W.W. Grainger: Counter-Cyclical Cash Flow And 44 Straight Years Of Dividend Growth

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

Summary

GWW has increased its dividend for 44 years and has plenty of opportunities for long term growth.

The company's business model results in higher free cash flow generation during periods of macroeconomic weakness, adding to the safety of its dividend payment.

Weak industrial activity has caused GWW's stock to sell off - is it now an attractive investment opportunity?

W.W. Grainger W.W. Grainger (NYSE:GWW) is a time-tested business that has rewarded investors with 44 consecutive years of dividend increases. Like many other industrial companies, weak energy markets, sluggish growth in China, and foreign currency headwinds are challenging GWW's current business trends.

As a result, the stock's dividend yield sits at 2.5%, which is well above its five-year average dividend yield of 1.5%. With a sturdy business model, healthy free cash flow generation, and decent long-term growth potential, GWW is a dividend growth stock we are watching for our Top 20 Dividend Stocks portfolio.

Business Overview

GWW was founded in 1927 and is a leading distributor of maintenance, repair, and operating (MRO) products that include motors, lab supplies, power transmission, test instruments, outdoor equipment, safety products, power tools, and janitorial supplies. More than 4,500 manufacturers supply GWW with 1.4 million products made available to customers through GWW's branches and distribution centers. The average customer invoice for GWW's products is about $250, and customers place orders over the phone, at local branches, online (36% of sales), and using mobile devices.

The company has over 1.4 million customers in the U.S. (78% of sales) and meaningful operations also in Canada (10%), Japan, and Western Europe.

Its customers represent a broad collection of categories including heavy manufacturing (18% of sales), commercial construction (14%), government (13%), contractors (11%), light manufacturing (11%), retail/wholesale (6%), transportation (6%), natural resources (5%), and more.

Business Analysis

GWW operates in extremely large, fragmented markets. According to a company presentation, GWW pegs the North American MRO market at $150 billion and the worldwide market at $545 billion. As seen below, the U.S. MRO market has also steadily grown in value over the last three decades.

GWW - U.S. MRO Market

Source: GWW Investor Presentation

As we mentioned, the MRO market is very fragmented. GWW provided the following image in its 2015 Fact Book. It shows that GWW has the largest market share in North America at just 6%, and the other 10 largest distributors collectively hold about 26% market share.

Click to enlarge

Source: GWW Fact Books

Understand why the MRO market is so fragmented is the key to understanding GWW's competitive advantages. GWW mostly serves large customers, and these businesses require a wide range of products that they need delivered quickly and cost effectively.

With the largest network of distribution centers and store branches (over 680) in the country, GWW is strategically positioned with localized inventory that is close to its most important customers. Being in close proximity to customers helps GWW deliver products to them very quickly, offer a high quality of service, and keep costs low. Competitors would need to acquire properties in the same service area to compete with GWW, but they wouldn't have the established book of business to cover all of their costs. The mature state of the MRO market makes it very difficult for new players to crack into a geography already covered by a capable distributor, somewhat limiting competition.

GWW's scale and inventory assortment are also advantages, especially in the large customer market. As the largest player in North America, GWW has somewhat better purchasing power than local or regional distributors. This allows it to offer very competitive pricing for its products, which are generally undifferentiated from one distributor to the next.

Importantly, GWW's size also enables it to afford an extremely broad selection of merchandise, making it a one-stop shop for large accounts that are constantly looking to save money by consolidating suppliers. GWW's U.S. catalog offering has grown more than seven-fold from 82,000 SKUs in 2005 to more than 592,000 SKUs in the 2014 edition. Impressively, the time a product is in stock has remained at nearly 100% even while increasing the product line substantially. With thousands of suppliers, this is no small feat. Grainger.com in the U.S. also offers access to 1.5 million SKUs.

On the topic of e-commerce, many investors are surprised when they learn that GWW was recognized as the 13thlargest e-retailer in North America by Internet Retailer. It started the industry's first e-commerce operations in 1996, and 36% of its sales last year were from this higher-margin channel (online orders require less data entry work, are primarily shipped from distribution centers to bypass the branch network, and have a higher average order size).

By investing significantly in technology, GWW is better positioned than many other distributors as more sales are made online and through multiple channels. E-commerce sales were only 15% of GWW's total revenue in 2009 and are expected to reach over 50% of total sales longer term.

Technology investments also help strengthen GWW's supply chain and customer service. More than 1,200 of GWW's employees are on-site at customer locations providing services such as inventory management to help them lower their costs and automate inventory orders from GWW when their supplies get low. This creates switching costs and builds up customer loyalty.

Going forward, GWW's strategy is to increase its presence with small and mid-sized businesses, which together account for more than 65% of the market. GWW has done very well serving large, complex customers, but its presence with smaller customers has been more limited.

The business seems to have the products, distribution, and e-commerce capabilities to more effectively serve these customers, but it needs to execute. If GWW is successful and the macro environment cooperates, management expects the business to report at least mid-single digit organic sales growth and consistent operating margin expansion each year, driven by operating leverage and continuous productivity improvements.

Key Risks

GWW's business is sensitive to the industrial economy, which has really been struggling. From low oil prices to slower growth in China to the strong U.S. dollar, numerous headwinds are impacting ordering trends and resulting in modest pricing pressure at GWW's customers. When growth is low, price competition can become fiercer between distributors as they look to protect market share and take out costs.

