W W Grainger (GWW) continues to struggle in an MRO market which faces continued headwinds from a strong dollar and the turmoil in the oil & gas market. That said, revenues have stabilized a bit, as cost cutting efforts and share buybacks offset the pressure on gross margins.
As the stock has been lagging for quite some time now, earnings yields have started to approach 6%, making me a buyer if shares dip below the $200 mark. The great track record, room for bolt-on dealmaking and generally stable business model should outweigh concerns about sluggish demand. While it is true that the dollar has recently gained some strength, oil prices have started a decent recovery as well.
Well Positioned To Address The Challenges
Besides seeing real pressure on demand, Grainger recognizes that the marketplace is changing at a rapid place. The introduction of the 2015 annual report is certainly worth a read. Management talks about new entrants and technologies changing the ways customers buy their products, often buying both online and on site.
To make Grainger successful in this environment, the company is committed to investing in the business even if demand is soft, thereby forfeiting some margin in the process. Grainger has seen large investments and growth into its online platform Zoro in the US. The platform grew sales by more than 60% in 2015, reaching a total of $300 million, equivalent to 3% of the overall sales.
The focus on playing a leading role with regard to industry consolidation, while trying to pursue online growth as well, has served the company well over the past decade. Grainger has grown sales from $6 billion towards $10 billion over the past decade, for an average growth rate of 5% per annum. Margins have expanded from 10% of sales to a peak of 13%, and currently trending closer towards 12%.
As operating earnings nearly doubled over this ten year period, investors have benefited from large share buybacks as well. The company bought back roughly 30% of its shares since 2006. The combination of sales growth, margin gains and share buybacks allowed earnings per share to rise by more than 250%.
The growth track record of Grainger is very good as shares essentially tripled over the past decade. Shares doubled from $100 in 2010 towards $200 by 2012, and hit a high of $260 per share in 2013. Ever since, shares have been stagnant, and have actually fallen back to current levels just above the $200 mark.
The reason for the stagnation is simple: a lack of sales growth. Following years of solid growth, sales have been stagnant at $10.0 billion in 2014 and 2015, before accelerating slightly into 2016 on the back of acquisitions. Third quarter sales were up by 2.5% to $2.6 billion, as sales are up by a similar percentage in the first three quarters of the year, with most of the growth originating from the Cromwell purchase.
The issue is that slow growth is hurting margins across the industry amidst fierce competition which results in lower prices. Third quarter gross margins came in at 40.0% of sales, down 190 basis points compared to the year before. The company actually did a great job of containing costs, but margins have come down amidst the price deflation. Operating margins fell by a point to 12.4% of sales.
Despite this margin pressure, Grainger managed to limit the fall in earnings to little over 3% as the effective tax rate came down quite a bit. Despite this drop in taxes, the effective tax rate still came in at 34.0%, as Grainger is certainly not a tax avoider. The continued buyback of shares actually allowed earnings per share to increase by 4% to $3.05 per share.
Outlook And Valuation
While third quarter results looked reasonable, Grainger is cutting the full year guidance. Growth is now seen at 1.5-2.5% for the year which is a bit disappointing given that growth came in at 2.3% for the first three quarters. Earnings are seen at $11.40-$11.70 per share, down from a previous midpoint of $11.70 per share.
So far this year earnings have come in at $8.82 per share, down by $0.42 per share versus the same period last year. Given the revised guidance, fourth quarter earnings are seen at $2.73 per share in what is typically a softer quarter. This would again indicate growing earnings, as reported earnings came in at $2.30 per share in the final quarter of 2015, with adjusted earnings totaling $2.49 per share.
The balance sheet remains solid containing $286 million in cash while debt stands at $2.28 billion. If I add in another $181 million in long term employee related liabilities (mostly pension related liabilities), net debt stands at roughly $2.4 billion. This is offset by a $1.4 billion EBITDA number, for a 1.7 times leverage ratio.
Multiple Compression Continues
MRO companies have typically been well liked by investors given the diversified nature of sales, stable margins and room to consolidate in fragmented markets. For years, companies in this area have done really well but a strong dollar and low oil prices have hurt these prospects over the past two years.
The same applies for Grainger whose shares hit a high at +$250 in 2013 already. Ever since revenues have only grown 5% and profits have come down from $800 million a year to roughly $700 million. This has been offset by sizable buybacks, as the company bought back some 10 million shares since 2013, cutting the outstanding share base by some 15%.
At the midpoint of the current guidance, shares now trade at 17-18 times earnings, for a 5.5% to 6.0% earnings yield. These earnings are distributed through a 2.4% dividend yield. With net capital expenditures being very low, most of the additional cash flow generation goes towards share buybacks and M&A.
So far shares have been trading flat in 2016, as the company has underperformed some of its peers and the wider market. A recent strengthening of the dollar has an adverse impact, although oil prices have started to recover a bit more meaningfully in recent weeks.
A 6% earnings yield translates into a $190 entry target, levels at which I feel comfortable owning the stock despite the continued sluggish environment, which is largely out of its control. Solid cash flow conversions, steady buybacks, some smart initiatives to cater e-commerce demand and stability of the business model give me reasons enough to obtain a stake at that price.
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.