(Published by Bob Ciura on April 20)
W.W. Grainger Inc. (GWW, Financial) has been among the biggest losers in the S&P 500 so far this earnings season. Shares have lost 20% of their value in just the past three months.
The stock fell 11% on April 18 after the company announced disappointing first-quarter earnings.
Not only did Grainger miss analyst expectations on both sales and earnings for the quarter, but it also lowered its forecast for the full year.
But long-term investors should not be swayed by one quarter’s results.
Grainger has a long track record of rewarding shareholders. The company has raised its dividend for 45 consecutive years, making it is a Dividend Aristocrat, a group of companies in the S&P 500 that have raised dividends for at least 25 years.
You can see the entire list of Dividend Aristocrats here.
With five more years of increases, Grainger will become a Dividend King, a group of just 19 companies that have raised dividends for over 50 consecutive years.
To see the complete list of Dividend Kings, click here.
Grainger’s 20% decline makes it more attractive for long-term investors, not less.
Business overview
Grainger supplies maintenance, operating and repair products—MRO, for short— around the world. These are things like safety products, power tools, test instruments and motors.
The company has a presence in many international markets, including Japan, the U.K., Mexico and Germany.
Most of its business is derived from North America, however, where it operates over 700 branches and more than 30 distribution centers.
Source: 2016 Analyst Meeting Presentation, page 6
Grainger’s core business is with large U.S. customers. These customers represent approximately 60% of the company’s total revenue.
Revenue from this customer segment declined 1% last year. This caused Grainger’s adjusted earnings per share to decline 3% in 2016.
Conditions have not improved so far in 2017.
In the first quarter, Grainger’s revenue rose 1%, but adjusted EPS declined 9% year over year.
At the heart of the issue is price deflation in its core market.
Source: 2016 Analyst Meeting Presentation, page 10
Customer spending habits are shifting to digital channels. In addition, competition is heating up. This has caused pricing deflation in the company’s most important business.
These pressures continued in Grainger’s first-quarter results, which missed analyst expectations on both the top and bottom lines. Sales and adjusted earnings clocked in at $2.54 billion and $2.93, respectively, for the quarter.
Analysts expected the company to post adjusted EPS of $3.01 on revenue of $2.56 billion.
On the plus side, lower prices have resulted in stronger product demand. Grainger’s sales volumes increased 4% last quarter, the strongest growth rate in the past two years.
Source: Q1 2017 Earnings Presentation, page 10
Volumes are expected to grow 6% for 2017.
Shifting to digital channel sales and lower prices will be detrimental to earnings this year, but are necessary steps to retain customers. Grainger needs to evolve in order to adapt to the industry changes, or it risks losing market share to the competition.
Going forward, the company hopes to keep earnings stable with cost cuts.
Growth prospects
Not only did Grainger disappoint with its first-quarter results, but it also whiffed on its full-year outlook. The company now expects 1% to 4% revenue growth in 2017, along with EPS of $10 to $11.30.
Both figures are below the company’s previous forecast, which called for 2% to 6% revenue growth and EPS of $11.30 to $12.40.
Source: Q1 2017 Earnings Presentation, page 12
It expects the pricing actions undertaken to keep market share will result in 5% price deflation in the U.S. in fiscal 2017.
The good news is it expects this pressure to moderate going forward. Price deflation is expected to drop to 2% in fiscal 2018.
In addition, Grainger has a plan to return to growth, even in the challenging environment.
The company has invested significantly in its e-commerce platforms, MonotaRO in Japan and Zoro in the U.S. Both are growing rapidly and contributed to the company’s 34% growth in its other businesses segment last year.
Approximately 60% of the company's sales are now initiated through its digital channels.
If the company retains market share through digital channels, it is possible that price deflation will eventually ease. Pricing deflation can only persist for so long before money-losing competitors are forced out.
Industry consolidation could allow for a pricing reversal.
In the meantime, the company is hoping it can offset margin compression from price deflation with cost cuts.
Source: Q1 2017 Earnings Presentation, page 15
Costs have fallen for the past several years.
This has allowed Grainger to continue generating strong cash flow. In 2016, free cash flow increased 23% to $774 million.
Its high free cash flow means Grainger can keep investing in new growth initiatives, allowing the company to raise its dividend each year.
Dividend analysis
The industrial sector is a great source of high-quality dividend growth stocks like Grainger.
Grainger currently pays an annual dividend of $4.88 per share. The stock has a current dividend yield of 2.5%, which is about 40 basis points higher than the average S&P 500 Index stock.
The company also grows its dividend regularly. It has increased its dividend for 45 years in a row, which is an excellent track record of dividend growth.
One of the negatives for the company is its dividend growth has slowed down lately. Grainger’s dividend growth rate has steadily declined over the past five years:
- 2012: 21% dividend increase
- 2013: 16% dividend increase
- 2014: 16% dividend increase
- 2015: 8% dividend increase
- 2016: 4.3% dividend increase
Grainger is due to announce its next dividend soon, as the company typically raises its payout in April. The company is very likely to raise its dividend once again.
Even though its fundamentals are challenged, the company has a modest payout ratio of 41% of 2017 expected EPS. This leaves plenty of room for a dividend increase.
That said, another low-to-mid single digit increase is likely given the company’s dividend growth is following a similar path as its earnings growth in recent years.
Final thoughts
Grainger is going through a difficult period for its business. Conditions have changed and are driving deflation in the MRO market.
The company is responding in the right way, however. It is becoming leaner and more efficient, steering investments to the strategic areas that will fuel its future growth.
Grainger has a long history of successfully navigating challenging times before. It has continued to raise its dividend for decades on end.
Its steadily rising dividends pay investors well to wait for the turnaround. Investors should continue holding the stock and could consider using the recent 20% decline as a buying opportunity.
Disclosure: I am long GWW.
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