This month’s Dividend Growth Stock of the Month is a company that I included in the Dividend Growth “ETF” that I launched in January at Motif Investing. You can see the first-quarter performance report on that portfolio by clicking here.
W. W. Grainger (GWW), with 2016 sales of $10.1 billion, is North America’s leading broad line supplier to businesses of maintenance, repair, and operating products such as hand tools, electric motors, light bulbs, and janitorial items. Headquartered in Illinois, the company generates about 78% of its sales in the USA and another 9% in Canada. It also has operations in Europe, Asia, and Latin America.
Grainger’s stock recently experienced a 12% overnight price drop after its first-quarter earnings announcement showed misses on both revenue and earnings as well as lowered guidance going forward. At the time of this writing, the stock is barely above its 52-week low price.
Market reactions like that to short-term disappointments sometimes present buying opportunities for investors with long-term outlooks.
Let’s take a close look at Grainger’s investability.
W. W. Grainger Dividend Picture
This is a good dividend growth resume, highlighted by the 45-year streak of dividend increases and the high dividend safety grades. Six of the 10 categories are ‘in the green,” scoring Good or Excellent ratings.
Grainger’s yield, even after the recent price drop, clocks in at 2.5%, which meets the requirements of some dividend growth investors but not others.
The 45-year record of increasing dividends is outstanding; the company has been a Dividend Champion for 20 years.
And here is Safety Net Pro’s:
Last year, Grainger announced its dividend increase in early May, payable on June 1. I expect a similar schedule this year.
The only flag in the dividend resume is the declining size of dividend increases. Here are the company’s compound annual dividend growth percentages from the most recent 10-year period to last year’s increase:
As you can see, the compound annual increase is smaller for each shorter time period, falling from 15.8% per year for the past 10 years to 5.2% for the last year (2016). That is a pattern that I don’t like to see. Perhaps the trend will be broken with the upcoming dividend announcement.
W. W. Grainger’s Business Model and Company Quality
Grainger is a business-to-business distributor of products used to maintain, repair, and operate facilities. About 3 million businesses worldwide rely on Grainger for products such as safety gloves, ladders, motors, and janitorial supplies, as well as services such as inventory management and technical support.
Grainger’s customers represent a broad collection of industries, with the largest segments being manufacturing, commercial, and government.
Customers place orders online, through handheld devices, over the phone, and at local branches. Grainger sources more than 1.5 million products from more than 4800 suppliers, which it stocks at 34 distribution centers and 668 branches. Its products cover the gamut:
Warehousers and distributors such as Grainger are important players in the manufacturing and industrial infrastructure. By acting as a middleman and reseller, Grainger enables its customers to maintain optimal inventory levels of essential but often seldom-used products.
At the front end of the chain, product manufacturers prefer to sell through distributors such as Grainger.
They don’t wish to sell directly and inefficiently to end-users.
Grainger’s field is highly fragmented.
It calculates that it holds about 8% of the U.S. market, 9% in Canada, and 3% worldwide.
There is obviously room to grow both organically and via acquisitions.
Grainger is most successful in markets where it has scale positions in purchasing, supply chain, and IT, and where it serves an established customer base.
Those markets include North America, western Europe and Japan.
Grainger serves its customers through a network of highly integrated branches, distribution centers, direct sales reps, and websites.
Like most sellers these days, Grainger is developing its online selling channel, which appeals especially to smaller customers. Per the company, Grainger is currently the 11th-largest e-retailer in North America. Online orders are generally more profitable. As shown here, online sales are growing, and enhancing the channel is one of Grainger’s strategic initiatives. Online sales have been growing at twice the company’s overall growth rate.
Through all of its channels, Grainger processes about 140,000 orders per day.
S&P Capital IQ awards Grainger a Quality rating of A, which is their 2d-highest rating, labeled “High.” S&P’s credit rating for Grainger is AA-, which is a high investment-grade rating.
Morningstar awards Grainger a Wide Moat rating. That is based on the network advantages of established relationships plus cost advantages over smaller rivals. Grainger has been taking advantage of its cost advantages with sweeping price reductions. While those have hurt its numbers in the short term, their strategy is to gain market share and benefit over the long term. We will discuss this more in the next section.
W. W. Grainger’s Financials
This is a mixed financial picture, but there are explanations behind some of the items. Good or OK categories include current ROE and its trend, the projected EPS growth rate of 8% per year, and the company’s free cash flow situation.
The cash flow situation is particularly strong. That is one reason that the dividend safety scores that we saw earlier are so good. (Source of graphs is Simply Safe Dividends.)
On the other hand, earnings per share (EPS) presents a mixed picture.
The growth trend until fiscal 2016 was generally upward at a moderate rate, but last year it dropped 15%. The drop helped lead to Grainger’s decision to implement price cuts across its business.
To me, that actually indicates business strength of the sort that supports Morningstar’s Wide Moat rating: Grainger is strong enough to create pricing pressure in the market in a bid to squeeze competitors and gain market share.
That’s a long-term strategy with a predictable short-term negtive impact on financial results: Over the short term, price reductions are likely to offset gains in unit sales volume. Over the longer term, Grainger should gain market share, and year-over-year comparables will become more positive.
At its recent earnings call for the first quarter of 2017, Grainger displayed the following slide illustrating the positive impact of its price-reduction program.
I see the situation as a probable long-term positive for the company. So does Grainger:
The other weak part of Grainger’s financial picture is its large debt load at 1.3 times equity. The average CCC (Dividend Champions, Contenders, and Challengers) company has a D/E ratio of 1.1.
