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

Perfect. Great. Well, thanks for joining us here today, everyone. We're joined by Erik Gershwind, CEO of MSC Industrial; and Ryan Mills, Head of Investor Relations. So for anyone that's unfamiliar with MSM, Erik runs the largest distribution business in North American metalworking markets with about 95% of sales here in the U.S. They offer a broader array of cutting tools and metalworking products. It's about 45% of sales and the remainder would be other MRO products that key business is running, largely in manufacturing end markets, like aero, auto, machinery and metal fabrication to name a few.So with that, Erik, I think I'd like to start with an update on trading conditions and what your conversations have been like with customers in the past few weeks as we've been dealing with all the tariff volatility and noise out there?

Ryan, so thanks for hosting us, first of all. I wish I had more insight to offer than I will because the story will probably sound familiar. But I would say -- and maybe as a point of reference, so we last reported earnings. We had the pleasure of scheduling our earnings call for the morning premarket after a liberation Day announcement post market. So it was a rather interesting call that had one subject and one subject only. I would say since that point in time, though, the discussions have been fluid, uncertain and agile is the way I would describe things. So we sell -- Ryan did a nice job summarizing the company. Most of our revenues, about 70% of our revenues Virtually all of our -- almost -- nearly all of our revenues are into North America, mostly U.S. And of that, we are about 70% into the manufacturing industry a large portion of heavy manufacturing. So all of the end markets that you'd expect to find aerospace, automotive, oil and gas, heavy equipment and machinery, metal fabrication and so on. So take it with that context, but it's been really fluid. Unlike we -- leading up to the tariff headlines, we were sort of preparing -- we had a playbook from the last iteration of tariff 1.0 and we had a playbook ready. What I would say is the playbook has largely remained intact. It's just had to be modified and adjusted on a daily basis, which is how we're operating. But our customer base remains uncertain and the situation remains fluid, as you'd expect.

That all makes sense, and it's a good segue into the next question of how does the news of a lower China tariff rate change your game plan or outlook for the next few quarters? And maybe you could remind us like what amount of price are you seeing from your suppliers? What should we be expecting for the back half? And maybe how do you see that playing out [ if ] tariffs do dial back? Is there some rollback there?

So another maybe point of reference for the company. So of our -- from a sourcing perspective, our cost of goods are from China where we are the direct importer of record. So that percentage would go up where we're not the importer of record as a distributor the majority of our sales are products for resale from industry brands who may be sourcing from anywhere. From what we source directly, it's about 10%. I would say pricing, once again, has been a bit more unusual than it has been in the past just because of the uncertainty and kind of the lumpiness of how things have rolled out. So we -- ourselves, where we're an importer of record, took an increase late in March. Relative to past cycles, though, where we would have expected to go broad scale, significant price moves in big chunks. This go around, we're taking kind of a more scalpel-like approach based on what's been happening so we can avoid having to roll things back. So -- and I think that's been true of our manufacturers, our supplier community, manufacturers of the products. They've been less reluctant to go all out with big price increases because of the uncertainty and where there have been pricing moves and there have been some, and we pass those along. It's been a combination of pricing and surcharges more so than we've seen in the past. The only thing I'll call out, Ryan, is our industry, and I speak on behalf of MSC and then our industry as industrial distributors have been historically very good at passing pricing through. I would expect that to be the case all the uncertainty notwithstanding, expect that to be the case this time around, too.

And you'd be passing through price. Is that maintaining the margin or dollar for dollar? Just clarify that.

We certainly would -- our goal is the margin, not just the dollar for dollar.

Great. Makes sense. And tariffs have certainly been a topic of conversation for you guys added another kind of layer of complexity to the business. I think if we maybe just step back, could you just talk about how you feel better positioned to manage through things today versus, say, 5 years ago where you didn't have Kristen in the CFO role, Martina, COO and President, more, I guess, firepower in the leadership team.

