Leader in the MRO distribution sector
W. W. Grainger (NYSE: GWW) is the leading general maintenance, repair and operation distributor [MRO] products and services in North America. The company operates under the mission statement “Keeping the world working”, demonstrating its commitment to long-term customer relationships and allowing them to function. The company recently held its first Investor Day since 2017showing a clear strategy of long-term growth and outperformance.
Throughout this article, I will primarily refer to WW Grainger as Grainger or GWW.
Performance since Investor Day 2017
Since the last Investor Day, Grainger has managed to consistently gain market share in its High-Touch Solutions segment, achieve strong and profitable growth in its much smaller Endless Assortment segment, and significantly increase its cost structure and margins. . During this period, revenue increased by 7% CAGR (keep in mind that Grainger divested certain companies as its Chinese operations and did not acquire any businesses during this period), adjusted EPS by an impressive CAGR of 19% and the share price rose 126% against the S&P 500 to 46% during of the same period (excluding dividends). The stock has been a great investment in the past, so let’s look at the two segments the company reported.
Grainger estimates the total addressable market for direct and indirect NA B2B supplies to be approximately $1.4 trillion, of which Grainger can serve approximately 11.7%. In its current addressable market for the High-Touch Solutions business, the company is the largest player with only 7% market share, which shows how fragmented the market is. This leaves a big opportunity for further market share gains in the future and to buy competitors opportunistically, this could become particularly interesting if we see struggling competitors if we get a longer downturn in the economy. The Endless Assortment segment is a new, faster growing segment serving the United States and Japan with a combined addressable market very similar to the North American market. Endless Assortment has a much larger current addressable market (we’ll see why in the next two sections), with Grainger holding an insignificant 0.2% market share in the US and a 5% market share in Japan.
What makes this market interesting is that MRO products are resilient as they are primarily used to keep systems running and maintain them. This makes the segment much more resilient compared to, for example, new construction activity. New homes can be delayed, but if something breaks in your home, you will.
The High-Touch Solutions business (I’ll abbreviate it as HTS for this article) focuses on large to medium-sized customers with very complex operations and processes. These companies are looking for a trusted supplier who is reliable and can provide them with the products they need, where they need them and when they need them. Grainger can deliver on that promise with a supply chain and distribution network (most delivery is done through partners) that can reach 99% of US zip codes and 80% of Canadian zip codes the next day. High-Touch Solutions accounts for the vast majority of GWW’s revenue with 79% or $11.2 billion. This business is not a race to the bottom, so Grainger can maintain a healthy margin.
The goal is to develop long-term relationships with major clients and deepen those relationships. Grainger also offers services to its customers, including its KeepStock inventory management solution, specialists and advice and its eProcurement solution to make purchasing even easier. This is a big part of its competitive advantage as 60% of its customers use at least one of these solutions. Grainger is a technology company that develops its own solutions to increase the value it brings to its customers. Here is a quote from the CEO:
So I don’t think we’re probably going to talk about specifics in terms of the number of gearsneers. I will say that we have moved our team significantly from a team that was not some sort of in-house build software to one that is mostly or at least partly building in-house software. So we had a huge change. The team did a good job of – a lot new leaders and a lot of new software engineers hired than other areas we hired. So what I would say is that we are transitioning. We will continue to do as we build capabilities and find capabilities that we think we need to develop internally. So that continue to.
The endless assortment [EA] caters to small businesses with less complex operations and processes. The main focus of this business unit is to create an easy and streamlined online shopping process with a large number of Stock Keeping Units (SKUs). EA has a different strategy that aims to expand its product assortment (already 10 million SKUs versus 2 million for HTS) to drive increased web traffic and attract new customers. EA goes beyond Grainger’s offering by offering categories such as restaurant supplies, automotive, and ground maintenance, but 80% of revenue still comes from Grainger stocked items.
Clear objectives for 2025
Grainger expects to generate $19-20 billion in revenue with an operating margin of 14.5%, CAGR of 8-10% and a 70 basis point improvement in operating margin in 2025. On an EPS basis, they expect to achieve adjusted EPS of $40, a 42% increase from its FY22 guidance of $28 EPS (midpoint).
The company has a clear capital allocation strategy with the following priorities:
- Organic reinvestment
- A growing dividend
- Opportunistic share buybacks or M&A
I really like this capital allocation approach, combined with a modest leverage of 1.0x. The company has historically generated strong returns on capital employed of around 30% and an ROIC in the mid-30s. The company expects to stay in the same ballpark.
The company is guiding operating cash flow of $1,250-1,350 million and CapEx of $300-325 for FY22, leaving us with an FCF of between $950-1,050 million. I used the lower end of the guidance with a 10% discount rate, a 3% perpetuity growth rate and an assumption of 2.5% annual surrenders (based on historical trends and without a change in capital allocation strategy for the company) for an inverse DCF analysis. The model tells us that the market is assuming 8-10% annual FCF growth for Grainger on a diluted basis. This is in line with its revenue growth estimates and we can assume that FCF will grow faster due to improved margins.
Grainger is a well-run distributor with great potential for increased market share and margin gains due to its focus on technology to improve the customer experience. The company has many similarities to Watsco (WSO) and Ferguson (FERG), both also in the distribution business, see my articles about them here: Watsco, Ferguson. Investor day shows a clear path for growth and gradual improvement and based on my inverse, DCF stocks are currently fairly valued. The stock held up very well in this bear market, with a drawdown limited to 14%. I already own the HVAC Distributor Watsco, but I might consider a dollar average buy into Grainger in the near future and possibly make a larger purchase if the stock trades significantly higher.