UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended June 30, 2005
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Fof the transition period from _______ to _______
Commission File Number 1-5684W.W. Grainger, Inc.(Exact name of registrant as specified in its charter)
(847)535-1000 (Registrant’s telephone number including area code)
NotApplicable (Former name, former address and former fiscal year; if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes ___X____ No _______
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
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PART I — FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
W.W. Grainger, Inc. and Subsidiaries CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS (In thousands of dollars, except for per share amounts) (Unaudited)
The accompanying notes are an integral part of these financial statements.
W.W. Grainger, Inc. and Subsidiaries CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE EARNINGS (In thousands of dollars) (Unaudited)
W.W. Grainger, Inc. and Subsidiaries CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands of dollars, except for per share amounts)(Unaudited)
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W.W. Grainger, Inc. and Subsidiaries CONDENSED CONSOLIDATED BALANCE SHEETS (Continued)(In thousands of dollars, except for per share amounts)(Unaudited)
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W.W. Grainger, Inc. and Subsidiaries CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands of dollars) (Unaudited)
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W.W. Grainger, Inc. and Subsidiaries CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)(In thousands of dollars)(Unaudited)
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W.W. Grainger, Inc. and Subsidiaries NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)
1. BACKGROUND AND BASIS OF STATEMENT PRESENTATION
W.W. Grainger, Inc. is engaged in the distribution of facilities maintenance products, services and related information used by businesses and institutions in North 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, 2004, 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, 2004, 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 (consisting of normal recurring adjustments), which, in the opinion of management, are necessary for a fair presentation of the statements contained herein. Certain prior period amounts have been reclassified to conform to the current year’s presentation.
STOCK INCENTIVE PLANS
The Company maintains various stock incentive plans and accounts for these plans under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The Company recognizes compensation cost for restricted shares and restricted stock units granted to employees. No compensation cost is recognized for stock option grants. All options granted under the Company’s plans have an exercise price equal to the closing market price of the underlying common stock on the last trading day preceding the date of grant.
The following table illustrates the effect on net earnings and earnings per share if the Company had applied the fair value recognition provisions of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” to stock-based compensation. The following table also provides the amount of stock-based compensation cost included in net earnings as reported.
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W.W. Grainger, Inc. and Subsidiaries NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)(Unaudited)
NEW ACCOUNTING STANDARDS
In March 2005, the FASB issued Interpretation No. 47 (FIN 47), “Accounting for Conditional Asset Retirement Obligations.” FIN 47 is an interpretation of certain terms and concepts in SFAS No. 143, “Accounting for Asset Retirement Obligations.” FIN 47 clarifies that conditional obligations meet the definition of an asset retirement obligation as used in SFAS No. 143, and therefore should be recognized if the fair value of the contractual obligation is reasonably estimable. Clarification of when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation is also contained in FIN 47, as well as identification of certain disclosures required about unrecognized asset retirement obligations. The provisions of FIN 47 are effective no later than the end of fiscal years ending after December 15, 2005 (as of year-end December 31, 2005 for the Company). Retrospective application for interim financial information is permitted but not required. The Company does not expect adoption of FIN 47 to have a material effect on its results of operations or financial position.
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In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123R). This statement requires that the compensation cost relating to share-based payment transactions be recognized in the financial statements. Compensation cost is to be measured based on the estimated fair value of the equity-based compensation awards issued as of the grant date. The related compensation expense will be based on the estimated number of awards expected to vest and will be recognized over the requisite service period (often the vesting period) for each grant. The statement requires the use of assumptions and judgments about future events and some of the inputs to the valuation models will require considerable judgment by management. SFAS No. 123R replaces FASB Statement No. 123 (SFAS No. 123), “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.”
In March 2005, the SEC released Staff Accounting Bulletin No. 107, “Share-Based Payment” (SAB 107) which provides interpretive guidance related to the interaction between SFAS No. 123R and certain SEC rules and regulations, as well as provide the SEC staff’s views regarding the valuation of share-based payment arrangements for public companies. SAB 107 does not change the accounting required by SFAS No. 123R.
