Okay, thanks for joining us, everyone. I'm David Manthey, Baird's Senior Industrial Distribution Research Analyst. Today we have MSC Industrial to present with us today. We have CEO Erik Gershwind, Martina McIsaac, who's the Chief Operating Officer and President, and Ryan Mills, the Head of Investor Relations. I'm going to turn it over to Erik, who's going to go through a few slides here, and then we'll kick it right into Q&A. If you have questions at that time, it's session4@rwbaird.com. I can field those from the iPad small room. If you want to raise your hand, we can go ahead and do that, and we can call on you manually. So with that, Erik, you want to kick it off?
Great. Thank you, David, and good afternoon, everybody. Nice to see you. I will do a brief company overview, and then we can get right into the Q&A. And this is really intended for those who aren't that familiar with the story. MSC is an industrial distributor of over 2 million SKUs and over $3.8 billion in revenues in our most recent fiscal year, which was fiscal 2024. Our fiscal year runs September through August, so we're now well into fiscal 2025. We have a long history dating back to our founding in 1941 and have obtained over time a leading position within the industrial supply space in the metalworking category, which represents roughly 45% of our sales and is supported by a large sales force with a large dedicated team of technical specialists, which is a good part of our source of our competitive advantage.
We compete in the North American MRO market, which in total size is in excess of $200 billion, and that's U.S., Canada, Mexico, and interestingly, for a market that large, it's still amazingly fragmented, so the top 50 industrial distributors have roughly 35% of the market, which means the balance of 65% is made up of local and regional competitors, which shapes a really compelling growth opportunity for us and other well-capitalized distributors. I'll move briefly to our financials and highlight some of the characteristics that make MSC a compelling investment. We have a very strong balance sheet with a net debt leverage ratio of roughly one times and very compelling cash generation characteristics, as evidenced by free cash flow over the past fiscal year of roughly 120% for fiscal 24. For fiscal 25, our current fiscal year, we're targeting about 100% conversion.
And this has allowed us to return capital to shareholders in multiple forms. We have an ordinary dividend with a strong yield and the highest of our peer group, in fact, and we've shown steady growth of that over time. We have more recently made some enhancements to both our leadership and governance of the company that I think are worth highlighting. One is it was roughly a year ago when we made the decision to eliminate our longstanding dual-class share structure and collapse that, which we did, and we repurchased the share dilution over the course of the past year. More recently, we added another independent board member to our board, Rob Barnes, who brings very strong distribution and operating experience with him.
David alluded to it, but even more recently, a month ago or so, we promoted Martina, who's with us for the first time, who was our Chief Operating Officer to President and Chief Operating Officer. I'm sure during the Q&A we'll have a chance to explain what that means and how it benefits our company. Ryan, if we move on to the next slide, talk a little bit about the strategic direction of the company, which we outlined as what we call our Mission Critical program. We completed a strong three-year run of our first chapter in Mission Critical, which ran from post-COVID, our fiscal 2021 through fiscal 2023, in which we met or exceeded all targets. There's essentially to this next chapter three elements or pillars to the story, if you will.
The first pillar is maintaining the momentum that we've achieved in our high-touch, our solutions part of the business, which I'll get to in a second. The second is to add a couple of new elements to our growth story. And then third is to optimize our cost to serve to ensure that as we restore growth, we can expand operating margins. And we kicked off our second chapter during our fiscal 2024 of Mission Critical in the midst of what was certainly proved to be a challenging operating environment in which we saw deteriorating conditions in our end markets, which are primarily levered to manufacturing and within manufacturing, heavy manufacturing in particular, and any industry that's going to be consuming metalworking-related products.
I am, though, encouraged by the resiliency that has been demonstrated by our team, and we're actually pretty excited about the momentum that we see building and the story we see building, especially as we move through our fiscal 2025 into fiscal 2026. So let me touch briefly on the three pillars, if you will. The first, I mentioned maintaining the momentum in our high-touch solutions. And the idea here is to bring us closer to the industrial plant floor, our customers' plant floor, and to embed ourselves into their operations. Two proof points I'd point to there: our inventory management solutions, primarily our vending program, grew off of a large base at 9% in terms of installed base and signings year on year.
