Value Play: MSC Industrial Direct (NYSE: MSM)

Founder-CEO led firms not only have a higher firm valuation than non-founder-CEO firms, but also a higher stock market performance.

– Investing Daily

I especially look for companies managed by their entrepreneurial visionaries. I avoid professional managers who hop from one company to the next in search of a huge salary. The shortcut to finding honest, competent manager CEOs is founder CEOs.

Founder CEOs have created a product no one else has that can command a premium price. This product offers a sustainable competitive advantage, letting a company generate above-average returns on capital long term that results in strong stock price appreciation.

In a 1998 speech at the University of Florida (28:00 minute mark of the video or page seven of transcript), Warren Buffett uses the metaphor of a castle surrounded by a shark-infested moat to describe competitive advantages. The moat represents any advantage— customer service, product quality, low prices—but it’s got to be wide enough to keep competitors away from profitable customers.

Michael Raynor’s Three Rules for Superior Corporate Performance

To have a competitive advantage, a company must have a management team with the right focus. According to Michael Raynor, director at Deloitte Consulting and coauthor of The Three Rules: How Exceptional Companies Think, the managers of companies consistently delivering above-average returns on capital focus on three things:

1. Better before cheaper

2. Revenue growth before cost cutting

3. There are no other rules

MSC Industrial Direct Plays By the Rules

One company that clearly plays by Raynor’s three rules is MSC Industrial Direct (NYSE: MSM). Founded in 1941 by Sidney Jacobson, MSC is the 10th-largest distributor of industrial supplies in North America, offering 880,000 SKU items to customers online and through a 4,475-page catalog. Industrial supplies is a general term for virtually anything — from paper towels to industrial fasteners — that a company needs to run its day-to-day business activities, another name for which is maintenance, repair, and operations (MRO). MSC is the middle man connecting nearly 3,000 suppliers with 365,000 end-user customers.

Huge Market Opportunity for Consolidation Growth in Industrial Wholesale Supply

MSC estimates that the size of the U.S. MRO market is $140 billion and highly fragmented, with the top 50 distributors representing less than 30% of the market.  MSC itself only has 2% share of the total MRO market, so it has plenty of room to grow through acquisition, which it does frequently among the 150,000 small MRO distributors operating in the U.S. There are definite economies of scale and scope, along with network effects, to being a large player in MRO supply distribution and MSC is large. In fact, it is the largest U.S. distributor of metalworking products (e.g., aerospace and automotive) by a large margin — its 10% market share is five times larger than its nearest competitor in this $10 billion market segment.

Barnes Acquisition Was Transformational

Two years ago in April 2013, MSC acquired Barnes Distribution North America (BDNA) in order to diversify away from metalworking — which is heavy durables manufacturing equipment — and gain some lighter and less cyclical non-manufacturing exposure (e.g., “Class C” low-cost consumable items, as well as fasteners and hydraulics), along with non-U.S. revenue exposure (i.e., Canadian). When the acquisition was announced, MSC explained the benefits this way:

The addition of so many talented associates from BDNA nearly doubles MSC’s existing sales force and tremendously strengthens our future growth opportunities.

BDNA is also an expert in vendor managed inventory (VMI), which is an information technology solution that allows MSC to monitor a customer’s inventory levels and re-order supplies whenever inventory falls below a certain threshold without the customer’s express consent each time.

Family-Run Business With Integrity

MSC’s current CEO is the founder’s grandson, Erik Gershwind. He is a straight shooter who reminds me of Hill-Rom CEO John Greisch in his honesty about current business conditions. If you recall, I recommended Hill-Rom despite Greisch’s less-than-optimistic outlook about hospital beds precisely because the stock was cheap and I was confident Greisch’s integrity and commitment to turn the business around. I was right as Hill-Rom has appreciated more than 50% since it was recommended despite tough business conditions. MSC CEO Gershwind has a similarly realistic view of current business conditions in the MRO market that I find refreshing and confidence-inspiring. For example, in the April conference call, Gershwind frankly stated that the pricing and demand for MSC’s services had deteriorated during the company’s second fiscal quarter of 2015:

We’ve seen a significant and swift change in demand conditions since the start of the calendar year. We heard this in a change in tone from many of our customers and saw it in sentiment indicators like the ISM and MBI, both of which trended down through the quarter. Root causes included the impact of the rapid drop in oil prices and softening export demand. As you know, our business has very little direct exposure to the oil and gas sector. There is little doubt, however, that the dislocation in this sector and the resulting uncertainty is currently impacting broader manufacturing activity, particularly in energy producing states. Softening export demand is also impacting manufacturing and heavy manufacturing in particular as exchange rate headwinds have become more severe.

In addition, while weather was certainly a factor in the quarter, we believe the broader weakness that we’re seen is more than a temporary disruption. With respective to the pricing environment, conditions remain quite soft due primarily to the lack of commodities inflation.

Turning to our results, the slowing demand environment resulted in lower than expected organic growth which came in at 6.8% for the quarter. As you can see from our monthly numbers, growth rates were solid in December, improved in January, before dropping significantly in February as the environment deteriorated.

Tell us how you really feel, Eric! 🙂 It’s simply a fact of life that industrial supply distributors like MSC are vulnerable to economic slowdowns such as the U.S. experienced in the first-quarter of 2015. Industrial activity is highly cyclical and slows when the economy slows. But what I found so impressive about Gershwind is his laser-like focus on improving MSC’s competitive positioning by increasing spending directly in the face of the industry slowdown:

Depending upon how severe something got we actually view times like that dislocation and opportunities to put the foot on the accelerator, to really juice share gains coming out of it, and you’ve seen us do this through periods. So there is a chance that while we would certainly take cost down measures that we could actually step up growth investment. History has proven that times of dislocation create even more opportunity for MSC to forge ahead in the years that follow. If the recent softness continues or even worsens local and regional distributors will be hit disproportionally hard. Cash flow, margins, talent, customer payment terms, these things will all come under pressure if the demand and pricing environments persist. That would mean even more opportunity for MSC to execute our growth plan.

This opportunistic approach that prioritizes long-term growth over short-term profitability and cost cutting is directly out of Michael Raynor’s “three rule” playbook! Very impressive and indicative of the company’s family-management focus on a permanent business legacy. If you read MSC’s latest Schedule 14A proxy statement (page 78), you will see that the Jacobson/Gershwind family owns a 75% majority of voting shares in MSC so management has the both the power and financial incentive to do right by the average shareholder. Granted, MSC has a dual-class share structure, which gives the Jacobson family super-voting rights and veto-proof decision-making power — not ideal — but the Jacobson family also has a significant beneficial ownership interest of more than 39% in addition to its 75% voting interest, so it should make financial decisions that benefit shareholders because such decisions also benefit the Jacobson family’s ownership interest.

MSC Industrial Direct is Undervalued and Highly Profitable

The stock has been on a relentless decline since hitting an all-time high of $96.62 in June 2014. With the current stock price at $69.37, the stock has already suffered a 28% correction and is trading at multiples of earnings, book value, and sales that are all below their five-year averages. Furthermore, on my favorite snapshot valuation multiple of EV-to-EBITDA, the company is trading at 10.6 times, which is slightly above my 10 ceiling, but not by much and certainly within the wiggle room I reserve for extraordinarily well-run business such as MSC Industrial Direct.

 MSC Industrial Direct’s Competitive Advantage . . . 

 . . . Leads to Extraordinary Profitability

Source: Bloomberg

The slight decline in profitability starting in 2013 is due to the acquisition of Barnes Distribution North America (BDNA), which had lower profit margins, but the diversification benefits were worth the temporary profit decline and MSC is confident that it can integrate and improve  BDNA’s operations so that its profitability rises to match the rest of MSC’s distribution business.

Bottom line: The best time to buy a  value stock is when exogenous factors beyond the company’s control have reduced market prices, but the company itself is enhancing its intrinsic value by snapping up bargains caused by the difficult economic conditions. MSC is a steal below $70 and such a purchase should pay off handsomely during the next industrial upswing.

