MSC Industrial Direct Co., Inc. (NYSE:MSM) Q2 2024 Earnings Call Transcript

MSC Industrial Direct Co., Inc. (NYSE:MSM) Q2 2024 Earnings Call Transcript March 28, 2024

MSC Industrial Direct Co., Inc. beats earnings expectations. Reported EPS is $1.18, expectations were $1.16. 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 day, and welcome to the MSC Reports Fiscal Second Quarter 2024 Results Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today’s presentation there will be opportunity to ask questions. [Operator Instruction]. Please note, today’s event is being recorded. I’d now like to turn the conference over to Ryan Mills, Head of Investor Relations. Please go ahead, sir.

Ryan Mills: Thank you, and good morning, everyone. Welcome to our second 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 in 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 reconciliation of the adjusted financial measures to the most directly comparable GAAP measures. I will now turn the call over to Eric.

Erik Gershwind: Thank you, Ryan, and good morning, everybody. Thank you for joining us today. As we move past the halfway point of fiscal 2024, our performance to date has been mixed. Our high-touch programs such as vending and implant solutions continue capturing share and they’re performing ahead of expectations. On the other hand, growth has not yet inflected in our core customer base in the face of a sluggish macro environment, particularly in our heavy manufacturing end markets. This can be evidenced in the performance of our top 100 national accounts, where only 45 were growing last quarter. As a result, revenue growth to date has been below our expectations. At the same time, I’m pleased with how we’ve been managing the business in a challenging environment.

Gross margin performance, our productivity efforts and cash flow generation have been strong, and they’re expected to continue. And while our performance to date has been mixed, my conviction in our plan is as high as ever. We expect to improve the trend in revenues during the back half of our fiscal year and into fiscal 2025. And this belief is grounded in several factors. First, while macro conditions have not materially improved since the start of the calendar year, we continue to hear a more positive overall sentiment about the coming months from our team on the ground. Second, as I mentioned, our implant and vending signings continue to outpace our expectations. These signings should yield incremental growth through the balance of the fiscal year and beyond.

Third, we successfully completed our web pricing realignment initiative as planned in late February, and the benefits are just starting to be felt. Fourth, our website improvements which are running slightly behind schedule are expected to roll out during the back half of the year and should yield further benefit. And fifth, we’ve increased our marketing efforts to generate awareness and demand by featuring the recent enhancements to our value proposition. My conviction is also derived from our ongoing gross margin execution and as you’ll soon hear, a growing pipeline of productivity initiatives that provide runway for operating margin expansion as the business returns to growth. Before I turn it over to Kristen, I’ll walk through our performance in more detail and provide a key initiative update along the way.

And I’ll begin with our first mission-critical priority, which was maintaining momentum in our high-touch programs that mainly serve our larger customers. We grew implant programs by 39% and our vending installed base by 11% as compared to prior year. Public sector sales have also held up nicely with slight year-over-year growth despite temporary budget constraints. Moving to our metalworking offering on the next slide. We strengthened our leadership position during the quarter with two exciting additions to the portfolio. The first is car industrial, a distributor supplying metal working and related MRO supplies into Eastern Canada. This acquisition brings in a highly technical sales force and strengthens our presence in the region which currently represents 2% of sales.

We’ll look to drive top line synergies by providing card and e-commerce sales channel and equipping it with MSC’s large breadth of product. The second deal is exciting from a longer-term perspective, with the just recently announced acquisition of the intellectual property assets from Smart or SMRT, which consists of technology assets developed by Dr. Tony Schmitz and his wife Christine. This transaction brings to us one of the nation’s foremost manufacturing mines in Tony, and it brings us new capabilities, such as the next generation of predictive milling technology, which underpins MSC MillMax. I’ll now turn to our second growth priority on Slide 7, which is reenergizing our core customer. And clearly, that did not happen in the fiscal second quarter as seen by core customer average daily growth rates.

That said, Q2 numbers did not reflect the benefits of the initiatives being put into action. The web pricing reset we’ve been describing was completed for the remaining 70% of SKUs near the end of February, with early indications boding well for future growth rates. We’re seeing improvements already in customer Net Promoter Scores and improvements across several leading indicators on our website, such as how often do customers click on an item page, how often do they add to cart, and how often do those cards convert to order. All of these metrics are showing a nice uptick over the prelaunch baseline. Moving to e-commerce, we prioritized several improvements to the platform in the second quarter to enhance the customer experience. So this delayed the full launch of the new search engine, which was planned for late in Q2 and the rollout of subsequent search enhancements which are now all expected to launch in the back half of the year.

