The Long-Term Risk Remains For Grainger

While conceding that W W Grainger Inc GWW's quarter was a strong one, UBS said in a note it sees long-term risk to operating margins. Along with those margin risk, concerns about valuation prompted a downgrade of the shares by the firm.

As such, the firm downgraded its rating on the shares of Grainger from Neutral to Sell but raised its price target from $170 to $195.

In pre-market trading, shares of the company were down 0.87 percent at $207.

Margin Woes Beckon

Analyst Christopher Belfiore said, though pricing action trends thus far have been encouraging, he doesn't think the 2x multiple expansion and the 15 percent run up in the stock since the reporting of the third quarter is warranted. Despite his upward revision to estimates and multiple, the analyst believes gross margin pressure isn't sufficiently priced into Graingner's shares.

Belfiore sees a high degree of uncertainty associated with long-term risk of gross margin pressure, with the analyst modeling a 100 basis-point contraction in 2018 and 20 basis-point contraction in 2019. The analyst also sees continued pricing pressure across the customers, including recurring contracts.

See also: W W Grainger Wins With Sticky Contracts For Large Clients

Execution On Pricing Leads To Upward Revision To Estimates

Despite the continued pressure on gross margin from pricing actions, UBS said operating margins held steady around 11 percent, down only 20 basis points sequentially. The firm sees this as a function of improved mix, of higher margin medium- and large-spot buy growth.

The cost actions the company is contemplating, according to UBS, can only temporarily benefit operating margin. Therefore, the firm sees a longer-term structural change to the operating profile.

"Ultimately we see higher likelihood they get competed away to the customer over time — and therefore not fully improving what we view as structurally lower GMs," the firm said.

UBS thinks the management's 2017 guidance, the mid-point of which was held at $10.65, is achievable. Citing the volume improvements, the firm raised its earnings per share estimates for 2017 from $10.20 to $10.65 and for 2018 from $12.30 to $13.00. However, the firm sees medium-term risk.

For 2018, the firm forecasts volume growth of 6 percent, gross margin contraction of 100 basis points to 38.1 percent and operating margin contraction of 40 basis points in the U.S. business.

The firm clarified that the upward revision to its price target was due to the slight increase in multiple by 1 times, given the solid execution to the company's pricing strategy to-date. However, the firm continued to see risk to margin profile, going forward.