And the way I would view this is there's a spectrum of -- as we've gone through this repositioning. On one end of the spectrum would be the legacy pure spot by long tail business that MSC grew up with, and that would be our direct marketing channel. Moving along the spectrum one step further down the path would be where there's a salesperson involved in the relationship. It's no longer purely spot by this value being given by a salesperson. Right there, if you take that cut off rough terms, the direct marketing channel is 10% or less of revenue. So 90-ish percent of the business is, there's a relationship involved in this value being given. Go one step further on the spectrum, and we're introducing more than just a salesperson, but technical expertise and our solutions, so vending or VMI. And the way we'll look there is what percentage of our business flows through customers that have a vending machine of some sort, right? There were at roughly half of our business, plus or minus, fits into that umbrella. We'd like to see that over time, get much -- the vast majority of revenues. Moving all the way to the other end of the spectrum is what you described. So the implant program is basically a more extreme version where we actually have a full-time presence of an MSC person inside of the customer. Oftentimes, that is combined with a vending VMI, some sort of inventory management presence there. And that's probably the most extreme version of being closest to the customer. Dave, we're seeing -- so it's early. We were at -- before we announced the goal, we were at roughly 5% of our revenues. And what we said is we wanted to get it to 10% by 2023, a nice step this past year. And what we are seeing is the retention rates on these programs are really, really highlight. Like, we almost never lose one. So as you move further down the spectrum, customer retention rates, which tends to be the biggest driver of lifetime value, you just see a steady climb up. So that is -- the focus is basically moving everything from that end of the spectrum and pushing it towards the middle as a greater percentage of revenue.

And just to clarify on that, where you talked earlier about sort of a secular drift in gross margin. Is that the cause of it you're selling to larger customers, you're selling more of these formal relationships, which would tend to have lower gross margin? However, hopefully, long retention rates, hopefully, as good or better EBITDA margins?

Yes, that's right. We see great opportunity. I don't think there's implications on the EBIT margins, definitely on the gross margins. And you're right. Look, if you take sort of the core legacy of the business, we were a long-tail spot by supplier. There is no higher margin with the exceptions of maybe fasteners, that is the highest margin business that there is. And so most of the growth factors, there's a few that are high-margin growth factors that we have. E-commerce is an example where we tend to see apples-to-apples higher margins. The CCSG business, so these are C parts, like fasteners fitting fuses tend to be higher margins. That said, most of the growth initiatives are lower margins. And yes, it's larger customers. It's also the product set. So the deeper we penetrate a customer, the more we get into what we would call, planned usage where they can actually stage out and plan their spend. So there's sort of more of a line of sight, lower margins. But that's on the gross line, not on the net line. That's correct.

Okay. We have just under 1 minute to go. I'll give you 30 seconds to tell me about capital allocation priorities. Maybe just random.

Yes, sure. So we -- Dave, and what we've always said is we don't follow a set formula. We're going to -- but generally, #1 is going to be organic reinvestment as long as we see high return projects and there's a bunch right now, prior -- that's 1A. 1B would be steady, consistent ordinary dividend growth. This year, we held dividends flat really because we saw the payout ratio, particularly with the pandemic and earnings drop. We felt like the payout ratio was in a good place. But in general, we would see continued ordinary dividend growth. From there, it's -- what do we do with the excess free cash flow, which fortunately we should have. And then we're looking at share buyback and potentially holding on to cash for some period of time, but then it's eventually returning it, share buyback or special dividend or M&A. And what I would say is basically, we're looking on a risk-adjusted returns basis. So obviously, the risk associated with an acquisition is far higher. Therefore, the return hurdle is greater.

Terrific. Well, Erik, thank you very much. John, thank you for joining us. I appreciate your time, everyone. The next presentation, which will begin at 09:05 will be AMETEK Ecolab, Northrop Grumman, TE Connectivity, the Timken Company and Alamo Group. So thank you all for joining us. And again, MSC Industrial, thank you. We will proceed to the next presentation. Take care.

Thank you, Dave.

Thank you, Dave.