On the marketing front, as I mentioned earlier, we’ve launched a program, introducing customers to the exciting changes happening at the company. This initiative is aimed at generating awareness on our new web pricing and what’s to come on the website. Our final mission critical growth priority is expanding our OEM fastener offering by leveraging the successful cross-selling formula developed through CCSG. And while OEM sales remained down year-over-year due to acute customer softness, we’re encouraged by early cross-selling results. For instance, during the quarter, we achieved a sizable win from an existing MSC implant customer, serving the consumer leisure market by significantly improving their ability to manage inventory. I look forward to updating you on continued success as we build on this early momentum.

I’ll now switch gears to profitability and begin with gross margin. We performed well again in Q2 due to a combination of maintaining strong price discipline, realizing benefits from our category line reviews and mix management efforts. Additionally, our refreshed purchasing approach is yielding results in the form of improved inventory efficiency and reduced inbound freight expense as a percentage of sales. With respect to operating expenses, we’re taking a continuous improvement approach to increase our productivity. This is going to play a crucial role in our path to mid-teens adjusted operating margins under our new set of mission-critical objectives, and I want to highlight for you this morning 4 proof points that demonstrate how momentum inside the company is accelerating on this front.

First, on the next slide, you’ll see that after extensive analysis, we made the decision to close our Columbus distribution center. While there are 2 factors that made this decision clear cut, it was nonetheless a difficult 1 because of our culture that places people as our top priority. The first factor was the explosion in our solutions business and that being vending, VMI and implant. That business went beyond what we could have envisioned when we opened the building just over a decade ago. Today, customers with solutions represent nearly 60% of our revenues. The implication here is that a greater portion of our business can be staged out and planned. And as a result, the operational needs of our distribution center footprint evolved as our revenue mix shifted.

The other enabler of the move was the automation investments that we’ve made in recent years, primarily into our Elkhart, Indiana and Harrisburg, Pennsylvania facilities. As you can see on Slide 8, these investments not only allowed us to scale while easing the hiring burden, but they enhance efficiency and expand throughput capacity in both facilities. The closure of the Columbus facility will begin producing annualized operating savings of an expected $5 million to $7 million in fiscal ’25 with upfront expenses during the back half of fiscal ’24 in order to execute the plan while maintaining our highest customer service levels. Second, on the productivity front, we’ve recently launched an end-to-end supply chain network study, which is analyzing the entire flow of goods through our network.

We’re in the process of sizing the total profit improvement target from this, and we’ll return with more details on it by fiscal year-end. Third, we’ve opened a new shared services center in Carretero, Mexico to reduce labor costs while maintaining talent across many of our key functions. Our early hires are in place, and we’re pleased with the initial progress. And fourth, during our fiscal second quarter, we offered a voluntary separation package to associates across the company. The operating stats posted on the Investor Relations section of our website show a slight tick down in associate headcount from Q1. This is due primarily to departures from the voluntary separation, which were offset by headcount additions from the acquisition of KAR, the shared service center in Mexico, and continued support of implant growth.

Moving from our P&L. I’ll now turn to our balance sheet and cash flow, which remains strong. I’ve been particularly pleased with our inventory reductions of $25 million during the quarter, which most importantly, was accomplished while maintaining our high customer service levels. Our balance sheet remains at low levels of leverage, providing us with plenty of flexibility to pursue the investments that I’ve just outlined. I’ll now turn things over to Kristin to discuss our results and our updated guidance in more detail.

Kristen Actis-Grande: Thank you, Erik, and good morning, everyone. Please turn to Slide 9, where you can see key metrics for the fiscal second quarter on both a reported and adjusted basis. Fiscal second quarter sales of $935 million declined 2.7% year-over-year with the same number of business days in both periods. Despite the sequential improvement in our sales within the quarter off a particularly soft December, volumes remained negative year-over-year through the quarter. This was partially offset by ongoing solutions momentum and more modest benefits from price and acquisitions. By customer type, national accounts performed the best, with average daily sales up 1.1%, and 45 of our top 100 national account customers grew in 2Q.

When considering the macro challenges and significantly tougher comps in the first half of the year, I am encouraged by the resiliency despite here. The public sector had slight year-over-year growth of 0.6%, driven by mid-single-digit growth from our federal customers. We experienced softness in the state and local portions of the public sector due to temporary budget constraints. Core and other customers, average daily sales were challenged during the quarter, declining 5.7%. From an end-market perspective, we experienced acute demand softness in heavy manufacturing verticals, including end markets and tiered suppliers that support the earlier stages of production and automotive. From a solution standpoint, we continue to take share during the quarter despite a challenging market.

