MSC Industrial Direct Co., Inc. (NYSE:MSM) Q1 2024 Earnings Call Transcript January 9, 2024
MSC Industrial Direct Co., Inc. misses on earnings expectations. Reported EPS is $1.25 EPS, expectations were $1.3. MSM isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).
Operator: Good morning, and welcome to the MSC Industrial Supply Fiscal 2024 First Quarter Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note that today’s event is being recorded. I would now like to turn the conference over to Ryan Mills, Head of Investor Relations. Please go ahead.
Ryan Mills: Thank you, and good morning, everyone. Welcome to our first quarter fiscal 2024 earnings call. 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 data and the earnings presentation and operational statistics that accompany our comments, 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 earnings 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 now turn the call over to Erik.
Erik Gershwind: Thanks, Ryan. Good morning, everybody, and thank you for joining us today. I’ll begin by wishing everyone a happy and a healthy new year. As we look back on the first quarter of our fiscal 2024, which is the first step in our next mission critical chapter, the headline that comes to mind is strong execution in a challenging environment. On today’s call, I’ll provide more color on both our execution and the environment. Kristen will then give more specifics on our financial results and expectations for the year. And I’ll then wrap things up before we open up the call for questions. I’ll now begin with the environment. On our last call, which was midway through October, we described the sequential softening in demand that began in September.
The causes included reduced spending due to sustained high interest rates, the ripple effects of the UAW strikes, inventory burn down and an overall caution among our customer base. Following our call, we experienced an even softer back half of October, resulting in another sequential step down in our growth rate. At the time of our last call, which again, was roughly halfway through our fiscal month. We estimated October sales growth of 1% to 2% over prior year. As you can see on the op stats, we ended the month down over 1%, which demonstrates just how soft demand was in the back half of October versus our expectation, that softness carried into November and as you can see on the op stats into December as well. The root causes were largely the same as identified last quarter, along with belt tightening and inventory burn down heading into the holidays of calendar year end.
While the UAW situation did resolve itself, most of our customers were slow to bring spending back on — excuse me, back online due to high finished goods inventories. December was compounded by a slightly higher than normal holiday shutdown schedule, which is typical when demand is soft. All of this has been evidenced in IP readings distributor surveys and most acutely in metalworking related end markets, as demonstrated by recent MBI readings. As we look ahead to calendar 2024, the outlook on the ground from customers, suppliers and our own sales team is more encouraging, particularly after the first calendar quarter. End user demand while light has remained fairly stable. We’ve not seen the precipitous drops that many had feared. We’re hearing that automotive related customers should ramp up early in calendar 2024.
At the same time, stronger end markets like aerospace and defense should remain strong. In addition, the prospect for stable or even lower interest rates is giving customers more confidence in future capital spending. All of this bodes well for a more positive view of the back half of our fiscal 2024 and into fiscal 2025. With respect to pricing, the environment has remained stable. We did see some select supplier cost increases, which go into effect early in calendar ’24. As a result, we’ll be taking a small price increase during our fiscal Q2 to pass these along. I’ll now turn to our execution, I’m pleased with our team’s ability to remain focused on what’s within our control and to make progress in any market scenario. Focused execution has been a theme for the past three years with progress spanning our strategic growth pillars, our productivity initiatives and now our sustainability efforts as well.
As this progress continues, it sets us up for a strong rebound when the macro environment improves, and it makes for a better world in which to operate. I’ll show you what this looks like on the next few slides, and I’ll start with our sustainability progress on Slide 5. In December, we just reaffirmed MSC’s commitment to environmental, social and governance principles with the release of our 2023 ESG report. Within this document, we demonstrate how MSC is enabling a better world and a better tomorrow. For example, we’ve recycled over 20,000 pounds of carbide since 2021 through our regrind services, and we’ve recycled 1,500 tons of corrugated packaging just in 2023 at our CFCs. We’re also creating a better world by providing sustainable products and services to our customers as we reached over 20,000 environmentally preferred products within our offering.
