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W.W. Grainger, Inc.

Using the Preferred Procedure to Forecast EPS

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Editor’s note: The following is an edited adaptation of an online stock study of W.W. Grainger, Inc.(ticker: GWW) in early 2009 conducted by Brian Altschul, a director of BetterInvesting’s New Jersey Chapter. 
This article is for educational purposes only meant to illustrate a key concept of BetterInvesting's fundamental investing principles: that sales growth drives earnings growth. No investment recommendation is intended. Readers are urged to conduct their own stock study of anycompany of interest using their own judgments. Our thanks to Brian and the other volunteers for their participation in this event, which attracted more than 600 members.

Grainger provides products to keep a company’s facilities up andrunning. The customers are 1.8 million businesses in 150 countries.Obviously, all the businesses that they service are unique, so theyalways are looking to solve different problems for different companies.As of 2007, their sales were $6.4 billion.

They have three basic business segments:

• Grainger Branch-Based. The Industrial Supply division providesfacilities maintenance products in the United States. They also have abusiness in Mexico, and in September 2006 they opened their firstlocation in China.
•  Lab Safety. This supplies safety and other industrial products in the United States and Canada.
•  Acklands-Grainger Branch-Based. This is Canada’s leading broadline distributor of industrial, fleet and safety products.
Inthe frequently asked questions section of the company’s website, we cansee that their financial goals are for sales growth of 7 percent to 10percent, operating margin of 11 percent to 15 percent and a return oninvested capital of more than 20 percent. That’s good information,especially when we start completing an SSG.

Estimating Sales Growth

Onthe Grainger SSG, you can see that things look pretty good. In ’98 and’99, there was a bit of a downturn, especially in profits (the pinkline on Section 1 of the SSG) and earnings (the blue line). But they’vecertainly been doing well since 2000.
When you do an SSG,the first thing you want to look at is what’s going on with sales —that’s really the first decision you have to make. The 10-year salesgrowth has been 3.7 percent a year, but you can see that they’ve beendoing very well over the last five or six years. Earnings have beengrowing significantly as well, especially recently.
Whenforecasting sales, one resource I like to look at is Value Line. In thenew report, they’re projecting 7 percent annual growth for the nextthree to five years. In the Value Line report from three months before,the sales growth projection was actually 9 percent, and now they’relooking at 7 percent. Remember that Grainger is looking at 7 percent to10 percent growth over the next three to five years. And at Yahoo!Finance, the analysts’ consensus estimate of earnings growth for thenext five years is 11.7 percent.
Another resource is thePortfolio Evaluation Review Technique form (for trackingtrailing-four-quarter trends in sales, pre-tax profits and earnings).We can see that they’ve certainly been doing a good job keeping thosesales pretty steady and increasing.
So let’s get right into the poll for sales growth. The choices are:

•  3.7 percent, the 10-year growth rate
•  8.2 percent, the five-year growth rate
•  9.6 percent, the growth rate for the most recent four quarters as seen on the PERT form
•  11.7 percent, the analysts’ consensus estimate of long-term earnings growth at Yahoo! Finance
(Participantsselect 8.2 percent. With $6.9 billion in sales over the last fourquarters, this means sales would be almost $10.2 billion in five years.)

Using Preferred Procedure for EPS Growth

Nowwe’re going to use the Preferred Procedure to estimate growth inearnings per share. This method takes the sales growth projection — inthis case, 8.2 percent a year — and subtracts the expenses and taxes.What you’re left with are the earnings. Then you divide by theprojected number of shares outstanding to determine the earnings pershare (see table, left).
A projected growth rate of 8.2percent will result in almost $10.2 billion in sales five years out. Sonow we take a look at the profit margin (what’s left over afterexpenses but before taxes are subtracted). In Section 2A of the SSG,which covers percent pre-tax profit on sales, we can see that they’vebeen doing a very good job increasing the profit margin — 8.2 percentin 2003, 8.8 percent in 2004, 9.6 percent in 2005, 10.2 percent in 2006and 10.6 percent in 2007. The average for the last five years is 9.5percent.
Value Line doesn’t have a profit margin line, butthey do have operating margin. The difference is that operating margindoesn’t take out the taxes and profit margin does. But you can see thatGrainger has been doing a good job increasing the operating margin from10.2 percent in 2003 to 12.5 percent in 2007. Value Line also projectsthe operating margin to go to 15 percent three to five years out. Thisis a pretty significant increase of 20 percent.
Now we have to make a decision about Grainger’s future profit margin. Our choices for the estimated profit margin are:

•  9.5 percent, which is the average of the last five years
•  9.9 percent, a weighted average that puts the most emphasis on 2007 and the least emphasis on 2003
•  11.3 percent, the profit margin over last four quarters
•  12.7 percent, using the growth in the operating margin suggested by Value Line
(Participantsselect 9.9 percent. With the rate of pre-tax profits at 9.9 percent,projected pre-tax profits on $10.2 billion of sales would be just over$1 billion. This means expenses would amount to $9.2 billion.)
Thenext line in the Preferred Procedure is the tax rate paid on theprofits. The most recent year’s rate was 38.4 percent. I wouldn’tchange that number too quickly because in general, it won’t change verymuch. Over the last 10 years, the rate has been as low as 35 percentand as high as 42 1/2 percent. Most U.S. companies will be between 35percent and 40 percent.
The only time I would be sureabout changing this number would be in instances where maybe the ratewas currently at, say, 20 percent, much lower than in the past. I wouldsay, well, I don’t have any knowledge this is going to continue; theymust have gotten some kind of tax break or incentive to lower their taxrate. I would change it to somewhere between 35 percent and 40 percent,because that’s where I would suspect the rate would be in five years.
Soin this case, I’m going to leave the 38.4 percent tax rate, which wouldsubtract $387 million from net profits of $1 billion in five years.This would leave us with $621 million in projected earnings five yearsfrom now.
The next consideration is the number of commonshares outstanding. Grainger has significantly decreased the number ofshares outstanding. There were 94 million shares outstanding in 1998,then the number of shares went down to 84 million in 2006 and 79million in 2007. The current number is 76 million. Value Line isprojecting 75.5 million for 2008, 75 million in 2009 and 70 milliongoing out three to five years.
I generally wouldn’t be tooquick to change this number from the most recent figure, but in thiscase I’m going to use the Value Line forecast of 70 million. When acompany says that they plan to buy back shares, they don’t alwaysactually follow through. In this case, Grainger has obviously beenfollowing through, and there’s some feeling this will continue over thenext three to five years.
Changing this number actuallymade a big difference in the EPS growth. Using the 76 million figure,annual EPS growth was 6.4 percent. When I input 70 million, the resultis 8.2 percent growth, which very interestingly is actually ourfive-year projected sales rate. It doesn’t always work out that way,but it’s interesting that it did. So I’m going to go ahead and use thatgrowth forecast, which results in EPS of $8.87 five years out (thestarting point is the last four quarters of EPS — $5.98).

Forecasting High and Low P/Es

Nowwe’ll take a look at the price-earnings ratio history in Section 3. Wecan see that the spread between the high and low stock prices has beenpretty consistent. We have a current price of $78.81, with a high inthe past year of $94 and a low of almost $59. So the low this year waslower than in 2006 and 2007. We definitely want to keep that in mind aswe go into Section 4.
Grainger’s stock has had veryconsistent P/Es. For the high P/Es, the highest was 21.6 in 2003; thelowest, 19.2 in 2005. On the high side, the average was 20.4.Similarly, the low P/Es have been very consistent. The P/Es in thefirst five years of the 10-year history were higher than what we’vebeen seeing over the last five years, and over the last five years thehigh P/E has been much more consistent. This is good to know as we lookat what we want to use for our average high P/E.
For the10-year P/E history, one thing I like to do is eliminate the fivehighest high P/Es and low P/Es. For the high P/Es, the five highest areall from 1998 to 2002, so the average of the five remaining P/Es is thesame as the five-year average. On the low P/E side, the average of theremaining five figures is 13.7.
Now we’ll select the high P/E. The choices are:

•  24, a 20 percent expansion from the most recent year’s high P/E
•  22, a 10 percent expansion from the most recent year’s high P/E
•  20, the high P/E from the most recent year
•  17.5, the average of the high and low P/Es over the past five years
•  16, a 20 percent deflation from the most recent year’s P/E
(Thechoice of 22 has replaced 20.4, which was both the five-year averagehigh and the average of the lowest five high P/Es in the past 10 years,because 20.4 is so close to 20, the third choice. Participants select20.)
On the low P/E, we have:

•  14.7, the five-year average low
•  13.7, the average of the lowest five low P/Es for the last 10 years
•  12.5, the current P/E
•  10, a 20 percent deflation from the current P/E
(Thechoice of 13.9, the low P/E for the most recent year, has been removedbecause it’s so close to 13.7, the second choice. Participants select13.7.)

Setting a Low Price

Weselected 13.7 as our low P/E. We then multiply this by the most recentyear’s earnings to determine a choice for the low price. In 2007 theEPS was $4.94, but we can also take a look at this based on the lastfour quarters of EPS ($5.98), which I’m going to go ahead and do. Thatresults in $81.90.
Now, that’s significantly high, beingthat the low this year was $58.90. It’s also higher than the presentprice and a lot higher than the low price of the last couple of years.
Wehave other choices here. The average low price for the past five yearswas $53.50. The recent severe market low was $58.90, which is also the52-week low. The price a dividend will support is $82, but you can seethat the yield is less than 2 percent. So it isn’t a stock people arespecifically going to buy for the dividend.
In our final poll, the choices for the low price are:

•  $81.90, the result of multiplying the low P/E by the low EPS
•  $53.50, the average low for the past five years
•  $58.90, the recent severe market low
•  $82.10, the price the dividend will support
•  $47.10, 20 percent depreciation from the 52-week low
Myidea with the final choice is that this is something you may want toconsider if you think the price is going to continue to go down. If youhonestly believe that the price will go down by more than 20 percent,you probably aren’t all that interested in the stock and should lookelsewhere.
(The result is a tie between $53.50 and $58.90. $58.90 is used for the SSG.)

Studying Potential Return

Theresult of the projections is that the current price of $78.81 is in theBuy zone, with $58.90 being at the low end of the range and $88.50 atthe high end. The middle range goes up to $147.80, and the Sell zonegoes up to $177.40 (the result of multiplying the high P/E of 20 by thehigh EPS of $8.87).
With an average yield of 1.3 percentand total annual price appreciation of 17.6 percent, we’re looking at acompounded rate of return of 19 percent.

Assessing Grainger’s ROE and Debt Levels

Wealready took a look at the company’s profit margin (see the section onPreferred Procedure), so I won’t go too much more into that. Section 2Bof the Stock Selection Guide is for the percent earned on equity, orthe return on equity. This is basically the ability for the company toinvest in itself.
Grainger has been doing well here. The ROEwas 17.8 percent going back to 1998. It dropped to 12.1 percent in 1999and 11.2 percent in 2000, but since then they’ve been doing very well.The rate was 18.7 percent in 2007, and the average of the last fiveyears is 15 percent. So the trend is up. That’s terrific; they have theability to take the money they have and reinvest it in themselves.
Graingerhas also done a terrific job in reducing their debt. They didn’t havevery high debt to begin with. The debt-to-equity ratio was between 7percent and 10 percent, but most recently it has been 0.2 or 0.3percent.
This isn’t necessarily the end of the story,however. In the Capital Structure box of the Value Line report, I cansee they recently increased long-term debt to almost $500 million.Value Line is projecting they will continue to reduce this debt, whichthey actually have been doing already.
It does bring upkind of a red flag — why are they taking on this debt, especially inthis economy? — but it isn’t really a lot of debt for a company of thissize. Also, the company is saying they’re using this debt for theirexpansion into Mexico and especially China.

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