Published by Bob Ciura on November 8th, 2017
The Dividend Aristocrats are a group of 51 companies in the S&P 500 Index, with 25+ consecutive years of dividend increases.
We review each of the 51 Dividend Aristocrats once per year. Next up is W.W. Grainger (GWW).
Grainger has increased its dividend for 46 years in a row. Its most recent increase was a 5% raise on April 26th.
Grainger has struggled in the past two years, due to intensifying competition. This has led to price deflation, and lower profit margins.
However, the company has a long history of growth. It has a leading position in its core markets, and is investing in new growth initiatives.
This article will discuss why long-term investors should stick with Grainger for its dividend growth.
Business Overview
Grainger is a large supplier of maintenance, operating, and repair products, or MRO for short. These are products like safety gloves, power tools, ladders, test instruments, and motors. It also offers services such as inventory management.
Grainger has 3 million business and institutional customers worldwide. The majority of customers are large U.S. businesses.
The company generates annual sales exceed $10 billion. Over half of revenue is derived from the U.S., but Grainger also has operations in Japan, the U.K., Mexico, and Germany.
Source: Analyst Meeting Presentation, page 6
Grainger operates 700+ branches and 30+ distribution centers in North America.
This is a difficult time for Grainger. Competition is heating up in the MRO supply industry. This has caused pricing deflation in the company’s core businesses.
Grainger’s adjusted earnings-per-share declined 3% in fiscal 2016.
The good news is, Grainger has actively competed on price, and in e-commerce. This has eroded profitability, but volumes are increasing, and Grainger is capturing market share.
The company’s willingness to adapt to a new environment, has helped it secure its competitive position. It has struggled to start 2017, but it is in position to return to growth over the long-term.
Growth Prospects
Grainger’s adjusted earnings-per-share declined 7% through the first three quarters of 2017. However, net sales increased 1.6% in the same period.
In the most recent quarter, earnings-per-share of $2.90 were significantly above analyst expectations, which were for earnings-per-share of $2.56.
Price deflation has weighed on margins again this year. For example, adjusted gross profit margin declined by 150 basis points last quarter.
However, the company’s pricing actions have allowed it to continue growing volumes and taking share, particularly among large U.S. business customers.
Source: Third Quarter Earnings Presentation, page 6
Pricing was down 4% last quarter, but adjusted volumes surged 8%.
The near-term outlook for Grainger is still challenging. For fiscal 2017, Grainger expects earnings-per-share of $10.65. This would be a decline of roughly 8% from earnings-per-share of $11.58 last year.
Looking further out, Grainger could return to earnings growth. Higher oil and gas prices could generate higher demand from energy-segment customers.
The company also expects pricing deflation to moderate. Deflation in U.S. large and medium business sales is expected to decline to 2% in 2018, from 5% in 2017.
At the same time, volumes are expected to grow by 6%-8% in 2018 and 2019.
Another growth catalyst is e-commerce. It has various e-commerce platforms, including MonotaRO in Japan, and Zoro in the U.S.
Source: 2017 William Blair Conference, page 12
Last quarter, Grainger’s operating segment which houses e-commerce grew by 13%. MonotaRO and Zoro both experienced expanding operating margins.
All of these catalysts are likely to help Grainger return to earnings growth over the long-term.
Competitive Advantages & Recession Performance
Grainger’s first competitive advantage is its vast distribution network. It has the ability to offer services such as next-day ground delivery, which help it retain its competitive position.
Another competitive advantage is scale. Grainger kept operating expenses flat in the U.S. last quarter, despite strong volume growth. This demonstrates leverage and supply-chain efficiency.
These competitive advantages helped Grainger stay highly profitable during the Great Recession. Earnings-per-share during the economic downturn are as follows:
- 2007 earnings-per-share of $4.94
- 2008 earnings-per-share of $6.09 (23% increase)
- 2009 earnings-per-share of $5.25 (14% decline)
- 2010 earnings-per-share of $6.81 (30% increase)
Grainger only had one year of earnings decline during the Great Recession, in-between two very strong years. The company continued to grow after 2010. This indicates a high-quality business model that can withstand recession relatively well.
Valuation & Expected Returns
Based on Grainger’s earnings-per-share guidance of $10.65 in fiscal 2017, the stock has a price-to-earnings ratio of 19.2.
According to ValueLine, the stock has held an average price-to-earnings ratio of 18.1 in the past 10 years.
Source: Value Line
Grainger is currently trading slightly above its 10-year average valuation. However, the stock could deserve an above-average multiple, because the company is likely to return to earnings growth.
ValueLine analysts expect Grainger’s earnings to grow by 5% in 2018. Annual earnings growth is expected to accelerate to 12% from 2020-2022.
A price-to-earnings ratio of 19, combined with projected 2018 earnings-per-share of $11.20, would yield a fair value estimate of approximately $212.80. As a result, the stock could still be considered slightly undervalued.
Separately, future returns will be generated from earnings growth and dividends. A potential breakdown of future returns is as follows:
- 2%-4% revenue growth
- 2%-3% share repurchases
- 2.5% dividend yield
In this projection, total returns would reach approximately 7%-10% per year. Cash returns comprise a significant portion of total returns.
This is a benefit of investing in highly profitable companies like Grainger; they can continue to buy back stock and pay dividends, even during difficult operating climates.
Final Thoughts
Grainger is a company managed for the long-term. It has encountered difficulties in recent years, but it has gone through many ups and downs in its history.
These challenges have not stopped Grainger from raising its dividend for more than 40 years. The company still has a profitable business and multiple catalysts for future growth.
The stock appears to be slightly undervalued, with a solid 2.5% dividend yield, and annual dividend increases.
