W.W. Grainger: "Passing" in Apr. 2016
Traveling Through Time | 15 min read | What I learned from "passing" on Grainger in Apr. 2016
This is part six in a ten-part series. Before reading this segment in the Traveling Through Time case study series — please read the Introduction post here.
Essentially, I simulated an investment opportunity from many years ago based on Geoff Gannon’s Singular Diligence newsletter. The write-up below is a record of my thought process and a reflection on what happened.
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Simulating the Past: Arriving to a decision
WOULD I HAVE INVESTED 20% OF MY CAPITAL IN GRAINGER IN APRIL 2016?
Grainger is one of the Big MROs (maintenance, repair, and overhaul) distributors in the United States. Its domestic operations focuses on selling infrequently used supplies/items to large corporations (with multiple sites) for their facility needs, everything from safety equipment to plumbing to metalworking.
In the United States, Grainger operates 19 distribution centers and 350 stores. The company also owns and operates other MRO distributors in other parts of the world. Grainger generates approx. $9B in sales and 15% in pre-tax profits.
Grainger is not a cheap opportunity.
The company trades at an EV/S of 1.6x and over the long-term has only generated 10% in operating profit. Over the last seven years, it has been closer to 12%.
Grainger and the other two Big MROs (MSC and Fastenal) trade closely together. Grainger trades at EV/EBIT of 11x, MSC at 11x, and Fastenal at 15x.
So Grainger is trading slightly above the P/E of the average business. It is better than the average business, but the market price demands high long-term performance. The stock trades close to 2% dividend yield and EPS grows ~2% per year in buybacks. So the company would have to grow its sales and earnings by 6% per year.
Grainger is safer than the average company and as safe as its peers.
The MRO business is quite sticky. Customers both small and large struggle with changing their procurement process. There’s technical, psychological, organizational friction. It can take years for an MRO to gain more of a facility’s (not customer account) share of wallet.
And when the companies do face each other on the front lines, Grainger seems to be more advantaged for the simple reason that Grainger is larger. Grainger has more sales than both MSC and Fastenal combined. Large corporations use the Big MROs seek to save costs on overhead in their procurement department. And because Grainger covers a wide array of supplies, Grainger can can provide larger cost savings to each customer.
Grainger’s customer base is also less volatile than Fastenal and MSC, who depend on construction and manufacturing customers for the majority of their business. Grainger is spread across many different market segments.
And Grainger takes commodities like plumbers and safety goggles and HVAC motors and turns it into a service, making it hard for small and large players to compete unless they build the same infrastructure or provide the same type of cost savings in another way.
However, Grainger’s capital allocation is questionable.
Grainger has 4x more distribution centers than MSC, but has only 2x more sales than MSC. That’s not even including the 350 branches that Grainger uses (compared to MSC’s 100 branches). This explains why MSC’s Sales/Net PPE ratio is 11x vs Grainger’s 7x.
So Grainger’s business model takes up more capital. On the surface, it’s hard to tell why this is. But it isn’t even the main issue. The issue is that they have invested in non-domestic businesses.
Over the 25 years, they have spent 30% of their capital in deals. They tried to enter China, Brazil, Netherlands, all which have lost money for them (in real dollars as well as opportunity cost). They recently bought a big UK business for multiple higher than their current stock price. Time will tell if this deal follows the company’s past track record.
Grainger has had only one successful international acquisition: an investment in an online-only distributor focused on small customers in Japan. The success of this investment can’t be overlooked. It inspired Grainger to build their own online-only distributor for small customers in the United States. These two eCommerce companies will contribute ~$350M in operating profit by the end of the year.
Not all acquisitions have been in overseas operations. The company has made some smart decisions buying businesses where their market position is weak (f.e. metalworking). But that’s $1.2B in spent in acquisitions for <$500M in cumulative operating profit at best (estimated, incl. losses). As it stands today, it’s a bad track record.
I think I would feel differently if the company said they no longer wanted to expand internationally. There is no need to expand internationally. It doesn’t help their US moat. And if they only have 14% of the $40B market for large customers, they have a very long runway in their core domestic business. They could use capital to grow their market positions in new customer segments and geographic regions.
But it’s hard to tell if the company has changed their mind of international expansion or acquisitions. While they aren’t expanding in China, the company continues to keep operations there, describing as a “long-term play.”
