EUR 850.00 For Business Accounts Only

Morningstar | Cromwell Impairment and Operating Margin Miss Obfuscates Grainger's Solid 3Q Performance

Grainger's stock plunged over 10% on Oct. 16 after the narrow-moat industrial distributor released its third-quarter earnings, which featured a $139 million impairment charge related to its United Kingdom-based Cromwell business. Moreover, Grainger's third-quarter revenue growth and adjusted operating margin expansion came in lower than consensus estimates.

We're certainly not discounting the significance of the Cromwell impairment charge, which, in our view, is the result of a capital-allocation misstep dating back to 2015, but if we exclude that charge-off, we thought Grainger's third-quarter performance was solid. Grainger's United States segment continues to benefit from price reduction actions. U.S. revenue grew 9% year over year, mainly due to an 8% increase in volume and a 1% increase in price. Sales volume from large U.S. customers grew 8%, while volume from more-profitable medium-sized U.S. customers grew 22% despite a tough prior-year comparison (compared with 18% growth last year). Faster growth from medium-sized customers relative to larger customers is a tailwind for the U.S. segment's pricing and margins. While U.S. adjusted operating margin expanded 20 basis points to 15.1%, the segment's operating leverage ratio (calculated as adjusted operating income growth divided by sales growth) stalled during the quarter to 1.2. However, management noted that a variable compensation true-up was to blame, which while a drag on margins, indicates that the firm is meeting or exceeding internal goals.

The lack of a guidance update in Grainger's third-quarter investor presentation concerned us while we awaited the earnings call, but management assuaged our concerns when CFO Tom Okray commented that Grainger is trending toward the high end of its 2018 adjusted EPS guidance of $15.05 to $16.05 per share.

We increased our fair value estimate of Grainger's stock to $277 per share from $272 mainly due to the time value of money since our last update.

Grainger's other businesses, which mainly consists of MonotaRO, Cromwell, Fabory, and Zoro, grew revenue 13% year over year, and adjusted operating margin, which excludes the Cromwell impairment charge, expanded 160 basis points year over year to 6.6%. Including the impairment charge, Grainger's other businesses lost $100 million.

Grainger acquired U.K.-based Cromwell in September 2015 for approximately $460 million, or about 10.4 times Cromwell's trailing 12-month EBITDA. At the time, Cromwell's online revenue accounted for only about 5% of its total revenue, and Grainger saw an opportunity to expand Cromwell's online presence. However, Grainger has since found that a Cromwell-branded online model "created customer conflict with the core business." Slowing economic growth due to Brexit and a higher cost of capital were other factors that caused Grainger to lower its valuation of its Cromwell business. The $139 million impairment charge represents approximately 40% of the total goodwill and other intangible assets recorded following Cromwell's acquisition in 2015.

Grainger's Canadian business is still losing money as it navigates through a major restructuring effort; the segment lost approximately $4 million on a GAAP basis during the third quarter. There's light at the end of the tunnel, though, as management remains steadfast in its belief that the Canadian segment will "exit the year at a profitable run rate."

We were pleased to see a detailed analysis of the potential impact tariffs pose on Grainger's financial performance within its third-quarter investor presentation. Management noted that approximately 20% of the U.S. segment's cost of goods sold is sourced from China, but only half of the products sourced from China fall under the section 301 tariffs. Assuming a 25% tariff on Chinese goods included in section 301, Grainger estimates tariffs will increase U.S. costs by about 2%. However, management sounded confident that a combination of alternate suppliers and higher prices should help mitigate tariff-related cost burdens.