MSC Industrial Supply: "Passing" in July 2016
Traveling Through Time | 15 min read | What I learned from "passing" on MSC in July 2016
This is part seven in a ten-part series. Before reading this segment in the Traveling Through Time case study series — please read the Introduction post here.
Essentially, I simulated an investment opportunity from many years ago based on Geoff Gannon’s Singular Diligence newsletter. The write-up below is a record of my thought process and a reflection on what happened.
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Simulating the Past: Arriving to a decision
WOULD I HAVE INVESTED 20% OF MY CAPITAL IN MSC INDUSTRIAL SUPPLY IN JULY 2016?
MSC is one of the Big MROs (maintenance, repair, and overhaul) distributors in the United States. Its focuses on selling critical cutting and metalworking tools to large manufacturing corporations.
In the United States, MSC operates 5 distribution centers and 100 branches. Grainger generates approx. $3B in sales and 15% in pre-tax profits.
MSC is not clearly undervalued.
The company trades at an EV/S of 1.7x and over the long-term has only generated 14% in operating profit. Over the last, that figure has been closer to 16%.
MSC trades at an EV/EBIT (12.6x) slightly above Grainger (11.3x). Fastenal trades much higher at an EV/EBIT of 16.6x.
But the EV/EBIT multiple for MSC is based on today’s EBIT margin. You could say EBIT is depressed right now due to their recent investment in a fifth distribution center. In the past, the company has generated 17-19% EBIT margins. Right now, MSC is operating at 65% capacity. When they hit capacity at $4B in sales, it would be reasonable to assume that EBIT gets back to its historical peaks.
So MSC might trade closer to an EV/EBIT of 10x off normalized EBIT. This is slightly more expensive than the average business. With this lens, MSC trades at a discount to Grainger and at a premium compared to the average business.
MSC is certainly a safer business and has better future economics than the average business, but it’s not quite obvious that it will generate better returns than the average business today. The stock trades close to a 2% dividend yield and grows EPS by ~2% per year in buybacks. So the company would have to grow its sales by 6% per year (Note: I am only mentioning sales, not earnings; using normalized EBIT margins for today’s sales).
MSC is safer than the average company, but not as safe as Grainger.
Just like Grainger, MSC meets unplanned/infrequent needs for large customers, which ultimately helps them save money in the procurement process. So MSC is sticky in this sense.
You can read more about the Big MRO’s durability on the Grainger write-up. A lot of those things apply to MSC.
But MSC is unique in the fact that it specializes in (a) metalworking tools and (b) manufacturing customers.
MSC could be called world class in cutting tools. No one can match the number of units they sell annually in cutting tools. And MSC is the market leader in metalworking. But the Grainger and Fastenal have a significant presence in metalworking relative to MSC.
Their focus on metalworking also might mean that they have smaller share of wallet per customer. The throughput per customer matters. This is what leads to maximum cost savings for the customer (less distributors to work with). So this could potentially be a disadvantage when customers compare providers.
Additionally, MSC focuses on manufacturing customers. 70% of their sales come from this segment. And is a much more economically-sensitive customer base. In bad times, MSC sees larger decreases in sales; in good times, they also see faster increases in sales. It’s certainly more cyclical than Grainger and probably just as cyclical as Fastenal.
But the focus on metalworking and manufacturing isn’t all that bad.
You have to remember that the MRO market is fragmented. It’s made up of small, local distributors. And the MRO market is a regional business. The Big MROs are definitely known in the space, but using the Big MROs or a specific Big MRO is a different story. Every customer, even large corporations, has their own process, needs, and preferences, that are unique to them.
So MSC may not even be pitted against other distributors in this way. It’s not difficult to believe that MSC has smaller market share than its peers, but in certain regions and customers, MSC has the majority of the MRO spend from an account. In fact, MSC might even have a more durable reputation among manufacturing customers because they specialize in that segment and can help provide technical advice and support beyond traditional cost savings.
The focus on metalworking and manufacturing just brings a unique set of risks. In an industry, I typically prefer companies who are more focused on customer segments or specific competencies, rather than a general advantage. But in the MRO industry, I personally feel less comfortable in MSC and Fastenal’s specialization, compared to Grainger who is a true broadline distributor. I think over the long-term, scale and rigidity are important factors in this market.
So I would put MSC’s safety above the average business but below Grainger. If we use normalized EBIT, MSC trades at a slight discount to Grainger.
