Ernest Duplessis - Vice President of Investor Relations
Bill Chapman - Director of Investor Relations
W.W. Grainger, Inc. (GWW) Q3 2009 Earnings Call October 14, 2009 8:00 AM ET
This is Ernest Duplessis, Vice President of Investor Relations along with Bill Chapman, Director of Investor Relations. The purpose of this audio webcast is to provide you with additional perspective on Grainger’s results for the quarter ended September 30, 2009. For a complete view, be sure to reference our earnings release issued October 14, 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 webcast 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.
Our performance in the third quarter once again demonstrated the strength of Grainger’s business model and our ability to execute, despite a difficult economy. Sales were down 14% in the quarter, providing further evidence that we have yet to see an economic recovery. However, our sales performance, relative to the competition, provides further evidence that we are picking up market share. Strong cash flow generation of $275 million in the quarter was the result of solid execution and effective working capital management.
There were a number of unusual items in the quarter. One of the purposes of this audio webcast is to further explain those items. The largest such item was the gain recognized after Grainger obtained 53% or a majority ownership in MonotaRO in Japan. We closed on this transaction in mid September and recorded the fair value of all acquired assets and assumed liabilities at the end of the 2009 third quarter, including $97 million in intangibles and goodwill, based on the market price of MonotaRO’s stock at the time of the transaction.
Goodwill is evaluated for impairment on an annual basis and more often if circumstances require. We also recorded a one time non-cash gain of $47 million pre-tax or $0.37 per share based on the step up value less our investment. Beginning with the 2009 fourth quarter, we will consolidate 100% of the results of operations from this subsidiary on a one month lag, then back out the 47% we don’t own below the net earning line.
Let’s walk through two more unusual items in the 2009 third quarter; first, $0.06 per share benefit from the reduction in the LIFO reserve due to lower inflation on inventory purchases and lower inventory levels than previously estimated. Second, $0.04 cents per share benefit from the expiration of a statute related to a prior tax year. Reported earnings per share of $1.88, normalized for these items, would have been $1.41, down 20% versus the 2008 third quarter.
Now let’s begin our discussion by reviewing total company results, then move into an evaluation of performance by segment. For the 2009 third quarter, company sales were $1.6 billion down 14%. Operating earnings were down 19%, but net earnings increased 3%, mostly reflecting the gains from unusual items. As just noted, reported earnings per share were $1.88 and that compares to $1.77 in the 2008 third quarter, restated down $0.02 to reflect the adoption of FSP 3-6-1 related to accounting for stock based compensation.
Taking a closer look at some key drivers on the income statement, gross profit margins increased about 110 basis points to 41.5% versus 40.4% in the prior year. We benefited from 4% price inflation, which exceeded COGS inflation of 3% in the quarter. Excluding the benefit from the $10 million reduction in the LIFO reserve, gross profit margins for the company would have been 40.9%.
Our strong gross margin helped to partially offset the sales decline as operating margins decreased 90 basis points to 11.7%. Ongoing cost reduction efforts led to a 7% decline in operating expenses year over year. These actions helped us in the quarter, but were not sufficient to offset the 14% decline in sales. We expect that about one third of the decline in operating expenses in 2009 to be permanent while the remainder may return with improved volume and the return of bonuses and other performance related costs.
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 September. Second, an update on our Product Line Expansion Program in the United States. Third, operating performance by segment. Fourth, cash generation and capital deployment. And finally, we’ll wrap things up with some final thoughts about modeling the fourth quarter.
As mentioned earlier, sales for the company were down 14% for the quarter. There were 64 selling days in the third quarter of both years. This 14% decrease consisted primarily of a 17% decline in volume partially offset by a 4% year over year increase in price. In addition, foreign exchange contributed one percentage point to the decline.
Looking back on the quarter, daily sales dollars improved each successive month, although the percentage change was affected by the comparison with 2008. July was the toughest comparison, followed by September and August, respectively. To recap, sales were down 14% in July, down 13% in August and down 13% in September. It is important to note that we lapped the 4% price increase on August 1 of this year.
A large portion of the 6% price inflation in the first half of the year was attributable to this increase. For the remainder of 2009, we are forecasting price inflation of around 2% and slightly ahead of COGS inflation.
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 US 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.
Beginning with the 2009 fourth quarter, we will report our subsidiary in Japan as part of Other Businesses. A spreadsheet containing daily sales history, recast for the revised segmentation, can be found on the Investor Relations web site under News Releases and Quarterly Supplemental Information.
