Q2 2021 MSC Industrial Direct Co Inc Earnings Call
Good morning, and welcome to the MSC industrial supply of 2021 second quarter conference call.
All participants will be in listen only mode should you need assistance. Please signal conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. Please note. This event is being recorded and now I'd like to turn the conference over to John Corona, Vice President of Investor Relations and Treasurer. Please go ahead.
Thank you, Jason and good morning to everyone Erik.
Erik Gershwin, our Chief Executive Officer, and Christian Actis Grande, our Chief Financial Officer are both on the call with me today most of US continue to work remotely at MSC, So bear with US if we encounter technical difficulties 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 the Investor Relations section of our website.
Let me reference our Safe Harbor statement under the private Securities Litigation Reform Act of 1995, the summary of which is on slide two 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, including statements about the impact of COVID-19 on our business operations results of operations and financial condition expected future results expected benefits from our investment and strategic.
Plans and other initiatives and expected future growth and profitability. These.
These forward looking statements involve risks and uncertainties that could cause actual results to differ materially from those anticipated by these statements.
Formation about these statements is noted in our earnings press release and the risk factors of the MD&A sections of our latest annual report on form 10-K filed with the SEC as well as in other SEC filings. These risk factors include our comments on the potential impact of COVID-19. These forward.
Looking statements are based on our current expectations and the company assumes no obligations to update these statements except as required by applicable law.
Investors are cautioned not to place undue reliance on these forward looking statements in.
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, which contain the reconciliation of the adjusted financial measures to the most directly comparable GAAP measures on the.
Now I'll turn the call over to Erik.
Thank you John Good morning, everybody I hope. This this call finds you doing well and staying safe and healthy.
As we enter the second half of our fiscal year I wanted to focus my opening remarks. This morning on our company's mission.
Since the inception of MSC over 80 years ago and through our last 25 years as a public company.
Our mission has stayed the same to be the best industrial distributor in the world as measured by our for stakeholders and.
And we've not wavered from this.
Two concepts underpin our pursuit of this mission.
The first is reinvention.
We believe in the need to continuously reinvent ourselves.
In order to remain relevant.
And secure our future.
Our history demonstrates this and it can be captured in chapters.
Each one of those chapters being defined by a different reinvention.
From a storefront two of cat a lager.
From a regional metalworking distributor to a national broad line MRO distributor.
From catalog to digital.
From direct marketing to field sales.
From generalists to specialists.
The second concept that underpins our mission.
Is growth.
Which is the lifeblood of this company throughout its history.
Growth has enabled us to attract and retain great associates.
Better serve our customers.
Produce market share capture for our suppliers.
And generate returns for our shareholders.
Historically.
And up until the past few years.
We produce the revenue CAGR in the double digits.
With an organic revenue CAGR in the high single digits.
And these results were a product of continuous and focused investments.
This growth produced strong incremental margins.
Which allowed for reinvestment back into the business thus.
Thus, creating a virtual site virtuous cycle.
Our most recent reinvention.
It has been one we've talked about the repositioning of MSC from.
From spot buy supplier to mission critical partner on the plant floor.
Like the other ones that came before it.
This pivot was done to deepen the moat around our business.
And to secure our next phase of growth.
This reinvention was complex.
The moves took time.
And the impact of growth while changes were made.
We redesigned our value proposition.
And we reshaped our sales force from one size fits all two of more segmented one.
We re engineered our supply chain to move from the four walls of our distribution centers onto the customers plant floor.
And we sharpened our culture to move faster.
And more readily embrace change inside of our business.
While we did all of this.
We reduced the growth investments in areas like field sales.
Order to complete the reshaping into our new model.
We are now emerging as a stronger company and.
And are poised to reaccelerate growth.
We've strengthened our value proposition with still more to come.
And further strengthened and extended our leadership in our core business of the metalworking.
The history shows that market leader has capture of the largest portions of an industry's profit pool.
And we will do so.
Five levers will fuel our growth.
And we're investing into them in order to produce market share gains.
Market share capture will lead to growth.
Which leads to more reinvestment back into the business.
To further strengthen our core.
And to add more adjacencies over time.
We've also focused on structural cost take out.
