Although distribution is not typically a high-margin/high-return sort of business, industrial supply is a different story, as MSC Industrial (NYSE:MSM), Fastenal (Nasdaq:FAST), and Grainger (NYSE:GWW) have all managed to generate solid margins, returns on capital, and free cash flow. With the acquisition of Barnes' (NYSE:B) North American distribution business (BDNA) now complete, MSC Industrial has an interesting set of options in front of it. While management will find itself occupied initially with fixing BDNA's flabby margins, the opportunities for product, end market, and geographical expansion make this a name worth knowing and owning today.
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BDNA In Hand, Now The Real Work Can Begin
Although a $550 million deal isn't all that large by Wall Street standards, it's a significant transaction for a company of MSC's size (about $5 billion in market cap). The deal brings the company into many new businesses/markets - expanding its Class C supply business, but also adding product lines like fasteners and hydraulics and end-markets like transportation where MSC previously had a much smaller presence.
Arguably it's not even the different business lines and markets of BDNA that will make the integration challenging. Instead, this was a company that was run by managers more familiar with manufacturing than distribution and the results show it. Due at least in part to an inefficient distribution system (including poorly-leveraged distribution centers) and sub-optimally productive sales force, BDNA managed to translate gross margins higher than MSC's into much (high single-digit, by my calculations) operating margins.
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The bad news is that BDNA is a large business and it's really not possible to just flip a switch and have everything fixed by morning. The good news is that MSC not only has a history of integrating deals, but a very strong corporate legacy of efficient operations (particularly in the sales/distribution areas). Not all of MSC's experience can be directly brought to bear on BDNA – completely converting BDNA's model away from high-touch sales interaction to phone/internet-based ordering isn't going to work – but there's nevertheless ample opportunity to improve BDNA's performance, while providing more incentives to sales reps and managers to think in terms of growing the business.
A Platform For Growth?
MSC Industrial now has at least a foothold in multiple markets that could lead to better long-term growth. Thus far, MSC has thrived in large part on its strong market position in metalworking, and that market has long been more than half of the company's business. With BDNA, that can change (and not a moment too soon, as rivals like Fastenal look to expand into metalworking).
BDNA gives MSC the chance to compete with Fastenal in the fasteners market, a market at least as large as metalworking. BDNA will also expand MSC's presence into hydraulics (where companies like Applied Industrial Technologies (NYSE:AIT) specialize) and further grow its OEM business – basically industrial “private label” manufacturing. While MSC did have some presence in these markets prior to BDNA, the acquisition will certainly grow the company's profile and customer base, and grow its addressable market in a meaningful way.
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The same should be true in terms of end markets and geographical markets. BDNA brings with it a meaningful customer base in areas like transportation, railroad, and utilities, areas where MSC really hasn't focused much before. Assuming MSC can successfully cross-sell BDNA's customer base (something the company has been fairly good at in the past), this represents a largely new set of businesses for MSC to count as customers. Last and not least, BDNA brings with it exposure to Canada. While MSC has had exposure to the U.K. for some time now (and has been slow to address it), there is at least the option now to make this a more international business and one that doesn't rely solely on the U.S. industrial sector.
A larger presence in markets like hydraulics and expanded private label offerings should also help MSC withstand increased competition from Amazon (Nasdaq:AMZN) in industrial supply. While Amazon's existing distribution capabilities (and willingness to invest for the very long term)makes it a threat to the industry's margin structure, it could also inadvertently highlight the benefits of the elevated service offerings from companies like MSC.
The Bottom Line
In the short term, MSC is going to have to absorb margin dilution as it integrates and improves BDNA. While the internal rate of return from this deal probably won't be all that impressive for the first two or three years, I believe the long-term IRR should be in the low teens. Moreover, I think that analysis understates the potential benefits to be gained from cross-selling and organic expansion catalyzed by the transaction.
I'm still very nervous about the health of the U.S. industrial/manufacturing sector, and the possibility that ongoing weakness will lead to a disappointing upcoming earnings report. Still, I would use any such disappointment as an opportunity to buy shares. With BDNA in hand and its own internal efforts, I believe MSC can grow its top line at a high single-digit rate and produce free cash flow growth in the mid-teens. That works out to a fair value in the mid-$90s and a stock that, while vulnerable to a sluggish economy in the short run, offers compelling long-term opportunity.
At the time of writing, Stephen D. Simpson owned shares of MSC.