On April 14, 2005, the SEC approved a new rule that delays the effective date of SFAS No. 123R. The SEC’s new rule does not change the accounting required by SFAS No. 123R; it changes only the dates for compliance with the standard. Under the rule approved by the SEC, the provisions of SFAS No. 123R are now required to be applied by public companies as of the first annual reporting period that begins after June 15, 2005 (as of January 1, 2006 for the Company). The Company intends to continue applying APB Opinion No. 25 to equity-based compensation awards until the effective date of SFAS No. 123R. At the effective date of SFAS No. 123R, the Company expects to use the modified prospective application transition method without restatement of prior periods. This will result in the Company recognizing compensation cost based on the requirements of SFAS No. 123R for all equity-based compensation awards issued after January 1, 2006. For all equity-based compensation awards that are unvested as of January 1, 2006, compensation cost will be recognized for the unamortized portion of compensation cost not previously included in the SFAS No. 123 pro forma footnote disclosure. The Company is currently evaluating the impact that adoption of SFAS No. 123R may have on its results of operations or financial position and expects that the adoption may have a material effect on the Company’s results of operations depending on the level and form of future equity-based compensation awards granted.
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On June 1, 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,” a replacement of APB Opinion No. 20 and SFAS No. 3. SFAS No. 154 requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principle unless it is impracticable. SFAS No. 154’s retrospective application requirement replaces APB No. 20’s requirement to recognize most voluntary changes in accounting principle by including the cumulative effect of changing to the new accounting principle in net income of the period of the change. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005 (as of January 1, 2006, for the Company). Earlier application is permitted for accounting changes and correction of errors made in fiscal years beginning after June 1, 2005. The Company does not expect adoption of SFAS No. 154 to have a material effect on its results of operations or financial position.
On January 14, 2005, Lab Safety Supply, Inc. (Lab Safety), a wholly owned subsidiary of the Company, acquired substantially all of the assets and assumed certain liabilities of AW Direct, Inc. AW Direct, Inc., a targeted direct marketer of products to the service vehicle accessories market, had sales of more than $28 million in 2004. The acquisition of the AW Direct business will provide Lab Safety access to a new market with the potential to create additional demand for many of Lab Safety’s existing products.
The aggregate purchase price was $24.8 million in cash and approximately $2 million in assumed liabilities. Estimated goodwill recognized in this transaction amounted to approximately $15 million and is expected to be fully deductible for tax purposes. The purchase price allocation is preliminary and the final determination of required purchase accounting adjustments is not expected to have a material effect on the financial statements. Due to the immaterial nature of this transaction, disclosures of amounts assigned to the acquired assets and assumed liabilities and pro forma results of operations are not considered necessary.
On July 27, 2005, the Board of Directors declared a quarterly dividend of 24 cents per share, payable September 1, 2005 to shareholders of record on August 8, 2005.
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The Company has an outstanding guarantee related to an industrial development revenue bond assumed by the buyer of one of the Company’s formerly owned facilities. The maximum exposure under this guarantee is $8.5 million and it matures on December 15, 2005. The Company has not recorded any liability relating to this guarantee and believes it is unlikely that material payments will be required.
WARRANTY RESERVES
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:
The Company has a postretirement healthcare benefit plan that provides coverage for a majority of its retired employees and their dependents should they elect to maintain such coverage. Covered employees become eligible for participation when they qualify for retirement. 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 with a measurement date of January 1 of each year, consisted of the following components:
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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 and six months ended June 30, 2005, the Company contributed $0.8 million and $1.3 million, respectively, to the trust.
Beginning January 1, 2005, the Company changed its organizational structure. The FindMRO and Parts divisions were merged into the Industrial Supply division. Additionally, the Integrated Supply division, which had been reported as a separate segment, was also merged into Industrial Supply. Operations are now managed and reported in two segments: Branch-based Distribution and Lab Safety. Branch-based Distribution is an aggregation of the following: Industrial Supply, Acklands – Grainger Inc. (Canada), Global Sourcing, Grainger, S.A. de C.V. (Mexico), Export, Grainger Caribe Inc. (Puerto Rico) and China Distribution. Lab Safety is a direct marketer of safety and other industrial products.
Segment information has been modified for all periods in order to conform to the new structure.
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Following are reconciliations of segment information with the consolidated totals per the financial statements:
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 include non-operating cash and cash equivalents, and certain prepaid expenses and property, buildings and equipment – net. Unallocated expenses decreased $1.0 million and $5.4 million, respectively, for the three and six months ended June 30, 2005. The decrease in both the second quarter and six months was primarily due to severance in 2004 related to organizational changes. Unallocated assets decreased $124.4 million since December 31, 2004, primarily due to lower cash balances. Cash declined primarily as a result of the annual payments for profit sharing and bonuses, as well as purchases of treasury stock.
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Item 2.
W.W. Grainger, Inc. and Subsidiaries MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OverviewGeneral Grainger is the leading broad-line supplier of facilities maintenance and other related products in North America. Grainger distributes a wide range of products used by businesses and institutions to keep their facilities and equipment up and running. Grainger uses a multichannel business model to provide customers with a range of options for finding and purchasing products through a network of branches, field sales representatives, call centers, direct marketing media and the Internet. Grainger serves customers through a network of 586 branches, 18 distribution centers and multiple Web sites.
Starting January 1, 2005, Grainger changed its organizational structure. The FindMRO and Parts divisions were merged into the Industrial Supply division. Additionally, the Integrated Supply division, which had been reported as a separate segment, was also merged into Industrial Supply. Operations are now managed and reported in two segments: Branch-based Distribution and Lab Safety. Branch-based Distribution is an aggregation of the following business units: Industrial Supply, Acklands – Grainger Inc. (Canada), Global Sourcing, Grainger, S.A. de C.V. (Mexico), Export, Grainger Caribe Inc. (Puerto Rico) and China Distribution. Lab Safety is a direct marketer of safety and other industrial products. Prior year segment amounts have been restated to maintain comparability.
Business Environment Several economic factors and industry trends shape Grainger’s business environment. Current economic growth projections for both 2005 industrial production and GDP are 3.5 percent, which are lower than what had been projected in the first quarter. Current job reports showed the strongest gains in professional and business services and health-care end markets. Manufacturing payrolls declined from the beginning of 2005. However, May output increased reflecting increased productivity. Non-farm payrolls have grown, with increases in the first quarter and early projections for the second quarter showing continued increases. Early projections of manufacturing employment levels for the second quarter reflect slight decreases, while Grainger’s sales to the light and heavy manufacturing customer segments continue to show improvement over the prior year.
For the six months ended June 30, 2005, Grainger had approximately $77.2 million of gross capital expenditures, of which approximately $42.2 million related to its branch network and information technology initiatives. Expenditures for these initiatives and other capital spending projects are expected to increase in the second half of 2005.
Matters Affecting Comparability Grainger’s operating results for the six months of 2005 include the operating results of the AW Direct business (AW Direct) from the acquisition date of January 14, 2005. AW Direct’s results are included in the Lab Safety segment.
There were 64 sales days in both the second quarter of 2005 and 2004. There were 128 sales days in both the first half of 2005 and 2004.
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W.W. Grainger, Inc. and SubsidiariesMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Results of Operations – Three Months Ended June 30, 2005 The following table is included as an aid to understanding the changes in Grainger’s Consolidated Statements of Earnings.
Grainger’s net sales of $1,372.8 million in the second quarter of 2005 increased 9.3% compared with sales of $1,256.0 million for the comparable 2004 quarter. Second quarter 2005 sales benefited from a stronger economy, ongoing strategic initiatives and a favorable Canadian exchange rate. Also contributing to the improved comparisons was the positive effect from the timing of the Easter holiday, which fell into the first quarter of 2005 versus the second quarter of 2004. The increase in net sales in the quarter was driven by both the Branch-based Distribution and Lab Safety segments.
The gross profit margin improved 1.8 percentage points to 38.4% for the second quarter of 2005 from 36.6% in the comparable period of 2004. Contributing to the gross profit margin improvement were favorable changes in selling price category mix and a positive effect of product mix. Operating earnings for the period of $127.0 million increased 18.8% versus the 2004 quarter. The improvement in operating earnings was from both the Branch-based Distribution and Lab Safety segments, as well as from lower operating expenses at headquarters. The lower operating expenses at headquarters were primarily due to severance in the 2004 second quarter related to organizational changes. Total operating expenses of $400.2 million in 2005 increased 13.4% over the prior year, primarily driven by increased costs related to two strategic initiatives and higher accruals for sales commissions and profit sharing.
Net earnings for the second quarter of 2005 increased by 22.5% to $81.6 million from $66.6 million in 2004. Diluted earnings per share of $0.89 in the second quarter 2005 were 23.6% higher than the $0.72 for the second quarter of 2004. The growth in net earnings for the quarter resulted from the improvement in operating earnings, higher other income and a reduced tax rate for the Company.
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Segment Analysis The following comments at the segment level refer to external and intersegment net sales. Comments at the business unit level include external and inter- and intrasegment net sales. See Note 7 to the Condensed Consolidated Financial Statements.
Branch-based Distribution In the second quarter of 2005, net sales of $1,276.1 million increased by 9.0% compared to net sales of $1,170.6 million in the second quarter of 2004. Sales in the United States were up 7.6%, with growth in all customer end markets, led by the government, manufacturing, and commercial sectors. National account sales within all customer segments were up 12% in the quarter. The sales growth was reduced approximately 2 percentage points as a result of the wind-down of Integrated Supply and related automotive contracts.
Net sales in Canada in the second quarter of 2005 were 19.2% higher than the comparable quarter of 2004 due to a stronger economy, primarily in the natural resources sector, and a favorable exchange rate. In local currency, sales increased 9.1%. Sales in Mexico increased 24.3% in the second quarter of 2005, driven by an improving economy, an expanded telesales operation and incremental sales for one new branch added in the third quarter of 2004.
The gross profit margin increased 1.9 percentage points in the 2005 quarter over the comparable quarter of 2004. Contributing to the improvement in gross profit margin were favorable changes in selling price category mix and the positive effect of product mix. A major driver of the improvement in selling price category mix was reduced sales to Integrated Supply and automotive customers, which carry lower margins than the overall average.
Operating expenses for the Branch-based Distribution businesses were up 14.3% in the quarter. Increased costs related to market expansion and the SAP system were the primary drivers of operating expenses growing faster than sales. Higher accruals for sales commissions and profit sharing also contributed to the increase.
Operating earnings of $130.8 million for the second quarter of 2005 increased 15.6% over the $113.1 million for the second quarter of 2004. The earnings improvement resulted from higher sales and improved gross profits, partially offset by operating expenses, which grew at a faster rate than sales.
Lab Safety Net sales at Lab Safety were $97.7 million for the second quarter of 2005, an increase of $11.7 million, or 13.6%, when compared with $86.0 million for the same period in 2004. The sales growth was attributable to incremental sales from AW Direct, as well as increased volume in core product lines. Excluding AW Direct, sales increased 5.0%.
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The gross profit margin of 42.4% for the second quarter of 2005 increased 0.6 percentage points over the second quarter of 2004. The margin improvement was primarily attributable to inflation recovery, partially offset by the negative impact from AW Direct products, which generally have lower gross profit margins than other Lab Safety products.
Operating expenses at Lab Safety of $27.9 million were $4.0 million, or 16.9%, higher in the quarter due to incremental costs associated with the integration of AW Direct, as well as increased media spending.
Operating earnings of $13.5 million in the second quarter of 2005 were up 11.7% over 2004, resulting primarily from increased sales and improved gross profit margin, partially offset by higher operating expenses.
Other Income and Expense Other income and expense was $2.0 million of income in the second quarter of 2005 compared with $0.5 million of income in the comparable quarter of 2004. The following table summarizes the components of other income and expense:
The improvement in other income and expense was primarily attributable to the combination of higher interest income and lower interest expense versus the 2004 quarter, partially offset by losses related to fixed assets. The increase in net interest income in 2005 was primarily the result of higher average cash balances and higher interest rates and lower interest expense resulting from the payoff of debt in the third quarter of 2004.
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Income Taxes Grainger’s effective tax rate was 36.7% and 37.9% for the second quarter of 2005 and 2004, respectively. Excluding the effect of equity in unconsolidated entities, which is recorded net of tax, the effective income tax rate was 37.0% for 2005 and 38.0% for 2004. The one percentage point reduction in the effective tax rate was primarily the result of tax benefits related to the Medicare Act, the utilization of tax benefits related to operations in Mexico and lower provisions related to uncertainties.
Results of Operations – Six Months Ended June 30, 2005 The following table is included as an aid to understanding the changes in Grainger’s Consolidated Statements of Earnings.
Grainger’s net sales of $2,707.7 million in the first six months of 2005 increased 9.0% compared with sales of $2,483.8 million for the comparable 2004 period. The increase in net sales was in both the Branch-based Distribution and Lab Safety segments.
The gross profit margin for the six months ended June 30, 2005, improved to 37.9% from 36.5% in 2004 principally due to favorable changes in selling price category mix and favorable product mix. Operating earnings of $235.6 million for the first half of 2005 increased 13.5% over the comparable period of 2004. The improvement in operating earnings was from both the Branch-based Distribution and Lab Safety segments, as well as from lower operating expenses at headquarters. The lower operating expenses at headquarters were primarily due to severance in the 2004 second quarter related to organizational changes. Total operating expenses of $790.4 million in 2005 increased 13.0% over the prior year, primarily driven by increased costs related to two strategic initiatives and higher accruals for sales commissions and profit sharing.
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Net earnings increased by 19.5% in the first six months of 2005 to $154.4 million from $129.2 million in 2004. Diluted earnings per share of $1.68 in the first six months of 2005 were 19.1% higher than $1.41 for the first six months of 2004. The year-over-year growth was driven by improvement in operating earnings, higher other income and a reduced tax rate for the Company.
Branch-based Distribution Net sales of $2,518.3 million increased $204.7 million, or 8.8%, in the first six months of 2005 compared to net sales of $2,313.6 million in the first six months of 2004. Sales in the United States were up 7.9% with growth in all customer end markets, led by the government, manufacturing and commercial sectors. National accounts sales within all customer segments were up 12% in the first half. The sales growth was negatively affected by the wind-down of Integrated Supply and related automotive contracts.
Net sales in Canada during the first six months of 2005 were 15.7% higher than the comparable 2004 period, benefiting from the stronger Canadian economy fueled by its natural resources industry and a favorable exchange rate. In local currency, sales increased 6.8%. Sales in Mexico increased 19.9% in the year-to-date period ended June 30, 2005, driven by an improving local economy, increased telesales and incremental sales for one new branch added in the third quarter of 2004.
The gross profit margin increased 1.4 percentage points in the first half of 2005 over the comparable period of 2004. Contributing to the improvement in gross profit margin were favorable changes in selling price category mix and the positive effect of product mix. A major driver of the improvement in selling price category mix was reduced sales to Integrated Supply and automotive customers, which carry lower margins than the overall average.
Operating expenses for the Branch-based Distribution businesses were up 14.5% in the first six months of the year. Increased costs related to market expansion and the SAP system were the primary drivers of the operating expense growth. Higher accruals for sales commissions and profit sharing also contributed to the increase. Partially offsetting these increases were lower bonus accruals and lower bad debt expense.
In the first six months of 2005, operating earnings of $239.6 million increased 8.8% compared with $220.2 million for the comparable period of 2004. The earnings improvement resulted from higher sales and improved gross profit margin, partially offset by operating expenses that increased at a faster rate than sales.
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Lab Safety Net sales for Lab Safety were $191.2 million for the first half of 2005, an increase of $19.4 million, or 11.3%, when compared with $171.8 million for the same period in 2004. The sales growth was primarily attributable to incremental sales from AW Direct, acquired on January 14, 2005. Excluding AW Direct, sales were up 3.1%.
The gross profit margin of 42.8% for the first half of 2005 increased 1.3 percentage points when compared with the first half of 2004. The margin improvement was primarily attributable to the elimination of a 2004 fulfillment program that had lower than average gross profit margins. The 2005 gross profit margin also benefited from inflation recovery. These margin increases were partially offset by incremental sales of AW Direct products, which generally have lower gross profit margins than other Lab Safety products.
Operating expenses at Lab Safety of $54.7 were $7.4 million, or 15.6%, higher in the first six months of 2005 due to incremental costs associated with the acquisition of AW Direct, as well as increased investment in media.
Operating earnings of $27.2 million, up 13.5% in the first half of 2005 over 2004, resulted primarily from increased sales and improved gross profit margin, partially offset by higher operating expenses.
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Other Income and Expense Other income and expense was $8.6 million of income in the first six months of 2005 compared with $0.8 million of income in the first six months of 2004. The following table summarizes the components of other income and expense:
The improvement in other income and expense was primarily attributable to the gains realized on the sale of several facilities and the combination of higher interest income and lower interest expense versus the 2004 quarter. The gains from the sales of fixed assets resulted principally from the sale of seven facilities: four located in the United States that were related to the market expansion program and three located in Canada. The change to net interest income in 2005 from net interest expense in the prior year was primarily the result of higher average cash balances and higher interest rates and lower interest expense resulting from the payoff of debt.
Income Taxes Grainger’s effective tax rate was 36.8% for the first six months of 2005 and 38.0% for the comparable period of 2004. Excluding the effect of equity in unconsolidated entities, which is recorded net of tax, the effective income tax rate was 37.0% for 2005 and 38.0% for 2004. The one percentage point reduction in the effective tax rate was primarily the result of tax benefits related to the Medicare Act, the utilization of tax benefits related to operations in Mexico and lower provisions related to uncertainties.
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Financial Condition For the six months ended June 30, 2005, working capital of $1,102.2 million increased by $9.9 million when compared to $1,092.3 million at December 31, 2004. The ratio of current assets to current liabilities was 2.8 at June 30, 2005, versus 2.6 at December 31, 2004.
Net cash flows provided by operating activities were $114.6 million and $161.9 million for the six months ended June 30, 2005 and 2004, respectively. Net cash flows from operating activities serve as the Company’s primary source of funding its growth initiatives. Contributing to cash flows from operations were net earnings in the first six months ended June 30, 2005 of $154.4 million and the change in non-cash items such as deferred income taxes and depreciation and amortization. Partially offsetting these amounts were Changes in operating assets and liabilities – net of business acquisition, which resulted in a net use of cash of $115.6 million for the first six months of 2005. The principal uses of cash were increases in accounts receivable and inventories and a reduction of other current liabilities. The increase in accounts receivable was due primarily to higher sales, partially offset by improved collections. The increase in inventories was primarily in the Branch-based Distribution segment and was due to volume increases, inventory additions to provide greater availability of products and market expansion. Other current liabilities declined primarily due to the annual cash payments for profit sharing and bonuses.
Net cash used in investing activities was $89.8 million and $34.9 million for the six months ended June 30, 2005 and 2004, respectively. In the first half of 2005, Grainger continued funding of the Company’s growth initiatives with the purchase of AW Direct and its ongoing investment in the market expansion program. The cash portion of the AW Direct purchase price was approximately $24.8 million. AW Direct is included as part of the Lab Safety segment. Cash expended for additions to property, buildings, equipment and capitalized software was $77.2 million in the first six months of 2005 versus $41.8 million in the first six months of 2004.
Net cash used in financing activities was $127.9 million and $42.4 million for the six months ended June 30, 2005 and 2004, respectively. Grainger’s purchases of treasury stock were $56.4 million higher in the first six months of 2005 as Grainger repurchased 1,840,400 shares in the first six months of 2005, as compared with 975,900 shares in the comparable period of 2004. As of June 30, 2005, approximately 5.2 million shares of common stock remained available under Grainger’s repurchase authorization. Dividends paid to shareholders were $39.7 million and $35.0 million for the first half of 2005 and 2004, respectively. Partially offsetting these cash outlays were proceeds from stock options exercised of $14.6 million and $39.0 million for the six months ended June 30, 2005 and 2004, respectively.
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 commercial paper sales and bank borrowings under lines of credit. Total debt as a percent of total capitalization was 0.5% at both June 30, 2005 and December 31, 2004, respectively.
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Critical Accounting Policies and Estimates 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 estimate is made and when different estimates than those management reasonably could have made 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 the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.
Forward-Looking Statements This document may contain forward-looking statements under the federal securities laws. The forward-looking statements relate to Grainger’s expected future financial results and business plans, strategies and objectives and are not historical facts. They are often identified by qualifiers such as: “believes,” “estimated,” “intended,” “expect,” “projections,” “may,” “will,” “preliminary,” “ongoing” or similar expressions. There are risks and uncertainties the outcome of which could cause Grainger’s results to differ materially from what is projected.
Factors that may affect forward-looking statements include the following: higher product costs or other expenses; a major loss of customers; increased competitive pricing pressure on Grainger’s businesses; failure to develop or implement new technologies or other business strategies; the outcome of pending and future litigation and governmental proceedings; changes in laws and regulations; facilities disruptions or shutdowns; disruptions in transportation services; natural and other catastrophes; unanticipated weather conditions; and other difficulties in achieving or improving margins or financial performance.
Trends and projections could also be affected by general industry and market conditions, gross domestic product growth rates, general economic conditions, including industrial production, interest rate and currency rate fluctuations, global and other conflicts, job creation and employment levels in manufacturing, non-farm and other sectors, and other factors.
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W.W. Grainger, Inc. and Subsidiaries
PART II — OTHER INFORMATION
Items 3, 4 and 5 not applicable.
Item 1. Legal Proceedings In its Form 10-Q for the quarter ended September 30, 2004, the Company reported an administrative complaint filed by the U.S. Environmental Protection Agency (EPA) against Grainger for alleged violations of federal clean-air regulations. The Company and the EPA settled this matter on May 18, 2005. Under the settlement, the Company agreed to pay a penalty of $177,156 for the alleged violations, without admission of liability.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Equity Securities – Second Quarter
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.