And this type of uncertainty is scary when you know that the company needs to return about ⅓ of their earnings through buybacks to offset dilution. To be fair, management has some decent incentives. For the fiscal year 2014, stock options were granted to employees if the company grew more than 4% and generated a ROIC higher than 18%.
So stock compensation isn’t egregious in anyway. But if management stops offsetting dilution with buybacks, then shareholders could get less and less of the value from much needed performance.
Grainger’s future is steady, but might not be good enough.
To achieve a 10% annual return, Grainger would need to generate more than 6% in earnings growth.
The company has grown its sales by 7% over the last 20 years. And the 30 years before that, by 11% per year. So Grainger is very much a growth company.
And Grainger’s type of growth opportunities have lower hurdles than other companies. Expanding within existing customer accounts, both in sites and departments, is a safe strategy (even if it takes time for customers to switch their processes). Stealing market share from small players is a compelling strategy. And it’s certain that Grainger’s customer count will grow somewhat.
The market for large customer MRO needs only grows by 3-5% per year. So Grainger should be in-line or better than this market growth. But the combination of acquisitions and stock-based compensation could dilute this growth. And the company doesn’t have amazing opportunities to improve their profitability.
Grainger is a very durable business, but the ability to grow at an adequate rate with high certainty makes it hard to justify this as a no-brainer opportunity.
Grainger is unique that I don’t see the company losing sales. Out of all the companies in this case study series so far, Grainger probably has the most durable business. The free cash flow on the other hand could be a very different story.
I could be wrong on Grainger’s growth. Sales and earnings might continue to grow at 7-8% for another 5-10 years. They could grow within accounts much faster than I expect, which would in turn increase profitability from productivity gains. And this may be just enough to offset any value destruction from from dilution or acquisitions.
But Grainger seems like it grow closer to 5-7% per year. And with those growth rates, I don’t feel that it provides enough margin of safety to achieve 10% returns with certainty.
Grainger could very well grow shareholder capital by 10% per year. In fact, out of all the case studies I have done so far, MSC and Grainger have the best safety and best growth prospects out of all of them. I think of all of those companies, these companies would be the ones who could generate 10%+ annual returns.
But I think the odds of achieving a 10-15% return and a 6-8% return are more similar than different. The bets that I try to make are 20% 8-10% returns and 80% 10-15% returns. So that’s why I wouldn’t put 20% of my capital in Grainger today.
Back to the Present: What actually happened
HOW WOULD HAVE IT PLAYED OUT IF I SOLD MY STAKE TODAY?
First, let’s talk about how the business has performed.
In 2015, Grainger had about $1.1B in net debt and had $1.4B in net PP&E.
The company spent on average $250M in capex each year, or about $1.4B from 2016-21. Over the same period, Grainger didn’t buy any businesses and winded down, in total dollar amounts, its operations outside of United States and Japan.
This resulted in 5% annual sales growth, growing from ~$10B in 2015 to $13B in 2021. Gross margin declined to ~35%, but management reduced their opex such that operating margin averaged 12% in any given year.
Additionally, management returned $1.9B through common dividends and returned ~$800M in buybacks, net of stock issuances. In most years during the 2016-21 period, management kept their net debt to EBITDA at around 1.5x.
Now, let’s see the return investors received at the investment date.
When the Singular Diligence Report was published in April 2016, the market cap was around $14.5B. Since then, their market cap has grown to ~$29B. When you add in the $1.9B in dividends, an investment in April 2016 would have created $16.7B for shareholders, or a 17% annual shareholder return.
Reflecting for the Future: On getting better
HOW WOULD I HAVE CHANGED MY PROCESS, GIVEN THE RESULTS?
Given the results, it “seems” I have made the wrong decision.
I would have compounded my capital above 15% over 6-7 years, which is a great record.
That’s where analyzing past results gets tricky in this case study. It’s not exactly black and white.
I am working off a write-up. And although it is very detailed and researched and written by clear thinkers, the 10,000 page report doesn’t contain all the answers to my questions.
Remember, the most important thing to do is analyze my approach (process) from the outcome (result). That’s the only way I can get better. And my approach relied on the following key quotes from the report (I’ve gone to the liberty to pick the quotes I was actually using in real time to make my decision):
“Since 1991, Grainger has spent $3.32 billion in cap-ex versus just $1.28 billion in acquisitions.”