In vending, Q2 average daily sales improved 6% year-over-year, and represented 17% of total company net sales. Sales through our implant program grew approximately 10% year-over-year and represented approximately 16% of total company net sales despite only 46 of our top 100 implants showing growth in 2Q. Signing rates across both solutions remained at healthy levels during the quarter, especially in implants where fiscal year-to-date signings are exceeding our internal targets. Moving to profitability for the quarter. Our gross margin of 41.5% improved 20 basis points year-over-year. The improvement in gross margin was largely driven by continued benefits from our countermeasure efforts, including category line reviews. These efforts were partially offset by price cost headwinds and acquisitions.

Both reported and adjusted operating expenses for the quarter were approximately $291 million. We recorded roughly $6 million in restructuring expense primarily related to the voluntary separation that Erik mentioned. On an adjusted basis, operating expenses were up $11 million compared to 2Q of last year. Combined with lower sales year-over-year, this resulted in a 200 basis point increase in adjusted operating expense as a percentage of sales. The year-over-year step-up in operating expenses was largely driven by merit of $6 million and approximately $10 million of costs associated with our strategic investments. Roughly a third of this expense is associated with headcount to support our solutions growth and digital initiatives. Sequentially, adjusted operating expenses increased by a couple of million dollars as expected due to a full quarter of merit.

Reported operating margin for the quarter was 9.7% compared to 11.9% in the prior year. On an adjusted basis, operating margin was 10.5%, a decline of 170 basis points compared to the prior year. The previously mentioned step-up in operating expenses combined with lower sales were the largest contributing factors to the year-over-year decline. GAAP earnings per share was $1.10 compared to $1.41 in the prior year period. On an adjusted basis, EPS was $1.18 versus $1.45 in the prior year. Turning to Slide 10 to review our balance sheet and cash flow performance. We continue to maintain a healthy balance sheet with net debt of approximately $530 million representing roughly 1 times EBITDA. We made progress on our working capital during the quarter, including roughly $25 million in inventory reductions.

This resulted in second quarter operating cash flow conversion of 128%, and 122% fiscal year-to-date, keeping us on track to achieve our target of greater than 125% for the full year. Capital expenditures during the quarter of $25 million increased approximately $10 million year-over-year, primarily driven by investments tied to digital and ongoing solutions growth. Together, this drove strong free cash flow generation of approximately $53 million in fiscal 2Q and $116 million fiscal year-to-date. Our balance sheet and cash generation remains strong and continues to fuel our capital allocation priorities shown on Slide 11. We deployed cash in several of these buckets during the quarter including the strategic acquisition of KAR Industrial and the intellectual property assets from Smart that Erik alluded to earlier.

We also repurchased $16 million of shares in the second quarter. Moving to our full year outlook on Slide 12. Given our performance halfway through the fiscal year, it is likely we will be at the bottom end of the range in both average daily sales and adjusted operating margin. There is some downside risk if the expectations for the remainder of the year, which I am about to outline, provide benefits later than anticipated. Starting with revenue. To achieve the lower end of our outlook, it would imply ADS improves meaningfully throughout the remainder of the year. This confidence is based on the following assumptions: starting with what’s not in our control is macro conditions, which we expect will begin to improve off of fiscal 2Q levels, particularly in heavy manufacturing verticals.

Additionally, we expect budget constraints in the public sector to ease as we progress through the fiscal year. Within our control, there are several factors driving expectations of improvement. First is the rate of signings for our solutions, especially in implants where momentum is particularly strong. This should drive growth in the second half as our recent wins ramp in revenue. Second, our benefits from our strategic investments as they begin rolling out in the second half. As Erik previously mentioned, our new web price strategy went into full effect at the end of February and is yielding favorable early results. Additionally, our enhanced product discovery platform will be fully launched in the second half. The effectiveness of both will be supported by our marketing campaign that kicked off this month.

On the profitability side, our gross margin performance during the first half was better than expected and above our annual assumption. We expect second half gross margin to continue at or be slightly above 2Q levels. As it relates to operating expenses, we see benefits from our fixed costs and productivity being leveraged on higher volumes, driving improved profitability in the second half. Before I move on to expectations on other line items, the effectiveness of some of these second half drivers will increase throughout the remainder of the year. As a result, it will likely be the case that our second half doesn’t follow historical patterns and will instead be more weighted on the fourth quarter. As it relates to the relationship between sales growth and profitability, the way that we’re thinking about fiscal ’24 is that every point of revenue growth is worth approximately 20 basis points of adjusted operating margin.

Regarding other assumptions in our updated outlook, I will highlight two minor adjustments. G&A expense will likely come in at the lower end of prior guidance of approximately $85 million. And lastly, our tax rate is now expected to be 24% to 24.5%. With that, I will now turn the call over to Erik for closing remarks.

