How Much Room Does W.W. Grainger Have to Grow?

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- By Daniel Seens

Introduction

What a year it has been for W.W. Grainger (GWW), one of our top-performing stocks for 2017. Anytime one of our picks jumps by over 100% in a single year, we know it's time to re-evaluate whether it's still worth holding.

This has been the case for the company due to favorable currency movements and rebounding domestic sales. As a result, demand for the stock has surged. This has given a tremendous boost to our portfolio returns for 2017 and so far for 2018 as we continue to see substantial positive momentum behind the stock.


The magnitude of the stock's uptick over the last year calls on us to re-evaluate whether we believe the strength and sustainability of the company's competitive advantage remains intact. Do we believe that after some past dips in company earnings and free cash flows that margins will keep moving in the right direction?

Well, the short answer is yes, we do believe the company remains operationally strong and that earnings and earnings growth have stabilized.

But, just because we still like the company operationally, it doesn't mean we necessarily believe there is much more room for the stock to grow.

Company overview

W.W. Grainger is North America's largest supplier of maintenance, repair and operating supply products. It sells more than 2.4 million products to more than 3 million customers worldwide through its network of distribution centers, websites, branches and inventory management solutions. Products sold include material handling equipment, safety and security supplies, lighting and electrical products, power and hand tools, pumps and plumbing supplies, cleaning and maintenance supplies and metalworking tools. Services offered primarily include inventory management solutions (see their 2017 annual report). Some of the company's top-selling products include such things as safety supplies, gloves, ladders, motors and janitorial supplies.

The majority of the company's products are purchased in the U.S. The company has substantial negotiating power with suppliers as it sources goods from more than 2,600 suppliers, most of which are direct manufacturers. The company also purchases products from over 400 international suppliers. No single domestic or international supplier accounts for more than 5% of total sales.

W.W Grainger's customers are found primarily in the U.S. and Canada, with a small segment found in Europe and South America. Customers range from small and mid-sized industrial businesses and maintenance businesses to large corporations, government agencies and other organizations operating in the manufacturing, hospitality, transportation, government, retail, health care and natural resources industries. The company has substantial negotiating power with buyers generating over 100,000 transactions per day without having a single customer account for more than 4% of total sales.

As of Dec. 31, 2017, the company had over 280 branches, three national contact centers and 37 regional contact centers. Most of its distribution centers range in size from approximately 45,000 square feet to 1.3 million square feet, the largest of which can accommodate more than 500,000 in-stock products. The company's advanced inventory management system allows it to handle almost all customer delivery requests within about 24 hours.

Purchase considerations

  • In our view, W.W. Grainger is the best in the industry. And--don't forget--the biggest. This awards the company substantial cost advantages that we think will remain intact for many years to come. The next closest competitor is only about a quarter of its size and the rest of the market, while still reasonably competitive, remains highly fragmented.

  • U.S. economic fundamentals remain favorable. That is, several economic factors and industry trends will support continued growth and strengthening profitability for the company. In particular, strengthening business investment, declining inventories, growing exports and rising industrial production will all support sales and earnings moving forward. In addition, rising GDP and oil prices in Canada--the company's second-largest market--should help boost international sales.



  • Without question, the company has the best and largest product portfolio. We believe this is a critical success factor for any company in the industry. It's estimated that almost half of all purchases are quick and unplanned. If you want to win at this game, you have to have the largest product portfolio, the easiest purchasing system, the fastest mechanism and the best customer service and return policies. We think Grainger is the best in all of these areas.

  • The company is largely recession-proof. Just look at the numbers. Sales and earnings were barely impacted.

  • There remains tremendous growth opportunities in the industry. We need to be clear here that we're talking about growth in market share. This is the biggest and best company in the industry, but still only controls about 6% of a $127 billion market. Big growth opportunity!

  • The company has minimal leverage and is a cash-generating machine.

  • The company is expanding its presence internationally with new distribution chains in South America, Japan and Korea. We do think that there is a good international opportunity here.