“Grainger’s acquisition activity has been very low over the last 10 years. Most acquisitions were small. We have details on only a few.”
“Profit contribution from everything outside of the U.S. and Canada is minimal.”
“Grainger says it is staying in China and sees it as a long-term play. We’re not convinced.”
“Grainger recently made an even bigger investment along these lines in the U.K. It bought a company called Cromwell… Grainger’s own business in Canada isn’t that different from the figures we’ve seen for Cromwell. Grainger paid 11 times EBITDA for Cromwell. It hopes to increase the online business.”
“Grainger constantly lowers its share count. The company dilutes shares – by about 1.5% a year – by issuing stock options to employees. But then the company buys back even more of the shares than it issued. Over the last 15 years, annual share dilution from stock options – net of shares repurchased using proceeds from the exercise of stock options – was 0.7% a year.”
The reason why the investment turned out to be wildly success is because (1) management didn’t buy any new businesses (2) management essentially exited out their operations outside of USA and Japan (3) management used the remaining capital to repurchase its stock aggressively.
Could I have perceived these things with those quotes? Let’s investigate further.
For the first two points, I had known that company spent about 30% of their capital in M&A over the last 25 years. The report also claimed that they had very low acquisition activity in the last 10 years. I had no idea what “low acquisition activity” meant. The report even claimed that 30% of capital spent on M&A was low. To me, that is high.
And although businesses outside of USA and Japan contributed only 5% of EBIT, I rationalized that management could definitely spend much more than 5% of their earnings in these businesses. They had opted to stay in China, which is strange to believe they wouldn’t reinvest in the business if they see it as a “long-term play,” as described in the report. And they had failed in every other venture aside from Japan.
So I was skeptical with what “low acquisition activity” meant. And management’s track record made me skeptical that they would change.
My skepticism on the report turned out to be right. I just pulled from financials from 2006-15. And to the writers, “low acquisition activity” over the last decade meant $1.3B. This was 25% of earnings, or 37% of total capital spend. This was an extremely uncomfortable number.
So I feel like I was rightly justified to believe that they could maintain or increase their spend in acquisitions, especially international ones.
But management didn’t do any of those things. They completely stopped acquisitions. And they exited out of their international businesses, except for MonotaRO.
Even if I had information outside of the Singular Diligence report – shareholder letters, transcript, investor presentations and the like – I don’t know if I would have been able to spot it looking strictly backwards. I would have needed to see a change in management attitude each year in the 2016-2021 period.
I think this is similar to what Buffett does. Buffett often invests in companies he has followed for a long time after there seems to be a change or shift in capital allocation.
If I was investing back in 2016, I most likely would have passed on Grainger but kept it on my watchlist. Remember, I said, “Grainger is unique that I don’t see the company losing sales. Out of all the companies in this case study series so far, Grainger probably has the most durable business.” So ideally, I would have followed to see if the situation would have changed with management.
And it turns out that management telegraphed this to some extent in their November 2016 Investor Day.
“You won't see us taking positions in markets outside of these core markets. We have some existing positions that are breakeven or better than that, that we'll hold. Good example is China, where we've gone through a period where we lost money for years. We're now making money. That market continues to evolve, but it's a relatively modest position. In general, our portfolio is going to be very, very focused geographically. And consistent with that strategy, our portfolio is really heavily concentrated in North America, Japan and the U.K. We've eliminated a number of positions outside of these markets, and what remains outside is really, really small.”
And then management walked the walk when they didn’t buy a single company in 2016. Prior to that, management bought at least one company each year for previous 10 years. And if one year wasn’t enough evidence for me, I think two years of zero deals and an Investor Day in 2017 would have given me enough conviction. If I bought the stock at either period – after the 2016 10-K release and after the 2017 Investor Day – I would have generated double-digit returns (half of the value creation was during from 2021-2022, but we’ll come back to that).
So I think my process was justified in regards to management’s acquisition and international philosophy. And because the acquisition faucet was turned off, more of their cash flow went towards buybacks than ever before. These three things were all dependent on each other.
There’s one thing I haven’t mentioned yet. If you look, 50% of the sales growth and market value growth came from the last two years. COVID-19 is a black swan. There is no way anyone could have predicted that. Grainger certainly benefited from the pandemic.