And our In-Plant program, in which we're actually placing MSC associates inside of their operations to help them improve productivity, grew 30% in terms of program count during the year. So the momentum there is strong. The second pillar I mentioned, adding new elements to our growth story. And the biggest highlight here would be our core customer base, which makes up a little over half of the company's revenues and are our small and medium-sized customers. And there are a couple of linchpin initiatives set to re-accelerate growth in this core customer. During fiscal 2024, we completed the realignment of our public-facing web pricing to this large segment of customers. And that is now behind us.
And we're also in the process of building a best-in-class e-commerce experience with upgrades really continuing over the course of the next one to two quarters to continue to improve our experience and, along with that, enhanced marketing efforts that will begin in our fiscal second quarter and particularly once we get through the calendar, so really the second half of our fiscal second quarter after we get through the holidays. On the third pillar, I mentioned optimizing our cost to serve. So we have several, which I'm sure we'll touch on, productivity initiatives that are going to build particularly through the year into 2026 on top of a couple that are already in place on the network front, such as a decision that we made to close one of our distribution centers, yielding between $5 and $7 million in benefits this year.
Over time, as we build and look past 2025, our long-range goals remain unchanged, which is to grow organically at 400 basis points or more above the industrial production index and to achieve 20% incremental margins or better over the course of a cycle, which puts us back on a path towards mid-teens operating margins, which is our goal, along with 20% returns on capital. So at the highest of levels, that's the story and the outlook. And I think, David, I'll maybe turn it over to you for some questions.
Sounds good. So first couple of questions, pretty standard we're asking everybody. You mentioned you hadn't heard anyone ask you about tariffs or the election or anything, but let's start there. Maybe you could just talk about any potential fallout from whether it's tariffs or something else related to the new administration.
Yeah, surprised to hear you ask that, and maybe for context, I think just reiterating the lens with which MSC comes from, so 70% of our nearly all of our business is North American. Of that, 70% of our revenue base is into manufacturing, with most of that being heavy manufacturing, so think machinery and equipment, automotive, aerospace, and the like, fabricated metals, job shops, and the like, so from our perspective, before I get to the election question, maybe just even looking back, we saw pretty steady deceleration through our last fiscal year of those end markets and a couple of things going on, certainly the sustained high interest rates catching up, and caution that we see every four years around leading up to an election cycle.
So there's some of this that I think probably you're hearing from most companies at this conference that just getting through the election, regardless of outcome, is a relief to everybody. In general, though, given our exposure, anything that's going to be done to encourage manufacturing in North America here in the U.S. is going to be likely a tailwind for us. So we think that's certainly a net positive. I think our whole take on this is a net positive. The other big one, wildcard you mentioned, is tariffs. So from an exposure standpoint, MSC sources under 10% of our products directly from China. But we're also mindful that many of our products we sell are branded industry manufacturers who do business. So there's going to be an indirect effect that's much larger for anybody.
Over time, if I look back at past cycles, David, as you've been covering this industry a long time, inflation, and it certainly seems like it could lead to inflation, has been a distributor's friend and has been more tailwind than it has headwind. So assuming that plays out, as I suspect it would, I think it's a net positive for the company.
Yep, sounds good. I think I've heard from some that they're anticipating greater than normal or maybe normal year-end shutdowns, turnarounds, things like that. What do you think? What are your views on that? When you talk to customers, are they saying, "Yeah, we're..." And I haven't even looked at where Christmas is placed in the week sort of thing. What are you anticipating for year-end shutdowns this year?
Yeah, so we definitely looked at that, and David, again, before I answer, which I will answer that directly, so we announced we're on a sort of a different cycle, but we announced and gave guidance for our fiscal Q1, which runs September, October, November, and normally, the last few years, we've been giving sort of an annual outlook. And we felt like with all of the uncertainty swirling, with the softness we had seen, we made the decision to keep it to a quarter because we thought it would be really difficult, number one, to project the macro, and number two, we think we have some exciting self-help initiatives to improve our performance. Some of those, it's difficult to say when they come online, so we shrunk things in terms of a guidance perspective.
