(This post is a reprint of one of the nine sections that make up last month's Singular Diligence issue on MSC Industrial Direct.)
MSC Industrial Direct is an MRO (maintenance, repair, and overhaul) distributor focused on the metalworking industry. The company’s initials originally stood for Manhattan Supply Company. This is a company MSC’s predecessor acquired many years ago. MSC can trace its roots to Sidney Jacobson’s Sid Tool Company. Sid Tool was founded in 1941 in Manhattan. Sid Tool’s store sold cutting tools and accessories to New York City machine shops. The company moved to Long Island in the 50s. Business grew rapidly after World War Two. But Sid Tool soon became dependent on two key customers. Grumman Corporation and Republic Aircraft made up 90% of Sid Tool’s sales. To diversify its sales, Sid Jacobson started a catalog business. The catalog offered discount prices on imported cutting tools. Since it was a catalog instead of a store, the book was able to offer a wider range of products. Sid Tool’s catalog was launched in 1961. By 1964, it had over 150 pages. Today, MSC’s catalog – known as the “Big Book” has over 4,000 pages.
Within a few years, Sid Tool’s catalog sales were greater than the sales it had been making to those two key customers. Sid Tool was selling products it found at trade shows. Jacobson would visit trade shows and make up lists of the products he wanted to sell. Or manufacturers who saw Sid Tool’s catalog would contact him and ask to be put in the catalog. This allowed the catalog to have a wide range of products. But, it created a problem in the late 1960s. An imported item was out of stock. Sid Tool didn’t have the product on hand – though it was in the catalog – and was told it would take 6 months to fill the order. Jacobson wanted to make sure this would never happen again. So, in 1969, he installed a computerized inventory control system. MSC has been quick to adopt technology to manage inventory and fill orders quickly and accurately ever since.
In 1970, Sid Tool acquired Manhattan Supply Company. This is where the MSC name comes from. MSC opened its first distribution center in 1978. In the 1970s, Sidney Jacobson’s son, Mitchell Jacobson, joined the company and soon took over day-to-day management. Mitchell Jacobson was very young when he took over the company. So, he is actually still with MSC today. He serves as the company’s Chairman. Members of the extended Jacobson family control much of the economic interest – and a majority of the voting power – of MSC to this day.
Under Mitchell Jacobson, MSC started a geographic expansion. It went from 3 branches in the mid-1980s to 26 branches in 1990. That same year, MSC opened a second distribution center in Atlanta. This gave the New York based company better geographic coverage. The company also made same day shipping a priority. By 1991, MSC was shipping 98% of orders the same day it received them. This was several years before e-commerce became a reality in the U.S. So, same day shipping under almost all circumstances was not yet common. MSC’s management decided same day shipping helped differentiate the company from its competition. So, it pressed this advantage. For orders placed by 4:30 p.m., MSC said it would either ship the order that day or it would send the customer a check for $50. In the first 3 years of the program, MSC had a 99.99% same day shipping rate.
MSC went public in 1996. Revenue was $305 million at that time. We know what MSC’s sales were in the mid-1970s. So, we know that MSC had achieved a 20% annual sales growth rate from 1976 through 1996. It was a growth company. But, it was determined to invest in additional infrastructure. From 1996 through 2004, MSC opened 3 new distribution centers, added 60 branches, and increased its catalog by 400,000 stock keeping units. In the 20 years since its 1996 IPO, MSC has grown sales by 12.6% a year and earnings per share by 13.3%. The stock price has compounded at 11% a year while the company stuck to a 30% to 50% dividend payout rate throughout those two decades.
There are two ways to look at MSC today. The first is to see it as one of the big MROs like Grainger and Fastenal. By this measure, MSC has 2% of the North American MRO market. It has 1.1 million stock keeping units available online. And it actually stocks 880,000 of these items. Orders placed by 8 p.m. have a 99% chance of being shipped that same day. If you think of MSC as just another broad line MRO distributor like Grainger and Fastenal – it appears more centralized. MSC ships almost everything out of just 5 distribution centers. The company still has 100 branches. But, these branches should not be thought of as stores like the small ones Fastenal operates or the large ones Grainger runs. MSC’s 100 branches are really just sales offices. They carry very little inventory.
So where is the inventory? It’s in MSC’s 5 distribution centers. And it’s in vending machines. MSC is mostly an e-commerce company. MSC has sales of $3 billion. About 57% of those sales come from electronic sources. Metalworking revenue is 50% of all sales. So, actually, MSC is almost 30% a pure online metalworking supply company. It can be thought of as about half online and half offline and it can be thought of as about half metalworking and half non-metalworking. MSC’s relative market share within metalworking supplies is big. The company has 10% market share in metalworking. This is several times the size of its nearest competitor.
The Jacobson family has 82% of MSC’s voting power and 49% of its economic interest. We’ve included shares owned by the Chairman (Mitchell Jacobson), a Jacobson family trust, shares held by Mitchell’s sister, and shares held by his niece and nephew. Calculated this way, the Jacobson family controls MSC. It is a family controlled company despite being public for 20 years now.
MSC has $3 billion in sales. It just completed a major expansion of its infrastructure which included a second headquarters and a fifth distribution center. The company will not be running “at capacity” till it hits $4 billion in sales. The EBIT margin is 13% now. But, Quan estimates the EBIT margin will peak in the 16% to 18% range when MSC once again operates at capacity. This is an important point to keep in mind throughout the issue. MSC might look like it is trading at a P/E of 19. But, over the next 5 years, MSC can increase sales, increase margin, and pay out free cash flow without additional investment in infrastructure. So, 2016 earnings are very low compared to what we expect 2021 earnings to be. When a buy and hold investor looks at a stock, it isn’t this year’s earnings they should price the stock off of. It’s earnings five years down the road. MSC is not cheap compared to what it is earning if you buy it today. But, today’s stock price is cheap compared to what MSC will be earning when you sell it in 2021.