W. W. Grainger - 10-K annual report

TABLE OF CONTENTS

 

 

W.W. Grainger, Inc., incorporated in the State of Illinois in 1928, distributes facilities maintenance products and provides services and related information used by businesses and institutions primarily in the United States, Canada and Mexico to keep their facilities and equipment running. In this report, the words “Grainger” or “Company” mean W.W. Grainger, Inc. and its subsidiaries.

Grainger is the leading broad-line supplier of facilities maintenance and other related products in North America. Grainger uses a multichannel business model to provide customers with a range of options for finding and purchasing products through a network of branches, sales representatives, direct marketing including catalogs and a variety of electronic and Internet channels. Grainger serves approximately 1.8 million customers through a network of 617 branches, 18 distribution centers and multiple Web sites.

Grainger’s three reportable segments are Grainger Branch-based, Acklands – Grainger Branch-based (Acklands – Grainger) and Lab Safety Supply, Inc. (Lab Safety). Grainger Branch-based is an aggregation of the following business units: Grainger Industrial Supply (Industrial Supply), Grainger, S.A. de C.V. (Mexico), Grainger Caribe Inc. (Puerto Rico), Grainger China LLC (China) and Grainger Panama S.A. (Panama). Acklands – Grainger is the Company’s Canadian branch-based distribution business. Lab Safety is a direct marketer of safety and other industrial products. Late in 2008, the Company announced plans to integrate Lab Safety Supply with Grainger Industrial Supply. During 2009, Grainger will be integrating the Lab Safety business into the Grainger Industrial Supply business as well as reviewing the Company's current operating structure to ensure that it will meet the current and future needs of the business. Grainger is also evaluating the impact that this integration will have on reportable segments. Any changes to reportable segments will include a restatement of prior periods for consistency purposes. For segment and geographical information and consolidated net sales and operating earnings see “Item 7:  Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 18 to the Consolidated Financial Statements.

Grainger has internal business support functions that provide coordination and guidance in the areas of accounting and finance, business development, communications and investor relations, compensation and benefits, information systems, health and safety, human resources, insurance and risk management, internal audit, legal, real estate, security, tax and treasury. These services are provided in varying degrees to all business units.

Grainger does not engage in product research and development activities. Items are regularly added to and deleted from Grainger’s product lines on the basis of customer demand, market research, recommendations of suppliers, sales volumes and other factors.

The Grainger Branch-based businesses provide customers with solutions for facilities maintenance and other product needs through logistics networks that are configured for rapid product availability. Grainger offers a broad selection of facilities maintenance and other products through local branches, catalogs and the Internet. The more significant businesses in this segment are described below.

 

Industrial Supply offers U.S. businesses and institutions a combination of product breadth, local availability, speed of delivery, detailed product information and competitively priced products. Industrial Supply distributes material handling equipment, safety and security supplies, lighting and electrical products, power and hand tools, pumps and plumbing supplies, cleaning and maintenance supplies and many other items primarily focused on the facilities maintenance market. Its customers range from small and medium-sized businesses to large corporations, governmental entities and other institutions. During 2008, Industrial Supply completed an average of 95,000 sales transactions daily.

 

Industrial Supply operates 437 branches located in all 50 states. These branches are located within 20 minutes of the majority of U.S. businesses and serve the immediate needs of their local markets by allowing customers to pick up items directly from the branches.

 

Branches range in size from small, will-call branches to large master branches. Branches primarily fulfill counter and will-call needs and provide customer service. An average branch is 22,000 square feet in size, has 12 employees and handles about 125 transactions per day. In 2008, Industrial Supply opened 13 branches, relocated 13, expanded or remodeled 11 and closed 10 branches.

 

Industrial Supply’s logistics network is comprised of nine distribution centers (DCs). Using automated equipment and processes, the DCs handle the majority of the customer shipping and replenish branch inventories.

shops across a wide range of industries such as: manufacturing, hospitality, transportation, government, retail, healthcare and education. Sales transactions during 2008 were made to approximately 1.3 million customers. Approximately 24% of 2008 sales consisted of private label items bearing Grainger’s registered trademarks, including DAYTON® motors, SPEEDAIRE® air compressors, AIR HANDLER® air filtration equipment, DEM-KOTE® spray paints, WESTWARD® tools, CONDOR™ safety products and LUMAPRO® lighting products. Grainger has taken steps to protect these trademarks against infringement and believes that they will remain available for future use in its business. Sales of remaining items generally consisted of products carrying the names of other well-recognized brands.

The Industrial Supply catalog, most recently issued in February 2009, offers approximately 237,000 facilities maintenance and other products and is used by customers, sales representatives and branch personnel to assist in customer product selection. Approximately 2.2 million copies of the catalog were produced.

Customers can also purchase products through grainger.com. With access to more than 475,000 products, this Web site serves as a prominent service channel for Industrial Supply. Grainger.com provides real-time product availability and detailed product information and offers advanced features such as product search and compare capabilities. For customers with sophisticated electronic purchasing platforms, Grainger utilizes technology that allows these systems to communicate directly with grainger.com.

 

 

Competition

Grainger faces competition in all markets it serves, from manufacturers (including some of its own suppliers) that sell directly to certain segments of the market, wholesale distributors, catalog houses and retail enterprises.

Grainger provides local product availability, a broad product line, sales representatives, competitive pricing, catalogs (which include product descriptions and, in certain cases, extensive technical and application data), electronic and Internet commerce technology and other services to assist customers in lowering their total facilities maintenance costs. Grainger believes that it can effectively compete with manufacturers on small orders, but manufacturers may have an advantage in filling large orders.

Grainger serves a number of diverse markets. Based on available data, Grainger estimates the North American market for facilities maintenance and related products to be more than $150 billion, of which Grainger’s share is approximately 4 percent. There are several large competitors, although most of the market is served by small local and regional competitors.

 

None.

 

A brief description of significant facilities follows:

 

Item 4:  Submission of Matters to a Vote of Security Holders

Following is information about the Executive Officers of Grainger including age as of February 26, 2009. Executive Officers of Grainger generally serve until the next annual election of officers, or until earlier resignation or removal.

 

 

PART II

Grainger’s common stock is listed on the New York Stock Exchange and the Chicago Stock Exchange, with the ticker symbol GWW. The high and low sales prices for the common stock and the dividends declared and paid for each calendar quarter during 2008 and 2007 are shown below.

Grainger expects that its practice of paying quarterly dividends on its Common Stock will continue, although the payment of future dividends is at the discretion of Grainger’s Board of Directors and will depend upon Grainger’s earnings, capital requirements, financial condition and other factors.

The approximate number of shareholders of record of Grainger’s common stock as of January 31, 2009, was 1,050 with approximately 70,000 additional shareholders holding stock through nominees.

 

 

 

The results for 2006 included an effective tax rate, excluding the equity in net income of unconsolidated entities, of 36.7%, compared to 38.5% in 2007. The 2006 rate included tax benefits from the resolution of uncertainties related to the audit of the 2004 tax year and a tax benefit from a reduction of deferred tax liabilities related to property, buildings and equipment. These benefits increased diluted earnings per share by $0.15.

Effective January 1, 2006, Grainger adopted Statement of Financial Accounting Standards (SFAS) No. 123R, “Share-Based Payment,” for the accounting of employee stock-based compensation using the modified prospective method. The effect of the adoption was an approximately $0.14 earnings per share reduction for 2006. See Note 12 to the Consolidated Financial Statements for further discussion of information related to SFAS No. 123R.

Historically, Grainger’s sales trends have tended to correlate positively with industrial production growth and non-farm payrolls. In more recent years, Grainger’s sales growth in the United States has outperformed both economic indicators. For the first five months of 2008, Grainger benefited from the growth in industrial production and non-farm payrolls. Both economic indicators began to deteriorate in May 2008, however, Grainger continued to outperform both until late 2008, at which time Grainger’s sales began to be negatively affected by the economic downturn.

The light and heavy manufacturing customer sectors, which comprised approximately 25% of Grainger’s total 2008 sales, have historically correlated with manufacturing employment levels and manufacturing production. Manufacturing employment levels in the United States declined approximately 5.7% from December 2007 to December 2008, while manufacturing output decreased 9.9% from December 2007 to December 2008. This decline in manufacturing employment and output contributed to low single-digit sales growth in the light manufacturing customer sector and flat sales growth in the heavy manufacturing customer sector for Grainger in 2008.

 

upgraded electronic commerce platforms, and the normal recurring replacement of equipment. Grainger expects to fund 2009 capital investments from operating cash flows, with spending planned for the following major projects:

Since June 2008, Grainger’s operating results have included the operating results of Excel F.I.G. Inc. (Excel) in the Acklands – Grainger segment, and since July 2008 Grainger’s operating results have included the operating results of Highsmith Inc. (Highsmith) in the Lab Safety segment.

 

 

See Note 3 to the Consolidated Financial Statements for additional information regarding business acquisitions.

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

Grainger’s net sales of $6,850.0 million for 2008 increased 6.7% when compared with net sales of $6,418.0 million for 2007. There was one more selling day in 2008 versus 2007. Daily sales were up 6.3%. The increase in net sales was led by high single-digit sales growth in the government sector, and mid single-digit sales growth in the commercial and reseller sectors. Approximately 1 percentage point of the sales growth came from Grainger’s product line expansion initiative and approximately 5 percentage points came from price and volume. Refer to the Segment Analysis below for further detail of Grainger’s ongoing strategic initiatives.

The gross profit margin for 2008 improved 0.4 percentage point to 41.0% from 40.6% in 2007. The improvement in the gross profit margin was primarily driven by positive inflation recovery, partially offset by unfavorable selling price category mix.

Operating earnings of $782.7 million for 2008 increased 16.7% over the $670.7 million for 2007. This earnings improvement exceeded the sales growth rate due to an improved gross profit margin and positive operating expense leverage.

Net earnings for 2008 increased by 13.1% to $475.4 million from $420.1 million in 2007. The growth in net earnings for 2008 primarily resulted from the improvement in operating earnings, partially offset by lower interest income, higher interest expense and the write-off of Grainger’s $6.0 million investment in Asia Pacific Brands India Ltd. (Asia Pacific Brands). Diluted earnings per share of $6.04 in 2008 were 22.3% higher than the $4.94 for 2007. This improvement was higher than the percentage increase for net earnings due to the effect of Grainger’s share repurchase program.

 

reseller sectors. Approximately 2 percentage points of the sales growth came from Grainger’s product line expansion initiative and approximately 4 percentage points came from price and volume. Sales volume was negatively affected by approximately 1 percentage point due to a decline in sales of seasonal products.

In 2004, Grainger launched a multiyear market expansion program to strengthen its presence in top metropolitan markets and better position itself to serve local customers.  The market expansion program was completed in 2008, however, the benefits realized from this initiative are expected to continue.

 

Over the past three years, Grainger has added over 150,000 new products to supplement Industrial Supply’s plumbing, fastener, material handling and security product lines as part of its ongoing product line expansion initiative. The most recent catalog, issued in 2009, offers a total of 237,000 products, an increase of 50,000 products over the 2008 catalog.

Sales in Mexico increased 11.9% in 2008 versus 2007. Daily sales were up 11.5%.  In local currency, daily sales were up 12.7%, driven primarily by increased market share coming from the ongoing branch expansion program.

 

The segment gross profit margin increased 0.5 percentage point in 2008 over 2007, driven primarily by positive inflation recovery, partially offset by unfavorable selling price category mix.

Operating expenses in this segment were up 3.4% in 2008. Expenses grew at a slower rate than sales primarily due to lower advertising expenses, bonus accruals, severance and lower bad debt expense, the result of improved collection efficiency.

For the segment, operating earnings of $782.7 million for 2008 increased 16.9% over the $669.4 million for 2007. This earnings improvement exceeded the sales growth rate due to an improved gross profit margin and positive operating expense leverage.

The gross profit margin increased 0.3 percentage points in 2008 over 2007. The improvement in the gross profit margin was primarily due to positive inflation recovery.

Operating expenses were up 13.7% in 2008. The increase in operating expenses was primarily due to payroll and benefits as a result of increased headcount, merit increases and commissions, and higher advertising and occupancy expenses, and expenses related to the bankruptcy of a provider of freight payment services.

Operating earnings of $54.3 million for 2008 were up $10.0 million, or 22.7%. This earnings improvement exceeded the sales growth rate due to an improved gross profit margin and operating expenses that grew at a slower rate than sales.

Net sales at Lab Safety were $450.7 million for 2008, an increase of $16.0 million, or 3.7%, when compared with $434.7 million for 2007. Daily sales were up 3.3%. Excluding sales from the Highsmith acquisition, sales declined 3.3%.

The gross profit margin decreased 0.6 percentage point in 2008 over 2007, driven primarily by unfavorable selling price category mix and product mix.

Operating expenses were up 10.0% in 2008. Expenses grew at a faster rate than sales primarily due to costs associated with the Highsmith acquisition.

Other Income and Expense

Other income and expense was $9.5 million of expense in 2008, a decrease of $20.7 million as compared with $11.2 million of income in 2007. The following table summarizes the components of other income and expense (in thousands of dollars):

The change from net interest income to net interest expense was primarily attributable to the four-year bank term loan obtained in May 2008. The write-off of the investment relates to Asia Pacific Brands as described in Note 6 to the Consolidated Financial Statements. Unclassified – net increased primarily due to higher foreign exchange transaction gains.

Income taxes of $297.9 million in 2008 increased 13.8% as compared with $261.7 million in 2007.

Grainger’s effective tax rates were 38.5% and 38.4% in 2008 and 2007, respectively. Excluding the effect of after tax items related to the write-off and the earnings of unconsolidated entities, the effective income tax rates were 38.4% and 38.5% for 2008 and 2007, respectively.

For 2009, Grainger is projecting its estimated effective tax rate to be approximately 38.9%, excluding equity in net income of unconsolidated entities.

Grainger’s net sales of $6,418.0 million for 2007 increased 9.1% when compared with net sales of $5,883.7 million for 2006. There was one more selling day in 2007 versus 2006. Daily sales were up 8.7%. The increase in net sales was led by sales growth in the upper teens in the government sector, high single-digit sales growth in the commercial sector and mid single-digit sales growth in the manufacturing sector. Approximately 3 percentage points of the sales growth came from Grainger’s ongoing strategic initiatives, market expansion and product line expansion, with another 1 percentage point from foreign exchange. Partially offsetting these sales improvements was a negative 1 percentage point effect from the continued wind-down of low margin integrated supply contracts. Refer to the Segment Analysis below for further detail of Grainger’s ongoing strategic initiatives.

The gross profit margin for 2007 improved 0.6 percentage point to 40.6% from 40.0% in 2006. The improvement in the gross profit margin was primarily driven by positive inflation recovery, partially offset by unfavorable selling price category mix.

 

Operating earnings for 2007 totaled $670.7 million, an increase of 16.0% over 2006. This earnings improvement exceeded the sales growth rate due to an improved gross profit margin and operating expenses which grew at a slightly slower rate than sales.

Net earnings for 2007 increased by 9.6% to $420.1 million from $383.4 million in 2006. The growth in net earnings for 2007 primarily resulted from the improvement in operating earnings, partially offset by lower interest income, no counterpart to a gain on the sale of Acklands – Grainger’s interest in the USI-AGI Prairies joint venture in 2006, and a higher effective tax rate in 2007. The results for 2006 included tax benefits from the resolution of uncertainties related to the audit of the 2004 tax year and a tax benefit from a reduction of deferred tax liabilities related to property, buildings and equipment. These benefits increased diluted earnings per share by $0.15 in 2006. Diluted earnings per share of $4.94 in 2007 were 16.5% higher than the $4.24 for 2006. This improvement was higher than the percentage increase for net earnings due to the effect of Grainger’s share repurchase program.

Product line expansion contributed approximately 2 percentage points to the growth in the segment. Over the past two years, Grainger has added approximately 90,000 new products in the plumbing, fastener, material handling and security product lines as part of its ongoing product line expansion initiative.

Daily sales in Mexico increased 22.7% in 2007 versus 2006. In local currency, daily sales were up 22.8%, driven primarily by the ongoing branch expansion program and an improved economy.

The segment gross profit margin increased 0.4 percentage point in 2007 over 2006, driven primarily by positive inflation recovery, partially offset by unfavorable selling price category mix.

Operating expenses in this segment were up 9.0% in 2007. Expenses grew at the same rate as sales with payroll and benefits growing at a slower rate than sales offset by other operating expenses growing faster than sales, primarily due to increased bad debt expense and provisions and higher facility costs related to market expansion.

For the segment, operating earnings of $669.4 million for 2007 increased 12.8% over the $593.5 million for 2006. This earnings improvement exceeded the sales growth rate due to an improved gross profit margin.

Net sales at Acklands – Grainger were $636.5 million for 2007, an increase of $71.4 million, or 12.6%, when compared with $565.1 million for 2006. Daily sales were up 12.2%. In local currency, daily sales increased 5.8% due to a stronger economy. This increase was led by the mining sector with sales growth in the low twenties, high single-digit sales growth in the oil sector and mid single-digit sales growth in the government sector. These increases were partially offset by a mid-teens sales decline in the forestry sector.

The gross profit margin increased 2.6 percentage points in 2007 over 2006. The improvement in the gross profit margin was primarily due to positive inflation recovery.

Operating expenses were up 6.7% in 2007. Expenses grew at a slower rate than sales due to operating expense leverage, the result of improved cost management and lower severance costs.

 

Operating earnings of $44.2 million for 2007 were up $29.0 million, or 190%. This earnings improvement exceeded the sales growth rate due to an improved gross profit margin and operating expenses that grew at a slower rate than sales.

Net sales at Lab Safety were $434.7 million for 2007, an increase of $23.2 million, or 5.6%, when compared with $411.5 million for 2006. Daily sales were up 5.2%. Sales from the acquisitions made during 2007 and late 2006 contributed 6.1 percentage points to the growth.

The gross profit margin decreased 0.5 percentage point in 2007 over 2006. Gross profit margin was down as a result of increased freight costs and unfavorable selling price category mix and product mix, partially offset by positive inflation recovery.

Operating expenses were 4.6% higher in 2007 and grew at a slower rate than sales due to cost management efforts.

Other income and expense was $11.2 million of income in 2007, a decrease of $13.8 million as compared with $25.0 million of income in 2006. The following table summarizes the components of other income and expense (in thousands of dollars):

The decrease in interest income was primarily attributable to lower average cash balances due to working capital needs and share repurchases. There was a decrease in equity in net income of unconsolidated entities in 2007 versus 2006 primarily driven by the absence of earnings related to the joint venture that was sold.

 

Income taxes of $261.7 million in 2007 increased 19.2% as compared with $219.6 million in 2006.

Grainger’s effective tax rates were 38.4% and 36.4% in 2007 and 2006, respectively. Excluding the equity in net income of unconsolidated entities, the effective income tax rates were 38.5% for 2007 and 36.7% for 2006.

The 2006 tax rate benefited from resolution of uncertainties related to the audit of the 2004 tax year and from a reduction of deferred tax liabilities related to property, buildings and equipment.

Excluding the equity in net income of unconsolidated entities and the tax benefits noted above, the effective income tax rate for 2006 was 38.9%.

Grainger expects its strong working capital position, cash flows from operations and borrowing capacity to continue, allowing it to fund its operations, including growth initiatives, capital expenditures, acquisitions and repurchase of shares, as well as pay cash dividends.

Net cash flows from operations of $530.1 million in 2008, $468.9 million in 2007 and $436.8 million in 2006 continued to improve Grainger’s financial position and serve as the primary source of funding. Net cash provided by operations increased $61.2 million in 2008 over 2007, driven primarily by increased net earnings. The Change in operating assets and liabilities – net of business acquisitions used cash of $143.1 million in 2008. This use of cash was driven primarily by an increase in inventory due to the product line expansion initiative.

The increase in net cash flows from operations from 2006 to 2007 of $32.1 million was primarily attributable to increased net earnings. The Change in operating assets and liabilities – net of business acquisitions used cash of $106.4 million in 2007. This use of cash was primarily driven by increases in inventory and trade accounts receivable as well as a decrease in trade accounts payable due to the timing of payments at year-end. The increases in inventory and trade accounts receivable were due to product line expansion and increased sales. These changes were partially offset by an increase in other current liabilities due to higher compensation, benefit and profit sharing accruals, the result of increased headcount and improved Company performance.

Net cash flows used in investing activities were $202.6 million, $197.0 million and $139.7 million in 2008, 2007 and 2006, respectively. Cash expended for property, buildings, equipment and capitalized software was $195.0 million, $197.4 million and $136.8 million in 2008, 2007 and 2006, respectively. Additional information regarding capital spending is detailed in the Capital Expenditures section below. In 2008, Grainger continued to fund the Company’s market expansion initiative ($40 million) and acquired two companies, Highsmith and Excel ($34.3 million). In 2007, Grainger funded the market expansion initiative ($88 million), purchased McFeely’s ($4.7 million) and purchased its distribution center in China ($6.7 million).

 

Net cash flows used in financing activities for 2008, 2007 and 2006 were $36.8 million, $513.9 million and $492.9 million, respectively. Treasury stock purchases were $394.2 million in 2008 as Grainger repurchased 5.5 million shares compared to purchases of $647.3 million in 2007 to repurchase 7.2 million shares. As of December 31, 2008, approximately 7.4 million shares of common stock remained available under Grainger’s repurchase authorization. Dividends paid to shareholders were $121.5 million in 2008 versus $113.1 million in 2007. Grainger also used cash in

financing activities to pay off $81.4 million of short-term borrowings versus an increase in short-term borrowings of $102.3 million in 2007. Partially offsetting these cash outlays were proceeds of long-term borrowings of $500 million in 2008, as well as proceeds and excess tax benefits realized from stock options exercised of $60.4 million in 2008 versus $144.2 million in 2007.

Treasury stock purchases were $472.8 million for 7.0 million shares and dividends paid to shareholders were $97.9 million in 2006. Partially offsetting these cash outlays was proceeds and excess tax benefits realized from stock options exercised of $77.8 million for 2006.

Internally generated funds have been the primary source of working capital and of funds used in business expansion, supplemented by debt as circumstances dictated. In addition, funds were expended for facilities optimization and enhancements to support growth initiatives, as well as for business and systems development and other infrastructure improvements.

Working capital was $1,382.4 million at December 31, 2008, compared with $974.4 million at December 31, 2007 and $1,155.8 million at December 31, 2006. At these dates, the ratio of current assets to current liabilities was 2.8, 2.2 and 2.6. The increase in the current ratio and working capital for 2008 primarily relates to increases in cash and inventories and the replacement of short-term borrowings with long-term borrowings.

In each of the past three years, a portion of operating cash flow has been used for additions to property, buildings, equipment and capitalized software as summarized in the following table (in thousands of dollars):

 

In 2008, Grainger completed its investments in the market expansion program in the United States which realigned branches in the top 25 major metropolitan areas. In addition, there was continued international investment, including branch expansion in Mexico, as well as the normal recurring replacement of equipment.

In 2007 and 2006, Grainger’s investments included the market expansion program, Mexico and China expansion and the normal recurring replacement of equipment.

 

At December 31, 2008, Grainger’s contractual obligations, including estimated payments due by period, are as follows (in thousands of dollars):

Purchase obligations for inventory are made in the normal course of business to meet operating needs. While purchase orders for both inventory purchases and noninventory purchases are generally cancelable without penalty, certain vendor agreements provide for cancellation fees or penalties depending on the terms of the contract.

Other liabilities represent future benefit payments for postretirement benefit plans and postemployment disability medical benefits as determined by actuarial projections. Other employment-related benefits costs of $31.0 million have not been included in this table as the timing of benefit payments is not statistically predictable. See Note 10 to the Consolidated Financial Statements.

See also Notes 9 and 11 to the Consolidated Financial Statements for further detail related to the interest on long-term debt and operating lease obligations, respectively.

Grainger has recorded a noncurrent liability of $26.3 million for tax uncertainties and interest at December 31, 2008. This amount is excluded from the table above, as Grainger cannot make reliable estimates of these cash flows by period. See Note 15 to the Consolidated Financial Statements.

 

Grainger does not have any material exposures to off-balance sheet arrangements.  Grainger does not have any variable interest entities or activities that include non-exchange-traded contracts accounted for at fair value.

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.

Note 2 to the Consolidated Financial Statements describes the significant accounting policies used in the preparation of the Consolidated Financial Statements. The most significant areas involving management judgments and estimates follow. Actual results in these areas could differ materially from management’s estimates under different assumptions or conditions.

The amount of stock option compensation expense is significantly affected by the valuation model and these assumptions. If a different valuation model or different assumptions were used, the stock option compensation expense could be significantly different from what is recorded in the current period.

Compensation expense for other stock-based awards is based upon the closing market price on the last trading date preceding the date of the grant.

For additional information concerning stock incentive plans, see Note 12 to the Consolidated Financial Statements.

A 1 percentage point change in assumed healthcare cost trend rates would have had the following effects on December 31, 2008 results (in thousands of dollars):

Grainger may terminate or modify the postretirement plan at any time, subject to the provisions of the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code, as amended. In the event the postretirement plan is terminated, all assets of the Group Benefit Trust inure to the benefit of the participants. The foregoing assumptions are based on the presumption that the postretirement plan will continue. Were the postretirement plan to terminate, different actuarial assumptions and other factors might be applicable.

Grainger has used its best judgment in making assumptions and estimates and believes such assumptions and estimates used are appropriate. Changes to the assumptions may be required in future years as a result of actual experience or new trends and, therefore, may affect Grainger’s retirement plan obligations and future expense.

For additional information concerning postretirement healthcare benefits, see Note 10 to the Consolidated Financial Statements.

Grainger is responsible for establishing accounting policies on insurance reserves. Although it relies on outside parties to project future claims costs, it retains control over actuarial assumptions, including loss development factors and claim payment patterns. Grainger performs ongoing reviews of its insured and uninsured risks, which it uses to establish the appropriate reserve levels.

 

The use of assumptions in the analysis leads to fluctuations in required reserves over time. Any change in the required reserve balance is reflected in the current period’s results of operations.

The following new accounting standards exclude those pronouncements that are unlikely to have an effect on Grainger upon adoption.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), "Business Combinations" (SFAS No. 141R). SFAS No. 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree and the goodwill acquired. SFAS No. 141R also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. The statement is effective for fiscal years beginning after December 15, 2008, and will be applied to acquisitions after adoption by the Company.

 

In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements – an amendment of Accounting Research Bulletin No. 51" (SFAS No. 160). SFAS No. 160 establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent's ownership interest and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. SFAS No.160 also establishes disclosure requirements that clearly identify and distinguish between the interests of the

parent and the interests of the noncontrolling owners. The statement is effective for fiscal years beginning after December 15, 2008. The Company currently does not have any noncontrolling interest in consolidated financial statements, therefore does not expect the adoption of SFAS No. 160 to have a material effect on its results of operations or financial position.

In June 2008, the FASB issued Staff Position EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities” (FSP 03-6-1).  FSP 03-6-1 states that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method.  Upon adoption, a company is required to retrospectively adjust its earnings per share data presentation to conform with the FSP 03-6-1 provisions.  FSP 03-6-1 is effective for fiscal years beginning after December 15, 2008.

The Company’s unvested share-based payment awards, such as Performance Shares, Restricted Stock and Restricted Stock Units (see Note 12 to the Consolidated Financial Statements) that contain nonforfeitable rights to dividends meet the criteria of a participating security as defined by FSP 03-6-1. Accordingly, the adoption of FSP 03-6-1 will change the methodology of computing the Company’s earnings per share to the two-class method. This change will not affect previously reported consolidated net earnings or net cash flows from operations. Under the two-class method, earnings will be allocated between common stock and participating securities, resulting in lower earnings per share. Refer to the table below for further analysis of the impact adoption would have had on 2008 earnings per share.

See Note 2 to the Consolidated Financial Statements for further discussion of new accounting standards.

 

Inflation during the last three years has not had a significant effect on operations. The predominant use of the last-in, first-out (LIFO) method of accounting for inventories and accelerated depreciation methods for financial reporting and income tax purposes result in a substantial recognition of the effects of inflation in the financial statements.

The major impact of inflation is on buildings and improvements, where the gap between historic cost and replacement cost accumulates for these long-lived assets. The related depreciation expense associated with these assets would likely increase if adjustments were to be made for the cumulative effect of inflation.

Grainger believes the most positive means to combat inflation and advance the interests of investors lies in the continued application of basic business principles, which include improving productivity, maintaining working capital turnover and offering products and services which can command appropriate prices in the marketplace.

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.

Grainger is exposed to foreign currency exchange risk related to its transactions, assets and liabilities denominated in foreign currencies.  For 2008, a uniform 10% strengthening of the U.S. dollar relative to foreign currencies that affect Grainger and its joint ventures would have resulted in a $2.6 million decrease in net earnings. Comparatively, in 2007 a uniform 10% strengthening of the U.S. dollar relative to foreign currencies that affect Grainger and its joint ventures would have resulted in a $2.1 million decrease in net earnings. A uniform 10% weakening of the U.S. dollar would have resulted in a $3.1 million increase in net earnings for 2008, as compared with an increase in net earnings of $2.6 million for 2007. This sensitivity analysis of the effects of changes in foreign currency exchange rates does not factor in potential changes in sales levels or local currency prices or costs. Grainger does not hold derivatives for trading purposes.

Grainger is also exposed to interest rate risk in its debt portfolio. During 2008 and 2007, all of its long-term debt was variable rate debt. A 1 percentage point increase in interest rates paid by Grainger would have resulted in a decrease to net earnings of approximately $2.5 million for 2008 and $0.3 million for 2007. A 1 percentage point decrease in interest rates would have resulted in an increase to net earnings of approximately $2.5 million for 2008 and $0.3 million for 2007. This sensitivity analysis of the effects of changes in interest rates on long-term debt does not factor in potential changes in long-term debt levels.

Grainger has limited primary exposure to commodity price risk on certain products for resale, but does not purchase commodities directly.

The financial statements and supplementary data are included on pages 27 to 64. See the Index to Financial Statements and Supplementary Data on page 26.

 

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.

Management’s report on the Company’s internal control over financial reporting is included on page 27 of this Report under the heading Management’s Annual Report on Internal Control Over Financial Reporting.

The report from Ernst & Young LLP on its audit of the effectiveness of Grainger’s internal control over financial reporting as of December 31, 2008, is included on page 28 of this Report under the heading Report of Independent Registered Public Accounting Firm.

There have been no changes in Grainger’s internal control over financial reporting during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, Grainger’s internal control over financial reporting.

The information required by this item is incorporated by reference to Grainger’s proxy statement relating to the annual meeting of shareholders to be held April 29, 2009, under the captions “Election of Directors,” “Board of Directors and Board Committees” and “Section 16(a) Beneficial Ownership Reporting Compliance.” Information required by this item regarding executive officers of Grainger is set forth in Part I of this report under the caption “Executive Officers.”

 

Grainger has adopted a code of ethics that applies to the principal executive officer, principal financial officer and principal accounting officer. This code of ethics is incorporated into Grainger’s business conduct guidelines for directors, officers and employees. Grainger intends to satisfy the disclosure requirement under Item 5.05 of Form 8-K relating to its code of ethics by posting such information on its Web site at www.grainger.com/investor. A copy of the code of ethics incorporated into Grainger’s business conduct guidelines is also available in print without charge to any person upon request to Grainger’s Corporate Secretary. Grainger has also adopted Operating Principles for the Board of Directors, which are available on its Web site and are available in print to any person who requests them.

The information required by this item is incorporated by reference to Grainger’s proxy statement relating to the annual meeting of shareholders to be held April 29, 2009, under the captions “Board of Directors and Board Committees,” “Director Compensation,” “Report of the Compensation Committee of the Board” and “Compensation Discussion and Analysis.”

The information required by this item is incorporated by reference to Grainger’s proxy statement relating to the annual meeting of shareholders to be held April 29, 2009, under the captions “Ownership of Grainger Stock” and “Equity Compensation Plans.”

The information required by this item is incorporated by reference to Grainger’s proxy statement relating to the annual meeting of shareholders to be held April 29, 2009, under the captions "Election of Directors" and "Transactions with Related Persons."

The information required by this item is incorporated by reference to Grainger’s proxy statement relating to the annual meeting of shareholders to be held April 29, 2009, under the caption “Audit Fees and Audit Committee Pre-Approval Policies and Procedures.”

PART IV