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

Okay. Thanks for joining us, everyone. I'm Dave Manthey, Baird's senior industrial distribution research analyst. Today, we have MSC Industrial to present with us today. We have CEO, Erik Gershwind; Martina McIsaac, who is the Chief Operating Officer and President; and Ryan Mills, the Head of Investor Relations. I'm going to turn it over to Erik who is going to go through a few slides here, and then we'll kick it right into Q&A. [Operator Instructions] So with that, Erik, do you want to kick it off?

Great. Thank you, Dave, and good afternoon, everybody. Nice to see you. I will do a brief company overview, and then we can get right into the Q&A. And this is really intended for those who aren't that familiar with the story. MSC is an industrial distributor of over 2 million SKUs and over $3.8 billion in revenues in our most recent fiscal year, which was fiscal '24, our fiscal year runs September through August. So we're now well into fiscal '25. We have a long history dating back to our founding in 1941, and have obtained over time, a leading position within the industrial supply space in the metalworking category, which represents roughly 45% of our sales and is supported by a large sales force with a large dedicated team of technical specialists, which is a good part of our -- source of our competitive advantage. We compete in the North American MRO market, which in total size is in excess of $200 billion, and that's U.S., Canada, Mexico. And interestingly, for a market that large it still amazingly fragmented. So the top 50 industrial distributors have roughly 35% of the market, which means the balance of 65% is made up of local and regional competitors, which shapes a really compelling growth opportunity for us and other well-capitalized distributors. I'll move briefly to our financials and highlight some of the characteristics that make MSC a compelling investment. We have a very strong balance sheet with a net debt leverage ratio of roughly 1x, and very compelling cash generation characteristics, as evidenced by free cash flow over the past fiscal year of roughly 120% for fiscal '24 for fiscal '25. Our current fiscal year, we're targeting about 100% conversion. And this has allowed us to return capital to shareholders in multiple forms. We have an ordinary dividend with a strong yield and highest of our peer group, in fact, and we've shown steady growth of that over time. We have more recently made some enhancements to both our leadership and governance of the company that I think are worth highlighting. One is it was roughly a year ago when we made the decision to eliminate our long-standing dual-class share structure and collapse that, which we did, and we repurchased the share dilution over the course of the past year. More recently, we added another independent board member to our Board, Rob Aarnes, who brings very strong distribution and operating experience with him. And Dave alluded to it, but even more recently, a month ago or so, we promoted Martina, who is with us for the first time who was our Chief Operating Officer to President and Chief Operating Officer. And I'm sure, during the Q&A, we'll have a chance to explain what that means and how it benefits our company. Ryan, if we move on to the next slide, talk a little bit about the strategic direction of the company, and which we outlined as our mission -- what we call our Mission Critical program. And we completed a strong 3-year run of our first chapter in Mission Critical, which ran from post-COVID our fiscal 2021 through fiscal 2023, in which we met or exceeded all targets. And there's essentially to this next chapter Three elements or pillars to the story, if you will. The first pillar is maintaining the momentum that we've achieved in our high touch or solutions part of the business, which I'll get to in a second. The second is to add a couple of new elements to our growth story. And then third is to optimize our cost to serve to ensure that as we restore growth, we can expand operating margins. And we kicked off our second chapter during our fiscal 2024 of Mission Critical in the midst of what was certainly proved to be a challenging operating environment in which we saw deteriorating conditions in our end markets, which are primarily levered to manufacturing and within manufacturing, heavy manufacturing, in particular, and any industry that's going to be consuming metalworking-related products. I am, though, encouraged by the resiliency that has been demonstrated by our team, and we're actually pretty excited about the momentum that we see building and the story we see building, especially as we move through our fiscal '25 into fiscal '26. So let me touch briefly on the three pillars, if you will. The first, I mentioned maintaining the momentum in our high-touch solutions. And the idea here is to bring us closer to the industrial plant floor, our customers plant floor and to embed ourselves into their operations. Two, proof points, I'd point to there, our inventory management solutions, primarily our vending program grew off of a large base at 9% in terms of installed base and signings year-on-year. And our In-Plant program in which we're actually placing MSC associates inside of their operations to help them improve productivity, grew 30% in terms of program count during the year. So the momentum there is strong. The second pillar I mentioned, adding new elements to our growth story. And the biggest highlight here would be our core customer base, which makes up a little over half of the company's revenues, and are small- and medium-sized customers. And there are a couple of lynchpin initiatives set to reaccelerate growth in this core customer. During fiscal 2024, we completed the realignment of our public-facing web pricing to this large segment of customers. And that is now behind us, and we're also in the process of building a best-in-class e-commerce experience with upgrades really continuing over the course of the next 1 to 2 quarters to continue to improve our experience. And along with that enhanced marketing efforts that will begin in our fiscal second quarter and particularly once we get through the calendar, so really the second half of our fiscal second quarter after we get through the holidays. On the third pillar, I mentioned optimizing our cost to serve. So we have several which I'm sure we'll touch on productivity initiatives that are going to build, particularly through the year into 2026 on top of a couple that are already in place on the network front, such as a decision that we made to close one of our distribution centers yielding between $5 million and $7 million in benefits this year. Over time, as we build and look past 2025, our long-range goals remain unchanged, which is to grow organically at 400 basis points or more above the Industrial Production Index, and to achieve 20% incremental margins or better over the course of a cycle, which puts us back on a path towards mid-teens operating margins, which is our goal along with 20% returns on capital. So at the highest of levels, that's the story and the outlook. And I think Dave, I'll maybe turn it over to you for some questions.

