W.W. Grainger, Inc.
Q2 2015 Earnings Call Transcript

Published: 17 Jul 2015

[Laura 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 2015 second quarter results. Please also reference our 2015 second quarter earnings release issued on July 17th, in addition to other information available on our Investor Relations Web site to supplement this podcast. Before we begin, please remember that certain statements and projections of future results made in the press release and in this podcast constitute forward-looking information. These statements are based on current market conditions, and competitive and regulatory expectations, and involve risk and uncertainty. Please see our Form 10-K for a discussion of factors that relate to forward-looking statements. Today we reported results for the 2015 second quarter, and updated our sales and earnings per share guidance for the full year. We delivered a solid quarter from an EPS standpoint. And while our gross profit margin was less than we expected, we were able to generate positive cost leverage as an offset. I'd like to share with you what we are seeing in the market. We remain in a soft demand environment. Deflationary commodity prices, the strength of the U.S. dollar, and the economy in Canada continue to be headwinds. Despite all of this, we continue to gain share with customers who value a broad product offering, inventory management services, technical services, and fast, reliable delivery. In addition, we are growing rapidly with small customers through Zoro, and MonotaRO. And we remain focused on productivity to fund our growth and infrastructure investments and reduce the effect of lower gross profit margins. Last month, we announced that D.G. Macpherson will assume the newly created role of Chief Operating Officer, effective August 1st. We expect this move will ensure tighter coordination between operating functions, business units, and business models. Also last month, we issued $1 billion in new 30-year debt. We are using the proceeds as part of our $3 billion share buyback program announced on April 16th. Before we begin the review of results, I'd like to remind you that there were adjustments to reported results in the second quarters of both 2015 and '14. In 2015, we took $0.02 per share in charges related to restructuring at Fabory, and the shutdown of the Brazil business. In 2014, we recorded a $0.15 per share charge related to the transition of Fabory's employee retirement plan in Europe. During the 2015 second quarter, Grainger invested in a limited liability company established to produce clean energy. In addition to supporting the operations of this entity, we receive a pro rata share of energy tax credits. Tax credits earned net of operating losses from this investment lowered the company's effective tax rate in the 2015 second quarter, and contributed approximately $0.09 per share to earnings. For the full year, energy credits are expected to result in a 1.4 percentage point reduction in the company's effective tax rate. With that as a backdrop, let's look at our results for the 2015 second quarter. Company sales for the quarter increased 1% versus the 2014 second quarter. Excluding foreign exchange and acquisitions, organic sales increased 3%. There were 64 selling days in both quarters. Reported operating earnings increased 5% or 1% adjusted. Reported net earnings increased 7%, and adjusted net earnings were up 3%. Reported earnings per share were $3.25 for the quarter, an increase of 11% versus the 2014 second quarter. Excluding the adjustments from both years, earnings per share were $3.27, up 6% versus the prior year. We also revised guidance for sales and earnings per share, which Bill will cover in detail at the end of the podcast. Our 2015 guidance issued on April 16, 2015, included 1% to 4% sales growth and earnings per share of $12.25 to $12.95. We now expect 2015 sales growth of zero to 2%, and earnings per share of $12 to $12.50, which includes the benefit of the energy tax credits. Now let's walk down the operating section of the income statement in more detail. Gross profit margins in the second quarter decreased 50 basis points to 42.6%, versus 43.1% in 2014, due primarily to faster growth with lower gross margin customers, lower supplier rebates tied to volume and price deflation versus cost inflation driven by foreign exchange. Operating expenses for the company declined 3%, driven by lower payroll and benefits. The company generated $28 million of productivity savings to fund $25 million of incremental growth in infrastructure spending. Total company operating earnings were $357 million, an increase of 5% versus the prior year. The reported operating margin was 14.1%, an increase of 50 basis points versus the prior year. The adjusted operating margin was 14.2%, an increase of 10 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. First, sales by segment in the quarter in the month of June; second, operating performance by segment; third, cash generation and capital deployment; and finally we'll wrap up with a discussion of our 2015 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 used 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 1%. Daily sales growth by month was as follows

