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

Good afternoon. I'm Sam Darkatsh. On behalf of Raymond James, we'd like to welcome you to the MSC Industrial Direct presentation for today. With us today from the company, Erik Gershwind, President and Chief Executive Officer; as well as John Chironna, Vice President, Investor Relations and Treasurer. Erik and John, I think will both be presenting this afternoon. There may be a few minutes for questions, but certainly, we'll have the breakout session immediately following. So with that, Erik, welcome back.

Thank you, Sam. Very good to be back. Nice to see everybody. Good afternoon. So we're going to spend a few minutes giving you a rundown of the company and thought we'd begin with the punchline of some of the highlights. And I think there's 5 themes that you'll hear as we go through today's discussion about the company. Theme #1 is growth, and that's both kind of a historic track record of the company's performance, along with an outlook of growth in what is a large and highly fragmented marketplace. The second theme is around differentiation. We have and have built over the last number of years, a highly differentiated value proposition that we'll describe in more detail. The third is a customer-focused culture that anchors everything we do. And John, you're going to -- you'll advance for me. Okay. You got -- can you go back to one more? It's a sensitive clicker. So the third theme is around a customer-focused culture that really anchors everything we do. Theme #4 is around delivering on commitments and on our financial targets, and in particular, the targets that we set out for ourselves about 2.5 years ago that we'll describe in more detail. And the fifth theme is around using capital allocation as a means of enhancing TSR. So moving along, just a little bit more of an intro on the company. MSC is a leading North American MRO distributor. We're approaching $4 billion in sales in this fiscal year. And as one caveat, we are in fiscal '23, which runs from September through August, so we're not on a calendar cycle, but we will approach $4 billion this year in a market that is roughly $200 billion in size in North America. And of that $200 billion, the top 50 distributors have only 30% or more of that market. So it is, as I mentioned earlier, highly fragmented. We have a long track record of growth, spanning multiple decades and yet significant runway in front of us for continued growth. From a profitability standpoint, EBIT margins in the low teens, with plenty of room for expansion to at least the mid-teens in the near term and a return on capital that is approaching 20% and in which we also see room for expansion well above 20% over time. Moving along, I had mentioned a unique and differentiated value proposition. And I'd say that MSC, we've been in business over 80 years now, and that 80-year history could be looked at or defined in chapters of a story. And most recently, we went through a repositioning, and that would be the latest chapter in the story from what was strictly what we'd call a spot buy supplier or a long tail supplier to become more of what we refer to as a Mission Critical partner on the plant floor of industrial and manufacturing customers around North America. So to be clear, the elements of the prior chapter of our spot buy business remain firmly in place and that include a product offering of over 2 million SKUs, a next-day delivery engine that covers everywhere in Continental U.S. with next-day delivery and a really strong seamless customer service experience. But on top of that, in our most recent chapter here, we've built out what is a highly technical and a high-touch value proposition. That value proposition is anchored in metalworking products, things like cutting tools which represent a little under 50% of the company's revenue and is our historic core strength. And we support that with hundreds of metalworking and machining experts in the field. And the reason we think that's relevant is for industrial manufacturing customers, metalworking products are important in influencing the final output of their business. We've added adjacent product categories over time that also fit the bill of being technical or high touch. And our Class C consumables business and OEM fastener businesses are good examples of that. Combined with metalworking, those together represent roughly 2/3 of company revenues. Those product categories are supported by high-touch services, vending, VMI and a recent implant program that, when combined, our services businesses are roughly 55% of revenues and growing. We have a strong digital platform that underpins all of this. E-commerce revenues as a percentage of sales are in excess of 60%. And all of this together translates to what you see here on the slide, which is, I mentioned, a customer-focused culture, the end result that we are laser focused on inside the company, and that is improving our customers' output. That could mean improving their lead times. In some cases, examples you see here are improving our customers' ability to get products out the door and improve their revenue generation. In other cases, it's about improving input costs productivity and taking cost out of their business. But all of those services in that value proposition are aimed at helping our customers improve their operations. About 2.5 years ago, we outlined what we referred to as our Mission critical Program. And the intent of this program was to translate this new value proposition into superior financial performance. And you can