W.W. Grainger, Inc. (NYSE:GWW) Q3 2016 Earnings Conference Call October 18, 2016 7:30 AM ET
Laura Brown - Senior Vice President Communications and Investor Relations
Bill Chapman - Senior Director of Investor Relations
Hello, this is Laura Brown, Senior Vice President of Communications and Investor Relations. With me is Bill Chapman, Senior Director of Investor Relations. The purpose of this podcast is to provide you with additional information regarding Grainger’s 2016 Third Quarter Results.
This podcast supplements our 2016 third quarter earnings release issued today, October 18th and other information available on our Investor Relations website. This material contains forward-looking statements that are based on our current view of the competitive market and the overall environment. Future risks and uncertainties could cause our actual results to differ materially. Please see our SEC filings, including our most recent periodic reports filed on Form 10-K and Form 10-Q, which are available on our Investor Relations website for a discussion of factors that may affect our forward-looking statements.
Today we reported results for the 2016 third quarter and updated our sales and earnings per share guidance for the full year to reflect our performance to-date and the challenging industrial economy.
Before we begin our review of results, I’d like to remind you of the adjustments to reported results in the third quarters of 2016 and 2015. In general, we adjust the reported results to exclude any items that are unrelated to the ongoing operations of the business. We believe this gives investors a better view of our core operational performance.
Tables reconciling reported to adjusted results and other non-GAAP measures accompanying today’s earnings release and the transcript of this podcast, both of which are available on our Investor Relations website.
The 2016 third quarter included restructuring charges in the U.S. and Canadian segments. In both countries, we are closing branches and reducing headcount to proactively address changes in customer buying behavior and better position the business for profitable growth. These actions had a net charge of $0.01 to earnings per share.
In 2015, we took restructuring actions that resulted in net charges of $0.11 per share. All figures from this point forward represent adjusted amounts unless specifically noted.
With that as a backdrop, let’s look at our results for the 2016 third quarter. Company sales for the quarter increased 3% versus the 2015 third quarter. Excluding acquisitions and foreign exchange, organic sales were flat. There were 64 selling days in both quarters. Operating earnings decreased 5%, and net earnings decreased 6%. Earnings per share were $3.06, up 1% versus the prior year.
Bill will cover our revised guidance in detail at the end of this podcast. We now expect 2016 sales growth of 1.5% to 2.5% and earnings per share of $11.40 to $11.70. Our 2016 guidance issued on July 19th 2016 was 1% to 4% sales growth and earnings per share of $11.20 to $12.20.
Let’s now walk down the operating section of the income statement in more detail. Gross profit margins in the third quarter decreased 180 basis points to 40.1% versus 41.9% in 2015, due primarily to unfavorable customer mix and modest negative price-cost mix in the United States and price deflation versus product cost inflation in Canada.
Operating expenses for the company were essentially flat. We attained positive expense leverage as operating expenses as a percent of sales were 27.3%, down 80 basis points versus the prior year. The third quarter benefited from operating expense favorability from the timing of certain professional expenses and other program-related expenses.
Total company operating earnings were $332 million, a decrease of 5% versus the prior year. Company operating margin for the quarter was 12.8%, a decline of 110 basis points versus the 2015 quarter.
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 the month of September, second, operating performance by segment, third, cash generation and capital deployment and finally we’ll wrap up with a discussion of our 2016 guidance.
Before we begin our sales discussion, please note that some of our businesses have a different number of selling days due to local holidays. Despite this, we use the number of selling days in the United States as the basis for our calculation of daily sales.
As mentioned earlier, company sales for the quarter increased 3%. Daily sales performance by month was as follows: up 3% in July, up 4% in August and flat in September. Excluding the Cromwell acquisition in the first two months of the quarter, sales performance by month was down 1% in July, up 1% in August and flat in September.
Results for the quarter included two percentage points from the Cromwell acquisition, which we anniversaried on September 1st, and 1 percentage point contribution from foreign exchange. Excluding acquisitions and foreign exchange, organic sales were flat consisting of a 1 percentage point contribution from sales of seasonal products offset by a 1 percentage point decline in price.
Let’s move on to sales by segment. We report two business segments, the United States and Canada. Our remaining operations are reported under Other Businesses. Sales in the United States, which accounted for 74% of total company revenue in the quarter, decreased 1%.
Results for the quarter included a 1 percentage point decline from volume and a 1 percentage point decline from price, partially offset by 1 percentage point from intercompany sales, primarily to Zoro.
