W.W. Grainger – Patiently Waiting For Further Pullback

Summary

• GWW reported Q4 and FY2018 results on January 24^th and it shares retraced ~11% from the previous day’s close.
• Many industrial companies to whom GWW supplies products have reported strong FY2018 results and are expecting to increase their revenue and earnings in 2019.
• Macro issues (trade tensions and tariffs) still exist and if the US government shutdown drags on, investor sentiment may turn negative.
• The likelihood of a broad pullback in share prices within the next few months should provide investors with an opportunity to acquire GWW shares at more attractive levels than current.

Introduction

In my October 16 2018 W.W. Grainger, Inc. (NYSE: GWW) article I provide an overview of GWW, touch upon the Amazon threat, and address the Goodwill and Intangible Assets Impairment charges related to GWW’s UK business (Cromwell).

The distribution business is challenging. Low barriers to entry and customer and supplier bargaining power can erode profitability.

The growing popularity of e-commerce (GWW is the now the 10th-largest e-commerce site in North America) has improved price transparency and has created opportunities for Internet-based competition (eg. Amazon Business).

Despite the challenges presented by the increasingly competitive maintenance, repair, and operating products (MRO) distribution industry, GWW’s scale (it is one of the largest industrial distributors in North America) gives it cost advantages over smaller competitors. The cost advantages come from preferential supplier pricing, global product sourcing, an, private-label brands, and national accounts.

GWW’s global product sourcing, preferential supplier pricing, and efficient and scalable distribution network lowers its cost of goods sold which helps it generate superior gross profit margins than its smaller competitors.

The following image provides a high level overview of GWW’s portfolio performance (the most current available is for FY2017) and how GWW intends to create unique value for each of its markets.

Source: GWW – Standard Investor Relations Presentation – October 16, 2018

Despite the headwinds GWW faces and the challenges with its UK and Canadian businesses, I felt that GWW was taking the appropriate course of action. Following my analysis in mid-October I initiated a position with the purchase of 200 shares @ $274.75/share for the ‘side accounts’ within the FFJ Portfolio.

Now that GWW has just released Q4 and FY2018 results I am taking this opportunity to briefly review FY2018 results, management’s guidance for FY2019, and current valuation.

Q4 and FY2018 Results

GWW’s results can be found here.

Source: GWW – Q4 and FY2018 Earnings Call – January 24, 2019

The rollout of a more competitive pricing model is expected to hurt the bottom line over the next couple of years but management is of the opinion that volume improvements will more than offset price reductions.

GWW achieved results which exceeded guidance or which were at the high end of guidance.

The Canadian market has been challenging and for the first time in 11 quarters, GWW turned a quarterly profit in Q4 2018. Although one quarter of profitability is not a trend, management is cautiously optimistic that the structural reset of the Canadian operations is complete and profitability on a consistent basis has been restored.

The plan is to continue to use the high-touch, high-service model to continue the turnaround in Canada. The focus is now on stabilizing volume and driving profitable growth.

Source: GWW – Standard Investor Relations Presentation – October 16, 2018

 

Source: GWW – Q4 and FY2018 Earnings Call – January 24, 2019

FY2019 Guidance

Management has provided the following guidance.

Source: GWW – Q4 and FY2018 Earnings Call – January 24, 2019

Credit Ratings

There has been no change in GWW’s long-term senior unsecured debt credit ratings subsequent to my October 16^th article.

Moody’s still rates GWW’s long-term debt A3 and S&P Global still rates it A+; this is a 2 notch difference. Moody’s rating is the lowest tier of the upper medium grade category while S&P’s rating is the top tier of the upper medium grade category.

Both ratings are investment grade and are satisfactory for my purposes.

Valuation

At the time of my October 16^th article, GWW had just released results for the 9 months ending September 30^th. On the October 16^th Q3 conference call management indicated:

‘Finally, in July, we gave EPS guidance of $15.05 to $16.05. Further, we mentioned that it did not include the tax benefit from stock-based compensation for the second half. We’ve stayed away from predicting the exercise of stock-based awards, which is inherently difficult. Excluding that benefit, which was $0.14 in Q3, we are trending to the high-end of our guidance. As a reminder, we will provide 2019 guidance on our Q4 earnings call in January.’

