These are not great times for the industrial sector. Worries about the fiscal cliff transitioned into fears of sequestration, and a variety of metrics are showing decreasing industrial activity. That is spilling into the results of industrial component suppliers like Fastenal (Nasdaq:FAST) and MSC Industrial (NYSE:MSM). While MSC Industrial's near-flat revenue growth this quarter and flat guidance are certainly unsettling , I think the long-term growth story here is still an attractive one and I'm happy to hold onto my shares.
A Bad Fiscal First Quarter Leads To An Even Worse Fiscal Second Quarter
It's looking like this is going to be a challenging quarter for the likes of Fastenal, MSC, and other industrial MRO suppliers like Grainger (NYSE:GWW), DXP (Nasdaq:DXPE), Lawson (Nasdaq:LAWS) and the like.
MSC saw revenue rise just 1% for the fiscal second quarter, slightly below the average sell-side estimate. Average daily sales growth was almost identical to reported revenue growth, while manufacturing growth (1.3%) outpaced non-manufacturing growth (0.4%). While the company's vending business added to the growth rate, the company suffered in choosing not to implement its typical mid-year price increase.
Relative to the revenue performance, MSC's margin performance was pretty solid. Gross margin declined 110bp from the year-ago period, with about 40% of the erosion coming from the expansion of the vending operations and the bulk of the remainder coming from purchase cost increases that weren't offset with corresponding price hikes. Operating income (adjusted) declined about 4% and the company saw operating margin erosion of 90bp – showing a pretty solid level of operating expense control relative to the weak demand environment.
The active customer count declined for the second consecutive quarter, down about 2% this time, while transaction size increased 3%. I think it's worth noting that management warned of this weakness and has responded accordingly – inventories are down about 7% from the beginning of the fiscal year and the company has held off on hiring new sales reps.
Not All Markets Are Created Equal
Listening to management's detailed discussion of operating conditions on the post-earnings conference call, it sounds like the company's heavy focus on metalworking is biting them in the tuckus. Although areas like aerospace and automotive are relatively strong in the U.S., metalworking overall is still in some pretty serious doldrums. That may explain, at least in part, MSC's lagging performance relative to Fastenal, but I don't think investors should entirely dismiss the threat that increased competition from Fastenal and Amazon.com (Nasdaq:AMZN) (through AmazonSupply) is playing a part too.
Along those lines, I encourage investors to watch the earnings reports from companies like Eaton (NYSE:ETN), Illinois Tool Works (NYSE:ITW), Middleby (Nasdaq:MIDD), Lincoln Electric (Nasdaq:LECO) in the following weeks. If there is a relatively widespread malaise in machinery and heavy equipment, it would suggest that MSC's problems are more market-oriented than competitive. That said, remember that MSC largely serves small and medium-sized businesses, so the performance of these larger companies may not be entirely representative.
SEE: Equity Valuation In Good Times And Bad
The Bottom Line
I'm still quite bullish on MSC for the long haul. While expensive, I believe the company's acquisition of the Barnes (NYSE:B) North American distribution business will provide some very valuable market and customer expansion (including expanding more into vendor-managed inventory and new verticals like transportation and natural resources). Likewise, I believe the company's efforts to expand its private label offerings and grow into adjacent markets (like fasteners) will pay considerable dividends down the road.
I am looking for MSC to grow its top line by about 9% and its free cash flow (FCF) by about 17% a year for the long term. That very robust growth rate (almost equal to the much faster-growing Fastenal) is predicated on the Barnes transaction (and improving the margins of that business), as well as ongoing scale benefits as MSC grows within the enormous $150 billion-plus MRO/industrial distribution market. With that growth rate, MSC could carry a fair value well into the $90s, and while I do believe investors have reason to worry about the likelihood of the much-discussed second-half recovery, I believe MSC is a good company to play that eventual economic rebound.
At the time of writing, Stephen D. Simpson owned shares of MSC Industrial