W.W. Grainger -- A Company that should be on All Investors' Radar Screens

W.W. Grainger Inc. – A Company that should be on All Investor’s Radar Screens

Overview

W.W. Grainger Inc. is one of the world's largest suppliers of maintenance, repair and operating (MRO) supplies and other related products and services used by businesses and institutions primarily in the United States and Canada, with a presence in Europe, Asia and Latin America. The company sells more than 1 million products, including tools, fasteners, instruments, welding and shop equipment, material handling equipment, safety and security supplies, lighting and electrical products, power and hand tools, pumps and plumbing supplies, cleaning and maintenance supplies, building and home inspection supplies, vehicle and fleet components and many other items primarily focused on the facilities maintenance market.

The company sources its products from more than 3,100 suppliers inside and outside the United States through a network of 24 distribution centers, various websites, and over 500 branches. An average U.S. branch is 22,000 square feet in size, has 12 employees and handles about 150 transactions per day. Branches and distribution centers have been strategically located in close proximity to end users so as to serve their immediate needs by allowing them to pick up items directly from the branches or by providing them with same-day/next-day delivery.

GWW serves more than 2 million customers worldwide. Customers range from small and medium-sized businesses to large corporations, government entities and other institutions. They are primarily represented by purchasing managers or workers in facilities maintenance departments and service shops across a wide range of industries such as manufacturing, hospitality, transportation, government, retail, healthcare and education. Sales in 2013 were made to approximately 1.4 million customers averaging 109,000 daily transactions. No single customer accounted for more than 3% of total sales. Customers' buy decisions are based on a combination of product breadth, local availability, speed of delivery, detailed product information and price. GWW is one of the best firms to meet client needs along each of these dimensions.

Purchase Considerations and Reasons for Caution

What we like most about GWW are its size and broad distribution network--and the cost advantages it derives therefrom. Furthermore, as the industry is highly fragmented, it would be particularly difficult and take a long time for a competitor to build itself to comparable scope and size. Also, with over 1.2 million products sold online and almost 600,000 products stocked in the Grainger Catalog, GWW has by far the deepest and most diverse product line. We also value GWW's strong reputation for fast delivery and efficient pre- and post-purchase service. These are particularly important in the MRO industry as almost half of buyer purchases are unplanned and require same-day delivery. In addition, we think that GWW's growth prospects remain favourable. Specifically, GWW estimates that, given its relatively large size, it still only controls about 7% of the U.S. MRO market, 8% of the Canadian market, and about 1% of the Mexican, Chinese, European and Japanese markets leaving it substantial domestic and international growth opportunities.

What concerns us most about GWW is its sensitivity to economic cycles. We also dislike that it is heavily reliant on U.S.-based industrial production. While international expansion activities are helping somewhat, the more that manufacturing shifts oversees to emerging markets, the more important it will be to accelerate its international expansion.

Financial Highlights

About $9,437M in revenues moved through GWW's door in 2013. GWW’s revenues for the Dec 2004 to Dec 2013 period clocked in at an average annual rate of growth of 7%. Improved industrial production, greater cost controls, improved market share and strong internet-based sales have all led to solid revenue performance. Revenues grew at an annual rate of 7% over the last 5 years and 10% over the last 3 years.

Year-over-year GWW continues to make substantial sums of money off revenues after subtracting costs of goods sold (COGS), with gross profits reaching $4,136M in 2013. GWW's production costs appear well under control, with COGS rising by 6% per year over the last 10 years against revenue growth of 7%. GWW does not appear to be experiencing any difficulties passing on the cost of inflation to consumers. Gross margins have expanded from 38% in 2004 to 44% in 2013. In addition to being on an upward trend, the strength in GWW's gross margins is exceptional. As a general rule, we want to see consistent gross profit margins above 35% for firms in the sector. Gross profit margins consistently above 35% for a firm in the sector is, in our opinion, indicative of a firm with a strong competitive advantage that has substantial pricing power. GWW has surpassed this target in each of the last 10 years.

GWW spends between 60% and 70% of gross profits on hard costs associated with selling expenses, management salaries, payrolls, advertising and legal fees. We consider this an acceptable result. Cost of SG&A have been increasing at an increasing rate, rising by 7% per year over the last 5 years and 10% per year over the last 3 years. We consider this an acceptable result when viewed against annual revenue growth of 7% and 10% over the same periods respectively. Strength in end markets and continued improvements in operating efficiencies are contributing to GWW's margin support.

GWW has shown substantial strength and stability in its operating earnings picture, rising by 13% per year over the last 10 years. The long-term trend in operating income has been upward, rising from $441M in 2004 to $1,297 in 2013. GWW has earned on average about 11% in operating earnings on total revenues over the last 10 years--an acceptable result. GWW carries a small amount of debt on its books and, consequently, pays out about 1% of operating income on interest payments annually. This is a very good result and lower than much of the competition.

Bottom line results show a strong upward long-term trend in earnings, with minimal volatility, growing at an average annual rate of 12% over the last 10 years. Earnings are expected to tick upwards in 2014 and 2015 driven by domestic and international growth in the manufacturing, construction, and transportation sectors. We like seeing that, since 2004, earnings growth has outpaced revenue growth by 5% per year. To us this is a sign of earnings quality strength.

GWW’s strong competitive position has allowed it to maintain net margins of about 7% over the last 10 years, expanding slightly from 6% in 2004 to 9% in 2013. We do not expect margins to expand much further without an improvement in pricing power or the introduction of new services or higher value-added products. Diluted EPS grew by 15% per year from $3.13 per share in 2004 to $11.13 in 2013. GWW's ROE and ROA performance has been exceptional, averaging 21% and 13% respectively over the last 10 years.

Valuation

A company’s fair value estimate can be calculated as the present value of expected future free cash-flows to equity. Free cash-flows to equity represent the amount of cash-flows available to common stockholders after all operating expenses, interest and principal payments to lenders have been paid and necessary investments in capital equipment and working capital have been made to maintain and grow operations.

Here we estimate fair value in 5 steps:

1. we forecast the firm’s free-cash flows to equity for the next 10 years using econometric processes;

2. we discount those cash-flows to the present;

3. calculate a terminal value for the firm 10 years out based on a long-term expected growth rate and terminal discount rate and discount it to the present;

4. add the discounted terminal value to the discounted value of free-cash flows to equity over the next 10 years; and

5. divide the present value of all cash-flows by the diluted number of shares outstanding.

Table 1 presents our free-cash flow estimates. Table 2 presents valuation inputs and results.

Table 1: Free Cash-Flow to Equity Estimation

Table 2: Valuation Inputs and Results

Conclusion

GWW’s per share earnings in 2013 were $11.13. Historical earnings per share grew at an annual rate of approximately 15% per year since 2004. GWW’s sales per share in 2013 were $133.72. We project that sales will grow at a rate of about 6% per year between 2014 and 2023. We expect slight margin compression on the operating and bottom line. Interest expenses will remain stable. Capital expenditures will remain at recent historical levels in the amount of approximately 2% of sales. Our fair value estimate of GWW equals $264.54. At its current price of $242.35, GWW is underpriced by about 9%. While for us the margin-of-safety isn't sufficient to qualify for investment, this company is a financial powerhouse with a strong competitive advantage that we will definitley keep on our radar screen.