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

Kick things off. My name is Mike McGinn, senior analyst, Wells Fargo Industrials. With me, delighted to have the MSC Industrial team. Erik and John, thank you for being here.

Good morning, Mike.

Good morning, everyone.

So as many of you know, MSC is a leading distributor of MRO and manufacturing products with roots tracing right back here to New York and the metalworking industry. $3.5 billion sales, $4.5 billion market cap. The company is unique in that they operate an asset-light, hub-and-spoke distribution model with a highly trained salesforce, aerospace, machinery, transports, metals and mining, key verticals, along with some of their top suppliers, Kennametal, Sandvik and their own private label.

So kicking it off, I just -- I wanted to get an update and talk about Mission Critical. This is an initiative, it seems, you had in the works and alluded to a few hundred basis points of SG&A savings pre-COVID. You leaned into that through the hectic period, and you've come out the other side. I just want to get a sense of the benefits that are now accruing to the bottom line and kind of what you learned about the team and your ability to react in such an environment.

Yes, Mike, I think -- and what I'd start by saying is the Mission Critical, sort of the program extends beyond just productivity and cost, and it's really been about responding to a repositioning of the company and the value we bring in the market and along the way of realization that in order to do so and need to realign the business model, the cost structure. As you've said, we've been really encouraged by -- so we set a goal. We had a couple of big goals, one, around market share capture, another around productivity, to take out $100-plus million in cost, and this is relative to, as you said, pre-COVID or fiscal 2019. We are on track, really ahead of plan tracking to -- the original goal was $90 million to $100 million in cost. We're tracking to $100 million plus right now by our fiscal '23. And I would say I've been pleased with, if you ask like sort of what surprised -- what are my observations is just seeing this is a company that, for a long time, has been in a growth market and a growth business and never really had to look at productivity and cost structure in the way that we have over the past couple of years. I've been really pleased with how the team has responded because, culturally, it's been a change. And I think what surprised me the most is just seeing how people are responding to a raising of the bar on setting goals and rallying around it. So we see momentum continuing, and it's something that will turn into from a onetime goal for fiscal '23 to something that will become a way of life for us.

Yes. That was my next question is, objectively, you look at that $100 million target during the latter stages, late innings, as people say. But from a run rate perspective, can you just talk about the benefits that come with changing the culture in terms of growth-oriented, profit-oriented mindset, lean, things of that nature?

Yes, I think so. As I mentioned, a couple of really big goals. One is on market share, which I'm sure we'll get to. On the productivity front, yes, ongoing. This is going to become a way of life. And the thinking inside of the company now is around how do we make process improvement and structural cost improvements a way of life, such that we can take a big chunk of ongoing inflation and investment and fund that through productivity. There's really 3 kind of levers or tracks that we're looking at right now. One would be structural moves. And we made a series of them during the pandemic, whether that's shrinking real estate footprint and hybrid work model, network, et cetera but structural changes, and we see more beyond the pandemic and others we have our sights on. The second is what I refer to as business process reengineering, just some of the fundamental ways we get orders out the door. We receive. We generate bills. There's fundamental process improvements to be had. And then the third is really a lean, continual improvement mindset. And again, I've been encouraged. We have a team that's led by Kristen, our CFO, who's sort of full-time driving this through all areas of the business. And that will be the goal, though, to eat into inflation and investment through productivity beyond '23.

Yes. And within there, you mentioned something interesting. It's other companies talk about their sales model. You're talking about your share gain model, right? And so you've added MillMax. You brought vending in-house. You're doing some digital quoting. You're pretty product-agnostic to creating customer value. I guess adding it all up, looking at these tools, what gets you most excited today? And then looking forward, what are some of the leading-edge things that you're looking at right now?