Sounds good. So first, a couple of questions, pretty standard. We're asking everybody. You mentioned you hadn't heard anyone ask you about tariffs or the election or anything. But let's start there. Maybe you could just talk about any potential fallout from whether it's tariffs or something else related to the new administration.

Yes. Surprised to hear you ask that. And maybe for context, I think, just reiterating the lens with which MSC comes from, so 70% of our -- nearly all of our business is North American, of that 70% of our revenue base is into manufacturing with most of that being heavy manufacturing. So think machinery and equipment, automotive, aerospace, and the like. Fabricated metals, job shops and the like. So from our perspective, before I get to the election question, maybe just even looking back, we saw pretty steady deceleration through our last fiscal year of those end markets. And a couple of things going on, certainly, the sustained high interest rates catching up and caution that we see every 4 years around -- leading up to an election cycle. So there's some of this that I think probably you're hearing from most companies at this conference that just getting through the election regardless of outcome is a relief to everybody. In general, though, given our exposure, anything that's going to be done to encourage manufacturing in North America here in the U.S. is going to be likely a tailwind for us. So we think that's certainly a net positive. I think our whole take on this is a net positive. The other big one wildcard you mentioned is tariffs. So from an exposure standpoint, MSC sources under 10% of our products directly from China. But we're also mindful that many of our products we sell are branded industry manufacturers who do business. So there's going to be an indirect effect that's much larger for anybody. Over time, if I look back at past cycles, Dave, as you've been covering this industry a long time, inflation, and it certainly seems like it could lead to inflation has been a distributor's friend and has been more tailwind than it has headwinds. So assuming that plays out, as I suspect it would, I think, it's a net positive for the company.

Yes. Sounds good. I think, I've heard from some that they're anticipating greater-than-normal or maybe normal year-end shutdowns, turnarounds, things like that. What do you think, what are your views on that? Are you -- when you talk to customers and they say, yes, we're -- and I haven't even looked at where Christmas is placed in the weeks sort of thing. What are you anticipating for year-end shutdowns this year?

Yes. So we definitely looked at that. And Dave, again, before I answer, which I will answer that directly. So we announced we're on a sort of a different cycle, but we announced and gave a guide for our fiscal Q1, which runs September, October, November. And normally, the last few years, we've been giving sort of an annual outlook. And we felt like with all of the uncertainty swirling with the softness we had seen, we made the decision to keep it to a quarter because we thought it would be really difficult, number one, to project the macro, and number two, we think we have some exciting self-help initiatives to improve our performance, some of those, it's difficult to say when they come online. So we shrunk things in terms of a guidance perspective. In terms of December, and we gave a little bit of this commentary on the call that it wouldn't surprise us. So there's the euphoria post-election, but it leads right into the holiday season. And typically, when our customers are soft, they will use holidays as a time to do shutdowns and extra vacations. That's what we're expecting. You compound that, Dave, so Christmas and New Year's this year fall on Wednesday. So usually, when that happens, those last 2 weeks of December are pretty slow. So it wouldn't surprise us if December is soft. And I think from our perspective, the real telltale signs about how quickly will there be the bump or any sort of lift will tell after the holidays. The challenge for us, by the way, we'll be giving our next earnings call on January 8. So we'll have -- the first week in January will be a little bit of holiday noise, and we'll have like a day or 2 under our belts before our earnings call to get a read on January.

