MSC Industrial Direct Co., Inc. (NYSE:MSM) Q2 2023 Earnings Call Transcript April 4, 2023
Operator: Good day, and welcome to the MSC Industrial Supply Company's Second Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode. After today's presentation there will be an opportunity to ask questions. Please note today's event is being recorded. I would now like to turn the conference over to John Chironna, Vice President of Investor Relations and Treasurer. Please go ahead.
John Chironna: Thank you, and good morning, everyone. 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 and management data in the presentation slides that accompany our comments, as well as our operational statistics, 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 accompanying 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'll now turn the call over to Erik.
Erik Gershwind: Thanks, John. Good morning, everybody, and thank you for joining us. On today's call, I'll begin with some perspective on our recent performance and our longer term outlook. I'll then provide color on the current environment. Kristen will provide more specifics on our fiscal second quarter Mission Critical accomplishments and our financial performance and then she'll share our expectations for the back half of our fiscal year. I'll wrap things up and then we'll open up the line for questions. As we move into the back half of our fiscal 2023, there is a growing momentum inside of MSC, and it has me encouraged about our future. Let me provide you with some color so that you can see from the outside what we see on the inside.
First, we continue outgrowing IP or industrial production by numbers in excess of our long range targets. We're seeing the strongest contribution from the programs most closely tied to the repositioning of MSC to a Mission Critical partner on the plant floor. In-plant, vending and vendor managed inventory are all examples of high touch, high retention programs that are growing ahead of company average. I'm equally encouraged by the momentum on new account wins that we see developing through our national accounts and our public sector teams. And while a portion of our performance above IP is price driven, we're excited by the trajectory of these market share capture programs. On the M&A front, we continue to bolster our technical and high touch product categories.
Our recent acquisitions are living up to our high expectations in their early days and are fortifying our position within metalworking and OEM fasteners, areas where we continue to see significant opportunity for long term growth. Most recently in January, we completed an acquisition that fits nicely into our core metalworking business. Buckeye Industrial Supply Company is a metal working distributor located in Ohio and that serves planned production needs of manufacturing businesses in the area. Tru-Edge Grinding also located in Ohio brings us new capabilities in the way of custom tool manufacturing and regrinding. Tru-Edge along with our existing regrinding business represents an adjacent value added service to our core cutting tool business.
And it therefore creates a new growth path for us. It also supports our company's effort to drive cost savings for our customers. Second, on the gross margin line, our success over the past couple of years has come largely from achieving strong price realization during historic levels of inflation. As the market settles, we have reoriented our focus towards improved product assortment, supplier portfolio and cost position. The category line reviews that we announced last quarter have kicked off with our first wave in (ph) gear. Wave 2 has been launched as we will roll through our entire product offering over the next several months. We expect to see a slight gross margin benefit in our fiscal fourth quarter and then more substantial savings will come in fiscal 2024.
Third, our productivity efforts remain in full force and continue to yield strong operating leverage in the form of lower OpEx to sales ratios. As we move towards the close of our three year targets, our Mission Critical program, under the leadership of Kristen and Martina, is transitioning from a onetime program to an ongoing way of life or continual improvement. Beyond the numbers, There are four other important elements to our story. First, strategy. The repositioning of MSC into a high touch Mission Critical partner is taking hold. Customer reception to our enhanced role is high. And this is evidenced in the growth rates of our high touch programs and the rate of new customer wins. The plan is working. Second, culture. MSC has always had a strong culture, one that's grounded in respect for people and an intense focus on the customer.
Our new management team is building on that strong foundation. We're adding new elements, including more aspirational target setting, a more robust execution model and more extensive collaboration across functions. In other words, thinking end-to-end about our business. Third, technology. It's been nearly a year since John Hill joined us as MSCs first Chief Digital and Information Officer and progress with our technology function is encouraging. We are enhancing our e-commerce functionality and expect to see incremental benefits in the coming quarters. We are improving our product information and customer data, making for a better customer service experience and a more efficient business. We're eliminating inefficiencies as part of Mission Critical where older systems inhibit productivity or where improvements can unlock further value.
