Geoff Gannon May 10, 2017

Grainger (GWW): Lower Prices, Higher Volumes

The Original Pick

I picked Grainger (GWW) for a newsletter I used to write. The pick was made in April of 2016. Grainger traded at $229 a share when I picked it. Today, the stock trades for $188 a share. That’s one reason to look at the stock now.

Reason #1 for considering GWW:

I picked the stock when the price was 22% higher than it is now.

There’s another. Over the last twelve months, here’s how Grainger’s stock performed versus the shares of is two closest peers.

  • Grainger: (16%)
  • Fastenal (FAST): (2%)
  • MSC Industrial (MSM): +19%

I picked MSC Industrial for the newsletter too. Last year, one of the questions I had to ask myself was which stock I liked better: Grainger or MSC Industrial? Back then, it was a tough question. Today, it should be a lot easier to answer.

Reason #2 for considering GWW:

Grainger is now 14% cheaper relative to Fastenal and 29% cheaper relative to MSC Industrial than it was a year ago.

So, is Mr. Market right? Does Grainger really deserve a downward re-valuation of 14% versus Fastenal and 29% versus MSC?

Before we can answer that question, we need to know why I picked Grainger in the first place.

 

Reason for Picking Grainger in the First Place

I thought Grainger was a Growth At a Reasonable Price (GARP) stock. Here’s what I wrote a year ago:

“…Grainger can grow sales by at least 5% a year. Profit growth should be more than 5% and less than 8% a year. At that pace of growth in sales, Grainger would return two-thirds of its earnings each year. So, if you bought Grainger at around a P/E of 16 or 17, the company would pay out 4% of your purchase price each year in buybacks and dividends while companywide profit would grow 5% to 8% a year. Your return in the stock would be in the 9% to 12% a year range. This is far better than you’ll get long-term in the S&P 500. So, Grainger is a ‘growth at a reasonable price’ stock even when priced as high as 17 times earnings and when growing sales as slowly as 5% a year. The combination of margin expansion and share buybacks mean the company could grow sales as slow as 5% a year and yet grow earnings per share at close to 10% a year. The ‘growth’ in ‘growth at a reasonable price’ that an investor should care about is only earnings growth and only in per share terms. It doesn’t matter whether companywide sales grow 10% a year or 5% a year if EPS growth is 10% a year in both scenarios, the stock is no more or less valuable due to the difference in sales growth. Companywide sales growth doesn’t benefit shareholders. Only growth in earnings per share makes any difference to an investor. So, by that measure, a stock with a P/E of 15 or 20 and a growth rate of 8% or 10% a year is actually a reasonably priced growth stock. Grainger fits that description.”

Let’s break down my year-old argument into its 3 key assumptions:

  1. Grainger will grow sales at least 5% a year
  2. Grainger will grow net income between 5% and 8% a year
  3. Grainger will pay out two-third of its earnings in dividends and buybacks

These are the 3 assumptions that need defending if I’m to prove my case for Grainger. But, before we hear my defense of Grainger, let’s listen to the bear case.

 

The April 18th Earnings Release: Why Grainger’s Stock Dropped

Most of the decline in Grainger’s stock price over the last year took place in just one day. Grainger shares closed trading on April 17th, 2017 at $223 a share (just 3% below where I’d picked the stock a year before). The company then reported its quarterly results. Shares re-opened the following day at $200 a share. So, you had a decline of 10% on a single earnings report.

How bad was that earnings report?

Let’s start with the actual quarterly results:

“…sales of $2.5 billion increased 1 percent versus $2.5 billion in the first quarter of 2016….earnings for the quarter of $175 million were down 6 percent versus $187 million in 2016.  Earnings per share of $2.93 declined 2 percent versus $2.98 in 2016.”

So:

  • Sales rose 1%
  • Earnings per share fell 2%
  • And net income fell 6%

Obviously, the company bought back a lot of stock during the year. This, however, is only part of the problem. The bigger problem for the stock price was the change in guidance:

“…(Grainger) now expects sales growth of 1 to 4 percent and earnings per share of $10.00 to $11.30, which incorporates the effect of the pricing acceleration…The company’s previous 2017 guidance, communicated on January 25, 2017, was sales growth of 2 to 6 percent and earnings per share of $11.30 to $12.40.”