Let’s review sales performance by customer-end market in the United States: Government and Retail were up in the mid-single digits; Light Manufacturing was up in the low single-digits; Commercial was flat; Heavy Manufacturing and Contractor were down in the mid-single digits; Reseller was down in the low double-digits and Natural Resources was down in the mid-teens.
We believe that growth in the Government and Retail end-markets was primarily a function of share gains as we outperformed our estimated growth of the market.
Now let’s turn our attention to the Canadian business. Sales in Canada represented 7% of total company revenues. Sales for the quarter decreased 16% in U.S. dollars and local currency, consisting of a 15 percentage point decline in volume and a 1 percentage point decline in price.
All end-markets in Canada were down for the quarter. From a geographic standpoint, sales in Alberta were down 22%, compared to all other provinces which were down 12% in aggregate. In addition to a challenging economy, we are aggressively working through process standardization and change management related to the new IT system and expect improvement in the coming months.
Let’s conclude our discussion of sales for the quarter by looking at the Other Businesses, which represented 19% of total company sales. Sales for the Other Businesses increased 36%, consisting of 16 percentage points from the Cromwell acquisition, 15 percentage points from volume and price and 5 percentage points from foreign exchange.
The organic sales increase was primarily due to growth from the single channel online businesses of Zoro U.S. and MonotaRO. Earlier in the quarter, we reported sales results for July and August and shared some information regarding performance in those months.
Let’s now take a look at September. There were 21 selling days in September of 2016, the same as 2015. Company sales were essentially flat in September versus the prior year. The sales performance consisted of 1 percentage point from volume offset by a 1 percentage point decline in price.
In the United States, September daily sales were flat, driven by a 1 percentage point from intercompany sales, primarily to Zoro, offset by a 1 percentage point decline from price. September customer end-market performance in the United States was as follows: Government and Retail were up in the low single-digits; Light Manufacturing was flat; Commercial and Heavy Manufacturing were down in the low single-digits; Contractor was down in the mid-single-digits and Natural Resources and Reseller were down in the low double-digits.
The benefit often seen from federal government customers at the September fiscal year end appears to have been realized a month early, as we saw strong growth to that end-market in August.
In addition, the strong sales of seasonal products that benefited August did not continue into September. Sales in Canada for September were down 14% in U.S. dollars and 15% in local currency. The 15% decrease was driven by a 15 percentage point decline in volume. All end-markets except Light Manufacturing were negative.
From a geographic standpoint, sales in Alberta were down 22%, compared to all other provinces which were down 13% in aggregate. As mentioned in the quarter recap, we are aggressively working through process standardization and change management related to the new IT system.
Sales for our Other Businesses increased 17% percent in September, consisting of 14 percentage points from volume and price and 3 percentage points from foreign exchange. September was the first month where Cromwell sales were already included in the base results. The organic sales increase was primarily due to strong revenue growth from Zoro U.S., MonotaRO in Japan and the business in Mexico.
Sales growth in the month of October to-date is slightly below the sales performance in September. Multiple branches in the southeast and the distribution center in Jacksonville, Florida were closed earlier this month due to Hurricane Matthew. We believe there may be an effect on October sales, but it is too early to quantify that impact or any possible cleanup benefit.
Now I would like to turn the discussion over to Bill Chapman.
Thanks Laura. Let’s talk about performance by reportable segment since we have already analyzed company operating performance. As a reminder, all figures below represent results adjusted for restructuring charges that Laura discussed earlier.
In the United States, operating earnings decreased 6% in the quarter, driven by lower sales and lower gross profit margins. Gross profit margins for the quarter declined 130 basis points, primarily driven by negative customer selling mix and price deflation exceeding product cost deflation.
Operating expenses were down 2% due to lower payroll and benefits costs. The operating margin for the U.S. segment was 17.2% versus 18.1% in the 2015 quarter.
Let’s move on to our business in Canada, which had an operating loss of $11 million in the quarter, versus operating earnings of $5 million in the 2015 third quarter, primarily driven by lower sales and lower gross profit.
The gross profit margin in Canada declined 520 basis points versus the prior year, driven by product cost inflation and unfavorable foreign exchange from products sourced from the United States. Due to service gaps stemming from the systems transition, we have not passed on price increases to customers this year and this is putting pressure on our gross profit margins.
Operating expenses were down 9% versus the 2015 quarter driven by lower SAP costs and lower headcount. The new IT system continues to be a change management challenge for this business. However, we are making progress in areas such as direct-to-customer shipping, which has already increased each quarter for the year.