Yes. Well, that's important to note. I hadn't thought about that. And I know when that happens, that does tend to lead to some strangeness around year-end, Wednesday, people taking up before it, after it, the whole week, whatever, right?

Those two usually -- history would say those two weeks become really abnormal...

Yes. Okay. It's good to know. Well, Martina, we have you here. This is great. So exciting. And I know the question is always, well, what are you going to do different? Is there anything -- and I know, but just functionally, is there anything with your new -- this new title, does anything in your function changed? Or is it just a formality? Tell us just about what it means for you.

Very good. So yes, when we created the COO role, and I think our last COO was Erik a while ago, right? So when we created the original COO role, it was with the intent to try to look at our business end-to-end and build an operating system and a process foundation that would let us continue to drive productivity. So with this change, we bring the last of the functions together, so in particular, technology and marketing. So we will join the group. And so that was a big change. In '24, we had a few stumbles around our technology group, and it just showed us that it was really important that they'd be closely integrated with our sales team and with our product teams. And so bringing that together is one of our goals.

Well, can you talk about the sales force and if there's any changes happening there? I get the sense there's -- it's kind of a point of cognitive dissonance at the company given that it feels like you don't want to do too much because you don't want to upset the sales situation, but it seems like there's some work that you may need to do. Can you just talk about how you're striking a balance between those two things.

Yes, absolutely. So Erik mentioned that reenergizing our core customer is one of our key initiatives. And part of that is how we support the customer digitally. And so he talked about that, some of our web enhancements. Part of it is our pricing, and we spent a lot of time last year bringing our pricing into a fair and credible range. But part of it is also how we cover those customers in the field. And so he also used the word self-help. Regardless of the macro, we feel there's an unlock in terms of sales effectiveness and how we deploy our field personnel. And so we're looking right now at territory redesign looking for situations where we have under capacity or overcapacity, matching our deployment to our customers' locations. And we think that will allow us to access about $300 million of additional potential without adding heads. So that's the kind of self-help that we're looking for right now. And of course, the first question like you say is, what about relationships, how sensitive do we have to be, and we're taking our time. We're doing it in a very planful way. We're not disrupting any major relationships. We're looking sort of for the long tail of portfolios and reassigning those and we're taking our time. So these changes will be implemented over the next couple of quarters. But we really do see an opportunity for increased sales head -- productivity per head.

Got it, Okay. I'll check the iPad here, but if there's any questions, feel free to raise your hand and -- no, no questions. Okay. We can keep moving...

Erik, just is Interested in listening to what you have to say, Dave...

Yes, I doubt that highly. But the -- you mentioned earlier the productivity enhancements and the initiatives you have going on, some cost-cutting efforts. Can you talk about those in the context of as we look to fiscal 2025, how you hope to offset some of the, I guess, the annual just normal operating expense increases.

