W.W. Grainger, Inc. released Q2 2019 results and FY2019 guidance on July 24, 2019. Despite softer demand and lowered Sales guidance, management has reiterated Gross Profit Margin, Operating Margin, and adjusted diluted EPS guidance.
- GWW reported Q2 results on July 24th. Gross and Operating Margins and adjusted EPS guidance have been maintained but sales guidance has been lowered.
- Management discussed headwinds on the Q2 analyst call but initiatives recently put in place, or in the process of being implemented, should improve GWW’s competitive advantages over the long-term.
- Despite projected sales headwinds investors have bid up GWW’s share price ~17% in the past 2 weeks.
- GWW is but 3 years away from qualifying for the honor of being in the exclusive Dividend King group of companies (50 consecutive years of dividend increases).
NOTE: In this article I provide my opinion on W.W. Grainger, Inc.’s (GWW) valuation and present a potential conservative option strategy which can be employed if you own the underlying shares and reach a similar opinion as me regarding GWW’s current valuation and short-term stock price outlook.
Before investing in any company it is wise to familiarize yourself with the company. In this regard, I provide this link to GWW’s 2019 Fact Book.
I now look at GWW, a company in which I initiated a position on October 16, 2018 for one of the ‘side accounts’ within the FFJ Portfolio and for which I wrote this article.
In my January 24, 2019 GWW article, at which time shares were trading at $286.22, I wrote that I viewed shares as being a tad expensive.
Subsequent to my January article, GWW retraced to the upper $250 – lower $260 range in late May and early July. Despite my intent to acquire additional shares at the time I wrote my January article, I did not add to my GWW position because my outlook on the broad North American market had turned decidedly more ‘bearish’; I am of the opinion that a broad market pullback will come about before the end of 2019.
In addition, where possible, I try to own shares in an industry’s two largest industry participants. Examples of this include VISA Inc. (V) and Mastercard Incorporated (MA), Automatic Data Processing, Inc. (ADP) and Paychex, Inc. (PAYX), The Coca-Cola Company (KO) and PepsiCo, Inc. (PEP).
GWW is currently the second largest Wholesale Industrial Equipment industry participant from a market capitalization standpoint with FAST being the largest. GWW’s annual revenue, however, is twice that of FAST.
FAST has also rewarded shareholders to a slightly greater extent than GWW over the past 10 years.
While my intent is to initiate a FAST position before acquiring additional GWW shares, I still like to see how my existing investment is faring and I also want to learn about management’s business outlook.
Before looking at GWW’s valuation and outlook, let’s quickly look at GWW from a high level.
GWW is one of the largest industrial distributors in North America. As a result, I am of the opinion it benefits from scale-driven cost advantages over smaller competitors in a highly fragmented markets (7% market share in the U.S., 5% in Canada, and 4% global). In fact, much of GWW’s competition comes from smaller local and regional distributors that lack GWW’s scale and global reach.
Looking at GWW’s 2019 Fact Book we see that it has in excess of 450 global branches and 30 distribution centers across the globe. With its scalable distribution network and centralized order fulfillment centers GWW can cost-effectively serve its customer base, including multinational customers that require consistent product availability and service quality around the globe.
In my opinion, GWW has technological capabilities, including its e-commerce sales channel, integrated customer purchasing and inventory management solutions, and warehouse automation from which it can drive distribution efficiencies that make it extremely difficult for smaller competitors to replicate.
Roughly 21% of sales are generated from higher-margin private-label products which have higher profit margins.
In addition, an increasing number of companies have been consolidating their spending with large national distributors. This vendor consolidation allows customers to simplify their procurement processes and leverage their buying power. With its sizable distribution network and robust portfolio of products and valued-added services, GWW is well-positioned to capitalize on this trend and to acquire marketshare from its smaller local and regional competitors.
While national accounts typically generate lower gross profit margins, the volumes are much higher and thus GWW should be able to improve operating margins.
Q2 2019 Results and FY2019 Guidance
Source: GWW – Q2 2019 Earnings Call – July, 2019
Having read GWW’s Q2 2019 Earnings Release, reviewed the accompanying Q2 Earnings Presentation, read the transcript of the analyst call, and looked at the behavior of GWW’s stock price, I admit that I am puzzled.
GWW’s Chairman and CEO remarked on the July 24th Analyst call that:
‘The demand environment has softened throughout the year.’
‘In times of slower growth, we partner with our customers to lower their cost, which strengthens our relationships.’
‘We're through much of the heavy lifting on our cost takeout initiatives and are now focused squarely on driving profitable growth to our U.S. and endless assortment businesses.’
‘At AGI, the top line recovery has been slower than we anticipated.’
‘At Cromwell…performance has lagged in the short term, resulting from market conditions and our actions in the region.’
‘In the quarter, market growth slowed across all of our end markets with the exception of health care.’
‘Our 2019 total company outlook remains the same for gross profit margins, operating margin and EPS based on our strong operating performance so far this year. We are lowering our estimate for market growth to minus 1% to 2% and lowering our revenue guidance to 2% to 5% growth due to the weaker demand environment and performance at AGI and Cromwell.’
Despite lower sales guidance and the increasing risk of a broad market snapback, GWW’s share price has jumped from ~$258 on July 10th to the current ~$300. This is a ~16% increase in ~2 weeks!
You can see from the Earnings Release that GWW’s Gross Profit Margin was weaker than that in Q2 2018 but its Operating Margin improved relative to Q2 2018.
We also see that reported EPS of $4.67 in Q2 increased 12% from the $4.16 reported in Q2 2018 and adjusted Q2 EPS of $4.64 increased 6% from $4.37 in Q2 2018. Management attributes this improvement primarily to operating earnings growth and lower average shares outstanding.
In addition, we see that the all important cash flow improved to $0.323B in Q2 2019 versus $0.248B in Q2 2018.
Despite acknowledging a softer demand environment and the lowering of FY2019 sales growth guidance, full-year profit guidance has been reiterated and there is still a commitment to outperform market growth by 3% - 4% over the next several years. (cont'd.)
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Disclosure: I am long GWW.
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