Published by Nicholas McCullum on May 13th, 2017
W.W. Grainger’s (GWW) business has been under pressure lately by the king of all industry disruptors – Amazon (AMZN).
This led to the company releasing a less-than-favorable first quarter earnings report. W.W. Grainger’s stock price declined by ~11% after the announcement and is down by nearly 20% year-to-date.
However, long-term investors should not be alarmed. W.W. Grainger has a very long history of running a profitable business.
W.W. Grainger’s longevity extends to its dividend growth. In fact, W.W. Grainger has increased its annual dividend for 45 consecutive years. This qualifies W.W. Grainger to be a member of the Dividend Aristocrats, a group of companies with 25+ consecutive dividend increases.
In 5 years time, it is highly likely – barring any surprising dividend cuts – that W.W. Grainger will qualify to be a member of the Dividend Kings. To be a Dividend King, a company must have an incredible 50 years of consecutive dividend increases – twice the requirement to be a Dividend Aristocrat.
Despite W.W Grainger’s remarkable business and dividend longevity, there are still plenty of investors who are concerned about how the ‘Amazon effect’ may harm its business model.
This article will analyze the effect of Amazon (and eCommerce in general) on W.W. Grainger in detail.
To understand the negative impact that Amazon is having on W.W. Grainger, it is important to first understand W.W. Grainger’s business model.
W.W. Grainger is the world’s leading supplier of maintenance, operating, and repair products (or MRO, for short). In layman’s terms, W.W. Grainger distributes motors, power tools, safety supplies, and other industrial equipment to its customers (businesses, not individuals).
W.W. Grainger was founded in 1927 in Chicago. The company has expanded massively since that time, and now has a market capitalization of $10.9 billion, sales of $10.1 billion in 2016, and employs more than 25,000 people.
W.W. Grainger also has more than 3.2 million active customers and stocks more than 1.6 million products.
More details about W.W. Grainger’s impressive size can be seen below.
Source: W.W. Grainger Fact Sheet
W.W. Grainger operates an impressively diversified business model. No product category represents more than 18% of the company’s sales, and no customer category contributes more than 17% to W.W. Grainger’s revenues.
Source: W.W. Grainger Fact Sheet
W.W. Grainger reported first quarter earnings on April 18, 2017. The release was not well-received by investors, and the company’s stock declined by ~11% in the first day of trading after the announcement.
Looking at the data, it’s not hard to see why. The company saw a meaningful decline in its most important financial metrics.
On a GAAP basis, W.W. Grainger saw operating earnings decrease by 7% and earnings-per-share decrease by 2%, partially offset by a small 1% increase in company-wide sales. Margins were compressed versus the same period a year ago.
More details about W.W. Grainger’s GAAP first-quarter financial performance can be seen below.
Source: W.W. Grainger First Quarter Earnings Presentation, slide 4
Unfortunately, W.W. Grainger’s adjusted results were no better.
The company saw sales still increase by 1%, but operating earnings declined by 14% and earnings-per-share declined by 9%. Again, margins declined and operating expenses actually increased.
Source: W.W. Grainger First Quarter Earnings Presentation, slide 5
However, there was a bright spot in this earnings release.
The company’s ‘Other Businesses’ segment – which includes the company’s digital channels as well as its international businesses – experienced significant growth. Sales increased by 12%, and operating earnings increased by 45%. Operating margin also ticked upwards by 140 basis points.
Source: W.W. Grainger First Quarter Earnings Presentation, slide 6
Perhaps most importantly, W.W. Grainger’s online business grew by an eye-popping 23% over the same period a year ago. Grainger’s online business is thriving and currently, more than 65% of the company’s orders are originated online.
The ‘Amazon Effect’
In the last section, we saw that W.W. Grainger’s online business is growing at a healthy clip. Thus, it might not seem like Amazon is having much of an effect on this MRO company.
However, the opposite is true. While it can’t be seen by looking at W.W. Grainger’s online business in isolation, Amazon’s low prices are having a profound effect on the overall W.W. Grainger business.
This is manifesting itself through price cutting – W.W. Grainger is having to reduce the prices of most of its products to keep up with Amazon, who is unafraid to sell products at razor-thin margins to differentiate itself from competitors.
