Market’s Too Pessimistic on Grainger

After

We now forecast the company to generate a 10.4% adjusted operating margin in 2017 versus our previous 10.2% estimate; however, our increased estimate is still at the low end of management’s guidance range. We have not materially changed any of our longer-term key valuation assumptions, and we are therefore maintaining our $202 fair value estimate.

Although Grainger beat the consensus adjusted earnings per share estimate ($2.74 versus $2.65) and maintained its 2017 guidance and 2019 financial goals, the stock traded off as the company’s second-quarter results were not enough to assuage the market’s concerns about the Amazon AMZN threat. We share some of the market’s concerns, but after the July 19 sell-off, we think the market is pricing in too much pessimism.

After completing a review of Grainger’s fundamentals in early June, we downgraded our moat rating to narrow from wide, took our moat trend rating to negative from stable, and raised our fair value uncertainty rating to high from medium. Given what we view as an increasingly competitive environment, we are skeptical of Grainger’s targeted 2019 operating margin goal of 12%-13%; instead, we only assume sustainable operating margins of around 11%, well below the company’s 14% peak. Still, we believe the market is painting an unrealistically dire future for Grainger, and we think the stock looks more attractive now that it has a wider margin of safety after the second-quarter sell-off.

Although we believe Grainger may never again enjoy the pricing power it once had, we think it 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 we cover, it is entrenched in many of its larger customers’ operations, and its 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 unproved, and the online behemoth does not offer many of the inventory management solutions that Grainger’s customers value.

Although we view the Amazon threat as real, industrial distribution is a very fragmented market--Grainger has only 6% market share in the United States and 3% globally. So as customers look to consolidate their spending with larger distributors, we think there is plenty enough of the pie for both Amazon and Grainger. One of Grainger’s key goals is to capture an increased share of more-profitable midsize customers. While our outlook for growth from midsize customers may not be as optimistic as management’s targets, we think Grainger’s pricing actions and increased focus on the midsize market will certainly help the company win some business. While we think growing price transparency and competition may pressure the profitability of Grainger’s larger accounts, we are not convinced that Amazon will be able to outright steal these accounts from Grainger.

Grainger also announced that CFO Ron Jadin, 56, will retire at the end of 2017. Jadin joined Grainger in 1998 and has been its CFO since 2008. The company intends to fill his vacant role with an external candidate. We think that this news may have also contributed to the July 19 sell-off.