[Bill Chapman:]

Thanks, Laura. Since we've already analyzed company operating performance, let's talk about performance by reportable segment. In the United States, gross profit margins for the quarter declined 70 basis points, primarily driven by faster growth with larger customers, higher sales to Zoro, reflecting the lower transfer price used to account for these inter-segment sales, and price deflation exceeding cost deflation. Excluding Zoro, gross profit margins were down 40 basis points versus the prior year. Operating expenses were down slightly in the quarter, driven primarily by lower payroll and benefits, which offset incremental growth and infrastructure spending of $23 million. Operating earnings for the U.S. segment increased 1% in the quarter, driven by the 2% sales growth and positive operating expense leverage, partially offset by lower gross profit margins. We also wanted to provide a midyear update on our growth initiatives in the United States. Year-to-date, we have hired 80 sales representatives with a plan to hire several hundred total by year end. Most of the new sellers will call on our large customers where we see additional opportunity to gain share. In addition, ecommerce represented 40% of sales in the first half of the year, up from 35% in the first half of 2014. Let's move on to our business in Canada. The gross profit margin in Canada declined 110 basis points versus the prior year, driven by unfavorable foreign exchange from products sourced from the United States, and inventory markdowns related to the Toronto D.C. move, partially offset by price increases, and higher freight revenue. Excluding WFS, gross profit margins were down 30 basis points. Operating earnings in Canada declined 51% in the 2015 second quarter, driven by the 9% sales decline, lower gross profit margins and negative expense leverage. Because of the affect of foreign exchange, we wanted to also share Canada's results in local currency. Operating expenses in Canada increased 10% in local currency due to the WFS acquisition, relocation to the new Toronto distribution center and SAP implementation cost. As a reminder, in the second quarter of 2014, we wrote off $4 million of capitalized software development costs. Operating earnings in Canada were down 44% in local currency, representing a 330 basis point decline in operating margin. We have taken measured actions primarily in Alberta to reduce headcounts and freeze open roles. Operating earnings in the other businesses were $15 million in the 2015 second quarter, which included $2 million of restructuring charges. Operating earnings in the 2014 second quarter were essentially breakeven, which included $14 million for the retirement plan transition in Europe, and $2 million for the write off of capitalized software development costs for Mexico. Adjusting for these items, earnings increased $2 million versus the prior year. The results included strong performance for Zoro U.S. and Japan, and also included an incremental $3 million in expense for the single channel online business in Europe. Below the operating line, other income and expense was a net $8 million expense in the 2015 second quarter versus a net $2 million expense in the 2014 second quarter. The increase was driven by higher interest expense associated with the $1 billion in long-term debt issued in early June bearing an interest rate of 4.6%. In addition, the investment in clean energy made during the quarter generated losses that contributed to the increase in other expense. Accounting guidance requires us to record the tax credit provision based on a full year estimate of the annual rate applied to the year-to-date earnings. Accordingly, the 2015 second quarter includes the benefit of half the annual energy tax credits anticipated for the year. When netted against the losses generated in the quarter, the energy investment generated $6.4 million or $0.09 per share of earnings. On a full year basis, the expected impact is also $0.9 of earnings per share. The full year estimate takes into consideration the forecasted operating loss from the date of investment, associated tax benefits, and the tax credits expected for the year. The tax rate for the quarter was 35.4% compared to 38.2% in the 2014 second quarter. Excluding the benefits of the energy tax credits for the first quarter of 2015 recorded in the second quarter, the tax rate for the 2015 second quarter was 36.9%. In comparison, the 2014 second quarter reflected a higher tax rate due to the effect of the retirement plan transition in