EUR 850.00 For Business Accounts Only

Morningstar | Grainger Proved Naysayers Wrong in 2018; 2019 Outlook Calls for Continued Growth and Better Margins. See Updated Analyst Note from 24 Jan 2019

It's been a wild two years for narrow-moat-rated W.W. Grainger. The company's stock began selling off in early 2017, reaching a low of $163 per share in the summer of 2017, as investors became increasingly concerned that the Amazon Business would disrupt Grainger's business. In early 2017, Grainger announced sweeping price reductions to bolster its competitive positioning. While management expected pricing actions to result in near-term margin pressure, they also projected a strong increase in volumes. Since then, Grainger's growth and profitability have met or exceeded management's expectations, and the stock price has responded favorably, closing Jan. 24 at $286 per share.

Fourth-quarter revenue grew a solid 5% year over year to $2.8 billion, which narrowly missed Wall Street's expectations; however, the firm's adjusted EPS of $3.96 easily beat the $3.60 consensus estimate. On a full-year basis, sales grew a robust 8% to $11.2 billion and adjusted EPS increased 46% to $16.70. We were impressed with Grainger's profitability in 2018; despite a 70-basis point decline in adjusted gross profit margin to 38.7%, adjusted operating margin expanded 100 basis points to 12% versus our 11.5% estimate.

Grainger's 2019 guidance calls for another year of solid top line growth and operating margin expansion, although the range of expectations are quite wide at this point. Management expects sales to grow 4% to 8.5%, a 12.2% to 13% operating margin, EPS of $17.10 to $18.70, and operating cash flow of $1.1 to $1.3 billion.

We've become more confident in Grainger's ability to expand its operating margin, and we now assume Grainger achieves a 12.7% operating margin over the next four years, on average, versus 12.2% previously. However, we still assume a 12.5% midcycle operating margin. Our upward revised operating margin assumptions, along with the time value of money since our last update, resulted in a 4% increase in our fair value estimate, which is now $288 per share.

While a solid economic backdrop certainly helped Grainger's top line, we think its strong sales growth is indicative of a favorable customer response to the firm's pricing actions, especially from smaller, more profitable customers. Indeed, volume from Grainger's large customer in the United States grew 7% in 2018, while volumes from medium-size customer grew a whopping 22%.

Grainger's Canadian business has been losing money since 2016, and management has been actively working on restructuring the business. On an adjusted basis, the Canadian business finally turned a profit during the fourth quarter, albeit only $1 million on $145 million of sales. Still, management projects this business to achieve a 1% to 5% operating margin in 2019, which will help support improved consolidated profitability.

We're now forecasting Grainger to achieve a 13% consolidated operating margin by 2022, however, we assume a tempered midcycle operating margin of 12.5% in the final year of our explicit forecast (2023). While Grainger is successfully navigating through an intensifying competitive environment so far, our midcycle operating margin assumption acknowledges our belief that Grainger is more exposed to price competition as compared with other industrial distributors we cover.