MSC Industrial Earnings Review

It's been a long time coming, but it finally looks like the U.S. is coming out of an industrial recession. At least it does if the latest results from MSC Industrial Direct  are anything to go by. Industrial supply companies tend to have short sales cycles -- rendering them useful as bellwethers of change -- and MSC Industrial's positive earnings and outlook suggest the industrial sector may have bottomed. Let's take a closer look at the report.

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MSC Industrial (MSM) Earnings Review and Analysis

MSC Industrial Direct  (NYSE: MSM  ) must have left investors with mixed feelings after its first-quarter results. In a nutshell, the earnings and second-quarter guidance were below analyst estimates, but the commentary around the trading environment was more positive than it has been for a while. Time to take a closer look.


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MSC Industrial Earnings Analysis

MSC Industrial (NYSE: MSM  ) reported a mixed set of results for its fourth quarter. Revenue came in better than analyst expectations, but in common with rival industrial supply company Fastenal, MSC Industrial is seeing ongoing margin pressures. Moreover, its guidance for the first quarter of fiscal 2015 was lighter than analyst expectations.

MSC Industrial meets earnings expectations, but guidance disappoints

A quick look at the highlights of its fourth-quarter earnings:

• Fourth-quarter sales of $726.6 million versus internal guidance of $718 million-$730 million and analyst estimate of $724.8 million
  
• Gross margin of 45.6% versus internal guidance of 45.7%-46.1%
  
• Operating expenses of $231 million versus internal guidance of $230 million
  
• Tax rate of 37.7% versus internal guidance of 36.7%
  
• Adjusted non-generally accepted accounting principles EPS of $1.02 versus internal guidance of $0.98-$1.02 and analyst estimate of $1.01
  

Sales came in ahead of analyst estimates (and above the midrange of company guidance) and EPS topped internal guidance. So why was the stock marked down initially after the report?

3 considerations

There are three things to consider about these results, and investors should watch them closely, because the industrial equipment wholesale industry is always a useful bellwether of the economy.


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What the Industrial Supply Companies are Saying About the Economy

Investors in the industrial sector have faced a significant imponderable over the winter. Severe weather conditions were always going hit quarterly earnings, but they were also going to make it harder to judge the underlying conditions in the industrial economy. With these thoughts in mind it's a good idea to look at industrial supply companies such as Fastenal , MSC Industrial Supply, and WESCO International. Not only are they all exposed to the industrial sector, but they tend to have short-cycle order patterns. In other words, they get the first view on where trends are headed.

Fastenal and MSC Industrial give earnings
At the start of this earnings season, Alcoa came down on the side of those who saw the weather as the primary cause of weakness in the construction industry over the winter. The subsequent results from MSC Industrial and Fastenal offer a pretty similar story. For example, MSC's management talked of a weather-relate "slow start" in December and January, but then its organic growth rate picked up from 2%-3% to "the mid-6% range in February." 

Fastenal's improvement in March can clearly be seen by looking at sales growth at its stores that have been open for more than five years:

 

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Is Fastenal Good Value?

Last year was a difficult one for investors in industrial supply company Fastenal  $FAST . The stock ended the year flat, and managed to underperform sector peers such as Grainger $GWW  and MSC Industrial  $MSM. Furthermore, the Institute for Supply Management, or ISM, manufacturing data got a lot stronger in the second half, but Fastenal's performance did not. What's going on? Can the market expect more from the company this year?

Fastenal disappoints, again
Having warned investors that it would miss quarterly earnings per share estimates of $0.36  in its update in December, Fastenal then managed to miss its upgraded estimate of "growth in net earnings per share" by reporting flat earnings growth of $0.33 for its fourth quarter.

Superficially, this is surprising given the strength of the ISM manufacturing data:

Source: Institute for Supply Management

In addition, MSC Industrial's management reported on its January conference call that feedback from its manufacturing customers "confirms the current theme of stabilization and gives us some cause for greater optimism about 2014."

So why did Fastenal miss esimates?

Fastenal adjusts its sales operations, gets heavy too
In the December update, Fastenal outlined the three reasons for the earnings miss.

