Seeking Alpha
Profile| Send Message| ()  

Company Description (from recent 10-K)

W.W. Grainger, Inc. (GWW) is a is a broad-line distributor of maintenance, repair and operating supplies and other related products and services used by businesses and institutions primarily in the United States and Canada, with an expanding presence in Asia and Latin America.

W.W. Grainger is a dividend aristocrat, having raised its dividend for 40 consecutive years.

A 10-year summary of Sales, Earnings Before Interest and Tax (EBIT), Earnings per share (EPS), yearly high and low stock price, corresponding high and low P/E (calculated by dividing the high and low price by the EPS for the year), and average P/E (average of high and low P/E) is shown below. Prices are adjusted for stock splits.

Key 10-year data for W.W. Grainger

Year

Sales (in Millions)

EBIT (in Millions)

EPS

High Price

Low Price

High P/E

Low P/E

Average P/E

2011

8080

1050

9.07

190

130

20.9

14.3

17.6

2010

7180

854

6.93

139

98

20.1

14.1

17.1

2009

6220

707

5.62

100

61

17.8

10.9

14.3

2008

6850

773

5.97

94

65

15.7

10.9

13.3

2007

6420

682

4.91

99

69

20.2

14.1

17.1

2006

5880

603

4.24

80

61

18.9

14.4

16.6

2005

5530

533

3.78

75

53

19.8

14.0

16.9

2004

5050

445

3.13

67

45

21.4

14.4

17.9

2003

4670

281

2.46

53

43

21.5

17.5

19.5

2002

4640

298

2.5

59

41

23.6

16.4

20.0

From these data, we can plot Sales, EBIT, and EPS versus Year, as shown in the chart below.

Sales (in Millions), EBIT (in Millions), and EPS versus Year for W.W. Grainger, 2002-2011

As evident from the chart above, GWW has demonstrated quite predictable sales and earnings over the past 10 years, allowing us to predict EPS in the near future, say in five years (i.e. Year 2016), using the linear regression equation for EPS = 0.6673 (2016) - 1334.1 = 11.1768.

A conservative average P/E estimate for the stock can be obtained as follows:

Signature P/E: A well established stock has a signature P/E, an average P/E it commands in the market based on its business. We calculate this by averaging the Average P/E over the past 10 years, excluding any outliers (data points that fall significantly beyond the other data points). There are no significant outliers, so we average the Average P/Es from the past 10 years to arrive at a signature P/E of 17.

High P/E estimate: a conservative high P/E estimate can be calculated by averaging the five lowest High P/Es of the 10 High P/Es from the past 10 years. Averaging the 5 lowest High P/Es from the past 10 years gives 18.5.

Low P/E estimate: a conservative low P/E estimate can be calculated by averaging the five lowest Low P/Es of the 10 High P/Es from the past 10 years. Averaging the 5 lowest Low P/Es from the past 10 years gives 12.8.

Average P/E estimate: this takes the average of the High P/E estimate and the Low P/E estimate, as calculated above, to give a conservative estimate of an average P/E for the stock we can expect. Averaging 18.5 and 12.8 gives us 15.63.

Target Price

Multiplying our EPS projection for 5 years hence by the average P/E estimate gives us a projected average price for the stock: $11.1768 * 15.63 = $174.65, which represents an annual stock price return of -3.5% from the current price = $201. When we add in the 1.3% dividend yield, the total return expected is -2.2%, which means an investment in GWW today is expected to lose value in 5 years, a bearish signal.

Given a beta = 0.92 for GWW, a risk-free rate = 2% (using the yield on 10-year Treasury bond as a benchmark), and estimated risk premium of about 5% for the general stock market, we have a discount rate = 2% + 0.92*(5%) = 6.6%. Applying this discount rate of 6.6%, our projected price of $174.65 in 5 years translates to a target price = $127 in today's dollars, which is 37% below the current price of $201 for the stock, suggesting the stock is overvalued right now. For a good margin of safety, investors are well advised to buy only if the current price is at least 20% below the target price, which means a buy price of $101.