MSC Industrial Direct is a buy up to $81; I’m also adding the stock to my Value Portfolio.



 

Value Sell Alert

To make room for MSC Industrial Direct, Roadrunner is selling:

• Stewart Information Services (STC)

The U.S. housing market is healthy, but title insurers like Stewart are facing regulatory headwinds that are going from bad to worse. As CEO Matthew Morris said in the company’s first-quarter financial release:

“Looking ahead, we are mindful of general economic volatility, as well as an expected decline in mortgage origination volume in the second half of the year,” continued Morris. “2015 will bring the most significant changes in the industry’s history with the implementation of new Consumer Financial Protection Bureau regulations. These regulations, which go into effect in August 2015, not only are adding regulatory costs and one time implementation expenses this year, but also have the potential to cause temporary operational delays across the industry later in 2015.”

In addition, the company warned in the conference call that “a significant contract renew at lower pricing, which would put downward pressure on revenue starting in the second quarter.” If the revenue pressure was a one-quarter thing, I wouldn’t worry, but management used the word “starting” which suggests a several-quarter problem. Lastly, the stock has been propped up by speculation that activist shareholders will force either a sale of the company or at least elimination of the dual-class structure, but there is no evidence that such changes will actually take place and the stock will react negatively if the activists give up. As things stand now, corporate governance is weak:

If you look at the corporate governance for some 2,300 companies in the U.S. with a market cap greater than $500mm, there’s only 110, or roughly 4%, with dual share classes. And of those 110, Stewart gives insiders the most control with the lowest economic stake in the company.

Combine all this with an unwanted overweighting in financial services in the Value Portfolio (DHIL, NMIH, and WRB are the others), and Stewart is the weak link that has to go.

Stewart Information Services is being sold from the Value Portfolio.

Momentum Buy:

Multi-Color Corp. (Nasdaq: LABL)

Multi-Color Corp.  is a 99-year-old company in Cincinnati, Ohio that produces innovative labels for consumer products in a multitude of different industries, including home and personal care, wine and spirit, food and beverage, healthcare, and automotive. Procter & Gamble was one of the company’s first — and remains one of the largest — clients. Award-winning innovations in labeling include pressure sensitive labels, holograms, heat transfer, peel-away, and scratch off. Labels are critical to garnering consumer attention in highly-competitive markets. The company’s revenue growth has averaged 27.8% over the past three years, while the industry has seen its revenue growing at a much lower rate of only 7.6%. Earnings have beaten analyst estimates for each of the past four quarters and analyst estimates for future quarters continue to rise.

• Price gain between 12 months ago and 3 months ago = 107.23% (99th percentile)
• Price gain over the past 2 months =-9.34%
• Price gain over the past month = -2.64%
• Roadrunner Momentum Rating: 107.23 – (-9.34) – (3*-2.64) = 124.48

Multi-Color Corp. is a buy up to $73.50; I’m also adding the stock to my Momentum Portfolio.

Momentum Sell Alert

To make room for the new momentum stock, Roadrunner will be selling the following price laggard: 

• Anika Therapeutics (ANIK)

Investors hated Anika’s first-quarter financials because it reported revenues down 54.4% that missed analyst estimates. Even worse, management warned that the revenue slowdown would continue for two more quarters as the company’s U.S. distribution partner Mitek changed its spending patterns by switching from inventory building to inventory reduction:

The inventory reset that Mitek decided to implement is roughly about a 50% reduction of their targeted on-hand inventory level and the impact for 2015 overall is that inventory purchase from us to them will be roughly flat.  We’re not pleased with the inventory purchase interruption due to their planning and business practice changes.

While I continue to like Anika’s health-care products and its long-term growth potential, this revenue slowdown has destroyed the stock’s upward price momentum and a quick rebound is unlikely given that Mitek’s reduction in inventory purchases could continue for two more quarters. 

Anika Therapeutics is being sold from the Momentum Portfolio.