Additionally, our metalworking solutions enabled customers to reduce electricity consumption by 32 million kilowatt hours during the fiscal year. On the social and governance front, as you’re aware, we strengthened MSC’s corporate governance practices through the elimination of our dual class share structure, but we did more than that. Our community relations program is a vibrant part of our culture. We support many not-for-profits across the country, examples of which can be found in our ESG report. In summary, we’re proud of our ESG achievements in fiscal ’23, and we’re focused on building on this momentum in fiscal ’24. I’ll now turn to progress on the three strategic pillars we outlined for this next mission critical chapter, maintaining momentum of existing growth drivers, adding a couple of new elements to our growth formula, and driving further profit improvements through three productivity initiatives.
I’ll now take you through performance against each of these. First, on Slide 6, maintaining momentum on existing growth drivers. We continue gaining traction in the public sector with high-single digit growth during the quarter. We saw a similar level of growth in our CCSG business, which primarily consists of Class C consumable products, and we did so despite a softening demand environment. Metalworking, while soft due to manufacturing conditions made important strides for future progress with the formal launch of the Machining Cloud relationship, extending our reach to tooling engineers who are configuring new machining jobs. Despite our metalworking market leadership, we continue to see ample opportunities to expand in various regions across North America.
Most significant was our solutions performance. During the quarter, we achieved vending signings growth of more than 25%, while our installed base grew 10% year-over-year. For implants, we achieved a record rate in signings and grew our program count by more than 35% compared to prior year. It’s also worth noting that VMI installations were up year-over-year in the low-teens as well. These numbers are indicative of market share gains and bode well for our future growth outlook. As a reminder, signings take roughly three months to convert to revenue generation depending upon the solution and the size of the win. As a result, the costs associated with these wins occur before the revenues do. I’ll now discuss progress on the two new elements to our growth formula, which are shown on Slide 7.
First is reenergizing our core customer growth. On the last call, I highlighted two foundational priorities for unlocking the growth, realigning our public facing web pricing and implementing the new product discovery functionality on our website. With respect to pricing, our goal is to provide market competitive prices to smaller core customers while remaining roughly gross margin neutral through better discounting disciplines. We are currently 30% of the way through the realignment, and we’re on track to achieve that goal. In addition, we’re seeing encouraging early indicators such as improved web conversion rates, and more favorable levels of growth compared to non-piloted SKUs. We plan to complete the balance of the portfolio by the end of our fiscal second quarter.
With respect to the new product discovery platform, it’s now in market in the form of a pilot program and will be fully deployed before the end of our fiscal second quarter. Early indicators are also promising for search. We’re watching conversion rates and other performance measures carefully, and we’re pleased with what we’re seeing. More exciting is what’s yet to come in the following quarters as we build on the base functionality being launched now with significant enhancements such as new table views and schematics, customer self-service analytics, and AI-driven personalization. We will more aggressively market the pricing and the web improvements in the back half of our fiscal year after both projects are complete. The other new element to our growth strategy is building on our OEM fastener foundation of AIS and Tower.
We plan to do so by capitalizing on the cross-selling blueprint that we’ve proven out with CCSG. While we’re still in the early innings, initial indications are promising, with the build-out of a large funnel and several early wins. These efforts will allow us to significantly expand our share of wallet across our customers. I’ll now touch on our third mission critical priority, improving profitability through productivity. And here, we highlighted three initiatives: improving category management, accelerating supply chain efficiencies, and upgrading our digital core systems and business processes. Our category management efforts, which include line reviews, portfolio optimization, and product mix and margin management helped us to exceed our first quarter gross margin expectations.
As you may recall, we shared on the last call that gross margins for the year should be flat to slightly down versus fiscal 2023’s 41.0%. We also felt that Q1 and Q2 would be the most challenging due to the worst of the price cost dynamics. So we were pleased to come out of the gate strong at 41.2%, which provides some potential upside for the year. Supply chain improvements are noteworthy and are just getting started. Martina has built a strong team with a mix of existing MSC performers and some new talent from the outside. This team is bringing a fresh perspective to many areas within supply chain. During Q1, we saw improvements in freight expenses both in absolute terms and as a percentage of revenues and in inventory efficiency. As inventory levels dropped $17 million despite end of calendar year buying, for rebate opportunities.