With a portion of the savings being being reinvested back into growth even more aggressively.
We've captured both of these elements growth and structural cost improvements in.
And the two mission critical goals that we laid out at the start of the fiscal year.
And as a reminder of those goals of reaching 400 basis points of market share capture by the end of fiscal 2020 three.
And returning return on invested capital.
Into the high teens.
By improving our operating expense to sales ratio.
Inclusive of the 90 to 100 million dollar gross cost takeout target.
We're in the early innings of this journey.
But the proof points so far are encouraging.
You saw our commitment to these goals evidenced with the recent announcement regarding the move to virtual customer care hubs.
We are redeploying cost from back office from management roles and from rent and putting it into growth.
We eliminated 110 positions.
And we're adding 135 positions that are customer facing and that will drive growth.
This will represent the largest year over year increase in customer facing sales role that we've seen in years.
The recent announcement was also about talent.
By moving to a virtual customer care network.
We retain our local one to one connection with our customers well.
While knocking down geographic boundaries.
We're now able to recruit technical talent.
Wherever it resides.
The improving economic outlook makes our story even more exciting.
With the vaccine rollout of picking up steam we're.
We're seeing significant positive signs from our customers.
Such as building backlogs and activity levels.
All indications suggest the continued firming of the environment.
At the same time.
The speed of the recovery coming on the back of significant economic disruption.
Is leading to supply chain shortages and disruptions.
And we are well positioned to help our to help address these for a couple of reasons.
The first.
The local distributors, who have been struggling for the past year.
And from whom we focused on market share capture.
We will struggle even more during a snapback.
Due to working capital constraints limited product offerings and limited delivery capabilities.
The market share capture opportunity will only accelerate.
Second.
Well, we all face supply chain disruptions and shortages.
M S sees broad and deep product assortment.
Our multiple brand choices, including exclusive brands.
And our next day delivery capabilities position us very well against the 70 per cent of the market made up of local and regional distributors.
The speed of the recovery.
Commodity scarcity and supply shortages are also leading to commodities inflation.
We typically benefit in the early stages of an inflation cycle.
And should see of gross margin tailwind as we go capture price earlier than realizing cost.
As we look ahead to the latter part of 2021 of our fiscal 2021 and into our fiscal 'twenty 'twenty two.
Assuming the economic recovery continues on its current pace.
Here's what we expect.
We anticipate improving average daily sales levels.
With strong growth rates in our non safety of non janitorial business.
This will be fueled by the investments that we're making.
And their contribution will grow over time.
Keep in mind that we will see high P. P E comparables in our fiscal third quarter.
And this will mute our overall growth rate.
However, this moderates by our fiscal fourth quarter.
And we should see strong overall growth rates.
We anticipate a bounce back in gross margin from the Q2 anomaly, which I'll talk about in a bit.
We should return to at least the levels of which gross margins have run over the past year.
With some potential upside.
Due to the early stages of an inflation cycle.
We also expect the continued stream of structural cost work.
That is moving us towards the higher end of our $90 million to $100 million cost takeout range.
All of this should yield healthy growth the translates into expanding operating margins as we look ahead to fiscal 'twenty 'twenty two.
Yes.
It's an exciting time for our company.
And we remain heads down.
Focused on executing so the we can capitalize on the opportunity in front of us.
I'll now turn to our second quarter performance.
Yeah.
Before getting into the details.
I'll start by addressing the obvious issue on our second quarter that impacted results, which is the inventory write down on P. P E of roughly $30 million.
The write down is exclusive to P. P inventory.
And is primarily comprised of disposable masks.
It's no secret that we moved aggressively in the early stages of the pandemic to acquire large quantities of P. P and specifically disposable masks.
At the time.
We were selling millions of masks per week.
Inclusive of some very large quantity purchases for several of our large customers.
Some of these customers were not only buying large quantities at the time.
But also committing to even more large quantity buys in the coming weeks and months.
As a result, we bought big in order to ensure we can keep these customers safe and keep their operations up and running.
As time went on these customers found that their consumption was not as great as anticipated.
When that happens we decided to play the long game.
Even in cases, where agreements were in place.
We decided not to impose them.
We wanted to support our customers through the pandemic.
