MONOY - Grainger Is Setting New Standards For Industrial Distribution

Summary

• Grainger's fourth quarter results were more in-line with expectations, but 17% adjusted top-line growth was still very impressive.
• Management expects another 400bp-500bp of market outgrowth in FY'23, and the outlook implies a relatively benign overall economic environment.
• Company guidance out through 2025 is aggressive, but management's execution track record has been excellent of late and the opportunities are there.
• Grainger is no value stock, but relative to the potential growth, the valuation could still prove more than reasonable.

Distribution is a tough business, but there are definitely rewards if you do it right – Applied Industrial Technologies ( AIT ) is up almost 50% over the past year and Grainger ( GWW ) is up close to 35%, with both stocks enjoying big post-earnings spikes. In the case of Grainger, the performance relative to Fastenal ( FAST ) (down about 5%) and MSC Industrial ( MSM ) (up 5%) is pretty remarkable, and the two-year comps aren’t much different. Then again, that’s what happens when you outgrow the market by around 600bp-1,000bp, which Grainger appears to have done over the last five quarters.

At this point, with the track record that Grainger management has established, it’s hard to argue with their guidance and outlook. I do think availability and assortment will matter less in 2023 than it did in the last two years (as supply chains improve and smaller distributors are better stocked), but clearly Grainger has hit on something with its restructuring and repositioning efforts over the past few years. Using the same 14.5x multiple I’ve been using, I can argue for a fair value close to $740 now.

A More Modest Beat, But Against Higher Expectations

The worst I think I can say about Grainger’s performance versus expectations for the fourth quarter is that expectations seem to be catching up with what management can deliver. Then again, when you grow at a high-teens rate and far faster than your closest rivals, maybe that’s not so bad.

Revenue rose 13% as reported, but average daily sales growth was 17% on an organic basis, a bit ahead of sell-side expectations. Grainger claimed 9% of price leverage in the quarter and 8% volume growth.

The High-Touch North American business grew about 17%, with 11.5% from price and 5.7% from volume. Following these companies (including Fastenal), it’s clear that pricing and market commentary from distributors can be a little wonky on a quarterly basis. In this case, Grainger either priced ahead of the market, or the market saw volume shrinkage in a quarter with industrial production growth of around 2%. I doubt that was the case, but either way it’s pretty clear that Grainger grew well ahead of underlying industrial production of around 2% in the quarter.

The Endless Assortment businesses ( MonotaRO ( OTCPK:MONOY ) and Zoro) grew 18% on a constant currency average daily sales basis. Registered users rose about 17% yoy, and management continues to hit its SKU growth targets at Zoro (up 28% to over 11.1M this quarter).

Gross margin improved 230bp yoy and 110bp qoq to 39.6%, considerably better than the -120bp/-60bp performance at Fastenal and -10bp/-40bp at MSC, but I’d note that both have higher margins (45.3% and 41.5%), as part of Grainger’s strategic shift years ago was to compete more on price and trade margin for volume. In any case, gross margin was about 130bp better than expected, as the company benefited from better pricing and freight costs.

Operating earnings rose 25%, with margin up 140bp to 13.8%, and this was a very modest miss on the operating line that the company compensated for with lower interest and tax expenses (driving a per-share bottom line beat). High-Touch profits grew 33%, with margin up 180bp to 15.5%, while Endless Assortment fell 19%, with margin down 180bp to 7.3% due in large part to non-recurring costs related to distribution centers.

Strong Guidance Suggests Market Share Growth, But Also An Okay Macro

Commentary on 2023 from many industrial companies has been generally neutral to good so far this earnings season. Many companies are acknowledging weakening trends, including order declines, and significant uncertainty, but backlogs are still generally healthy and guidance hasn’t been bad so far.

Management doesn’t expect a repeat of its 800bp market outperformance, but is guiding for 400bp-500bp market outgrowth consistent with its medium-term vision (through 2025) laid out during September’s analyst day. With Grainger management calling for 5% to 9.5% growth in its High-Touch North American business, the implication is end-market performance of flat worst to possibly up more than 5%. That strikes me as bullish, even relative to benign-to-positive commentary from other companies, but Grainger management has built a guidance track record that suggests they should be listened to in such things.

Grainger management is also looking for a continuation of strong growth in the Endless Assortment business, with a 17% to 19% constant currency revenue growth guide.

Management noted strength in natural resources (up mid-30%’s), transport (up mid-20%’s), and heavy manufacturing (up low-20%’s). The manufacturing growth (low-20%’s for heavy, high-teens for light) compare favorably to the 13% to 19% growth Fastenal saw from manufacturing customers through the fourth quarter, but I think this will be a hard pace to maintain as companies start to run down channel inventories in anticipation of weaker demand. I likewise don’t expect such strong trends in transport given current freight market dynamics (weak trucking rates and lower volume demand), but natural resources should remain quite healthy.

The Outlook

Management’s call for multiyear growth of 400bp to 500bp in excess of the market seems aggressive, but they’ve been executing well on this plan for some time, including effectively targeting mid-sized customers and growing vendor-managed inventory and web-based services. I do think the company is going to see some headwinds from pricing and improved availability at smaller distributors (particularly if my suspicion that Grainger has been more aggressive on pricing recently is accurate), but I still buy the basic story of ongoing share gains … albeit in a slower market.

I’m not entirely comfortable modeling multiple years of high single-digit revenue growth from here, but clearly Grainger is doing something right, and doing so only gets me to the lower edge of their $19B-$20B 2025 revenue target ($19.2B). A 10-year forward revenue growth rate of about 6.5% likewise feels bold next to a trailing average of 5.8% across the past quarter-century, when Grainger was a much smaller company, but I do think there are opportunities to squeeze smaller, less competitive vendors out, while also benefiting from potential drivers like manufacturing reshoring.

As I’ve written in reference to all of these MRO distributors, it is tough to maintain margins in this business – there is near-constant downward pressure on gross margin now, and that puts a premium on operating efficiency. This has long been a key positive for Fastenal, and MSC’s recent attempts to improve efficiency have been exceeding my expectations. For Grainger, I think management targets are aggressive/demanding, but still possible. I’m looking for free cash flow margins to improve to over 9% over time (against a long-term trailing average of about 7%); that feels aggressive, but I think there’s scale leverage here that can do it.

These shares, not surprisingly, don’t look cheap on discounted cash flow even with those aggressive assumptions (6.4% revenue growth and 9.6% FCF growth over a decade). Using a 14.5x multiple on my ’23 EBITDA estimate gets me to around $740, and I suppose there could still be upside to 2023 EBITDA from here.

The Bottom Line

If you believe in sticking with winners, I can certainly see why you’d want to keep owning Grainger. I think a lot of things have to go right from here, though, and while I’m not worried about management executing on what’s within their control, that may not be enough. I’d certainly be more positive on a pullback, but I can’t fault much with Grainger today beyond high expectations, and I can’t even say that the shares are obviously overpriced at this point.

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