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About the company

MSC Industrial (MSM) is a leading distributor of metalworking and maintenance, repair, and operations products and services across North America. With an extensive catalog boasting around 2.1 million active, saleable stock-keeping units (SKUs), the company excels at catering to customer needs through various channels, including eCommerce platforms, strategically located warehouses, and regional inventory centers.

Impressively, MSC Industrial's stock price has witnessed a remarkable surge of 22% since hitting a low of $77.99 in March 2023. The catalyst behind this impressive growth can be attributed to the company's robust financial performance during the second and third quarters of FY23. Notably, in Q1 FY23, MSC Industrial reported a 10% year-over-year increase in revenue, driven by a combination of pricing actions, strategic acquisitions, and notable market share gains resulting from their ongoing mission-critical initiative. While the company's revenue showed significant growth, the adjusted operating margin experienced a slight decline of 150 basis points year-over-year, settling at 13.1% due to shifts in customer mix and a lower-margin project win.
 

Revenue Outlook

In Q3 FY23, the company’s revenue benefited from healthy demand in manufacturing end markets, pricing actions, and the acquisitions of Tower Fasteners and Engmen-Taylor. The manufacturing end markets, such as aerospace and oil and gas, are experiencing good demand. Additionally, the automotive industry is showing signs of strength, as automakers are posting substantial sales gains. The recovery in these businesses is driving good sales growth and more than offsetting the weakness in the consumer-facing industries due to rising interest rates and affordability. Despite a challenging macroeconomic environment, the company remains focused on gaining market share during this downcycle. To achieve this, MSC Industrial has placed emphasis on its mission-critical initiatives, including metalworking, solutions, digital engagement, selling portfolio, and expanding into diversified end markets, particularly the public sector.

In metalworking, MSC Industrial is improving its customer productivity levels through best-in-class technical expertise, product breadth, and service levels that continue to drive competitive differentiation. Under the solutions initiative, the company is capturing market share with its vending and in-plant solutions. Vending machine ADS continued to grow 10% year-over-year and represented 15.3% of total company sales compared to Q1 FY23. In-plant signings remained strong in Q3, and sales grew 13% year-over-year representing 13% of total sales. 

MSC Industrial's e-commerce division, which encompasses its digital engagement efforts, continues to experience steady growth. The company recently forged a partnership with Machining Cloud to expand its reach and influence among decision-makers involved in the procurement process. Looking ahead, MSC Industrial aims to leverage its investments to further enhance its digital capabilities and capitalize on the opportunities presented by digital and small customer growth.

In selling its portfolio, MSC Industrial leverages its product strength to increase wallet share by focusing on ancillary products, particularly in the Class-C Consumable Group (CCSG) business. The CCSG business offers services and solutions for consumable items with higher margins, such as fasteners, fittings, and fuses. Furthermore, the company is actively diversifying its customer base and exploring opportunities in the public sector. Notably, MSC Industrial has secured significant projects at the state and federal levels, including contracts serving the U.S. Marine Corps base in recent years. In Q3 FY23, the public sector business experienced a remarkable growth rate of over 80% year-over-year, driven by successful contract penetration and notable wins.

Looking ahead, I believe that MSC Industrial should sustain revenue growth in Q4 2023 and 1H FY24, fueled by robust demand in manufacturing end markets such as aerospace, automotive, and oil and gas. The pricing actions implemented by the company over the past few quarters to mitigate inflationary costs are also expected to support sales growth. The continued focus on mission-critical initiatives positions MSC Industrial to gain further market share in the upcoming quarters. Although the economy is slowing down and some end markets are affected, the strength observed in the aerospace, automotive, and oil and gas sectors, combined with pricing actions and market share gains, is anticipated to outweigh any weaknesses.

In the long term, MSC Industrial is well-positioned to benefit from the increased domestic manufacturing activity resulting from the reshoring trend in the United States. Furthermore, the company's expansion into other promising end markets like medical and electric vehicles, leveraging their technical expertise and capabilities gained through recent acquisitions, presents additional growth opportunities. Therefore, I maintain an optimistic outlook regarding MSC Industrial's prospects for topline growth.
 

Margin Outlook

During Q3 FY23, MSC Industrial experienced a decline in adjusted gross margin by 220 basis points year-over-year, settling at 40.7%. This decrease can be primarily attributed to a 160 basis point headwind resulting from a recent contract win in the public sector and customer mix related to the growth in that sector. Additionally, acquisitions contributed to a further 40 basis point headwind. The remaining 20 basis points reflect higher inventory costs working through the profit and loss statement. Consequently, the adjusted operating margin also witnessed a decline of 150 basis points year-over-year, reaching 13.1%. While the lower gross margin played a significant role in this decline, it was partially offset by a decrease in operating expenses as a percentage of sales.

Looking ahead, the gross margins should continue to be impacted in Q4 FY23 and 1H FY24. This is due to the margin dilution resulting from the recent acquisitions of Buckeye Supply and Tru-Edge, as well as the influence of a contract win in the public sector. A substantial portion of the public sector growth observed in Q3 FY23 stemmed from numerous small capital purchases, such as machines related to a recent contract win. These wins typically yield margins below the company average as they require modest investments in working capital. However, MSC Industrial is actively consolidating its stock-keeping units (SKUs) and suppliers, which is expected to streamline operations and ultimately enhance operating margins in FY24.

Overall, it is important to acknowledge that margins are likely to remain impacted in the near term. Nevertheless, there is optimism for gradual improvement in FY24. As MSC Industrial consolidates its operations and optimizes its supplier relationships, the company should witness a gradual recovery in margins, allowing for increased profitability and improved financial performance in the long run.
 

Valuation

In my DCF calculations, I am assuming revenue growth to be in the mid-single digits in 2023, given the healthy demand and pricing actions. Beyond 2023, I have assumed growth to be in the mid-single digits, with a terminal growth rate in the low-single digits, as the company will continue to benefit from mission-critical initiatives and reshoring activities in the United States. I used a discount rate of 7.24% and arrived at a fair value of $120.16 for MSM.
 

Conclusion

In summary, I believe MSC Industrial presents compelling value due to its promising growth prospects and attractive valuation. The company's focus on its mission-critical initiatives positions it well to drive top-line growth even amidst the uncertainties of the macroeconomic landscape. While margins may face challenges in the near term, there is optimism for improvement in FY24.

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