MSC Industrial Direct Co., Inc. (NYSE:MSM) Q1 2023 Earnings Call Transcript

MSC Industrial Direct Co., Inc. (NYSE:MSM) Q1 2023 Earnings Call Transcript January 5, 2023

MSC Industrial Direct Co., Inc. beats earnings expectations. Reported EPS is $1.48, expectations were $1.46.

Operator: Good day, and welcome to the MSC Industrial Supply’s Fiscal 2023 First Quarter Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to John Chironna, Vice President of Investor Relations and Treasurer. Please go ahead.

John Chironna: Thank you, Allison, and good morning to everyone. Happy New Year as well. Erik Gershwind, our Chief Executive Officer; and Kristen Actis-Grande, our Chief Financial Officer, are both on the call with me today. During today’s call, we will refer to various financial and management data in the presentation slides that accompany our comments, as well as our operational statistics, both of which can be found on our Investor Relations web page. Let me reference our safe harbor statement, a summary of which is on Slide 2 of the accompanying presentation. Our comments on this call, as well as the supplemental information we are providing on the website contain forward-looking statements within the meaning of the U.S. securities laws.

These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those anticipated by these statements. Information about these risks is noted in our earnings press release and our other SEC filings. In addition, during this call, we may refer to certain adjusted financial results, which are non-GAAP measures. Please refer to the GAAP versus non-GAAP reconciliations in our presentation or on our website, which contain the reconciliations of the adjusted financial measures to the most directly comparable GAAP measures. I’ll now turn the call over to Erik.

Erik Gershwind: Thank you, John. Good morning, everybody, and thank you for joining us today. I’ll start by wishing everyone a Happy New Year and I hope you had a restful and a happy holiday season. On today’s call, I’m going to reflect on our first quarter performance. I’ll offer my perspective on the current demand environment and update you on our accomplishments against our mission critical initiatives. Kristen will then provide more specifics on the quarter and our reaffirmed fiscal 2023 framework and I’ll then wrap things up and we’ll open up the line for questions. Before I get into Q1, I’m excited to announce that we produced our first ever ESG report at the start of our fiscal year in November, actually. You can view this report in the Investor Relations section of mscdirect.com.

Our ESG journey has been one of continual improvement and we look forward to receiving your feedback as we enhance our reporting each year. On a related front, we continue to make progress on our DE&I journey by adding diversity to our senior management and our Board of Directors. Most recently, we welcomed Rahquel Purcell as our newest Board member and she brings with her more than 30 years of supply chain, strategy, and digital experience and we’re very happy to have her on board. This is the latest in what has been a series of moves to infuse new energy and new excitement and intensity into our company’s leadership. Turning to our performance, I’m pleased with another strong quarter that continues our string of success in the face of uncertain conditions.

Our primary goals for fiscal 2023 are gaining market share, expanding adjusted operating margins, and improving adjusted return on invested capital or ROIC. Our fiscal Q1 demonstrated success on all of those dimensions. Looking beyond the quarter, our five growth levers and for the productivity momentum that we’re seeing, have us set up to continue achieving our mission critical targets. Our manufacturing centric end market exposure also provides us with strong resiliency in the event of economic softening. Manufacturing verticals like aerospace are not yet back to pre-COVID levels and therefore have plenty of room for continued growth. Additionally, we stand to benefit from reshoring in the future as we are just beginning to see the positive impacts from those activities.

In addition to our focus on market share capture and productivity, we are pivoting our emphasis within category management. Since COVID began, our priorities were securing product availability for our customers, and staying ahead of the rapid cost inflation that we all experienced. And I’m proud of our team’s efforts on both fronts. Our inventory position allowed us to service customers, keep plants running, and drive revenue growth. And thanks to our strong value proposition, we were able to keep pricing ahead of purchase costs and improved gross margins during a challenging time. As the world now returns to a more normalized state of moderating inflation and stabilizing supply chains, we are initiating a fresh look at our supplier and assortment strategy.

Our priorities will migrate towards reducing purchase costs, streamlining operational efficiencies, improving the customer shopping experience, and channeling more market share to those suppliers who partner with us. We will accomplish these objectives through a formalized category line review process that will begin over the next couple of months led by our new COO, Martina McIsaac. will cycle through our product lines in WAVE’s, the better part of the next year. We expect most of the benefits to accrue in fiscal 2024 and beyond with some benefit hitting the latter portion of fiscal 2023. I’ll now turn to the specifics of the quarter. Results continued to be aided by strong pricing contribution, our recent bolt-on acquisitions, and execution of our growth drivers.

