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W.W. Grainger, Inc. (NYSE:GWW)

Q2 2009 Earnings Call

July 15, 2009 8:30 am ET


Laura Brown – VP IR

William Chapman – Director IR

Laura Brown

Hello, this is Laura Brown, Vice President of Investor Relations along with William Chapman, Director of Investor Relations. We are pleased to provide additional perspective on Grainger’s results for the quarter ended June 30, 2009 via this audio web cast. You should also reference our earnings release issued July 15th, along with other information available on our Investor Relations website.

Before we go any further, please remember that certain statements and projections of future results made in this press release and in this web cast constitute forward-looking information. These statements are based on current market conditions and competitive and regulatory expectations and involve risk and uncertainty. Please see our Form 10-K for a discussion of factors that relate to forward-looking statements.

The second quarter showed the relative strength of Grainger’s business model and continued execution of our strategy. In spite of weak economic conditions, sales were down 13% and earnings per share down 15%.

Our sales performance in this economy indicates that we are picking up market share relative to competitors. Operating cash flow of $190 million in the quarter is further evidence of strong execution and effective working capital management.

Let’s begin by reviewing total company results, then move into a discussion of performance by segment. For the 2009 second quarter, company sales were $1.5 billion. Operating earnings were down 17% and net earnings declined 18%. Earnings per share were $1.21 and that compares to $1.42 in the 2008 second quarter.

As a reminder beginning with 2009, we adopted an accounting change related to stock-based compensation. This adoption led to a change in the calculation of earnings per share. As a result, earnings per share for the 2008 second quarter were originally reported $0.01 higher or $1.43. The revised calculation also resulted in a $0.01 reduction in the 2009 second quarter earnings per share. For additional information and a restatement of last year’s earnings per share by quarter, please see page K-41 in our 2008 Form 10-K.

Taking a closer look at some key drivers on the income statement, gross profit margins increased about 60 basis points to 40.8% versus 40.2% in the prior year. We benefited from positive inflation recovery in the quarter, although we expect some of this benefit versus prior year to dissipate going forward as we lap the 4% price increase implemented for Grainger U.S. in August of 2008.

Our strong gross margin helped to partially offset the sales decline as operating margins decreased 50 basis points to 10%. Our cost reduction efforts led to a 10% decline in operating expenses year-over-year. These actions helped us in the quarter, but were not sufficient to offset the 13% decline in sales.

Other factors that affected comparability between the second quarters of 2009 and 2008 included the following. First, severance charges. In February we announced the decision to eliminate 300 to 400 jobs over the course of the year. During the quarter, we eliminated nearly 100 positions, resulting in severance charges of $3 million or $0.02per share.

Second, there were no gains on the sale of property in the 2009 quarter versus $0.02 per share of gains in last year’s quarter. Finally, last year’s quarter included a $0.05 per share provision for a legal reserve that did not repeat in 2009.

Let’s now focus on the key factors that drove performance during the quarter. In doing so, we’ll cover the following. First, sales by segment in the quarter and in the month of June. Second, an update on our Product Line Expansion Program in the United States, and third, operating performance by segment. And, then we’ll wrap things up with our cash generation and capital deployment.

As mentioned earlier, sales for the company were down 13% for the quarter. There were 64 selling days in the second quarter of both years. This 13% decrease consisted primarily of a 19% decline in volume partially offset by a 6% year over year increase in price.

In addition, foreign exchange contributed two percentage points to the decline. Incremental sales from businesses acquired over the past 12 months in Wisconsin, Canada and India contributed one percentage point. Incremental sales for products related to the H1N1 virus contributed less than one percentage point. The sales of seasonal products were not a factor in the quarter.

Looking back on the quarter, daily sales in dollars improved each month, although the percentage change was affected by the comparison with 2008. We had tougher comparisons in April and June and an easier comparison in May.

To recap, daily sales were down 15% in April, down 10% in May and down 13% in June.

Let’s move on to our segments. As a reminder, beginning with the 2009 first quarter, we changed our segmentation to reflect the integration of Lab Safety Supply into the U.S. branch-based business.

As a result, we now report two segments, the United States and Canada. Our remaining operations in Mexico, India, Puerto Rico, China, and Panama, that are dissimilar in profitability and size, are now reported under a grouping titled Other Businesses.

For your assistance, a spreadsheet containing daily sales history, recast for the new segmentation, can be found on the Investor Relations web site under News Releases and Quarterly Supplemental Information.

Sales in the United States, which represents about 88% of total company sales, were down 12% for the quarter. Sales performance drivers were similar to company results with volume declines being partially offset by price increases.