However, safety isn’t only dependent upon durability and moat. It is also influenced by capital allocation.
MSC has a very similar capital allocation pattern to Grainger. They use ⅓ of earnings to pay dividends, ⅓ to buyback stock, and ⅓ to offset dilution through buybacks. So MSC only uses 10-15% of their earnings re-investing in their business. And the company has grown sales in the double-digits for the past two decades, which leads to very high pre-tax ROIC.
The problem is the ⅓ in buybacks to offset dilution. This is less of a problem at MSC than Grainger because Grainger often acquired companies with a combination of earnings and debt. MSC doesn’t seem to have the same type of appetite for inorganic growth.
If they were to ever pull back on their buybacks, dilution would heavily impact growth. The track record of this capital allocation pattern provides some level of comfort that it won’t happen. The fact that the family owns a controlling stake in the company is another. But it’s a big risk.
MSC has a good future ahead of itself, but betting on growth seems risky.
To achieve a 10% annual return, MSC would need to grow sales by 6% annually.
The company grew sales by ~20% over the last 20 years. MSC is a powerhouse growth company. Management has a $10B sales target. They are currently at ~$3B. So management sees a long runway for growth opportunities.
Although, the manufacturing MRO market grows ~2% each year. Historical growth has come from the combination of customer count and spend per customer (across their different facilities), so they aren’t necessarily limited to the 2% per year.
In fact, this fifth distribution center could help add another ~$400-600M alone.
But the combination of 4-6% annual growth, with the possibility that 1-2% of it could be diluted, doesn’t seem like it could generate amazing returns with high certainty.
MSC has above-average durability business, but the ability to grow at an adequate rate with high certainty makes it hard to justify this as a no-brainer opportunity.
MSC will easily be around for two more decades. MSC isn’t as durable as Grainger, but it’s certainly very durable. The return to shareholders doesn’t seem as durable though.
I could be wrong on MSC’s ability to growth. MSC could grow 8-10% for another 5-10 years from the combination of customer growth and customer spend. That would be enough to generate 10% returns with enough margin of safety.
I could be wrong here on the level of MSC’s risk to capital allocation. You could say that MSC and Grainger are equal in terms of capital allocation safety because MSC is family-owned and family-controlled whereas Grainger has performance incentives above a certain growth rate and ROIC.
But a company who engages in dilution, even if it offsets it, creates a risky profile. They could let dilution trickle in if they were to invest more aggressively towards their $10B goal. They could let stock options dilute shareholders if they acquired companies, which seems to be a common strategy for growth in this industry. It’s not hard to imagine any of these things happening.
MSC might be able to grow shareholder capital by 10% per year. In fact, out of all the case studies I have done so far, MSC and Grainger have the best safety and best growth prospects out of all of them. I think of all of those companies, these companies would be the ones who could generate 10%+ annual returns.
But similar to Grainger, I think the odds of achieving a 10-15% return and a 6-8% returns are split. The bets that I try to make are 20% weighted toward 8-10% returns and 80% toward 10-15% returns. So that’s why I wouldn’t put 20% of my capital in MSC today.
Back to the Present: What actually happened
HOW WOULD HAVE IT PLAYED OUT IF I SOLD MY STAKE TODAY?
In 2015, MSC had about $175M in net debt and had ~$300M in net PP&E.
On average, the company spent 2% per year in capex and acquisitions, 60% towards PP&E and 40% towards deals. The acquisitions began in 2017 and were small – as small as $10M and only as large as $90M.
So the company reinvested closer to ⅓ of its earnings back into the business. This resulted in 3% annual sales growth, growing from ~$2.9B in 2015 to $3.7B in 2022. Gross margin was quite steady around 44%, which led to 12.5% in annual operating margin.
Additionally, management returned $1.4B through common and special dividends and returned ~$500M in buybacks, net of stock issuances. Between the 2016-22 period, management kept their net debt to EBITDA between 0.5x and 1.5x.
Now, let’s see the return investors received at the investment date.
When the Singular Diligence Report was published in July 2016, the market cap was around $4.5B. Since then, their market cap has shrunk to ~$4.3B. When you add in the $1.4B in dividends, an investment in July 2016 would have created $1.5B for shareholders, or a 5% annual shareholder return.
Reflecting for the Future: On getting better
HOW WOULD I HAVE CHANGED MY PROCESS, GIVEN THE RESULTS?
Given the results, I believe I made the correct decision.
