MSC Industrial Direct Cash Flow Increases The Safety Of Its Dividend Yield

Recap from July’s Picks

On a price return basis, the Safest Dividend Yields Model Portfolio (+2.0%) outperformed the S&P 500 (+0.9%) by 1.1% from July 22, 2021 through August 18, 2021. On a total return basis, the Model Portfolio (+2.3%) outperformed the S&P 500 (+0.9%) by 1.4% over the same time. The best performing large cap stock was up 5% and the best performing small cap stock was up 10%. Overall, 11 out of the 18 Safest Dividend Yield stocks outperformed their respective benchmarks (S&P 500 and Russell 2000) from July 22, 2021 through August 18, 2021.

This Model Portfolio only includes stocks that earn an attractive or very attractive rating, have positive free cash flow and economic earnings, and offer a dividend yield greater than 3%. Companies with strong free cash flow provide higher quality and safer dividend yields because I know they have the cash to support the dividend. I think this portfolio provides a uniquely well-screened group of stocks that can help clients outperform.

Featured Stock for August: MSC Industrial Direct Co, Inc.

MSC Industrial Direct Co, Inc. (MSM) is the featured stock in August’s Safest Dividend Yields Model Portfolio.

MSC Industrial Direct has grown revenue by 2% compounded annually and net operating profit after-tax (NOPAT) by 3% compounded annually over the past five years. MSC Industrial Direct NOPAT margin remained flat at 8% from 2015 to the trailing-twelve-month period (TTM) while its return on invested capital (ROIC) rose from 12% to 13% over the same time.

The firm’s economic earnings, or the true cash flows of the business, increased from $143 million in 2015 to $178 million over the TTM.

Figure 1: MSC Industrial Direct’s Revenue & Economic Earnings Since 2015

Free Cash Flow Supports Dividend Payments

MSC Industrial Direct has paid a quarterly dividend since 2003, and its standard dividend in fiscal 2020 was $3/share. The current quarterly dividend, when annualized provides a 3.6% dividend yield.

Since 2015, MSC Industrial Direct’s cumulative free cash flow (FCF) easily covers its standard dividend payments. Over the past five years, MSC Industrial Direct generated $1.2 billion (25% of current market cap) in FCF while paying $646 million in dividends, per Figure 2.

Figure 2: MSC Industrial Direct Co’s FCF vs. Standard Dividends Since 2016

Companies with strong FCF provide higher quality dividend yields because I know the firm has the cash to support its dividend. On the other hand, dividends from companies with low or negative FCF cannot be trusted as much because the company may not be able to sustain paying dividends.

MSM Is Undervalued

At its current price of $85/share, MSM has a price-to-economic book value (PEBV) ratio of 0.8. This ratio means the market expects MSC Industrial Direct’s NOPAT to permanently decline by 20%. This expectation seems overly pessimistic given that MSC Industrial Direct Co has grown NOPAT by 6% compounded annually over the past decade and 9% compounded annually over the past two decades.

Even if MSC Industrial Direct Co’s NOPAT margin remains at 8% (equal to TTM and lowest level in the last decade) and the firm’s NOPAT grows by less than 1% compounded annually over the next decade, the stock is worth $110/share today – a 29% upside. See the math behind this reverse DCF scenario. Should the firm grow NOPAT more in line with historical growth rates, the stock has even more upside.

Critical Details Found in Financial Filings by My Firm’s Robo-Analyst Technology

Below are specifics on the adjustments I make based on Robo-Analyst findings in MSC Industrial Direct’s 10-K and 10-Q:

Income Statement: I made $42 million in adjustments with a net effect of removing $21 million in non-operating expenses (1% of revenue). See all adjustments made to MSC Industrial Direct’s income statement here.

Balance Sheet: I made $174 million in adjustments to calculate invested capital with a net increase of $154 million. The most notable adjustment was $21 million (1% of reported net assets) in other comprehensive income. See all adjustments MSC Industrial Direct’s balance sheet here.

Valuation: I made $936 million in adjustments with a net effect of decreasing shareholder value by $936 million. Apart from total debt, one of the most notable adjustments to shareholder value was $110 million in net deferred tax liability. This adjustment represents 2% of MSC Industrial Direct’s market value. See all adjustments to MSC Industrial Direct’s valuation here.

Disclosure: David Trainer, Kyle Guske II, Alex Sword, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.

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