Yes. So I've been CEO of the business for -- it's now going on -- sort of like dog years, like 13 -- 12, 13 years as CEO, I've been in the business for over 25 years. And over the past few years, as you mentioned, particularly the past 3 years, Ryan, we've really put an emphasis on building out bench strength at the leadership level. And so Martina McIsaac came to us about 2.5 years ago as our Chief Operating Officer, which is the first Chief Operating Officer we had since I filled the role about 15 years ago. And our CFO, Kristen Actis-Grande, has been with us about 4.5 years. And the 2 of them, Martina has since taken over as President in the fall and really with a charter to improve performance on the base business. And so she has all responsibility for the day to day. She partners with Kristen and it's given me time really to focus on strategy, on more direct interaction with all of our stakeholders and team development has been. So I think, actually, from that standpoint, much better positioned than we were from a leadership standpoint.

Great, that sounds like a positive change. And I think one area that you've been clear that has been more of a focus for you with this, I mean is reinvigorating growth in that core and other customer group. Could you maybe just talk about what you view as kind of -- what are the 1 or 2 things that need to be achieved to unlock better growth there? Would you say website enhancements is one of those areas of focus? Or are those largely underway at this point?

Yes. Maybe -- what I'll do, Ryan is maybe I can take a step back and just talk a little about the company's growth agenda. We call our growth program, our mission-critical program and mission-critical 1.0 was a 3-year period that ended in our fiscal year runs September to August. So we're squarely in the middle towards the back stages of fiscal '25. But through the 3-year period, fiscal '21 through '23, we saw really strong organic revenue growth, which our benchmark there is 400 basis points above Industrial Production Index, and we were at about 500-plus and operating margin expansion. We are now in mission-critical 2.0. We've had a rough 18 months. And so really a combination of two things, I would say, macro softness with our portfolio exposure, metalworking products, manufacturing markets have been really historically soft in terms of the length of time a protracted 24 months and then some execution issues that we've since shored up. But basically, the mission-critical program has 3 priorities to it: Number one is to maintain momentum in what we refer to as our high-touch portions of the business. So MSC, if I go back a decade ago, would have been more of a spot buy supplier, catering to unplanned customer needs, next-day delivery, great service and a great product offering. And while those things are still intact, we felt like that was no longer -- those were becoming more table stakes in the industry, and we were hearing a cry from the manufacturing community for productivity, help to run their businesses better. And so we have been on really over the past decade an aggressive campaign to migrate MSC to play a much bigger role inside of manufacturing customers. So today, you would find MSC inside of our customers with technical experts, with sourcing people, with vending machines or inventory management, industrial-grade vending machines. So it's a very different face to the customer. So the first priority is to maintain momentum there. And two data points I would share. One is our vending or inventory management footprint continues to grow. So that business products running through a vending machine are around 15 -- a little over 15, Ryan, [ is that ] right, percent of revenues and continuing to grow the footprint there, continuing to grow at close to a 10% clip year-on-year. The second one is a newer program but fits into this high-touch priority, and that is our implant program, where we're actually placing full-time MSC employees inside of our customers. So this would have to be a larger customer, certainly to justify the cost of a full-time person, but that person is playing the role of store room and tooling management of procurement of put away of some value-added services like kitting and technical expertise. And we think we're really tapping into something there because our customer base who are manufacturers, all of them are challenged with labor and -- skills gap and a labor shortage. So we're certainly tapping into something that program pre-COVID was low single digits as a percentage of revenues. As of last quarter, it was 18% of revenue. So we want to continue momentum there in that portion of the business. And just an interesting data point there is so that program is growing in terms of signings and a footprint over 20% year-on-year and yet revenues on a per site basis are down in the double digits. And I think that's illustrative of what we see happening in the heavy manufacturing end markets with reluctance to spend. But we feel very good about that footprint. We see sort of what we refer to as a coiled spring effect building as the environment restores. We get through some of the tariff noise that there's a lot of latent growth potential there at very low marginal cost. So that would be the first priority. The second priority I'm getting to -- this is a long-winded way of getting to your answer is around reenergizing growth in our core customer. So this is more back to the legacy MSC sort of traditional spot by business. And our core customer makes up roughly 50% of revenues. And it would be small and medium-sized customers. So the other two, there's core customers. The other ways we chunk out the business are National Accounts and Public Sector, both of whom tend to be larger, more sophisticated buyers with more complex contracts in place. There's a stickiness factor there. The small and medium-sized customers are where we've lost ground and have an effort to reenergize growth there. And the nice thing about that is to the extent we can get that going, it's higher gross margin, lower cost to serve. So there's a lot of goodness there. And there's really 4 priorities. You had mentioned the web, but there was 4 things that we felt needed to be in place to restore growth in our core customer. Number one is our public-facing pricing or web pricing to the marketplace, which, over the years, had gotten high as we offer more value-added services to the large customers. We executed successfully a [indiscernible] about a year ago. And our goal is certainly not to win business on price because we sell on value and total cost savings, but not to lose business on price. So price reset, number one, that's complete. Number two is upgrading our e-commerce experience to make it world class. It had been world class. It was certainly okay. But as time went on and competitors moved more quickly there, their experience got better. So that upgrade is, by and large, complete. We completed what we said we would complete last quarter. We've certainly learned in e-commerce, you're never done. So the work is ongoing, but the heavy lifting behind us. The third element was marketing program. And we felt like the critical path there was getting the pricing and the web experience to be where we wanted it. We did. So we've launched enhanced marketing efforts, much more aggressive marketing efforts, primarily digital, some print, some human touch. But towards the end of our fiscal quarter, what we had telegraphed on the last call, so beginning really in the February time frame marketing. And then the fourth element to the formula is optimizing sales coverage. So we have a large sales force well over 1,000 people in the field calling on customers that could be medium-sized businesses, albeit not at the size of a National Account and ensuring that our coverage model is optimal -- optimized, I should say. That's one of the areas where Martina has been heavily focused. And we feel like we had shared on a recent earnings call that we can unlock through just some effective productivity techniques in growth without adding to headcount. So those are the 4 elements, Ryan, of reenergizing the core customer base. And then the third of our mission-critical priorities, I'm sure we'll get there at some point is reducing cost to serve through productivity initiatives. And we've got a whole slew of them.