Europe. Excluding the retirement plan transition cost, the tax rate was 37.7% in the 2014 second quarter. The company expects to benefit from the energy tax credits going forward, and is currently projecting an effective tax rate of approximately 36.6% to 37.2% for 2015. Lastly, let's take a look at cash flow for the quarter. Operating cash flow was $213 million versus $161 million in 2014. On April 16, 2015, the company announced a plan to repurchase $3 billion of stock over the next three years. In June, the company issued $1 billion in new 30-year debt to fund part of the share repurchase program. The net EPS impact of the buyback in the quarter was negative by $0.01 as the borrowing cost exceeded the share repurchase benefit. We continue to expect $0.08-$0.12 per share benefit for the full year. We bought back 1.3 million shares of stock for $293 million in the second quarter, and ended the quarter with 13.7 million shares remaining on our share repurchase authorization. Grainger returned to a total $373 million to shareholders in the quarter, including $80 million in dividends, reflecting the 8% increase in the quarterly dividend announced in April 2015. Capital expenditures were $71 million in the quarter versus $90 million in the second quarter of 2014. While we still anticipate full year capital spending of $375 million to $425 million, we are likely to be at the low end of that range. Spending will be back-half weighted as the investment in the new distribution centre in the Northeast picks up. As reported in our 2015 second quarter earnings release, we revised our 2015 sales and earnings per share guidance to reflect a softer top-line, lower growth profit margins, and a lower effective tax rate. For the full year 2015, we now expect zero to 2% sales growth, and earnings per share of $12 to $12.50. This guidance assumes incremental growth spending of $150 million, although we are currently assessing our spending plan for the back-half of the year given the tenure of business. Let's look more closely at our current expectations. We will begin with sales. We now expect sales to be flat to up 2%. This compares to our April guidance of 1% to 4% and reflects a weaker economy and lower than expected sales in oil and gas, and heavy manufacturing in both the United States and Canada. We have also revised our full year price realization estimate to negative 1% versus flat, given the current deflationary environment. From an organic gross perspective, the midpoint of our sales guidance anticipates second half sales consistent with our second quarter results. The low end of our sales guidance at zero is based on further weakness in the economy, oil and gas, and the further strengthening of the U.S. dollar, and as a reminder, we anniversary the WFS acquisition at the beginning of September. Moving on to gross profit margins; for the full year we now expect gross profit margins to be down about 60 basis points. For the back-half of 2015, we are expecting gross profit margins to contract about 60 to 80 basis points versus 2014. Gross profit margin compression in the second half is slightly worse than the second quarter as we lap prior year pricing actions. Let's take a closer look at operating margin expectations. For the full year, we expect our operating margin to be down between 40 and 70 basis points depending on volume. Growth and infrastructure investments will continue with the expectation of fueling market share gains. In the back-half of the year, we intend to drive continue productivity and manage expenses to fund the incremental growth in infrastructure spending. However, margins versus the second half of 2014 are forecasted to decline 90 to 110 basis points, primarily due to the anticipation of back-half weighted gross spending. Please see Exhibit 4 for more information. The other interest and expense section of the income statement will look dramatically different going forward. Interest expense will increase in the second half of the year due to the new $1 billion debt offering, which carries a 4.6% interest rate. Also the loss from the clean energy investment is expected to be $9 to $11 million per quarter for the third and fourth quarters. Finally, earnings per share; as noted in our revised guidance, we now expect EPS of $12 to $12.50, reflecting the headwinds from the economy and the expected margin compression from lower gross profit margins, and continued growth in infrastructure spending, partially offset by our productivity programs. As a reminder, similar to April guidance, our new EPS guidance reflects the benefit of the $0.8 to $0.12 of accretion from the $1 billion in incremental share repurchases in 2015, all of which should be realized in the back-half of the year. Finally, our EPS guidance includes the lower tax rate of 36.6% to 37.2% for the full year. Finally, please mark your calendar for the following important dates