We achieved average daily revenue growth of 12.9% well above the IP index. We expanded operating margins by 140 basis points over prior year or 100 basis points on an adjusted basis, driven by the continuation of our mission critical initiatives, which yielded additional savings of $6 million in the quarter. We remain on track to achieve our goal of at least $100 million of savings by the end of fiscal 2023. Our mission critical initiatives and efforts of our entire team on cost containment and productivity has also boosted our adjusted ROIC into the high teens and now stands at 18.3%. We’ve now already reached our original fiscal 2023 goal and we aim to continue improving that number over time. Our growth formula remains anchored in the five priorities that we’ve discussed as part of mission critical, solidify metalworking, expand solutions, leverage the portfolio strength, grow e-commerce, and diversify customers in end markets with an emphasis on public sector.

I’ll now update you on each one of those. Our expertise in metalworking remains the cornerstone of our value proposition, driven by the depth and breadth of our product portfolio, our large network of technical metalworking experts and our focus on innovation as a tool to elevate productivity and lower cost for customers. In many cases, we also help our customers to reduce waste and energy consumption. Here’s a recent example from the aerospace end market. One of our customers who is a Fortune 500 company was using a four step drilling process that took them 2.5 minutes to 3 minutes to machine a certain part that goes into an airplane. After an in-depth review by our metalworking experts, we were able to take that four-step process and bring it to one-step and reduce cycle time from the 2.5 minutes to 3 minutes to just 10 seconds.

We also improved quality along the way and by the customer’s own calculation, they’re now expecting to save over $4 million annually. Our solutions growth driver is anchored by our vending and implant programs, both of which have been fueling market share caps over the past several quarters. Vending signings remain strong with Q1 signings comparable to Q4. Vending machine revenues grew in the mid-teens and now represent over 15% of total company sales. Implant signings also remained strong with Q1 again running at a similar pace to Q4. Implant customer revenues were up over 20% year-over-year and now represent 12% of total sales, up a 100 basis points from the prior quarter. We will continue to push on this growth driver and would expect implant to be at 15% of total sales by the second quarter of fiscal 2024.

Sales to customers with our solutions offering now represent 56% of the company’s total sales, up over 200 basis points from prior year. Importantly, our solutions capabilities are also bringing us into diversified end markets. With recent wins coming in industries spanning from medical manufacturing, packaging, and even the hospitality sector. The third priority is selling the portfolio, which is about increasing share of wallet through ancillary products, especially our CCSG business. Here, we provide an outsourced vendor managed inventory service for the high margin C-Part consumables that keep plants running. Momentum in this business continues building with Q1 ADS growth in the mid-teens. Our fourth priority is digital, which includes all aspects of MSC’s digital engagement with customers, suppliers, and associates.

John Hill and his team have completed a comprehensive review of our entire digital offering and have built a roadmap for our evolution in the space. For example, in e-commerce, recent work is focused on improving the customer experience on our website by enhancing product discovery, and enriching product data. This investment is producing early returns as e-commerce sales grew mid-teens in the first quarter. On an ADS basis, we reached 61.9% as a percent of total company sales, up roughly 150 basis points compared to prior year. Our fifth growth driver is customer diversification through our public sector business. Over the past few quarters, I’ve described significant contract wins such as the 4PL contract serving U.S. Marine bases, where we supplemented that win with others at the state and federal level.

And these have helped to produce continued strong growth with Q1 ADS coming in over 20% and we expect that momentum to continue throughout fiscal 2023. Each of our five growth levers are not only powering growth, but they’re positioning MSC as a productivity partner to our customers expanding our historic role is spot by supplier. In Q4 of fiscal 2022, we expanded our portfolio through two acquisitions in areas that we consider important to our business. In June, we acquired Engman-Taylor, a premier metalworking distributor in the Midwest that expands our network of technical experts. We also bolstered our OEM fastener distribution business through the acquisition of Tower fasteners in August, which broadens our end market exposure and increases our geographic footprint in the high touch DMI inventory category.