Great. Now that's very helpful, comprehensive answer. Thank you, Erik. Maybe to drill into that the third point that you were talking about with reinvigorating the core and other customer. So the marketing efforts, you've done a lot over the past 12 months and now in more recently in the last couple of months, you've been going out and trying to win back that share. Is there anything, I guess, tangible that you could share with us in terms of like KPIs or metrics that you've seen in terms of the pickup there?

Yes. So look, the ultimate result will be seeing the core customer growth rate restore. And as of the last quarter, and this was right on the cusp of liberation Day, but we had started to see I would say, some sequential improvement after a rough stretch we were seeing sequential improvement in strengthening. But underneath, we're looking at a lot of metrics. So the marketing program, there were some basic blocking and tackling like pricing and web. But then I think the big thing, our business -- so we sell over 2 million SKUs to over 400,000 customers is really primed for AI, both productivity and growth. And so one of the priorities in our marketing effort has been to apply technology -- digital technology and some AI into our marketing efforts. And what that's allowed us to do is get much more targeted, much more personalized and much more real time with the offers that we serve up to customers, whether that's on the website, whether that's through e-mail, whether that's by a salesperson via CRM, but that's probably been the biggest theme that I'd call out. In terms of the KPIs we're looking at, we're looking carefully at customer counts, and we did start to see a nice climb in customer counts and sequential improvements there and a new customer acquisition. We're looking at retention rates and then we're looking at average order value share of wallet. So I would say still early started to see some signs of life, but all 4 -- we felt like those 4 initiatives need to be in place. They're just put in place, and now it's a matter of harvesting them and seeing the results.

Great. And I guess how do you suggest we think about kind of the time line to realizing those benefits? Understandably, this is more of a spot buy model as opposed to more contractual on the National Account side. So is it a quick snapback in your view? And do you have any visibility into kind of where share was seeded with those customers? More a larger player? Mom-and-pop competitors?

