Grainger to Outperform

We have recently upgraded W.W. Grainger Inc. (GWW - Analyst Report) from Neutral to Outperform encouraged by its successful market share strategy which includes increased product offerings, expansion of private label products, sales force investment and focus on e-commerce. A sound balance sheet coupled with cash flow enables Grainger to further invest in growth opportunities, increase dividends and reinvest capital through share repurchases.

Grainger reported third-quarter EPS and revenues of $2.51 and $2.11 billion, respectively, both outperforming Zacks Consensus Estimates. The company maintained the sales momentum in October and November, posting growth of 16% and 15%, respectively. For 2011, the company expects sales growth of 11% to 12% and EPS in the range of $8.85 to $9.00.

Grainger remains focused on expanding its product offerings and growing the share of its private label products. The company’s catalog, issued in February 2011, offers around 350,000 compared with 307,000 products in the February 2010 issue.

The company plans to expand its offerings to 413,000 products in February 2012 and has a long-term vision to expand the count to 500,000 products by 2015. The company has historically seen approximately 2% in incremental growth per year on sales from products added through the program.

Currently, 23% of Grainger sales are from private label, but the company expects to increase that to 40% over time. Private label has been a significant driver of sustainable margin expansion over the past few years, especially in the globally sourced product category.

Grainger also focuses on expansion programs to strengthen its businesses in each of its operating regions, mainly in Asia and Latin America. Approximately 25% of 2012 sales are expected to come from outside the U.S compared with 10% in 2002. The focal areas for international growth are sales and earnings growth in the existing markets, selective expansion into new markets in a phased approach and ongoing development of global infrastructure.

E-commerce is one of Grainger’s most efficient channels as it is reportedly growing twice as fast as other channels and is considered Grainger’s most profitable channel. Grainger continues to invest in e-commerce and expects to increase the number of customers utilizing this channel and up its contribution to overall sales.

The e-commerce business currently generates 25% of Grainger’s revenues and there is scope to drive it up to 50% in the next five years. This channel also carries higher margins as it requires lower selling, general and administrative costs.

Grainger’s sound balance sheet, low debt level and cash flow characteristics enable Grainger to further invest in growth opportunities, increase dividends and reinvest capital through share repurchases. The company has been rewarding shareholders with an uninterrupted streak of increased dividends for 40 consecutive years, a record that only 12 companies in the S&P 500 can claim.

Going forward, the company will continue to redeploy cash and plans to repurchase approximately 2% of outstanding shares each year. We expect Grainger to announce a significant increase in its dividend as the company has indicated that it would grow its payout ratio over time.

Considering the overwhelming positives, we upgrade our recommendation from Neutral to Outperform on Grainger. The quantitative Zacks #1 Rank (short term Strong Buy rating) for the company indicates upward pressure on the stock over the near term.

Illinois-based Grainger is a leading North American distributor of material handling equipment including safety and security supplies, lighting and electrical products, power and hand tools, pumps and plumbing supplies, etc. The company’s services comprise inventory management and energy efficiency solutions. The company competes with Applied Industrial Technologies Inc. (AIT - Snapshot Report) and WESCO International Inc. (WCC - Analyst Report).

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