Sales in the United States, which represents 88% of total company sales, were down 14% 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 Grainger’s 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 down mid single digits versus last year. Commercial was down in the high single digits. Light manufacturing was down in the low double digits. Retail was down in the mid teens. Contractor was down in the high teens. Reseller was down in the low twenties. Heavy manufacturing was down in the high twenties.
Sales in Canada, which represent 10% of total company sales, declined 13% in US dollars and 8% in local currency. We continued to see weakness in the forestry, manufacturing and gas sectors of the economy, while trends improved in the utilities, infrastructure construction and oil end markets.
Let’s conclude our review of sales for the quarter by looking at the Other Businesses. This group includes our operations in Mexico, India, Puerto Rico, China and Panama and represents 2% of total company sales. Sales for this group were up 11%, primarily the result of the business in India acquired in June, along with strong growth in China and Panama. This increase was partially offset by a 21% decline in Mexico due to foreign exchange. In pesos, sales in Mexico were up 2%, led by strength in the food industry along with oil and gas, while automotive and construction continued to lag.
For the month of September, total company sales were down 13%. There were 22 sales days September of both years. A 15% decline in volume, partially offset by the benefit of 2% price, drove sales performance for the month.
Now let’s move on to sales by segment for the month of September. Daily sales for the United States were down 14%. Customer end markets within the 50 states were as follows; Government sales were down mid single digits versus last year, although sales to state agencies were up mid single digits, commercial and light manufacturing were down high single digits, retail was down in the low double digits, contractor and reseller were down in the low twenties, heavy manufacturing was down in the mid twenties.
For our Canadian segment, sales in September were down 11% in US dollars and down 9% in local currency for primarily the same reasons noted for the quarter. Sales for our Other Businesses were up 14%, primarily the result of the incremental sales from the business in India, along with strong growth in China. This sales increase was partially offset by a 15% decline in Mexico due to foreign exchange. In local currency, sales in Mexico were up 6%, primarily the result of an easy comparison.
As we move into the fourth quarter, we should begin to benefit from some easier sales comparisons, particularly in the United States. Comparisons in Canada, however, will remain rather difficult as daily sales in local currency were up 16% in the 2008 fourth quarter. To review, total company sales reported in 2008 versus 2007 were; up 4% in October, down 2% in November and down 5% in December.
Average daily sales dollars in the United States for the early part of October have remained fairly consistent with what we saw in September, but comparisons to 2008 will be 5 percentage points easier than what we were up against in September. Also, beginning in October, we will benefit from the inclusion of sales from the business in Japan.
I’d now like to turn the mike over to Bill Chapman.
Let’s move on to a quick review of our Product Expansion initiative. Sales from products added to our offering accounted for $251 million in sales during the quarter. This compares to a $196 million contribution in the 2008 third quarter. As a reminder, we have tripled the number of skus in the Grainger catalog since 2005. Product Line Expansion has helped us pick up market share by making Grainger more relevant to customers by offering a broader product line. 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 declined by 19% versus the 2008 third quarter. This decline was primarily the result of the 14% sales decrease coupled with operating expenses, which declined at about half the rate of the sales decline. This was partially offset by an increase in gross profit margins. Operating earnings for both segments were down year over year, while the operating performance for the Other Businesses improved.
Let’s now take a look at operating performance by segment. Operating earnings in the United States decreased by 15% versus the 2008 third quarter. Operating margins declined by 20 basis points to 14.6%. This performance was primarily the result of the 14% sales decline and operating expenses, which declined 7% for the quarter. Partially offsetting this decline in operating earnings was a robust 190 basis point increase in gross profit margins due primarily to price increases exceeding COGS inflation and the reduction in the LIFO inventory reserve.
The 7% reduction in operating expenses was driven by lower payroll and benefits costs, which were due to lower headcount, reduced commissions and no bonus accruals. Going forward, we expect that roughly a third of the decrease in operating expenses will be permanent. In addition, approximately $10 million in synergies from the Lab Safety integration in the quarter partially offset the decline in operating earnings for this segment.
Let’s move on to the segment in Canada where operating earnings were down 41% for the quarter. This decline was primarily due to reported sales in US dollars being down 13% coupled with a 260 basis point decline in gross profit margins. The lower gross profit margins in Canada were attributable to two things.
First, higher cost of goods sold due to the effect of foreign exchange on products purchased from the United States, which represent about 25% of COGs. We were particularly affected by this given that many of the products sold in the third quarter were purchased from the United States in the first half of the year as the dollar’s value improved relative to the Canadian dollar. Second, a negative shift in mix due to better sales performance among large customers who generally pay lower prices. In Canadian dollars, operating earnings were down 38%.