In terms of December, and we gave a little bit of this commentary on the call that it wouldn't surprise us. So there's the euphoria post-election, but it leads right into the holiday season. And typically, when our customers are soft, they will use holidays as a time to do shutdowns and extra vacations. That's what we're expecting. You compound that, David. So Christmas and New Year's this year fall on a Wednesday. So usually when that happens, those last two weeks of December are pretty slow. Yeah, so it wouldn't surprise us if December is soft. And I think from our perspective, the real telltale signs about how quickly will there be the bump or any sort of lift will tell after the holidays. The challenge for us, by the way, we'll be giving our next earnings call on January 8th.
So, we'll have the first week in January will be a little bit of holiday noise, and we'll have like a day or two under our belts before our earnings call to get a read on January.
Yeah, well, that's important to note. I hadn't thought about that. And I know when that happens, that does tend to lead to some strangeness around year-end Wednesday, people taking off before it, after it, the whole week, whatever, right?
Those two, usually history would say those two weeks become really abnormal weeks.
Yeah, okay, that's good to know. Well, Martina, we have you here. This is great. It's so exciting. I know the question is always, well, what are you going to do different? Is there anything that... I know, but just functionally, is there anything with this new title? Does anything in your function change or is it just a formality? Tell us just about what it means for you.
Very good. So yeah, when we created the COO role, and I think our last COO was Erik a while ago, right? So when we created the original COO role, it was with the intent to try to look at our business end-to-end and build an operating system and a process foundation that would let us continue to drive productivity. So with this change, we bring the last of the functions together. So in particular, technology and marketing. So we'll join the group. And so that was a big change. 2024, we had a few stumbles around our technology group, and it just showed us that it was really important that they be closely integrated with our sales team and with our product teams. And so bringing that together is one of our goals.
Can you talk about the sales force and if there's any changes happening there?
Yes.
I get the sense there's kind of a point of cognitive dissonance at the company, given that it feels like you don't want to do too much because you don't want to upset the sales situation, but it seems like there's some work that you may need to do. Could you talk about how you're striking a balance between those two things?
Yeah, absolutely, so Eric mentioned that re-energizing our core customer is one of our key initiatives, and part of that is how we support the customer digitally, and so he talked about that, some of our web enhancements. Part of it is our pricing, and we spent a lot of time last year bringing our pricing into a fair and credible range, but part of it is also how we cover those customers in the field, and so he also used the word self-help. Regardless of the macro, we feel there's an unlock in terms of sales effectiveness and how we deploy our field personnel, and so we're looking right now at territory redesign, looking for situations where we have undercapacity or overcapacity, matching our deployment to our customers' locations, and we think that that will allow us to access about $300 million of additional potential without adding heads.
So that's the kind of self-help that we're looking for right now. And of course, the first question, like you say, is, well, what about relationships? How sensitive do we have to be? And we're taking our time. We're doing it in a very planful way. We're not disrupting any major relationships. We're looking sort of for the long tail of portfolios and reassigning those. And we're taking our time. So these changes will be implemented over the next couple of quarters. But we really do see an opportunity for increased sales head productivity per head.
Got it, okay. I'll check the iPad here, but if there's any questions, feel free to raise your hand, and no, no questions. Okay, we can keep moving.
Everyone just is interested in listening to what you have to say, David.
I doubt that highly. But you mentioned earlier the productivity enhancements and the initiatives you have going on, some cost-cutting efforts. Can you talk about those in the context of, as we look to fiscal 2025, how you hope to offset some of the, I guess, the annual, just normal operating expense increases?
Yeah, and I think important to understand the value creation story with this company right now, we believe, is really around fiscal 2026 and moving forward. So 2025, which we're in now, is a bit unusual. Number one is the environment continues to be soft. And hopefully, we see that turn. We have a lot of the self-help programs lined up, but we come into the year with contracting revenues. And at the same time, there is an operating expense step up from 2024 to 2025. And there's a couple of reasons for that, idiosyncratic things, company-specific things, one being incentive compensation and a reset of our bonus accrual, which is a big step up that is sort of one-time in nature, David. And if our goal was to optimize 2025, we'd be in a different playbook right now than we are.
But what we see as we look out is we get past 2025, number one, some of these expense idiosyncratic things normalize. So our OpEx sort of returns to a normal cadence as we move past 2025. And then on top of that, there really are on the revenue line and then on the productivity line, several programs in flight that Martina primarily is driving that will start to build as we move through the year and move out to 2026. So if I were to work my way down the P&L, we've been in a soft environment getting hit particularly hard by our heavy manufacturing exposure that at some point, I can't tell you one, but at some point that does turn.