Yes. And I think important to understand the value creation story with this company right now, we believe, is really around fiscal 2026. And moving forward. So 2025, which we're in now is a bit unusual. Number one is the environment continues to be soft. And hopefully, we see that turn. We have a lot of the self-help programs lined up, but we come into the year with contracting revenues. And at the same time, there is an operating expense step up from '24 to '25. And there's a couple of reasons for that: idiosyncratic things, company-specific things, one being incentive compensation and a reset of our bonus accrual, which is a big step up. There's sort of onetime in nature, Dave. And I think if our goal was to optimize 2025, we would be in a different playbook right now than we are. But what we see as we look out is we get past 2025. Number one, some of these expense idiosyncratic things normalize. So our OpEx sort of returns to a normal cadence as we move past 2025. And then on top of that, there really are on the revenue line and then on the productivity line, several programs in flight that Martina primarily is driving that will start to build as we move through the year and move out to 2026. So if I were to work my way down the P&L, we've been in a soft environment getting hit particularly hard by our heavy manufacturing exposure that at some point, I can't tell you one, but at some point, that does turn. The MBI, which is sort of like the PMI. It's the metalworking version of the PMI index has been negative for 20 or 21 months in a row and severely negative, like 43 and 44 readings, like history says -- I don't know when it changes, but history says that won't last. So that the environment will normalize. And then we talked about some of the programs we have that we really feel like will give us outsized benefit on the top line and then a more normalized expense cadence with the productivity on some of the supply chain initiatives that Martina has moving really sets us up nicely to get back to the kind of growth and margin expansion that we expect of ourselves and that we delivered in Mission Critical 1.0, if you will. So that's really the story, is about setting ourselves up for a run for fiscal '26.

Okay. And then could you talk about the web enhancements and the marketing initiatives and the things that going with that, there was a delay. And I guess that might be part of it why we're being in August fiscal year it's not that far off. We're talking about 2026. So can you talk about how those roll out, what those look like? And then what the expected outcomes are once you get to the other side of this after you've adjusted pricing and you implement these changes.

Yes, sure. And Martina, you can certainly chime in, I'll take a first step. So no question, as I look back to 2024, part of our story, I mean, we were not pleased with our performance. Part of it was macro and then part of it was 1 or 2 self-inflicted things, particularly in this area in technology, where our website upgrades, which the web has been a source of competitive advantage over the years for MSC, an important part of our value proposition. Just were slow going and rolling out. We are now -- it's basically, Dave, week by week, month by month. It's an area that I have dug into. So Martina mentioned her new organization, inclusive of technology. One of the nice added benefits to the reorganization, if you will, Martina and I work really well together, and it's freed me up. And one of the things that we do is identify areas where I can kind of like dive in, working with Martina and the team and given my experience at the website, that's one of them. So we're getting back to a cadence of just ongoing improvements and upgrades and releases every few weeks. New features. That will continue. That will continue through the fiscal year, but we feel like we're back to a good cadence. What we did -- what we have been talking about is enhancing our marketing efforts beginning our fiscal second quarter. And we expect that to happen. I mentioned it will probably be after just given what's likely to be holiday noise after the holidays. And our marketing efforts, if I think about the formula here of how does e-commerce become once again a growth engine for the company, it's a mathematical formula of how many people are coming to -- what's traffic like? How many visitors are coming to the site, and then what's the conversion rate for those who come to the site? And then once the conversion rate happens, what's the average order size? And we're looking along all three dimensions to how do we once again -- and internally, we have a quantified plan for each one of those three. The traffic will primarily be through marketing efforts, our list price positioning that work we did last year helps. And then the conversion and the average orders are a function of the continued improvements to the site that are happening now.

Sounds good. We have a question here.

Where are your margins today? And where could they be 3, 5 years from now as well as the [ reasonable ] expectations. It sounds like you're saying that [indiscernible] is getting a bit better, distributing something on the number is getting a bit better. So where are the margins today [indiscernible].

So today, we haven't given a full guidance, Ryan, just share where we finished in fiscal '24.

Yes. Op margin was 10.7%. And our first quarter guidance, the midpoint -- the range was 7% to 7.5%. And as Erik mentioned earlier, our long-term goal, which we feel confident in achieving is operating margin in the mid-teens. We didn't put a time frame on that. But the way to think about it is our target is 20% incremental margins over the cycle.

So if that's all true. You are generating a massive amount of debt [indiscernible] higher than your income. What's the highest [indiscernible] 3 to 4x debt-to-EBITDA today, buy back all the stock and then have shareholder [indiscernible].

So we -- our view on leverage is we've always been fairly conservative. And so we run at 1x. We have gotten as high as 2.5x, 3x temporarily, I'd say, but not on a steady state.

But that logic is based on the fact that you have [indiscernible] public company. Has that mindset changed over time? Or is it not changing? Or is there something about the business I am not understanding. It sounds like you have gone through difficult times and you have still done an incredible job of generating massive cash flows even in difficult economic times. Difficult times for your business. Can you [indiscernible].