Both businesses are running ahead of their original case in their early days. We expect both to produce ROIC above our weighted average cost of capital by the end of their first full-year of operations. Kristen will discuss our capital allocation priorities in more detail, but we remain committed to seeking out bolt-on acquisitions that fit our strategic, financial, and cultural filters. Turning to the external environment, the picture remains similar to last quarter with sentiment readings declining and IP readings moderating. The majority of our customers are seeing stable order levels, demand, and general activity. We are hearing though continued talk of softening among a portion of our customers. More recently, we experienced a higher prevalence of extended holiday shutdowns along with weather disruptions during the second half of December.

As Kristen will describe, this resulted in a strong start to the month, but a slow finish, as activities saw a sharper decline, than in the last two weeks of prior year. Zooming-out though, the need for our customers to find productivity to offset their cost headwinds is as strong as it’s ever been. And this plays nicely into our value proposition. So, we remain focused on delivering that productivity for our customers. I’m going to now turn things over to Kristen.

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Kristen Actis-Grande: Thank you, Erik, and good morning, everyone. On Slide 5 of our presentation, you can see key metrics for the fiscal first quarter on a reported basis. Slide 6 reflects the adjusted results, which will be my primary focus this morning. Our first quarter sales were up 12.9% versus the same quarter last year and came in at 957.7 million. Our first quarter acquisitions represented roughly 3 percentage points of the growth and FX was a 30 basis point headwind year-over-year. Looking at growth rates for our average daily sales by customer type, public sector sales increased over 22% fueled by fulfillment under our 4PL contract for the U.S. Marine bases and other public sector spending. National Account growth was low teens and core customers grew high-single-digits.

Our gross margin for the fiscal first quarter was 41.5%, down 10 basis points on a year-over-year basis and up 30 basis points organically driven by increased price more than offsetting product cost inflation. Sequentially, gross margin ticked down as expected due to the ongoing realization of previously incurred product cost increases, some mix impact from our growth drivers along with a small impact from a full quarter with tower fasteners in our numbers. Looking forward, we continue to see new cost increases from our suppliers although not at the fast and furious pace of last year. As a result, we anticipate taking a small pricing adjustment within the next month. Our ability to deliver continual cost savings and tangible productivity gains to our customers continues driving solid realization rates.

Reported operating expenses in the first quarter were 280 million versus last year’s reported operating expenses of 257 million. Adjusted operating expenses were also 280 million or 29.2% of net sales versus last year’s adjusted operating expenses of 257 million or 30.2% of net sales. This yielded a 100 basis point reduction in adjusted OpEx to sales year-over-year. Our reported operating margin was 12.1%, compared to 10.7% in the same period last year. Adjusted for restructuring and acquisition-related costs, adjusted operating margin was 12.3% as compared to adjusted operating margin of 11.3% last year, a 100 basis point improvement year-over-year. That resulted in an adjusted incremental margin for our first quarter of approximately 20%.

Reported earnings per share were $1.45 for the quarter as compared to $1.18 in the same prior year period. Adjusted for restructuring and current year acquisition-related costs, adjusted earnings per share were $1.48, as compared to adjusted earnings per share of $1.25 in the prior year period, an increase of 18%. This continues to reflect strong execution at all levels, sales performance, gross profit, and operating expenses. Turning to the balance sheet. At the end of the fiscal first quarter, we were carrying 726 million of inventory, up 10 million from Q4’s balance. The inventory build is consistent with our double-digit revenue growth, advantageous year-end buys, and continuing inflation. We are targeting an annual cash conversion rate of at least 100% for fiscal 2023 and we are pleased with our performance this quarter at 94%, despite double-digit revenue growth and the related receivables growth.

Our capital expenditures were 26 million in the first quarter and included elevated vending installations, new warehouse automation, and continued investments in digital. Our capital spending is frontloaded this year and we currently expect annual CapEx spend in the range of 70 million to 80 million in fiscal 2023. You can see on Slide 7, our free cash flow is up year-over-year at 51 million for the current quarter as compared to 43 million in the prior year quarter. Note that we also spent about 19 million buying back shares during the quarter, just over 200,000 shares at an average purchase price of . We currently have 4.5 million shares remaining on our current repurchase authorization. Our total debt at the end of the fiscal first quarter was 780 million, reflecting a 15 million decrease from the fourth quarter of fiscal 2022.

