Good afternoon. I'm Sam Darkatsh. On behalf of Raymond James, we'd like to welcome you to the MSC Industrial Direct presentation for today. With us today from the company, Erik Gershwind, President and Chief Executive Officer, as well as John Chironna, Vice President, Investor Relations and Treasurer. Erik and John, I think will both be presenting this afternoon. There may be a few minutes for questions, but certainly we'll have the breakout session immediately following. With that, Erik, welcome back.
Thank you, Sam. Very good to be back. Nice to see everybody. Good afternoon. We're gonna spend a few minutes giving you a rundown of the company, and thought we'd begin with the punchline or some of the highlights. I think there's five themes that you'll hear as we go through today's discussion about the company. Theme number one is growth, and that's both kind of a historic track record of the company's performance, along with an outlook of growth in what is a large and highly fragmented marketplace. The second theme is around differentiation. We have and have built over the last number of years, a highly differentiated value proposition that we'll describe in more detail. The third is a customer-focused culture that anchors everything we do. John, you're gonna You'll advance for me?
Yeah.
Okay. Oh, can you go back?
That one?
Yeah, back two. One more. This is a sensitive clicker. The third theme is around a customer-focused culture that really anchors everything we do. Theme number four is around delivering on commitments and on our financial targets, in particular, the targets that we set out for ourselves about two and a half years ago that we'll describe in more detail. The fifth theme is around using capital allocation as a means of enhancing TSR. Moving along, just a little bit more of an intro on the company. MSC is a leading North American MRO distributor. We're approaching $4 billion in sales in this fiscal year. As a one caveat, we are in fiscal 2023, which runs from September through August, we're not on a calendar cycle.
We will approach $4 billion this year in a market that is roughly $200 billion in size in North America. Of that $200 billion, the top 50 distributors have only 30% or more of that market. It is, as I mentioned earlier, highly fragmented. We have a long track record of growth spanning multiple decades, and yet significant runway in front of us for continued growth. From a profitability standpoint, EBIT margins in the low teens, with plenty of room for expansion to at least the mid-teens in the near term, and a return on capital that is approaching 20%, and in which we also see room for expansion well above 20% over time. Moving along, I'd mentioned a unique and differentiated value proposition.
I'd say that MSC, we've been in business over 80 years now, and that 80-year history could be looked at or defined in chapters of a story. Most recently, we went through a repositioning, and that would be the latest chapter in the story from what was strictly what we'd call a spot buy supplier or a long-tail supplier, to become more of what we refer to as a mission-critical partner on the plant floor of industrial and manufacturing customers around North America. To be clear, the elements of the prior chapter of our spot buy business remain firmly in place, and that include a product offering of over 2 million SKUs, a next-day delivery engine that covers everywhere in continental US with next-day delivery, and a really strong, seamless customer service experience.
On top of that, in our most recent chapter here, we've built out what is a highly technical and a high-touch value proposition. That value proposition is anchored in metalworking products, things like cutting tools, which represent a little under 50% of the company's revenue and is our historic core strength. We support that with hundreds of metalworking and machining experts in the field. The reason we think that's relevant is for industrial manufacturing customers, metalworking products are important in influencing the final output of their business. We've added adjacent product categories over time that also fit the bill of being technical or high touch, and our Class C consumables business and OEM fastener businesses are good examples of that. Combined with metalworking, those together represent roughly two-thirds of company revenues.
Those product categories are supported by high touch services, vending, VMI, and a recent in-plant program that when combined, our services businesses are roughly 55% of revenues and growing. We have a strong digital platform that underpins all of this. E-commerce revenues as a percentage of sales are in excess of 60%. All of this together translates to what you see here on the slide, which is, I mentioned a customer-focused culture. The end result that we are laser-focused on inside the company, and that is improving our customers' output. That could mean improving their lead times. In some cases, examples you see here are improving our customers' ability to get products out the door and improve their revenue generation. In other cases, it's about improving input costs, productivity, and taking costs out of their business.
All of those services and that value proposition are aimed at helping our customers improve their operations. About two and a half years ago, we outlined what we referred to as our Mission Critical program. The intent of this program was to translate this new value proposition into superior financial performance. You can see some of the objectives at a high level laid out here, but we had a few that we focused on, and specifically, one was organic revenue growth. To us, that meant over time, outgrowing the industrial production index, which is a fairly good proxy for our end markets, by a minimum of 400 basis points and hopefully more over time. The second would be to expand operating margins by improving our cost structure.
We had set forth a goal of a cost takeout of a minimum of $100 million within those three years. Then we wanted to expand our return on invested capital from what was in the mid-teens to the high teens through those moves, along with support from capital allocation philosophy. Encouraging, we're now 2 1/2 years into, so we're right in the middle of our fiscal 2023. We're 2 1/2 years into those three-year targets, we have so-to date met or exceeded each of them.
