GWW

Business Context and Reporting Period

Company: W.W. Grainger, Inc.
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2003
Business Overview: Grainger is the leading broad-line supplier of facilities maintenance products in North America. It operates through three primary segments: Branch-based Distribution (Industrial Supply, Acklands-Grainger in Canada, FindMRO, Global Sourcing, Parts, Mexico), Lab Safety (direct marketing of safety and industrial products), and Integrated Supply (outsourcing of indirect materials management). The company serves over 1.6 million customers via a multichannel model including branches, catalogs, and the Internet.

Key Financial Metrics (2003)

Material Changes vs. Prior Period

• Revenue: Net sales were essentially flat (+0.5%) compared to 2002, impacted by general U.S. economic weakness. Branch-based Distribution sales were flat, while Lab Safety grew 6.5% (driven by the Gempler's acquisition) and Integrated Supply declined 6.3%.
• Profitability: Gross margins improved to 35.1% from 34.4% due to favorable product mix and price increases. However, operating earnings declined 1.5% due to higher operating expenses, primarily driven by increased severance and healthcare costs.
• Net Earnings: Increased 7.3% to $227.0 million. This growth occurred despite lower operating earnings, largely because 2002 included a $23.9 million after-tax charge for the cumulative effect of a change in accounting principle (SFAS No. 142 goodwill write-down).
• Debt Structure: Long-term debt decreased significantly as a $114.1 million commercial paper issuance (used to refinance Canadian debt) was reclassified as a current maturity due to uncertainty regarding the renewal of a cross-currency swap maturing in 2004.
• Acquisitions: The company acquired Gempler's in April 2003 for $36.7 million, contributing to Lab Safety segment growth.

Guidance, Outlook, and Risks

• 2004 Capital Expenditures: Management anticipates capital spending of $200 to $225 million in 2004, more than double recent years. This includes $70-$85 million for the branch network, $50-$55 million for IT, and $10 million to complete the logistics network.
• Market Outlook: Grainger expects to focus on government and commercial customers to offset declining manufacturing employment. Internet sales growth is expected to continue.
• Legal Contingencies: The company is a defendant in approximately 3,300 asbestos/silica lawsuits. Management believes these claims are largely covered by insurance and will not have a material adverse effect on financial position.
• Accounting Changes: Implementation of EITF Issue 02-16 will reclassify vendor advertising allowances from operating expenses to cost of merchandise sold starting in 2004, which will increase reported gross margins but not affect net earnings.
• Postretirement Benefits: A reduction in the discount rate for postretirement healthcare benefits from 6.5% to 6.0% is expected to decrease 2004 pretax earnings by approximately $1.4 million.

Investor Verification Checklist

• Debt Classification: Verify the impact of the $144.1 million commercial paper reclassification from long-term to current liabilities on liquidity ratios and covenant compliance.
• Expense Trends: Monitor the trajectory of healthcare and severance costs, which were the primary drivers of increased operating expenses in 2003.
• Capital Spending Execution: Track the execution of the planned $200-$225 million capital expenditure program in 2004 and its impact on cash flow.
• Segment Performance: Assess the organic growth of the Lab Safety segment excluding the Gempler's acquisition and the recovery of the Integrated Supply segment.
• Legal Exposure: Review updates on the asbestos/silica litigation and insurance coverage status.