To keep up with Amazon, W.W. Grainger is being very proactive at reducing its prices to maintain market position. While this reduces ticket sizes and harms Grainger’s sales figures, the company is playing the long game – it understands that by keeping prices constant, customers would leave in flocks to buy cheaper products at Amazon (or elsewhere) and this would result in a larger negative effect on its business.
Details about W.W. Grainger’s recent price-cutting initiatives can be seen below.
Source: W.W. Grainger First Quarter Earnings Presentation, slide 9
As per the above slide, one of the positive unexpected consequences of these price reductions has been a meaningful increase in the company’s sales volumes.
After three quarters of declining U.S. volumes, W.W. Grainger saw a 4% increase in the most recent quarter. Further, the company is expecting volume growth of 6% during fiscal 2017 – very impressive considering the poor volume trend in 2016.
Source: W.W. Grainger First Quarter Earnings Presentation, slide 10
This is a welcome sight. If Grainger can meaningfully increase volumes and improve its efficiency, price reductions are unlikely to have a meaningful effect on the long-term prospects of this company.
Aside from the beneficial volume increase that W.W. Grainger is experiencing, the company is also taking more deliberate measures to improve its business performance.
Namely, W.W. Grainger is focusing on cutting costs wherever possible. The company has made significant progress, as its expense/sales and expense/cost of goods sold have been made meaningful downwards progression over the past seven years.
This trend is outlined in the following diagram.
Source: W.W. Grainger First Quarter Earnings Presentation, slide 15
The company is also encouraging customers to bundle all of their MRO volumes with W.W. Grainger by offering them more competitive prices delivered through digital channels.
For an overview of how this works, consider the following quote from W.W. Grainger’s first quarter conference call:
“In early February, we introduced web pricing for about 450,000 SKUs, which is essentially market based pricing. To get that pricing customers today have to opt in to that price online or on the phone. We also continue to negotiate large customer contracts with the updated pricing structure that’s a process that we started in the fourth quarter of 2015. As a reminder, large contract customers generally have competitive prices. We’re adjusting the structure to make it more attractive for them to consolidate all of their volume with Grainger.”
Despite these efforts, W.W. Grainger’s guidance has been decreased. The company is now expecting earnings-per-share f $10.65 (at the midpoint) for fiscal 2017.
Source: W.W. Grainger First Quarter Earnings Presentation, slide 13
Right now, W.W. Grainger’s stock price is $187.69. Management’s forecast for $10.65 of earnings-per-share in 2017 means that the stock is currently priced at a forward price-to-earnings ratio of 17.6.
Source: Value Line
Right now represents a historically good time to initiate or add to a position in W.W. Grainger. Investors have not had the opportunity to purchase shares at this attractive valuation (on average) since 2011.
W.W. Grainger also pays a healthy dividend.
The company’s current quarterly dividend of $1.28 is good for a dividend yield of 2.7% at today’s stock price of ~$188. For context, the S&P 500 has a current dividend yield of 1.9%, which means that investors generate ~42% more income from an investment in W.W. Grainger than from an S&P 500 index fund.
To conclude, W.W. Grainger is trading at an attractive valuation and pays a healthy dividend. Right now seems like an opportune time to purchases share of this high-quality, well-managed enterprise.
Without a doubt, W.W. Grainger is being affected by the transition of its customers to digital platforms.
What investors often forget is that W.W. Grainger has a very impressive operating history. The company has increased its annual dividend payments for an amazing 45 consecutive years – and this certainly isn’t the first time the business has experienced significant changes to its operating model.
W.W. Grainger is making the right moves to battle the competitive pressures posed by Amazon. By cutting prices and growing its online channel, it is solidifying its leadership position in the MRO industry.
The company has gone through more significant changes in the past, and it is almost certain to endure the current transition to eCommerce.
“The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table.” – Warren Buffett
Warren Buffett said it best – buying business experiencing temporary trouble is a great way to build wealth.
Fortunately for investors, W.W. Grainger is far from being ‘on the operating table’ (although its stock price might suggest otherwise).
Investors should look at the recent price decline as a buying opportunity, rather than a reason to be fearful.
If you’re interested in reading more Sure Dividend analysis about W.W. Grainger, the following Sure Dividend articles might be of interest: