Market Overreaction Moves MSC to 4 Stars

MSC’s third-quarter gross margin came in at 44.3% versus 45% in the year-ago quarter. Management expects the fourth-quarter gross margin to compress 50 basis points sequentially to 43.8%. We believe the market is worried that MSC’s gross margin compression is indicative of increased competition from Amazon Business AMZN and others; however, management said the third-quarter gross margin was negatively affected by a mix shift to lower-gross-margin national accounts and vending.

Despite generating lower gross margins, national accounts and vending relationships can result in operating leverage opportunities that can more than offset gross margin pressure and drive operating margin expansion. Furthermore, such accounts favor larger distributors with national scale such as MSC, which creates opportunities to take share from smaller local and regional distributors. We continue to see a nice growth story for MSC as its manufacturing end markets recover and the company uses its scale and value proposition to take share from smaller competitors. While we believe mix and competition will keep gross margins below the 46% 10-year average, we expect stronger operating leverage will help operating margins expand from 13% in 2017 to a midcycle 15.7%, in line with MSC’s 10-year average and still well below the company’s 18% peak operating margin.

We See a Return to Double-Digit Growth Over the past 20 years, MSC has become one of the largest industrial distributors in United States. It is especially well known in the metalworking industry, where it enjoys 10% market share. MSC has historically been a conservatively capitalized company, but it is not afraid to flex its balance sheet when the right opportunity presents itself. The company spent $900 million to acquire J&L Industrial Supply in 2006 and Barnes Distribution North America in 2013, which bolstered its metalworking and inventory management products and services. In our view, these acquisitions were prudent uses of capital that improved MSC's competitive standing.

Although soft industrial end markets and a weak pricing environment have hindered MSC’s recent performance, we think a return to double-digit top-line growth and mid- to high teens operating margins is in the cards. Over the longer term, we expect end-market demand and pricing to improve and believe MSC can gain market share from smaller local and regional distributors. Over the past couple of years, larger companies have been consolidating their spending with large national distributors that offer value-added services. Because MSC has national scale and a robust portfolio of products and value-added inventory management services, we think it is well positioned to capitalize on this trend. Although these accounts can generate lower gross profit margins, they also generate much higher volume, which MSC can leverage to improve operating margins. MSC’s focus on providing inventory management solutions has helped the company expand customer wallet share over the years, and we expect that trend to continue.

MSC has proved itself to be a consistent free cash flow generator throughout the business cycle, and in our view, the company has allocated its free cash flow in a balanced, shareholder-friendly manner. We expect MSC to continue to use its free cash flow to increase its regular dividend, repurchase shares, and occasionally pay special dividends.

Inventory Availability and Management Set MSC Apart Product distribution can be a tough business; low barriers to entry combined with customer and supplier bargaining power can erode returns on invested capital for industry players. Despite these competitive pressures, MSC's superior scale and ability to monetize its strong network of customers and suppliers have allowed the company to earn excess returns, and we expect it will maintain its competitive advantages over at least the next 10 years. As such, we award MSC a narrow economic moat, supported by its network effect and scale-driven cost advantages.

Product selection and availability are key facets of MSC’s value proposition. The company offers 1,150,000 stock-keeping units, with most of those stocked in inventory across five main customer fulfillment centers and seven smaller fulfillment facilities. MSC boasts a 99% order fill rate on same-day shipments versus the industry average of around 60%. The company utilizes a “good, better, best” product stocking strategy including its exclusive brands, which allows customers to choose products across the price and quality spectrum.

MSC’s inventory management solutions and technical expertise are also very important components of the company’s value proposition. Under a vendor-managed inventory arrangement, the customer largely outsources the product procurement process to MSC, which reviews inventory consumption, automatically places orders, and physically refills the inventory at the customer’s facilities. MSC’s vending machines are kept at customer facilities and stocked with customer-specified inventory items. From a customer’s perspective, these solutions can significantly improve supply chain and operational efficiency and reduce costs. From MSC’s perspective, these solutions drive incremental sales and build stickier customer relationships as MSC becomes deeply embedded in the customer’s procurement process. Metalworking can be a highly specialized and capital-intensive industry, and MSC employs nearly 100 metalworking specialists who assist customers with manufacturing process improvements and efficiency initiatives. The company also has a dedicated technical support staff to assist clients with technical issues. We believe MSC’s inventory management solutions and technical expertise enhance the company’s value proposition and build enduring relationships with its customer base.