It is important to note, however, that will it might sound like it's all rainbows and sunshine, the company will always be sensitive to economic shocks and manufacturing distortments in the U.S. and Canada as it is not yet a geographically diversified country. It's more recent push into international markets is helping, but it's a risk that remains. Any major and structural distortion in any of its key industries will hit the bottom line. Recently, we've also wondered how long it will take for the next biggest players to begin consolidating the industry. It's only a matter of time. Margin differentials make this a certainty.

So is now a good entry point? Let's run through a simple valuation process and see.

Estimating sales growth

When assessing the competitive strength and investment merit of a company, we like to first assess what's going on with sales. Ideally, we are looking to invest in companies whose sales are strong, consistent and are generally growing faster than nominal GDP growth (that is, real GDP growth and inflation combined). Based on W.W. Grainger's historical sales data, you can see the company's revenues have grown by about 5% over the last 10 years. This compares to average nominal GDP growth of 3.2% per year over the same period.

W.W. Grainger's sales have grown by 3.1% per year over the last five years and 1.5% per year over the last three years. It is worth noting that W.W. Grainger's three-year revenue growth rate is ranked higher than 78% of the 187 companies in the industrial distribution industry. We think the company is on solid ground. We also believe it retains modest pricing power. We feel comfortable recommending investing in this company for growth and expect impressive things from it in the future.

The second thing we like to do when assessing sales is to look at consensus market estimates. As reported by Morningstar, the market is projecting 7.6% annual growth for this year, 6.7% annual growth for next year and 7.8% for the year after that. These growth estimates translate into $11.2 billion in sales for this year and $12 billion in sales for next year. The projected increase in sales is expected to be driven by an increase in product demand, stable pricing power and improved production capacity.

A third thing we like to do when assessing sales is to compute the company's sustainable growth rate. The sustainable growth rate reflects the rate of growth in sales that a company can support given its existing earnings power, capital resources and dividend payout policy. In any given year, a company's sustainable growth rate is calculated by multiplying its return on equity by its retention rate. Rather than rely on data from only one year, however, we calculate sustainable growth by using the company's three-year average ROE and three-year average retention rate. W.W. Grainger's ROE averaged 28.8% over the last three years while its retention rate averaged 53.3%, giving the company a sustainable growth rate of 15.4% per year.

Let's recap briefly what the sales data is showing us. From what we can tell, it is not unreasonable to estimate that sales over the next five years could grow at a rate of somewhere between 1.5% and 15.4%.

We're going to select a rate of 4.8%. This represents a blended rate forecast reflecting consensus three-year rate projections scaled by a three-year average incremental change for the last two years of the five-year forecast horizon. With $10 billion in sales generated last year, this means we believe sales will reach about $13 billion in five years. This estimate reflects our understanding of the company's historical results, market demand, pricing trends, levels of competition and changing regulatory requirements.

Estimating earnings per share

Now that we have generated our sales estimate, we're going to estimate growth in earnings per share. The method applied below takes the sales growth projection -- in this case, 4.8% per year -- and subtracts the expenses and taxes. What we're left with are the earnings. Then we divide by the projected number of diluted shares outstanding to determine the earnings per share (see table below).

A projected growth rate of 4.8% will result in about $13 billion in sales five years out. Now we need to take a look at the company's pretax profit margin (what's left over after expenses but before taxes are subtracted). In the figure below, we can see W.W. Grainger produces some pretty stable margins -- 9% in 2017, 10.1% in 2016, 12.5% in 2015 and 13.4% in 2014. The average for the last five years has been 11.7% and the average for the last 10 years has been 11.9%. We believe W.W. Grainger's margins will hold at 10.5%. At this rate, projected pretax profits on $13.2 billion in sales would be about $1.4 billion. This means expenses would amount to $11.8 billion.