First, despite the strong ISM numbers, Fastenal is having some issues with its particular end markets. The company generates 50% of its sales from manufacturing, 25% from non-residential construction and the rest from a diverse set of business. Within its manufacturing sales, heavy manufacturing makes up 80% of sales with heavy equipment making up half in turn. Be sure to distinguish between Fastenal's heavy manufacturing and its heavy equipment sales, the latter is a subset of the former.

All told, heavy equipment makes up 20% of total company sales and this segment was weak in 2013. In fact, Fastenal disclosed that heavy equipment sales (agriculture, mining, construction, defense, etc.) grew less than 2% in the third quarter, and only 1.5% in the fourth, even as heavy manufacturing sales were up "between 6% and 7%". The good news is that heavy manufacturing sales appear to be recovering (in line with the ISM) with a 7.2% in the fourth quarter following a 5% gain in the third.

Indeed, the theme was confirmed by MSC Industrial's management on its recent conference call: "Overall, we continue to see that our core customer segments in heavy metalworking are still lagging the broader industrial economy." Grainger also reported that its light manufacturing sales grew in "the high-single digits" in the third quarter, but its heavy, commercial and natural resources sales were only up "mid-single digits". 

In addition, Fastenal's sales to non-residential customers have been weaker in 2013, as poor weather plus sequestration issues hit the commercial and industrial construction markets.

Source: company presentations.

Second, gross margins ran below expectations. According to Fastenal's  December update, this was due to "lower utilization of our trucking network and lower supplier incentives", and "the final components relate to product mix (fasteners carry our highest gross margin and have had a weak 2013) and a very competitive marketplace".

In fact, fastener sales started 2013 by comprising 42.9% of total sales, but only made up 40.6% at the end of it.  However, on the recent conference call, Fastenal's management outlined that gross margin is expected to get back to its historical 51%-52% range in the first quarter, recovering from a disappointing 50.6% in the fourth quarter of 2013.

The third factor was due to the expansion in store headcount made in the second half. Earlier in the year, Fastenal had outlined a plan to hire 600-900 more in-store staff in order to enable existing managers to increase their sales visits. In addition, there was a change of approach whereby the company went for quality over quantity with the expansion of its vending machines; a policy set to be reversed in 2014. It appears that the sales changes caused some initial problems, and Fastenal's management was quite upfront on the failure to execute in the second half.

Where next for Fastenal?
It's a mixed outlook for Fastenal.

On the positive side, 2014 it could be a better year for commercial construction, and the new orders component of the ISM manufacturing index (see above) indicates that manufacturing growth will be strong in the coming months. Furthermore, its gross margin looks set to bounce back, while its sales execution has the potential to improve.

On the downside, the stock remain expensive related to its peers:

FAST EV to EBITDA (TTM) data by YCharts

Moreover, Grainger and MSC Industrial have the potential to grow their e-commerce revenues and vending machine sales, while sales to customers with vending machines already  make up 36.6% of Fastenal's  net sales.

In conclusion, the U.S. industrial sector looks like it will be healthy in 2014, and Fastenal is likely to bounce back, but there are cheaper ways to buy into the sector than this. The valuation is still not compelling.

PPG Industries is a Stock to Buy

Investors in paintings and coatings company PPG Industries (NYSE: PPG) have enjoyed a nearly 45% rise over the last year, but the stock has remained in a tight $150-$160 range over the last few months. Is this a sign that it’s time to take profits on the stock?  Before you rush to hit the sell trigger, you should consider the upside potential in this stock. PPG can move higher in 2013, and here is why.

End market conditions

PPG’s prospects for 2013 will largely be governed by its performance within the industrial and architectural/construction end markets.

With regard to the industrial sector, it’s been a mixed earnings season so far. As a general rule, companies exposed to sub-sectors such as aerospace and automotive have done really well, while the rest of the industrial sector has faltered. For example, aluminum manufacturer Alcoa (NYSE: AA) started this trend in this earnings season by affirming its forecast for 9%-10% growth in its aerospace market, and also upgrading its expectations for the North American automotive market.

