By Guan Wang
Wholesale industrial equipment may not be the sexiest industry, but it is a profitable one. Going forward, we expect the global economy to improve gradually and, as such, we are bullish on this industry. We think the light manufacturing and retail sectors as well as the contractor sector will rebound in the upcoming years. Even though the economy in Europe is likely to remain weak, we see strong growth in emerging markets such as Asia and Latin America. According to Standard & Poor's the current market for facilities maintenance supplies in China is about $38 billion, and the number will grow to above $70 billion by 2014.
W.W. Grainger (GWW) is strong in heavy manufacturing and commercial volume in North America, but it still tries to leverage its North America business by entering into developing markets. Grainger plans to continue to widen its geographic reach in the next couple of years, mainly focusing on areas with significant growth opportunities, such as Asia and South America. In other words, Grainger is following the action and has our attention.
As of December 31, 2011, Grainger had 368 branch stores in United States, 172 Canadian branches, 22 in Mexico, five in Colombia, four in Puerto Rico, and one each in China, Panama and the Dominican Republic. In 2011, the U.S. branches generated about 80% of Grainger's total sales. One of the major strategies of Grainger is expanding internationally to increase purchasing power and diversify risks. It also focuses on increasing the number of products it offers.
To supplement its organic growth, Grainger focuses on strategic acquisitions. For instance, in August last year, the company bought Fabory Group, a leading fastener distributor in Europe, for $344 million. The Netherlands-based company sells over 80,000 products in 14 countries. The acquisition enables Grainger to have a well-established business in the largest maintenance, repair and operations market in the world.
However, due to the poor market conditions in Europe, Grainger reduced its expectation of its EPS growth brought by the Fabory acquisition. In November last year, Grainger announced that it expected the acquisition to add $0.03 per share to its EPS in 2012, versus its previous estimate of $0.12 per share. Despite that, we are still in favor of Grainger's expansion plan. Grainger is expected to make $10.57 per share in 2012, which makes its forward P/E ratio about 20.4, versus the industry average of 22.15.
Grainger spends a large portion of its earnings on these investments. It expects capital expenditures to account for 26% of its cash flow in 2012. In addition to investing and acquisitions, the company also pays out part of its earnings as dividends to its shareholders - Grainger pays out about 28% of its earnings and its current dividend yield is about 1.22%. The dividend yield is not high but Grainger has an impressive record of raising its dividends - 40 consecutive years to be exact - and these are not small increases. Last year, it raised its quarterly dividend by over 22% from $0.54 per share to $0.66 per share.
Over the past five years, Grainger's average annual earnings growth rate has been about 16.5%. In turn, the strong earnings growth has driven Grainger's dividend growth. In the next couple of years, Grainger's sales are expected to grow at 7-10% annually and its earnings are expected to grow at about 13% per year. As a result, we expect the company to continue raising its dividend payouts in the future.
In addition to dividends, Grainger also uses the money it makes to repurchase its shares. Since 2006, Grainger has reduced the number of its shares by over 17%. Last year, it bought back one million shares - a value of roughly $151 million. It still has over seven million shares authorized for repurchase. The repurchase program will definitely benefit Grainger's shareholders as it will boost Grainger's EPS and share price.
There are a few hedge fund managers bullish about Grainger. During the fourth quarter last year, four hedge funds initiated new positions in Grainger, including Ken Heebner's Capital Growth Management and Glenn Russell Dubin's Highbridge Capital Management. Chuck Royce was also in favor of Grainger. Of the 350-plus hedge funds we track, Royce was the most bullish about the stock. His Royce & Associates had $23 million invested in Grainger as of December 31, 2011.
Grainger's main competitors include Applied Industrial Technologies Inc (AIT) and Wesco International (WCC). Their forward P/E ratios are relatively lower than that of Grainger - Applied Industrial Technologies has a forward P/E ratio of 17 and Wesco's forward P/E ratio is 14 - but the size of these two companies is much smaller than that of Grainger. Their market caps are between $1.5 billion to $3 billion, versus $15.2 billion for Grainger. As a market leader with double-digit growth, Grainger deserves an above historical P/E ratio of about 22X its 2012 EPS expectation, leading to a target price of over $230 per share. It recently traded at $215 a share, so that would be a roughly 7% upside to look forward to, plus its dividend.
We recommend investors buy Grainger because we believe the company will continue to expand globally and gain market share. We are also optimistic about the company's dividend growth and share repurchase program.