So, Grainger lowered its projected sales growth from a 2% to 6% range down to a 1% to 4% range. It also added a new low-end to its EPS guidance. The company is now guiding for as low as $10 a share in earnings. Let’s take Grainger’s new sales growth and new EPS guidance and compare it to my year-old assumptions.

 

Sales Growth

My year-old sales growth assumption:

Grainger will grow sales by at least 5% a year.

Versus the company’s present-day sales growth guidance:

Grainger will grow sales by 1% to 4% in 2017.

Obviously, in 2017, Grainger isn’t going to grow its sales as fast as I expected. Actually, it will grow unit sales almost as fast as I expected (for the quarter, volume growth was 5%). It’s dollar sales that will come in below what I expected. More on that in a moment. But, first…

We’ve discussed the “growth” part of my year-old “Growth At a Reasonable Price” argument in favor of buying Grainger stock. Now, we need to talk about that “reasonable” price part.

 

Earnings Per Share

My year-old earnings per share assumption:

“The company has 63 million shares outstanding. So, that puts ‘normal’ earnings per share – without any leverage – at $14.76.”

Versus the company’s present-day earnings per share guidance:

Grainger will earn between $10 and $11.30 a share in 2017.

That puts the top-end of Grainger’s EPS guidance range 23% below my estimate of normal earnings and the low-end of Grainger’s range ($10 a share) at 32% below my estimate of normal earnings.

 

The “Right” P/E: What Me and Mr. Market Agree On

We should pause here and note something. When I picked Grainger in April of 2016, I pegged normal earnings per share at $14.76 a share and appraised the stock at an intrinsic value of $268.94. That means I assigned Grainger a P/E of 18.

Now, let’s look at where Mr. Market has Grainger priced and where the company is guiding for 2017 earnings. Grainger’s share price is now $193 a share. The company has provided guidance of $10 to $11.30 for 2017 EPS. That translates into a P/E of 17 to 19. So, the market is putting a P/E of 17 to 19 on Grainger’s current earnings and I’m putting a P/E of 18 on Grainger’s “normal” earnings.

There is no disagreement here about valuation. The only disagreement between Mr. Market and me is whether Grainger should trade at 18 times an EPS of about $10 or 18 times an EPS of about $15. Mr. Market says earnings of $10 a share are normal. I say earnings of $15 a share are normal. If Mr. Market is right, the stock should be priced around $180 a share. If I’m right, the stock should be priced around $270 a share. That’s the crux of the argument.

So, let’s focus on that one simple question:

Is Grainger’s normal earning power now $10 a share or $15 a share?

There are a few checks we can perform. We can look at past history. We can look at the company’s predictions for the future. And we can look at my predictions for the future. Let’s start with past history.

This is what Grainger reported in EPS over each of the last 5 years:

 

2012: $9.52

2013: $11.13

2014: $11.45

2015: $11.58

2016: $9.87

 

So, we have a range of $9.52 (in 2012) to $11.58 (in 2015). The median is $11.13 (2013) and the mean is $10.71. Till last year, the trend was – as it always had been at Grainger – one of consistently higher EPS year-after-year. Normally, Mr. Market would use peak earnings for a constant EPS grower like Grainger.

So, normally the market would treat $11.58 as the “normal” EPS for Grainger. If you slap a P/E of 18 on an EPS of $11.58, you get a stock price of $208 a share. Grainger trades at $193 a share. So, the market probably isn’t using Grainger’s prior peak earnings of $11.58 a share.

Why not?

Probably because of the company’s own guidance. But, before we get to Grainger’s own predictions about the future – we need to make one adjustment.

The figures I just gave you were earnings per share figures – not net income figures. Here is the trend in Grainger’s number of shares outstanding:

 

2012: 71.2 million

2013: 70.6 million

2014: 69.6 million

2015: 65.8 million

2016: 60.8 million

 

Now: 59.2 million

Grainger is what Charlie Munger calls a “cannibal”. It’s a stock that gobbles up its own shares year-after-year.