However, while Alcoa is seeing strength within some of its key end markets, companies exposed to general industrial trends like supply companies Fastenal (NASDAQ: FAST), and MSC Industrial (NYSE: MSM), are seeing weaker conditions. Both companies cited the softening Institute for Supply Management (ISM) survey data as being indicative of a difficult industrial environment. Fastenal reported disappointing industrial fastener sales (an indication of cyclical weakness), and announced plans to hire new staff in an effort to generate revenue growth. Similarly, MSC Industrial declared that it wouldn’t be pushing through its usual midyear price increase due to softening demand from its customers.

The architectural markets have also seen some mixed performances. A look at the data from the Architectural Billings Index from the American Institute of Architects (AIA) reveals the difference in performance between the residential and commercial markets in 2013.

Source: American Institute of Architects.

The idea is that a recovering residential market will lead to an improvement in commercial/industrial conditions, but it hasn’t happened so far in 2013.

How is PPG faring?

A brief look at its segmental income demonstrates that PPG is generating income growth from a variety of sources.

Source: PPG accounts.

In its recent earnings release, PPG disclosed that its performance coatings saw its automotive and aerospace refinish businesses deliver ”mid-to-high single digit sales increases”. PPG received a major contribution to sales and income growth, from its acquisition of Akzo-Nobel’s US household paints division.  However, its North American architectural coatings sales (excluding acquisitions) actually declined 5%. The decline was partly due to a major customer changing its product mix, but PPG also referenced some cautious purchasing patterns amongst independent dealers.

 Indeed, its rival Sherwin-Williams (NYSE: SHW) referenced similar market dynamics in its conference call on July 18. Sherwin-Williams spoke of the loss of business from a key retailer (in this case Wal-Mart), and outlined that its non-residential sales were lagging residential. In addition, its consumer group sales declined 1% even after a positive 3.2% contribution from an acquisition. 

Industrial coatings sales benefitted from a 12% rise in volumes from its automotive sales, and PPG was keen to highlight that this is partly a result of excellent long-term positioning within the leading car companies. It claims to be the number one player in automotive coatings in North America and China.

Perhaps the most surprising aspect of PPG's results were that its Europe, Middle East and Africa (EMEA) – architectural coatings income increased by $5 million to $69 million, despite sales declining 5%. This increase is a testimony to how well its management is implementing cost savings programs.

Where next for PPG?

The company has a number of good catalysts for growth. Input costs are moderating, the automotive and aerospace sectors are growing strongly, and investors can look forward to some improvement in the commercial/industrial construction market. PPG is a well-run company that has coped admirably with the slowdown in Europe. In addition, it plans for to generate around $200 million in synergies thanks to the Akzo-Nobel acquisition.

With regard to valuation, the stock trades on a discount to its peers:

In conclusion, I think the company is set for good growth going forward, and its valuation makes the stock attractive for the long term investor.

Fastenal Reports on the Industrial Sector

It’s always interesting to use earnings season as a way to formulate a view on the economy. Unfortunately, anyone looking for some positive news on the industrial sector would have been disappointed by the recent results from industrial supply companies Fastenal (NASDAQ: FAST) and MSC Industrial Direct(NYSE: MSM). What did these companies say, and what does it all mean for the industrial sector?

Mixed growth in the industrial sector

In short, outside of areas like aerospace and aviation, the industrial sector remains weak. Earlier in the week, aluminum supplier Alcoa (NYSE: AA) came out with a positive report that gave cause for optimism.

The company always gives good color on its industrial end markets, and the fact that it failed to reduce guidance for China has to be taken as a positive. The good news on China was somewhat surprising because companies like FedEx, Pall, and Oracle have all come out and stated specific weakness in China. Nonetheless, we should take what Alcoa said at face value.

Similarly, Alcoa’s global aerospace, automotive, and industrial gas turbine segments remain set for good growth in 2013, even if Europe is a little weaker. Since Alcoa is saying good things, surely the industrial supply companies would, too?  They are always useful as a bellwether because their sales cycle is relatively short. This means that any change in conditions will immediately be seen in their sales figures.

