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Executives

Ernest Duplessis -- VP, IR

Bill Chapman -- Director, IR

W.W. Grainger, Inc. (GWW) Q4 2009 Earnings Call January 26, 2010 8:00 AM ET

Ernest Duplessis

Hello, this is Ernest Duplessis, Vice President of Investor Relations. Joining me is Bill Chapman, Director of Investor Relations. We are pleased to be sharing with you today Grainger’s fourth quarter and full-year 2009 results via this audio webcast. This recording is intended to provide you with more information related to our recent performance. Please also reference our 2009 fourth quarter and full-year earnings release issued January 26, in addition to other information on our Investor Relations web site to supplement this webcast.

Before we begin, please remember that certain statements and projections of future results made in the 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.

Let’s begin by summarizing our full-year 2009 results. Sales of $6.2 billion were down 9% versus 2008. Net earnings decreased 9% and earnings per share decreased 6% to $5.62 versus $5.97 in 2008. Over the next 25 minutes, we want to explain in more detail how we achieved these results and give you some idea of what we’re seeing and expecting for 2010.

Taking a closer look at the income statement for the year, gross profit margins increased about 80 basis points to 41.8%. Operating margins decreased approximately 70 basis points to 10.7%. The decrease in operating margins for the year were mainly driven by the 9% sales decline for the year and operating expenses, which declined at a slower rate than sales.

For comparability, it is important to note that our earnings per share of $5.62 for the year 2009 included a non-cash gain of $0.37 in the third quarter from the step-up of our investment in our Japanese business, MonotaRO. If you exclude this one-time gain of $0.37, EPS for 2009 was $5.25. As mentioned in our earnings release, there were also some severance and impairment charges taken throughout the year. As we continue to examine ways to improve our cost structure and address underperforming assets, you may see charges like these continue in 2010.

Let’s now focus on our 2009 fourth quarter results. Sales of $1.6 billion were up 3% versus last year’s fourth quarter. In a few moments, we will address some of the factors that contributed to our sales performance. Operating earnings, however, decreased 8% and net earnings decreased 10%. Bill will discuss some of the factors in the operating earnings performance shortly.

Let’s take a look at what went into earnings per share for the quarter. Overall, EPS decreased by 7% to $1.27. This was impacted by a couple of significant items. First, during the quarter, the company closed 12 branches which, along with other asset write-downs, resulted in the company recognizing asset impairment charges of $9 million or $0.07 a share. Second, the company reduced headcount by more than 200 positions in the fourth quarter, incurring a $7.5 million or $0.05 per share charge for severance. Fourth quarter EPS were $1.39 excluding these items, versus $1.37 in the prior year.

Let’s now focus on performance drivers during the quarter. In doing so, we’ll cover the following topics: First, sales by segment in the quarter and in the month of December, including an update on our U.S. Product Line Expansion Program. Second, our operating performance by segment. Third, our cash generation and capital deployment; and finally, we’ll wrap up with a discussion on our 2010 guidance and other key items of interest.

As mentioned earlier, total company sales for the quarter were up 3% versus the prior year. There were 64 days in both the 2009 and 2008 fourth quarters. Daily sales decreased 3% in October, then increased 2% in November and increased 11% in December. The 3% increase for the quarter included a 4 percentage point contribution from acquisitions, a 2 percentage point benefit from foreign exchange and a 2 percentage point lift from price increases, partially offset by a 5 percentage point decline in volume.

Let’s move on to sales by segment. We now report two segments, the United States and Canada. Our remaining operations in Japan, Mexico, India, China, and Panama are now reported under a grouping titled Other Businesses. As a result of obtaining a controlling interest in the Japanese business in September 2009, beginning with the 2009 fourth quarter, we also began reporting 100% of the sales of our subsidiary in Japan as part of Other Businesses. However, it adds only a small increment of its profits to earnings since we had already been reporting our previous share of the profits in equity income.

Sales in the United States, which represents 84% of total company sales, decreased 2% in the 2009 fourth quarter. By month, sales were down 7% in October, down 3% in November and up 5% in December.

We are beginning to see small signs of improvement in the overall U.S. economy, although our optimism is tempered by the outlook for unemployment and economic uncertainty in the back half of the year. Here is what we saw in the quarter, specifically by customer end-market: Government and Commercial sales were up in the low single digits. Light manufacturing was essentially flat. Retail was down in the mid single digits. Heavy manufacturing was down in the low double digits. Contractor was down in the low teens. And reseller was down in the high teens.

Also contributing to sales as well as operating earnings in the U.S. segment in the quarter was the benefit of the ongoing work to integrate Lab Safety Supply with Grainger Industrial Supply. We stated last year that we expected this combination to deliver $70 million to $100 million in incremental revenue and $20 million to $30 million in cost savings by the middle of this year. Through the end of the fourth quarter, the integration has generated $44 million of additional revenue and $22 million of cost savings and remains on track to achieve our stated sales goal, having already reached the range for cost savings.