Knowing that what's really important.
The securing long term loyal customers and keeping them safe.
As a result, we took on the extra inventory.
Pricing on these items has come down considerably.
And at the same time demand slowed.
Even through the winter months when the virus searched.
And so we were left with the exposure that we addressed in our fiscal second quarter.
This was an extremely unique set of circumstances.
And if you look back we've not had any meaningful inventory write downs over the last decade.
Putting the P P inventory of side.
Our fiscal second quarter reflected solid execution in the choppy, but clearly improving environment.
You can see our reported numbers on slide for an adjusted numbers on slide five.
Overall sales were down one of 1.5 per cent for the quarter.
We're seeing continued sequential improvement in our sales levels and most notably our non safety of non janitorial product lines improved throughout the quarter from low double digit declines in our first quarter.
The mid single digit declines in our second quarter.
Sales of safety and janitorial products continued progressing nicely growing in the low teens for the quarter.
Looking at our performance by customer types.
Government sales continued to grow significantly year over year due to large safety and janitorial orders.
National accounts improved sequentially and declined in the high single digits, while our core customers also improved sequentially and declined in the mid single digits C. C. S. G. Finally improve to declines in the low single digits.
As you can see on slide six industrial production through the Ipi or industrial production index continued improving.
Though it did remain negative through our fiscal second quarter.
Most manufacturing end markets behaved consistent with this trend.
Although the metalworking centric end markets did continue to lag.
The broader of IP index.
Notably the GAAP between IP and our growth rate flipped to positive.
Recall that the 200 basis points spread was our target for our fiscal fourth quarter.
So while it's still early we are encouraged by our recent performance.
March showed continued improvement.
Our non safety of non janitorial business turned positive growth for the month as the C. C. S G.
Both of which grew in the mid single digits.
Safety and janitorial on the other hand, we're down roughly 20% against last year's P. P E search.
We expect strong growth rates in our non safety of non janitorial product lines for the balance of the fiscal year.
Regarding gross margin.
Due to the P. P write down our GAAP gross margin was 38, 1%, but excluding that write down adjusted gross margin was 42.0 per cent.
Down just 10 basis points versus the prior year and up 10 basis points sequentially from the first quarter.
Looking ahead, we took our mid year price increase in early March in response to the early stages of the inflation cycle, which again are generally a nice tailwind for gross margins.
So we expect the recent trending to continue into the back half of the year.
In terms of our mission critical growth initiatives, we're particularly pleased with our metalworking market share capture from local and regional distributors.
We track new customer market share wins by MSA of Metropolitan Statistical area.
And have seen strong performance through this downturn.
We're just now scratching the surface in terms of the revenue contribution from these wins, primarily because the metalworking customer spend has been suppressed to now due to the soft conditions.
As things rebound, we should see an outside lift an outsized lift excuse me.
I'll now turn things over to Christian to cover the financials and overall progress on our mission critical program.
Thank you Erik I'll begin with the review of our fiscal second quarter, and then update you on the progress of the mission critical initiatives.
On slide four of the presentation, you can see key metrics for the fiscal second quarter on a reported basis.
Slide five reflects the adjusted results.
Our second quarter sales were 774 million.
For $12 7 million on an average daily sales basis, both the decline of one 5% versus the same quarter last year.
Moving to gross margins, our second quarter gross margin was $38 one per cent decline.
The decline of 400 basis points compared to the second quarter of last year.
Erik mentioned this was primarily the direct result of the roughly $30 million PPE write down we recorded during the quarter, which was primarily related to masks.
Excluding this write down our second quarter gross margin was 42 per cent of 10 basis point decline from the prior year in the 10 basis point increase sequentially from our first quarter.
Our pricing realization has remained strong and solid execution of our supplier programs has continued.
I'll add two points here.
One we don't expect any further impairments going forward.
And to our mid year price increase had no impact on our fiscal second quarter.
Momentum in March the first month of our fiscal third quarter.
Operating expenses in the second quarter were $245 1 million or 31 seven per cent of sales.
First of its $251 4 million for 32 per cent of sales in the prior year.
This includes about 700000 of legal costs associated with the nitrile gloves prepayments, we impaired in the first quarter.