see some of the objectives at a high level laid out here, but we had a few that we focused on. And specifically, one was organic revenue growth. And to us, that meant, over time, outgrowing the Industrial Production Index, which is a fairly good proxy for our end markets by a minimum of 400 basis points and hopefully more over time. The second would be to expand operating margins by improving our cost structure, and we had set forth a goal of a cost takeout of a minimum of $100 million within those 3 years. And then we wanted to expand our return on invested capital from what was in the mid-teens to the high-teens through those moves along with support from capital allocation philosophy. Encouraging, we're now 2.5 years into -- so we're right in the middle of our fiscal '23, we're 2.5 years into those 3-year targets. And we have to date, met or exceeded each of them on the organic growth front. Of late, we are tracking well above 500 basis points or more above IP and that is powered by our growth initiatives, along with certainly an outsized pricing tailwind, no question relative to what we expected to see 2.5 years ago. We are on track to exceed our $100 million cost takeout goal as a result that is yielding improvements in OpEx to sales ratio in our prior fiscal year in excess of -- well in excess of 100 basis points of improvement. It's also yielding operating margin expansion in the last fiscal year, also well in excess of 100 basis points of operating margin expansion. And on the return on invested capital front, we actually already achieved our high-teens goal and are looking to raise the bar and set our sights higher. Adding to our organic growth story. We've also supplemented particularly of late our performance with tuck-in M&A. We've done several acquisitions within the past 12 to 18 months. We highlight 3 of the most recent here. And I thought what I would do is just outline what our strategy and approach is and how we've been doing of late. Essentially, we're focused, I mentioned tuck-in, but we're focused on acquiring local branch-based businesses that can fold into 1 of those 3 platforms that I mentioned earlier, and those are metalworking, Class C parts, which think of small odds and ends that keep plant -- that are low dollar value, but keep plants running and the third being OEM fasteners or the fasteners that actually go into a finished part. As we evaluate an acquisition candidate, we essentially have 3 filters that we use. And those 3 filters are strategy, culture, and financial. With respect to strategy, we're looking -- basically, we're looking for best-in-class companies within a local market that bring to us more scale, that bring to us geographic reach and penetration and that bring to us technical talent in the way of salespeople that bring strong customer relationships. From a culture standpoint, we're looking for businesses that line up with our values. And the best proxy for us there is understanding the owners really well, how they run their business. We generally look at the reputation of -- these are companies that we will have competed against in the local market for years. So their behavior speaks volumes. And then the third filter, of course, is financial. And while there are several metrics we look at, the primary one is we want to see returns on capital on these deals above our weighted average cost of capital in 3 years or less. The recent deals that we have up here are tracking very nicely, along with a few others that we didn't mention here are tracking well -- very nicely. In fact, Tower and Engman-Taylor up here are actually on track to exceed our weighted average cost of capital in their first full year of operation. So those are off to a good start. The third here, Buckeye Tru-Edge, which is one portfolio, still very early. The acquisition was just done a month or 2 ago. I'll talk a little bit more about the goals that we had set for our fiscal '23, again, running from September '22 to August of '23 and really a continuation of building on the mission-critical targets that I had mentioned before. So that's continued growth above IP and operating margin expansion at most points along the framework that John will touch on a little more in some more detail. Our assumptions for fiscal '23 at the time we laid it out range because we did give a range, ranged from a slightly contracting Industrial Production Index on the low end to a flat industrial production index on the high end and assumed roughly 200 basis points of the acquisition impact from the deals that were noted above. The other thing I will call out about fiscal '23 is we did use the last quarter or 2 as an opportunity to tighten up our capital allocation framework. So we sort of gave a handful of priorities. Priority one, is reinvestment into the business organically to the extent we see high-return projects, which we do. The second priority is continued ongoing growth in our ordinary dividend. And then from there, 2 priorities, that being share buyback and branch-based tuck-in M&A that we look at kind of together on a risk-adjusted basis. In terms of our framework, what I'll say, and I do have to be careful because we are in a quiet period, and I have to go back to our comments as of early January, but at the time of our last earnings call, we did say that we saw industrial demand as being stable. And certainly, looking outside the company to macro indices, we hope that continues. I'm going to turn things over to John now who's going to cover our financials, and then I'll give a brief wrap up before some questions.

