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MSM - Msc Industrial Direct


kab60
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Company is facing macro headwinds due to weak manufacturing environment but there is a long growth runway in a fragmented MRO industry. Stock has been hit but it is not exactly screaming bleeding bargain. Up today on better than expected Q3, mainly due to cost measures, but growth in FY15 has been lower than expected. Arlington Value added in Q1, Vulcan Value increased in the same quarter. Moderate buyback and divy in place. Operating margins are depressed compared to historic levels and the thesis is, I suppose, that when margins improve you have a winner since it's a secular growth story. Anyone taken a look?

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MSM is 4% of my portfolio and I added slightly today. MSM continues to take market share in the fragmented MRO industry. As a result, the company can grow revenue faster than GDP. The company is investing heavily in growth -- hiring sales people, moving headquarters, and building new distribution facilities. At the same time, the industry is suffering due to the high dollar, low oil prices, and weak manufacturing. As a result, margins are compressed. Due to multiple compression, shares are down 25% over the last year. When the manufacturing sector returns to normal, customer will restock inventory, margins will improve, growth will accelerate, and the stock will sell at a premium multiple. MSM should provide 15% annual return over the next 5 years, according to my projections. (Valueline projects 14-24% annual return. If I am wrong, at least I am not alone).

 

If manufacturing remains weak, MSC should be able find bargain acquisitions. Distributors release working capital during downturns, which creates a nice margin of safety. The growing 2.3% dividend also provides some support.

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Cashflows have been depressed due to opening of a new distribution center which was a couple of years underway. Not sure I agree re the numbers of GWW - I think MSM looks better and cheaper. Plus it is sorta owner-operated so they are investing wisely it seems even though they have had issues with an acquisition.

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What makes MSM better than GWW?  The numbers for GWW seems better than MSM.

 

Fastenal, Grainger, and MSC are all exceptional companies. I'd agree that GWW (and FAST) are slightly better companies. However, both GWW and FAST have high current profit margins while MSC has depressed profit margins. These trends might continue. But I think MSC's margins will mean revert. This will give the stock an extra boost.

 

FWIW, Valueline agrees. Projected annual returns:

GWW: 10-14%

FAST: 11-19%

MSC: 14-24%

 

 

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I have been following/looking more into FAST. It seems the worry about the business now (and a result its multiple coming in) is the threat from others esp Amazon allowing same day service and vast part accessibility. FAST has counteracted this to a large degree with their vending program.

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Just fyi, Msc has a vending program as well. Fastenal seems the superior company atm, but as KCLarkin said, Msc is also about mean reverting. It seems their new distribution center and the acquisition of Barnes has depressed margins. They changed a lot of salesmen at Barnes and just recently the CEO I believe. 5m runrate cost savings in Q3 indicates there are still low hanging fruit.

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Vending is one part, but Amazon has nowhere the technical expertise and salesforce that the other two have. As a customer, Fastenal's blue people are at your shop almost everyday, and if you have a technical question (manufacturing problem, workaround, defect, ...) you can count on their expertise. My guess is that this is very important for these companies their client base.

 

Disclosure: I might be wrong.

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i went through msc's catalog and compared to amazon supply. just spot checked it. i was surprised the degree of overlap, particularly for the non-metal working stuff, like safety, etc. amazon was much cheaper.

 

i don't worry about msc losing the business, there service is quite good. i worry about them having to match amazon's price. after all, this is a distribution business with 15% margins! they have lots of room to give on price.

 

i would love others to tell me why i am wrong, because i really like this business...

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These are are all very good companies and one could certainly own all 3 if you believe in the long-run growth outlook. I would highly recommend looking at GWW's recent investor presentation from Blair conference. They are targeting 7-12% top-line growth plus margin expansion over the next 5 years and I don't see why those trends couldn't apply to FAST and MSM (though they are all very different companies).

 

I believe the Amazon Supply thing is a bit overblown. I would reach out to the companies to better understand their model. They are providing more than just a catalog of products from which their customers order tools/fasteners. They have deeply embedded relationships with very large customers and assist them in understanding precisely what they need for a specific project, etc. Amazon could eat into their "walk-in" business whereby someone shows up at a retail location to purchase a nut/bolt/screw but that is a very small part of overall revenue for the distributors.

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hmm. well i somewhat agree with you today, valuedontlie. i spoke recently with someone who runs a large distribution business, which is somewhat specialized in that it includes industrial gas and services welders, which requires special sales/support expertise, and he shares your view that amazon supply is a non factor. but i think this may be a special case.

 

but if you and i were running amazon supply, my bet is that we could make a lot of progress in the next 5 years. the inventory is already in our warehouses. the online catalog is at parity with MSC's, etc. in terms of functionality (i.e. tax, PO process, etc.), but probably has some holes in inventory (not a big problem, everyone uses multiple MRO distributors anyway). we probably don't have to fully "pay for" our overhead since it is shared with Amazon retail. our s/w engineers are certainly better. we might have better shipping services at lower prices than MSM, etc. our competitors have 45% gross margins, 15% op margins and they are distributors, not manufacturers! and our boss doesn't require us to make money and might be willing to spend some money and fancy RSUs to poach some experienced sales guys. every purchaser we would pitch to has bought personally on Amazon. and every procurement manager would like to look smart by reducing costs. and it is relatively easy to shift 5-10% of spend over and see how it goes.