Excluding these costs operating expenses as a percentage of sales of 31, 6% of 40 basis point improvement from the prior year in which there were no operating expense adjustments.
With regard to the nitrile gloves impairment, we announced in our fiscal first quarter. We're pleased to report that interest for suspicion of fraud has been made and we've been notified that bank accounts holding a substantial portion of the impaired value have been frozen.
The legal process is going to take some time to resolve this matter and we will provide you with updates as developments occur.
Moving back to our fiscal second quarter result, we incurred approximately $21 6 million of restructuring costs.
Primarily related to the move to virtual customer care hub and the review of our operating model both related to mission critical.
Execution of our mission critical initiatives continued to deliver savings and I'll go into more detail on that in a minute.
In Q2 of the last year, we incurred $1 9 million of of restructuring charges and that was primarily related to consulting cost.
All of that led to operating margin on a GAAP basis of three 6%, but that was significantly influenced by the P. P E write down and the restructuring charges related to the virtual customer care of hubs.
Excluding this write down as well as the restructuring and other related costs. Our adjusted operating margin was 10, 4% up 30 basis points from the prior year due to our progress on mission critical and despite lower sales.
GAAP earnings per share for 32% adjusted for the inventory write down as well as restructuring and other charges adjusted earnings per share were of dollar three.
Turning to the balance sheet and moving ahead to slide seven our free cash flow of its $4 million in the second quarter as compared to $58 million in the prior year.
The largest contributor with our increasing inventory and accounts receivable balance as our sales picked up in January and February.
As of the end of fiscal Q2, we were carrying $533 million of inventory up $12 million from last quarter.
This is net of the 30 million of inventory write down during the quarter.
We're actively managing inventory levels to ensure we can support our customers out of sales accelerated in the second half.
Therefore inventory will likely continue to be of use of cash.
We now expect Capex for the fiscal year of a profit only $50 million to $60 million, we still expect our cash flow conversion or operating cash flow of divided by net income to be above the 100 per cent for fiscal 'twenty one.
As we mentioned on our last call we increased our debt to fund the 195 million special dividend paid in December.
Our total debt as of the end of the second quarter was 684 million comprised primarily of the 115 million balance on our revolving credit facility.
About 200 million on our uncommitted facilities.
20 million of short term fixed rate borrowings and $345 million of long term fixed rate borrowings.
Cash and cash equivalents for $20 million, resulting in net debt of 664 million at the end of the quarter.
Let me pivot now and provide you an update on our mission critical productivity goals.
On slide eight you can see our original program goals of $90 million to $100 million of cost take out for your fiscal 'twenty three.
And that's versus fiscal 19.
On our last call. We shared that we had taken out $8 million of growth savings and invested roughly $2 million to $3 million in the first quarter.
During our fiscal second quarter, we achieved additional growth savings of 9 million, bringing our cumulative savings for fiscal 'twenty, one to 17 million against our goal of $25 million by the end of this year.
We also invested roughly $5 million in Q2, bringing our total investments of $7 million to $8 million, which compares to a failure of target of $15 million.
We're ahead of plan on savings in our investment program is also progressing very well.
In fact these results are such that we anticipate making some additional growth investments to capture more of the opportunities that we're seeing.
On balance this means that our net savings target for mission critical remains roughly the same or slightly larger for the full year.
The most significant initiatives during the quarter was of course are moved to virtual customer care had including the closure of 73 sales branches the.
The growth savings related to that move are expected to be between seven to 9 million in fiscal 2020, one and reach an annualized level of approximately 15 to 18 million starting in fiscal 2022.
Before I turn it back over to Erik Let me walk you through some of our expectations for the back half of fiscal 'twenty one.
With respect to revenue growth as Erik described we expect to turned nicely positive in our non safety and non janitorial business this quarter and assuming these trends continue we should see healthy growth rates for the total business in the fiscal fourth quarter for.
For the year, while still early in its likely that we will be flat to positive for total company growth.
We expect our gross margins to remain at levels, where they've been running excluding the write down.
In terms of adjusted operating expenses, you can expect to see a step up sequentially from volume based expenses increased incentive compensation and increased growth investment.