Thank you, Erik. So this slide is really intended to give you the history, if you will, 10 years and even longer than that on the revenue, operating income and gross margin look. I think what you can see on this slide, importantly, is the impact of our strategic programs and mainly Mission Critical. So you can see that, for instance, revenues are back in grow mode since 2019, basically, our OpEx to sales ratio is declining. That's the light blue Line and our operating margin is improving. That's the red line. On the right side of the graph, you can see that we continue to generate healthy levels of both operating cash flow and free cash flow. Now I'll talk a little bit more about that in a minute.

That was clear.

I'm not sure why that's showing that way. Well, the idea here was to dig a little deeper into sales. And what you would see is basically in about -- from about 2020 on a separation of our sales growth compared to the IP line. So before that, they were kind of flat or even, if you will. But through the Mission Critical programs, the organic sales have increased above -- and our goal is to get to at least 400 basis points of outgrowth over IP by the end of this year and in essence, through the cycle. What I would have also said that you would be able to see is that, yes, a lot of that growth was price last year. What gives us confidence about the future is that we know internally that our various growth programs, particularly the solutions-oriented ones are not yet firing on all cylinders. So even as inflation tempers this year potentially, and it looks like that's what it's doing a little bit, we still believe there's good unit volume growth that will come from our various growth drivers. This is turning to our balance sheet, I guess. Our balance sheet remains quite strong. This gives you a little more recent -- our last quarter, where we generated about $50 million in free cash flow. This also allows us to do things like Erik mentioned, growing our ordinary dividend which we last quarter, increased by 5%. We typically just increase it once a year. So it's increased for all 4 quarters for the coming 4 quarters. And our net debt is quite low with our leverage ratio being just a tad over 1x. Well, I'm not sure. I think you hit our -- Erik hit our capital allocation strategy here. So not sure there's a whole lot to say here, but you mentioned the deprioritizing of the special dividend. That's something we did a quarter ago as a result of an investor perception study we did. We always want to drive organic -- sorry, ordinary dividend growth and invest in organic growth investments as much as possible. But now with the deprioritization on specials, that leaves more cash flow to be used for share buybacks and M&A. And you've seen the M&A. At some point, you'll see the share buybacks. Oh, the other thing I would mention here, actually -- as Erik mentioned, we made ROIC a key financial target as part of Mission Critical. We've also included that now ROIC as a metric for the management performance share programs. So kind of putting the money where the mouth is, what gets measured, gets fixed or gets improved. I think here, Erik kind of went through some of these as well in some of the slides. This is the fiscal '23 outlook. So he mentioned the 5% to 9% ADS growth. The adjusted operating margin of 12.7% to 13.3%. For me, importantly here, and I think for you as well might be the fact that basically at all points in that range, if you back out the 20 basis points from the extra week because we're on this fiscal calendar, so we had an extra week of business last year, it would evidence expansion of operating margins all along that range. And that's pretty much it. I'll turn it back to Erik to close up before we open for Q&A.

Thanks, John. You've asked 1 slide. So Look, I think you could read the slide and it's just sort of a recap of what we discussed. I thought maybe hit on a couple of things sort of looking ahead that may be not so obvious from the numbers or the slides that have me excited. Number one is there's momentum building inside the company right now that if you were in the walls of the company, it's an exciting time. We feel like there's been an inflection in performance that we're building on and are excited. And I think related to cultural shift, the management team. I've been with the business 25 years plus, but our senior executive team is largely new and I think they're bringing a boldness to the aspirations we're setting for the business and what's been exciting is seeing our team rise to the challenge. So we're coming to the end of our 3-year targets at the end of our fiscal year here. And certainly, we're going to refresh and offer a new set of targets for our next fiscal year and beyond. But I think more importantly is the mindset inside the company is shifting from making Mission Critical a program to turning it into a continual improvement mindset. So I think with that, it is an exciting time. The last point I'd make is I think it's a compelling time to look. There is a relative discount valuation on the stock. It's an interesting time to be looking at the company. I think Sam, with that, I'll turn it back to you and see if there's any questions.

Yes, terrific. I think for folks that are less familiar. You have a vending operation, you have implant or what some other folks might call on-site. You also have a consumables business with fasteners. I just described what a lot of folks know about Fastenal. So could you talk about differences between your offerings and value proposition versus Fastenal as an example in those 3 areas?

Yes, sure. Yes, Sam and I think the starting point would be going back to the repositioning of the company. If you went and looked at NMSC a decade ago, the value proposition, when I mentioned the spot buy or long tail supplier would have more been strictly around the availability and the next-day shipping in the customer service. And to your point now, most of our customers, our bread and butter customers are now getting a lot more value. The equation becomes less about just availability of product and more about helping our customers improve their operation. You mentioned a few of the key ingredients, our vending program, our consumables business and our implant program, and you're saying sort of comparing those to a Fastenal. I think, look, I think the -- each of us in the market, I mean, you could find other competitors beyond the 2 of us that are doing bits and pieces of that. I think for us, kind of the secret sauce, what binds it together is 2 things that I mentioned during the remarks. One is the customer focus. So all of those programs for us are a means to an end as opposed to the end in and of itself is not implementing a vending machine and putting people inside of a plant. The end that we're obsessed with is improving customer productivity. And our customers tell us how they want to measure that. In some cases, it's cost out. In some cases, it's increased throughput or reduction in lead times, but that's really the focus for us. And we have a continual improvement process that we work with our customers that each quarter, we're going back and laying out new goals, implementing some of these programs and then measuring them like crazy. So it sounds simple, but that's probably the first thing that I think distinguishes us. And then the second one, Sam would be relative to our peers, I think a more technical overlay because of the heritage of MSC, metalworking products tend to be highly engineered and highly technical. So our sales force is in the thousands, but several hundred of those people, as I mentioned, have years or decades of machining experience. So they're going into the plant and not just putting a machine in place but are actually walking the plant, auditing the plant and making performance recommendations that improve output.

