W.W. Grainger, Inc.
Q2 2016 Earnings Call Transcript

Published: 19 Jul 2016

[Laura D. Brown:]

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 Second Quarter Results. This podcast supplements our 2016 second quarter earnings release issued today, July 19, 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 second 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. I also wanted to report on our progress on key initiatives since we're at the midpoint of the year. We've made many important investments in this business despite the current economic challenges. We're investing in our supply chain, our eCommerce capability, our onsite services and tools to make our sales force more efficient. In the United States, in the quarter, we launched a new inside sales team, which has 275 representatives calling on our medium-sized customers. We closed 27 branches in the United States, as part of a previously announced plan, to adjust the U.S. branch network. In Canada, we installed SAP to allow for better visibility to our data and our inventory at a North American level. We also increased direct-to-customer shipping to improve service and efficiency. As of the end of the quarter, 24% of shipments were going direct to the customer. eCommerce represented 46% of sales in the first half of the year, up from 40% in the first-half 2015, illustrating our strength in helping customers using the tools and channels they prefer. And the single channel online businesses increased revenue 34% on a daily basis over the 2015 second quarter. Overall, we remain confident in our U.S. performance for the year, despite the tough environment we're operating in. Canada's results were lower than anticipated and significantly contributed to the earnings shortfall versus our expectations, but we believe in the long-term prospects of the business and are executing a plan to improve performance. Finally, our single channel online businesses continued their rapid growth, serving mostly small customers in the United States and Japan. Before we begin review of our results, I'd like to remind you of the adjustments to reported results in the second quarters of 2016 and 2015. In general, we will adjust the reported results to exclude 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 accompany today's earnings release and the transcript of this podcast, both of which are available on our Investor Relations website. In the quarter, we took several actions to restructure the business for long-term success. We initiated $6 million of restructuring costs in the United States. Those costs were more than offset by gains on sales of branch real estate of $15 million. Overall, we realized a net savings of $0.09 earnings per share. We had restructuring costs of $8 million in Canada, primarily related to severance, or $0.09 per share. Also in Canada, we reported a $10 million, or $0.12 per share, negative adjustment to inventory as a result of revisions to the reserves methodology, based on additional visibility of inventory performance provided by the recent conversion to the U.S. SAP system. We wrote down the value of a plane we are selling as part of eliminating aviation operations, which had a $0.09 impact to earnings per share. Lastly, the quarter also included a benefit of $0.11 per share from the effective settlement of certain federal income tax issues under audit for the years 2009 through 2012. These actions had a net effect of $0.10 of charges to earnings per share. In 2015, we took $0.02 per share in charges related to restructuring at Fabory and the shutdown of the Brazil business. With that as a backdrop, let's look at our results for the 2016 second quarter. All figures below reflect adjusted results unless specifically noted. Company sales for the quarter increased 2% versus the 2015 second quarter. Excluding acquisitions, organic sales decreased 2%. There were 64 selling days in both quarters. Operating earnings decreased 10%, and net earnings decreased 20%. Earnings per share were $2.89, down 12% versus the prior year. Bill will cover our revised guidance in detail at the end of the podcast. We now expect 2016 sales growth of 1% to 4%, and earnings per share of $11.20 to $12.20. Our 2016 guidance issued on April 18, 2016, included 0% to 6% sales growth and earnings per share of $11.00 to $12.80. Let's now walk down the operating section of the income statement in more detail. Gross profit margins in the second quarter decreased 160 basis points to 41% versus 42.6% in 2015, due to unfavorable price-cost mix in the United States and Canada. Operating expenses for the company increased 2%, primarily due to the addition of Cromwell expenses not recorded in last year's results. Operating expenses as a percent of sales were 28.4%, up 10 basis points versus the prior year. Total company operating earnings were $323 million, a decrease of 10% versus the prior year. The operating margin was 12.6%, a decrease of 160 basis points versus the prior year. Let's now focus on performance drivers during the quarter. In doing so, we'll cover the following topics