After taking all of this into account we remain on track with our adjusted annual operating margin framework for fiscal 2020, one, which you can see on slide nine of our presentation.
Where we fall within that framework will primarily be of function of how quickly revenues accelerate and how the how much growth margin tailwind we see from price.
And I'll turn it back to Erik now.
Thank you Kristen.
As we move to the back half of fiscal 2021.
Momentum is building both inside and outside of the company.
On the outside the environment continues to firm.
On the inside we're accelerating progress with respect of growth investments and structural cost take out.
I'd like to thank our entire team for their commitment to our mission during the past year.
And while we're just getting started.
We are encouraged by the progress that is beginning to evidence itself.
And we'll now open up the lines for questions.
Yeah.
Thank you we will now begin the question and answer session to ask a question you mean per stores and one of your touch tone from you.
If you use of any sense of phone. Please pickup your handset before pressing the keys to withdraw your question. Please press Star then two.
Our first question comes from Hamzah, Missouri from Jefferies. Please go ahead.
Good good morning, hope you're well the odd thank you for the question.
I guess the the first question you know you mentioned.
Outside of the lift as as things rebound.
Could you maybe touch on diet of little more is there is there just pent up demand that you're hearing from your customers. I know you mentioned the customers are building backlogs you hired 135 people.
The most of your you've done in a long time, so clearly you're confident on on what's to come maybe just give us a sense of are you know the level of confidence in and are in the outsized lift I, whether its qualitative is fine. However, you want to answer that question.
Yeah sure Hamzah, Thanks, and hope you well.
Look I I think what you're hearing from for me and Kristen. This morning is encouragement and excitement about.
The future of of the business and the trajectory we were on and really feeling like where we're at an inflection point here, we're coming off of.
A whole lot of repositioning work and we're moving into now execution on growth and cost take out and I think the confidence is coming really in terms of the outsized list homes from two things the macro and the micro so the macro is what's happening in the environment clearly, we're hearing from customers as the vaccine rollout picks up steam things.
Things are firming up, particularly starting to firm up and some of the metalworking markets that have lagged so much for the past year, you combine that with some infrastructure stimulus and the macro looks.
Pretty darn encouraging and then you know I'd say the same thing for what's happening inside of the company. You know we've we've added cost take out to an equation that we haven't had before and that's allowing US the fund investment.
Well the 135 are not yet fully onboard hamzah, that's going to build as they do it is the largest increase we've had and we're encouraged by what we're seeing and what I would say, it's qualitatively and quantitatively. So quantitatively well look by the very early we did start to see of positive spread to IP.
In our fiscal second quarter, which was a bit ahead of where we felt we'd be and if you recall at the start of the fiscal year, we were running under IP. So that's just beginning but really that's just the start and as these share wins and investments kick in we see this building. So you know just to put a little more quantitative to what as we look ahead right around the corner.
And you take out the P. P E product lines in which there was going to be very high comps in our fiscal third quarter look at non safety non janitorial business and we're seeing you know sort of in March we saw that turn positive we would anticipate in Q3 Q for a healthy double digit growth rates in non safety non janitorial busy.
So we do think Ah, it's starting to happen and again the nice thing is the investments, we're making now haven't even kicked in yet in terms of realizing the benefits. So that's still to come.
Gotcha Gotcha and just my follow up question is just I.
I guess two parts one is.
On the safety piece do you have a sense of what what is reoccurring versus non reoccurring for U a force in the you know sort of in a post vaccinated world I know, it's probably tough to know how many mass of people will.
We'll continue the wearables vaccine, but.
Any any rough sense of that and then secondly, you know the.
For the virtual hubs could you talk a little more about that line.
You know what I mean by that is.
And these virtual hubs replace your entire branch network or where are you reporting the virtual the hubs are the.
The sort of strategic locations did it have any is there any negative impact you've seen initially when you moved to the words of virtual heartburn shutdown of brands just any more color around those yeah sure. Thank you Toms of absolutely. So the two questions. So let me start with the safety or the P. P. E. R. You know its really been safety and janitorial.
I would say is look still it's still early to say what will continue post the pandemic here, which we hope is right around the corner of what I will say is we know where we're likely going to be negative and we saw it in March in our fiscal third quarter because that was when we had the huge surge last year, but if we look beyond our fiscal third quarter looked the safety and Janet.
