W.W. Grainger: A Look At The Math Of A Rich Valuation

| About: W.W. Grainger, (GWW)

Summary: Grainger is one of the United States' best companies, with consistently improving operations, a great reputation, and room for continued growth. This is where an investor must maintain a Graham-and-Dodd discipline, however: the valuation simply leaves absolutely no room for error. To obtain a fair return in the next 5 years, wait until a better entry point at $220.

Grainger is consistently best in class

W.W. Grainger (NYSE:GWW) is one of the best performing companies in the United States. It's reputation within its industry is outstanding amongst its employees, suppliers, customers, and even competitors. More importantly for shareholders, it has demonstrated the ability to generate returns:

  • Gross margins have improved every year since 2000
  • Dividends have increased every year for 41 years
  • ROE has nearly continuously improved from 12% in 2000 to 25% today
  • Total Shareholder Return of 236% for the past 5 years.

Grainger's great service not just a buzzword

Grainger has always been, as CEO Jim Ryan often says, about service. When I visit my local Grainger store I meet a store manager who has worked there fore 15 years and who genuinely tries to please customers. Grainger rewards this, too: he has also enjoyed nearly 20% of his salary in profit sharing, on average, a year. Grainger sells many of the same products as Home Depot, but the level of service expected and provided is incomparable.

Grainger also has moved outside of simply a supplier of parts to the inventory manager of major Fortune 500 companies--meaning they are intimately involved with their customers' operations and procurement. In many cases, it would be costly and burdensome for a company to switch from Grainger, and this helps maintain their "stickiness" with the biggest and most profitable customers.

Too expensive!

The primary concern about Grainger, however, has usually been valuation. That is especially the case now, as it recently pushed through 20x next year's earnings estimates, the first time GWW has been priced that high in the data I have available1. So should you consider the stock?

At a conference in Florida yesterday, CEO Jim Ryan said during his presentation that he expects to continue taking market share and grow at the 5%-8% they have forecast. Out of curiosity, I made a back-of-the-envelope calculation of what their valuation would be should they execute well.

Basic assumptions are:

  • Sales continue to grow at the same 7%/year path over the next 5 years
  • Gross Margins continue to improve at the same rate as the past 10 years: about 1% every year
  • SG&A/sales increases at the same rate as the past 10 years: about +0.5%/year
  • Tax Rate: 40%
  • Shares stay the same, at 71M outstanding.

This forecast is aggressive: Other than the shares outstanding, for which you could argue Grainger deserves more credit in the forecast, I think all of these assumptions are optimistic. Some analysts think Grainger can continue taking market share from smaller distributors, but it seems optimistic to assume there won't be an economic slowdown to push that growth slower, even for a year or so. Amazon Supply also hangs over Grainger's forecasts--while I don't think they will be a major threat to Grainger's sales, I think it is likely that margins become pressured more than in the past, meaning that GM improvement slows or disappears.

What do the results show?

In the above scenario, the earnings per share would grow to $16.08/share by 2017, up from $9.52 in 2012. This is an impressive 11% in earnings growth.

If you apply Grainger's historical average LTM PE, however, of about 19x, this entails a stock price of $305. Compared with the current price of $259, this makes a paltry annual return of 3.4% over 5 years.

But what about share buybacks? Grainger has reduced its shares outstanding significantly over the years, and prudent forecasts would include buying back shares. Leaving the P/E at 19x, GWW could raise annual returns to 8% from 3.4% by buying back 11M shares in those five years. At the current price, that would cost $2.5B, or roughly what GWW has spent over the previous 6 years. This is definitely plausible under the scenario.

How comfortable are you with Grainger's ability to execute?

The crux of the math, then, leads to this conclusion: if Grainger continues to perform as it has for the previous 5-10 years--expands margins, continues to gain market share, and buys back shares, you will likely earn an annual return of 8%...or roughly the cost of equity, from capital gains. Dividends will provide additional returns, averaging between 2-3%/year.

Little room for error

To me, though, as much as I respect Grainger's management and performance, this is a very difficult expectation to invest in. There are too many specific business risks with Grainger, including:

1) Grainger is unable to increase prices by 2-4% a year, as they have in the past, either due to customer resistance or competition

2) Amazon Supply (NASDAQ:AMZN), Fastenal (NASDAQ:FAST), or MSC Industrial Direct (NYSE:MSM) force Grainger into little or no gross margin expansion

3) The sequester further affects sales to the US government

4) Fastenal's vending machine proves to be a more significant innovation that Grainger currently admits

These factors cause me to stay on the sideline for now. The company is one of the best, but invest at your own risk.

1Beginning with the year 2000

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.