We anticipate more improvements to come as the team is conducting a thorough review of our supply chain end to end. Finally, with respect to our digital core systems upgrade, the project is on time and on budget. We expect to launch sometime around the end of fiscal 2025 and which will unlock further productivity gains across the order to cash and procure-to-pay value streams. All-in-all, despite the subdued growth rate in our fiscal first quarter, our execution remains at high levels and supports future profitable growth. I’ll now pass things over to Kristen to discuss our first quarter performance and annual outlook in greater detail.
Kristen Actis-Grande: Thank you, Erik and good morning, everyone. Please turn to Slide 8, where you can see key metrics for the fiscal first quarter on both a reported and adjusted basis. Fiscal first quarter sales of $954 million declined 0.4% year-over-year with the same number of business days in both periods. The year-over-year decline was mainly driven by lower volumes due to the demand softness experienced in the second half of the quarter that Erik mentioned earlier. This was partially offset by ongoing momentum in our mission critical growth drivers as well as more modest tailwinds from price and acquisitions. Foreign exchange was also a slight top line benefit to the tune of 30 basis points. By customer type, we experienced 9% growth in the public sector as we continue to further penetrate that portion of the market.
Sales to national account customers improved 4% compared to the prior year period, while core and other customers declined approximately 5% year-over-year. As it relates to national accounts and core customer base, impact from the UAW strike and acute demand softness in metalworking related end markets at quarter end were the primary drivers to the step down. From a solutions standpoint, we continue to take share during the quarter. In vending, Q1 average daily sales improved 5% year-over-year and represented approximately 17% of total company net sales, an improvement of roughly 80 basis points compared to the prior year. Sales through our implant program continued growing in the double-digit range with 10% growth and improved more than 200 basis points year-over-year to 15% of total sales.
Signing rates across both solutions remained healthy during the quarter, especially in implants where we achieved quarterly signings at a record rate. Moving on to profitability for the quarter. Our gross margin of 41.2% declined 30 basis points year-over-year. As expected, price/cost is a larger drag on margin during the quarter, which will be the case for 2Q before leveling off in the second half of the year. That said, I’m pleased with our gross margin countermeasures, which offset the majority of price cost headwinds during the quarter. Reported operating expenses during the quarter were approximately $291 million, up $11 million year-over-year. On an adjusted basis, operating expenses were approximately $289 million, up $10 million year-over-year.
Combined with sales being essentially flat year-over-year, this resulted in adjusted operating expenses increasing roughly 115 basis points as a percentage of sales. This step-up in operating expenses was largely driven by elevated costs associated with our strategic investments of roughly $10 million. To give some perspective, more than half of this investment was associated with payroll related costs to support implant growth, web price realignment initiatives and upgrades to our digital core. Outside of costs associated with strategic investments, payroll and payroll related costs were up primarily due to merit and higher health care costs, which were largely offset by productivity. On a sequential basis, Q1 adjusted operating expenses were roughly flat with Q4 levels.
Revenues were down in the neighborhood of $50 million sequentially after backing out the non-recurring public sector orders, which came with very little operating expense. All else being equal, one would have expected Q1 operating expenses to flex down by a few million dollars. The GAAP and the reason they did not was primarily the investments I just described which support solutions growth, web price realignment initiatives and upgrades to our digital core. We are pressing on with those investments because our confidence in their ability to create long-term value for stakeholders and our constructive outlook for the back half of the fiscal year, which I will describe in just a bit. Reported operating margin was 10.6% compared to 12.1% in the prior year period.
On an adjusted basis, operating margin of 10.9% declined 140 basis points compared to the prior year. The year-over-year decline was primarily due to the previously mentioned step-up in operating expenses combined with lower sales volumes. GAAP earnings per share was $1.22 compared to $1.45 in the prior year period. On an adjusted basis, EPS was $1.25 versus $1.48 in the prior year. Turning to Slide 9 to review our balance sheet and cash flow performance. We continue to maintain a healthy balance sheet with net debt of approximately $513 million, representing 0.94 times EBITDA. Share repurchases during the quarter to offset share reclassification dilution was the largest contributor to the sequential increase in net debt. We made progress on our working capital during the quarter, including roughly $17 million in inventory reductions.
