It's fair to say the market wasn't entirely happy with the third-quarter results from MSC Industrial Direct Co Inc (NYSE:MSM). The stock's double-digit drop following its earnings report on Wednesday raises red flags as to the growth prospects of the industrial sector -- industrial supply companies are always useful bellwethers of current business conditions -- but is it an MSC Industrial issue or a macroeconomic issue? Let's take a closer look at what happened in the quarter.

MSC Industrial Direct third-quarter results: The raw numbers

Starting with the headline numbers from the third quarter, it's clear that the results were broadly in line with management's expectations.

  • Net sales of $743.9 million came in above the midpoint of the guidance range of $734 million to $748 million.
  • Gross margin of 44.3% came in slightly below the guidance range of 44.4% to 44.8%.
  • Operating expenses of $227.7 million were below guidance for $230.5 million.
  • Diluted EPS of $1.09 was at the high end of the guidance range of $1.05 to $1.09.

In short, revenue and earnings were good and management did a good job with operating expenses, but the issue appears to be with gross margin.

What happened in the quarter

To get a clearer picture of events, let's break out sales growth and gross margin movements. As you can see below, average daily sales growth appears to be strengthening in line with an improving industrial economy. Indeed, the midpoint of management's guidance for the fourth quarter assumes 7% growth in average daily sales -- a significant improvement on the 3.8% reported in the third quarter. It's a linear improvement that management saw coming in January and also in April

daily sales growth recovering strongly

Data source: MSC Industrial Direct presentations. Chart by author.

Clearly sales trends are coming in in-line with expectations, but gross margin isn't. The following chart shows the degradation in gross margin performance in the last few years. Moreover, the midpoint of fourth-quarter guidance of 43.8% implies another disappointing quarter.

gross margin declining

Data source: MSC Industrial Direct presentations. Chart by author.

In usual business cycles, companies can expect some margin expansion as pricing power kicks in alongside an improving sales environment. However, this doesn't appear to be the case with MSC Industrial right now. What's going on?

MSC Industrial's gross margin

The subject was extensively discussed on the earnings call, with CEO Erik Gershwind and CFO Rustom Jilla fielding a number of questions on it. Essentially, they made three points.

First, Gershwind outlined that the pricing environment remains tough. "[T]here is no price inflation right now. So, you don't have any meaningful price to offset the headwinds in the business." He went on to state that due to a "spotty" pricing environment the company wouldn't be making particularly large pricing increases in the summer.

Second, Gershwind said that "growth is really accelerated... in some areas where gross margins are lower." In a sense this is deliberate, because, as Gershwind also pointed out, the company had strategically focused on growing sales in lower gross margin areas like "[n]ational accounts, vending customers and some of the new product introductions."

A pricing ticket with three red dollar signs on it

Image source: Getty Images

Third, Jilla argued that, as you can see in the chart above, the fourth quarter of 2016 saw an unusually small drop in gross margin between the third and fourth quarters, which means the fourth quarter of 2017 will come up against a more difficult comparison.

Looking ahead

All told, the sales environment appears to be improving but, as yet, pricing and gross margin do not. This is a key point for MSC Industrial investors because they are surely expecting a combination of margin expansion and sales growth in order to improve earnings in the future. Until that happens, it won't be clear that the margin decline is a cyclical rather than a structural problem. 

Lee Samaha 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.