The MBI, which is sort of like the PMI, it's the metalworking's version of the PMI index, has been negative for 20 or 21 months in a row and severely negative, like 43s and 44 readings. History says, I don't know when it changes, but history says that won't last, so the environment will normalize, and then we talked about some of the programs we have that we really feel like will give us outsized benefit on the top line, and then a more normalized expense cadence with the productivity on some of the supply chain initiatives that Martina has moving really sets us up nicely to get back to the kind of growth and margin expansion that we expected of ourselves and that we delivered in Mission Critical 1.0, if you will, so that's really the story is about setting ourselves up for a run for fiscal 2026.
Okay. And then could you talk about the web enhancements and the marketing initiatives and the things that go with that? There was a delay. And I guess that might be part of it why we're being in August fiscal year. It's not that far off. We're talking about 2026. So could you talk about how those roll out, what those look like, and then what the expected outcomes are once you get to the other side of this after you've adjusted pricing and you implement these changes?
Yeah, sure. And Martina, you can certainly chime in. I'll take a first step. So no question, as I look back to 2024, part of our story, I mean, we were not pleased with our performance. Part of it was macro, and then part of it was one or two self-inflicted things, particularly in this area in technology where our website upgrades, which the web has been a source of competitive advantage over the years for MSC, an important part of our value proposition, just were slow going and rolling out. We are now. It's basically, David, week by week, month by month. It's an area that I have dug into. So Martina mentioned her new organization, Inclusive of Technology. One of the nice added benefits to the reorganization, if you will, Martina and I work really well together, and it's freed me up.
And one of the things that we do is identify areas where I can kind of like dive in, working with Martina and the team and given my experience with the website, that's one of them. So we're getting back to a cadence of just ongoing improvements and upgrades and releases every few weeks, new features. That will continue. That'll continue through the fiscal year, but we feel like we're back to a good cadence. What we haven't been talking about is enhancing our marketing efforts beginning our fiscal second quarter. And we expect that to happen. I mentioned it'll probably be after, just given what's likely to be holiday noise after the holidays.
Our marketing efforts, if I think about the formula here of how does e-commerce become once again a growth engine for the company, it's a mathematical formula of how many people are coming to, what's traffic like, how many visitors are coming to the site, and then what's the conversion rate for those who come to the site. Then once the conversion rate happens, what's the average order size. We're looking along all three dimensions to how do we once again, and internally, we have a quantified plan for each one of those three. The traffic will primarily be through marketing efforts. Our list price positioning that work we did last year helps. Then the conversion and the average orders are a function of the continued improvements to the site that are happening now.
Sounds good. We have a question here.
Where are your margins today? And where could they be three to five years from now? What would be a reasonable expectation? It sounds like you're saying that this is a transitory year. Business is going to get better. Distributing 40-something on the number, it's going to get better. So where are the margins today? Where could they be five years from now?
So today, we haven't given a full guidance. Ryan, just share where we finished fiscal 2024.
Yep, yeah. Operating margin was 10.7%. Our first quarter guidance, the midpoint, the range was 7%-7.5%. And as Erik mentioned earlier, our long-term goal, which we feel confident in achieving, is operating margin in the mid-teens. We didn't put a timeframe on that. But the way to think about it is our target is 20% incremental margins over the cycle.
So if that's all true, you'll generate a massive amount of free cash. We started the presentation by saying that your free cash flow is higher than your net income. It's a free cash machine. So what's the highest debt you've ever had on the company? I think you said you're running like one times debt to EBITDA. Why wouldn't you be three, four times debt to EBITDA today to buy back all the stock and then have shareholders enjoy the margin expansion or the top line expansion for the next five years?
Our view on leverage is we've always been fairly conservative. And so we run at one times. We have gotten as high as two and a half, three times temporarily, I'd say, but not on a steady state.
But that logic was based on the fact that you have found your royalty shares. You never wanted to lose money. But as a public company, does that mindset change over time or does it not change? Or is there something about the business I'm not understanding? It sounds like you've gone through difficult times and you've still done an incredible job of generating massive free cash flow, even in a difficult economic time, a difficult time for your business. These would be some of the not-so-great years. So if the great years are ahead of you, what are you going to do with all the free cash?