Fastenal adjusts its strategy

Unfortunately, Fastenal and MSC Industrial both had negative outlooks on the industrial sector.

Fastenal spoke of a slow economic condition causing its fastener sales (a cyclical product) to remain weak. In a sense, this apes the overlying Institute for Supply Management (ISM) manufacturing numbers, which have been softer in 2013. The ISM surveys private manufacturing companies in order to produce its Purchasing Managers Index (PMI), which is the leading manufacturing indicator in the U.S.

Note how the strength in new orders (which usually precede a pick-up in the headline PMI numbers) quickly dissipated in February, while the headline PMI number has averaged 49.7 this year. A number below 50 indicates negative growth.

In fairness, Fastenal did point out in the previous conference call that its sales were not represented by the stronger ISM data in the first quarter (ISM new orders had averaged 54.2 in the first three months). However, this historical relationship came back into line in the second quarter as both the ISM and Fastenal’s sales growth was weaker.

The company’s response is to try to drive sales by making significant new hires (mainly sales support staff) in its stores. The idea is to hire 600-900 new in-store staff by the end of the year. The plan would enable its existing managers to have more free time to visit more customers, increasing sales accordingly.

It’s an interesting approach, because previously Fastenal’s main focus was on expanding the installations and sales of its vending machines.  However, with competitors like MSC Industrial also building out its vending machines and Amazon increasingly moving in on the industrial supply market, Fastenal may feel that a balanced approach to growth is a better way to deal with a slow industrial market.

MSC Industrial also weak

The theme of adjusting to macro weakness was shared by MSC Industrial. The company decided against implementing its mid-year pricing increase in a concession to a softer demand environment. It’s tough to get customers to accept price increases at the best of times, let alone when end demand is weak. The good news for MSC Industrial is that it has non-cyclical ways to increase profitability:

• The acquisition of Barnes Distribution North America will increase revenues, margins and create opportunities.

• Its e-commerce revenues are growing at north of 40%.

• It has the potential to increase vending machine installations.

Obviously, these three aims are easier to achieve given a stronger demand environment, and if you buy the "second-half industrial recovery" story, then MSC and Fastenal are interesting propositions. On the other hand, until the headline ISM manufacturing indices improve, investors should brace themselves for more disappointments and negative sentiment around the sector.

In comparing the two companies, MSC Industrial comes out on top in terms of valuation and potential to grow earnings despite the economic cycle.

FAST EV / EBITDA TTM data by YCharts

The bottom line

In conclusion, these results told similar story to the first quarter's about MSC and Fastenal and their end markets. It appears that Alcoa’s optimism is more related to the strength of some of its particular industry segments, such as aerospace and automotive. Investors in Fastenal and MSC would do well to ignore Alcoa and focus more on the ISM numbers in order to see where prospects for the two companies are headed.

Alternatively, there is a strong case for simply staying invested within the areas of strength in the industrial sector. It’s too early to proclaim a general second half pick-up.

Time to Buy Autodesk?

There have been two major themes to the first quarter reporting season. The first is that tech spending has been weak across the board, and the second is that--outside of pockets like aerospace and automotive--the industrial sector has been weak too. Cue Autodesk’s latest set of results. It’s a software company and its end markets are industrial. The rest is history--the company's results were disappointing and it guided lower. What's next for Autodesk, and what do its latest results say about the industrial sector?

Autodesk’s first quarter results

I have previously covered the stock, and those wanting to assess the migration of its earnings can get some background information on the company there.

 A brief look at Autodesk's first quarter numbers versus its internal guidance:

• first quarter revenue of $570 million vs. internal guidance of $570-590 million

•  first quarter earnings-per-share of $0.42 vs. internal guidance of $0.41 to $0.46

• second quarter revenue guidance of $550 to $570 million vs. analyst estimates of $583 million

• second quarter EPS guidance of $0.39 to $0.44 vs. analyst estimates of $0.45

• Full-year revenue guidance of $2.38 billion vs. analyst estimates of $2.45 billion

The end result is that the company's revenues and earnings for the first quarter came in at the bottom end of guidance, and its future projections were lower than analyst estimates. I appreciate that the lowered guidance may appear to be somewhat easier for the company to hit, but I want to demonstrate how even this might prove tough.

