Caldwell North American Equity Strategy – Monthly Update January 31st, 2015
W. W. Grainger (GWW-us)
About the Company: Grainger is the largest broadline distributor of maintenance, repair and operation (MRO) supplies in North America. Nearly 80% of revenue comes from the US with the balance split between Canadian and International operations. The company offers 1.4 million products that are sold to a diverse set of end markets such as heavy and light manufacturing, commercial, government, contractor, natural resources, retail/wholesale, transportation and reseller. Grainger is a highly profitable company with a 10 year average return on capital of 18% and a balance sheet with minimal debt.
Investment Thesis: As the largest player with only 6% market share, Grainger has significant opportunity to consolidate the $135 billion U.S. market. Grainger’s core customer base is larger companies with 100+ employees. It has been growing above the market rate and gaining share in this area as their customers look to consolidate suppliers to lower costs and improve working capital through just in time inventory. We believe Grainger will continue to capture share at the expense of smaller competitors given the scale advantages of Grainger’s full service model, which consists of integrated inventory management and purchase processing software at client sites, an online ordering system (Grainger is the 13th largest e-retailer in North America), retail locations for emergency parts, dedicated sales teams, and a distribution network rivaled only by fedex, ups and amazon. Grainger is also starting to penetrate the medium to smaller customer segment through its online channel, which has shown good results.
Reasons We Sold the Stock: We owned Qualcomm for their participation in the growth of mobile connected devices through a) royalties from their 3G/4G patents; and b) their leading market position on mobile chipsets. The stock underperformed the last couple quarters as several Chinese OEMs have been underpaying their royalties. Our view was that this issue would be resolved given Qualcomm had successfully resolved similar disputes in the past and, in the meantime, the chipset business was posting great results. Turning to this most recent quarter, while Qualcomm announced good progress on the licensing issues, having signed a deal with a large Chinese OEM, they confirmed reports that Samsung will be dropping its chip from a major product launch. This resulted in guidance for the second half of 2015 to come in well below market expectations. We sold the stock on this news. Qualcomm’s dominance in the chipset space has made it tough for competitors to gain ground. We fear that competitors will view this slip as an opportunity to gain share, and our expectation is that they will do this aggressively through pricing, hurting margins and profitability for the foreseeable future.
Company Updates: A Few Highlights
Over the last few months, Onex has taken steps to ease concerns about the amount of cash on its balance sheet (something the market saw as a drag on investment performance). It first announced that it would increase its stake in its newest fund, Onex Partners IV, by 40% to $1.7B. It has also started investing the cash in the fund, making three investments to date. The companies acquired operate in the 1) aseptic packaging, 2) aerospace automation, tooling and maintenance, and 3) aerospace and nautical lifesaving/survival equipment industries. We think global economic uncertainty is positive for Onex as it provides opportunities to put cash to use and see continued upside to shares, despite strong performance so far this year.
Fourth quarter earnings were significantly impacted by legal and restructuring charges of $3.2B. As a reference, earnings came in at $326M and since much of the legal costs were not tax deductible, the effective tax rate was 72%. While future legal charges are not in management’s control, management believes “we have put a significant portion of our outstanding legal matters behind us.” Restructuring charges should also come down as the company slows closing/selling non-core business units. Tangible book value fell 1.2% over the prior quarter, one of only two declines in the last 19 quarters. Shares are trading at 84% of tangible book value, which we believe provides significant upside to the share price. Capital returns to shareholders have been a focus after being rejected by the Fed last year. This is likely the next catalyst for the shares.
Varian Medical (VAR-us)
Varian reported a strong December quarter driven by 28% growth in North America and 13% growth in its order backlog. The company is being conservative on guidance and we see significant upside in the coming quarters. Varian is still one of the cheapest names in the medical device space, despite strong demand for its cancer radiation-therapy equipment.
Amdocs also had a great quarter with 5% revenue growth and strong margin performance. The company announced 3 significant contract wins with cable/telecom companies around the world. Amdocs is well positioned to benefit from growing complexity in service provider offerings. The stock offers a very attractive 6%+ free cash flow yield, despite robust growth opportunities.
We appreciate your continued support. Please feel free to contact us at any time.
Investment Management Team