W.W. Grainger, Inc. (NYSE:GWW)
Q2 FY08 Earnings Call
July 15, 2008, 08:00 AM ET
Laura D. Brown - VP, IR
William D. Chapman - Director, IR
Laura D. Brown - Vice President, Investor Relations
Hello, this is Laura Brown, Vice President of Investor Relations; and I'm here with Bill Chapman, Director of Investor Relations.
Welcome to Grainger's quarterly audio webcast covering results for the second quarter ended June 30th 2008. This recording is intended to provide you with information on our recent performance. Please use this information in conjunction with the earnings release, and other financial information posted on our Investor Relations website.
Before we begin, I'd like to remind you that certain statements and projections of future results made in the press release in this webcast constitute forward-looking information. These statements are based on current market conditions and competitive and regulatory expectations, and involve risks and uncertainty. Please see our Form 10-K for a discussion of factors that relate to forward-looking statements. Grainger posted record sales of $1.8 billion in the 2008 second quarter.
Sales were up 10% versus last year's second quarter. Both quarters contain 64 selling days. Operating earnings increased 11% and net earnings increased 8%. Earnings per share grew by 18% to $1.43. It is important to note that these results include a special charge. During the quarter, the company recognized $0.05 per share in unallocated expenses for our legal reserve. This expense relates to allegations involving sourced items and the Trade Agreement Act compliance under the company's GSA contract.
Excluding this charge, operating earnings were up 14%, net earnings were up12%, and earnings per share were up 22%. Operating margins increased about 10 basis points in the quarter to 10.5%, once again excluding the charge operating increased 40 basis points to 10.8%. This operating margin expansion was due to positive operating expense leverage and an 18 basis point improvement in gross profit margins.
Again excluding the charge, operating expenses as a percent of sales decreased from 29.6% in the second quarter of 2007 to about 29.3% in the 2008 second quarter. The 18% increase in earnings per share for the quarter was a combination of the growth in net earnings in our share repurchase activity. During the quarter, we purchased 85,000 shares for $75 million. Over the last 12 months, we have bought back about 9.3 million shares of stock.
Let's now focus on performance drivers during the quarter. In doing so, we'll cover the following topics: first, sales by customer end market and geography in the quarter and in the month of June; second, an update on our key growth initiatives in the United States; third, our operating performance; and last, out cash generation in capital deployment. Sales growth in the quarter of 10% largely consisted of market share gains as general economic growth was minimal with U.S. GDP growth expected to be 1.7%.
Sales price inflation contributed more than 2 percentage points to sales growth. Foreign exchange from our businesses in Canada and Mexico added about 1 percentage point to the top-line. In addition, our sales growth benefited by about 1 percentage point from the timing of the Easter holiday, which fell in March this year versus April a year ago.
Sales in Grainger's branch based business, which includes operations in the United States, Mexico, and China increased 9%. The company's two main growth programs market expansion and product line expansion contributed nearly 6 percentage points to this growth. Similar to total company results, the timing of the Easter holiday also contributed about 1 percentage point to the top line. The sale of seasonal products were not a factor in the quarter.
Similarly, the flooding that occurred in several states in mid-western United States did not affect the sales growth rate for the quarter. Sales in United States increased 9%. This increase was driven by growth to all customer and markets. Here is its complete list: government was up low-double digits; Light manufacturing and commercial were up high-single digits; heavy manufacturing, contractor and reseller were up mid-single digits; and retail was up low-single digits.
On a geographic basis within United States, we saw a strong sales growth across all geographic regions with the exception of the Great Lakes in the Southeast, which grew in mid-single digits. Sales in Mexico were up 25%, driven primarily by the increased market share accompanying from our expansion program. In addition, the timing of the Easter holiday added about 5 percentage points.
In local currency, Mexico was up 20%. For the Acklands Grainger branch-based segment in Canada, sales were up 24%, including a 2 percentage point benefit from the timing of Easter. In local currency, Acklands was up 14%. We saw a continued strength from customers in oilsands, mining and government, partially offset by weakness in forestry customers.
Sales for the Lab Safety Supply segment were essentially flat for the quarter, excluding sales from the McFeeley's acquisition completed in May 2007, Lab was down 2%. We remain disappointed with the lack growth, particularly from sales to manufacturing customers and from safety and security products. We are developing a plan to improve the sales effectiveness, of this business, and expect to show that in November at our annual analyst meeting.
Let's move on to sales results for the month of June. Company sales in June were up 10%. June had 21 selling days, the same number as June of 2007. Foreign exchange contributed about 1 percentage point to total company growth, while the sales of seasonal products were not a factor in the month. For the Grainger Branch-based segment, June sales accelerated to 10% growth, following the 6% growth posted in May. Sales in the United States for June were also up 10%.
Let's take a look at results by customer end-market for the month. Commercial was up in the low-double digits; government, light manufacturing and reseller were up in high single digits. Heavy manufacturing and contractor were up mid-single digits. And retail was up low-single digits.
Growth by geographic region in the United States, essentially follow the patterns described for the quarter. Sales in Mexico were up 15%, 9% in local currency. For the Acklands Grainger branch-based segment, sales were up 17%, 11% in local currency. Sales for the Lab Safety Supply segment in June were down 2%. As we move into the third quarter, we are encouraged by the early read on July sales growth. For the first two weeks of July, daily sales is tracking within our guidance for the year of 7% to 10% growth.
Now I would like to turn the call over to Bill Chapman.
William D. Chapman - Director, Investor Relations
Thanks Laura. Let's move on to a brief review of our primary growth initiatives in the United States. During the quarter, market expansion and product line expansion once again delivered incremental sales growth and market share gains. As Laura noted, these two programs contributed about 6 percentage points of the 9% sales growth for the segment.