Part of our integration effort is the establishment of a common distribution platform for all the brands in the U.S. business. We should complete that by the end of the first quarter of 2010.

Now let’s talk about our U.S. Product Line Expansion. Over the course of 2009, we have continued to add products to our already broad offering that will result in having approximately 307,000 in-stock products in the 2010 catalog. This represents a company record of 74,000 net new products added to the catalog since last year. Products added over the last four years have cumulatively resulted in $934 million in sales in 2009, with $260 million of that coming in the fourth quarter alone. This continues to be an area which allows us to pick up market share, and we expect several more years of sizable additions to our already broad product line.

Now let’s turn our attention to the Canadian business. Sales in Canada represents about 11% of total company sales. For the quarter, sales in Canada increased 11% in U.S. dollars but were down 3% in local currency compared to the fourth quarter last year. On a daily basis in local currency, sales were down 7% in October, down 8% in November and up 7% in December. The Canadian economy is also starting to show signs of a recovery, but with unemployment still at high levels, just as we find in the United States.

For the quarter, we saw strength in the agriculture/mining, government and utilities sectors, while weakness prevailed in the construction/contractors, heavy manufacturing and forestry sectors. The business also saw improvement in sales resulting from several large contracts at the end of the quarter.

Let’s conclude our review of sales for the quarter by looking at the Other Businesses. This group now includes Japan, Mexico, India, Puerto Rico, China and Panama and represents about 5% of total company sales. Sales from this group were up 214%, primarily the result of incremental sales from the businesses in Japan and India, with Mexico and China making positive contributions as well.

For the month of December, total company sales were up 11% on a daily basis. There were 22 selling days in both December of 2009 and 2008. Contributing to the higher sales in December were 2 percentage points due to favorable exchange rates and 5 percentage points from acquisitions. The sales of seasonal products were not a factor in the month. However, we estimated that the timing of the Christmas holiday in 2009 provided 1 percentage point of favorability. Because Christmas 2008 fell on a Thursday, sales on that Friday were significantly lower. In 2009, Christmas was on a Friday. So, the combined effects of foreign exchange, acquisitions and holiday timing were 8 to 9 percentage points of growth, leaving organic growth at 2% to 3%, which is at the lower end of the new organic sales growth guidance of 2% to 5%.

In the United States, December sales were up 5%. The combined effects of acquisitions and the timing of the Christmas holiday contributed 3 percentage points to the growth for the month. Here is how each of the U.S. customer end-markets performed in the month: Government, Light Manufacturing and Commercial were all up in the mid single digits. Retail was essentially flat. Heavy Manufacturing was down in the low single digits. Contractor was down in the mid-single digits. Reseller was down in the high single digits. Remember that comparisons in the month were easier since December sales in 2008 were down 5%.

Sales in Canada in December were up 26% in U.S. dollars and up 7% in local currency. As noted in the earnings release, sales in December benefited from some large customer orders and incremental sales from the acquisition of the assets of K&D Pratt Industrial Division, made in November of 2009. For the month, we saw the most strength in the government, agriculture/mining and utilities sectors, while the wholesale and heavy manufacturing segments showed the greatest weakness.

Daily sales growth in the month of January is similar to what we saw in December. However, keep in mind that there are two factors contributing significantly to this trend. We expect the combined effects of the favorable timing of the New Year’s Day holiday in 2010 and the stretch of extremely cold weather at the beginning of the month provided about 2 percentage points of benefit.

January organic sales are running 2% to 3%, similar to December, excluding acquisitions, foreign exchange and the timing of the January 1st holiday. As a reminder, January sales in 2009 were down 9%, so the company has easier comparisons.

Now I would like to turn the discussion over to Bill Chapman.

Bill Chapman

Thanks, Ernest. Fourth quarter operating earnings for the company decreased by 8% versus the 2008 fourth quarter. This decline was the result of an 80 basis point decrease in gross margins, primarily due to unfavorable mix of lower gross margins from the newly consolidated businesses in Japan and India.

Operating expenses increased by 4% for the quarter. This was driven by a number of factors including $9 million in asset write-downs and $7.5 million in severance charges mentioned earlier. Company operating margin was 10.1%.

Let’s now take a look at operating performance by segment. Operating earnings in the United States were down by 6% versus the 2008 fourth quarter. Operating margins declined by 60 basis points to 13.1%. Gross profit margins remained unchanged at 42.7%.