As for the composition of our debt, roughly 55% was floating rate debt and the other 45% was fixed rate debt. Cash and cash equivalents were 26 million, resulting in net debt of 754 million at the end of the quarter, up slightly from 751 million at the end of the fourth quarter. Our net leverage at the end of the first quarter was 1.3x, in-line with our target range of 1x to 2x. I would also like to highlight that subsequent to closing our fiscal Q1, we closed on a 300 million receivables facility, which is a committed senior secured revolving trade receivables facility that we will use to reduce our debt and overall funding rate. It will bring our leverage ratio to just under one-time. Before updating you on our mission critical productivity goals, I would like to spend a few minutes to refresh our capital allocation strategy, which you can see on Slide 8.

Our top two priorities remain investing into the business and turning capital to shareholders through our ordinary dividend. From there, our next two priorities are tuck-in acquisitions and share buybacks at the right valuation levels. We are de-prioritizing use of special dividends as we see higher return prospects and other uses of cash. Let me now update you on our mission critical productivity goals and I’m now on Slide 9. In our fiscal first quarter, we achieved additional gross savings of 6 million and invested another 1 million. We are targeting our fiscal 2023 goal to be at least 15 million in gross savings. Warehouse automation remains an area of focus as evidenced by our recent capital investment. We’re extending new automation technology through our fulfillment centers to strengthen our operations and mitigate the effects of labor inflation.

For the total program to date, we have achieved gross savings of 91 million and we remain on target to hit at least 100 million of gross cost savings by the end of this fiscal year. Now, let’s turn to the fiscal year 2023 guidance, which is shown on Slide 10. We are reaffirming our 2023 guidance as introduced during our fiscal fourth quarter 2022 earnings call last October. We’re estimating average daily sales growth of 5% to 9% and an adjusted operating margin between 12.7% and 13.3%. A few reminders as it pertains to our estimates for the year. Specific to the ADS growth range, fiscal 2023 has 252 days, 6 fewer than fiscal 2022. The full fiscal calendar can be found on our website. Our Engman-Taylor and Tower Fasteners acquisitions are included in the guidance and add roughly 200 basis points to our ADS growth for the year.

When we introduced guidance last quarter, forecast indicated a softening economic environment and we factored that into our annual guidance range. As of now, we would characterize the environment and our growth trajectory as tempering a bit, but still solid. At the gross margin level, we remain on plan and expect fiscal 2023 to be down 40 basis points to 70 basis points versus prior year, which is inclusive of the 30 basis point to 40 basis point acquisition headwind. As we think about the cadence of our gross margins for the remainder of the year, we expect the back half of the year to be flat to slightly higher than the first half. This is due to several factors. First, the realization of product cost increases in our P&L is expected to peak over the next quarter.

Second, freight costs should subside beginning in Q3. Third, we have several gross margin initiatives in play whose contribution builds in the back half of the year. Erik mentioned one, which is a new category line review process, but there are others with a near-term time horizon. On the operating expense line, we expect a slight increase in operating expense as a percentage of sales in Q2 consistent with our typical seasonal pattern with sequential declines thereafter. Our mission critical productivity efforts will allow us continue investing in our growth strategy despite ongoing inflation headwinds. Factoring in those assumptions, we expect adjusted operating margin to be in the range of 12.7% to 13.3%. Excluding the 20 basis points benefit of the extra week from fiscal 2022, this would reflect operating margin expansion at nearly all points within our range.

As a reminder, our fiscal 2022 fourth quarter acquisitions dilute operating margins by approximately 20 basis points in fiscal 2023, their first full-year with us. While dilutive to operating margins in the first year, both acquisitions are accretive to EPS and on-track to achieve an ROIC above weighted average cost of capital in their first full-year of operations. Holding fiscal 2023 debt constant with current levels, we would expect roughly 8 million to 10 million of interest and other expense per quarter and tax rate is slightly under 25%. Given our expectations for an operating cash flow conversion of roughly 100%, we will have flexibility to deploy free cash flow into debt reduction, buybacks, or accretive acquisitions. During our last call, we introduced our downturn playbook that we have should we experience a significant demand slowdown.

We have clearly defined triggers for changes in our actual or forecasted revenue and operating profit that initiate a series of actions we’ll take across the business. This includes everything from pullbacks on discretionary spending, changes in staffing levels and reprioritization of investments. In addition, our balance sheet remains strong and when the economy slows, we generate high levels of cash flow as working capital becomes a source of fund. This will enable us to pay down debt and/or strategically invest through the downturn. We are not in that mode as of now and we well-positioned to navigate a change in the environment if required by enacting these levers to control costs. I will now turn it back over to Erik.