I think the place to start, Mike, fundamentally, is what we stand for in the market and what it is that we try to do, and that's I've been mentioning, repositioning the company, that if I go back 10 years ago and we went with MSC's best customers and said, "Tell me about MSC. What do they do for you?" We would probably hear a lot of things around great product, broad product offering, great delivery, a great, seamless service experience, more of a spot buy model. And today, you'd still hear those things, so it's not like our spot buy business has gone away. It's been supplemented. And the things you'd hear now are around MSC is on the plant floor. They're finding they're technical, and they're finding productivity opportunities for me to improve my business, fundamentally different. And the way we're doing that is through some of the tools that you mentioned whether that's technology like MillMax and like e-commerce. It's through people. We've invested heavily in technical expertise, both through recruiting and through training, particularly around metalworking products and machining, which is kind of the core of the business. As I look forward, that's really what's going to anchor us, though. And what we're finding, particularly right now, there's 2 things that customers respond to. One is availability. We are still in a scarce supply environment, so having product matters a lot. The second is productivity. Our customer base, which is primarily manufacturing but certainly North American heavy industry, they are starving for productivity. Especially in a high inflation environment, everyone is feeling cost pressure. They need ways to take cost out of their business. They need ways to speed up lead times, to get products into their customers' hands faster. All the things we're working on, the technology, the people, the technical expertise are aimed at doing that for the customer.

Yes. Great. And I guess switching gears to more of the short-term results. You reported fiscal Q2 quarter started out slow. You built momentum. And any sense of the industrial demand equation? I mean, we're entering this phase of negatively revised global growth, but you asked a machine shop, channel check and work's abundant, price is abundant. If anything, they're turning away projects or pricing to a premium because of how much work there is. So just walk us through what you're seeing in terms of the landscape, the longevity of the cycle and where we are.

Yes, Mike, I would say we would describe very much what your channel checks are showing, which is that the demand environment is still robust. And it does seem like a bit of a disconnect for now in terms of what some of the macro indices are indicating versus what we see on the ground, which is pretty strong, so -- in fact, quite strong. Things remain robust as best we can see. And one of the things we talked about is there's also there's pockets of our end market base. So we are heavily manufacturing exposed where we feel like, if anything, there's a lot more upside than downside. So 3 examples would be aerospace; automotive, for sure, which has been extremely supply constrained; and the third one being oil and gas/energy, which while a small direct exposure for us, the indirect exposure is quite large because it does -- oil and gas does power a lot of the industrial economy. And with oil prices where they are and likely to stay, we see a lot more upside.

Yes. So great color there. And sticking with the quarter, solid beat and raise. You added a high end to your financial framework. And I guess the pushback you would get or I've gotten is at a low teens valuation with your balance sheet, you'd be a buyer of your own stock, right? So maybe just walk me through capital allocation in terms of being nimble to you want to add more working capital. And then if you consider MSC the growth company or like a total return, sorry, just your overall perspective.

Yes, Mike. So on capital allocation, our philosophy has always been around deploying capital like with an owner's mindset. And so we try not to subscribe to set formulas of this much goes to M&A, this much to share buyback. I would say 2 1a and 1b priorities, if you will. The first is organic reinvestment, and that will be the case as long as we continue to see a high-return profile in the core business. And certainly, now we do. And I would say, if anything, my appetite for organic investment has grown, or ours, in the last year, just because I think we went through extensive repositioning. The business is starting to perform at a level that I'd expect us to perform at. And so the confidence goes up and the ability to invest organically, the willingness then goes up. So that's certainly 1a. 1b would be consistent ordinary dividend growth over time. And if you look at a CAGR, we've been a bit lumpy. But over time, we feel good about our payout ratio, and that should continue to grow. From there, there's generally excess free cash flow, which is good. We're sitting right now at around 1.5 turns of leverage. I think in a market like this, we're definitely seeing -- a couple of factors lead me to want to keep dry powder. We generally like to keep leverage modest in the business. And by modest, certainly, we would flex up beyond 1.5x. We could flex to 2 to 3x for the right opportunities but like having dry powder. Right now, we do see a double-digit growth possibility for this business. We've been producing it to date. We could see that continuing based on our end market discussion. And when we grow at double digits, we do eat up working capital, to your point, inventory receivables. And I want to make sure we have dry powder there. And the other constraint on the buying the stock, and this doesn't mean we're not looking at it, for sure, is the M&A funnel, I would say, has heated up. There's just a lot more interested sellers than there were 1 year or 2 ago, I think, for a number of reasons. And we're going to stay quite disciplined. And if we entertain something, it would be something that could fit into our core business. I think that's been one of our learnings from the M&A. Our M&A track record, it gets a lot better. When it's in our core business, we tend to do really well. When it's something that's a new platform is where our track record gets much spottier. So we would stay close to our knitting, but I do want to have some dry powder there as well.