In Canada, operating earnings were up 59% versus the 2008 fourth quarter. The improvement was the result of increased sales, a 90 basis point improvement in gross profit margins, and operating expenses which increased at a slower rate than sales. The improvement in gross margins was attributable to favorable inventory adjustments. The 2008 fourth quarter included a $2 million charge for the bankruptcy of a provider of freight payment services. Excluding these items, operating earnings were up 6% in U.S. dollars versus 2008.

Operating losses for other business were $3 million in both 2009 and 2008 quarters. India, Panama and China were primary drivers of the losses, with Japan reporting net income.

Lastly, let’s take a look at our operating cash flow. Operating cash flow for the quarter was $223 million versus $195 million in 2008. The full-year 2009 operating cash flow was $732 million, the strongest in company history. Cash allocated to capital expenditures was $53 million in the quarter and $142 million for the year. For the full year, the company returned $507 million in cash to shareholders in the form of dividends and share repurchases. The company bought back 2.5 million shares in the fourth quarter and 4.5 million shares for the year.

As reported in our fourth quarter 2009 earnings release, we raised both sales and earnings guidance for 2010. We now expect sales growth in the range of 6% to 10% and EPS in the range of $5.40 to $5.90. Keep in mind that we expect about 3 percentage points of the top line growth to come from acquisitions and that the earnings drop-through in the initial year is less than company average.

I won’t repeat what we said at the Analyst Meeting here, but 2010 is a transition year as we move from being a minority owner to a majority owner of the business in Japan. Also, let me emphasize that we now expect 100 to 200 basis points of top line growth coming from foreign exchange. The earnings drop-through for foreign exchange is about $0.01 to $0.02 of earnings per share, which is lower than what you would expect from a 1% to 2% increase in organic sales.

The question you may be asking is, “so what has changed since mid-November when Grainger initially unveiled guidance for 2010?” First, we finished the year stronger than originally expected. Sales for the quarter were up 3%, versus our forecast of down 2% to up 1%. About 1 to 2 percentage points of that outperformance came from a larger contribution from foreign exchange. Second, the forecast for both Industrial Production and GDP has improved modestly. In November, 2010 IP was forecasted to be up 4.2%. Today, that forecast has moved to 4.4%. The same is true for GDP. In November, we were expecting 2010 GDP growth of 2.7%. Today, that has moved up to 2.9% growth. However, we remain cautious because job growth is expected to lag the recovery and we believe our growth is, in part, tied to non-farm payrolls.

In terms of modeling 2010, here are a few things to consider: First, sales are expected to be up in the range of 6% to 10% with organic growth from price, share gain and market growth of 2 to 5 percentage points; acquisitions made in 2009 adding 3 percentage points; and foreign exchange contributing 1 to 2 percentage points. Again to repeat, a foreign exchange contribution of 1 to 2 percentage points will only yield $0.01 to $0.02 of EPS.

Also, while sales comps versus 2009 get sequentially easier through April of 2010, we remain cautious since organic growth is trending at the lower end of our range with a great deal of economic uncertainty for second half of 2010.

Second, gross margins in 2010 should be slightly ahead of 2009 with lower but positive cost and price inflation than in 2009. We expect to see gross margin expansion from organic growth, partially offset by unfavorable mix from consolidating Japan and India, which have lower gross margins.

Third, operating expenses in 2010 will be up versus 2009 for two reasons: First, the incremental expenses from the businesses acquired in 2009 and second, a portion of the costs taken out last year will come back. Here’s how it breaks out. We expect that about one-third of the cost reduction will be permanent, another third will return -- things like merit increases and bonuses, and the final third is variable depending on growth in sales and earnings -- things like part-time hours, commissions, higher bonus and profit sharing.

Bottom line, operating expenses as a percentage of sales for the organic portion of the business should improve slightly, assuming we hit the middle of our sales range. If the economy continues to strengthen and sales trends accelerate, we may choose to fund some additional sales and marketing programs to increase market share.

Lastly, if we grow closer to the high end of the sales range, variable costs like bonuses, commissions and benefits will grow at a faster rate than sales based on the nature of these plans.

Fourth, we will see favorable SG&A benefits in 2010 from a change in our paid time-off program worth about $0.25 per share. We expect that about a third will be realized in the first half of the year, with the remaining two-thirds appearing in the back half of 2010.

And finally, we expect our tax rate to increase to 39.3% due to higher U.S. state taxes and an unfavorable mix of taxes from our foreign businesses.

To conclude, we continue to be pleased with our execution and operating performance in a challenging environment, and are encouraged by the opportunities in front of us to gain share and create value for our shareholders. Thank you for your interest in Grainger.

Please mark your calendar for the release of January sales on Thursday, February 11. If you have any questions, please do not hesitate to contact Ernest at 847-535-4356, Nancy Hobor at 0065, or me at 0881. Thank you.

Question-and-Answer Session

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