If you held from April 2016 to February 2020 (before COVID-19 hit), your annual return from capital appreciation and dividends would have been around 6%, which is below our hurdle. Additionally, sales growth in 2020 and 2021 averaged 7% per year, which is higher than the 4% between 2016 and 2019.
So can you count Grainger as a successful investment in light of this black swan event?
It’s hard to say. I tried to make my decision without the hindsight of COVID-19. Even though I can’t deny that my knowledge of the pandemic happened, it’s clear I didn’t factor it into my analysis. Re-reading my thesis, it’s clear that I just assumed normal economic conditions.
In my case study on Town Sports, the company went bankrupt during COVID, I wrote:
“COVID-19 was a negative factor for a lot of industries, including the gym industry. However, I don’t think it is appropriate to say that COVID-19 was the reason that I was right (I knew I would have been right anyways judging by 2019 results). It is always impossible to predict what black swan events will occur. However, if you are planning to hold for 10 years, you should always expect some type of black swan event to occur. Prepare for black swan events by having an adequate margin of safety baked into the price. In a situation where a company needs a significant amount of debt (not by preference, but by intrinsic nature), it is very hard to protect yourself from catastrophic loss even with a 30%+ margin of safety (from intrinsic value).”
I think Grainger is a little different from Town Sports. Yes, Grainger had debt just like Town Sports. But certainly not as much debt. And the demand for Grainger’s services is much less discretionary than Town Sports.
When you invest, you shouldn’t strictly expect “normal economic environments.” You should always factor in some type of abnormality. And the best way to do that is by buying companies with disciplined attitudes towards debt and businesses whose industries have durability and longevity in and through cycles.
So although the business and market performance for Grainger wasn’t amazing before COVID-19, I struggle to believe that Grainger would have actually been a bad buy-and-hold investment for 5 years if COVID-19 never happened. They were already exiting out of their international businesses before COVID. And they were aggressively buying back their stock.
There were a few other things that should be mentioned. First, gross margins declined much more rapidly than my expectations. It fell from 45% to 36%. Management reduced its opex accordingly to get operating margins more similar to its past, but they were 300 basis points lower than their long-term average of 15%. Second, Grainger’s working capital became much more efficient, thus generating more operating cash flow compared to its net income. And lastly, sales grew in-line with my expectations. I could dig into more about how and why I was right on any of these things, but they are undoubtedly less important than what has already been discussed. The point of the case study is to look at the things that were most critical to the investment result so that I could calibrate my process.
This was the most unique case study I have done.
I did the case study on Grainger and MSC at the same time. Technically, I read the Singular Diligence report on MSC first, then Grainger second.
Because these two companies were in the same case study, it made sense to look at them at the same time. If I were actually investing in 2016, I would have definitely looked at them at the same time, both as a peer and as an investment opportunity.
For Grainger, it was helpful, but not essential, to know how MSC approached the MRO market. For MSC, it was critical to know how Grainger fit into the industry.
Although the results differed than my expectations, I think my process was justified in the fact that the narrative changed. And I laid out how I would have probably approached it if I was investing around that time.
I felt much more decisive when dealing with Grainger. I felt much more indecisive with MSC. Maybe it’s because I read Grainger second, so I knew what to compare it to. But because Grainger and MSC were similarly priced in each case study, it was easy to compare – all I had to do was decide which business and management team I liked better.
What does decisive feel like? It’s hard to explain. Because as I said, out of all the case studies, Grainger felt like the one that was most on the border of achieving 10% annual returns. But looking back at my notes and writing, I think the “decisiveness” came from (a) a high price (b) a mixed track record of capital allocation. The combination of these two made it feel like it wasn’t a no-brainer.
In conclusion, I think I made a reasonably fast decision. I spent a total of 5.5 hours thinking and writing my investment thesis, after about 3.5 hours of analyzing and reflecting on the results. After the Grainger and MSC case study, I am feeling more confident about where my strike zone is.
This is a great case study for evaluating two similar stocks trading at a similar price. And how to think about the results of a stock in the context of a Black Swan Event.
I recommend that anyone looking to improve their process find their own way to do case studies like these.
If you want to read write-ups similar to Geoff Gannon’s Singular Diligence newsletter, please visit focusedcompounding.com where Geoff and Andrew currently publish their content.