Okay. Maybe one more before I poll the audience. Another point of pushback is SG&A benefits being front-end loaded. And although you had a pretty decent headwind from an accrual comp catchup last quarter, you would really like to be growing that headcount low single digits. Just maybe walk me through your confidence with the freight environment where we now have and just maybe being able to hold incrementals at that mid high teens level as we enter the back half of this year.

Yes. Look, we would expect -- Mike, we would expect to be able to -- and we may have mentioned this on our call. But if we look to the back half of the year, I would expect incremental margins to be in the 20s. And hopefully, if we do our jobs, mid-20s. And the case there, yes, there's some -- certainly some freight pressure and some freight inflation. One thing that mitigates that for MSC is that most of our business goes to small parcel, where we're feeling more pressures on LTL, which is a relatively small percentage of total. But bigger picture, what we see the prospect for a strong top line growth, we're doing a good job on price realization, which certainly helps with incrementals. And then our ongoing productivity efforts to offset and mitigate some of that inflation that we would expect incrementals in the 20s for the back half of our fiscal.

Then I'll open up, if there are any questions. All right. I'll keep going. So on the pricing front, we've had this conversation a couple of times. I've spoken to a couple of companies in industrial land, and they're like we got to become smarter with how we quote, how we put lead times, leaving things open. You're doing some interesting things in terms of basketing, indexing. Just walk me through kind of like old-world distribution versus what it needs to be going forward.

Yes. And Mike, what I'd start out by saying is we have put inside the company a heavy, heavy focus on pricing -- I'll call it pricing excellence. I mean, that's what we aspire to. I wouldn't say we're there but pricing strategy, pricing execution. And we think now is a great time. For one thing, this is like a once-in-a-generation inflation environment. And if we don't capitalize on it now, shame on us. But the second thing is realizing that this environment is not going to last forever. And there's going to come a time when inflation slows, and we have higher costs in our system. And so we're really trying to build up our muscle now to prepare us for what will be more difficult pricing environments down the road. What does that mean? It means a couple of things. One is we've built up capability internally around a pricing team and using science. And I think you asked -- you mentioned in your question, old world versus new world. I think old world in distribution was a product manager, a marketing manager, a sales manager using their intuition and their experience to set pricing. And in the new world, certainly, intuition and experience matters, but it's got to be supplemented by data. At MSC, we're dealing with hundreds -- several hundred thousand customers and something like 2 million SKUs. No human being could possibly optimize pricing. Intuition is really important. It's just not enough. And so what we've done is we've built a lot of science. We've put some software in place. We've hired some pricing experts. So one is around using science. And then the second thing is a heavy focus on building out the capability of our sales force to get price. But beyond just get price, face into it with the customer. So again, going old world to new world. I think the old-world mentality in distribution was avoid the price discussion at all costs with your customers. And we're training our sales force now is actually no. It's okay to face into it. These are real -- it's how you do it and what value are we bringing, along with price. So one of the things that we've done and I think is helping our realization now is I mentioned in these inflationary times, our customers are starving for productivity. So we're doing a lot of role playing, a lot of training and equipping our team to go in and say, "Hey, if you're going to go in, we have to face the music and deal with the fact that prices are going up." But when we do it, what are we bringing to the customer to offset that price increase? What productivity ideas? How are we documenting it for them? And that -- it's been a game changer for us, Mike. So I think that's one of the reasons that we've been touting our price realization, it's because of some of the training that we do is really it's great now, but it's to prepare us for future times when it's not so easy.