Longer-term, we think GWW's greater breadth of products, strong reputation, gradually expanding distribution network, and future acquisitions should help it continue growing. The overall health of the economy will dictate the pace and timing of growth, but GWW's large markets seem to offer plenty of opportunities.

Regarding competitive threats, Amazon (NASDAQ:AMZN) should be mentioned given the increasing importance of online sales in the industry. GWW noted during a recent conference call that Amazon has been in its business for about 15 years. Management sees Amazon mostly in its small customer business, which represents a much lower proportion of GWW's overall sales. For now, large customers' needs are generally more complex than what Amazon or other pure-play e-commerce players can provide, but it's something worth monitoring.

Beyond Amazon, other non-traditional players that have distribution and a broad selection of inventory are stores like Home Depot and Lowe's. However, we are not aware of any threats from that front today. Regardless, the large, fragmented nature of GWW's markets seems to mitigate many of these competitive risks. Perhaps the bigger risk is whether or not GWW can get profitable growth going with small and mid-sized customers, which it has historically been less effective at targeting.

Dividend Analysis

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Dividend Safety Score

Our Safety Score answers the question, "Is the current dividend payment safe?" We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

GWW's dividend is literally one of the most reliable payments you can find. The company's dividend Safety Score is an outstanding 100. Let's learn why.

Over the last four quarters, GWW's dividend has consumed 40% of its earnings and 50% of its free cash flow. As seen below, the company's payout ratios have increased slightly over the last decade but have remained fairly stable. This means that GWW's dividend growth has largely been fueled by earnings growth, a healthy situation. Payout ratios below 50% also provide plenty of cushion and room for future dividend growth.

GWW EPS Payout Ratio

GWW FCF Payout Ratio

Source: Simply Safe Dividends

As we mentioned in our introduction, GWW's business is sensitive to the broader economy. However, many MRO products are "mission-critical" and needed by businesses regardless of how the economy is doing. If a valuable piece of equipment breaks down, it needs to be fixed. As seen below, GWW's sales fell by 9% during fiscal year 2009, and the company's earnings contracted by just 6%. Not bad for an industrial business! GWW's stock also outperformed the S&P 500 by 29% in 2008.

GWW Sales Growth

It's also worth noting that GWW's business model has generated extremely predictable free cash flow every single year over the last decade. Importantly, distributors actually generate more free cash flow during recessions (see the jump in fiscal year 2009) because they are able to collect their accounts receivables and liquidate some of their inventory, freeing up cash. You will also note in our earlier graph of GWW's free cash flow payout ratio that the company's payout ratio dropped from 35% in 2008 to 23% in 2009 as a result. This unique business model characteristic further strengthens the security of GWW's dividend.

GWW FCF

While GWW's business is fairly boring and basic, its returns on invested capital are anything but. The company's lowest annual return on invested capital over the last decade is 15%. GWW is clearly a well-run business with meaningful advantages in the markets it serves.

GWW ROIC

GWW's consistency and counter-cyclical cash flows certainly provide a deal of comfort. However, analyzing the balance sheet is always relevant. Too much debt can still get even the safest business into unexpected trouble.

GWW recently took on debt to repurchase shares, but its balance sheet still looks to be in decent shape. All of the company's net debt could be covered with cash on hand and one year of earnings before interest and taxes (EBIT). GWW also has an "AA-" debt rating.

Click to enlarge

Source: Simply Safe Dividends

Overall, there's not much to dislike about the quality of GWW's dividend. The company's payout ratios are very reasonable, it generates counter-cyclical free cash flow, and the balance sheet is healthy. This is one of the most reliable dividends out there.

Dividend Growth Score

Our Growth Score answers the question, "How fast is the dividend likely to grow?" It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

GWW's dividend Growth Score of 76 suggests that the company's dividend growth potential is higher than 76% of all other dividend-paying stocks in the market.

GWW has increased its dividend for 44 consecutive years and is an S&P 500 Dividend Aristocrat. If the company increases its dividend for the next six years as well, it will join the exclusive list of dividend kings, which contains all companies that have raised their dividend for at least 50 straight years.

As seen below, GWW has recorded double-digit dividend growth over all periods during its last 10 fiscal years. While macro headwinds have created a challenging near-term business environment, we expect the company to keep growing its dividend by at least 4-6% per year until conditions improve, at which point growth could return closer to 10%.

GWW Dividend Growth

Source: Simply Safe Dividends

Valuation

GWW trades at about 16x forward earnings and has a dividend yield of 2.5%, which is significantly higher than its five year average dividend yield of 1.5%.

Assuming macro conditions eventually recover and the company gets back on track with at least mid-single digit organic sales growth, we believe earnings could grow at a high-single digit rate. When combined with GWW's 2.5% dividend yield, the stock appears to offer double-digit total return potential. Macro conditions could further deteriorate, but patient investors seem likely to be rewarded over the next 3-5 years.

Conclusion

GWW is a high quality industrial business with strong staying power. Its broad assortment of products, extensive distribution network, reputation for quality, and leading e-commerce presence will likely keep GWW relevant for a long time in the slow-changing MRO market.

The company's dividend payment is highly secure with above-average growth potential, and macro headwinds have caused this blue chip dividend stock to trade at an attractive price relative to history. Patient dividend growth investors should keep an eye on GWW.

Disclosure: I/we 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.