And Fourth, the market. We continue to operate in a marketplace with attractive dynamics that support continued growth. The North American distribution market is over $200 billion and remains highly fragmented with the top 50 distributors still holding just over 30% of the market. The opportunity for organic and inorganic share capture remains vast. In addition, MSCs concentrated manufacturing exposure sets us up well for the next decade. The reshoring trend that we've all heard about is moving from my as we are seeing an increased number of new plant construction projects. And while our participation in the early stages of construction is minimal, this bodes well for growth in our end markets over time and should serve as a further growth tailwind.
Before turning it over to Kristen to discuss our second quarter performance, I want to spend a few moments discussing the environment. While sentiment in IP readings continued moderating, the tone on the ground is stable. Most of our customers continue to see solid order levels and demand activity. Of course, we're watching the banking situation closely to monitor any potential ripple effect on the broader industrial economy. At this time though, our overall read on the environment remains constructive. With respect to pricing, the situation is pretty much the same as we reported last quarter. We continue seeing increases from our suppliers, albeit not at the rate or level of the past two years. As such, we passing those along as warranted and we continue seeing strong realization.
All of this means that the need for our customers to find productivity that offsets their own cost headwinds remains as strong as ever and this plays very nicely into our value proposition. So we remain focused on delivering that productivity for our customers. Kristen will now take you through our quarterly performance, capital allocation priorities, balance sheet and our reaffirmed fiscal 2023 guidance.
Kristen Actis-Grande: Thank you, Eric, and good morning everyone. Please turn to Slide 5 of our presentation, where you can see key metrics for the fiscal second quarter on a reported basis. Slide 6, reflects the adjusted results, which will be my primary focus this morning. Our second quarter marked another quarter of strong execution and results. We remain on track or even ahead of schedule on our primary goals for fiscal 2023 of gaining market share, expanding adjusted operating margins and improving adjusted ROIC. Our five growth levers and productivity improvements have us positioned to meet or exceed our Mission Critical goals. The execution of our growth drivers, as well as price contribution and our bolt-on acquisitions, continued to fuel our results.
Our revenues came in at $961.6 million, which represents average daily revenue growth of 11.5% versus the same quarter last year, well above the IP Index, which was basically flat in our fiscal second quarter. Growth from acquisitions contributed just under 4 percentage points of that increase. Looking at growth rates by customer type. Public sector sales increased roughly 20%, national accounts grew in the mid-teens and core and other customers continued to grow high single-digits. Another way to view our sales performance is through the growth drivers we initiated as part of the Mission Critical program, solidify metalworking, expand solutions, leverage the portfolio strength, grow ecommerce and diversify customers and end markets with an emphasis on the public sector.
Let me update you on each of these growth drivers. Our expertise in metalworking remains the cornerstone of our value proposition, driven by the depth and breadth of our portfolio, our large network of technical metalworking experts and focus on innovation as a tool to elevate productivity, while lowering costs for customers. This expertise is helping us win new customers and penetrate high growth end markets like aerospace, commercial space and medical. These industries consume large amounts of metalworking tooling by working on intricate, complex and lightweight materials. Our technical expertise applied in these situations is often able to yield considerable savings and throughput improvements. In a recent large scale win in the aerospace industry, the customer told us that no other competitor was able to bring the kind of technical advice and productivity savings that MSC offered.
It was the primary driver behind the win, which will ramp up over the next couple of quarters. Instances like this are becoming more and more common and are fueling our National Accounts performance. Our solutions growth driver is anchored by our vending and in-plant programs, both of which have been delivering market share capture over the past several quarters. Vending machine revenues continued to grow mid-teens and represent 15.5% of total company sales. That compares to 15% of sales a year ago. Q2 in-plant signings remained quite strong and in-plant customer revenues grew nearly 20% year-over-year and now represent 12.5% of total sales. Sales to customers with our solutions offerings that includes vending, VMI and in-plant represent over 56% of the company's total sales, up over 200 basis points from prior year.
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The third priority is selling the portfolio, which is about increasing share of wallet through ancillary products, especially our Class C consumable product category. Here, we provide an outsourced vendor managed inventory service that keeps plants running. So, we also include this business as part of our overall solutions offering. Q2 growth for this business remained solid with an ADS growth rate of low teens. Our fourth priority is digital, which includes all aspects of MSCs digital engagement with customers, suppliers and associates. E-commerce sales reached 62% as a percent of total company sales in our fiscal second quarter, up roughly 130 basis points compared to the prior year. As Erik mentioned, John Hill and team are enhancing our e-commerce functionality and we expect this number to continue growing over time.
