Is There a Buying Opportunity in This Long Term Growth Story?

Lee is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It’s early in earnings season, but I think that one trend is already appearing in the industrial sector. Acuity Brands said earlier that its lighting customers had adopted a ‘wait and see’ approach to purchasing in the previous quarter (you can read about here). Its argument was that a combination of election and ‘fiscal cliff’ considerations caused customers to delay purchasing. It was a similar story with MSC Industrial Direct’s (NYSE: MSM) results. So is it time to give up on industrials, or is this a buying opportunity?

MSC Industrial Disappoints but is there Upside?

IMSC’s results were disappointing and guidance was weak. Any company that comes out and guides Q2 revenues to $563-$575 million and EPS of $0.86-$0.90, when the market is expecting $592 million and $0.98 deserves to be looked at with a significant amount of circumspection. At the last set of results MSC talked of its end markets being in a ‘holding pattern’ which continued over the last quarter and then turned into ‘paralysis’ in December.

Naturally this is not the sort of environment with which MSC can push through any price increases, so there will be no margin relief there either. Indeed the usual Q2 price increase (undertaken to soften the impact of seasonal weakness in the quarter) is unlikely to take place this year. Not good.

However, I think there are reasons to be optimistic

  • The new CEO may be setting low guidance deliberately
  • Guidance is based on December trends, with little data on January so far to go on
  • The ISM data has been stronger than the sectors results and this looks like temporary bit of weakness
  • MSC’s visibility is always low which implies its purchasers have short lead times, things can turn around quickly
  • E-commerce and vending initiatives offer strong long term growth prospects
  • Its industry is fragmented and MSC can be a consolidator in any protracted downturn
  • Expansion of own label sales

I’ll try and deal with these points in turn.

MSC Industrial’s Near Term Upside

Call me a skeptic, but I think that when a new CEO takes over there is usual a kind of settling in period where the investment community wants to size up the new guy. This can cause a tendency for companies to be a little conservative with guidance in order to start off on a good footing and this may be a part of the cause for such weak guidance. Furthermore on the conference call the management stated that the guidance was based on its limited visibility and current trading. In other words, it’s based on end markets in pseudo ‘paralysis’. Two good reasons to suspect guidance is conservative.

I also think that it is hard for MSC to rely on current trading conditions at any time. It’s the same situation with other industrial supply companies like Fastenal (NASDAQ: FAST) or W.W. Grainger (NYSE: GWW). Their visibility is always limited, but that’s why they are such short term barometers of the US industrial economy. You can’t buy any of these stocks and expect very accurate guidance, nor should you pile in when everything is going great and guidance is strong because the market will usually price them in fully and the risk will be on the downside.

Moreover, the overriding ISM data has actually been a lot stronger than the sector’s recent results would suggest. I’ll articulate graphically; all data is interpolated from the ISM. Inventories refers to manufacturing companies' inventory positions, so when times look tough they get reduced in line with projected sales.

<img src="/media/images/user_12882/msm1_large.png" />

I’ve highlighted some points to demonstrate how inventory movements nearly always lag the top line purchasing managers index (PMI) data. I’ve also highlighted to recent data points, which coincide with a heightened period of political risk around budgetary stand offs. In both cases inventories declined while the headline ISM data was okay. Anything above 50 on the PMI indicates an economy in expansion. So why the sudden drop off in inventories?

It’s hard not to conclude that this mainly due to some form of temporary political effect that may well cause a snapback in confidence in the coming quarters. The graph indicates some unsual activity, and until I see another reason for it (such as a major drop off in other industrial indicators) I am prepared to run with the idea that it is unusual.

MSC Longer Term Drivers

Thinking longer term, Fastenal provides a good model for MSC to follow in terms of expanding its vending sales, and Grainger might be looked at as a model for its online activities. Fastenal has managed to increase margins and cash flow conversion via expanding the share of sales made through vending machines, and this is clearly on MSC’s mind as it spends more money on rolling them out. As one of the few bright spots in this report signings for vending solutions were declared to be ahead of internal estimates. In addition, investment in e-commerce is going to ramp up this year in line with plans.

Investment in e-commerce and other initiatives is forecast to take capital expenditures up to an unusually high figure of around $100 million. MSC needs to do this, not least because Amazon (NASDAQ: AMZN) is expanding in the space. Amazon is highly unlikely to develop into a focused player in this industry, but given that the national market is so fragmented, if MSC is going to consolidate via acquisitions then it will be helpful to have e-commerce facility already in place. Otherwise, MSC might find it hard to expand in regions where Amazon is already establishing a strong presence.

Where Next For MSC Industrial?

This stock now offers a compelling and curious mix of near term upside from -what I think- conservative guidance and long term potential from industry consolidation, vending expansion. and e-commerce development. It also offers a US focused industrial growth proposition. It is an attractive mix of the tactical and strategic. I like the stock. but would prefer it a little cheaper than it is now in order to price in the execution risk. I also think that I might be able to find a stock that has more pure exposure to the theme of a snapback in industrial demand. After all, investments in vending and e-commerce initiatives do entail some element of risk.

Nonetheless, others might like the tactical opportunity here.


SaintGermain has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and MSC Industrial Direct. The Motley Fool owns shares of Amazon.com and MSC Industrial Direct. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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