MSC is an important channel partner for thousands of suppliers, and we think its growing customer base strengthens its standing with its suppliers. MSC uses its reputation with suppliers and its scale to expand its vendor base and product selection, take advantage of sales incentives and volume rebates, and gain preferential access to supplier training programs and support. This in turn allows MSC to offer its customers better product selection, pricing, and services. As a key middleman that provides a valuable service to both customers and suppliers, MSC has leveraged its market-leading position to create a virtuous cycle, which allows it to sustainably grow faster than its markets. The more customers and suppliers that MSC serves, the more valuable the business becomes.

Scale Results in Global Sourcing and Preferential Pricing As one of the larger industrial distributors in North America with an established leadership position in metalworking, MSC benefits from scale-driven cost advantages over smaller competitors, in our view. MSC operates in a very fragmented market (145,000 distributors with the top 50 controlling 30% share), and much of its competition comes from smaller local and regional distributors that lack its scale and capital. We believe the company's cost advantages stem from preferential supplier pricing, global product sourcing, an efficient and scalable distribution network, national accounts, and exclusive brands.

MSC has been able to leverage its purchasing scale to globally source products and take advantage of volume-based rebates and other sales incentives. Global sourcing and preferential pricing from suppliers lower the company’s cost of goods sold and promote better gross profit margins relative to smaller distributors that lack such scale.

MSC’s efficient North American distribution network is another source of scale-driven cost advantages. The company operates a centralized distribution model, with its 85 branches primarily used as sales offices. The company estimates that its current distribution footprint can handle $4 billion of annual sales before further investment is needed. MSC is operating five fewer branches than it did 15 years ago, but average sales per branch has grown from about $9.7 million in 2001 to $33.7 million in 2016. We believe MSC’s technological capabilities, including its e-commerce sales channel, integrated customer purchasing and inventory management solutions, and warehouse automation, drive distribution efficiencies that would be difficult for smaller competitors to replicate.

An increasing number of companies are consolidating their spending with large national distributors that offer value-added services. Vendor consolidation allows customers to simplify their procurement processes and leverage their buying power. Because MSC has national scale and a robust portfolio of products and value-added services, it has been increasing its share of national accounts. Although these accounts can generate lower gross profit margins, they also generate much higher volume that MSC can leverage to improve operating margins.

About 18% of SKUs are higher-margin private-label products, and MSC is the only national distributor of Kennametal’s premier brand tooling. Because exclusive brands boost profit margins, we believe distributors offering such products have a cost advantage over those that do not sell exclusive brands.

Amazon's Entry Isn't the End Some industry observers have speculated that Amazon's entrance into industrial distribution is the beginning of the end for many incumbent distributors. Although we think the threat should not be dismissed, Amazon's decision to hold low or no inventory and its inability to easily replicate MSC's product expertise and high-touch inventory management offerings will prevent the giant from gaining significant share in the most profitable industrial distribution segments.

Increased customer or supplier bargaining power as a result of disintermediation and consolidation could negatively affect MSC’s profitability. However, we think MSC has a relatively diverse customer and supplier base, which damps bargaining power. As national customer accounts gain prominence, MSC could face gross margin pressure, but these accounts also provide an opportunity for the company to gain market share and increase volume, which should drive better operating leverage and improved operating margins. Still, there is no guarantee that customers will choose MSC over larger competitors.

Its niche in U.S. manufacturing, particularly metalworking, could put the company at risk if efforts to keep these industries in the country fail. MSC has a very limited international footprint and would be unable to cost-effectively service non-U.S. operations without material capital spending, in our view. Even if there is no meaningful future migration of U.S. manufacturing operations and MSC maintains or expands its customer base, the company still has significant exposure to cyclical end markets. However, MSC’s exposure to nonmanufacturing customers (32% of sales) and inventory management services offers some stability, and the company has proved its ability to generate strong free cash flow even during downturns.