Fifth is customer diversification through our public sector business. And I already mentioned our Q2 ADS growth of roughly 20%. Based on additional program wins, we expect momentum to continue during the back half of fiscal 2023 and into fiscal 2024. Each of our five growth levers are not only powering our performance, but they are positioning MSC as a trusted productivity partner to our customers, expanding our role from solely a spot buy supplier. Our gross margin for the fiscal second quarter was 41.3%, down 120 basis points year-over-year. The impact of acquisitions accounted for roughly 50 basis points of the dilution. The remaining 70 basis points are made up of lapping last year's large price increase, the increasing impact of costs through the numbers and mix.
Sequentially, gross margin ticked down 20 basis points as expected, due to a slight compression in the price cost spread and the impact from the Buckeye acquisition in our numbers. Looking forward, while inflation has tempered, we are still seeing some suppliers move on price, still not at the levels of the past year. In March, we implemented a small increase of 1% to 2%, which follows our similar size increase in late January. The customer cost savings and productivity gains we deliver continue to support strong realization rates. Reported operating expenses in the second quarter were $281 million versus last years reported operating expenses of $266 million. Adjusted operating expenses were $280 million or 29.1% of net sales versus last years adjusted operating expenses of $266 million or 30.8% of net sales.
This yielded a 170 basis point reduction in adjusted OpEx to sales year-over-year. Our reported operating margin was 11.9% compared to 11.3% in the same period last year. Adjusted for restructuring costs, costs associated with the proposed share reclassification and acquisition related costs, adjusted operating margin was 12.2% as compared to adjusted operating margin of 11.6% last year, a 60 basis point improvement year-over-year. That improvement was driven by the continuation of our Mission Critical initiatives, which yielded additional savings of $4 million in the quarter. That puts us at $10 million for fiscal 2023 and $95 million for the programs cumulative savings. We remain on track to achieve our goal of at least $100 million by the end of fiscal 2023.
Already last quarter our Mission Critical initiatives and the efforts of our entire team on cost containment and productivity boosted our adjusted ROIC to 18.3%. During our fiscal second quarter, we increased our adjusted ROIC to 19%, which includes the impact of the $300 million securitization facility we put in place back in December. Turning to earnings per share. Our reported EPS was $1.41 for the quarter as compared to $1.25 in the same prior year period. Adjusted for restructuring costs, costs associated with the proposed share reclassification and current year acquisition related costs, adjusted earnings per share were $1.45 as compared to adjusted earnings per share of $1.29 in the prior year period, an increase of 12%. This continues to reflect strong execution at all levels: sales performance; gross profit and OpEx leverage.
Turning to the balance sheet, at the end of the fiscal second quarter, we were carrying $747 million of inventory, up $21 million from Q1 balance. The inventory build is consistent with our double-digit revenue growth, continuing inflation and calendar year-end by opportunities. We do expect to bring inventory levels down by year-end. Our operating cash flow conversion rate for Q2 was 429%, which includes the benefit this quarter from the $300 million sale of receivables related to the securitization program. Excluding the benefit of securitization, we are still targeting an annual conversion of roughly 100% for fiscal 2023. Our capital expenditures were $15 million in the second quarter and we continue to expect annual CapEx spend in the range of $70 million to $80 million in fiscal 2023.
You can see on Slide 7. Our free cash flow is $325 million for the current quarter as compared to negative $16 million in the prior year quarter. Note, that we also spent about $12.5 million buying back shares during the quarter, just over 150,000 shares at an average price of $81.76. We currently have 4.4 million shares remaining on our current repurchase authorization. Our total debt at the end of the fiscal second quarter was $550 million, reflecting a roughly $230 million decrease from the first quarter of fiscal 2023 primarily from the benefit of the securitization facility. As for the composition of our debt, roughly 45% was floating rate debt and the other 55% was fixed rate debt. Cash and cash equivalents were $50 million resulting in net debt of $500 million at the end of the quarter, our net leverage at the end of the second quarter was 0.9 times.