Operating results for the Other Businesses improved year over year, moving from a loss of $3 million in the 2008 third quarter to a loss of $2 million in 2009. The better performance was attributable to year over year operating improvement for all businesses in this group, including a return to profitability for our business in Mexico. Results were partially offset by operating losses from the recently acquired business in India.
Let’s cover a few more items which influenced results for the quarter. The effective tax rate for the quarter was 38.1% versus 38.8% last year. The third quarter 2009 tax rate benefited from the expiration of a statute related to a prior tax year. Excluding the effect of this one time benefit, the effective tax rate for the 2009 third quarter was 39.1%, compared to 38.8% in the 2008 third quarter. The increase in the 2009 effective rate is due to lower earnings reported in non US tax jurisdictions with lower tax rates, as well as an increase in current estimates of overall US state income tax rates. Going forward, we expect the effective tax rate to continue to be at 39.1%.
Lastly, let’s take a look at our operating cash flow for the quarter, which was $275 million, or nearly two times net income. Cash generated by the business through effective operating performance and strong working capital management, was used to fund capital expenditures of $36 million and return capital to shareholders through dividends. Please note that the level of capital expenditures will most likely pick up in the fourth quarter as we continue to add capacity to the US supply chain, including the west coast distribution center announced in May. Capital expenditures for the first nine months were $87 million and we expect to end the year with total capital expenditures below $150 million.
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. Instead, during the last two quarters, we built our cash balance to invest in our supply chain and potentially pursue select acquisitions to penetrate particular vertical markets while valuations are depressed. That leads to our last topic, the deal announced on October 14.
We reported the acquisition of Imperial Supplies LLC, a distributor of fleet maintenance products to the transportation industry. This business is headquartered in Green Bay, Wisconsin and will be reported as part of the US Segment. Imperial had $67 million in sales in 2008. The deal is expected to be accretive by $0.03 to $0.05 per share in 2010.
This acquisition strengthens our position in a key vertical, the $4 billion transportation industry, where Grainger has only a small market share position. Imperial’s profitability is in line with the company’s operating margins, and we see an opportunity to improve these results through cost and revenue synergies. The cost synergies support our purchase valuation with revenue synergies providing upside value.
As we look to the final quarter of the year, here are some general thoughts I’d like to leave with you. First, we are still waiting to see an improvement in underlying demand, although sales comparisons do get easier in the fourth quarter. Second, gross profit margins in the fourth quarter should be in the range of 40.5% to 41.5%, primarily due to lower volume rebates, smaller potential benefit from inventory reserves as some of this was recognized in the third quarter and finally a mix shift due to lower gross margins from the businesses acquired during 2009 in Japan and India. That being said, we still expect gross profit margins for the year to be above 2008. Through the first nine months, gross profit margins were 41.7%, up 120 basis points versus the comparable period last year.
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. Last year, lower advertising, bonus accruals and commissions, along with a $4.6 million gain on the sale of real estate, contributed to operating expenses being lower in the fourth quarter versus the third quarter. We are currently forecasting operating expenses to be higher in the 2009 fourth quarter than in the 2009 third quarter given these factors coupled with the incremental expenses from the businesses acquired during the year.
Fourth, as noted earlier, we will be consolidating the results of the business in Japan beginning in the fourth quarter. Total sales for this business in 2008 were $136 million, with operating margins in the mid to high single digits. Finally, we are making progress with the Lab Safety integration and we are on track to deliver the anticipated revenue and cost savings synergies by the middle of 2010. To date, we have generated $24 million of incremental revenue and that trend should allow us to achieve the bottom end of the projected range of $70 to $100 million in incremental revenue and $15 million in cost savings, which puts us on track to be closer to the high end of projected cost synergies of $20 to $30 million.
To conclude, we continue to be pleased with our execution and operating performance in a very challenging environment. We are also very appreciative of our employees and how they have responded by maintaining extraordinary customer service. We strongly believe that this commitment to serving our customers should benefit our shareholders in the years to come through market share gains and even more effective cost leverage.
Thank you for your interest in Grainger. Please mark your calendar for November 18 when we will host our annual analyst meeting at our headquarters and release our October sales results. Normally, we would report our sales in the middle of the month, but we have decided to hold them for the analyst meeting. If you have any questions, please do not hesitate to contact Ernest at 847-535-4356, Nancy Hobor at 0065 or me at 0881.
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