If I adjusted Grainger’s old EPS figures to reflect what the company would earn if it reported the same corporate net income it had in that year but instead had the number of shares outstanding (59.2 million) it does now, the totals would look a little different.

Here are Grainger’s past 5 years of earnings adjusted for the company’s current share count:

2012: $11.45

2013: $13.27

2014: $13.38

2015: $12.87

2016: $10.14

At the risk of overkill, I want to pause now and present a table. The left-hand column shows Grainger’s EPS as originally reported for the years 2012-2016. The right-hand column shows Grainger’s EPS for the years 2012-2016 adjusted to reflect today’s share count:

  As Originally Reported Adjusted for Today’s Share Count
2012 $9.52 $11.45
2013 $11.13 $13.27
2014 $11.45 $13.38
2015 $11.58 $12.87
2016 $9.87 $10.14

 

Now, I hope we can all agree that only the right-hand column has any relevance. Grainger may have had 71 million shares outstanding in 2012. But, it’s not 2012 anymore. It’s 2017. And Grainger only has 59 million shares outstanding in 2017. So, any historical figure that is based on an outdated share count won’t help us predict the future.

What will help us predict the future?

 

The Consistency That Had Been, The Uncertainty That Now Is

Grainger grew EPS year-over-year in 21 of the 24 years leading up to 2016. On top of this, Grainger never recorded back-to-back EPS declines. The company’s record over the last quarter-century is about as consistent an EPS growth record as you’re going to find. Almost without exception, Mr. Market tends to use one of 3 numbers when valuing a consistent EPS grower:

  1. The most recent year’s EPS
  2. The company’s guidance for next year’s EPS, or
  3. The stock’s prior peak EPS

In probably 9 out of 10 years, it doesn’t matter which figure Mr. Market picks as “normal” for a company like Grainger. Such a consistent grower only registers a single EPS decline about once a decade – and usually right as the economy heads into a recession. So, a company like Grainger is almost always at a point where it is currently reporting record EPS for last year and simultaneously guiding for a (new) record level of EPS next year.

However, Grainger’s net income peaked in 2014 and its EPS peaked in 2015. Since then, the company’s net income and EPS has been falling. Grainger has also been lowering its guidance for future EPS.

 

Simplifying Assumption: Grainger Will Earn $13.38 a Share Eventually

I’m going to stop here and make a statement that might be counter-intuitive, but isn’t really up for debate. I view Grainger as a GARP (growth at a reasonable price) stock. The company’s highest ever net income was recorded in 2014. Taking Grainger’s 2014 net income and dividing that figure by today’s share count gives you a peak EPS of $13.38. If I think Grainger is still a growth stock, I think it’ll surpass that prior peak. Therefore, let’s simplify this discussion. I’m going to assume Grainger’s “normal” earning power is no less than $13.38 a share, because either:

  1. Grainger will earn more than $13.38 a share in the future, or
  2. Grainger isn’t a growth stock anymore

If Grainger isn’t a growth stock anymore, I’m not interested in buying it. And, if Grainger is a growth stock, it’ll earn more than $13.38 a share in a normal, future year.

Therefore, let’s just assume Grainger will – if it’s still a growth stock – earn at least $13.38 a share in a normal year. And then, let’s address the one key question left:

Is Grainger still a growth stock?

Grainger has given EPS guidance of $10 to $11.30 a share in 2017. I’m a long-term investor. So, I don’t care what Grainger is going to earn in 2017. I want to know what Grainger is going to earn in 2022. Grainger’s management team doesn’t give guidance quite that far out. But, it’s come close.

In 2015, Grainger’s CFO said this about growth:

“And as we look forward five years…what should our growth be and what do you have to believe to think that it can grow organically (at) high single digits, so 6% to 10%?

You need to believe that the share gains with our larger customers will ramp back up like we’ve been seeing the last five years…That the market will grow 2% to 3% as it’s been growing for some time except this year.