Erik Gershwind: Thank you, Kristen. Our performance thus far in fiscal 2024 is mixed, both not yet meeting our expectations. Despite this, I remain confident, I see evidence of solid execution across our mission-critical initiatives, providing optimism for the back half of fiscal 2024. And longer term, we remain squarely focused on our objectives of 400 basis points or more of outgrowth above IP and operating margins in the mid-teens. I want to thank our entire team for their dedication in supporting our customers and our mission. And we’ll now open up the line for questions.

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Q&A Session

Operator: [Operator Instructions] Today’s first question comes from David Manthey with Baird. Please go ahead.

David Manthey: Erik, Kristen, first question is on your outlook. What is the IP growth that you’re assuming as you say, the acceleration into the back half? What’s the underlying assumption for second half IP growth?

Kristen Actis-Grande: Yes, Dave. So for the second half, I’ll give you kind of overall, we’re not expecting a significant inflection of where we’ve seen IP, some steady improvement, but the more meaningful thing to note is expected IP improvement particularly in machinery and equipment and fabricated metals. In 2Q, machinery and equipment was down about 5%, the subindex of IP and fabricated metals was down a little bit over 1 point. So when we look at sort of our exposure to given end markets, our top 5 end markets, which are roughly 50% of our revenue four of those 5 were declining. Their IP index declined in our fiscal second quarter. And then if you think about how the IP index is weighted, while that’s 50% of our revenue, it only makes up about 10% to 20% of the IP index. So when we think about composition of improvement in macro, we are looking particularly within those top 5. And I guess just to add the 1 that is growing of our top 5 unsurprisingly is arrow.

Erik Gershwind: Dave, I’ll add Kristin summarize it beautifully. Just one other point to add, which is beyond the IP assumption. I’d say another factor going on is inventory burn and that we do expect that to be easing through the back half of the year. We’ve seen evidence of that, particularly in our national accounts area. And when we win accounts, for instance, a little bit of a slower ramp on implants that we expect to accelerate in the back half as inventory burning eases.

David Manthey: Okay. Can you also help us bridge OpEx from where you sit today in the second quarter into the second half? You mentioned benefits from leverage, but there’s a lot of moving parts here. You talked about the Columbus DC, voluntary separation, acquisitions, merit, other investments. I mean from the level we’re at right now, can you sort of bridge us into the back half with the puts and takes.

Kristen Actis-Grande: Yes, sure. So obviously, you’re going to put in a variable OpEx assumption depending on how you’re flowing revenue through the year, roughly, let’s call it, 8% to 10%, and then if you’re — I’m not going to give quarterly OpEx guidance, but I will give a little guidance on how we’re thinking about the cadence throughout the year because there are some differences there, too. As you mentioned, there are a lot of things that are happening in, so as we think about moving into the third quarter, we are going to be a little bit more weighted on investments in 3Q. Some of that is due to timing of expenses associated with the Columbus shutdown, which are not technically qualified restructuring expenses, and then there’s also a heavier investment lift in 3Q tied to some of the efforts around advertising and the solutions growth.

Q4, if you move from Q3 to Q4, what I would tell you to think about is you’ll have obviously a step-up in variable expense, will offset a good chunk of that sequentially based on investments that don’t repeat in the fourth quarter, and we have a bigger productivity target in 4Q, so if I step back broadly and think about expectations on OpEx on a year-over-year basis for the full year, to your point, there are a lot of moving pieces. The way that I would try to simplify the explanation, the two tallest candle sticks are merit, which is about half of the increase and strategic investments, which is the other half. To your point, a lot of moving pieces on G&A, on acquisitions. We’re covering those with productivity, so to simplify the story, the things that emerge are merit and strategic investments that make up the year-over-year lift.

Operator: And our next question today comes from Tommy Moll with Stephens Inc. Please go ahead.

Tommy Moll: I wanted to drill down a bit on the revenue progression or more precisely the average daily sales progression you expect for the second half versus the first half. And as you mentioned, it does imply a pretty significant step-up on our math, it’s approaching 10%., second half versus first half. So if there’s anything you can quantify for us for that bridge or even just again, run through qualitatively the drivers there? And in particular, on the macro part of that bridge, what more can you tell us that gives you reason to be optimistic that you’re going to see some improvement there, particularly given the March trend?

Erik Gershwind: Yes, Tommy. So let me start and then Kristin will give you a more detailed breakout and a bridge because your numbers are exactly right. Our confidence, obviously, Q2 came in softer than we expected, primarily weighed down by macro. But clearly, you could see it in the core customer number. I mean the numbers came down across the board, which taught us was mostly macro. But obviously, we’re not satisfied with what we’re seeing in the core customer. I think the confidence is coming from, certainly, we’ll touch on, and Kristen mentioned the assumptions behind some moderate improvements in the macro, but also the execution of the growth initiatives that we have that are tracking to plan. So we do have confidence that they’re going to work.