Over the past five years, the market expansion program has improved our presence and penetration in the top 25 markets across the United States. During the quarter, we completed ten Branch projects. Five more are expected in the back half of the year, which will complete all six phases of market expansion. Despite the completion of the program this year, we expect market expansion to continue to deliver incremental sales and earnings through 2013.
Let's now take a look at the product line expansion program. Part of the value we bring to customers is being a one stop shop for all the MRO items they need to repair and maintain their facilities. Since the program began in 2006, we have added more than 100,000 new products to the catalog. In addition, we have added another 35,000 products that are available to customers now and will be featured in our 2009 catalog in February. This program coupled with improved local availability resulting from market expansion has enabled Grainger to say yes, more often to our customers.
As a result, we have deepened our relationship with customers and have captured market share. Given the success to date, we expect to continue to add new products and drive growth for several more years. Second quarter operating earnings for the company increased by 11% versus the 2007 second quarter. The improvement came from the Grainger branch-based segment in Acklands Grainger. This 11% increase for the company was the result of positive operating leverage attained through the 10% sales growth. Again, excluding the $0.05 charge, operating earnings were up 14%.
Before we jump into operating performance by segment, I'd like to take a moment to discuss the effect of escalating raw materials and fuel prices on our performance. Inflation continues to be top of line for many customers and investors. Price increases from metal, petroleum, and other commodities are well documented. So how does this affect Grainger? One of the benefits of our size and scale is the fact that we have contractual agreements with many of our product and transportation suppliers that limits the amount of cost inflation we will accept each year. This allows us to thoughtfully plan the amount of price inflation we will pass on to our customers as part of our February catalogue release.
Entering 2008, we originally forecasted price inflation of about 2% slightly above the pattern of the last few years. Given the extraordinary commodity inflation to-date in 2008, we've seen more cost inflation than originally expected. As a result, we increased prices on approximately 40,000 steel based products in May, and we now expect price inflation slightly above the 2% for the year. As inflationary pressures continue, we will pass those higher costs on to our customers through price increases.
Let's now take a look at operating performance by segment. Operating earnings for the Grainger branch-based businesses increased 13% versus the 2007 second quarter. Operating margins increased about 50 basis points to 13.4%. This margin expansion was primarily the result of positive operating expense leverage, combined with a 30 basis point improvement in gross margins.
Operating expenses as a percent of sales declined about 20 basis points, despite absorbing higher spending in Mexico for the expansion program, and continued operating losses from the business in China. Pre-tax ROIC for this segment declined 20 basis points to 36.9% reflecting improvements in operating performance, offset by additional investments in working capital and branches.
Let's move on to the Acklands Grainger branch- based segment, where operating earnings increased 52% for the quarter, the result of the 24% sales increase in operating expenses, which grew at a slower rate than sales. Operating margins in Canada increased 20 basis points to 8.1% for the quarter resulting from the positive operating leverage. Pre-tax ROIC improved to 14.5% versus 12.1% a year ago.
We continued to be pleased with the operational improvements in our Canadian business. This business acquired Excel Industriel in Quebec during the quarter adding about $11 million Canadian in annual sales. Operating earnings for the Lab Safety segment decreased by 5% for the second quarter versus 2007.
The flat sales growth and higher operating expenses were responsible for this performance. Although Lab remains a very profitable business, the sluggish sales growth continues to be a disappointment. The recently announced acquisition of Highsmith is forecasted at $20 million to $30 million in sales in the second half of the year, but integration costs are expected to reduce profitability during the same period. Within 12 months, the acquisition is expected to breakeven.
Lastly, let's take look at cash flow. Operating cash flow was $106 million for the quarter. During the quarter, the company used its cash flow and the proceeds from $500 million in intermediate term debt to payoff $330 million in short-term debt. Fund growth initiatives through capital expenditures of $72 million and return cash to shareholders through dividends of $31 million and $75 million in share repurchases.
The majority of capital expenditures were dedicated to branch expansion in the United States, Canada and Mexico. As announced in May, the company secured a four year term loan of $500 million. The debt is carrying a floating interest rate tied to the LIBOR rate and will begin to amortize in the second year of the loan. As a result of this loan in a lower cash balance than a year ago, the company had $2.5 million in net interest expense in the quarter versus $3.5 million in net interest income in the 2007 quarter representing about a $6 million negative swing.
As mentioned in today's earnings release, we reiterated our earnings per share guidance and continued to expect 2008 earnings per share of $5.80 to $6.10 including the $0.05 charge. Looking forward, here are some additional items to consider as you think about the remainder of the year. The 2008 third quarter will have 64 selling days, versus 63 selling days in 2007 third quarter. The 2007 third quarter included $1.3 million or $0.01 per share for gains on the sale of assets.
We are projecting an effective tax rate of 38.9% in 2008, versus 38.5% on 2007. Excluding the effect of equity and net income from unconsolidated entities, the back half of 2008 will include $0.02 to $0.03 per share of dilution from the Highsmith acquisition made by Lab Safety Supply on July 10.
To conclude, we are very pleased about the results for the quarter with sales up 10% and earnings per share up 18%, up 22% excluding the charge. And we remain optimistic about the remainder of the year.
Thank you for your interest in Grainger and please mark your calendar for the following events. August 12, when we plan to issue sales results for July; September 25th, when we will host our first Analyst Day in Toronto, Canada; October 14th, when we expect to report third quarter results; and November 19th, when we will host our annual analyst meeting in our headquarters in the Chicago area.
Copyright policy: All transcripts on this site are copyright Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.