W. W. Grainger - 10-Q quarterly report FY2011 Q1

 

 

(In thousands of dollars, except for share and per share amounts)

(Unaudited)

 

 

The accompanying notes are an integral part of these financial statements.

(In thousands of dollars)

(Unaudited)

 

 

 

The accompanying notes are an integral part of these financial statements.

W.W. Grainger, Inc. and Subsidiaries

(In thousands of dollars, except for share and per share amounts)

 

 

 

 

W.W. Grainger, Inc. and Subsidiaries

(In thousands of dollars, except for share and per share amounts)

 

 

 

 

The accompanying notes are an integral part of these financial statements.

(Unaudited)

 

 

 

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 an expanding presence in 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, 2010 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, 2010 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.

 

 

On April 27, 2011, the Company’s Board of Directors declared a quarterly dividend of 66 cents per share, payable June 1, 2011, to shareholders of record on May 9, 2011.  This represents a 22% increase from prior quarterly rate of 54 cents per share. 

 

 

 

The Company generally warrants the products it sells against defects for one year.  For a significant portion of warranty claims, the manufacturer of the product is responsible for the expenses associated with this warranty program.  For warranty expenses not covered by the manufacturer, the Company provides a reserve for future costs based on historical experience.  The warranty reserve activity was as follows (in thousands of dollars):

 

 

(Unaudited)

 

 

The Company uses foreign currency forward contracts to minimize the foreign exchange rate effect on its net investment in its Canadian subsidiary.  These forward contracts are designated and qualify as a hedge of a net investment in a foreign subsidiary.  The Company uses the forward method of assessing hedge effectiveness for derivatives designated as hedging instruments of a net investment in a foreign subsidiary.  All changes in fair value of the derivatives are reported as a component of other comprehensive earnings (losses), net of tax effects, as long as specific hedge accounting criteria are met.  The Company from time to time also enters into cash flow hedging instruments.  The Company does not enter into derivative financial instruments for trading or speculative purposes.

 

During the fourth quarter of 2010, the Company entered into multiple foreign currency forward contracts with a total notional value of Canadian Dollar (CAD) $160 million maturing in September 2014. At March 31, 2011 and December 31, 2010, the fair value of these contracts (Level 2 input) included in Deferred income taxes, tax uncertainties and derivative instruments was a liability of $9.4 million and $5.8 million, respectively.

 

 

 

The Company has a postretirement healthcare benefits plan that provides coverage for a majority of its employees 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):

 

 

The Company has established a Group Benefit Trust to fund the plan and process benefit payments.  The funding of the trust is an estimated amount which is intended to allow the maximum deductible contribution under the Internal Revenue Code of 1986 (IRC), as amended.  There are no minimum funding requirements and the Company intends to follow its practice of funding the maximum deductible contribution under the IRC.  During the three months ended March 31, 2011, the Company contributed $1.0 million to the trust.

 

 

(Unaudited)

 

 

The Company has two reportable segments:  the United States and Canada.  The United States operating segment reflects the results of Grainger’s U.S. business.  The Canada operating segment reflects the results for Acklands – Grainger Inc., the Company’s Canadian business.  Other Businesses include the following operating segments which are not material individually and in the aggregate:  MonotaRO Co., Ltd. (Japan), Grainger, S.A. de C.V. (Mexico), Grainger Industrial Supply India Private Limited (India), Grainger Caribe Inc. (Puerto Rico), Grainger China LLC (China), Grainger Colombia SAS (Colombia) and Grainger Panama S.A. (Panama).  Operating segments generate revenue almost exclusively through the distribution of maintenance, repair and operating supplies as service revenues account for less than 1% of total revenues for each operating segment.  Following is a summary of segment results (in thousands of dollars):

 

 

 

 

 

 

(Unaudited)

 

 

 

 

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

 

 

 

Unallocated expenses and unallocated assets primarily relate to the Company headquarters’ support services, which are not part of any business segment.  Unallocated expenses include payroll and benefits, depreciation and other costs associated with headquarters-related support services.  Unallocated assets primarily include non-operating cash equivalents, certain prepaid expenses, deferred income taxes and non-operating property, buildings and equipment.

 

 

 

 

 

 

(Unaudited)

 

 

 

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):

 

 

 

 

 

 

(Unaudited)

 

 

As previously reported, in December 2007, the Company received a letter from the Commercial Litigation Branch of the Civil Division of the Department of Justice (the “DOJ”) regarding the Company’s contract with the United States General Services Administration (the “GSA”).  The letter suggested that the Company had not complied with its disclosure obligations and the contract’s pricing provisions, and had potentially overcharged government customers under the contract.

 

Discussions with the DOJ relating to the Company’s compliance with its disclosure obligations and the contract’s pricing provisions are ongoing.  The timing and outcome of these discussions are uncertain and could include settlement or civil litigation by the DOJ to recover, among other amounts, treble damages and penalties under the False Claims Act.  Due to uncertainties surrounding this matter, an estimate of possible loss cannot be determined. While this matter is not expected to have a material adverse effect on the Company’s financial position, an unfavorable resolution could result in significant payments by the Company.  The Company continues to believe that it has complied with the GSA contract in all material respects.

 

As previously reported, the Company received a subpoena dated August 29, 2008 from the United States Postal Service (“USPS”) Office of Inspector General seeking information about the Company’s pricing compliance under the Company’s contract with the USPS covering the sale of certain Maintenance Repair and Operating Supplies (the “MRO Contract”).  

 

As previously reported, the Company received a subpoena dated June 30, 2009 from the USPS Office of Inspector General seeking information about the Company’s pricing practices and compliance under the Company's contract with the USPS covering the sale of certain janitorial and custodial items (the “Custodial Contract”).   

 

Discussions with the USPS and DOJ relating to the Company’s pricing practices and compliance with the pricing provisions of the MRO Contract and the Custodial Contract are ongoing.  The timing and outcome of the USPS and DOJ investigations are uncertain and could include settlement or civil litigation by the USPS and DOJ to recover, among other amounts, treble damages and penalties under the False Claims Act.  Due to uncertainties surrounding these matters, an estimate of possible loss cannot be determined. While these matters are not expected to have a material adverse effect on the Company’s financial position, an unfavorable resolution could result in significant payments by the Company.  The Company continues to believe that it has complied with each of the MRO Contract and the Custodial Contract in all material respects.

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 an expanding presence in Asia and Latin America.

 

Grainger uses a multichannel business model to provide customers with a range of options for finding and purchasing products utilizing sales representatives, direct marketing materials and catalogs.  Grainger serves approximately 2.0 million customers worldwide through a network of highly integrated branches, distribution centers, multiple websites and export services.

 

Grainger’s two reportable segments are the United States and Canada.  The United States segment reflects the results of Grainger’s U.S. business.  The Canada segment reflects the results for Acklands – Grainger Inc., Grainger’s Canadian business.  Other businesses include the following:  MonotaRO Co., Ltd. (Japan), Grainger, S.A. de C.V. (Mexico), Grainger Industrial Supply India Private Limited (India), Grainger Caribe Inc. (Puerto Rico), Grainger China LLC (China), Grainger Colombia SAS (Colombia) and Grainger Panama S.A. (Panama).

 

Business Environment

Several economic factors and industry trends tend to shape Grainger’s business environment.  The overall economy and leading economic indicators provide insight into anticipated Company performance for the near term and help in forming the development of projections for the rest of the year.  Historically, Grainger’s sales trends have tended to correlate with industrial production and non-farm payrolls.  According to the Federal Reserve, overall industrial production increased 5.9% from March 2010 to March 2011.  The improvement in the economy has positively affected Grainger’s sales growth for the first quarter of 2011.

 

In April 2011, Consensus Forecasts-USA projected 2011 Industrial Production and GDP growth for the United States of 4.9% and 2.9%, respectively.  In April 2011, Consensus Forecasts-USA projected GDP growth of 2.9% for Canada.

 

The light and heavy manufacturing customer end-markets have historically correlated with manufacturing employment levels and manufacturing output.  Manufacturing output increased 1.7% from March 2010 to March 2011 while manufacturing employment levels increased 1.0%.  Grainger’s heavy and light manufacturing customer end-markets outperformed these indicators as sales to these customer end-markets increased in the high teens and high single digits, respectively, for the three months ended March 31, 2011.

 

 

As a result of strong sales growth and operating performance during the quarter, combined with continued economic strengthening, Grainger raised 2011 sales growth guidance on April 18, 2011 to a range of 7 to 10 percent and earnings per share guidance to a range from $8.10 to $8.60.  In November 2010, the Company issued its initial 2011 guidance of 5 to 9 percent sales growth and earnings per share of $7.15 to $7.90.

 

The new sales guidance reflects stronger demand patterns for the remainder of the year than originally estimated at the end of 2010, although sales growth for the remainder of the year is not expected to be as strong as sales growth experienced in the first quarter of 2011.  The first quarter of 2011 included one extra selling day.  In addition, the second quarter is the anniversary of the 2010 Gulf of Mexico oil spill which generated significant incremental sales that will not repeat in 2011.

 

The new earnings per share guidance reflects a moderation of gross profit margins and a higher level of spending during the remainder of the year versus the first quarter. Grainger’s gross profit margins follow a fairly consistent seasonal pattern, with higher gross margins in the first and fourth quarters than in the second and third quarters.  A contributor to higher first quarter gross margins is supplier funding for annual customer trade shows.  Gross profit margins for the remainder of the year are also expected to be lower than the first quarter due to higher product and fuel costs.

 

Operating expenses are anticipated to be higher the remainder of the year driven by increased spending on growth initiatives such as additional sales representatives, eCommerce and advertising. In addition, there will be incremental operating expenses associated with a project to extend Grainger’s U.S. SAP platform across remaining operations in the Americas and the opening of the new distribution center in Northern California in the 2011 fourth quarter.

 

 

 

 

 

 

 

Matters Affecting Comparability

There were 64 and 63 sales days in the first quarter of 2011 and 2010, respectively.  Grainger completed several acquisitions throughout 2010, all of which were immaterial individually and in the aggregate.  Grainger’s operating results have included the results of each business acquired since the respective acquisition dates.

The following table is included as an aid to understanding the changes in Grainger’s Condensed Consolidated Statements of Earnings:

 

 

Grainger’s net sales of $1,883.6 million for the first quarter of 2011 increased 13% compared with sales of $1,672.4 million for the comparable 2010 quarter.  Sales were up 11% on a daily basis.  For the quarter, approximately 7 percentage points of the sales growth came from an increase in volume, approximately 2 percentage points from price and approximately 1 percentage point of the sales growth came from business acquisitions.  In addition, sales were positively affected by 1 percentage point due to foreign exchange.  Sales to all customer end-markets increased for the first quarter of 2011.  The overall increase in net sales was led by a low twenties increase to agriculture and mining customers, followed by a high teens increase to heavy manufacturing customers.  Refer to the Segment Analysis below for further details.

 

Gross profit of $829.6 million for the first quarter of 2011 increased 18%.  The gross profit margin during the first quarter of 2011 increased 1.8 percentage points when compared to the same period in 2010, primarily driven by price increases exceeding product cost increases.  See the Outlook section for a discussion of expectations for gross profit margins for the remainder of the year.

 

Operating expenses of $567.0 million for the first quarter of 2011 increased 8%.  Operating expenses increased at a slower rate than sales, although benefits-related expenses increased at a faster rate than the sales increase due to higher profit sharing tied to performance and higher healthcare costs.

 

 

 

 

 

Operating earnings for the first quarter of 2011 were $262.6 million, an increase of 44% compared to the first quarter of 2010.  The increase in operating earnings was primarily due to higher sales, an improved gross profit margin and operating expenses which increased at a slower rate than sales.

 

Net earnings for the first quarter of 2011 increased by 59% to $157.9 million from $99.2 million in the first quarter of 2010.  The increase in net earnings for the quarter primarily resulted from an increase in operating earnings.  Diluted earnings per share of $2.18 in the first quarter of 2011 were 66% higher than the $1.31 for the first quarter of 2010 due to increased net earnings and fewer shares outstanding.  During the first quarter of 2010, Grainger recorded a non-cash charge of $11.2 million, or $0.15 per share, to write down a deferred income tax asset following the passage of the Patient Protection and Affordable Care Act.  Grainger also recognized a $10.3 million benefit that resulted from a paid time off policy change, which reduced the related liability and which positively benefited earnings per share by $0.08.  Excluding these items, earnings per share would have been 58% higher than the first quarter of 2010.

 

Segment Analysis

The following comments at the segment and business unit level include external and intersegment net sales and operating earnings.  See Note 6 to the Condensed Consolidated Financial Statements.

 

Net sales were $1,537.7 million for the first quarter of 2011, an increase of $129.6 million, or 9%, when compared with net sales of $1,408.1 million for the same period in 2010.  Sales in the United States were up 7% on a daily basis.  For the quarter, approximately 5 percentage points of the sales growth came from an increase in volume and approximately 2 percentage points due to price.  Sales to all customer end-markets increased for the first quarter of 2011.  The overall increase in net sales was led by a high teens increase to heavy manufacturing customers.

 

The gross profit margin increased 1.8 percentage points in the 2011 first quarter over the comparable quarter of 2010 primarily driven by price increases exceeding product cost increases.  See the Outlook section for a discussion of expectations for gross profit margins for the remainder of the year.

 

Operating expenses in this segment were up 7% in the first quarter of 2011 versus the first quarter of 2010.  Operating expenses increased at a slower rate than sales, although benefits-related expenses increased at a faster rate than the sales increase due to higher profit sharing tied to performance and higher healthcare costs.

 

Operating earnings of $256.4 million for the first quarter of 2011 increased 27% from $201.6 million for the first quarter of 2010.  The increase in operating earnings for the quarter was primarily due to higher sales, an improved gross profit margin and operating expenses which increased at a slower rate than sales.

 

 

Net sales were $242.4 million for the first quarter of 2011, an increase of $48.3 million, or 25%, when compared with $194.1 million for the same period in 2010.  Daily sales were up 23% or 17% in local currency for the quarter driven by 11 percentage points from volume, 4 percentage points from acquisitions and 1 percentage point each from price and sales of seasonal products.  The increase in net sales was led by growth in the heavy manufacturing, agriculture and mining, forestry, oil and gas, transportation and government customer end-markets.

 

The gross profit margin increased 3.8 percentage points in the 2011 first quarter versus the first quarter of 2010 driven by less price discounting and better customer mix.  In addition, product cost deflation tied to the strength of the Canadian dollar, along with price increases, contributed to this expansion.  See the Outlook section for a discussion of expectations for gross profit margins for the remainder of the year.

 

Operating expenses were up 14% in the first quarter of 2011 versus the first quarter of 2010.  In local currency, operating expenses increased 8% primarily due to increased commissions, bonus accruals and incremental costs for acquisitions.

 

Operating earnings of $23.9 million for the first quarter of 2011 were up $17.6 million, or 279% over the first quarter of 2010.  In local currency, operating earnings increased 260% in the first quarter of 2011 over the same period in 2010.  The increase in earnings was primarily due to an improved gross profit margin and operating expenses which increased at a slower rate than sales.

 

Net sales for other businesses, which include Japan, Mexico, India, Puerto Rico, China, Colombia and Panama, increased 44% for the first quarter of 2011 when compared to the same period in 2010. The sales increase was due to strong growth from Japan and Mexico, along with incremental sales from the business in Colombia, acquired in June 2010.  Operating earnings were $6.4 million for the first quarter of 2011, an improvement over operating results that were essentially breakeven in the first quarter 2010.  The improvement was primarily driven by strong earnings growth in Japan and Mexico along with lower operating losses in China and India.

 

Other Income and Expense

Other income and expense was expense of $1.5 million in the first quarter of 2011, a decrease of $0.4 million compared to $1.9 million of expense in the first quarter of 2010.

 

Income Taxes

Grainger’s effective income tax rates were 39.1% and 45.1% for the first quarter of 2011 and 2010, respectively.  Excluding the one-time impact from the health care legislation, the first quarter 2010 effective tax rate was 39.3%.  The year-over-year 0.2 percentage point decrease in the effective rate was primarily due to higher earnings reported in foreign jurisdictions with lower tax rates, partially offset by a higher income tax rate adopted in the state of Illinois in the first quarter of 2011.

 

 

 

 

Cash from operating activities continues to serve as Grainger’s primary source of liquidity.  Net cash provided by operating activities was $118.4 million and $113.2 million for the three months ended March 31, 2011 and 2010, respectively.  Contributing to cash flows from operations were net earnings in the three months ended March 31, 2011 of $159.1 million compared to $99.4 million in 2010.   Offsetting these amounts were changes in operating assets and liabilities, which resulted in a net use of cash of $79.0 million in the first quarter of 2011 compared to $36.7 million in the first quarter of 2010.  Other current liabilities declined primarily due to annual cash payments for profit sharing and bonuses, which were higher in 2011 versus 2010.

 

Net cash used in investing activities was $28.0 million and $22.9 million for the three months ended March 31, 2011 and 2010, respectively.  Cash expended for additions to property, buildings, equipment and capitalized software was $28.4 million in the first three months of 2011 versus $13.8 million in the first three months of 2010.  Capital expenditures in 2011 included funding of infrastructure improvement projects for distribution centers in the United States and Canada.

 

Net cash used in financing activities was $73.4 million and $7.2 million for the three months ended March 31, 2011 and 2010, respectively.  The $66.2 million difference in cash used in financing activities for the three months ended March 31, 2011 was due primarily to higher treasury share repurchases.  Cash paid for treasury stock purchases was $50.7 million for the first three months of 2011 versus $6.4 million for the first three months of 2010.  Grainger also used cash to pay dividends to shareholders of $38.3 million and $34.1 million for the first three months of 2011 and 2010, respectively.

 

For the three months ended March 31, 2011, working capital of $1,479.7 million increased by $110.9 million when compared to $1,368.8 million at December 31, 2010.  The increase in working capital primarily relates to higher accounts receivable balances on higher sales.  The ratio of current assets to current liabilities increased to 2.9 at March 31, 2011 versus 2.6 at December 31, 2010.

 

Grainger maintains a debt ratio and liquidity position that provides flexibility in funding working capital needs and long-term cash requirements.  In addition to internally generated funds, Grainger has various sources of financing available, including bank borrowings under lines of credit.  Total debt as a percent of total capitalization was 17.0% at March 31, 2011 and 17.8% at December 31, 2010.

 

 

 

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.

 

 

 

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.

 

 

 

For quantitative and qualitative disclosures about market risk, see “Item 7A: Quantitative and Qualitative Disclosures About Market Risk” in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010.

 

Item 4.       Controls and Procedures

 

 

Grainger carried out an evaluation, under the supervision and with the participation of its management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of Grainger’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15.  Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that Grainger’s disclosure controls and procedures were effective as of the end of the period covered by this report.

 

 

There were no changes in Grainger’s internal control over financial reporting that occurred during the first three months that have materially affected, or are reasonably likely to materially affect, Grainger’s internal control over financial reporting.

 

 

Items 1A, 3 and 5 not applicable.

 

 

 

 

As previously reported, in December 2007, the Company received a letter from the Commercial Litigation Branch of the Civil Division of the Department of Justice (the “DOJ”) regarding the Company’s contract with the United States General Services Administration (the “GSA”).  The letter suggested that the Company had not complied with its disclosure obligations and the contract’s pricing provisions, and had potentially overcharged government customers under the contract.

 

Discussions with the DOJ relating to the Company’s compliance with its disclosure obligations and the contract’s pricing provisions are ongoing.  The timing and outcome of these discussions are uncertain and could include settlement or civil litigation by the DOJ to recover, among other amounts, treble damages and penalties under the False Claims Act.  Due to uncertainties surrounding this matter, an estimate of possible loss cannot be determined. While this matter is not expected to have a material adverse effect on the Company’s financial position, an unfavorable resolution could result in significant payments by the Company.  The Company continues to believe that it has complied with the GSA contract in all material respects.

 

As previously reported, the Company received a subpoena dated August 29, 2008 from the United States Postal Service (“USPS”) Office of Inspector General seeking information about the Company’s pricing compliance under the Company’s contract with the USPS covering the sale of certain Maintenance Repair and Operating Supplies (the “MRO Contract”).  

 

As previously reported, the Company received a subpoena dated June 30, 2009 from the USPS Office of Inspector General seeking information about the Company’s pricing practices and compliance under the Company's contract with the USPS covering the sale of certain janitorial and custodial items (the “Custodial Contract”).   

 

Discussions with the USPS and DOJ relating to the Company’s pricing practices and compliance with the pricing provisions of the MRO Contract and the Custodial Contract are ongoing.  The timing and outcome of the USPS and DOJ investigations are uncertain and could include settlement or civil litigation by the USPS and DOJ to recover, among other amounts, treble damages and penalties under the False Claims Act.  Due to uncertainties surrounding these matters, an estimate of possible loss cannot be determined. While these matters are not expected to have a material adverse effect on the Company’s financial position, an unfavorable resolution could result in significant payments by the Company.  The Company continues to believe that it has complied with each of the MRO Contract and the Custodial Contract in all material respects.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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