Geoff Gannon April 27, 2016

Distributors Like Grainger (GWW) Can Benefit From Their Biggest Corporate Customers Wanting to Consolidate Suppliers for Decades to Come

(This post is a reprint of one of the nine sections that make up the Singular Diligence issue on Grainger.)

Grainger distributes the products needed to keep a large business running smoothly. It sells light bulbs, motors, gloves, screwdrivers, mops, buckets, brooms, and literally thousands of other products. About 70% of the orders customers place with Grainger are unplanned purchases. By unplanned we mean things like the filter in an air condition system, the up / down button on an elevator’s control panel, the motor for a restaurant kitchen’s exhaust fan. The customer knows these things break eventually. But, they don’t know when they will break. These aren’t cap-ex purchases made when the place first opens. And they aren’t frequent, predictable purchases. Things like light bulbs, safety gloves, and fasteners – a key part of Fastenal’s business – are bought more frequently in greater quantities as part of planned orders. Grainger sells to both large customers and small customers. And customer orders are sometimes planned and more frequent, sometimes unplanned and less frequent. But, the biggest part of Grainger’s business is unplanned purchases made by large business customers who have a contract with the company. Almost all of the company’s profit comes from the U.S. So, when you think about what Grainger does – think unplanned purchases by big U.S. businesses.

Grainger was founded by William W. Grainger (hence the W.W. in the company’s name) in 1927 in Chicago. The company is still headquartered in Illinois. It started as a wholesale electric motor distributor. At the time, manufacturers were switching their assembly lines from a central DC driven line to separate work stations each with their own AC motor. Grainger focused its business on customers with high volume electric motor needs. It was a catalog retailer. The original “Motorbook” catalog was just 8 pages. Today, Grainger’s “Red Book” catalog is over 4,000 pages. It features more than 1.4 million stock keeping units. Grainger started opening branches in the 1930s. From Chicago, it expanded into Philadelphia, Atlanta, Dallas, and San Francisco. By 1937, it had 16 branches. In 1953, Grainger started a regional warehousing system. The company added distribution centers to both replenish stock at the branch level and to fill very large customer orders. The company eventually added distribution centers in Atlanta, Oakland, Fort Worth, Memphis, and New Jersey. As alternating current became standard throughout the U.S., Grainger focused on doing more than just selling motors to American manufacturers. It sought out smaller scale manufacturing customers, service businesses, and other parts of the economy. Today, Grainger’s customer list is very diversified. It is much less dependent on the manufacturing sector than publicly traded peers like MSC Industrial and Fastenal. Grainger basically sells to any U.S. business customer who makes a lot of small orders. So, high frequency combined with low volume per order. Grainger is best at dealing with big customers. The company’s competitive position is strongest where the customer has a contract with Grainger and is served by a specific account representative. These customers make purchases at their different sites across the country under the same overarching agreement that provides steep discounts to the list price shown in Grainger’s catalog.

Grainger went public in 1967. At the time, sales were $80 million. Those sales have since compounded at 10% a year over the last 39 years. Grainger has changed its logistical footprint several different times. It eliminated its regional distribution centers by the mid-1970s. But, it brought them back in a different – heavily automated form – starting with a distribution center in Kansas City in 1983. Grainger rapidly increased its branch system during the late 1980s. It was opening about one branch a week by the end of that decade. In 1995, the last Grainger family CEO – David Grainger – retired. In that same year, the company launched its first website. Online became a huge part of Grainger’s business. Today, Grainger is the 13th biggest online retailer in the U.S. It is one of UPS’s top 10 customers. And it gets 40% of all U.S. revenue through the internet.

Over time, Grainger also expanded a little internationally. It acquired a Canadian company in 1996. And it entered a few different countries – like Mexico, Japan, Brazil, and China – in recent years. Some of these attempts succeeded. Others failed. The U.S. business provides most of the company’s profits. The Canadian business is big and successful. The Mexican business is small but profitable. Brazil and China were failures. However, Grainger is still in China. But, we don’t expect them to invest any further there. Japan was a huge, huge, huge success. We’ll talk more about Grainger’s model in Japan and how it brought that over to the U.S. later. For now, we’ll just let you know that Grainger is the majority (53%) owner of a publicly traded Japanese company called MonotaRO. The stock – which is a wildly expensive, Japanese growth stock – has a market cap of $2.4 billion (that’s U.S. dollars). That gives Grainger’s stake a $1.3 billion value at market. I’m not sure that’s the correct value. The P/E on the stock is astronomical. But, so is the growth rate.

The reason for Grainger’s success in the U.S. is supplier consolidation. Big customers want to consolidate purchases across their various sites. In high GDP per capita countries – places where labor cost per hour worked is expensive – there is a lot of interest in reducing complexity. For example, Grainger’s business in China was unsuccessful in part because in China employers will just send an employee out to a big open market to browse through various parts for the one replacement part the company needs. This kind of set up is not reasonable in countries where an employee’s time is more valuable. Customers in the U.S. like using one supplier for more and more of their maintenance supply needs. They like that Grainger can install vending machines, provide inventory management by re-stocking inventory, and give a discount below the list price on a wide variety of the products the company might need to buy however infrequently.