So maybe I'll hit that question first and then go to the time line. But the interested fascinating thing about the industrial supplies, the distribution market is so -- it's large and it's incredibly fragmented. So the marketplace in North America is around $250 billion when we aggregate all the end markets and the product categories. The top 50 distributors have around 35% share. So that means 65% of the market sits with regional and local distributors. And I think if you gauge where MSC win share, where we lose share, it generally doesn't vary too much from what the marketplace looks like. So I would say in the case of the core customer, it wouldn't look too different from how the marketplace would shake out. In terms of time line, and obviously, we put environment to the side and let's assume things normalize. I mean we'd expect to start to see improvements, to your point, Ryan, it's not like a contract win where there's an on-off spicket where it happens overnight. This is probably more gradual, but we would expect to see a building improvement in our core customer growth rate and in growth spread relative to IP.

So clearly, a lot of momentum building in the core and other customer side. I guess maybe we could just spend a moment on the other 2 customer groups with National Accounts, Public Sector. You alluded to earlier on National Accounts. You've seen very strong KPIs there. In-Plant signings growing double digits. Vending installations also growing double digits. How do you think about the like a near-term or midterm growth algo for that part of the business in that regard? And I guess, similar, if you could touch on Public Sector, where we've seen double-digit growth roughly through the first half of this year, how do you think about forecasting that for the second half?

Yes. I think National Accounts, which is around 35%-ish of our business. And by national accounts, our definition these are companies with multiple buying locations where there's a program in place typically with the potential to spend in the 7 figures. The value proposition we have there seems to be resonating really well as evidenced by the inventory management, the vending growth and the In-Plant growth. And our growth rate has been suppressed there relative to where I'd expect it. And I think there, the execution has been pretty good. The value proposition is resonating. So Ryan, that's an area where, as things restore, I would expect to see improvement. So just back to the In-Plant example, 18% of revenues, 25% year-on-year growth in signings and yet Ryan likes to point out that the In-Plant -- if you take the revenue growth of the pool, it's only up mid-single digits. So again, down low double digits on a per location basis. We think there is a lot of growth -- share capture embedded there that's just waiting to get unlocked with some improvement in the macro. So we feel pretty good about -- and I had mentioned some of the sales changes we made. We did this in waves, not all at once. Public Sector came first at the end of our fiscal '24. National Accounts early in '25. So we feel like the sales changes are complete. The value proposition is strong. The footprint is in place. So we would expect strong growth as things restore. The other one you mentioned, Public Sector has been actually a shining star for us, double-digit growth most recently. I think that's a combination of some of the sales changes that were made there along with strong contract wins. Look, if we had the guy up here who runs our Public Sector business, and I'll tell you, I would expect -- I expect that of the group, the double-digit growth would be the rallying cry. He may get a little squeamish, but that would be certainly our long-term goal.

And it seems like you felt really no impact from stimulus rollback or DOGE implications there?

So I would say a little bit of noise but not a lot. So of our Public Sector business, we are about 2/3 Federal, 1/3 State. So the -- obviously, you'd be looking at the 2/3 Federal. We saw a little bit of near-term chop in the quarter last quarter. But big picture, obviously, still pretty good. And I think the reason is that when we focus on Public Sector, we're focused on business that is consistent with our high-touch value proposition where we want to be close to the customer, helping them. So a lot of our federal business is military, Department of Defense and a lot of it, you would find not just the transactional relationship but you'd have an MSC presence on a base, for example, our In-Plant program.

So I guess as we wrap together those comments with everything we've gone through with the core another customer, how are you thinking about the time line to ADS inflecting positive today? And getting back to outgrowth versus your IP benchmark, do you think this divergence between MSM growth and IP benchmark goes away in the next 1 or 2 quarters? And then mid-single-digit growth in '26 and beyond? Or how should we be thinking about things?

I would certainly hope so, Ryan. Look, I think that to some degree, the macro will play an influence. We don't feel like we need a robust environment to get back to the kind of growth above IP. We just need more of a stable environment, particularly in the heavy manufacturing end markets. So if we get past the tariff noise and that happens, that is certainly our expectation. I think from a margin and operating margin expansion standpoint, our goal is 20% plus incremental margins on growth. We feel like -- so our fiscal year '26 will begin in September, we feel like we positioned the company where that should be achievable at a mid-single-digit growth range. And then certainly, if we do better as we would hope we do -- there would be more room for expand.