Questions from the room here.

Last quarter, you -- for the first time, at least in my memory for a few years, talked about the importance of a vendor line review process, which is not something that we've heard at least from a post-COVID standpoint. Talk about what that process is, how it may differ. You clearly go through that on an annual basis is as you called it out specifically this time. You also have the 4 major metalworking vendors. How does it work with those versus the more of the MRO suppliers if you could explore that with us?

Yes. Sure, Sam. Great question. So yes, maybe I'll start with the impetus for it. Obviously, as a distributor, doing a line review, it's kind of SOP over time. But I will say, really since once COVID started, our normal category management playbook was out the window. And for the most part, our priorities were on securing product because we felt like availability was king and queen and that would allow us to capture market share and customer relationships. And then the other big priority was making sure that we stayed ahead of inflation. So there was a heavy focus on availability and on pricing. And look, I applaud the team. I thought we did a really good job during COVID. Coming out of it, we see a real opportunity here to take a fresh look at our product lines. And the goal here, to be clear, the first -- the first guardrail or priority is for each product line that we take a look at is to optimize the customer experience. The second guardrail or priority is around improving -- streamlining operations and improving purchase costs. But this is not going to be an exercise strictly in narrowing down the portfolio. It's really going to be around what is the optimal assortment and mix of business for our customers. And we think that the answer is going to vary quite a bit by product category. So the way we're approaching this line review initiative is it's not going to be one size fits all and it's not happening all at once. It's happening in waves. We're right now in wave 1, where we'll take sections of our offering by product line and go through a process to look at the line because in some cases, we probably are over-assorted and have an opportunity to streamline the offering. There's other cases where we may be about product expansion. So Sam, to your point, more specifically, metalworking is an area because it's highly technical, the brands -- many of the brands are really important to us and important partners. So as a for instance, what you wouldn't see us do in a line like metalworking is remove a brand that has a ton of value to our customers and large market share at the expense. -- we wouldn't do something at the expense of the customer. But what I'd tell you is there's plenty of -- even within metalworking, we see parts of our offering where we could tighten things up. We also see a really big opportunity with private brand. So we are today at roughly 15%-or-so penetration across the business, that varies by product line. And we think we have some really good brands that with the proper mix management and moves through line reviews, we think we can take that higher, which becomes a margin tailwind for us.

Which leads me to my next question. So long-term gross margin trajectory, especially now that you've identified an increasing private label opportunity and then the corollary to that would be, okay, now that you -- we're quickly getting passed where Mission Critical timing plays out what might incremental margins realistically look like over the next 3 to 5 years or so?

Yes, Sam and maybe what I could do is even just sort of walk the P&L to say how we think about the growth algorithm in this business because I'll start at the top. I mean, priority one for us is generating organic growth because we are a fairly high-margin business that really produces strong returns. And so if we think about the end markets we play in growing at roughly the rate of industrial production index. Historically, that's been 2%. And there's a case to be made that the future could look better because of reshoring and some other tailwinds, but even conservatively, if we say historic average is what the next 3 to 5 years brings at 2%, we would layer on -- recently, we've been getting a lot from price as everybody has i inflation. But if we take historic averages on pricing and say 1% to 2% there and then layer on our unit volume aspirations, we see a path to get to high single digits on the top line organically. That could certainly be supplemented by these tuck-in acquisitions, but high single-digit organic growth. On the gross margin line, I think flat would be an aspiration. I think realistically, if I look at the trajectory where we're growing and even with some of the tailwinds like private brand, I would expect some modest gross margin dilution. And by modest if we looked at 30, 40 bps, something like that. And the -- we do see a considerable opportunity to generate OpEx to sales improvements in 2 ways. One is leveraging growth because if we're getting growth in the high single digits by itself, that brings OpEx-to-sales down considerably. On top of that, I mentioned the cost -- the structural cost improvements and the continual improvement mindset, which is something we didn't have in the company prior to the last 3 years, which should add to the leverage story. So you put that together and the punchline is we would see an incremental margin picture on our growth of 20% or better as our goal. And then -- so it's high single digits top line, 20% incrementals gets you to low double-digit operating profit growth and then add on to that, if we make smart capital allocation decisions and opportunity to enhance TSR and earnings growth through capital allocation.

I think we're out of time here. So we'll continue this in the breakout session.