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Morningstar | MSC's 2Q Margin Guidance Disappoints, but Higher Prices Could Drive Stronger 2H Profitability

MSC Industrial Supply reported fiscal first-quarter results that largely met management's and Wall Street's expectations. The narrow-moat industrial distributor's first-quarter revenue grew 8% year over year (6% organically), operating income grew 4% to $103 million, and EPS increased 27% to $1.33. Most of the significant growth in EPS was due to a lower tax rate and share count relative to the year-ago quarter.

MSC's shares traded down almost 1.5% after reporting earnings Jan. 9, while close peers and the broader market closed the trading day modestly higher. We think the stock price underperformance was probably the result of management's disappointing second-quarter gross margin guidance of 42.8%, down 20 basis points sequentially and 110 basis points year over year. Cost of goods sold inflation is the main culprit behind the expected gross margin decline, but the company plans to implement a price increase in February. While the timing of this price increase won't help margins for MSC's fiscal second quarter ending in February, depending on market acceptance, this increase has the potential to materially improve second-half profitability. Because of the uncertainty surrounding price realization, management avoided setting firm expectations for the pricing-related margin expansion opportunity, but CEO Erik Gershwind said the pricing environment is robust and it's a good time for pricing discussions with customers.

After reviewing MSC's first-quarter results and considering management's commentary, we've lowered our full-year operating margin estimate to 13.2% from 13.5%. However, we've maintained our $100 fair value estimate as our longer-term outlook, which assumes a 15% normalized, sustainable operating margin, is unchanged.

If MSC's 2019 operating margin comes in as we expect (13.2%), it will mark the fifth consecutive year the firm has generated operating margins in the low 13s--disappointing for a company that has delivered high teens operating margins in the not-so-distant past (18% peak in 2008 and above 17% in 2011 and 2012). Historically, inflation has been a boon for distributors, but sustained pricing gains have been fleeting for the industry following the industrial production downturn in 2015 and amid increased competition.

It appears to us that the pricing environment is becoming for more constructive for MSC and other industrial distributors. And while MSC is certainly not immune from competition from e-commerce competitors like Amazon Business, we think its niche in metalworking, technical expertise, and ability to document how much money its value-added services can save customers does differentiate MSC from many of its competitors and affords it some degree of pricing power. While we're hopeful that the pricing environment Gershwind described during MSC's first-quarter earnings call persists over the coming years and benefits MSC's profitability, we acknowledge that an economic slowdown would prolong MSC's margin recovery story. Still, we remain comfortable with our midcycle margin assumption of 15%, which, based on our analysis, we think is a reasonable level of profitability for MSC in a normalized environment.

When asked about MSC's strategy during an economic slowdown during the earnings call, Gershwind said his team sees no sign of a recession. He noted that while there are some "yellow flags," the environment remains robust; MSC's customer order volume is up and industry sentiment remains positive.