On the organic growth front, as of late, we are tracking well above 500 basis points or more above IP. That is powered by our growth initiatives, along with certainly an outsized pricing tailwind, no question, relative to what we expected to see two and a half years ago. We are on track to exceed our $100 million cost takeout goal as a result. That is yielding improvements in OpEx-to-sales ratio in our prior fiscal year, well in excess of 100 basis points of improvement. It's also yielding operating margin expansion in the last fiscal year, also well in excess of 100 basis points of operating margin expansion.
On the return on invested capital front, we had actually already achieved our high teens goal and are looking to raise the bar and set our sights higher. Adding to our organic growth story, we've also supplemented, particularly of late, our performance with tuck-in M&A. We've done several acquisitions within the past 12-18 months. We highlight three of the most recent here, and I thought what I would do is just outline what our strategy and approach is and how we've been doing of late. Essentially, we're focused, I mentioned tuck-in, but we're focused on acquiring local branch-based businesses that can fold into one of those three platforms that I mentioned earlier.
Those are metalworking, Class C parts, which think of small odds and ends that are low dollar value, but keep plants running, and the third being OEM fasteners or the fasteners that actually go into a finished part. As we evaluate an acquisition candidate, we essentially have three filters that we use, and those three filters are strategy, culture, and financial. With respect to strategy, we're looking for best-in-class companies within a local market that bring to us more scale, that bring to us geographic reach and penetration, and that bring to us technical talent in the way of salespeople that bring strong customer relationships. From a culture standpoint, we're looking for businesses that line up with our values, and the best proxy for us there is understanding the owners really well, how they run their business.
We generally look at the reputation of these are companies that we will have competed against in the local market for years. Their behavior speaks volumes. The third filter, of course, is financial. While there's several metrics we look at, the primary one is we wanna see returns on capital on these deals above our weighted average cost of capital in three years or less. The recent deals that we have up here are tracking very nicely, along with a few others that we didn't mention here, are tracking very nicely. In fact, Tower and Engman-Taylor up here are actually on track to exceed our weighted average cost of capital in their first full year of operation. Those are off to a good start. The third here, Buckeye Tru-Edge, which is one portfolio. Still very early.
The acquisition was just done a month or two ago. I'll talk a little bit more about the goals that we had set for our fiscal 2023, again, running from September 2022 to August of 2023, and really a continuation of building on the Mission Critical targets that I had mentioned before. That's continued growth above IP and operating margin expansion at most points along the framework that John Chironna will touch on a little more in some more detail. Our assumptions for fiscal 2023 at the time we laid it out range, because we did give a range, ranged from a slightly contracting industrial production index on the low end, to a flat industrial production index on the high end and assumed roughly 200 basis points of the acquisition impact from the deals that were noted above.
The other thing I will call out about fiscal 2023 is we did use the last quarter or two as an opportunity to tighten up our capital allocation framework. We sort of gave a handful of priorities. Priority 1 is reinvestment into the business organically to the extent we see high return projects, which we do. The second priority is continued ongoing growth in our ordinary dividend. From there, two priorities, that being share buyback and branch-based tuck-in M&A that we look at kind of together on a risk-adjusted basis. In terms of our framework, what I'll say, I do have to be careful because we are in a quiet period, and I have to go back to our comments as of early January.
At the time of our last earnings call, we did say that we saw industrial demand as being stable. Certainly, looking outside the company to macro indices, we hope that continues. I'm gonna turn things over to John now, who's gonna cover our financials, and then I'll give a brief wrap-up before some questions.
Thank you, Erik. This slide is really intended to give you the history, if you will, 10 years and even longer than that on the revenue, operating income, and gross margin look. I think what you can see on this slide importantly is the impact of our strategic programs and mainly Mission Critical. You can see that, for instance, revenues are back in growth mode since 2019, basically. Our OpEx to sales ratio is declining. That's the light blue line. Our operating margin is improving. That's the red line. On the right side of the graph, you can see that we continue to generate healthy levels of both operating cash flow and free cash flow. I'll talk a little bit more about that in a minute.
Don't look right.
That was clear.
Yeah, I'm not sure why that's showing that way. Well, the idea here was to dig a little deeper into sales. What you would see is basically, from about 2020 on, a separation of our sales growth compared to the IP line. Before that, they were kinda flat or even, if you will. Through the mission-critical programs, the organic sales have increased above, and our goal is to get to at least 400 basis points of outgrowth over IP by the end of this year, and in essence, through the cycle. What I would have also said that you would be able to see is that, yes, a lot of that growth was price last year.