So just one caveat I would say is that so the way our business, like many distribution businesses work, when revenues decelerate, we generate more cash. When they accelerate, we actually consume more cash. So if we, it's one of the reasons for the dry powder. And by the way, just to be clear, buybacks are absolutely part of our priority scheme here in terms of capital allocation. But one of my hesitancies or our board's hesitancies to just lever up to three, four times now would be in the event of a snapback, which we're all hopeful for, whether that's macro or micro-induced, we start consuming cash pretty good in terms of receivables and inventory.
So if the markets deteriorate better, you're going to generate less cash?
More or less. Hey, it's still a nice cash-generating business. But during the period of a snapback, we do consume cash.
Erik, maybe you could share with us what percentage of MSC today is federal government, specifically sales?
Public sector overall is roughly around, it moves around a little bit, David, but around 10% of that. Ryan, have we shared our breakout?
I think we said, but directionally, more than half is.
More than half is federal.
More than half. Okay, yeah. So with the new administration and with whatever Elon's going to look at, you could look at it one way or the other. One way is if they're targeting eliminating waste and you're talking about reducing consumption, perhaps. You're talking about maybe reducing the number of departments, perhaps. So there's a potential for a downdraft. Flip side of that might be if I'm looking at efficiency and I'm buying from 100 distributors, I can focus that with the most efficient, most value-add distributors, and that might actually benefit MSC. How are you thinking about it today?
I think both statements are probably true, David. I think the other nuance I'd add in here is the portfolio, the government public sector business is a very broad array that can look very different. So where you're going to find MSC is even within the federal government, it's going to be in places that look, resemble more like our position on the manufacturing plant floor than just an administrative or office environment. For example, military bases. The dynamic there is probably different from where the waste, I would guess, where the waste is going to get targeted for consumption reduction. So I feel pretty good about our portfolio on the federal side, but I'm sure both of those factors will also be in play.
And I think I don't have a good answer for you yet as to how that plays out in terms of headwind or tailwind, but we feel pretty good with our portfolio on the federal side.
In terms of Vending and In-Plant, I mean, that's been a bright spot, I think, going through what we're going through. You keep that continues to become a larger portion of the business. You've seen good growth there. Could you talk about where you are today, how you feel about it, and what the outlook should be there?
David, we feel really good. And the company with our Mission Critical program intentionally made a pivot, as I mentioned, to become higher touch, more technical, and have a greater presence on our customers' plant floor. We think it deepens the moat around the company. It's helping our customers. And those are two good examples. Interestingly, as successful as we've been with them, I mean, even during fiscal 2024, they were also illustrative of some of the softening we're feeling because Ryan's been making the point, Vending signings plus nine last quarter, Vending average daily sales were flat. So if you think on a per machine basis, it's down high single digits. And those are customers that we're deeply embedded with, indicative of just consumption reduction. But those are both areas that we have the foot on the accelerator. It's adding value to the customer.
What we're excited by is at some point when the environment normalizes and the heavy manufacturing markets restore, we should see an outsized benefit because we get the benefit of the end market coming back and then the embedded market share capture with the In-Plant and the Vending program where today's spend is suppressed, so they're absolutely top priorities for us to continue.
And in terms of those, I mean, is it auto? What is the, and I know you don't sell primarily to just the manufacturers themselves. You sell to sort of tier one and tier two suppliers, and sometimes that gets lost in metalworking. But when you're saying that when metalworking gets better, what are you thinking about as what would be the key indicator for you as to what that looks like?
Today, the softness, David, is fairly broad-based with the exception of aerospace. Examples of end markets that are driving machinery and equipment would be things like agriculture, which in our Midwest regions is a fairly sizable percentage of our business. Think the Deere and the Caterpillars. All the tiers down in those supply chains are quite soft. Heavy truck would be another one. Automotive would be a third. In terms of a leading indicator, amazingly, the sentiment surveys have been fairly predictive over time as good leading indicators.
Meaning MBI and ISM?
Yeah. Meaning if we start to see turns there, they have been over time fairly predictive of when does end market.