This resulted in first quarter operating cash flow conversion of 117% keeping us on track to achieve our target of greater than 125% for the full year. Capital expenditures during the quarter of $18 million declined approximately $7 million year-over-year. Together, this drove free cash flow generation of approximately $63 million compared to $51 million in the prior year. The strength of our balance sheet and cash generation supports our capital allocation priorities shown on Slide 10. As you can see, our decision to deprioritize special dividends continues creating significant room for strategic optionality such as the investments currently being made this fiscal year. Looking forward, this will likely gravitate towards other organic investment opportunities, bolt-on M&A with a focus on metalworking and OEM fasteners and further deployment to shareholders.
As it relates to the ordinary dividend, we will target moderate and consistent increases. Moving to Slide 11 for an update on our repurchasing efforts. I’m pleased to announce that we repurchased all the dilution from the share reclassification, which was approximately 1.9 million shares. This was achieved by approximately 1.4 million shares repurchased during the first quarter following the 650,000 shares repurchased in fiscal Q4. With this buyback initiative complete, we have approximately 2.4 million shares remaining on our current authorization. Looking forward, we will look to offset annual stock-based compensation dilution and look for windows of opportunity to be more aggressive. Turning to Slide 12. We are maintaining our outlook for the fiscal year despite the slow start.
As a reminder, this entails average daily sales growth of 0% to 5% and adjusted operating margin in the range of 12% to 12.8%. I would like to provide additional color on the expected cadence of our performance for the remainder of the fiscal year. Starting with revenues, the midpoint of our outlook assumes that average daily sales improved meaningfully as we move through the back half of the fiscal year. This expectation is based on the following assumptions: first, improving macroeconomic conditions beginning in early calendar 2024, as Erik described earlier. Second, the recent surge in solution signings continued to produce a growth tailwind as it takes roughly three months to convert to revenue generation, depending on the solution and the size of the win.
Third, our strategic investments, such as the pricing realignment and new web search platform will begin yielding benefits as we move through the back half of the fiscal year. On the profitability side, our gross margin performance during the quarter was better than expected and at a rate higher than our annual assumptions. We expect second quarter gross margin to be similar to the first quarter with some potential upside later in the fiscal year, given easing price cost headwinds, increasing contributions from category line reviews and the small pricing actions during fiscal 2Q. As it relates to adjusted operating expenses, we expect to see the typical seasonal lift in dollar terms for 2Q related to the timing of merit increases. From there, we would expect any step-up in adjusted operating expenses to be more modest with the increases being driven by variable costs associated with volumes as strategic investments begin to ease.
As a result, we would expect to see strong operating leverage in Q3 and Q4. With that, I will now turn the call back over to Erik for closing remarks before we open the line for Q&A.
Erik Gershwind: Thank you, Kristen. I’m proud of our team’s execution in a challenging environment during the fiscal first quarter. We demonstrated high levels of performance throughout our previous three-year mission critical journey, and that is carrying into this next chapter. We’re focused on maintaining momentum on existing initiatives, investing into new ones that will accelerate performance, and creating new productivity levers to drive margin expansion. The work we are doing now will yield dividends, particularly as macro conditions improve. Our Board and our management team are confident in our people, our plan and our future. I’ll close by thanking our entire team of 7,000 plus associates for their hard work and commitment to our mission. And we’ll now open up the line for questions.
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Q&A Session
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Operator: Thank you. [Operator Instructions] Today’s first question comes from Tommy Moll with Stephens. Please go ahead.
Thomas Moll: Good morning and thank you for taking my questions.
Erik Gershwind: Good morning, Tommy.
Kristen Actis-Grande: Good morning, Tommy.
Thomas Moll: I wanted to start on the demand environment, and you’ve both provided some helpful context on how you see the year shaping up and improving as we go forward. But there were two points that, I wanted to circle back on. First is just on the macro improving as we get into the first calendar quarter, any additional insight you can provide there on what you’re seeing or assuming. And then the related point, you’ve describe some of the benefits from strategic investments in the second half. You’ve got a slide today that provided a lot of positive early updates, but what confidence or visibility do you have that when you continue to lean in there that will really move the needle in terms of the ADS? Thank you.