Given the size and diversity of our customer base, we are often asked about what we are seeing in the economy. With that in mind, let’s take a look at sales in the United States for the quarter by customer end-market.

Government sales were up low single digits versus last year. Commercial was down in the high single digits. Retail and light manufacturing were down in the low double digits. Contractor was down in the mid-teens. Reseller was down in the high teens. And heavy manufacturing was down almost 30%.

Sales in Canada, which represent about 10% of total company sales, decreased 19% in US dollars, but were down 6% in local currency. Sales results were negatively affected by the Easter holiday in April and being closed on Good Friday, which resulted in having one less selling day versus 2008.

The Canadian economy remained weak throughout the quarter, particularly in the forestry, manufacturing, transportation and mining sectors. This weakness contributed to sales declines in most provinces during the quarter, though sales to the government remained strong, as did sales to utilities and infrastructure related sectors.

Let’s conclude our review of sales for the quarter by looking at Other Businesses. This group includes our operations, in the order of size, in Mexico, India, Puerto Rico, China and Panama and represents about 2% of total company sales.

Sales for this group were down 9%, primarily the result of a large decline in Mexico and Puerto Rico, partially offset by increases in China and Panama along with one month of sales from the business acquired in India. For Mexico, sales in dollars were down 27%, down 7% in pesos reflecting the continued weakness in manufacturing, natural resources and hospitality sectors of the Mexican economy.

For the month of June, total company sales were down 13% on a daily basis. There were 22 sales days in the month versus 21 last year. Volume declines partially offset by the benefit of previous price increases continued to be the story in June. In addition, we were hit by a one percentage point headwind due to unfavorable exchange rates between the US dollar, the Canadian dollar and the Mexican peso.

In addition, lower sales of seasonal products due to mild weather across most of North America contributed about one percentage point to the sales decline for the month.

As noted in our last audio web cast, we expected the percentage change in daily sales in June to be weaker than May, and that turned out to be the case. The biggest factor was that we had a tougher comparison in June. Last year, daily sales in June were up a robust 10%, whereas daily sales in May were up a more modest 7% versus 2007.

Let’s move on to sales by segment for the month of June. Daily sales for the United States were down 14%. Customer end-markets within the 50 states were as follows. Government sales were up low single-digits versus last year. Commercial, light manufacturing and retail were down in the low double-digits. Contractor was down in the mid-teens. Reseller was down in the low 20’s. And heavy manufacturing was down in the high 20’s.

For our Canadian segment, daily sales in June were down 15% in US dollars and down 6% in local currency for primarily the same reasons noted for the quarter.

Daily sales for our Other Businesses were up 6%, primarily the result of increases in China and Panama, along with incremental sales from the acquisition in India. This 6% increase was partially offset by continued declines in Mexico and Puerto Rico. In Mexico, daily sales were down 24% in US dollars, and down 2% in local currency.

As we move into the first part of July, the general sales trends experienced in the second quarter of the year are continuing. To date, we have yet to see an increase in underlying demand. I’d now like to turn the microphone over to William Chapman.

William Chapman

Thanks Laura. Let’s move on to a quick review of our product expansion initiative. Sales from products added to our offering accounted for $231 million in sales during the quarter. This compares to a $169 million contribution in the 2008 second quarter.

As a reminder we have tripled the number of SKU’s in the Grainger catalog since 2005. This has helped us pick up share by allowing us to say yes more often to customers. It also enables customers to save money by consolidating their MRO spend with Grainger.

Let’s now take a closer look at operating performance. Operating earnings for the company decreased by 17% versus the 2008 second quarter. This decline was primarily the result of the 13% sales decrease coupled with operating expenses, which declined at a lower rate than sales.

This was partially offset by an increase in gross profit margins. Operating earnings for both segments and the Other Businesses were down year-over-year. Let’s now take a look at operating performance by segment.

Operating earnings in the United States decreased by 16% versus the 2008 second quarter. Operating margins declined by 60 basis points to 13%. This performance was primarily the result of the 12% sales decline and operating expenses, which declined at a slower rate than sales, down 7% for the quarter.

Partially offsetting this decline in operating earnings was a robust 100 basis point increase in gross profit margins due primarily to price. Gross margins would have been another 50 basis points higher, but were reduced by the free freight promotion.

We have decided to end the freight promotion because we did not see a sufficient lift in sales. However, we expect to hire additional customer facing employees in the back half of the year to selectively invest for growth, particularly as we come out of the recession.