Great. Switching gears. You've been adding some finer points to the business and how it's evolving, in-plant solutions with vending, either or combined. You mentioned it was closing in on your 10% interim target. Just walk me through kind of where you started on this journey and kind of where you think it can go long term. Obviously, you have a big competitor out there that kind of leads with vending in-plant first.

Yes. And Mike, I think just to back up for a second because those are sort of the tools and the tactics. The spirit behind the idea was if you look at the company, as I mentioned, 5, 10 years ago, we would have been, for the most part, nearly exclusively a spot buy supplier. And the pivot that we made is to say, look, customers need more, the -- what was once really unique value proposition as a spot buy supplier is now somewhat table stakes. The role we play need to change. And that was really the impetus behind repositioning the company over the past several years towards what we refer to being a mission-critical partner on the plant floor. So interestingly, the spot buy business hasn't gone away. In fact, it's actually as big or bigger than it was years ago. It's just now, as a percentage of our revenues, it's lower. So the programs, the tools and the tactics, the things like vending, like our in-plant program are ways we bring that to life. There are ways that we deliver on improving the customers' productivity, helping them get products out the door, helping them shrink inventory, helping them cut costs. In terms of where they can go, I think, to use the baseball analogy, we're still in the middle innings of the story. So vending as a -- for instance, if you take our vending program and look at percentage of revenues with customers that have a vending machine as opposed to just what flows through, but how big is our business with customers where we've put an MSC inventory management system in, and this is a vending and actually in our VMI as well, we're at around half the business right now. I think that can keep pushing higher. If you look at in-plant, which is even more kind of integrated or extreme version of the value proposition, that's where we have, beyond just inventory management, we actually have full-time people. That's the number where we were. I mean, if you go back 5 years ago, it was basically 0. We're at, last quarter, was, John, right, at about 8%. And yes, we had 10% as our goal for end of next year. We should -- I think we're on pace to beat that. I think that number continues to grow. So the percentage of business that is just a pure stand-alone spot buy relationship where there is no -- today, that's at under 10% of our revenues. I think that, even if it doesn't shrink in dollars, will shrink as a percentage. So I think we're still in the middle innings.

Yes. And so staying with the national account focus, can you discuss selling to the national account level versus the core customer, how that differs in terms of volume considerations, price mix and then adding customer stickiness and lower attrition rate into that?

Sure. And I would say national accounts, which, for us, are there's a dollar threshold and a location threshold are kind of a more extreme form of what our target market is. But really where we're focused, Mike, is even beyond national accounts, customers that are looking for more than just a transactional relationship. Typically, it does correlate with size, but not always, because there are some really big customers who are all about just price, and they'll quote out every order. And that's not our target customers. And similarly, there could be very small customers in the core who really do value sort of total cost of ownership. In general, though, it does -- our target market does tend to correlate with size. We tend to -- the smaller -- when you get to a really small shop, it tends to, on average, function more like a consumer behavior. And -- but by the time you get to a medium-size business, and by medium size, certainly something over 10 people in a shop, over 50 people, over 100 people. When you get to that level, it tends to be more of a full relationship. By the time you get up to national accounts, to answer your question, definitely, what we see, not surprisingly, we see our national accounts business, the gross margins because the volumes are there and the customers more sophisticated, gross margins tend to be lower. Op margins do not, interestingly. And the reason is a combination of, over time, we've learned some efficiencies around average order sizes, around how to optimize. And the other thing is the nature of the business tends to be, as you said, it's stickier. The retention rates are much stronger, which leads to stronger lifetime value. So for instance, when we put -- we look at when we put a vending machine in, what is our retention rate? When we put in-plant in, which is most extreme, like in-plant, in particular, I mean, over the past several years, I could probably count on one hand the number of instances in which we lost the customer. So all of that leads into profitability. And so national accounts is just sort of the more extreme version of what our target market is, which is medium-sized to large sized businesses that are looking for productivity improvement.