 

to say it succinctly, i find it hard to believe that there isn't 20-30% of GWW, MSM, FAST business that doesn't require "embedded relationships" and "understanding precisely what they need for specific projects" that are functionally over-charged versus their opportunity cost and could attrite. not saying it does attrite, only that this will lead to pricing pressure. we can be highly confident that amazon is going to try very hard to break into the business...

 

i think this will remain a nonfactor until it suddenly is a major factor, and i can't call the timing. but i've been worried about it for a long time and have been wrong so far, so i very well continue to be. steve romnick started talking about this risk in june (google FPA June 2015 CFA to get the speech) so its probably not jiggery-pokery.

 

valuedontlie, your past comments are first rate! you may be right - can you elaborate on the source of your confidence? Given the high P/S and high margins in these businesses, owners will be impaired if i am right and margins contract. i'm hoping to learn something...

 

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The reason that the distribution business is fragmented is that working capital limits how fast companies can grow. The secret to Amazon's success is the negative cash conversion cycle. They borrow from their customers and suppliers to fund their growth. If Amazon undercuts MSC's margins, where do they get their growth capital from? Do they divert it from AWS? Amazon.com? Prime? Video?

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really? if i had to guess why the distribution business is fragmented, i would have several explanations before high working capital costs.

 

MSC has $700 in WC and $2B in sales. With 15% margin on those 3 turns! And WC costs favor those with scale advantages. I may very well be wrong, but it won't be because Amazon can't afford the WC costs of this business.

 

For what it is worth, my understanding is that following WWII, US manufacturers who required support for their products organized distribution by geography, with generally small exclusive areas. that is why many industrial distribution businesses (HVAC, packaged industrial gas, MRO, etc.) developed into fragmented geographic competitors, and provided the opportunities for acquisitive growth by FAST, PX, ARG, WSO for many years.

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Amazon is a perpetual motion machine. Without any profit, it is able to disrupt Walmart, IBM, Apple, Barnes and Noble, Best Buy, Netflix, book publishers, the fashion industry, the industrial distributors, P&G. Who am I missing?

 

I accept this as fact. Yet, I cling stubbornly to the economic law that a company's natural growth rate is limited by ROE. At some point Amazon will overreach. In the meantime, my shares of IBM, MSM, Apple, and others will become worthless. Still, it is fun to watch AMZN destroy trillions of dollars of wealth.

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it is important to recognize that ~70% of industrial distribution is still local mom and pops and regional players - the other 30% is MSM, FAST, GWW etc....  over time this is a business where scale matters, and the industry is consolidating.

 

MSM is feeling operational pain at the moment b/c of investments in new distribution center etc, but also top line pain tied to a slowing in metal working.  metal working is heavily tied to exports, and the strong dollar hurts.

 

i don't fully understand why (yet) but it seems like the large distributors - who all carry the same skus - are niched out to an extent, with MSM being the favored player in metal working, even thought FAST and GWW and others have a presence.  this may have something to do with MSM relationship with KMT, who is a well known and respected brand.  regardless, it seems like FAST and GWW are somewhat resigned to the fact that MSM is the main player in metal working, and they thus spend their efforts elsewhere.  regardless, with 70% of the industry still in the hands of smaller players, those are the guys that will be hurt by AMZN, and there is a lot of room for consolidation before MSM, GWW, and FAST have to go head to head on pricing etc.

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MSC Industrial and Fastenal are medium-sized players in the industrial distribution space.  Wolsley, WESCO, Anixter, Distribution Now, MRC Global all have a larger market shares in industrial distribution than MSC or Fastenal.

 

Per MSC Industrial's latest investor presentation, the top 50 players in the US MRO industry account for 30% of the market.  Per Grainger's latest presentation stated that the top 11 players make up about 30% of the market.  Either way, it's a lot more than Grainger, Fastenal, and MSC that account for the top 30%.

 

I'm not sure exactly how MSC maintains such strong margins and/or returns on investment - they claim that a 99% fill rate is their source of competitive advantage, but Grainger 'targets' a 99.9% fill rate.  Perhaps the latest slip in returns aren't a blip, but a new normal for them?  I'm just speculating...

 

If you're going to pay a big multiple (P/Rev or P/E) on a company, I'd take Grainger over MSC (although Mecham would likely claim otherwise).  Grainger has three times the market share of MSC, and 40% of sales are online.  They're the 13th largest e-tailers in the country.  They're a beast.  They get the best prices and they have the most customers.