Real businesses, even going back pre pandemic, where growth businesses for us we'd anticipate them continuing to be growth businesses. In it you know a good case in point would be just look back at our Q2 results. So Q2 was sort of still in the midst of the hopefully the tail end of the pandemic no no crazy comps and the.
Business was up double digits, I think that would be our expectation of what could be fairly representative of once we get past.
The fiscal third quarter into sort of of more of a steady state that would be on zone on the safety of P. P E of the.
The second question on the on the virtual care of hubs. We're excited about this one and what I would say is this move the seeds were planted on this move well before the pandemic and the seeds that were planted were really around technology.
Around of smart integrated phone system and around the CRM system that allows our entire of sales team inside outside to get the 360 degree of view of the customer. So what we did Hamzah is is actually you know most of the branch locations that we had are now closed.
What so what's changed is the physical footprint.
And the removal of some management layers, what hasn't changed is the one to one connection.
Of our inside people with their customers. So our our our same inside salespeople that have built sticky relationships with customers for years and years are still there just the they're working from home, they're working remotely, but they're still the same one speaking to customers every day and it's what we've been able through the technology to create.
Eight of virtual local branch, if you will and what that does again is it is not only take out costs that we can reinvest into growth, but it allows us. The then open up hiring of technical talent wherever and individual may sit even if it's not where one of our branch locations of our so we are encouraged a we had a good plan going in I think we've moved through it quickly early written.
Turns have been positive I think the other thing I'd add at the buzzer is you know realize our branch locations were not primarily inventory stocking locations. So our service in terms of inventory through the customer.
Delivery has also not changed so on the on the risk from very low I do think look realistically, probably a little bit of distraction as we move through things are in January and early February but we're through it and returns have been positive.
Wonderful thanks, so much.
The next question is from Ryan Merkel from William Blair. Please go ahead.
Hey, everyone. My first question was non gross margin. Good morning, I guess of to partner on gross margin. How should we think about gross margin sequentially into fiscal <unk> and then given the price increases you've announced from price cost be neutral in the second half of 2021.
Hey, Ryan Yeah, so for sequential.
Or kind of second half perspective on gross margin I'll start with the Q2 to Q3. So we do expect margin to bounce back in the third quarter to the levels that they've been running at sort of around 42%.
There should be a nice tailwind from the price increase and as I touched on the prepared remarks that went into place in March and Q3. The Q4, just the caution that we do see of typical seasonal downtick in the fourth quarter, but if you put all of this together and excluding the PPE write down we would expect our annual 21 gross.
Margins to be at least flat with full year 'twenty and this one and I guess just as the caution contemplate any other major pricing moves related to the strength of the inflation cycle.
Got it Okay, Ryan I think and just just to piggyback I think Kristen nailed it for 'twenty one of the only yeah. It is and how you've been covering us for a while I think you know one of the other things for the story as we look beyond even the back half of fiscal 'twenty, one and 'twenty two it does seem like the makings of there for a pretty robust inflation cycle and that you know generally you know the increase.
We took now if that is the case would just be the beginning of the moves to come down the road in response to continued inflation and again early stages of that should be a tailwind for us.
Yeah that actually.
It leads to my second question, which was about incremental margins looking out since that's the question I'm getting from clients. So I don't know maybe this is for Christian but how should we think about incremental margins in 'twenty, two and 'twenty three can we get the old days of mid twenties and what level of top line would you need and then Erik you mentioned the price environment. That's also.
The considerations and maybe how should we think about that.
Sure Yeah, let me take that one Ryan and I guess I'll kind of walk you down how we're thinking about 'twenty, two and 'twenty three just sort of thinking about the structure of the P&L and that's the kind of frame. It up you heard Eric talk a lot of about a lot of these themes, but you know look we're really excited about what's building here and I think Erik you used the term inflection point I totally agree with that it's a good.
The descriptor, we we like what's happening inside the company, we like what's happening outside the company you know from a macro perspective as we touched on environment looks good everything is kind of pointing to a strong recovery and also the early stages of a pretty healthy.