Yes, yes, I think that, on one hand, that's not a lot relative to...

No, no. By the way, one interesting point related to this that we talk to our customers about all the time is if you look at a manufacturer and you break out into a pie chart, where does cost go for a manufacturer, which is our bread-and-butter customer. The cost of the supplies is under 10% of their total cost. The 2 biggest chunks are labor and materials. That's well -- labor and materials come out well over half of the total cost of running manufacturing. So our pitch to our customers, if you're focused on just bidding out every order and driving price down, you can optimize, but you're going to optimize in what is a bucket that's less than 10% of your total cost. The way to move the needle is on labor and materials. And then the way to move the needle on labor and materials is you really have to improve the manufacturing process. And that's where MSC is focused. And one of the things we've invested heavily in over the past few years, I've mentioned, is technical support because doing this -- saying that is easy. Actually doing it is difficult, and it takes people with a lot of skill and a lot of experience.

So running with that theme, kind of -- can you kind of frame up for how many customers you've addressed with MillMax or seen the benefits or made a switch, is there a high-level percentage or a percentage of the portfolio you've curated or addressed with your customer base already with the MillMax technology you're starting to see the benefits?

The beautiful thing is it's still a low percentage. So MillMax, as a for instance, which is relatively new technology, has been deployed to our sales force. But it's a -- because it is new technology, it's gradual, and it's ramping. So I would say if our vending program would be middle innings, let's say, I would call the in-plant program still early innings because it's less than 5 years old and MillMax also early innings. So if I look at -- even vending at half of our revenue base, if you look as a percentage of customer base, it's much, much smaller. So we still have a ways to go on all of those, especially in MillMax.

Yes I saw an interesting press release or an interesting strategic opportunity a couple of weeks ago. I sent the press release to John, looking for some color. And this is really high level. But in the world that's like deglobalizing, a lot of industrial companies say like the knowledge is being moved, being lost internally. And you have this team of experts that are now coming in at the quoting process, able to save either time, process, material upfront. Do you feel -- do you get the sense that as people have moved machine shops externally and decentralized their operations that you're now becoming the foreleader in thought and technical innovator within metalworking?

Mike, what I would say -- look, I think the short answer would be yes. Let me just back up for a second. I think if you went to any -- and this predates the pandemic. I think the pandemic just accelerate it. But what are the 1 or 2 or 3 biggest issues facing U.S. manufacturing, North American manufacturing? Either 1 or 2 on anyone's list is going to be skills gap, labor shortage, not just labor shortage, but a skill shortage in terms of people. And this is a combination of people leaving the workforce, not -- more going out than coming in, but there is a real skills gap in manufacturing. We feel like at MSC a combination of because of our strong base of technical talent and people, combined with technology, we feel like we have been and even more so now are positioned to help our customers solve it. So we've invested a lot in people. We've invested a lot in training. The other thing we've done, I know the press release you're referencing, is we've actually carved out -- we have a group inside the company that's called our metalworking Innovation group that's thinking about how to deploy -- so it's got some really highly skilled people and then some partnerships with third parties who we work with, who we think really understand manufacturing, the intersection between manufacturing and technology. And so while MillMax is exciting to us and it's still early stages, there's a portfolio of ideas that are in incubation stage behind that, all aimed at improving productivity and helping solve the skills gap. So like the one you mentioned, which was a way sort of virtually to exchange on the quoting process, the early stages of a quoting process would do both. It's a productivity gain, and it also helps with labor challenges.

Great. Question?