Erik Gershwind: Hi, Tommy. It’s Erik. So I’ll let you take both. So let me start with the demand environment and you heard in the prepared remarks, what we’ve seen over the past three months or so, particularly since the call. And really, in speaking to customers, you’ve got a few things going on. Certainly, high interest rates catching up with the industrial economy in terms of lower capital spending and we saw that evidenced in some acute softness in certain of our product lines that would be more akin to a capital type purchase, very typical. The second thing, certainly, the UAW situation, which — while the situation itself resolved itself, our customers were slow to come back online. And then the third factor, the closer we got to the end of the year, the calendar year, the more we saw what we described as belt tightening and inventory burn.
Again, pretty typical in a slow environment that customers would use end of year to take more than typical time off, so you saw that in our December numbers. As we look forward, what informs our outlook is pretty much the same process that we go through on a normal basis. We’ll look at macro indicators, look at what’s going on around us and then lean heavily on what we hear on the ground. And what we hear on the ground is from our customers, from our sales team who are interfacing with our customers every day and from our supplier community. And I would say, in general, a couple of things. One is, we would expect that part of what happened at the year-end here with the belt tightening, the holiday schedule and the burn down, that sort of falls off as we move into the calendar year.
But as — particularly what we’re hearing on the ground as we move past the first month or two of the calendar year that with interest rates stable, hopefully coming down, confidence is building among our customer base. And again, we’re hearing this from our reps, our customers and our suppliers. All of that feeds into — you look to the back half of our fiscal year and into ’25, what seems like a more encouraging constructive environment. So that would be the first thing I’d say on the demand side, Tommy. And yeah, you’re right. If you look at our framework for the back half of the year, certainly, it’s back-end loaded now given the way the slow start we came out of the gate. So some of that is environment and then some of that is initiatives, and that was the second part of your question.
With respect to the initiatives, I’d sort of break it into two pieces as we did in the prepared remarks on the slide. The first tranche is the stuff that’s already been in motion that’s maintaining momentum on existing growth drivers. So that would particularly what we call out there is the solutions performance where we have seen a nice step-up in the growth rate of some of these growth drivers. And as Kristen mentioned, we see a lag somewhere plus or minus three months from the time that we get a new signing, whether it’s a vending or an implant to the time that we start to see meaningful revenue contribution. So that would be one of the things that gives us confidence. And then the other is the newer growth initiatives, and particularly the two foundational elements that we highlighted directed at reenergizing the core customer.
What I’d say on both is while it’s still relatively early stages on both particularly on the web pricing realignment, we do have enough experience there under our belt to feel pretty good about the metrics that we’re seeing and that it’s doing what it’s expected to do. So certainly, that factors into our constructive outlook for the back half of the year as well.
Thomas Moll: Thank you. That’s all helpful. And for my second question, I wanted to follow up on gross margins. Kristen, maybe to just make sure that I heard you correctly and then give you an opportunity to give any additional insight here. But what I think I heard you say first quarter was better than you would have expected, second quarter should be roughly similar to first quarter in terms of the margin rate and then second half versus second quarter potentially higher. So if you could just step us through all those, make sure we’re tight and then any of the drivers you’d like to call out would be helpful as well? Thank you.
Kristen Actis-Grande: Yeah. Sure, Tommy. So let’s start with Q1 and to your point, we were definitely pleased with where we saw gross margin land in the first quarter. I’ll break it down on a year-over-year basis. So we did see a sizable headwind from price cost as expected, that was offset by a combination of things, the largest being the gross margin countermeasures that we’ve been working on. So think about things here like inventory efficiency driving improvements in our variances, our rebates influencing favorable product mix. And then we also started to get a bit of benefit from the category line reviews in Q1. Then as we think about Q2, to your point, expecting that to be roughly flattish, a slight easing in price cost into Q2, but not really notable until the second half.
