W.W. Grainger (GWW ) is a U.S.-based supplier of maintenance, repair and operating products. It has a dominant position in its industry that provides the company with competitive advantages like pricing power and a wide economic moat. There are high barriers to entry to compete with W.W. Grainger because the company enjoys significant economies of scale.
As a result, W.W. Grainger maintains high margins and consistent earnings growth each year. This has allowed it to raise its shareholder dividend for more than four decades in a row.
In addition, W.W. Grainger stock is undervalued. It trades for a lower valuation than the S&P 500, and is also undervalued in relation to its future dividend growth potential. These qualities make W.W. Grainger an attractive stock for value investors.
Fundamental Review
W.W. Grainger has a large and diverse customer base, which consists of approximately 3 million customers around the world. The company generates annual sales in excess of $10 billion.
The current business climate for W.W. Grainger is challenging but still supportive of modest growth. As a global company, W.W. Grainger is moderately exposed to headwinds including slowing global economic growth and elevated geopolitical uncertainty. As a result, W.W. Grainger’s total revenue increased 1.6% in 2016. Fortunately, W.W. Grainger’s currency exposure is limited by the fact that approximately 80% of the company’s annual sales are derived from the U.S. and Canada.
Reported earnings per share decreased by approximately 15% in 2016, which the company attributed to weak global demand. However, earnings were negatively impacted by more than $100 million in one-time costs such as restructuring expenses and goodwill impairments. Excluding these non-recurring items, W.W. Grainger posted a 3% decline in 2016 earnings per share.
Growth Catalysts
Going forward, W.W. Grainger will look for growth from its strategic initiatives, which include growth in international markets and in new channels. E-commerce is a high-growth industry. W.W. Grainger’s e-commerce platforms include MonotaRO, which is based in Japan, and Zoro, which is based in the U.S. These businesses helped W.W. Grainger’s sales in the Other Businesses segment to grow by 34% in 2016.
Lastly, W.W. Grainger is in the process of a significant round of cost cutting. The restructuring charges the company incurred in 2016 should result in meaningful cost savings in the years ahead. For example, capital expenditures were cut by 41% in the fourth quarter of 2016 compared to the same quarter in 2015. Separately, non-operating expenses declined by 33% during the year.
Together, these initiatives are expected to produce strong earnings growth going forward. Analysts currently expect the company to report earnings per share of $11.50 in 2017, which would represent 16.5% growth. Earnings per share are expected to increase another 6.5% in 2018, to $12.25.
Valuation
W.W. Grainger’s future expected returns will come mostly from earnings growth. But there is also potential for capital gains from an expanding valuation multiple.
W.W. Grainger is a reasonably valued stock. It currently trades for a price-to-earnings ratio of 22. It is valued at a slight discount to the S&P 500 Index, which has a price-to-earnings ratio of 25. Based on the company’s strong brand and steady growth, the stock could see an expansion of its price-to-earnings ratio. It appears to be undervalued on a relative basis, and also when using the Dividend Discount Model.
Assuming a risk-free rate of 2.45% – which corresponds to the current yield on the 10-year U.S. Treasury bond, 7% annual dividend growth and a beta of 0.80 – fair value for W.W. Grainger stock comes out to $276.76 per share. The Dividend Discount Model analysis indicates W.W. Grainger stock is currently undervalued by approximately 16%. As a result, the stock could see an expansion of its valuation multiple, which could boost total investor returns.
Dividends
Based on its current share price, W.W. Grainger stock has a dividend yield of 2.05%. This is roughly on par with the average dividend yield in the S&P 500 Index. Furthermore, the company has a long track record of delivering consistent dividend growth. It has raised its dividend each year for 45 consecutive years. This makes it a member of the Dividend Aristocrats, companies in the S&P 500 that have increased their dividends for at least 25 consecutive years.
The company maintains a solid dividend growth rate that typically exceeds the rate of inflation. For example, W.W. Grainger’s 2016 dividend raise was 5.2%. It has maintained its impressive dividend growth history because of its strong free cash flow. Even in the difficult climate of 2016, W.W. Grainger generated $1 billion of operating cash flow. Free cash flow increased 23% for the year.
Rising free cash flow fuels the company’s returns to shareholders. W.W. Grainger returned $1.1 billion to investors in 2016 through share repurchases and dividends. The company should continue to grow its dividends as it keeps a healthy payout ratio. The company’s forward annualized dividend of $4.88 per share represents approximately 42% of projected 2017 earnings per share.
The Bottom Line
W.W. Grainger is reliant on global economic growth, which has slowed over the past year. In particular, the economic slowdown in the emerging markets is a concern for the company in 2017. That being said, W.W. Grainger has displayed the ability to remain profitable and reward its shareholders with dividend increases, even during recessions. This is a testament to the company’s strong brand and durable competitive advantages.
The stock is currently cheaper than the S&P 500 Index on average, but that could change in the year ahead. W.W. Grainger is a high-quality company, and premium companies typically command premium valuations. There is considerable potential for share price appreciation due to expansion of the valuation multiple.