Let’s move on to the segment in Canada where operating earnings decreased 39% for the quarter. This decline was primarily due to reported sales in US dollars being down 19% coupled with a 210 basis point decline in gross profit margins.

The lower gross profit margins in Canada were attributable to three things. First, higher cost of goods sold due to the effect of foreign exchange on products purchased from the United States. Second, growth among larger customers who generally pay lower prices and finally, an increase in inventory reserves.

In Canadian dollars, operating earnings were down 30%. Operating results for the Other Businesses declined year over year, moving from a loss of $1.9 million in the 2008 second quarter to a loss of $3.3 million in 2009.

The decline in performance was primarily attributable to Mexico moving to a loss position due to the steep 27% sales decline, and the inclusion of losses from the business in India for the month of June. Results were partially offset by lower losses in China versus the 2008 quarter.

Let’s cover a few more items which affected results for the quarter. The effective tax rate for the quarter was 39.0% versus 38.6% last year. The higher effective tax rate this quarter was primarily the result of lower earnings in foreign jurisdictions with lower income tax rates, as well as increases in current estimates of overall U.S. state income tax rates.

Lastly, let’s take a look at our operating cash flow for the quarter, which was $190 million, or 206% of net income. Cash generated by the business through effective operating performance and strong working capital management, was used to fund capital expenditures of $25 million and return capital to shareholders.

Please note that the level of capital expenditures should pick up in the back half of the year as we begin to work on the west coast distribution center announced in May. During the quarter, we paid $35 million in dividends, reflecting the 15% increase in the quarterly dividend rate announced in April.

This marks the 38th consecutive year of increased dividends, a record of which we are very proud. We did not buy back any shares this quarter, although 5.7 million shares remain on the current authorization.

Looking forward, we have yet to see any sign of a pick up in demand. The good news is that the steep decline that began in the 2008 fourth quarter has moderated for now and things have not gotten worse.

We’re managing expenses tightly given our current sales levels, focusing on the things we can control. In the event the business environment deteriorates from here, we have contingencies in place to further reduce our cost structure. But for the time being, these actions do not seem necessary.

With that as a backdrop, until we have greater visibility, we do not believe it is appropriate to provide guidance. In the meantime, we are taking additional steps to gain market share using our financial strength. We continue to add modestly to our sales force to further improve customer coverage and are purposely keeping inventory availability at record levels to meet the unplanned needs of our customers and gain market share.

As mentioned earlier, we are also selectively investing for growth to drive awareness and customer penetration. As we look at the second half of 2009, here are some general thoughts I’d like to leave with you.

First, we have not seen an up tick in underlying demand, although sales comparisons do get easier in the fourth quarter. The budget crisis being experienced in many states across the US may eventually affect our sales to these customers going forward.

Second, gross profit margins in aggregate for the second half of 2009 should be roughly equivalent to the second half of 2008, although lower volume rebates could put pressure on margins in the fourth quarter. That being said, we still expect gross profit margins for the year to be above 2008.

Third, we will face more difficult comparisons with operating expenses as we begin to lap the cost reductions implemented in the 2008 fourth quarter when sales growth began to decelerate. As previously discussed, we are selectively investing for growth by adding more sales representatives and customer facing employees.

We still expect the incremental expense for growth initiatives to be in the range of $25 million to $50 million, although more likely toward the lower end of that range since we have decided not to continue with the free freight promotion.

We are also pushing ahead with the Lab Safety integration and still expect to harvest the incremental sales of $70 million to $100 million and $20 million to $30 million cost synergies as originally forecasted, although we should see the majority of that in 2010.

To date, we have generated about $13 million of incremental revenue and $5 million in cost savings as a result of the integration, and remain on track. As we move forward, some of these integration benefits will hinge on the release of the 2010 Grainger catalog in February, which will include several thousand Lab Safety products, along with the conversion of Lab Safety’s IT system to the Grainger SAP system in the early part of next year.

To conclude, while we certainly would like to see a better top line, we are very proud of our earnings performance in the face of a very difficult economy. Earnings per share down 15% on a 13% sales decline is a respectable accomplishment.

We are also very proud and appreciative of our employees and how they have responded, paring back expenses while at the same time maintaining extraordinary customer service. We believe that our steadfast dedication to maintaining our customer-facing resources should benefit our shareholders in the years to come through share gains and even more effective cost leverage.

Thank you for your interest in Grainger. Please mark your calendar for August 12th when we plan to release July sales results. If you have any questions, please do not hesitate to contact Laura at 847-535-0409, Nancy Hobor at 847-535-0065 or me at 847-535-0881. Thank you.

Question-and-Answer Session

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