So just one caveat I would say is that, so the way our business like many distribution businesses work when revenues decelerate, we generate more cash when they accelerate, we actually consume more cash. So if we -- it's one of the reasons for the dry powder. And by the way, just to be clear, buybacks are absolutely part of our priority scheme here in terms of capital allocation. But one of my hesitancies and our Board's hesitancies to just lever up to 3x, 4x now would be in the event of a snapback, which we're all hopeful for, whether that's macro or micro induced, we start consuming cash pretty good in terms of receivables and inventory.

[indiscernible]

More or less. It's still a nice cash-generating business. But during the period of a snapback, we do consume cash.

Erik, maybe you could share with us what percentage of MSC today is federal government, specifically sales.

So Public Sector overall is roughly around -- it moves around a little bit, Dave, but around 10%. Of that, Ryan, have we shared our breakout or...

But directionally, more than half...

More than half is federal.

More than half. Okay, yes. So with the new administration and with whatever Elon is going to look at, you could look at it one way or the other. One way is if they're targeting eliminating waste, and you're talking about reducing consumption perhaps. You're talking about maybe reducing the number of departments perhaps. So there's a potential for a downdraft. Flip side of that might be if I'm looking at efficiency and I'm buying from 100 distributors, I can focus that with the most efficient, most value-add distributors, and that might actually benefit MSC. How are you thinking about it today?

I think both statements are probably true, Dave. I think the other nuance I'd add in here is the portfolio. The government public sector business is a very broad array that can look very different. So where you're going to find MSC is even within the federal government, it's going to be in places that look -- resemble more like our position on the manufacturing plant floor than just an administrative or office environment. For example, military bases. The dynamic there is probably different from where the waste, I would guess, where the waste is going to get targeted for consumption reduction. So I feel pretty good about our portfolio on the federal side. But I'm sure both of those factors will also be in play. And I think, I don't have a good answer for you yet as to how that plays out in terms of headwind or tailwind, but we feel pretty good with our portfolio on the federal side.

And then in terms of vending and In-Plant. I mean that's been a bright spot, I think, going through -- we're going through, you keep -- that continues to become a larger portion of the business. You're seeing good growth there. Could you talk about where you are today, how you feel about it and what the outlook should be there?

Dave, we feel really good. And the company with our Mission Critical program intentionally made a pivot as I mentioned, to become higher touch, more technical and have a greater presence on our customers' plant floor. We think it deepens the moat around the company. It's helping our customers. And those are two good examples. Interestingly, as successful as we've been with them, I mean, even during fiscal '24, there were also illustrative of some of the softening we're feeling because Ryan has been making the point, vending signings plus 9 last quarter, vending average daily sales were flat. So if you think on a per machine basis, it's down high single digits. And those are customers that we're deeply embedded with indicative of just consumption reduction. But those are both areas that we have the foot on the accelerator. It's adding value to the customer. And what we're excited about is at some point when the environment normalizes and the heavy manufacturing markets restore, we should see an outsized benefit because we get the benefit of the end market coming back and then the embedded market share capture with the In-Plant and the vending program where today's spend is suppressed. So they're absolutely top priority for us to continue.

And in terms of those -- I mean is it auto? What is the -- and I know you don't sell primarily to the -- just the manufacturers themselves. You sell to sort of Tier 1 and Tier 2 suppliers and sometimes that gets lost in metalworking. But when you're saying that when metal working gets better, what are you thinking about is what would be the key indicator for you as to what that looks like?

So today, the softness, Dave, is fairly broad-based with the exception of aerospace. But -- so examples of end markets that are driving some machinery and equipment would be things like the agriculture, which in our Midwest regions is a fairly sizable percentage of our business. So I think the Deere and the Caterpillars, all the tiers down in those supply chains are quite soft. Heavy truck would be another one. Automotive would be a third. In terms of a leading indicator, amazingly, the sentiment surveys have been fairly predictive over time as good leading indicators.

Meaning, the MBI and ISM.

Yes. Meaning if we start to see turns there, they have been over time, fairly predictive of when does end market demand start to pick up.

All right. We'll stay in tune for that. All right, everybody. Thanks for joining us. Thank you.

Thank you.

Thank you.