What gives us confidence about the future is that we know internally that our various growth programs, particularly the solution-or-oriented ones, are not yet firing on all cylinders. Even as inflation tempers this year, potentially, and looks like that's what it's doing a little bit, we still believe there's good unit volume growth that will come from our various growth drivers. This is turning to our balance sheet, I guess. Our balance sheet remains quite strong. This gives you a little more recent, our last quarter, where we generated about $50 million in free cash flow. This also allows us to do things like Erik mentioned, growing our ordinary dividend, which we in last quarter increased by 5%. We typically just increase it once a year, so it's increased for all four quarters for the coming four quarters.
Our net debt is quite low with our leverage ratio being just a tad over one time. Well, I'm not sure. I think Erik hit our capital allocation strategy here, not sure there's a whole lot to say here. You mentioned the deprioritizing the special div, that's something we did a quarter ago as a result of an investor perception study we did. We always wanna drive ordinary dividend growth and invest in organic growth investments as much as possible. Now with the deprioritization on specials, that leaves more cash flow to be used for share buybacks and M&A. You've seen the M&A. At some point, you'll see the share buybacks.
Oh, the other thing I would mention here, actually, as Erik Gershwind mentioned, we made ROIC a key financial target as part of Mission Critical. We've also included that now ROIC is a metric for the management performance share programs. Kinda putting the money where the mouth is, what gets measured gets fixed or gets improved. I think, you know, here, Erik Gershwind kinda went through some of these as well in some of the slides. This is the fiscal 2023 outlook. He mentioned the 5%-9% ADS growth. The adjusted operating margins of 12.7%-13.3%.
For me, importantly here, I think for you as well, might be the fact that basically at all points in that range, if you back out the 20 basis points from the extra week because we're on this fiscal calendar, so we had an extra week of business last year, it would evidence expansion of operating margins all along that range. That's pretty much it. I'll turn it back to Erik Gershwind to close up before we open for Q&A.
Thanks, John. You'll advance one slide.
Yeah. There you go.
Look, I think you could read the slide, and it's just sort of a recap of what we discussed. I thought maybe hit on a couple of things sort of looking ahead that may be not so obvious from the numbers or the slides that have me excited. Number 1 is there's momentum building inside the company right now that if you're in the walls of the company, it's an exciting time. We feel like there's been an inflection in performance that we're building on and are excited.
I think related to cultural shift, the management team, I've been with the business 25 years plus, but our senior executive team is largely new, and I think they're bringing a boldness to the aspirations we're setting for the business, and what's been exciting is seeing our team rise to the challenge. We're coming to the end of our three-year targets at the end of our fiscal year here, and certainly, we're going to refresh and offer a new set of targets for our next fiscal year and beyond. I think more importantly is the mindset inside the company is shifting from making Mission Critical a program to turning it into a continual improvement mindset. I think with that, it is an exciting time. The last point I make is I think it's a compelling time to look.
There is a relative discount valuation on the stock. It's an interesting time to be looking at the company. I think, Sam, with that, I'll turn it back to you and see if there's any questions.
Yeah, terrific. I think for folks that are less familiar, you have a vending operation, you have in-plant or what some other folks might call on-site. You also have a consumables business with fasteners. I just described what a lot of folks know about Fastenal. Could you talk about differences between your offerings and value proposition versus Fastenal's as an example in those three areas?
Yeah, sure. Yeah, Sam Darkatsh, I think the starting point would be going back to the repositioning of the company. If you went and looked at MSC a decade ago, the value proposition, when I mentioned a spot buyer, long-tail supplier, would've more been strictly around the availability and the next-day shipping and the customer service. To your point now, most of our customers, our bread-and-butter customers, are now getting a lot more value. The equation becomes less about just availability of product and more about helping our customers improve their operation. You mentioned a few of the key ingredients: our vending program, our consumables business, our in-plant program. You're saying sort of comparing those to a Fastenal.
Yeah, that's right.
Look, I think the each of us in the market, I mean, you could find other competitors beyond the two of us that are doing bits and pieces of that. I think for us, kind of the secret sauce, what binds it together, is two things that I mentioned during the remarks. One is the customer focus. All of those programs for us are a means to an end, as opposed to the end in and of itself is not implementing a vending machine or putting people inside of a plant. The end that we're obsessed with is improving customer productivity. Our customers tell us how they wanna measure that. In some cases, it's cost out. In some cases, it's increased throughput or reduction in lead times.
That's really the focus for us, and we have a continual improvement process that we work with our customers that each quarter we're going back and laying out new goals, implementing some of these programs, and then measuring them like crazy. It sounds simple, but that's probably the first thing that I think distinguishes us. Then the second one, Sam, would be relative to our peers, I think a more technical overlay. Because of the heritage of MSC, metalworking products tend to be highly engineered and highly technical. Our sales force is in the thousands, but several hundred of those people, as I mentioned, have, you know, years or decades of machining experience.
they're going into the plant and not just putting, you know, a machine in place, but are actually walking the plant, auditing the plant, and making performance recommendations that improve output.
Questions from the room here. I think last quarter, you for the first time, at least my memory for a few years, talked about the importance of a vendor line review process, which is not something that we've heard, at least from a post-COVID standpoint. Talk about what that process is, how it may differ. You clearly go through that on an annual basis. It's just you called it out specifically this time. You also have the four major metalworking vendors. How does it work with those versus the more the MRO suppliers? If you could explore that with us.
Yeah, sure, Sam. Great question. Maybe I'll start with the impetus for it. Obviously, as a distributor, doing a line review is kind of SOP over time. I will say, really, once COVID started, our normal category management playbook out the window. For the most part, our priorities were on securing product because we felt like availability was king and queen, and that would allow us to capture market share and customer relationships. The other big priority was making sure that we stayed ahead of inflation. There was a heavy focus on availability and on pricing. Look, I applaud the team. I thought we did a really good job during COVID.
Coming out of it, we see a real opportunity here to take a fresh look at our product lines. The goal here to be clear, the first and the first guardrail or priority is for each product line that we take a look at is to optimize the customer experience. The second guardrail or priority is around improving streamlining operations and improving purchase costs. This is not gonna be an exercise strictly in narrowing down the portfolio. It's really gonna be around what is the optimal assortment and mix of business for our customers, and we think that the answer is gonna vary quite a bit by product category. The way we're approaching this line review initiative is it's not going to be one size fits all, and it's not happening all at once.
It's happening in waves. We're right now in wave one, where we'll take sections of our offering by product line and go through a process to look at, look at the line. In some cases, we probably are over-assorted and have an opportunity to streamline the offering. There's other cases where it may be about product expansion. Sam Darkatsh, to your point, more specifically, you know, metalworking is an area because it's highly technical. Many of the brands are really important to us and important partners. As a for instance, what you wouldn't see us do in a line like metalworking is remove a brand that has a ton of value to our customers and large market share at the expense. You know, we wouldn't do something at the expense of the customer.
What I'd tell you is there's plenty of, even within metalworking, we see parts of our offering where we could tighten things up. We also see a really big opportunity with private brand. We are today at roughly 15% or so penetration across the business that varies by product line. We think we have some really good brands that with the proper mix management and moves through line reviews, we think we can take that higher, which becomes a margin tailwind for us.
Which leads me to my next question. Long-term gross margin trajectory, especially now that you've identified an increasing private label opportunity, the corollary to that would be, okay, now that we're quickly getting past where mission-critical timing plays out, what might incremental margins realistically look like over the next three to five years or so?
Yeah. Sam, maybe what I could do is even just sort of walk the P&L to say how we think about the growth algorithm in this business, because I'll start at the top. I mean, priority one for us is generating organic growth because we are a fairly high margin business that really produces strong returns. If we think about the end markets, we play in growing at roughly the rate of industrial production index. Historically, that's been 2%, and there's a case to be made that the future could look better because of reshoring and some other tailwinds. Even conservatively, if we say, you know, the historic average is what the next three to five years brings at 2%, we would layer on, you know, recently we've been getting a lot from prices. Everybody has an inflation.
If we take historic averages on pricing and say 1%-2% there, and then layer on our unit volume aspirations, we see a path to get to high single digits on the top line organically. That could certainly be supplemented by these tuck-in acquisitions, high single digits organic growth. On the gross margin line, I think flat would be an aspiration. I think realistically, if I look at the trajectory where we're growing and even with some of the tailwinds like private brand, I would expect some modest gross margin dilution. By modest, if we looked at 30, 40 basis points, something like that. We do see a considerable opportunity to generate OpEx to sales improvements in two ways.
One is leveraging growth, because if we're getting growth in the high single digits by itself, that brings OpEx to sales down considerably. On top of that, I mentioned the cost, the structural cost improvements and the continual improvement mindset, which is something we didn't have in the company prior to the last three years, which should add to the leverage story. You put that together and the punchline is, we would see an incremental margin picture on our growth of 20% or better as our goal. You know, if high single digits top line, 20% incrementals gets you to low double digits operating profit growth, add on to that, if we make smart capital allocation decisions and opportunity to enhance TSR and earnings growth through capital allocation.
I think we're out of time here, so we'll continue this in the breakout session.