Market Expectation

What is the market's expectation of GWW's growth rate given its current market price = $201? Since stock price = dividend * (1 + growth rate) / (discount rate - growth rate), we have growth rate = ((stock price) * (discount rate) - dividend) / (stock price + dividend). Plugging in stock price = $201, dividend rate = $2.64, and discount rate = 6.6%, we get growth rate = 5.2%. This seems slightly reasonable, given that GWW has grown its revenue by 6.6%, earnings by 11%, and dividend by 18% annually over the past 5 years. Growth is supposed to slow down as a company matures, and the market appears to have priced that in.

Current P/E Compared with Signature P/E

We should also determine how the stock's current P/E compares with its signature P/E, since established stocks tend to revert back to their respective signature P/Es over the long term. The current EPS = 9.09, giving us a current P/E = 22. This is about 130% of the stock's signature P/E of 17, suggesting the stock is overvalued right now. To provide some margin for error, we should look to buy when the current P/E is 80% or less of the stock's signature P/E, which means a buy price around $124.

W.W. Grainger's P/E Compared with Competitors' P/Es

It is helpful also to compare W.W. Grainger's valuations with those of its competitors and peers in the industrial equipment industry. Current P/E and Forward P/E are tabulated below for the company and its competitors/peers.

Stock

Current P/E

Forward P/E

W.W. Grainger (GWW)

22.31

16.83

MSC Industrial Direct Co. (MSM)

21.72

17.01

Wesco International (WCC)

16.75

12.26

Anixter International (AXE)

12.37

9.93

Fastenal (FAST)

39.64

27.56

Applied Industrial Technologies (AIT)

17.25

15.15

Mean

21.67

16.46

Median

19.49

15.99

Compared to its peers, W.W. Grainger appears slightly overvalued based on both current and forward P/Es. Fastenal appears to significantly overvalued, while Wesco, Anixter, and Applied Industrial Technologies appear to be undervalued on both measures.

Risk Index

Lastly, we calculate the Risk Index, calculated as (Current Price - Forecast Low Price)/ (Potential High Price - Forecast Low Price) to give an estimate of the risk: reward ratio. Risk index less than 20% is desired, which gives us +200% potential returns for every risk of 50% loss we assume.

The Forecast Low Price is calculated by multiplying the Low P/E estimate by the Forecast Low EPS, to give a conservative estimate of low price for the stock in 5 years, assuming zero EPS growth and low valuation. Forecast Low EPS is estimated by averaging the EPS over the past 5 years. For growth stocks with predictable earnings growth, EPS in 5 years should not be any lower than this conservative estimate. For GWW, the forecast low EPS is equal to 6.5, so the Forecast Low Price = 12.8 * 6.5 = $83.14.

The Potential High Price is calculated by multiplying the High P/E estimate by the projected EPS in 5 years, giving us a price target in 5 years should the stock command a high P/E. For GWW, this equals 18.5 * 11.1768 = $206.34.

Thus, the Risk Index = ($201 - $83.14) / ($206.34 - $83.14) = 96%. Since this significantly exceeds 20%, the stock has an unfavorable reward to risk ratio at the current price. A pullback to $108 would give a risk index less than 20%.

Conclusion

W.W. Grainger, Inc., currently selling around $201, has a target price = $127, suggesting the stock is significantly overvalued. Additionally, the stock sells at a 30% premium to its historic P/E, it is relatively overvalued compared to its peers, and downside risk significantly outweighs upside potential. While Grainger is a great company with a stellar track record, its stock price has become too high right now. As a cyclical stock, it is bound for a correction in the next recession. Therefore, I rate the stock a SELL at the current price. A pullback to around $101 would provide conservative investors adequate margin of safety to buy as a long term investment.

Disclaimer: Use this information as a starting point for your own due diligence, before buying or selling any stock. By recommending a sell, I advise taking profits if you own this stock and have long term gains. Shorting the stock, however, should be reserved for the rare investor with prodigious amount of capital and a strong stomach, because the stock has strong price momentum, which can propel the stock price higher still for another 6 months up to a year.

Source: W.W. Grainger: Overvalued