And that price — well, we are kind of weighting it down probably heavily by our current experience, but — because historically it has been 1% to 2%, we are saying zero to 1% growth each year over the next five years. And that is how we get to the 6% to 10%.”

  • Ron Jardin, CFO of Grainger (May 2015)

Let’s break down the 3 key drivers Jardin said Grainger needs to grow over the next 5 years:

  1. Share gains with the company’s largest customers
  2. The overall market growing 2% to 3% a year
  3. Price growing 0% to 1%

Grainger’s growth targets are above the growth I projected for the stock. So, we can take the low end of each of those ranges and ask:

  1. Will Grainger still grow its share with the company’s largest customers?
  2. Will the overall market still grow 2% a year?
  3. Will prices stay stable in nominal terms?

The answer to question #1 is yes. Nothing that happened recently will threaten Grainger’s market share with its existing big, corporate clients.

Grainger’s earnings declined because of across the board price cuts it made combined with greater online price transparency. There are real risks to doing what Grainger just did. But none of those risks involve Grainger’s volume share with large customers.

The changes Grainger made to the level of its prices and how those prices are shown make 3 things more likely:

  1. Lower, more competitive prices in the future
  2. Greater weighting toward the kind of smaller business customers that consumer focused retailers like Amazon can also compete for
  3. Greater weighting toward smaller, less frequent orders for “one-off” items

This all sounds very, very bad. And it might be. But, we need to stop and talk a little about the truly weird way Grainger has grown over the last 10 years or more:

Grainger hasn’t really added new customers for at least a decade.

That’s not an exaggeration. I think it’s possible the “Grainger” brand in the U.S. almost never wins truly new customers. Management has said things that back up this belief:

“The reality is we have not been able to acquire a customer into the Grainger brand for years and we are now going to start acquiring customers for the Grainger brand starting in the third quarter. And so that’s a big shift for us and one that we’re really excited about and we’re confident we are going to get the results.”

  • Donald Macpherson, CEO of Grainger (April 2017)

In fact, I think Grainger actually has tended to have fewer customers over time. Price increases that Grainger passes on to its customers are very small. Over the last 10 years, Grainger’s catalog has increased in price by something like 0% to 2% a year. So, almost all of Grainger’s earnings have come from volume gains rather than price gains. Also, like I said, Grainger hasn’t added new customers over time. Now, it also tends not to lose its big customers. But, still, we’re talking about a company with almost no:

  1. Price growth
  2. Customer growth

So, almost all of Grainger’s growth comes from actual unit volume growth with existing, large customers. The real amount of stuff that a big corporate client buys from Grainger tends to go up, up, up over time.

Actually, Grainger has had one other source of growth:

Grainger Owns Two Very Fast Growing E-Commerce Businesses

Grainger owns 53% of MonotaRO. MonotaRO is a high-flying Japanese stock. It’s incredibly expensive. Grainger also owns all of Zoro. Zoro is basically just the MonotaRO business model transplanted to the U.S. Both MonotaRO and Zoro tend to grow sales at something like 20% to 25% a year. They are online only businesses.

So, those are the two sources of Grainger’s growth:

  1. Volume gains with existing large, corporate customers
  2. E-commerce websites that are still in their fast growth phase

Everything else at Grainger has shrunk over time. The Grainger brand in the U.S. used to serve a lot of small and medium sized customers. It lost those customers over the last decade.

So, the three questions we need to focus on are:

  1. Will Grainger’s online only businesses – Zoro and MonotaRO – keep growing?
  2. Will Grainger keep growing its volumes with existing large, corporate customers
  3. And: Will Grainger’s prices with existing large, corporate customers stay flat?

Let’s answer those questions one by one.

Question #1 is the least important. Grainger’s U.S. business – which is both online and offline – made up 80% of the appraisal value I gave the stock in 2016. I might have been overly conservative in my valuation of the fast-growing online only businesses, MonotaRO and Zoro. However, there’s just no way that Grainger’s U.S. business could ever count for less than 50% to 75% of the stock’s total value. So, we should really focus all our discussion on growth in the Grainger branded business in the United States.

