W. W. Grainger - 10-Q quarterly report FY2015 Q2

W.W. Grainger, Inc. is a broad-line distributor of maintenance, repair and operating supplies, and other related products and services used by businesses and institutions.  W.W. Grainger, Inc.’s operations are primarily in the United States and Canada, with a presence in Europe, Asia and Latin America.  In this report, the words “Company” or “Grainger” mean W.W. Grainger, Inc. and its subsidiaries.

The Condensed Consolidated Financial Statements of the Company and the related notes are unaudited and should be read in conjunction with the consolidated financial statements and related notes for the year ended December 31, 2014 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (SEC).

The Condensed Consolidated Balance Sheet as of December 31, 2014 has been derived from the audited consolidated financial statements at that date, but does not include all of the disclosures required by accounting principles generally accepted in the United States of America for complete financial statements.

The unaudited financial information reflects all adjustments (primarily consisting of normal recurring adjustments) which, in the opinion of management, are necessary for a fair presentation of the statements contained herein.

The Company uses derivative instruments to manage a portion of exposures to fluctuations in interest rates and foreign currency exchange rates. The Company does not enter into derivative financial instruments for trading or speculative purposes. The fair values of these instruments are determined by using quoted market forward rates (level 2 inputs) and reflect the present value of the amount that the Company would pay for contracts involving the same notional amounts and maturity dates. These instruments qualify for hedge accounting and the changes in fair value are reported as a component of other comprehensive earnings (losses) net of tax effects.

The Company has a postretirement healthcare benefits plan that provides coverage for a majority of its United States employees hired prior to January 1, 2013, and their dependents should they elect to maintain such coverage upon retirement. Covered employees become eligible for participation when they qualify for retirement while working for the Company. Participation in the plan is voluntary and requires participants to make contributions toward the cost of the plan, as determined by the Company.

The net periodic benefit costs charged to operating expenses, which are valued at the measurement date of January 1 and recognized evenly throughout the year, consisted of the following components (in thousands of dollars):

Following are reconciliations of segment information with the consolidated totals per the financial statements (in thousands of dollars):

Assets for operating segments include net accounts receivable and first-in, first-out inventory which are reported to the Company's Chief Operating Decision Maker. Other current and non-current assets include all other asset balances for the operating segments.

The following table sets forth the computation of basic and diluted earnings per share under the two-class method (in thousands of dollars, except for share and per share amounts):

From time to time the Company is involved in various legal and administrative proceedings that are incidental to its business, including claims related to product liability, general negligence, contract disputes, environmental issues, wage and hour laws, intellectual property, employment practices, regulatory compliance or other matters and actions brought by employees, consumers, competitors, suppliers or governmental entities. As a government contractor selling to federal, state and local governmental entities, the Company is also subject to governmental or regulatory inquiries or audits or other proceedings, including those related to pricing compliance. It is not expected that the ultimate resolution of any of these matters will have, either individually or in the aggregate, a material adverse effect on the Company's consolidated financial position or results of operations.

Grainger is a broad-line distributor of maintenance, repair and operating supplies, and other related products and services used by businesses and institutions. Grainger’s operations are primarily in the United States and Canada, with a presence in Europe, Asia and Latin America. Grainger uses a combination of multichannel and single channel business models to provide customers with a range of options for finding and purchasing products utilizing sales representatives, catalogs, direct marketing materials and eCommerce. Grainger serves more than 2 million customers worldwide through a network of highly integrated branches, distribution centers and websites.

Given Grainger's large number of customers and the diverse industries it serves, several economic factors and industry trends tend to shape Grainger’s business environment. The overall economy and leading economic indicators provide general insight into projecting Grainger's growth. Grainger’s sales in the United States and Canada tend to positively correlate with Gross Domestic Product (GDP), Industrial Production, Exports and Business Investment. In the United States, sales also tend to positively correlate with Business Inventory. In Canada, sales also tend to positively correlate with oil prices. The table below provides these estimated indicators for 2015:

On July 17, 2015, Grainger revised the 2015 sales growth guidance from a range of 1 to 4 percent to a range of 0 to 2 percent and also revised the 2015 earnings per share guidance from a range of $12.25 to $12.95 to a range of $12.00 to $12.50. The revised sales and earnings per share guidance reflects expectations of slower macroeconomic growth.

The increase in net sales was led by growth in sales to government, diversified commercial services and light manufacturing customers. The sales growth was partially offset by declines to the natural resources, heavy manufacturing, resellers and contractors customer end markets. Refer to the Segment Analysis below for further details.

The table below reconciles reported diluted earnings per share determined in accordance with generally accepted accounting principles (GAAP) in the United States to adjusted diluted earnings per share, a non-GAAP measure. Management believes adjusted diluted earnings per share is an important indicator of operations because it excludes items that may not be indicative of core operating results. Because non-GAAP financial measures are not standardized, it may not be possible to compare this financial measure with other companies' non-GAAP financial measures having the same or similar names.

Grainger’s two reportable segments are the United States and Canada. The United States segment reflects the results of Grainger’s U.S. operating segment. The Canada segment reflects the results for Acklands – Grainger Inc., Grainger’s Canadian operating segment. Other businesses include Zoro and operations in Europe, Asia and Latin America.

The following comments at the segment and business unit level include external and intersegment net sales and operating earnings. See Note 8 to the Condensed Consolidated Financial Statements.

The increase in net sales was led by mid-single digit growth to government, commercial service and light manufacturing customers. Retail customers were up in the low single digits and heavy manufacturing and contractors were down in the low single digits. Net sales to resellers were down in the high single digits and the natural resources customer end market was down in the low teens. Low oil prices negatively impacted the performance of the heavy manufacturing and natural resources customer end markets. Sales to Zoro also contributed to sales growth as the U.S. business' supply chain network is Zoro's primary source of inventory.

Sales performance in Canada was driven by declines in the oil and gas, construction, reseller, commercial, retail and heavy manufacturing customer end markets, partially offset by growth from government, mining, utilities and light manufacturing customer end markets. The Alberta region, which represents more than one-third of the sales in the Canadian business, decreased 18% versus prior year as it was negatively impacted by lower oil prices. Sales growth for the remaining regions in aggregate was positive.

 

Costs associated with the shutdown of the business in Brazil and restructuring expenses for the business in Europe are expected to continue through the second half of 2015.

Other income and expense was $8 million of expense in the second quarter of 2015 compared to $2 million of expense in the second quarter of 2014. The increase in expense was driven by higher interest expense from the new $1 billion in long-term debt issued in early June, as well as operating losses from a new investment in a limited liability company established to produce clean energy. As discussed below, the operating losses in this investment were offset by energy tax credits that lowered Grainger's tax rate, which provided Grainger with positive net earnings and cash flow.

There were 127 sales days in the six months of 2015 and 2014. Grainger completed the WFS acquisition in the third quarter of 2014 and announced plans to close the business in Brazil in the fourth quarter of 2014, both of which were immaterial individually and in the aggregate.

Grainger’s net sales of $4,962 million for the six months of 2015 increased 1% compared with sales of $4,892 million for the comparable 2014 period. The 1% increase for the period consisted of the following:

The increase in net sales for the six months of 2015 was led by growth in sales to government, light manufacturing and commercial service customers. The sales growth was partially offset by declines in the natural resources, contractors and reseller end markets. Refer to the Segment Analysis below for further details.

Gross profit of $2,167 million for the six months of 2015 was flat compared to the same period in 2014. The gross profit margin during the six months of 2015 decreased 0.4 percentage point when compared to the same period in 2014, primarily driven by faster growth with lower margin customers, lower supplier rebates tied to lower-than-expected volume and price deflation versus cost inflation driven by foreign exchange.

Operating expenses of $1,459 million for the six months of 2015 were flat to the $1,462 million for the comparable 2014 period. Operating expenses in 2015 included $4 million in costs associated with shutting down the business in Brazil and restructuring the business in Europe. Operating expenses in 2014 included a $14 million charge related to the transition of the employee retirement plan in Europe. Excluding these charges from both years, operating expenses for 2015 were slightly higher than the comparable 2014 period, primarily driven by $58 million in incremental growth and infrastructure spending, offset by lower payroll and benefits and savings from productivity initiatives in the United States.

 

Operating earnings for the six months of 2015 were $708 million, an increase of $13 million, compared to the six months of 2014. Excluding the charges in both years mentioned above, operating earnings were flat versus prior year. Higher sales and positive operating expense leverage were offset by lower gross profit margins.

Net earnings attributed to W.W. Grainger, Inc. for the six months of 2015 increased by 2% to $432 million from $423 million in the six months of 2014. Diluted earnings per share of $6.32 in the six months of 2015 were 5% higher than the $6.00 for the six months of 2014, due to higher earnings and lower average shares outstanding.

The table below reconciles reported diluted earnings per share determined in accordance with generally accepted accounting principles (GAAP) in the United States to adjusted diluted earnings per share, a non-GAAP measure. Management believes adjusted diluted earnings per share is an important indicator of operations because it excludes items that may not be indicative of core operating results. Because non-GAAP financial measures are not standardized, it may not be possible to compare this financial measure with other companies' non-GAAP financial measures having the same or similar names.

Grainger’s two reportable segments are the United States and Canada. The United States segment reflects the results of Grainger’s U.S. operating segment. The Canada segment reflects the results for Acklands – Grainger Inc., Grainger’s Canadian operating segment. Other businesses include Zoro and operations in Europe, Asia and Latin America.

The following comments at the segment and business unit level include external and intersegment net sales and operating earnings. See Note 8 to the Condensed Consolidated Financial Statements.

Net sales were $4,002 million for the six months of 2015, an increase of $112 million, or 3%, when compared with net sales of $3,890 million for the same period in 2014. The 3% increase for the period consisted of the following:

The increase in net sales was led by mid-single digit growth to commercial service, light manufacturing and government customers. Retail and heavy manufacturing customers were up in the low single digits and net sales to contractors were down in the low single digits. Resellers were down in the mid-single digits and the natural resources customer end market was down in the high single digits. Sales to Zoro also contributed to sales growth as the U.S. business' supply chain network is Zoro's primary source of inventory.

The gross profit margin for the six months of 2015 decreased 0.6 percentage point compared to the same period in 2014, primarily driven by faster growth with large customers, price deflation exceeding cost deflation and the lower transfer price on intercompany sales to Zoro. Excluding sales to Zoro, gross profit margins decreased 0.2 percentage point versus prior year.

Operating expenses were up 1% in the six months of 2015 versus the six months of 2014, driven by $45 million of incremental spending on growth initiatives such as new sales representatives, eCommerce and inventory management solutions, partially offset by lower payroll and benefits and savings from productivity initiatives.

Operating earnings of $736 million for the six months of 2015 increased 2% from $719 million for the six months of 2014, driven by higher sales and positive operating expense leverage, partially offset by lower gross margins.

Net sales were $474 million for the six months of 2015, a decrease of $44 million, or 9%, when compared with $518 million for the same period in 2014. In local currency, sales increased 2%. The 9% decrease for the period consisted of the following:

Sales performance in Canada was driven by declines in the oil and gas, construction, commercial services and heavy manufacturing customer end markets, partially offset by growth from utilities, mining, government and light manufacturing customer end markets.

 

The gross profit margin decreased 0.9 percentage point in the six months of 2015 versus the six months of 2014, primarily due to lower margins from WFS. Excluding the impact of WFS, gross margins decreased 0.2 percentage point due to the effect of unfavorable foreign exchange from products sourced from the United States and inventory write-downs associated with transitioning to the new Toronto distribution center, partially offset by price increases and higher freight revenue.

Operating expenses in the six months of 2015 were flat versus the six months of 2014. In local currency, operating expenses increased 13%, primarily due to incremental costs from WFS, and one-time costs related to the relocation to the new Toronto distribution center.

Operating earnings of $19 million for the six months of 2015 were down $22 million, or 53%, versus the six months of 2014. In local currency, operating earnings decreased by 47%, driven by negative operating expense leverage and lower gross margins.

Net sales for other businesses, which include Zoro U.S. and operations in Europe, Asia and Latin America, were $617 million for the six months of 2015, an increase of $43 million, or 7%, when compared with net sales of $574 million for the same period in 2014. The drivers of net sales for the period consisted of the following:

Operating earnings of $25 million in the six months of 2015 increased $17 million compared to the six months of 2014.

Operating earnings in 2015 included $4 million in costs associated with shutting down the business in Brazil and restructuring the business in Europe. Operating earnings in 2014 included a $14 million charge related to the transition of the employee retirement plan in Europe and a $2 million write-off of capitalized software development costs in Mexico. Excluding these charges, operating earnings increased by $5 million versus the comparable 2014 period. The earnings performance for the period versus prior year was primarily driven by improved earnings from Zoro U.S. and the business in Japan, partially offset by startup costs for the single channel online business in Europe. Costs associated with the shutdown of the business in Brazil and restructuring expenses for the business in Europe are expected to continue through the second half of 2015.

Other income and expense was $12 million of expense in the six months of 2015 compared to $5 million of expense in the six months of 2014. The increase in expense was primarily driven by operating losses from a new investment in a limited liability company established to produce clean energy. As discussed below, the operating losses in this investment were offset by energy tax credits that lowered Grainger's tax rate, which provided Grainger with positive net earnings and cash flow.

Grainger’s tax rates were 36.9% and 38.0% for the six months ended June 30, 2015 and 2014, respectively. The decrease in the tax rate was due to energy tax credits associated with the investment in the limited liability company established to produce clean energy. Excluding the retirement plan transition cost, the tax rate was 37.7% in the 2014 period. Grainger is expecting a tax rate of approximately 36.6% to 37.2% for 2015.

Working capital consists of current assets (less non-operating cash) and current liabilities (less short-term debt and current maturities of long-term debt).

On April 16, 2015, Grainger announced plans to issue $1.8 billion in long-term debt over the next three years, to partially fund the repurchasing of $3 billion in shares. The remaining amount is expected to be funded from internally generated cash. In June 2015, Grainger issued $1 billion in long-term debt, which is the first of three expected debt issuances. The new debt is payable in 30 years and carries a 4.60% interest rate, payable semi-annually. With the new long-term debt, Grainger expects to maintain a debt to EBITDA ratio in the 1.0-1.5x range. EBITDA, which is defined as Earnings before Interest, Taxes, Depreciation and Amortization, is a non-GAAP measure and may not be defined and calculated by other companies in the same manner. See Note 4 to the Condensed Consolidated Financial Statements.

The preparation of financial statements, in conformity with accounting principles generally accepted in the United States of America, requires management to make judgments, estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses in the financial statements. Management bases its estimates on historical experience and other assumptions, which it believes are reasonable. If actual amounts are ultimately different from these estimates, the revisions are included in Grainger’s results of operations for the period in which the actual amounts become known.

Accounting policies are considered critical when they require management to make assumptions about matters that are highly uncertain at the time the estimates are made and when there are different estimates that management reasonably could have made, which would have a material impact on the presentation of Grainger’s financial condition, changes in financial condition or results of operations. For a description of Grainger’s critical accounting policies see Grainger's Annual Report on Form 10-K for the year ended December 31, 2014.

This Form 10-Q contains statements that are not historical in nature but concern future results and business plans, strategies and objectives and other matters that may be deemed to be “forward-looking statements” under the federal securities laws. These forward-looking statements include, but are not limited to, the Company’s expected or forecasted sales, earnings, tax rate, share repurchases, long-term debt, or earnings per share, and any associated guidance.

Grainger cannot guarantee that any forward-looking statement will be realized although Grainger does believe that its assumptions underlying its forward-looking statements are reasonable. Achievement of future results is subject to risks and uncertainties which could cause Grainger's results to differ materially from those which are presented.

Factors that could cause actual results to differ materially from those presented or implied in a forward-looking statement include, without limitation: higher product costs or other expenses; a major loss of customers; loss or disruption of source of supply; increased competitive pricing pressures; failure to develop or implement new technologies or business strategies; the outcome of pending and future litigation or governmental or regulatory proceedings; investigations, inquiries, audits and changes in laws and regulations; disruption of information technology or data security systems; general industry or market conditions; general global economic conditions; currency exchange rate fluctuations; market volatility; commodity price volatility; labor shortages; facilities disruptions or shutdowns; higher fuel costs or disruptions in transportation services; natural and other catastrophes and unanticipated weather conditions.

Caution should be taken not to place undue reliance on Grainger's forward-looking statements and Grainger undertakes no obligation to publicly update the forward-looking statements, whether as a result of new information, future events or otherwise.

Information on specific and significant legal proceedings is set forth in Note 10 to the Condensed Consolidated Financial Statements included under Item 1.