In the third quarter, 38% of shipments went direct to the customer, bypassing the branch network. We will provide more detail about the Canadian business at our Analyst Meeting in November.
Operating earnings for the Other Businesses were $25 million in the 2016 third quarter versus $15 million in the prior year, representing an earnings increase of 68%. Results included strong performance from Zoro U.S. and Japan and the earnings contribution from Cromwell.
Below the operating line, other income and expense was a net $29 million expense in the 2016 third quarter versus a net $21 million expense in the 2015 third quarter. The increase was driven by higher interest expense from the company’s $400 million debt offering in May of 2016.
Operating losses from the clean energy investments were higher as a result of higher demand from a warm summer resulting in a higher overall benefit to the company, net of tax credits.
For the quarter, the reported effective tax rate in 2016 was 34% versus 38.4% in 2015. The year-over-year decrease in the tax rate was primarily due to a higher benefit from the company’s clean energy investments, partially offset by a larger proportion of earnings from higher tax rate jurisdictions.
The 2016 third quarter also included a benefit from the conclusion of the federal income tax audit for the years 2009 through 2012 and other discrete items. Excluding the discrete items, the company’s effective tax rate was 36.1%.
We currently project an effective tax rate, excluding discrete items of 36.1% to 37.1% for the full year 2016 versus 36.8% to 37.8% provided on July 19, 2016. This decrease is driven by the expectation of higher benefit from the clean energy investments, partially offset by a larger proportion of earnings from higher tax rate jurisdictions.
Lastly, let’s take a look at cash flow for the quarter. Operating cash flow was $344 million versus $366 million in 2015, primarily the result of lower net income. We used the cash generated during the quarter and proceeds from the May 2016 debt offering to invest in the business and return cash to shareholders through share repurchase and dividends.
We returned a total of $275 million to shareholders in the quarter including $74 million in dividends, reflecting the 4% increase in the quarterly dividend announced in April of 2016.
In addition, we bought back 887,000 shares of stock for $201 million in the third quarter. Capital expenditures were $108 million in the quarter, versus $82 million in the third quarter of 2015.
As reported in our 2016 third quarter earnings release, we updated our 2016 guidance. For the full year 2016, we now expect 1.5% to 2.5% sales growth and earnings per share of $11.40 to $11.70.
Let’s look more closely at our current expectations. We’ll begin with sales. For the full year, our guidance is lowered to reflect year-to-date performance and the expectation of continued modest sales growth in the fourth quarter. As a reminder, we will have 63 selling days in the 2016 fourth quarter, one fewer than the 64 selling days in the 2015 fourth quarter.
Moving on to gross profit margins, for the full year, we expect gross profit margins to be down 170 to 180 basis points. We continue to see gross profit pressure due to unfavorable price-cost spread for the businesses in the United States and Canada, along with faster growth with the lower margin single-channel businesses. We expect gross margin pressure to continue into the fourth quarter.
Let’s take a closer look at operating margin expectations. For the full year, we now anticipate operating margin of 12.3% to 12.5%, down 100 to 120 basis points. For the fourth quarter, we expect operating expenses to increase as a percentage of sales versus the 2016 third quarter, reflecting the following: number one the loss of a selling day; two, three months of depreciation for the new distribution center in New Jersey versus two months in the 2016 third quarter; three, the hiring of 30 new inside sales representatives in the fourth quarter to call on medium-sized customers given the success of the 275 inside sales reps added in the 2016 second quarter and fourth, the operating expense favorability in the 2016 third quarter related to the timing of program-related expenses and professional services that are not expected to repeat in the 2016 fourth quarter.
Finally, earnings per share. As noted earlier, we expect 2016 EPS of $11.40 to $11.70. For the full year, we now expect a $0.10 benefit to earnings per share in 2016 from the two clean energy investments, compared to our prior projection of a $0.07 benefit on July 19, 2016. Through the first nine months of the year, we have realized $0.06 per share of benefit from the investments. Please see Exhibit 4 for more detail.
Finally, please mark your calendar for the following important dates: we will host our Annual Analyst Meeting on the morning of Friday, November 11th, which will be held at our headquarters in Lake Forest, Illinois. We also plan to release October sales on November 11th. On Tuesday, November 15th, we will participate in the Barclays Select Series Industrial Distribution Forum in New York, New York.
If you have any questions, please do not hesitate to contact Laura Brown at 847-535-0409, Michael Ferreter at 847-535-1439 or me, Bill Chapman, at 847-535-0881.
Thank you for your interest in Grainger.
End of Q&A
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