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So I would say, and [ Jeff ], for those who couldn't hear the question, was around unpacking the demand environment and whether there are end markets that I'm concerned about. Is that -- did I -- so in general, strong. I would say the area that we would have our eye on, consumer spending. I mean, that's probably the thing. The direct exposure for MSC is low. But certainly, that would have a ripple effect through the economy. And I think that's part of the bear case would be with interest rates rising, inflation, consumer spending, contracting, whether that's impact on production of appliances or goods or things like that, that would be the one we have our eye on. I have not seen any evidence to date that it's yet impacting.

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So prior cycles, this is so different from anything else. I mean, the one point I would look to, if you're looking for is like something predictive. And Mike, you would have better sense than I would. The sentiment indices, the ISM, MBI surveys, like we will do -- we will track those. They are sentiment indices, so they really move around. We will tend to look at them on a rolling basis to try to smooth out the highs and the lows. They tend to be predictive. And the lead time, I mean, if I look historically, 6 months or so.

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We're actually -- so we're not seeing strength in automotive at all. I mean -- and it's really, the automotive story is a supply constraint rather than a demand constraint. And so we think -- I mean, part of the upside case is, even if consumer spending slowed, I think we feel like there are several end markets that have a lot of upside in them. Oil and gas being one, automotive being a second because as supply eases, one would think that the industry will pick up. And then the third is aerospace is nowhere near back. So we had actually recently -- not so recently, a year ago, acquired a small metalworking distributor heavily levered to aerospace, which gives us a good sort of window into what's going on there. And we think there's way more upside in aerospace than what we're seeing today. Sure.

Sticking with the end markets, I haven't heard an update on MSC Mexico in a while. And presumably, that was a minority interest you went into. Presumably, it over-indexes auto. Just you also mentioned a robust M&A environment. I guess just tackle the couple of questions in terms does the strategic partnership makes sense, is an outright deal makes sense and then what kind of window you see into auto right now?

Yes, Mike. Actually, a really good question because we probably haven't talked enough about Mexico. What we did there, we had no presence. We actually -- so we own 75%. And the founder of the business, who's still its Chairman and overseeing it, retained the remaining portion of the business to align incentives. That has been a shining star. The business is, without giving too much, but several multiples the size that it was when we bought it. And the neat thing is, certainly, there were some pandemic-related sales, but we're able to strip that out and see what's stuck now post COVID, and it's still multiples bigger. It's been a great story. I think as it relates to M&A, I mentioned certainly the conversations are heating up much more so. And I think people -- owners of private businesses coming out of COVID, different perspective on life. The model we used with Mexico, the partnership model, is somewhat unique because it was a market we weren't in. And we thought having an owner that we could really trust and align incentives on was important. To the extent we acquire, I would expect to do it close to our core business and look to integrate it in. That doesn't work quite as well as when it's sort of a greenfield market, if that makes sense.

Okay. I guess, wrapping things up for investors on the fence, what do you want them to know? What do you want to articulate maybe what's misunderstood about the story or anything?

Mike, what I'd say is that the repositioning work done over the past 5 years was extensive. And I think a lot of folks who don't know the story that well looked at the past 5 years' financials and said, "Oh, boy, the business underperformed, but what's going to be different, right? And why?" I think the -- it was a very heavy lift to move the value proposition and realign the business. And what's exciting to me is while you've never done, the heavy lifting is behind us, and the business is starting to hit its stride. I think we're nowhere near reaching our potential. We're not at the level -- we're not performing at the level I expect and I want to see from us. But I do think if you look at our past few quarters, the performance is improving, and we're starting to hit our stride. So I think we've got a really strong strategy. I think we've got a very good team that's been put in place, and we're starting to hit our stride. And so I think there's a strong case to say that the valuation hasn't yet caught up with the execution and understandably so. I think there's some skeptics out there given several years of underperformance, but that I think we've got a great path in front of us, and I think it's an exciting time in the company.

Great. I appreciate the time. Thank you, everybody.

Thank you.