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Recurring Revenues and Industrial Distribution

(Guest Commentary by Rick Konrad – March 20, 2008)

Dear Subscribers and Readers,

For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary.  Rick is one of our two regular guest commentators (besides Bill Rempel) and usually writes for us every third Wednesday of the month.

In this commentary, Rick will be offering his thoughts on an industrial supply distribution company that is trading at a very decent valuation, and is pulling in tons of cash.  Rick argues that – in times of economic weakness – these firms are more important than ever, as they generate a great deal of recurring revenue and as their business models are designed to help other companies cut costs (which is especially welcomed in a slowing economy).  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Suits Me” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog and should you have any questions or thoughts for Rick after reading his commentary, you can also email him at the following address.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


What an incredible few days we have been through! Henry is to be complimented for his stalwart stand and his focus on valuation and the accompanying bearish sentiment that has served us so well.

In a recent Value Discipline, written prior to the two-buck offer for the Bear, we wrote about the information asymmetry that causes investors to throw up their hands at times of crisis. Please check “A Lemons Market

In the last few paragraphs, we highlight the need to move on, and the need to focus:

“But in the grand scheme of things, the market will survive this much as it has prior brokerage and banking crises. Great names like Drexel, LF Rothschild, Robertson Stephens, Gruntal, Hutton, and Continental Illinois are no longer part of today's world, having blown up.”

“Great investors understand the businesses in which they invest and ignore the noise. Focus, do your own work, and understand what it is you own. Emphasize the underlying economics of what you own and avoid the expensive distractions of today's tape.”

Here is an example of ignoring the noise. I believe that when economic times are uncertain, distribution companies frequently have a high degree of recurring revenue. This includes companies such as the health care distributors, the food distributors, and also the industrial distributors. Distribution is much more than warehousing, much more than merely stock-keeping. Successful distributors represent a means for their customers to achieve lower order costs by centralized purchasing. For example, it is estimated that in industrial supplies, the average order cost is $100. Consequently, having a central destination that can provide many supplies in a single order is a great cost saver. As well, successful distributors provide ways to provide inventory management by being a software supplier that keeps watch over the customer's inventory patterns and needs.

MSC Industrial (MSM) is one of the nation's leading industrial supply distributors. With a network of 4 regional Customer Fulfillment Centers and over 90 branches nationwide, the company assures its customers same day shipping, at no extra cost, with over 99.99% availability.

The company's history dates back to 1941 but became a more significant factor as a direct sales organization with the publication of its first catalog in 1964. In 1994, the company began to expand into maintenance, repair and operations (MRO) products, which provide a more stable demand stream of sales and cash flow for the business. In addition to its master catalogs, the company also publishes 123 specialty catalogs tailored to specific industries or products.

The company has a particular competitive advantage in its extensive e-commerce abilities that enable customers to lower their procurement costs. This includes many features such as swift search and transaction abilities, access to real-time inventory, customer specific pricing, workflow management tools, customized reporting and other features. The systems can also interface directly with many purchasing portals such as ARIBA and Perfect Commerce, in addition to Enterprise Resource Planning (ERP) Procurement Solutions such as Oracle, SAP and Infor. Consequently, the firm offers its customers inventory management solutions that reduce sourcing costs, out of stock situations, and inventory investment, all of which become even more important when business slows.

MSM's valuation has contracted significantly of late; likely discounting further manufacturing and economic weakness, yet investors may be ignoring the potential benefits from share gain trends.

The company is currently trading at an EV/EBITDA of about 8 times despite earning 20% return on invested capital last year. In the last five years, ROIC has averaged better than 15%. Here's a look at the ratio analysis courtesy of tenkwizard.com

Google Docs - msm ratios-marketthoughts

The company has generated over $700 million in cash flow from operations since 2000 and has spent only $128 million in capex over that period. Share buybacks have returned over $280 million to shareholders. Here is a look at the deployment of cash flow and returns to shareholders since 2000 courtesy of Reuters Knowledge:

http://tinyurl.com/yvfvv2

Dividends, which were instituted in 2004, have grown steadily from an initial rate of $0.32 per share annually to a current annual pace of $0.72 and have returned $231 million to shareholders. The current yield is about 1.9%.

In January, the company announced that it has authorized an increase in its stock repurchase plan to 7.0 million shares, which includes the approximately 1.9 million shares remaining under the previous authorization.

The company has shown steady improvement in working capital utilization and currently operates on a cash cycle of 98 days versus 113 days three years ago.

Effective voting control of the firm is held by the founder and his sister who cumulatively hold 63% of the vote. Lone Pine Capital, run by Steve Mandel, a well-known hedge fund manager holds about 7.9% of the company.

Overall, this is a high ROIC business with a reasonably steady growth in recurring revenues. It is a business that seems to becoming more important to its customers and is grabbing market share in a very fragmented industry of mom and pop shops. Its competitive advantages come from scale and technological prowess as well as logistics. Some slowdown will occur in economic times such as we have but the valuation appears to compensate adequately.

Disclaimer: I, my family, or friends have a current position in MSC.

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