Grainger (GWW) has seen its stock price slide by more than 20% since early February, catching the attention of many value-focused dividend growth investors.
After all, it’s rare to see such a high quality business tumble so quickly, and one of the most effective habits of dividend investing is to let market volatility work for you.
With 45 consecutive years of dividend increases, Grainger is particularly notable because it is one of the dividend aristocrats. You can learn more about all of the aristocrats here.
Despite Grainger’s impressive long-term track record, the company’s past success doesn’t necessarily mean the future will be just as bright.
That could be especially true if Amazon (AMZN) increasingly threatens Grainger’s business economics.
Let’s take a closer look at Grainger, the risks posed by Amazon, and whether or not the dip could be a buying opportunity for long-term dividend growth investors.
Grainger’s roots can be traced back to the late 1920s, and the company is now the largest distributor of maintenance, repair, and operating (MRO) products such as motors, lab supplies, power transmission, test instruments, outdoor equipment, safety products, power tools, and janitorial supplies.
Nearly 5,000 manufacturers supply Grainger with a broad offering of more than 4 million commercial and industrial products, which are made available to customers through Grainger’s branches and distribution centers.
The average customer invoice for Grainger’s products is about $250, and customers place orders over the phone, at local branches, online, and using mobile devices. Over 70% of the company’s sales are made to large customers.
Grainger serves customers across a number of markets, including heavy manufacturing (18% of 2015 sales), commercial (14%), government (13%), light manufacturing (11%), contractor (10%), transportation (6%), and retail/wholesale (6%).
The company’s customers essentially depend on Grainger to help them manage their inventory more efficiently and keep their businesses up and running. With an integrated supply chain, substantial purchasing power, strategically located distributions, and even on-site vending machines for convenience, Grainger has been an extremely reliable partner for decades.
Investors can learn more about some of Grainger’s competitive advantages in my original thesis here.
The Industrial Distribution Industry is Rapidly Evolving
In 2015, approximately 41% of Grainger’s total sales came from online channels, nearly triple their share of 15% in 2009.
Last year, Grainger’s e-commerce sales increased to 60% of total revenue, and management expects that figure to reach as high as 80% by 2022.
This marks a major change in how the company’s customers make purchasing decisions.
Historically, Grainger issued massive product catalogs to purchasing managers and relied on a steady flow of foot traffic and phone calls to its brick-and-mortar branches.
While Grainger has invested in its online platform since the mid-1990s, the rapid shift online has still forced Grainger to adapt.
The company’s total branch locations have declined from 390 in 2013 to 284 in 2016, and continued closures seem likely in response to shifting customer behavior.
Stepping even further back, the distribution industry has been evolving for quite some time.
In fact, distributors’ share of U.S. GDP has fallen from 20% in 1995 to 14% by 2010, according to the Industrial Supply Magazine.
The magazine article goes on to state that “new, lower-cost models of distribution, retail entities entering into the traditional distribution chain, and e-commerce entities including Amazon, Google, and eBay are slowly eating away at the established model of business.”
Amazon threw its hat into the industrial distribution ring in 2012 when it introduced Amazon Supply, which later merged into Amazon Business in 2015.
Amazon Business sells hundreds of millions of products to businesses and generated sales of more than $1 billion in its first year.
An Amazon executive recently called Amazon Business a “top priority” for the company and identified only Grainger and Staples as its main competitors.
The executive also noted that Amazon has been “pleasantly surprised” by the response from large customers (Amazon Business originally focused on small and medium sized businesses) and is using custom pricing to differentiate versus Grainger’s less transparent pricing.
For many years, Grainger was able to substantially mark up the prices on inventory it acquired from its thousands of products manufacturers, enjoying fat margins and dependable profit growth.
The company’s large customers could receive nice discounts on the list prices in Grainger’s product catalogues, but it was still difficult to determine what a “fair” price was.
Amazon is looking to change all of that, bringing low-cost inventory from thousands of business supply vendors online, where pricing is transparent and comparison shopping is easy.
With industrial distribution rapidly migrating online (remember, Grainger’s e-commerce sales as a percentage of total revenue are up from 15% in 2009 to 60% last year), pricing games can no longer be played so easily.
This is my biggest fear with Grainger, which could face margin compression and weaker long-term growth as a result.
Check out what Grainger’s CEO D.G. Macpherson recently said:
“We’ve had a very high-list, less-discount model. Large customers particularly valued getting discounts off of lists. We will continue to have that model, but our list prices are too high right now, so we’ve moderated some of those. The idea is that we have to be able to acquire customers through the Grainger brand, and you can’t keep digital marketing if the price you feature is always higher than everyone else…As product and price transparency has become more prevalent, it’s become a source of contention with customers and we don’t need that.”
His comments make it very clear that the rise of e-commerce and Amazon have begun to alter the way the company has to do business.
Rather than set prices high and profit from the lack of information available to customers, Grainger is now becoming much more of a price taker as e-commerce levels the playing field a bit.
I expect this trend to continue over the coming years, and I’m not sure there is much Grainger can do about it to continue its strong growth.
How Grainger Could Combat Amazon’s Threat
Perhaps Grainger’s biggest advantage over Amazon is its customer relationships. The company employs thousands of sales people and account managers who work directly with customers to help them place their orders and run their businesses more efficiently. It’s common for Grainger employees to visit customer sites several times per week.
Ryan Merkel, a William Blair analyst, argued the bull case well when he said, “For a professional, a Caterpillar procurement manager, he cares about technical support, too much inventory, the line being down, the safety of his people. He values the ability to call the call center or have a Grainger person show up two to three times a week.”
Large customers account for the majority of Grainger’s sales and tend to have more complex purchasing needs than small businesses, making Grainger’s high level of customer service more valuable and perhaps even more important than some of the prices it charges for various products. Grainger’s purchasing and inventory management systems are directly integrated with many large customers as well, increasing the stickiness of its relationships.
Grainger could also look to differentiate itself if it invested in services and even light manufacturing. This would position the company as much more than a basic distributor while increasing switching costs and perhaps making it easier for the company to maintain its current level of profitability in an increasingly online world.
Closing Thoughts on Grainger
As the e-commerce wave continues to wash over the industrial distribution industry, I suspect it will become more difficult for Grainger to command the price premiums it has historically enjoyed.
Online shopping makes it much easier for consumers and businesses to price shop, giving more negotiating leverage to Grainger’s customer base of large companies.
While Amazon is not an existential threat to Grainger’s business, I believe the rise of e-commerce will impair Grainger’s long-term earnings growth rate and the returns on invested capital it can earn.
The highly fragmented nature of the industrial distribution industry certainly provides a long runway for Grainger to continue taking market share and moderately grow over time.
However, I suspect incremental share gains will ultimately deliver lower returns compared to 20%+ return on invested capital that Grainger has generated for most of the past decade.
Consolidation isn’t exactly a great answer against Amazon’s low-cost, price-transparent model, and the continued rise of the online world could make Grainger look a lot more like a commodity business over the coming years.
With the stock trading at a premium forward P/E multiple of 18.5, I’m not sure that the market is acknowledging the long-term growth headwinds and lower returns Grainger could face.
For that reason, I am more inclined to pass on the stock even despite its large pullback, high Dividend Safety Score.