Fri, 1 Sep 2017
Though the narrow-moat distributor may not have the pricing power it once had, we think it can maintain high single-digit dividend growth.
Brian Bernard: W.W. Grainger began paying a regular dividend in 1971 and has increased its dividend every year since. The so-called dividend aristocrat currently offers just over a 3% dividend yield versus the S&P 500 with just under a 2% yield.
Grainger is one of the largest and most-well-known industrial distributors in the U.S. The company's business model--which we think benefits from a cost advantage, customer switching costs, and a network effect--has been the source of the company's historically enviable profitability, free cash flow generation, and dividend growth.
However, that business model has come under pressure from internet-based competitors such as Amazon Business that offer many of the same products as Grainger at lower prices.
We recently cut Grainger's moat rating from wide to narrow and its moat trend rating from stable to negative because Grainger's recent performance proves the company is not immune to an increasingly competitive environment, and we also think pricing pressure will persist.
Although we believe Grainger may never again enjoy the pricing power it once had, with operating margins peaking above 14%, we think the firm has strong enough competitive advantages to maintain 11% operating margins. While we think Grainger is more vulnerable to competitive pressure from Amazon than some of the other distributors under our coverage, Grainger is entrenched within many of its larger customers' operations, and the firm's ability to manage large, complex accounts and provide inventory management services support some degree of pricing power. As it stands today, Amazon Business' ability to penetrate large enterprises is unproven and the online behemoth does not offer many of the inventory management solutions Grainger's customers value.
We're certainly taking a less rosy view than management, who sees operating margins returning to 13% as soon as 2019. However, we think the market is painting an unrealistically dire future for Grainger right now, and we think the stock looks more attractive now that it has a wider margin of safety after selling off considerably in 2017.
Even with a new normal in terms of lower profitability, we think Grainger will continue to generate sufficient free cash flow to fund a growing dividend and opportunistic share repurchases. Although we view the Amazon threat as real, industrial distribution is a very fragmented market (Grainger has only 6% market share in the U.S. and 3% globally), and as customers look to consolidate their spending with larger distributors, we think there is plenty enough of the pie for both Amazon and Grainger to grow.
That said, over the next five years, we don't expect Grainger to grow its dividend at the blistering 14% compounded annual growth rate it did over the previous five years; however, based on our projections, a high single-digit dividend CAGR seems achievable.