If I owned the MSC through the holding period, I would have earned 5% in annual returns from capital appreciation and dividends. This is a subpar return, especially when compared to Grainger.
It’s a little complicated to compare MSC to Grainger. But it’s probably the best way to evaluate the outcome of MSC. If you haven’t read the Graigner case study, I would stop and read it. It will provide good context for what’s below.
In the Grainger post, I said that most of the stock’s returns came from the COVID period. This is important because MSC and Grainger had similar enough business performances from 2016 to 2019. Both companies grew sales by about 4% annually and both saw EBIT margins decline by about 1% from endpoint to endpoint.
So both Grainger and MSC weren’t great as stocks before COVID hit. Grainger’s stock did a little better than MSC, averaging about 5% per year. MSC averaged 2% per year. This isn’t just market sentiment. Investors didn’t irrationally like Grainger but hate MSC. Grainger had a better ROIC and better ROE. In fact, Grainger’s ROIC and ROE figures were almost 50-80% better than MSC’s. Grainger deserved to be valued at higher multiple.
I’m going to stew on this point before jumping into MSC’s performance during COVID.
MSC historically had superior ROIC compared to Grainger. And if MSC hit its sales capacity (around $4B), it would get back to prior peak margins. And because it had 35%+ in available capacity, it theoretically didn’t need to reinvest in its business. Therefore, MSC should be a stock that grows sales at a mid-single digit rate and earnings at a double-digit rate while paying out the remaining cash flow in dividends and buybacks.
But this thesis didn’t really play out from 2016 to 2019. It grew sales by 4% per year. It returned a meaningful amount of cash through buybacks and dividends. Management didn’t dilute as much from granting stock options. But MSC put a lot more cash back into the business, much more than one would have expected. And a lot of this reinvestment was in the form of acquisitions that didn’t create value.
So my expectation that growth of 4-6% might be diluted through stock options was wrong. Dilution didn’t affect the stock as much as I thought.
I wouldn’t necessarily call this a misjudgement in my part, though. I was right in the sense that I shouldn’t expect the 4-6% growth. Because if you told any investor in 2016 that MSC would buy a lot of companies over the next five years and Grainger wouldn’t, you would be called silly. MSC had no track record of buying companies. Grainger did. But on the flip side: was it justifiable to be more skeptical about MSC’s capital allocation than Grainger’s? No. I believed that Grainger’s capital allocation was slightly more risky than MSC’s. Grainger had some ROIC constraints on their stock option grants, but MSC was family-owned and family-controlled. So like most changes in capital allocation, it’s tough to look back in hindsight if you simply bought and held over that period.
Now, back to comparing Grainger and MSC post COVID. MSC didn’t do as well in the pandemic. Grainger’s EV/EBIT multiple nearly doubled since the 2016, whereas MSC’s multiple remained the same. In addition, Grainger’s sales grew twice as fast during MSC’s.
At a quick glance, it seems like MSC’s growth was due to its narrow focus on manufacturing and metalworking. Grainger, on the other hand, benefitted from selling a broad number of supplies to a diverse customer base.
I think I was correct in this. Over the last five years, MSC has highlighted the struggles of being solely focused on manufacturing and metalworking. Here are two quotes from the Shareholder Letter on FY 2021.
“Fiscal 2021 was an important year for MSC, as we made significant progress on our ambitious plan to transform MSC from a leading spot-buy distributor to an essential partner on the plant floors of our customers”
“While we began the year against a challenging backdrop, positive signs in the operating environment turned into tangible business drivers as customers began to rebuild backlog and manufacturing end markets grew stronger.”
I think this was something I did a good job betting on. I felt less certain about MSC’s durability given its narrow focus. I felt more certain given Grainger’s mass appeal, diversified business, and advantage in scale.
So although COVID was a black swan in many ways, I think I correctly determined that Grainger was a safer, more certain bet than MSC – at least in respect to its durability.
The learnings I got from the Grainger case study apply here.
I don’t normally look at two companies at the same time. But I think this case study showed me how valuable it was to look at multiple companies, not only as peers for comparable valuation, but as investment opportunities. I started with MSC first, then read Grainger. I know I wouldn’t have come to a rational decision with conviction unless I read Grainger.
The case study took about 13 hours, I recommend that anyone looking to improve their process find their own way to do case studies like these.
If you want to read write-ups similar to Geoff Gannon’s Singular Diligence newsletter, please visit focusedcompounding.com where Geoff and Andrew currently publish their content.