W.W. Grainger (GWW 3.33%) is a Dividend Aristocrat, with an incredible track record of 46 consecutive annual dividend increases. That's a dividend streak that few companies have managed. Although Grainger's business of supplying maintenance, repair, and operating products throughout the world may be boring, it has clearly been rewarding for dividend investors. However, the internet has forced the company to adjust its business model. Is the dividend safe through this transition period?
The digital wave hits Grainger
W.W. Grainger's goal is to sign customers to long-term contracts and then provide them with reliable service, with the hope of becoming an integral part of their business operations. Historically, part of the process of winning a customer was to have a list price for its products and then a contracted price, which was lower -- an enticement to sign a contract.
The internet didn't seem to be an issue for a long time, but the web's transparent pricing was clashing with W.W. Grainger's business model. That fact has started to catch up to it. The impact is most evident in the sales of one-off items, which the company calls spot volume. This is roughly 30% of its U.S. large company business, a segment that saw a nearly 15% volume decline in fiscal 2016. Essentially, it was cheaper to buy infrequently purchased, non-contract items from someone else online.
To management's credit, it saw the issue, recognized the potential scale of the problem, and took action. Cutting prices to be more competitive with online retailers, however, is a risky proposition because it upends W.W. Grainger's entire sales approach. It also puts notable pressure on margins. The company's EBITDA, operating, and profit margins all hit a peak in 2014 and then started to head lower until the second half of 2017, when a notable uptick began to take shape. It looks like W.W. Grainger is finally making some progress, but here's the big question for dividend investors: Does the company have the financial wherewithal to support the dividend while it adjusts to a changing market?
The good news and bad news
The first place to look for an indication of W.W. Grainger's ability to keep the dividend increases going is the balance sheet, a company's financial foundation. Long-term debt makes up around 55% of the company's capital structure -- a little higher than I would normally like to see but not unreasonable. The business is backed by the frequent sale of small products, which provides a constant flow of cash to support interest payments.
A comparison of W.W. Grainger's debt levels to fellow Dividend Aristocrats Colgate-Palmolive (CL 1.90%) and Kimberly Clark (KMB 1.80%), which sell small, frequently purchased items like soap, toothpaste, toilet paper, and paper towels, helps here. This pair of consumer goods giants has continued to increase dividends despite debt making up roughly 100% of the capital structure in recent years. Part of the reason they can handle such high debt levels is that their businesses are backed by frequent, small sales. W.W. Granger's balance sheet looks rock-solid by comparison.
Another important balance sheet metric for W.W. Grainger is the current ratio, which is a measure of a company's ability to pay its near-term bills. W.W. Grainger's current ratio of more than 2 suggests it has enough cash on hand to pay its day-to-day bills twice over. That's a nice counterbalance to the company's leverage, creating a total picture that looks quite strong.
That said, W.W. Grainger's earnings hit a peak in 2015 before declining in 2016. GAAP earnings picked up slightly in 2017, but were still roughly 14% below the level achieved two years earlier. It shouldn't be surprising, then, to hear that the dividend payout ratio has moved higher in recent years. The payout ratio was as low as 30% at the start of the decade but was 50% in 2017. That's a trend to keep an eye on, but still plenty of dividend coverage. In fact, there's even enough room for future increases. And if the company is successful in adjusting along with the markets its serves, which I think it will be, the payout ratio should start to come back down again.
Dividends, though, don't actually come out of earnings, they come out of cash flow, so you'll also want to take a close look at the cash flow statement. W.W. Grainger was able to increase its cash balance by nearly 20% year over year in 2017. But there's even more good news here: W.W. Grainger purchased roughly $600 million worth of stock compared to the approximately $300 million in dividends it paid out. Pull out the stock purchases and there's plenty of extra cash to support the dividend.
W.W. Grainger is a company working through a transition. You don't build an annual dividend track record like the one it has without some ups and downs along the way. With early indications of progress, the company's dividend appears to be on solid footing. The dividend's growth rate may be relatively slow for a few years, but that's a prudent move on management's part to ensure the long-term safety of the disbursement. That said, W.W. Grainger's shares have recovered sharply as its business has begun to show signs that it is adjusting to a new normal, so the stock looks a bit expensive today. But if you own it for the dividend, there doesn't appear to be much to worry about.