 

Personally, I think a company like Anixter or WESCO makes for a more interesting play - they have larger market shares than MSC and some heavy hitters are getting involved.  Alex Roepers and Jeff Ubben each just purchased 1MM shares in WCC - Grainger's EBITD margin is double WESCO's...if these guys can get WESCO's margins anywhere near Grainger, you're looking at some serious gains in the next few years...

 

The attractiveness with DNOW is their super-clean balance sheet.  They could add $100M in annual cash flows via acquisition and still have a balance sheet cleaner than most distribution companies right now - it looks like with their recent acquisitions they're already getting started too.

 

Best of luck!

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MSC Industrial and Fastenal are medium-sized players in the industrial distribution space.  Wolsley, WESCO, Anixter, Distribution Now, MRC Global all have a larger market shares in industrial distribution than MSC or Fastenal.

 

Per MSC Industrial's latest investor presentation, the top 50 players in the US MRO industry account for 30% of the market.  Per Grainger's latest presentation stated that the top 11 players make up about 30% of the market.  Either way, it's a lot more than Grainger, Fastenal, and MSC that account for the top 30%.

 

I'm not sure exactly how MSC maintains such strong margins and/or returns on investment - they claim that a 99% fill rate is their source of competitive advantage, but Grainger 'targets' a 99.9% fill rate.  Perhaps the latest slip in returns aren't a blip, but a new normal for them?  I'm just speculating...

 

If you're going to pay a big multiple (P/Rev or P/E) on a company, I'd take Grainger over MSC (although Mecham would likely claim otherwise).  Grainger has three times the market share of MSC, and 40% of sales are online.  They're the 13th largest e-tailers in the country.  They're a beast.  They get the best prices and they have the most customers.

 

Personally, I think a company like Anixter or WESCO makes for a more interesting play - they have larger market shares than MSC and some heavy hitters are getting involved.  Alex Roepers and Jeff Ubben each just purchased 1MM shares in WCC - Grainger's EBITD margin is double WESCO's...if these guys can get WESCO's margins anywhere near Grainger, you're looking at some serious gains in the next few years...

 

The attractiveness with DNOW is their super-clean balance sheet.  They could add $100M in annual cash flows via acquisition and still have a balance sheet cleaner than most distribution companies right now - it looks like with their recent acquisitions they're already getting started too.

 

Best of luck!

 

I think it is a mistake to compare "market share" for distributors with vastly different product lines. The O&G and housing dependent distributors are too cyclical for my style of investing. If you time the cycle right, you can do well of course. But, these businesses are also inherently lower margin. You can't really expect WESCO to ever have the same margins as Grainger, given the product mix.

 

I could make exceptions for DNOW (balance sheet, management) and WESCO (ValueAct), but I don't consider the other distributors listed "investment grade".

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MSC Industrial and Fastenal are medium-sized players in the industrial distribution space.  Wolsley, WESCO, Anixter, Distribution Now, MRC Global all have a larger market shares in industrial distribution than MSC or Fastenal.

 

Per MSC Industrial's latest investor presentation, the top 50 players in the US MRO industry account for 30% of the market.  Per Grainger's latest presentation stated that the top 11 players make up about 30% of the market.  Either way, it's a lot more than Grainger, Fastenal, and MSC that account for the top 30%.

 

I'm not sure exactly how MSC maintains such strong margins and/or returns on investment - they claim that a 99% fill rate is their source of competitive advantage, but Grainger 'targets' a 99.9% fill rate.  Perhaps the latest slip in returns aren't a blip, but a new normal for them?  I'm just speculating...

 

If you're going to pay a big multiple (P/Rev or P/E) on a company, I'd take Grainger over MSC (although Mecham would likely claim otherwise).  Grainger has three times the market share of MSC, and 40% of sales are online.  They're the 13th largest e-tailers in the country.  They're a beast.  They get the best prices and they have the most customers.

 

Personally, I think a company like Anixter or WESCO makes for a more interesting play - they have larger market shares than MSC and some heavy hitters are getting involved.  Alex Roepers and Jeff Ubben each just purchased 1MM shares in WCC - Grainger's EBITD margin is double WESCO's...if these guys can get WESCO's margins anywhere near Grainger, you're looking at some serious gains in the next few years...

 

The attractiveness with DNOW is their super-clean balance sheet.  They could add $100M in annual cash flows via acquisition and still have a balance sheet cleaner than most distribution companies right now - it looks like with their recent acquisitions they're already getting started too.

 

Best of luck!

 

I think it is a mistake to compare "market share" for distributors with vastly different product lines. The O&G and housing dependent distributors are too cyclical for my style of investing. If you time the cycle right, you can do well of course. But, these businesses are also inherently lower margin. You can't really expect WESCO to ever have the same margins as Grainger, given the product mix.

 

I could make exceptions for DNOW (balance sheet, management) and WESCO (ValueAct), but I don't consider the other distributors listed "investment grade".

 

On the other hand for someone like DNOW with a strong balance sheet and a roll up strategy the cycle allows them to buy companies out for less. The deeper the cycle the better for them in the long run. However, that assumes discipline on prices and not a lot of new capital flowing into the industry, none of which are a given.

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