So, as far as the online businesses are concerned – I think it’s enough just to quote what Grainger said about them in its most recent earnings release:

“…23 percent sales growth for the single channel online businesses. Operating earnings for the Other Businesses were $32 million in the 2017 first quarter versus $22 million in the prior year. This performance included strong results from Zoro in the United States and MonotaRO in Japan.”

So, MonotaRO and Zoro are doing fine. Let’s deal with the only two questions left:

  1. Will Grainger keep growing its volumes with existing large, corporate customers
  2. And: Will Grainger’s prices with existing, large corporate customers stay flat?

The first of those questions is easier to answer:

“Sales for the U.S. segment were down 1 percent versus the 2016 first quarter. The decrease was driven by a 4 percentage point decline in price and a 1 percentage point decline from lower sales of seasonal products, partially offset by a 4 percentage point increase from volume growth.”

Putting aside the seasonal products, we have a 4% price decline and 4% volume growth. Last fall, Grainger announced its plans to lower prices and especially make its online prices clearer and more competitive. So, both customers and competitors knew this was coming. Grainger has now announced it will fully implement these price cuts faster than planned:

“…the first quarter clearly fell short of our expectations, driven primarily by the stronger than anticipated customer response to our U.S. strategic pricing actions, with a greater volume of products sold at more competitive prices…Based on the positive customer response thus far, we are pulling forward the remaining pricing actions originally scheduled for 2018 into the third quarter of this year. This decision requires a significant change to our earnings per share guidance for the year but should enable us to accelerate growth with existing customers and attract new customers sooner than planned.”

Basically, Grainger’s customers turned out to be more “price-elastic” than planned. Grainger simultaneously raised the prices of some of its Stock Keeping Units (SKUs) and lowered the prices of other SKUs. On SKUs where the price was lowered, volume increased more than expected. And then on SKUs where the price was raised, volume decreased more than expected. Grainger had price declines of about 4% and volume gains of about 4% year-over-year. However, it’s accelerating the pace it was making these changes at. So, they are looking more for about a 6% price decline over 2017 as a whole.

That’s a huge change. It’s also a complex change. I think Grainger already implemented price changes on about 450,000 SKUs. The company has over 1.4 million SKUs. However, it only keeps about 500,00 SKUs in inventory, because most SKUs are very slow moving.

Grainger’s profits come mostly from its large customer accounts. So, the pricing of individual SKUs isn’t something the company really needs to target from a source of profit perspective. For example, it’s fine if Grainger gives its corporate clients especially competitive prices on slow moving SKUs and then less competitive prices on fast moving SKUs. Grainger only needs to make money on the entire customer relationship.

For these reasons, I think it’s too complicated to answer the question:

Will Grainger’s prices with existing large, corporate customers stay flat?

And that’s the key question. You need to be able to answer that question in the affirmative if you’re going to buy Grainger shares.

We know Grainger can grow volume with these customers. And higher volume leads to lower cost of goods sold on a unit basis. However, Grainger is essentially implementing a 6% price cut this year. That will immediately lower gross margins. The question is whether Grainger will ever return to its previous operating margins.

Right now, I don’t know the answer to that question. I’ll watch the company closely. Grainger should report continued bad results throughout 2017. So, the stock price might decline further. And, as we all know, Warren Buffett has said:

“The best thing that happens to us is when a great company gets into temporary trouble…we want to buy them when they’re on the operating table.”

Grainger is definitely on the operating table now. And, over the last 25 years, Grainger had definitely been a great company. But, is this trouble temporary?

I’ll be watching the business closely in 2017 to find out.

The key question is whether – starting in 2018 – Grainger will be able to keep the average selling price of its SKUs flat in nominal terms. If Grainger can do that, it will be a great company and a great compounder once again.

If it can’t, I’ll permanently eliminate Grainger from consideration as a long-term investment.

 

Verdict

  • Geoff will NOT buy shares of Grainger at this time
  • Geoff WILL add Grainger to his watchlist at a price of $187.84
  • Grainger move to #2 on Geoff’s new idea pipeline behind Howden Joinery
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