Following the significant one-day drop in GWW’s stock price I determined that on the basis of GWW’s closing stock price of ~$280 on October 16^th and a conservative $15.90 adjusted diluted EPS for the year, GWW’s forward adjusted diluted PE was ~17.6.

Now that FY2018 results have been released which reflect $13.73 in diluted EPS and $16.70 in adjusted diluted EPS for FY2018 we get a diluted PE of ~20.85 and an adjusted diluted PE of ~17.1 when we use GWW’s $286.22 closing stock price on January 24^th.

Management has also provided FY2019 adjusted EPS guidance range of $17.10 - $18.70. Using the current price of $286.22, the forward adjusted diluted PE range is ~15.3 - ~16.74.

I prefer to base my investment decision on GAAP EPS versus non-GAAP EPS (ie. adjusted). GWW, however, provides guidance on a non-GAAP basis so if I conservatively deduct $3/share from guidance (this is roughly the variance between GAAP and non-GAAP EPS for FY2018) I get an estimated FY2019 GAAP EPS range of $14.10 - $15.70. Using this range and the current stock price I get a forward PE range of ~18.2 - ~20.3 which compares favorably with GWW’s 5 year average GAAP PE of ~21.8.

Dividend, Dividend Yield, Dividend Payout Ratio, and Share Repurchases

GWW’s dividend and stock split history can be found here.

GWW will not appeal to yield hungry investors in that its dividend yield is sub 2%.

On the basis of GWW’s dividend track record and management’s stated intent to continue to return cash to shareholders through share repurchases and dividends, I anticipate that GWW will increase its quarterly dividend following the March $1.36/share dividend payment.

I am projecting a conservative 5% increase in GWW’s dividend ($5.44/share increasing to $5.71/share). This would result in a ~2% dividend yield which is consistent with GWW’s recent historical dividend yield.

Using the forward EPS range $14.10 - $15.70 which I calculated above, a $5.71/share annual dividend gives us a payout ratio of ~36% - ~40.1%. I view this payout ratio as acceptable.

GWW’s weighted average number of shares outstanding for FY 2018 and FY2017 amounted to 56,534 million and 57,983 million. This compares favorably with the ~78 million shares outstanding as at FYE2008.

Insider Activity

There have been no Insider purchases in the past several months. All Insider transactions have been related to either performance vested restricted stock units or deferred share units as part of compensation packages.

I note that GWW’s CEO/Chairman exercised his option to purchase 24,876 shares at a value of $149/share on August 1^st; he sold 21,448 at $342.40/share on August 1^st.

The second largest insider transaction was conducted by GWW’s Sr. VP and General Counsel who exercised his option to purchase 14,990 at $149/share. He sold all those shares at $368.2/share on August 22^nd.

The third largest insider transaction was conducted by GWW’s Vice President and Controller. He received 4,530 shares at different values (average ~$245/share) and sold 4,015 shares at different values in May, June, and July for an average value of ~$315/share.

Several insiders were awarded deferred stock units on September 1^st at a conversion price of $354.10/share and December 1^st at $314/share; terms require that the deferred stock units settle in shares of common stock on a one-for-one basis following end of service as a Director. The Directors who were awarded these deferred stock units typically received less than 100 at the beginning of September and again at the beginning of December.

Final Thoughts

When I analyzed GWW in October I came away with the opinion that it has competitive advantages which should enable it to outpace most competitors in this highly fragmented industry and viewed the $274.75/share price as an attractive entry point.

I would be prepared to acquire additional GWW shares if its share price retraced below the level at which I purchased shares in October but for now I am in no rush to acquire additional shares.

While the US government shutdown is more than a month old I have not yet seen a significant negative impact on stock prices. It is my understanding, however, that consumer and business sentiment has been hurt and if this shutdown continues another few weeks I think it will start to have a measurable impact on the economy. Once investors see that impact then I think stock prices across the board will pull back thus providing investors an opportunity to scoop up shares in great companies at more attractive valuations.

At this juncture I am going to sit on the sidelines and will refrain from adding to my GWW position.

I wish you much success on your journey to financial freedom.

Thanks for reading!

Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].

Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation

Disclosure: I am long GWW.

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.