MSC INDUSTRIAL DIRECT CO INC annual report, FY2019

Business Context and Reporting Period

MSC Industrial Direct Co., Inc. is a North American distributor of metalworking and maintenance, repair and operations products and services. The filing is an audited Form 10-K for the 52-week fiscal year ended August 31, 2019; it is not a quarterly filing, although unaudited fourth-quarter results are included. MSC operated 12 customer fulfillment centers, 99 branch offices and offered approximately 1.7 million active SKUs across the United States, Canada, Mexico and the United Kingdom.

Approximately 70% of fourth-quarter revenue came from manufacturing customers. The Metalworking Business Index averaged 49.3 in fiscal fourth quarter 2019, indicating contraction, compared with a 53.2 full-year average.

Key Financial Metrics

Metric	Fiscal 2019	Fiscal 2018	Change
Net sales	$3.364 billion	$3.204 billion	5.0% increase
Gross profit	$1.432 billion	$1.393 billion	2.8% increase
Gross margin	42.6%	43.5%	Down 90 basis points
Operating expenses	$1.032 billion	$972.4 million	6.1% increase
Operating income	$400.0 million	$420.6 million	4.9% decrease
Operating margin	11.9%	13.1%	Down 120 basis points
Net income attributable to MSC	$288.9 million	$329.2 million	12.3% decrease
Diluted earnings per share	$5.20	$5.80	10.3% decrease
Cash flow from operations	$328.4 million	$339.7 million	3.3% decrease

Fiscal 2019 fourth-quarter net sales were $842.7 million, operating income was $90.5 million and net income attributable to MSC was $66.6 million. Fourth-quarter results included $6.7 million of severance and separation charges, reducing quarterly earnings per share by approximately $0.09.

Cash and cash equivalents at year-end were $32.3 million.
Total debt was $441.9 million, compared with $535.3 million in the prior year; net debt was $409.6 million.
Working capital was $752.7 million and the current ratio was 2.7, compared with 2.3 in fiscal 2018.
Accounts receivable were $541.1 million and inventory was $559.1 million.
Debt maturities totaled $175.0 million in fiscal 2020, with $440.0 million of total debt maturities excluding capital lease obligations.
The Company had $595.8 million of unused availability under its committed facility, reduced by outstanding letters of credit, and $319.0 million of unused uncommitted-facility capacity after additional payments through October 1, 2019.
Cash used in investing activities was $36.4 million, including $51.8 million of capital expenditures and $11.6 million for the TAC acquisition.
Cash used in financing activities was $305.6 million, including $145.7 million of dividends, $84.6 million of share repurchases and $69.0 million of net repayments under credit facilities.
Annual dividends declared increased to $2.64 per share from $2.22. A $0.75-per-share quarterly dividend was declared for payment in November 2019.

Material Changes Versus the Prior Comparable Period

Revenue growth reflected $64.8 million of higher underlying sales volume, $45.2 million from AIS, $23.2 million from MSC Mexico and $31.2 million from pricing and mix, partly offset by a $4.5 million foreign-exchange impact.
Large Account Customer sales increased $43.1 million, while sales to other customers increased $116.8 million.
Gross margin declined primarily because of increased product costs and changes in customer and product mix. MSC Mexico reduced margin by approximately 20 basis points and AIS by approximately 10 basis points.
Operating expenses increased because of higher payroll, commissions, medical costs, freight and acquired-business expenses. Freight expense rose to $138.2 million from $130.3 million.
The effective tax rate increased to 24.6% from 18.9%. Fiscal 2018 benefited from a $40.5 million net tax benefit associated primarily with the Tax Cuts and Jobs Act; that benefit did not recur in fiscal 2019.
MSC completed the acquisition of certain TAC assets in Mexico on February 1, 2019 for total consideration of $18.5 million, with MSC’s 75% share equal to approximately $13.9 million. MSC Mexico contributed $23.2 million of revenue and a $0.4 million pretax loss in fiscal 2019.
MSC repurchased approximately 1.1 million shares for $84.6 million and retired approximately 8.2 million treasury shares acquired at a cost of $493.6 million.
Digital channels represented 60.0% of consolidated sales, versus 60.1% in fiscal 2018.

Guidance, Outlook, Commentary, Risks and Unusual Items

The filing does not provide explicit fiscal 2020 revenue or earnings guidance. Management stated that existing cash, available credit facilities and operating cash flow were expected to fund planned capital expenditures and operating requirements for at least the next 12 months.

Management noted that manufacturing activity weakened during the year, with the MBI below 50 in July and August 2019 and at 48.6 in September. The Company intends to pursue market-share gains through metalworking expertise, national and government accounts, sales-force productivity, value-added inventory solutions, eCommerce and vending, expanded product offerings and selective acquisitions.

Principal risks include cyclical industrial demand, economic downturns, customer credit losses, competitive and online pricing pressure, product and customer mix changes, vendor price increases, commodity and freight-cost volatility, tariffs and other trade-policy changes, and supply-chain disruptions.
Government contracting exposes MSC to compliance requirements and potential fines, penalties or contract termination.
Cybersecurity, data privacy, information-system failures, severe weather and interruptions at fulfillment centers could impair operations and delivery performance.
Debt agreements contain leverage and interest-coverage covenants. The Company was in compliance at August 31, 2019; failure to comply could accelerate debt or terminate revolving commitments.
Variable-rate debt creates interest-rate exposure. A 100-basis-point rate change was estimated to affect annual interest costs by approximately $2.1 million.
Goodwill and indefinite-lived intangible assets totaled approximately $690.2 million. Fiscal 2019 qualitative impairment assessments indicated no impairment, but adverse economic or operating changes could require future write-downs.
Contractual obligations totaled $549.0 million, including $440.0 million of debt maturities, $65.7 million of operating lease obligations and $40.3 million of estimated debt interest.
Pending litigation was considered incidental to the business, and management did not expect a material adverse effect. The Company also reported no off-balance-sheet arrangements.
The Company expected adoption of the new lease standard on September 1, 2019 to add approximately $55 million to $65 million of right-of-use assets and lease liabilities, with no material earnings or cash-flow effect expected.
The family group holding all Class B shares controlled approximately 70% of combined voting power, creating concentrated shareholder control.

Ernst & Young issued unqualified opinions on the consolidated financial statements and internal control over financial reporting. The auditor identified inventory valuation reserves as the critical audit matter because of the judgment required in estimating slow-moving and obsolete inventory reserves.

Investor Verification Priorities

Verify whether manufacturing demand and the MBI trend continued to weaken after the reporting date and how that affected fiscal 2020 sales.
Assess whether gross-margin pressure from product costs, customer mix, large accounts, AIS and MSC Mexico persisted.
Reconcile operating cash flow with earnings and monitor inventory, receivables, days sales outstanding and inventory turnover.
Review the $175.0 million fiscal 2020 debt maturity and the Company’s refinancing or repayment plans.
Evaluate the sustainability of dividends and share repurchases relative to cash generation and debt obligations.
Track the performance and integration of MSC Mexico and the existing AIS business, including potential goodwill impairment.
Review tariff, trade-policy, cybersecurity, privacy, government-contracting and environmental exposures.
Consider the effect of concentrated voting control and related-party share purchases on governance and capital-allocation decisions.