“Going forward, with our strategy and alignment, we expect to consistently outgrow the market by 300 to 400 basis points in our core high-touch solutions business in the U.S. In our endless assortment businesses, we expect about 20 percent annual revenue growth. In 2020, we are focused on several initiatives to support this growth”
-D. G. Macpherson, Chairman and CEO of W.W. Grainger
Can an industrial distribution company really “outgrow the market by 300 to 400 basis points” and consistently grow its top line by 20% per year? That’s the challenge W. W. Grainger, Inc. (GWW) has set for itself.
Apparently, half a dozen of the gurus followed by GuruFocus think growth is possible; at least, they have invested in the company, although two of them reduced their positions in the first two quarters of this year.
Grainger has two business models. One is called “high-touch” and involves customers with complex needs; for these customers, it develops advanced solutions that lead to “deep customer relationships.” It is this line that is expected to outgrow the market by 3% to 4%.
The other model is called “endless assortment” and refers to simpler products and solutions that can be served through its stores, phone orders or website. This line is expected to generate annual growth of 20%.
Altogether, the company offers more than a million and a half MRO (maintenance, repair, and operations) products, sourced from more than 5,000 suppliers.
In the 2019 Annual Report, Macpherson wrote, “When we execute against these two models, we consistently gain share, grow profitably and deliver strong shareholder value.”
Also notable is that Grainger is a Dividend Aristocrat, meaning it is an S&P 500 company with at least 25 years of continuously increasing its dividends. In just two more years, it will qualify for the most elite club of all, Dividend Kings, which signifies at least 50 years of continuous dividend increases.
Dividends
While we know Grainger’s dividend has increased every year for nearly five decades, it is not very high. In fact, at 1.7%, it is below the average of the S&P 500 companies.
Is this dividend yield affected by the stock price? A glance at this 10-year chart of yield and share price will give us insight:
The yield hit a high of just over 3% in August 2017, but for the past two years it has averaged around 2%. When Grainger’s share price dipped with the market earlier this year, the yield popped to about 2.5%, but since then has fallen back again.
For another perspective, we will look at just the level of dividend payments over the past decade:
While the company has done its part to increase dividends, the stock price has pulled it back to some extent.
Investors want to know if a dividend is sustainable, and that can be checked by reviewing the company’s payout ratio. Grainger has a payout ratio of 41%, which is quite conservative and likely to be sustainable.
But, to give ourselves an extra layer of comfort, we can check its free cash flow, the source of dividend payments. Here’s what’s happened with the firm’s free cash flow and free cash flow per share over the past 10 years:
The 5-Year Yield-on-Cost sits at 2.34%, indicating the average of what investors might receive if they buy the stock now and hold it for five years, given that the company continues to increase the dividend at the same rate as it did over the previous five years.
While it is not a dividend, a share buyback often amounts to the same thing: returning cash to shareholders. Grainger has been buying back its shares, and its average buyback rate over the past three years has been 3% per year. Combined, the buybacks and dividends offer a mid-single-digit return before capital gains or losses.
Financial strength
While Grainger gets a 6 out of 10 from GuruFoucs for financial strength, there’s no green in the table, indicating there are some concerns, but nothing too substantial.
On debt, for example, we see the company has taken on high debt and holds more than it has in the past, but also that the current level is not out of step with its competitors and peers. With interest coverage ratio of 13.39, operating income is significantly higher than interest costs. At 7, the Piotroski F-Score is solid and indicates good financial strength.
The company's return on invested capital (ROIC) is almost triple the weighted average cost of capital (WACC), so we can give the management team a high-five for effective capital allocation.
Profitability
We can also give management a high-five for turning revenue into profits, with a GuruFocus profitability rating of 9 out of 10.
The GuruFocus system issues warnings, though, for shrinking gross margins and operating margins. Yet, as this chart below shows, the company has recovered somewhat over the past two years:
Whether Grainger can sustain the recovery this year and in subsequent years will remain an open question for now.
Note, too, that the company has an excellent ROE (return on equity) and ROA (return on assets) to go along with increases in revenue, Ebitda and net earnings per share without non-recurring items over the past three years.
Valuation
Grainger’s valuation score is relatively low at 3 out of 10, indicating it is not available for less than its fair or intrinsic value.
Starting with the price-earnings ratio at 24.11, the stock is certainly more expensive than many other competitors. Yet, it has not really been much a bargain stock at any time in the past 10 years. GuruFocus reports, “During the past 13 years, the highest PE Ratio of W.W. Grainger was 28.47. The lowest was 15.22, and the median was 20.64.”
Because this is a high-predictability company witha business predicability rating of five out of five stars, we can look to the discounted cash flow (DCF) calculator’s estimates with confidence.
With a negative margin of safety, and especially one this high, Grainger is currently likely to be overvalued, and steeply at that.
Gurus
Still, some gurus and other investors were buying, even before the price slumped this spring:
The gurus with the biggest holdings at the ends of the first and second quarters were Jerome Dodson (Trades, Portfolio) of the Parnassus Endeavor Fund (Trades, Portfolio) with 330,000 shares (after a reduction of 5.71%), Jim Simons (Trades, Portfolio) of Renaissance Technologies with 323,600 shares (after adding 3.25%) and Pioneer Investments (Trades, Portfolio) with 37,563 shares (after a reduction of 23.29%).
Conclusion
Given that W. W. Grainger, Inc. is a soon-to-be Dividend King with a low dividend yield, investors may want to wait for a serious dip in the share price, or be willing to buy and hold for at least five years. Small dividends do grow into big payouts, but need extra time to compound.
And, in light of the high valuation, investors should probably look for both a lower price and a plan to hold for the long term. With very solid fundamentals and a plan to grow both the high-touch and endless assortment businesses more quickly than the market, stock ownership could be rewarding over time.
Disclosure: I do not own shares in any companies named in this article.
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