Before I reiterate our capital allocation strategy let me touch on the current banking environment. We recently conducted a comprehensive review of all of our main banks, those that participate in our revolving credit facility, as well as those banks with whom our recent acquisitions do business with. Three of the six main banks are designated as systematically important financial institutions, such that they are more heavily regulated and regional banks. And all six banks have strong common equity and liquidity ratios. We continue to monitor the situation closely. As a reminder, we refreshed our capital allocation strategy last quarter, which you can see on Slide 8. Our top two priorities remain reinvesting into the business and returning capital to shareholders through our ordinary dividend.
From there, our next two priorities are tuck-in acquisitions and share buybacks at the right valuation levels. We are deprioritizing use of special dividends as we see higher return prospects in the other uses of cash. We continue to see buybacks as an attractive way to return capital and enhance shareholder value. In the near term, however, we will not be buying shares in the open market, while based on legal advice we worked through the share reclassification proposal. As a reminder, the Special Committee of our Board of Directors remains engaged on evaluating the reclassification proposal and we cannot comment on the status of their evaluation at this time. Now, let's turn to the fiscal year 2023 guidance and assumptions, which are shown on Slide 10.
We are reaffirming our 2023 guidance of average daily sales growth of 5% to 9% and an adjusted operating margin between 12.7% and 13.3%. For modeling purposes, I'll provide additional color on our expectations for the back half of our fiscal year. As of now, we would characterize the environment as stable. Our growth trajectory likely temper a bit due to higher prior-year comparisons, including extra selling days last year, but should remain quite solid. March is indicative of this with estimated growth between 8% to 9%. I will note that our fiscal March, which extends through the end of this week, has a roughly 1% point headwind due to the timing of Good Friday and Easter weekend, which will be a tailwind in our fiscal April. For the full year, we expect to trend somewhere between the middle and high end of our sales range.
We continue to expect gross margins to be higher in the second half of the fiscal year than the first half, beginning with an expected sequential increase in Q3. This is due to several factors. First, the product cost increases in our P&L during the second quarter should be the peak for the fiscal year. Second, freight costs are moderating in the second half of our fiscal year. Third, as Eric mentioned, we have several gross margin initiatives that will be a tailwind over the remainder of the year and beyond. As of now the benefits are modest this fiscal year and builds for fiscal 2024. With respect to adjusted operating expenses, we expect our typical seasonal pattern to play out and adjusted OpEx to sales ratio will decline sequentially in the second half.
As of now, this would yield an adjusted operating margin in the middle of our range. As we can achieve a bit more gross margin improvement in the back half of the year, we can move the adjusted operating margin towards the higher end of the range. The last point I'll make is that, we are not changing our full year guidance for our most recent acquisitions of Buckeye and Tru-Edge. These acquisitions add approximately 50 basis points of growth and dilute both gross margin and operating margin by an additional 10 basis points. We are proud of the growth in our business during the fiscal second quarter and we continue to take steps to align the business for further topline and bottom line acceleration moving forward. I'll now turn it back over to Erik.
Erik Gershwind: Thank you, Kristen. As, we crossover the halfway point of fiscal 2023 and we enter the final leg of our three year targets. I'm excited by our company's performance. We are meeting or exceeding the targets that we set for ourselves nearly three years ago. The most exciting part for me, however, is that no one on our team is satisfied. In fact, we feel as if we're just getting started. We recently begun our strategy refresh process to create a new set of long range targets and we look forward to sharing those with you in a couple of quarters. In the meantime, I'd like to thank all of our associates for their hard work, dedication and strong execution for our customers. Before I open the line for Q&A, I do want to take a minute to let you know that John Chironna has decided to retire at the end of June.
Kristen, we'll keep you updated on progress in replacing John over the next few months. Let me spend a moment though thanking John publicly and recognizing the great job that he has done over the past decade. John has been a steadying, reliable and consistent face to our investment community, as well as inside the company with our associates. During a time of change and transformation, both within the company and across the industry, John provided clarity, transparency, honesty and most of all integrity. John, on behalf of our entire team, thank you. And on a personal note, it's been a pleasure working closely with you and I wish you all the best as you went through your next chapter in life. And we will now open up the lines for questions.
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