What Went Wrong With MSC Industrial's Earnings?

By Markets Fool.com

Industrial supply company MSC Industrial Direct delivered disappointing second-quarter results on Wednesday, and you only have to look at the price chart below to see the company remains in a difficult trading environment. In my article on theprevious quarter's report, I noted that management spoke of "a more optimistic outlook from customers," but that prediction was not borne out in the latest results. Let's take a more detailed look at what went wrong.

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MSM Chart

MSM data by YCharts.

The numbers
A quick rundown of the key numbers:

  • Net sales of $706.4 million versus internal guidance of $717 million-$729 million and analysts' estimate of $718.2 million.
  • Adjusted diluted earnings per share of $0.84 versus internal guidance of $0.84-$0.88 and analysts' estimate of $0.85.
  • Gross margin of 45.4%, hitting the high end of internal guidance of 45%-45.4%.
  • Guidance for third-quarter net sales of $740 million-$752 million versus analyst estimate of $780 million.
  • Guidance for third-quarter adjusted diluted EPS of $0.95-$0.99 versus analyst estimate of $1.09.

Gross margin stabilizing
The most positive development is that gross margin appears to be stabilizing, which helped EPS land within management's guidance, albeit at the bottom end of the range. CFO Jeff Kaczka highlighted this development in the earnings release: "[W]e delivered earnings per share within our guidance range. I am very encouraged by our stabilizing gross margins, reflecting the positive impact of our gross margin initiatives, and our continued expense management."

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He predicted gross margin would be "sequentially stable in the fiscal third quarter." That's a good sign.

Source: MSC Industrial Presentations.

Gross margin began its slide following the second quarter of 2014 amid faster growth in the company's larger accounts (which tend to have lower margins). A look at MSC's growth decomposition year to date confirms this sales trend is ongoing.

Source: MSC Industrial presentations. All figures in millions of U.S. dollars.

However, the company has still stabilized gross margin. So then what went wrong with sales in the quarter?

Sales disappointment
CEO Erik Gershwind said in the press release thatthe company has experienced a "significant and swift change" in demand so far in 2015 due to "the rapid drop in oil prices, softening export demand and poor weather." Meanwhile, national and government accounts (which tend to be larger and lower-margin than the core customer segment) continued their "double-digit growth" in the quarter.

Concerning the progression of the quarter, Gershwind said sales were "solid" in December, improved in January, then "dropped significantly" in February. Moreover, the current quarter has started weakly as "soft conditions continued into March," according to the CEO.

Indeed, a look at MSC's sales by end market reveals the problem has been with sales growth from its manufacturing customers -- which is usually a sign of economic weakness, as manufacturing activity tends to be highly cyclical.

Source: MSC Industrial Presentations.

All told, this was a disappointing earnings report that reflects a slowdown in manufacturing in the first calendar quarter of the year. A stronger U.S. dollar has probably hurt export activity, poor weather likely affected manufacturing, and weaker oil prices also hit MSC.

On a more positive note, if manufacturing activity bounces back from some of these factors -- which might prove temporary -- in the rest of the year, then MSC could outperform expectations.

The article What Went Wrong With MSC Industrial's Earnings? originally appeared on Fool.com.

Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends and owns shares of MSC Industrial Direct. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.