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Grainger Downgraded to Neutral

Zacks Equity Research

We have downgraded our recommendation on W.W. Grainger Inc. (GWW) from Outperform to Neutral, given the slowdown in its sales in April and the entry of Amazon.com Inc. (AMZN) in the maintenance, repair & operations (MRO) space.

Grainger’s first quarter 2012 earnings increased 19% year over year to $2.57 per share, while revenues advanced 16% to $2.193 billion. Both outperformed the respective Zacks Consensus Estimates.

Grainger remains focused on expanding its product offerings and growing the share of its private label products. The company’s catalog, issued in February 2012, offers around 410,000 compared with 350,000 products in the February 2011 issue.

The company has a long-term vision to expand the count to 500,000 products by 2015. It has historically seen approximately 2% incremental growth per year on sales from products added through the program.

Currently, 23% of Grainger’s 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 primary areas of focus 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 the global infrastructure.

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

The e-commerce business currently generates 27% 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 allow the company 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 41 consecutive years, a record that only 12 companies in the S&P500 can claim. Going forward, the company will continue to redeploy cash and plans to repurchase approximately 2% of outstanding shares each year.

On the flipside, we believe margins will be under pressure due to Grainger’s accelerated growth investments: product line expansion, sales force expansion, e-commerce, inventory services, distribution centers and international expansion.

Furthermore, Grainger’s sales growth of 12% in April 2012 was weaker than expected, as management had hinted in the first quarter conference call that even though sales growth in April had a slow start due to the religious holidays, but was expected to be roughly in line with the 15% growth in March. Sales growth has dipped as compared with the 17% growth witnessed in January, 18% in February and 15% in March this year.

Amazon has recently launched www.AmazonSupply.com, a website offering more than 500,000 parts/supplies to business, industrial, scientific and commercial customers at competitive prices. Grainger is presently a dominant player in industrial maintenance, repair & operations distribution, with a product offering of 413,000. With the entry of Amazon in this space, we expect pricing pressure.

We have thus downgraded our recommendation from Outperform to Neutral on Grainger. The quantitative Zacks #3 Rank (short term Hold rating) for the company indicates no clear directional pressure on the stock over the near term.

Illinois-based W.W. 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) and WESCO International Inc. (WCC).

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