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Morningstar | Grainger's 2Q Earnings: Pricing Reset Continues to Drive Strong Growth; Profitability Improves

Grainger's shares surged 11% on July 18 after the narrow-moat industrial distributor reported fantastic second-quarter results that easily beat consensus estimates. Consolidated revenue grew 9% year over year to $2.9 billion, beating the consensus estimate by about $36 million. Adjusted diluted EPS grew 59% year over year to $4.37 versus the $3.74 consensus estimate.

Peak pessimism hit Grainger's stock during the summer of 2017 after the firm announced it was accelerating price reductions across its product portfolio to improve its competitive positioning. Since then, Grainger has realized strong revenue growth, and profitability has met or exceeded management's expectations. We've been most impressed with Grainger's margin performance in 2018, which has been tracking above our expectations. After reviewing Grainger's second-quarter results, we increased our fair value estimate to $272 per share from $258. About $7 of the increase is due to our upwardly revised margin assumptions, $3 is due to our stronger revenue growth assumptions, and the remaining $4 is due to the time value of money since our last update.

While some of Grainger's revenue growth can be chalked up to its strengthening end markets, the firm's pricing actions are certainly another contributing factor. Volume growth among large U.S. customers grew 9% year over year, and midsize customer volume grew 29%. We believe Grainger's pricing actions are having the biggest impact on smaller customers, which are more profitable than larger accounts. Indeed, before the pricing actions were implemented, Grainger was losing share among this customer base.

Grainger's adjusted gross margin contracted 100 basis points year over year to 38.9%, but its adjusted operating margin expanded 150 basis points to 12.6% due to improved operating expense leverage. Given Grainger's margin performance, we now think a 12.5% midcycle operating margin is appropriate versus our prior assumption of 12.2%.

Grainger's normalized gross margin, which excludes the impact of a revenue recognition change and the timing of a supplier-funded sales meeting, declined 30 basis points to 39.2%, which was better than management had been expecting given its pricing actions. Grainger's selling, general, and administrative expense leverage so far in 2018 has been exceptional. Indeed, SG&A expense year to date has been flat, while revenue is up 9%.

Grainger's U.S. business grew revenue 9% year over year, and its adjusted operating margin expanded 90 basis points to 16.4%. Grainger's Canadian segment, which is in the midst of a turnaround, reported a $2 million adjusted operating loss during the quarter versus a $7 million adjusted loss last year. Management noted that restructuring activities are ahead of schedule and the segment is "in a good position to exit the year profitably and go on offense in 2019." Grainger's other businesses, which includes it online-only and international businesses, grew revenue 18% year over year and expanded operating margin 180 basis points to 7%.

Given the company's strong second-quarter results and favorable outlook, management increased its 2018 revenue, adjusted operating margin, and adjusted EPS guidance. Management now sees revenue growth of 5.5% to 8.5% (versus 5% to 8% previously), operating margin ranging between 11.5% and 11.9% (versus 11.1% and 11.5% previously), and adjusted EPS of $15.05 to $16.05 (versus $14.30 to $15.30 previously)

We think Grainger's efforts to address increased competition from the likes of Amazon Business have gone very well so far. The company is getting the stronger volume growth it desires and operating margins appear to be on track to achieve the firm's 2019 operating margin guidance of 12% to 13%. Still, we continue to believe that of the U.S.-based industrial distributors Morningstar covers, Grainger is the most exposed to competition from Amazon Business because, in our view, Grainger isn't a niche player like the other distributors we cover, and the firm's sales skew toward less-specialized products.

Grainger's year-to-date performance shows the firm is holding its own in a competitive environment, which caused us to modestly increase our midcycle operating margin operating margin assumption to 12.5% from 12.2%. However, we're still skeptical that Grainger will be able to push pricing and sustainably hold back on SG&A spending in an increasingly competitive market. As such, we currently don't forecast Grainger achieving operating margins in excess of 13%.