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Morningstar | MSC's 2Q Sales and EPS Fall Short of Expectations Due to a Softer Demand Environment

Shares of narrow-moat-rated MSC traded lower on April 10 after the company's fiscal second-quarter earnings release, which featured sales and EPS that missed the midpoint of management's guidance and sell-side consensus expectations. Second-quarter sales of $823 million increased 7% on a reported basis and 4% organically, but just missed the midpoint of management's guidance ($825 million) and the consensus estimate ($826 million). Excluding one-time tax benefits of $0.72 in the same period last year, related to the Tax Cuts and Jobs Act, EPS declined $0.10 year over year to $1.24, which slightly missed the midpoint of management's guidance ($1.25) and the consensus estimate ($1.26).

Management blamed lower-than-expected sales on the combination of "weather, destocking, softness in automotive and oil and gas, and some ripple effects from the prior government shutdown," but said that sales during the first week of April materially improved. However, the sustainability of that trend is not considered in management's third-quarter guidance. Management expects third-quarter revenue to increase 6.5% (at the midpoint of guidance), which equates to approximately 3% growth excluding the AIS acquisition and the firm's new Mexican operation.

While MSC's second-quarter gross profit margin (42.7%) and operating margin (11.7%) were in line with management's guidance, the firm's third-quarter margin guidance (42.7% gross margin and 13% operating margin) was a bit lighter than we had been forecasting. MSC's recent price increase will be a tailwind for gross margins over the remainder of fiscal 2019, but we expect product cost inflation, sales mix, the AIS acquisition, and MSC Mexico will continue to be gross margin headwinds in the second half. After considering MSC's recent performance, we've moderated our longer-term sales growth and operating margin projections, which lowered our fair value estimate by 6% to $94 per share.

Specifically, we now assume a five-year compound annual sales growth rate of 5% versus 6% previously and operating margins improving to about 14% by 2023 compared with our previous 15% assumption.

As mentioned above, we expect sales mix will continue to be a gross margin headwind. This dynamic is driven by lower gross margin revenue sources, such as vending, growing faster than the company average. During the earnings call, CEO Erik Gershwind said that vending signings are up over 50% year over year. Despite lower gross margins, we believe vending sales generate contribution margins that are commensurate with the company average.

Investors might have noticed a new noncontrolling interest line item on MSC's balance sheet and income statement. The noncontrolling interest relates to the firm's newly formed partnership with Mexican distributor TAC, which is called MSC Mexico. MSC has a 75% controlling ownership stake in the new venture. MSC expects its Mexican operation will allow the firm to gain a foothold in the growing Mexican manufacturing sector and increase the firm's wallet share with existing customers that have Mexican manufacturing operations. While we see this strategy as an attractive growth opportunity, management noted that MSC Mexico is currently immaterial to the firm's consolidated financial results.