Assuming that the mid-point of the second quarter guidance is hit, the remaining $1.25 billion in revenues that were forecast by Autodesk could be split up in the following manner. I note that the management stated that fourth quarter growth would be stronger than that of the third quarter, so some back-of-the-envelope revenue estimates of $593 million and $658 million for the third and fourth quarters respectively could be implied. I want to graphically demonstrate what this means to the back end of 2014’s revenues.

Looking at it, reaching these goals seems like a fairly big ask. The company was duly forced to spend significant time during its conference call discussing various reasons why targets like these might be feasible.

Can Autodesk hit guidance?

The main reasons that Autodesk gave to indicate that it can hit its (lowered) full year guidance are:

• Its business is becoming more back-end loaded with its major account business. As this was an area of weakness in the first quarter, the numbers are expected to contribute more in the second half.

• Autodesk argued that $24 million of growth for the first half of 2014 was pulled into the fourth quarter 2013, resulting in somewhat distorted seasonality for 2014.

• The comparisons from the second to fourth quarters of last year are a lot easier to beat.

• The ongoing transition in its business model towards selling software as a service (SaaS) suites (bundled software packages) rather than standalone flagship products should drive growth in the second half. This is similar to he way that Adobe Systems  is shifting its customers to SaaS-based solutions instead of standalone software.

• Autodesk sees improved strength in certain sectors of the economy that heavily use its software, such as global commercial construction. The company is also making progress in expanding its automotive accounts.

There are notes of caution against this, of course:

• The company reported that April is weak. With other manufacturing exposed companies like Fastenal and MSC Industrial Direct reporting weak numbers before April, this is not a good sign for the second quarter.

• Despite the second quarter of last year being relatively weak, the guidance for the second quarter of 2014 is not great.

• Emerging markets underperformed in the quarter. These markets are supposed to be a long-term growth driver for the company.

• Suite sales in emerging markets have been a bit disappointing, and piracy remains an issue.

• The transition to SaaS is making the company's revenues harder to predict, and with companies like Adobe shifting sales models towards SaaS and subscription-based sales it is causing some hesitation in the purchasing habits of customers.

Essentially, the manufacturing sector has been weak as both Fastenal and MSC Industrial confirmed in their earnings reports that are discussed here. Both companies have limited visibility and short sales cycles. MSC saw sequential weakness in the quarter to the end of March, and with Autodesk saying that its April got weaker then this is hardly good news for MSC.

It was a similar story with Fastenal, though interestingly it saw stronger results in its metal work operations. I think this is partly due to having more exposure to aerospace and automotive. Investors in the industrial manufacturing sector should watch the statements of these two companies quite closely while also keeping an eye on the ISM numbers.

As for Adobe, its shift looms large in Autodesk’s thinking because the former has started to regenerate growth in its core product range thanks to the shift to SaaS and subscription-based sales. At some point Autodesk may well emulate Adobe’s model of ending perpetual license sales (which will cause some short-term revenue shortfalls as customers shift), but until then we shouldn’t model too much of these effects onto Autodesk’s numbers. Prospects for Adobe look good in the mid-term but will it hit is (raised) expectations this year, bearing in mind how many other tech companies have warned in the first quarter?

Where next for Autodesk?

In conclusion, I think that it makes sense to wait for more evidence of a pick-up in general industrial conditions before buying into Autodesk. I've no doubt that many will be tempted into buying in after the fall as this has been a good tactic this quarter, but cautious investors may want to wait to avoid buying in while the stock still has room to fall.

General Electric Reports Mixed Results

Anyone who has watched the classic sales movie Glengarry Glen Ross or worked in sales will know that the acronym ‘ABC’ stands for ‘always be closing.’ However anyone who hasn’t and instead has solely listened to US blue chip conference calls over the last few years will probably conclude that it actually stands for ‘always be cost-cutting.’ In other words, investing for growth is still on the back-burner in favor of pruning and consolidating measures made in light of uncertain end demand. Such considerations came to mind when considering General Electric’s $GE latest results.