[William D. 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 adjusted results. In the United States, operating earnings decreased 8% in the quarter, driven by lower sales and lower gross profit margins. The operating margin for the U.S. segment was 17.2% versus 18.2% in the 2015 quarter. Gross profit margins for the quarter declined 90 basis points, primarily driven by negative customer selling mix and price deflation greater than product cost deflation. Operating expenses were down 2% due to lower advertising costs. Let's move on to our business in Canada, which had an operating loss of $10 million in the quarter versus operating earnings of $9 million in the 2015 second quarter, driven by lower sales and lower gross profit. The gross profit margin in Canada declined 640 basis points versus the prior year, driven by the combination of price deflation and cost of goods sold inflation and unfavorable foreign exchange from products sourced from the United States. Operating expenses were down 12% versus the 2015 quarter, driven by lower SAP costs versus the prior year and lower advertising costs. The Canadian business is undergoing significant change management as a result of the SAP conversion, though we have confidence in our leadership team and the plan to return the business to long-term profitable growth. Operating earnings in the Other Businesses were $30 million in the 2016 second quarter. Operating earnings in the 2015 second quarter were $17 million, representing an earnings increase of $13 million or 73% versus the prior year. 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 $23 million of expense in the 2016 second quarter, versus a net $8 million expense in the 2015 second quarter. The increase was driven by higher interest expense from the company's debt offerings in 2015 and 2016. Operating losses from the clean energy investments were lower than expected in the quarter as a result of lower demand for refined coal, given relatively mild weather. For the quarter, the reported effective tax rate in 2016 was 36.6%, versus 35.4% in 2015. The 2016 second quarter included an $0.11 per share benefit from the effective settlement of certain federal income tax issues under audit for the years 2009 through 2012. Excluding this discrete benefit, the company's effective tax rate was 39.1%. The effective tax rate for the 2015 second quarter, excluding a year-to-date adjustment for the benefit from the company's first clean energy investment, was 36.9%. The year-over-year increase in the tax rate, excluding the settlement benefit, was primarily due to a larger proportion of earnings from higher tax rate jurisdictions, and lower benefit from the clean energy investments in the quarter. We currently project an effective tax rate, excluding discrete items, of 36.8% to 37.8% for the full year 2016, versus 35.2% to 36.2% provided on April 19, 2016. The increase since April is driven by the expectation of continued earnings concentration in higher tax rate jurisdictions, and lower benefit from the clean energy investments. Lastly, let's take a look at cash flow in the quarter. Operating cash flow was $173 million versus $213 million in 2015, as a result of lower earnings. We used the cash generated during the quarter, along with borrowings, to invest in the business and return cash to shareholders through share repurchase and dividends. We bought back 1,033,000 shares of stock for $241 million in the second quarter. Grainger returned a total of $315 million to shareholders in the quarter, including $75 million in dividends, reflecting the 4% increase in the quarterly dividend announced in April of 2016. Capital expenditures were $54 million in the quarter, versus $71 million in the second quarter of 2015. We have revised our full year guidance for capital expenditures to $300 million to $325 million, from $300 million to $350 million announced in November of 2015. As reported in our 2016 second quarter earnings release, we revised our 2016 sales and earnings per share guidance. For the full year 2016, we now expect 1% to 4% sales growth, and earnings per share of $11.20 to $12.20. Let's look more closely at our current expectations. We'll begin with sales. For the full year, the midpoint of guidance is now 2.5% growth, reflecting lower-than-expected volume in the United States and Canada. We now expect foreign exchange to have no net impact on sales for the full year, due to the strengthening of the Japanese yen. As a reminder, we anniversary the Cromwell acquisition at the beginning of September. Moving on to gross profit margins, for the full year, we still expect gross profit margins to be down 130 basis points to 150 basis points versus 2015. Gross profit margins for the third quarter are forecasted to be down 100 basis points to 140 basis points versus the prior year. Let's take a closer look at operating margin expectations. For the full year, we now expect operating margin compression of 60 basis points to 130 basis points. The midpoint of operating margin guidance remains unchanged, as gross profit improvements over April guidance offset expense deleveraging on lower sales. The full year guidance implies modest improvement in the second half of the year versus previous guidance. This is due to continued strong expense management and better-than-expected gross profit margin in the United States. So for the third quarter, we expect operating margins to be down 80 basis points to 170 basis points versus the prior year. Next, other income and expense. We issued $400 million of new debt in mid-May, so there was about half of a quarter's worth of increased interest expense in the second quarter. The third quarter and fourth quarters will contain the full three months' of the higher interest expense. Finally, earnings per share. As noted, we revised our guidance and we now expect earnings per share of $11.20 to $12.20. We now expect a $0.07 per share benefit to earnings per share in 2016 from the two clean energy investments compared to the prior projection of $0.15 per share benefit on April 18, 2016. Please see Exhibit 4 for more detail. The earnings per share guidance includes the projected tax rate of 36.8% to 37.8% for 2016, reflecting a higher proportion of earnings from higher tax jurisdictions. Finally, please mark your calendar for the following important dates. On August 11, we plan to release July sales and we will host our Annual Analyst Meeting on the morning of Friday, November 11, which will be held at our headquarters in Lake Forest, Illinois. 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 so much for your interest in Grainger.