And that's a good entry to kind of the next topic I want to dig into, which is, growth is definitely an important factor in getting operating margins back on the path of expansion. We're kind of compressing to the high single-digit range in '25. How are you thinking about that pace of recovery as sales inflect positive? You mentioned at least 20% incremental margin framework you guys have long term. How do you think about the scope to overdrive or exceed that when you are in the upswing of a sales cycle?

Yes. I think the first thing I'd say, Ryan, step one is leveraging -- restoring growth and leveraging growth. And if we do start to see the kind of growth rate that we would expect to see in any sort of up cycle, high single digit, low double digit, that by itself would improve the incremental margin picture considerably. The second thing is really self-help around productivity. And there's a pretty big funnel that Martina and Kristen are driving right now. We've highlighted first body of work around supply chain. This fiscal year, we had closed the distribution center last fiscal year that provided some benefit without impacting our next-day service promise to our customers. We have another line of sight to $10 million to $15 million annualized that's been building in -- will build in the back half of this year through some other supply chain efficiencies. So that's the first body of work. There's another kind of closely related body of work around freight and transportation costs, which is closely coupled with supply chain for us. There's another body of work in flight around sales force optimization, where there, the play, to be honest, is less of cost down than it is get more revenue, i.e., the path to the $300 million at the same level of cost without having to add. And then there's a significant amount of work in the company right now. Kristen and Martina are driving around productivity, inclusive of AI. I mean, we mentioned, so we have a team fully deployed there that there are so many use cases that there's a portfolio being applied against the largest ones right now for productivity. So when you put that together, Ryan, looking ahead, we would expect to eat into a considerable amount of inflation that we have moving forward.

The only thing I'd add is if we close that gap between the core customer and average daily sales in rest of the business at core customers margin accretive. So that's another margin benefit that is on the horizon as well.

Yes. Definitely a lot of items called out at your back. I'm curious, outside of volume leverage, which of those do you see as like most important for improving SG&A intensity, which has stepped up from maybe high 20s historically to low 30s today.

So outside -- because I would say the #1 most important thing is restoring the core customer for the reason Ryan just mentioned. I would say, outside of that, the two biggest bodies of opportunity, supply chain and sales because that's where the most cost and resources are deployed. And I think we have really fresh looks on both on the supply chain side. And we've been strong historically, particularly on next-day delivery and had a strong team. But Martina has brought somebody in with a terrific background and just he's bringing a fresh set of eyes to productivity inside of the 4 walls of a distribution center and then across the network. And then she's bringing her own fresh set of eyes on the sales deployment, which is how we're going to unlock that -- the path to the $300 million, but those are the 2 biggest.

Sorry, go ahead...

[ And then Erik talked ] to the 18% of revenues through In-Plant -- per In-Plant down low double digits. When things inflect positively, we'll get the pull-through on sales where we really start to lever our fixed cost, the DNA and the salary of that rep where that In-Plant could be at or above company average op margin. So that's another area as well.

And just to clarify that, is that on mature In-Plants like over a period of time, they're accretive to operating margins? How long does it typically take to kind of scale up to that?

The scale up from revenue generation -- from signing to revenue generation to occur it takes about 3 months. You have to flesh out the incumbents inventory, train the rep, get him trained. And then you have about a 6-month ramp to -- you get closer to that contracted spend where it's at where it should be outside of production rates and consumption levels. So it's about, on average, a 9-month lag until you really start to see that revenue shine through.

And then, Erik, you had just mentioned some changes to the distribution footprint towards the end of last year. Do you see much scope to further rationalize that without impacting your next-day delivery promise?

I would say there's probably some -- so we now have 4 major hubs and then some other ancillary satellite facilities. There may be -- I don't see a major step function change at the moment. There may be some opportunity on network. I think probably the bigger opportunity -- and by the way, even moving from 5 to 4, the unlock there was really 2 things that enabled us to do it without impacting the service promise. One was the move to managed inventory as opposed to next-day delivery allows us to stage things out. And the second was investments we've been making into automation. So particularly automated picking was a big unlock for us in freeing up space and relieving capacity in our existing centers. I think the bigger supply chain unlock is likely to come in the form of what happens inside the 4 walls of the large 4 centers, we see a big opportunity there.

