Why MSC Industrial Direct Co Inc Stock Just Plummeted 17%

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What happened

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Shares of metalworking and power tools distributor MSC Industrial Direct Co. (NYSE: MSM) opened sharply lower on Wednesday following the release of the company's third-quarter earnings results. As of 11:30 a.m. EDT, the stock was down 17.2%.

So what

MSC Industrial reported its fiscal Q3 earnings before the market opened this morning. Sales increased 2.3% to $743.9 million, just shy of Wall Street's expected $745.4 million in sales, while profits were $1.09 per share, up 3.8% year over year and matching analyst estimates.

Company CEO Erik Gershwind provided an upbeat spin on the results, noting that MSC's market "improved through the quarter as the manufacturing economy continued to firm with improving sales growth across all of our customer types." Furthermore, "this momentum sustained into June, the first month of our fiscal fourth quarter. Customer feedback was consistent with a trend of steady and moderate improvement."

In this positive environment, MSC is now predicting its sales will run between $732 million and $746 million in its fiscal Q4 -- growing about 7% year over year -- while profits are likely to come in between $0.97 and $1.01 per diluted share. For context, that translates into better sales than analysts had been expecting for Q4 -- but worse profits. The consensus on Wall Street, prior to this guidance, had been that MSC would earn about $1.06 per share this current quarter.

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Now what

So why is MSC stock down? In a nutshell, I'd say it has little to do with the sales shortfall last quarter (because those missing sales are showing up in Q4 instead). Rather, MSC stock is down because analysts had told investors to expect 4% earnings growth this quarter -- but MSC is saying its earnings will instead decline by about 3%.

Is that an overreaction?

Ordinarily, I'd say so. But here' s the thing: With Q3's results in hand, MSC stock currently sells for 17.7 times earnings. That might not seem too expensive for a stock that is growing earnings, but MSC says its earnings will be shrinking this quarter instead. Furthermore, MSC's free cash flow of $187 million means the company is currently generating only about $0.80 in real cash profits for every $1 in GAAP profits that it reports -- so it's not even really earning as much as it appears to be earning.

In short, while MSC Industrial is doing fine as a business, in my opinion, its stock costs too much for the profits it's making. I think investors are right to sell. Of course, the analysts in our One and Stock Advisor services may not agree, as it's a current recommendation.

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Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of and recommends MSC Industrial Direct. The Motley Fool has a disclosure policy.