MSC INDUSTRIAL DIRECT CO INC quarterly report, Q2 FY2015

MSC Industrial Direct Co., Inc. — Fiscal 2015 Second-Quarter Form 10-Q

Business Context and Reporting Period

MSC is a North American distributor of metalworking and maintenance, repair and operations products and services. The filing covers the 13 and 26 weeks ended February 28, 2015, compared with the corresponding periods ended March 1, 2014. The fiscal year ends August 29, 2015. MSC operated 12 customer fulfillment centers, 101 branch offices and offered approximately 900,000 searchable SKUs, with more than 6,500 associates.

Financial Performance and Key Metrics

Metric	13 Weeks Ended Feb. 28, 2015	13 Weeks Ended Mar. 1, 2014	26 Weeks Ended Feb. 28, 2015	26 Weeks Ended Mar. 1, 2014
Net sales	$706.4 million	$661.5 million	$1,437.5 million	$1,340.0 million
Gross profit	$320.9 million	$306.8 million	$651.0 million	$621.7 million
Gross margin	45.4%	46.4%	45.3%	46.4%
Income from operations	$85.9 million	$81.7 million	$179.8 million	$178.5 million
Operating margin	12.2%	12.4%	12.5%	13.3%
Net income	$51.5 million	$49.5 million	$108.9 million	$108.6 million
Diluted EPS	$0.83	$0.79	$1.75	$1.72

Sales increased 6.8% in the quarter and 7.3% year to date. Management attributed the increase primarily to higher sales volume, partly offset by net pricing decreases and customer/product mix.
Large Account Customer sales increased approximately $31.7 million in the quarter and $68.6 million year to date.
Non-manufacturing customer average daily sales increased 14.0% in the quarter, versus 4.1% for manufacturing customers. Government accounts represented approximately 9% of year-to-date sales, compared with 7% in the prior-year period.
eCommerce sales, including electronic data interchange, vending and other electronic ordering channels, represented 54.9% of year-to-date consolidated sales, compared with 51.3% in the prior-year period.
Operating expenses increased 4.4% in the quarter and 6.3% year to date, primarily from payroll, freight, staffing and advertising investments. Freight expense was approximately $30.7 million for the quarter and $63.3 million year to date.
The effective tax rate was 38.5% for the quarter and 38.4% year to date.

Cash Flow, Liquidity and Capital Structure

Cash and cash equivalents were $27.4 million at February 28, 2015, compared with $47.2 million at August 30, 2014.
Year-to-date operating cash flow was $47.6 million, down from $151.5 million in the prior-year period. The decline primarily reflected increased inventories and receivables supporting sales growth.
Year-to-date capital expenditures were $25.1 million. The Columbus, Ohio fulfillment center began operations on September 30, 2014; MSC spent approximately $2.9 million on the facility during the first two quarters of fiscal 2015, following approximately $49.9 million in fiscal 2014.
Total debt, including capital leases and financing obligations, was $541.8 million at February 28, 2015, compared with $337.1 million at August 30, 2014. Revolver borrowings increased to $288.0 million from $70.0 million, while term-loan borrowings were $225.0 million.
The unsecured $650.0 million credit facility matures in April 2018 and includes a $400.0 million revolver and a $250.0 million term loan. The applicable borrowing rate was 1.31% at February 28, 2015.
MSC borrowed $298.0 million under the revolver and repaid $80.0 million of revolver borrowings and $12.5 million of term debt during the first 26 weeks. The company repaid an additional $46.0 million of revolver borrowings in March 2015, leaving $158.0 million of revolver availability.
The company was in compliance with its maximum 3.00-to-1.00 leverage covenant and minimum 3.00-to-1.00 interest coverage covenant.
Year-to-date financing uses included $234.9 million of cash dividends, including a $185.4 million special dividend, and $26.3 million of share repurchases. Working capital was $520.6 million and the current ratio was 2.0 at February 28, 2015.

Material Changes Versus the Prior Comparable Period

Revenue growth outpaced earnings growth as gross margin declined 100 basis points to 45.4% in the quarter and 110 basis points to 45.3% year to date.
Management cited higher product costs, constrained pricing, customer and product mix and increased vending-program sales as the primary causes of margin compression.
Quarterly operating income increased 5.1%, but year-to-date operating income increased only 0.8%; year-to-date operating margin fell from 13.3% to 12.5%.
Year-to-date net income increased only 0.4%, despite 7.3% sales growth, reflecting margin pressure and higher operating costs.
Operating cash conversion weakened materially because inventory increased to support higher sales. Inventories were $506.1 million at February 28, 2015, versus $449.8 million at August 30, 2014.
Balance-sheet leverage increased substantially following the special dividend and increased working-capital requirements.
Non-recurring CCSG integration and restructuring costs declined to approximately $0.2 million in the quarter and $1.1 million year to date, compared with $4.6 million and $8.4 million, respectively, in the prior-year periods. Prior-year results also included approximately $3.0 million of executive separation costs in the quarter and $2.5 million of headquarters relocation costs year to date.

Guidance, Outlook, Commentary and Risks

Management expects operating costs to continue increasing through the remainder of fiscal 2015 because of the Columbus fulfillment center, higher staffing and compensation, program development, vending initiatives and other growth investments. Management expects existing cash, operating cash flow and available revolver capacity to fund planned capital expenditures and operating requirements for at least the next 12 months. The filing does not provide specific numerical revenue or earnings guidance.

Management plans to continue expanding the field sales force, which reached 1,955 associates at February 28, 2015, up 5.4% from the prior year.
Approximately 63,000 searchable SKUs were added during the first two fiscal quarters, and management expects SKU expansion to continue through fiscal 2015.
The manufacturing environment remained expansionary but was slowing; management cited lower oil prices, reduced export demand, constrained commodity pricing and declining raw-material prices as relevant factors.
Key disclosed risks include economic and manufacturing conditions, competition, changing customer and product mix, commodity and energy-price volatility, credit risk, order cancellations, supply-chain disruptions, fulfillment-center delays, information-system failures and cyberattacks, key-personnel retention, regulatory or litigation outcomes, environmental compliance, and potential impairment of goodwill and intangible assets.
Various claims and lawsuits are pending, but management does not expect them to have a material adverse effect on financial position, results of operations or liquidity.
A related-party affiliate leased the Atlanta customer fulfillment center to MSC; rent paid during the first 26 weeks was approximately $1.2 million. Management stated that the lease terms approximated fair market value when executed.
On April 2, 2015, the board declared a quarterly dividend of $0.40 per share, expected to total approximately $24.7 million.

Most Important Facts for Investors to Verify

Whether gross-margin pressure from pricing, product mix, product costs and vending sales persists or reverses.
Whether sales growth generates sufficient operating cash flow after inventory and receivables investments.
The effect of increased revolver borrowings, current maturities and dividend policy on leverage, liquidity and covenant headroom.
Execution and returns from the Columbus fulfillment center, expanded sales force, eCommerce initiatives, SKU additions and vending investments.
Trends in manufacturing activity, government-account sales, customer concentration and Large Account Customer growth.
Future operating expenses, including staffing, freight, medical claims, advertising and facility-related costs.
Potential effects of newly issued accounting standards, particularly revenue recognition and lease accounting, which the company had not yet quantified.