As you can see from the next chart, Grainger has gone from operating with almost no debt 10 years ago to a high debt load now. I don’t like that, even in an era of low interest rates. On the plus side, Grainger’s strong AA- credit rating makes the debt load less worrisome. As we will see later, Grainger has been buying back its own shares, and much of that activity is funded by debt.
W. W. Grainger’s Stock Valuation
GWW announced its 2017 Q1 results after the market closed on April 17. As we saw earlier, the company’s misses on revenue and earnings, combined with lowered short-term guidance, caused the stock’s price to take a double-digit hit.
To many dividend growth investors, that kind of market reaction (or over-reaction) to a high quality company’s short-term financial results can create a buying opportunity. Let’s take a look at Grainger’s valuation.
My 4-step process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation.
Step 1: FASTGraphs Default. The first step is to compare the stock’s current price to FASTGraphs’ basic or default estimate of its fair value.
That basic estimate is based on a reference price-to-earnings (P/E) ratio of 15. That is the long-term average P/E of the stock market as a whole.
That fair-value estimate is shown by the orange line on the following chart, while the black line shows Grainger’s actual price.
You can see that the recent price decline did not quite bring Grainger into the fair-value range when using this first method. It had been overvalued by a lot, and it is still overvalued slightly.
GWW’s current price is 12% over its fair value estimate. I calculated that by comparing GWW’s current P/E ratio of 16.8 to the reference ratio of 15. We get 16.8 / 15 = 1.12.
This method suggests a fair price of $174 per share, compared to the stock’s current price of about $195 per share.
The other valuation methods paint a different picture.
Step 2: FASTGraphs Normalized. The second valuation step is to compare GWW’s price to its own long-term average P/E ratio.
This gives us a different perspective. Grainger’s 10-year average P/E ratio has been 19.0 (see the dark blue box in the right panel), meaning that the market has tended to value it about 27% higher than the historic valuation of all the companies at 15.0.
So by using this method, Grainger looks undervalued. I calculate the degree by comparing GWW’s current P/E ratio to its 10-year average P/E ratio: 16.8 / 19.0 = 0.88, or 12% undervalued.
This method suggests a fair price of $222.
Step 3: Morningstar Star Rating. Morningstar uses a discounted cash flow (DCF) process for valuation. Their approach is comprehensive and detailed, and it is one of the most thorough that I have seen. Many investors consider DCF to be the best method of assessing stock valuations.
In a nutshell, Morningstar makes a projection of all the company’s future profits. The sum of all those profits is discounted back to the present to reflect the time value of money. The resulting net present value of all future earnings is considered to be the fair price for the stock today.
On Morningstar’s 5-star scale, GWW gets 4 stars, meaning that they think the company is undervalued. They calculate a fair value of $225, which is 15% above the current price.
Step 4: Current Yield vs. Historical Yield. Finally, we compare the stock’s current yield to its historical yield. The idea is that a stock with a higher yield than its historical average, all else equal, might be undervalued.
So I calculate the percentage that the stock’s current yield is above or below its 5-year average. I consider this to be an indirect way of calculating fair value, so I cap the spread at 20% to avoid extreme results.
According to Morningtar, Grainger’s 5-year average yield has been 1.8%. The current yield of 2.5% is 39% over that number.
Applying the 20% cap, I get a fair price of $234.
So my overall assessment is that Grainger is priced 9% under fair value at the current time. I consider anything within 10% of fair value to be fairly valued, so I would label the current price as Fair.
Obviously, Grainger’s stock is on the border of being undervalued, and many investors would consider it to be undervalued now.
For an outside comparison, S&P Capital IQ calculates a fair value of $211, with a 12-month price target of $220.
Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility, because they present fewer occasions to react, as an investor, to price volatility.
Grainger’s 5-year beta of 0.8 indicates that the stock has been 80% as volatile than the market. I consider this to be a minor plus factor.
The analysts’ recommendations come from data collected by S&P Capital IQ.
Their most recent report shows the opinions of 22 analysts.
Their average recommendation is 2.9 on a 5-point scale, where 3.0 = Hold.
In other words, their average recommendation is just a little under Hold.
This is a neutral factor.
Grainger has been steadily reducing its share count for years. The number of outstanding shares has declined about 34% over the past 11 years.
That’s good, because each share remaining represents a larger piece of the total ownership pie. The company is in the midst of a $3 Billion share repurchase program approved by the board.
Not only that, future dividend distributions are spread out over fewer shares. That makes it easier for the company to increase its dividend each year. So Grainger’s persistent share reduction is a positive factor for shareholders. As we saw earlier, the share-reduction program is partially responsible for Grainger’s debt load.
Here are W. W. Grainger’s positives:
• Solid dividend, at 2.5% yield, that has been raised 45 straight years and is supported by low payout ratios and strong dividend safety.
• High quality company with a solid business model, wide moat, and excellent credit rating.
• Plenty of room for growth in a fragmented industry.
• Intermediate-term strategy based upon lower price for customers and gaining market share.
• Decent financials, with recent hits to revenue and earnings growth as a result of low-pricing strategy. Strong cash flows.
• Steady decline for more than a decade in number of shares outstanding.
• Stock is 9% undervalued.
And here are the negatives:
• Declining trend of dividend increase percentages over the past 10 years.
• Short-term decline in revenue and profits as a result of new pricing programs.
• High debt at 1.3 times equity.
As always, this is not a recommendation to buy, hold, or sell W. W. Grainger. Perform your own due diligence. And always be sure to match your stock picks to your financial goals.
— Dave Van Knapp
Disclosure: I own GWW through my ownership of the Motif Dividend Growth “ETF” that was launched on January 1, 2017. For more information about that portfolio, please click here.
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