Industrials

Brooke Sutherland is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

W.W. Grainger Inc.'s results weren't stellar, but what exactly were investors expecting?

The industrial-parts distributor has lost about a quarter of its market value over the past year amid worries that its efforts to combat Amazon.com Inc. with lower prices won't work and will make it less profitable. We got further proof of that Wednesday when Grainger reported a further deterioration in its gross margin during the second quarter as well as a deceleration in sales growth. Excluding the impact of currency swings and M&A, its revenue gains were actually weaker than peers Fastenal Co. and MSC Industrial Direct Co., notes RBC analyst Deane Dray. Those companies haven't implemented massive price cuts, suggesting they may not be having their desired effect at Grainger.

Punished
Investors pummeled Grainger's shares (again) on Wednesday
Source: Bloomberg
Note: Prices are intraday as of about noon.

Goldman Sachs Group Inc. analyst Joe Ritchie helpfully points out that the company's challenges have persisted this quarter. But why that's news for investors -- who punished Grainger with what was at times the biggest drop on the S&P 500 -- is a head-scratcher. They should have been prepared.

Gross margins, while down, are actually not quite as bad as analysts had been predicting they would be. Despite the slowdown, Grainger's revenue essentially matched expectations. The company maintained guidance for the full year. While sales from large customers didn't rise as much as Grainger had been predicting in May, revenue growth from medium-sized clients was better than forecast and that's been one of the markets the company has targeted most aggressively with its price reductions.  

More Pain Ahead
Grainger stood by its 2019 margin targets, but analysts have been increasingly pessimistic about its profitability. Based on current forecasts for that year's revenue, Grainger is expected to miss its goals.
Source: Bloomberg

Don't get me wrong, I don't think any of that is a sign of a miracle recovery in Grainger's business. Even if the price slashing eventually pays off in substantial sales growth (RBC's Dray notes the brunt of Grainger's expected 15 percent to 25 percent cuts will be completed by Aug. 1), the odds of Grainger recuperating its operating margin to reach its 2019 goals of 12 percent to 13 percent are slim.

But the more than 7 percent drop in Grainger's shares on Wednesday was its second-worst post-earnings performance since at least 2006, trailing only the first period of this year when it announced those aggressive price cuts and a correspondingly hefty pullback in guidance. This wasn't a hunky-dory earnings report, but it wasn't as bad as that. So either some Grainger investors have only just crawled out from underneath a rock and are still catching up on the fact Amazon is in the industrial-distribution business or this panicking has gone a bit too far, too fast.

How Low Can You Go
Grainger's precipitous drop has pushed it well below where even dubious analysts on average had predicted the stock would trade over the next year
Source: Bloomberg, analyst reports
Note: Only one analyst has a buy rating on Grainger. The price target reflected here is an estimate for what the company would be valued at in a takeover scenario in 2017. This data is as of a June 1 report, the analyst's most recent update on the company.

Consider that only a single analyst tracked by Bloomberg recommends buying Grainger stock, and yet as a group they are still on average calling for an 11 percent RISE in the shares over the course of the next 12 months. Among those that are recommending investors sell the stock, the average price target is about $166 -- about 3 percent above the current trading price.

Maybe analysts are still too optimistic, although their profit and sales forecasts for the current quarter did prove appropriate. Things are only going to get tougher for Grainger as the year goes on. But that should be a surprise to no one at this point.  

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Brooke Sutherland in New York at bsutherland7@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net