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Morningstar | MSC Grapples With Slowing Demand and Rising Costs During Tough 3Q; FVE Lowered to $90

Shares of narrow-moat-rated MSC Industrial Supply traded lower on July 10 after the firm released disappointing fiscal third-quarter results. Reported sales grew almost 5% (2% organic) year over year to $867 million, but fell 2% short of both management's midpoint guidance and the consensus estimate. Diluted EPS grew about 4% year over year to $1.44, falling shy of management's guidance range ($1.46-$1.52) and consensus ($1.49). MSC's EPS growth was driven entirely by a lower tax rate and share count; the firm's pretax margin contracted 130 basis points to 12.2% primarily due to gross margin pressure.

During the last earnings call, management noted that sales rebounded the first week of April. We were cautiously optimistic that this trend could continue through the rest of the fiscal third quarter, but it was not to be. Instead, management said that end market demand worsened since then. Still, MSC managed to post higher sales compared with the year-ago quarter driven by low-single-digit growth among core customers and mid-single-digit growth among national accounts. However, management only expects total revenue to grow less than 1% (midpoint of guidance) during the fourth quarter.

Lower-than-expected sales, along with cost pressure and customer mix (higher growth from lower-gross-margin national accounts), made it difficult for the firm to meet its profitability goals. MSC's 12.8% operating margin was 110 basis points lower than last year and missed midpoint guidance by 20 basis points.

Considering MSC's disappointing fiscal 2019 performance, we lowered our fair value estimate by about 4% to $90 per share to reflect our more cautious revenue growth and profitability outlook. Still, with a 4% dividend yield (following a 19% dividend increase) and trading at a 20% discount to our fair value estimate, MSC's stock is attractive for long-term investors who can look beyond the company's recent rocky performance and near-term uncertainty, in our opinion.

Our lower fair value estimate is the result of several measures we've taken to attach a more conservative narrative to our valuation considering MSC's recent performance. Specifically, we reduced our five-year compound annual sales growth rate by about 100 basis points to 4.5%; we reduced our five-year average operating margin by 30 basis points to 12.8%; and we lowered our stage II return on new invested capital assumption by 300 basis points to 20%.

Despite several concerning issues mentioned during the earnings call--increased customer uncertainty and the specter of a continued negative price-cost spread due in part to tariffs and aggressive pricing from local distributors--we still like MSC's longer-term prospects. We continue to believe that MSC's metalworking niche and service offerings help shield the firm from online competition (that is, Amazon Business). Furthermore, aggressive pricing from smaller local distributors is nothing new, in our view, and we continue to expect MSC to take share from smaller competitors that lack MSC's national scale, product and service breadth, and e-commerce savvy--factors that have become increasingly important to customers. We view customer uncertainty (and related softening demand) as a cyclical issue that will eventually give way to stronger demand, and with it, a more constructive pricing environment for MSC, which should result in stronger margin performance.