A mixed Industrial Environment

The earliest indication of how the industrial sector was faring was outlined by Alcoa $AA recently, and it was pretty positive in my view. Other than a slight weakening of its European automotive outlook, Alcoa kept its end markets prognosis constant. However, on closer inspection it is clear that Alcoa’s growth prospects in 2013 are highly reliant upon China. In addition it is exposed to a few industries that are doing relatively better.

As this article demonstrates, global aerospace is doing well with airlines surprising on the upside and passenger growth numbers growing at a decent clip. This is obviously good news for General Electric and its aviation segment. In addition, Alcoa’s North American outlooks for its automotive and commercial building & construction segments respectively were for 0-4% and 1-2% with China growing up to 10% in both. Europe is expected to decline in both of these segments. So while China is doing well and some global industrial sectors are doing okay, it is far from a universal situation.

More evidence of this divergence in the industrial sector can be gleaned from looking at what the industrial suppliers like Fastenal and MSC Industrial are saying. Aerospace and auto are fine but elsewhere there was weakness in Q1.

What GE Said

Fast forward to GE’s latest results and the company reported that its industrial segment profits were $200 million lighter than had been expected largely due to Europe being weaker than forecast. The power & water segment was particularly affected while elsewhere GE reported some reluctance to close orders in a few of its shorter cycle industries. Again, the latter statement correlates with what the industrial suppliers (who are as about as short cycle as you can get) indicated.

In order to see the relevance of the power & water segment here is a breakdown of GE’s segmental profitability in the quarter.

As the chart indicates the industrial segments that increased profitability were aviation, healthcare and transportation. GE capital profits improved in line with its rationalization strategy. Overall segment profits were down 4%, but net earnings rose 16% thanks to lower charges and eliminations.

See what I mean about ABC? Indeed, the immediate response to the weakness in the quarter was to announce more cost cutting measures. Plus ca change and all that.

What the Results Mean to The Market

Another area of interest was US healthcare, which GE said was a bit weaker than expected. Investors got an early read on this when Johnson & Johnson gave results and noted (within its medical devices and diagnostics segment) that US hospital procedures were weaker than the hospitals had forecast going into 2013. In addition hospital spending wasn’t as strong. It’s nothing dramatic for Johnson & Johnson because it has plenty of other profit drivers within pharma and consumer products, but for a company like Varian Medical Systems $VAR it is a cause for concern.

I like Varian, and based on a SWOT analysis think it has some very impressive long term growth prospects with its proton therapy solutions. In the near term it can expand its radiation therapy into indications like lung cancer, particularly within emerging markets. In addition its new deal (GE was its former partner) with Siemens (which is pulling out of radiation oncology) gives it a large installed base on which to target. On the other hand its systems require significant outlays, and with Johnson & Johnson and GE reporting some weaker conditions, can we really expect immediate upside from Varian?

On a more positive note GE forecast that its oil & gas and home & business segments are going to be ‘pretty solid’ for the year. Within the latter segment one of its key rivals is Whirlpool $WHR I think Whirlpool has good growth prospects in 2013. The US housing market is recovering, and Whirlpool is starting to anniversary the housing boom of 10 years ago. In other words, the white goods purchased back then should have depreciated by now and a replacement cycle should kick in. Furthermore, GE reported good results in emerging markets so we have reason to believe that Whirlpool will do okay in its key Brazilian market.

Where Next for GE?

Cost cutting isn’t sexy, but it does represent a key bottom line opportunity for GE this year. Europe was weaker than expected but China’s strength was a welcome positive note. As noted above GE’s end markets will be variable this year with areas like aviation, transportation and health care (especially in emerging markets) likely to remain strong and counteract areas more exposed to austerity measures like US military spending and European infrastructural spending.

Investors looking for a more focused exposure to their favorite end markets will not buy GE because of its diversification, but those looking for a 3.5% yielding global GDP type play will view this mini sell-off as a buying opportunity.