The most important thing to understand about Grainger is the nature of the orders customers are placing with the company. The orders can be fairly random looking – almost every business needs a mop, a screwdriver, a small motor, a light bulb, etc. sometime even if it’s far from the core of what they do. The average order size is small. However, it needs to be filled fairly rapidly. Customers are often satisfied with next day shipping on most items. They’re unlikely to be satisfied with next week shipping. This means Grainger has to keep a lot of inventory on hand. They also have to offer credit terms to customers. Business customers are used to buying on credit. They don’t want to have to pay their bills any faster than 30 days. So, Grainger has a lot of inventory and a lot of receivables. It has low turns. But, it has high margins. This surprises some people. Investors and analysts see 40% gross margins and wonder how that can be. Can a middleman really mark-up basic, boring products like we’ve talked about here – mops, buttons, motors, light bulbs, etc. – by 50% to 70% over the price they paid for that product? The answer is yes. But, it’s yes because of issues of quantity and timing. Grainger is willing to go to a maker of let’s say mops and order a thousand of them. It’s willing to hold those mops. And it’s willing to pay the mop maker before it collects payment from the eventual mop user. Grainger’s customer can buy one mop – just one mop – as part of an order with completely unrelated products. And that customer can buy on credit. They don’t need to buy more mops than they need. They don’t need to keep spares around. And they can get better credit terms – a longer time to pay – and a lower price than you could get from sending an employee to Wal-Mart looking for just one mop. This is why the gross margin is so high. The end user of the mop has no interest in dealing with the maker of the mop on terms the two would find acceptable. In some cases, a customer is buying a product they’ve never bought before. Using the example of a motor in an HVAC system. The plant manager or store manager or branch manager of some customer of Grainger’s may never have bought an HVAC motor before in his life nor may he ever have to again. He knows he needs a motor. But, he doesn’t know much about pricing, availability, etc. Having a main supplier of most replacement needs gives him a place to turn to for a consistently decent price, delivery time, and credit terms – even for products he knows little about. This is Grainger’s strength. It’s facility maintenance. Grainger isn’t as strong as MSC Industrial and Fastenal when it comes to the manufacturing floor. Those companies are better at selling cutting tools and fasteners and lots of related products to customers who have consistently high needs for some specialty products.

Like I said, Grainger is the most diversified company in its industry. The client list is extremely diversified. Manufacturing (18% heavy, 11% light) is just 30% of revenue. Commercial customers are 14%. Government is 13%. Contractors are 11%. Sellers – wholesale, retail, and resellers combined – are 10%. Transportation is 6%. And natural resources is 5%. It’s not quite as diversified as U.S. GDP. For example, manufacturing at nearly 30% of Grainger’s sales is clearly over-represented relative to the U.S. economy. But, it’s pretty close.

The products Grainger sells are so extraordinarily varied that I’ve had trouble talking to you about them so far. I’m sure that will continue to be the case. Grainger sells everything a business facility needs to keep running smoothly. Product categories include: Safety and security (18%), material handling (12%), metalworking (12%), cleaning and maintenance (9%), plumbing and test equipment (8%), hand tools (7%), electrical (6%), HVAC (6%), lighting (5%), fluid power (3%), power tools (3%), motors (2%), and power transmission (2%). So, concentrations in any one area are very low. For example, metalworking is a big, specialty category – but it’s still only 9% of the company’s total sales. A 10% drop in metal working sales would be less than a 1% hit to overall revenue.

Grainger has 1.4 million stock keeping units. About 500,000 SKUs are kept in inventory. Most orders ship same-day or next day. Grainger keeps products in inventory at 19 distribution centers and 350 branches across the country. Branches average 22,000 square feet.

Grainger divides customers into large customers, medium customers, and small customers. Quan and I think the real distinction is between customers covered by a specific Grainger sales representative (and attached to a corporate contract) and customers covered by a territory sales representative. Our best guess is that Grainger gets 85% or more of all revenue from customers covered by a specific sales rep under an attached account. Grainger says it has 14% market share in large customers. Large customers are customers with over 100 employees per location that buy over $100,000 worth of facility maintenance supplies each year. Grainger is very weak in small customers. These customers have fewer than 20 employees per site and buy facility maintenance supplies just once or twice a month. Almost all of Grainger’s growth has come from increasing sales to its biggest customers. Since 2009, sales to large customers have grown 8.6% a year. This is much, much faster than nominal GDP growth. Grainger has been increasing its share of wallet among these customers.

The company now has something called Zoro in the U.S. This company is modeled after Grainger’s joint venture in Japan. The Japanese joint venture – MonotaRO – was wildly successful in terms of revenue growth. So far, Zoro has been a fast grower too. The online only distributor had sales of $80 million in 2013, $180 million in 2014, and $300 million in 2015. Grainger hopes to copy Zoro’s success in both the U.K. and Germany. So, Grainger has several business units following this model. There is MonotaRO in Japan – which now has over $500 million in sales. There is Zoro in the U.S. – which now has $300 million in sales. And then Grainger hopes to use its U.K. acquisition to build a U.K. online only business. There is also Zoro Germany. So, one day, Grainger could have a meaningful online business in the U.S., Japan, the U.K., and Germany. These businesses compete directly with Amazon Supply. The rest of Grainger really doesn’t. Grainger sales reps always say that their largest competitors are other local or regional MRO companies. They say they rarely find themselves competing directly with Fastenal, MSC Industrial, or Amazon Supply – despite those being the competitors investors and analysts ask most about. Quan and I found in talking to people at the publicly traded MROs, that they are quite knowledgeable about each other’s business models, but actually don’t believe they compete very directly with each other or even do business in the same way. They all have different theories on which model is best. Part of the explanation for this can be that they each have different customer populations. Grainger’s success has really been on the least frequently purchased items by the biggest American companies. When it comes to frequently purchased items, smaller customers, or foreign countries – they’ve had a very mixed record. But, when it comes to large businesses, they are actually even more successful than the past record makes them seem. Sales growth looks mild in recent years due to the huge decline in sales to Grainger’s smallest customers. As we said, Grainger actually grew 10% a year since going public 40 years ago. And, it has grown sales to large businesses by more than 8% a year since the financial crisis. Earnings grow even faster than sales. So, Grainger is definitely a growth stock. In fact, it’s a growth at a reasonable price stock. As I write