W.W. GRAINGER, INC. quarterly report, Q3 FY2009

W.W. Grainger, Inc. — Q3 2009 Form 10-Q

Business and period: Grainger distributes facilities-maintenance and related products through branches, sales representatives, catalogs, and digital channels, primarily in North America. This unaudited report covers the three and nine months ended September 30, 2009, compared with the same 2008 periods.

Financial performance

Metric	Q3 2009	Q3 2008	Nine months 2009	Nine months 2008
Net sales	$1,589.7 million	$1,839.5 million	$4,588.2 million	$5,257.4 million
Gross profit	$659.9 million	$742.3 million	$1,914.3 million	$2,128.2 million
Operating earnings	$186.7 million	$231.5 million	$499.9 million	$602.1 million
Net earnings	$144.6 million	$140.0 million	$333.4 million	$367.4 million
Diluted EPS	$1.88	$1.77	$4.34	$4.60

Q3 sales fell 13.6%; management attributed the change to approximately 4 percentage points of price increases offset by a 17-point volume decline, plus about a 1-point negative foreign-exchange effect. Nine-month sales fell 12.7%; daily sales declined 12.3%.
Gross margin improved to 41.5% from 40.4% in Q3 and to 41.7% from 40.5% year to date. Management cited pricing ahead of product-cost inflation, lower freight and handling costs, and a lower LIFO inventory reserve; lower-margin large-customer sales partly offset these benefits.
Operating margin declined to 11.7% from 12.6% in Q3 and to 10.9% from 11.5% year to date. Operating expenses fell less quickly than sales. Lower headcount, commissions, profit-sharing and bonus accruals reduced costs; severance costs partly offset savings.
Q3 net earnings and diluted EPS increased despite lower operating earnings, primarily because of a one-time, noncash $47.4 million pretax ($28 million after-tax) gain on the MonotaRO investment. Excluding that gain, underlying net earnings were lower; the filing does not provide a directly stated adjusted EPS.
Q3 effective tax rate was 38.1%, or 39.1% excluding a one-time benefit from expiration of a prior-year tax statute. The nine-month reported rate was 38.7%, also 39.1% excluding that benefit.

Cash, liquidity, and debt

Nine-month operating cash flow was $509.7 million, versus $335.3 million in 2008. Inventory reductions were a major source of cash; cash flow also benefited from noncash expenses. Investing cash outflow was $76.9 million, compared with $152.9 million.
Cash and equivalents increased to $672.0 million at September 30, 2009, from $396.3 million at year-end 2008. Working capital was $1,611.0 million and the current ratio was 3.4, versus 2.8 at year-end.
Total debt was approximately $534.8 million, including current and long-term debt, compared with approximately $529.4 million at year-end. Debt as a percentage of total capitalization declined to 18.5% from 20.7%.
Financing activities used $161.9 million, including $127.7 million for treasury-stock purchases and $100.0 million in dividends. The company repurchased 1.9 million shares in the first nine months. Quarterly dividends paid per share were $0.46; the board declared another $0.46 dividend payable December 1, 2009.

Comparative and operational developments

Sales declined across all customer sectors. In the U.S., Q3 segment sales fell 14.2%; heavy manufacturing declined at a high-20% rate and reseller sales at a mid-20% rate, while government was comparatively resilient, down mid-single digits. Canada sales fell 12.8% in reported currency and operating earnings fell 41.0%. Other-business sales rose 11.5%, partly due to the India acquisition; the segment remained loss-making.
MonotaRO: Grainger increased its ownership from 48% to 53% in September, obtaining control. It remeasured its previously held interest and recognized the gain noted above. MonotaRO’s balance sheet was consolidated at quarter-end; its earnings were to be reported on a one-month lag beginning October. The preliminary purchase-price allocation included $97 million of intangibles, including goodwill, and remained subject to change.
India: Grainger acquired the remaining 50.1% of its joint venture in June for $1.2 million; its results entered the consolidated accounts from the acquisition date. Imperial Supplies, with $67 million of 2008 sales, was acquired on October 13, after quarter-end.
EPS comparisons reflect adoption of the two-class method for participating securities, with prior-period EPS restated. The filing says this accounting change did not affect net earnings or operating cash flow.

Outlook, risks, and contingencies

No company-specific earnings or sales guidance is provided. Management cited a weak economic environment: October 2009 consensus forecasts projected U.S. 2009 industrial production down 10.3% and GDP down 2.5%, and Canadian GDP down 2.4%. U.S. industrial production had declined 6.1% year over year through September.
Management said approximately one third of the Q3 operating-expense decrease was expected to be permanent. It also planned to expand the catalog to almost 300,000 products in 2010, from 233,000 in the 2009 catalog.
The DOJ is investigating alleged disclosure and pricing issues under Grainger’s GSA contract. Discussions were ongoing; possible outcomes include settlement or civil litigation, including treble damages and penalties under the False Claims Act. Grainger said it believes it complied in all material respects and did not expect a material adverse effect on financial position, but an unfavorable outcome could require significant payments.
Risks identified include prolonged economic weakness, competitive pricing, customer or supplier loss, currency and commodity volatility, litigation and regulatory matters, technology or data-security disruption, and transportation or facility disruptions. Management reported disclosure controls were effective and no material change in internal control during the first nine months.

Most important facts to verify

How much of Q3 earnings and EPS depended on the noncash MonotaRO remeasurement gain, and what earnings performance looks like without it.
Whether sales volumes and customer demand recover, particularly in manufacturing and reseller markets, and whether margin improvements persist as pricing, product costs, and customer mix change.
The eventual MonotaRO purchase-price allocation, goodwill and intangible-asset amounts, and contribution of the consolidated business to future results.
Developments and potential financial exposure in the DOJ/GSA matter.
Whether elevated operating cash flow is sustainable after inventory reductions and other working-capital movements.