Erik Gershwind: Thanks, Kristen. We are pleased with our first quarter performance, which is on the heels of a strong fiscal 2022 in what remains a complex operating environment. We remain on-track to achieve each of our mission critical goals for the end of fiscal 2023. And we are seeing momentum build quarter-over-quarter inside of the company. This is an exciting time for MSC as we position the company as a partner of choice among our customers. We see a bright future ahead and we’ll continue to reinvest into the business. Regardless of the macro environment, we remain squarely focused on what we can control. Capturing market share, growing above IP, and translating that growth into profit expansion. I’d like to thank our entire team for their hard work and dedication and we’ll now open up the line for questions.

Q&A Session

Operator: Thank you. And our first question today will come from Tommy Moll with Stephens. Please go ahead.

Tommy Moll: Good morning and thanks for taking my questions.

Erik Gershwind: Hey Tommy.

Kristen Actis-Grande: Good morning, Tommy.

Tommy Moll: I wanted to start by circling back on some of the macro commentary that you both offered. Erik, I took note of your comment about a pronounced slowdown in the second half of December; and Kristen, I think the keywords from your prepared remarks were the tempering a bit and just in terms of the macro and growth outlook. So, I was hoping you could give us any more insight you have there in particular if there’s any difference across some of the end markets that would be helpful? Thank you.

Erik Gershwind: Yes, Tommy, sure. Look, I think the headline in terms of the macro is pretty much more of the same. On the last quarter, we talked about some pockets of softening in-line with some of the readings coming down. And I think that’s what we’re still experiencing. So, we would characterize the environment as very solid. Look, I mean, we’re still talking about nice growth levels. Most of our customers are still talking about solid demand and solid order patterns. There are pockets though. And it tends to be the closer you get to consumer facing industries, the more extensive you’re going to hear the pockets of softening. So, you know, in general, I think we’re not seeing anything that suggests like anything falling off a cliff.

The words I think Kristen referred to are tempering, which would be an appropriate characterization. With respect to December in particular, from what we could tell, the back half of December is an isolated phenomenon. We saw a really strong start. So, to put some context on that, the first couple of weeks, the growth rates would have been better than Q1. The back half definitely slowed. And we did hear from our sales team that customer holiday related shutdowns were more widespread than the last couple of years and then throw in that disrupted things that week before Christmas. So, it appears to be what we saw back half of December isolated and nothing systemic.

Tommy Moll: Thank you, Erik. That’s helpful. As a follow-up, I wanted to touch on the pricing environment. It sounds like you’ve continued to see some supplier price increases. I think you said you’ve got another one of your own plan for next month. So, any context you could give there? And then just thinking through how that ties to your 2023 outlook for ADS? On my math, you saw about a 700 basis point contribution this quarter, presumably the range of expected contributions for the year would be significantly lower than that, just given the comps, but if there’s any way you could frame what’s reasonable for the full-year, that’d be helpful as well.

Erik Gershwind: Yes, Tommy, sure. I’ll start out. I’ll touch on the environment. I can give you a little context on our numbers and Kristen can fill in anything I missed. So, in terms of the environment, it’s an interesting time because on the one-hand, like the whole world is suffering from inflation fatigue. And our customers, our suppliers, we’re all not immune from that. At the same time, the reality of the situation is that there’s still inflation. And while it is definitely moderating, there’s still inflation and there’s still cost increases as evidenced by the fact that yes, we’re still seeing suppliers coming to us with increases. And so that is what drove €“ what I described is going to be a pricing adjustment coming up in the next month.

So, it’s a reality that we all have to deal with even though there’s a bit of fatigue. And I think the message for us is, we’re really focused for our customers on making sure we’re generating productivity for them. That’s going to offset it. I think that’s how I characterize the macro. Yes, in terms of our numbers and I’m pretty sure this is all sort of baked into what we gave as the guidance range at start of the year, we did anticipate that we would lap the very high pricing of prior year and that’s going to happen during our fiscal second quarter in the next month or so here. So, yes, as a percentage of sales, pricing contribution will absent some radical change in the environment, pricing contribution will come down because of the math of the comps.

Tommy Moll: I appreciate it and we’ll turn it back.

Operator: Our next question today will come from Steve Volkmann of Jefferies. Please go ahead.

Steve Volkmann: Great. Good morning, everybody. Thanks. Erik, I noted in your prepared comments that you actually said, you were starting to see some of the benefits of reshoring, poking their head up. Can you just expand on that a little bit?