The next step in our estimation process is to establish what tax rate will be paid on the company's profits. The most recent year's rate was 33.5%. Normally, we wouldn't play with that number too significantly because, in general, it shouldn't change very much from year to year. The only time we would make major changes to this number would be in instances where the current rate differed significantly from that of the past or if we had some knowledge about what rate was likely going to persist in the future, perhaps because the company is going to get some preferential tax treatment on operations abroad or because of a broad change in state or federal tax policy. For W.W. Grainger over the last 10 years, the company's tax rate has been as low as 33.5% and as high as 39.9%. Tax rates for most U.S. companies are around 16.1%. We're going to select a rate of 36%. This would result in a tax expense of $0.5 billion from pretax profits of $1.4 billion in five years. This would leave us with $0.9 billion in projected earnings five years from now.

Our next main consideration is a matter of determining the number of diluted shares that will be outstanding in five years. W.W. Grainger has decreased the number of shares outstanding over the last decade. There were 85 million shares outstanding in 2007, then the number of shares went to 71 million in 2012 and then fell to 66 million in 2015. Currently, there are 58 million shares outstanding. This data suggests the company has been redeeming about 3 million shares per year. We're going to rely on the company's historical share repurchase activities to guide our estimation process. As such, we project share repurchases of 3 million per year over the next five years.

With shares estimated at 45 million in five years, earnings per share are expected to rise at an annual compound rate of 14.7%. This is higher than our projected five-year revenue growth rate. Based on this growth forecast, we are expecting earnings of $19.85 per share five years out. Results of our forecasting procedure are summarized in the table below.

Forecasting a target price-earnings multiple

W.W. Grainger's stock has traded with a relatively stable price-earnings multiple over the last decade, averaging 20.2 times over the last 10 years, 22.0 times over the last five years and 21.5 times over the last three years. Currently, the company is trading at 26.8 times trailing 12-month earnings per share and 23.4 times expected future earnings.

For determining an estimated target price-earnings multiple, the first thing we like to do is eliminate any outliers from the historical data series. This includes abnormal ratios that are not reflective of the normal operations of the company, which could be the result of abnormal growth or significant one-time non-recurring charges or gains. The next thing we like to do is to run an optimization procedure that tells us what multiple yielded the best forecasting accuracy over the evaluation period. If in our judgement this multiple continues to accurately portray the earnings and cash-generating power of the company as well as its growth and risk characteristics, then we will use this as our target. If not, we will adjust it upward or downward accordingly.

The figure below presents the historical price-earnings profile for W.W. Grainger. We will utilize a target multiple of 20.8 times, which we believe reasonably characterizes the risk-return attributes of the company's stock. This multiple represents a contraction of 11.9% relative to the current multiple. It also represents a contraction of 9.5% relative to the five-year average price-earnings multiple.

Setting a target price and valuation range

Now we need to take a look at the price history of the company's stock. From the figure below, we can see the spread between the high and low stock prices has increased over the last 10 years. We have a current price of $365.77, with a high of $274.01 and a low of about $59.92 over the past decade. We want to keep this variability in mind when establishing our upper and lower valuation range. Specifically, given the company's historical price behavior, we should expect the stock to fluctuate by at least $50.78 over the course of a year.

Given our selected target price-earnings multiple of 20.8, to determine a price target five years out, we then multiply this by our earnings per share estimate. Earnings are estimated to reach $19.85 per share in five years, giving us a target price of $412.23. This price is higher than the current price. To properly judge to what extent the stock may be under- or overvalued, we need to determine a fair value range within which we expect the stock to trade. To do this, we rely on the trend-adjusted average annual trading range for the stock, which from the analysis above we know is $50.78. This means that, given our target price estimate, we expect the stock to trade naturally, and fairly, between $386.84 and $437.62. The result of this is that when the stock is trading below $386.84, it is in the buy zone. When the stock trades above $437.62, it is in the sell zone. Currently the stock is in the buy zone.

Return potential

So what return can we expect for holding W.W. Grainger's stock? Well, we now know we can expect stock price appreciation of 12.7%. We can also expect to earn dividend income of about $26 over the evaluation period. Added to our price estimate, this means we could earn a compound annual rate of return of 3.7%, provided our estimates prove accurate. All in all, we are happy with this company and believe it offers sufficient return potential to qualify for investment. We recommend buying the stock at current valuation levels.

Disclosure: We currently have a long position in this company's stock.

This article first appeared on GuruFocus.


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