Posted on January 8, 2015 by David Laidlaw
In early December, we bought Grainger (GWW) in client accounts. GWW is the market leading distributor in the maintenance, repair and operations (MRO) products industry. GWW supplies products to over 1.4 million customers ranging from hospitals to construction companies to gyms. GWW has been buying out competitors and enjoys outsized returns on invested capital (ROIC).
The most important research question that we try to answer before buying a new company is “what could go wrong with the underlying business?” In most cases, competitive pressures aimed at pricing and/or quality are the greatest threats to a company’s ability to generate future cash flows.
One of the largest threats to GWW, in the opinion of many analysts and our own research, is Amazon (AMZN) through its Amazon Supply website. AMZN represents a credible threat given that it already has distribution capabilities and it has shown a willingness to lose money (lots of money) in pursuit of market share. When we asked GWW’s investor relations contact about AMZN, we could hear the agitation in the executive’s voice. He had obviously dealt with the question before and seen GWW thrive despite AMZN’s entrance into the marketplace.
Investors bullish on AMZN often rely on the theory that AMZN can enter any market and dominate that market by lowering prices. The theory continues that even though Amazon loses money initially that it will then be able to raise prices and increase profitability after the competition is removed. This scenario hasn’t happened so far. In fact, the launch of its phone in June of 2014 at $199 with a 2 year contract with AT&T demonstrated the opposite. The phone’s price was dropped to $0.99 in September and has not received favorable reviews. AMZN’s stock declined more than 20% in 2014 as it missed expectations and lost even more money than expected. The phone’s failure has been a small reality check on AMZN’s long-term prospects. Maybe the company can’t take over any market it chooses.
Amazon Supply is in beta, but to some degree we can understand GWW’s annoyance with the question. GWW is the leader in its industry with years of experience, and the company’s executives don’t think AMZN can just swoop in and grab market share. We think GWW can protect its market share for a few reasons. One is that GWW mostly targets medium and large customers which requires a hands-on sales approach- from customized pricing to on-site delivery with inspection. These are not generally the customers targeted by Amazon Supply. Small customers account for only 4% of GWW’s total revenue. In addition, GWW operates a website similar to Amazon Supply called Zoro. Revenue from Zoro’s website has grown 40% over the past year. Also, prices are essentially the same between the two companies in the small customer segment and GWW’s Zoro has a wider product selection.
At the end of the day, AMZN is a threat to GWW and really any retailer or technology company given its willingness to lose money- and the market’s patience (for now) with that business model. But AMZN can’t be everything to everyone. Instead, we prefer the market leader with the proven ability to generate cash.