Great. And that was actually my next question on -- to what extent have you deployed automation across these facilities. Could you maybe give us like an inning that we're in, in terms of how widespread this is today?

Yes. I would say it's probably third inning or so. There's still a lot of opportunities. So the automation that we put in place is still only in place in 2 of our 4 centers in Harrisburg and Elkhart. So there's runway there. And then outside of picking, there are several opportunities for more automation that would yield good payback.

So still early innings there. We could pause now if we have any questions from the audience, if we could take those. Otherwise, we can continue up here.

I am not sure if I missed that point in the beginning about tariffs. Do you see any increased level of prebuy? And like how do you manage this versus, let's say, first wave we had before the Liberation Day. And how do you compare it and how do you manage the inventory based on that?

So -- and prebuy, not -- our customers [ pre-buy to ] us? We -- in preparation for our last earnings call, we dug deep here, and we did not find a material amount of prebuying. I'm sure there was some at the margin, but what we would be looking for and what we've seen in past times like this would have been a significant increase in large order activity, and we did not see that. So I would say not a ton. It's just been such an unusual time that no one is sure how much to prebuy. And I think about the calculus we went through as a distributor, not knowing what the rules were going to be. So I would say marginal.

Such a low cost of our customers' overall production spend that it might have been prebuying direct materials or somewhere else.

Great. Any others from the audience? Cool. We'll continue then. So maybe we could pivot over to capital deployment. MSM has been extremely consistent in delivering 100% free cash flow conversion or better over the past few years. How do we think about deployment priorities in the near term? Should we plan for a similar rate of shareholder returns in the back half is what we saw in the front half of the year?

Yes. Ryan, I think -- so I'd start out by highlighting what you just mentioned, which is the cash generation of the company has been good. As a distributor, it's great. It's somewhat countercyclical in that regard because we tend to generate more cash as sales drop because of inventory and receivables. So cash flow has been strong. From an allocation standpoint, our formula is more or less the same as it's been, which is there's kind of a 1a and 1b. 1a is reinvestment into sound organic investments into the company. And it basically, they fall along the lines of the priorities that we've already talked about. And to the extent we continue to see those, that's priority 1a. 1b will be consistent increases in the ordinary dividend. And then from there, we've been in a fortunate position to have more cash. I think return of cash through buyback and M&A would both be on the table. I would say that our M&A appetite right now, given what we just outlined, we think that the value creation story is really great. If we can just execute on the priorities I mentioned without doing a ton of M&A. So acquisitions that fold into our core that are relatively small in size, can make a lot of sense, and we've done those quite well. I don't expect right now to do anything big that would distract us from what we think is the best path to value creation. And -- so therefore, that would be the priorities. And I think it would be fair to say from a return of cash to shareholder standpoint, something similar to what you've seen would be a reasonable expectation.

It's very clear. I was going to dig more into M&A, but it sounds like we don't need to do much there, more so just bolt-ons. So I guess, just kind of final question I wanted to wrap up with was MSM has been a public company for close to 30 years now. Could you just leave us with why is now the right time to be investing in your business?

Yes. I think it's a really interesting time. Number 1 is the company took a lot of effort to go through a lot of change in reshaping the role we play in the marketplace and pretty much behind us at this point. So I think there's a really good value proposition that sold, that works and that the heavy lifting to get it done is behind us. Number two, from a timing standpoint, we're coming off of a period of suppressed operating margins right now after the past 2 years. And 2 years of contracted softness in heavy manufacturing. And if I look back in history, I'm not good at judging much of anything and certainly not timing anything, but it certainly would -- one would think we're a lot closer to the end of the cycle than the beginning of the cycle. So I think the heavy lifting to get the value prop is right is complete. I think that the timing from an end market standpoint is probably more favorable than unfavorable. I think we talked earlier the team, the quality of the leadership team put in place is good. And then the fourth thing is given the last 2 years' performance from a valuation standpoint, compared to historical, we're pretty cheap. So I think it's an interesting time.

Well, a lot to be excited about ahead of us. That concludes it for today. Thank you all for joining us. Thank you, Erik.

Thank you, Ryan. Appreciate it.