W.W. Grainger, Inc. (GWW) Earnings Call Transcript & Summary

Good morning. I'm Sam Darkatsh. On behalf of Raymond James, I'd like to welcome you to the Grainger for today. With us today from the company, D.G. Macpherson, Chairman, Chief Officer; also Irene Holman, Vice President of Investor Relations. Format this morning: D.G. will go over some prepared remarks, maybe 5, 10 minutes worth. We'll open it up for questions, basically a fireside chat type of format. I'll start with a number of questions, then we'll open it up to the audience here. So D.G., with that, welcome.

Great. Thanks, Sam. Appreciate it. Good morning, everybody. Nice to see you. Given that this is a fairly broad conference, I will provide some basics on the company in case some of you are new to the story. Then I'll talk a little bit about what we're doing from a strategic perspective. I figured you'd probably want me to touch on coronavirus before we go to Q&A. I'll do that a little bit, and then we'll move into Q&A. Sound okay? Excellent. Good. So this is Grainger. I would say there are a couple of characteristics about Grainger that I would point to that are unusual in most businesses. One is the sheer number of products and the sheer number of customers that we have. We have millions of products available for millions of customers. So it is a many-to-many business. And so finding -- managing our supply base, making sure we've got product in the right place, making sure we're providing the right product for our customer is a challenge, something we spend a lot of time on. I would also say we spend a lot of time on e-commerce. I guess we are the 11th largest e-commerce player in the U.S. It's a little bit different than consumer e-commerce in the sense that a big part of what we do from an e-commerce perspective is making sure that we can pattern our technical knowledge for customers. Because if our customers are looking for something, it might be something in metalworking category or motors or pumps. There's a technical component to that. And so we have to make sure that we get the product information right to help customers quickly find what they need and have confidence that they find what they needed. So we worked very, very hard on that. We have 2 types of businesses, which I'll talk about in a minute. And we are very diverse from a customer background. We are not exposed to any one industry as much as others might. We do a lot of manufacturing, a lot of health care. For us, health care mostly means hospitals. We do a lot in government. Government is about 1/3 federal and about 2/3 state and local. The federal portion for us is largely military bases, although there are other things. And I was at a state agency last week. State agencies can be corrections departments. It can be departments of transportation, so a very, very broad customer base that we typically deal with. And then from a financial highlight, we're $11.5 billion in revenue, very high profitability and very strong cash flow generation, and we would expect that to continue into the future. I'm going to dive in a little bit more on this page. So this is basically our strategy on a page, and we've put this together last year. And we did it because we wanted to get our strategy and our principles, what we expect of everybody, together on one page. And I'll talk about a few of these things. So in terms of our purpose, almost every customer you go into and talk to, it's about helping them do what they do best, so keeping the world working. What that means is if we're in a hospital, we aren't typically in patient rooms. We're fooling around the basement, making sure they have the right products so that they can focus on patient care. If you're at the university, we're focused on making sure they have the right products so they can focus on teaching. If you're in a manufacturing plant, we're focused on making sure they have everything they need, they're using the right products so they can produce what they produce. So our job is to help our customers keep working, keep up and working, and that's what we spent all of our energy doing. It has been for a long time, but it's just a declaration that, that's what we really care about. And I would say it's a pretty exciting -- it's an exciting purpose. It's one that our teammates take very, very seriously. In terms of our aspiration, the one thing I'd say that's different about this aspiration, and that's really important for us as a company, is the recognition that scale matters in our business. We need to make sure we have the scale and advantage that helps us stock the right products, provide great service at the right cost. And so share gain is a big part of what we're talking about in our aspiration. I'll talk about both business models in a second, but that's really key to what we're trying to do from an aspiration. In terms of our strategy, we go after gaining share and helping keep the world working through 2 models. One is what we call the high-touch solutions model. That's the model that Grainger operates under, the Grainger brands, whether that's Grainger brand in the U.S. or Canada or Mexico. That is really all about finding ways to embed ourselves with our customers to add value for them. And so if you think about what that is, we have 3 priorities there. We talk about MRO solutions. That's typically the right products, so making sure we really have a curated product assortment so we can meet and match the needs of our customers. That means having the right digital solutions for our customers, so working very hard to make sure that if a customer is on an ePro implementation, that we can connect very quickly and simply and allow customers to make it really easy for them to buy from us. So we spend a lot of time on making sure we've got the right solutions. That also includes how we design our network. So our distribution center network is designed such that we have as many as 600,000 items in any building, which allows us, if you order 10 items, to have a much higher probability in getting all those items together in 1 package next day so you can do your job. If you don't do that, if you start driven -- driving packages to the receiving dock in business is you drive them absolutely nuts. So our distribution network is built to make sure that we provide business customers the solution the way they want to have it. The second thing we do is differentiated sales and services. We have about 4,000, 4,500 people on the road every day with customers, and they're focused on making sure that they understand the customers' needs and then solving those needs. Our sellers are -- we call them sellers. They're really all about creating and helping customers with solutions. So I was at the customer in Tulsa a couple of weeks ago. And the big problem we had just solved was they were using grinding wheels and churning them up at unhealthy rates. And so we end up color-coding the wheels to match the application so they were using the right wheel for the right metal, which is obviously a simple thing. But it's something our sellers would work on, things like that day in and day out. We also have a group of people, over 1,000 of people, that help manage customers' inventory, which is a big part of our on-site service. And they're filling customers' bins, making sure that we have the right min-maxes and making sure that customers have what they need so they can keep up and running. And so that's our differentiated sales and services. We think it's critical for complex business customers. The high-touch solutions model is really focused on those more complex customers, midsized and up. And the last one is unparalleled customer service. I mentioned making sure that we have complete orders shipped next day. That's part of unparalleled customer service, but there's a lot that goes into this. And we have been working very hard to look end-to-end at the customer experience. We've made really big improvements the last 2 years on what we call first pass yield, so making sure that customers' orders don't need to be touched. And the service that we're getting and the feedback we're getting, whether that's on seller interactions, fulfillment, the website, KeepStock, is at an all-time high and continues to get better. So we're really excited about making sure that we have the best customer experience in our space. And that's always going to be critical. That's sort of an evergreen challenge for us and one that we work on every single day in our business. So taken together, the high-touch solutions model goes after customers with some complexity, and we really try to embed our solutions with the customer to make sure we're adding value to them. The second model, we call the endless assortment model. This model was started in Japan in 1998 and went live in '99 or 2000. And it really is based on having an endless assortment that goes after segments of customers that are typically small businesses. So if you think about our Japanese business, they now have 20-plus million products on their website. They don't stock all 20 million. They stock about 400,000 or 500,000 of those products, but they basically use that to get customers into the funnel. So they acquire customers at a very, very fast rate, and then they figure out which customers are attractive, and then they start marketing to those customers to develop relationships based on marketing, digital and product assortment that makes sense for different small customer segments. , We launched that business in the U.S. So that business today is valued at about $6 billion on the Tokyo Stock Exchange. We launched that business in the U.S. in 2011, and that has been a very successful business for us. It's now approaching $800 million plus of revenue this year, and we've done some pretty exciting things with that business over the last year to get it ready to accelerate growth, to get it ready to expand its assortment. It has over 3.5 million items online now, and it's going to grow and grow and grow. We've also done something, which is, the CEO of the MonotaRO business is now running Zoro U.S. as well and leading that team and leading our Zoro business in the U.K. And his name is Masaya Suzuki. He's a great leader, and he's already working with the teams effectively and doing some great things to improve the performance of the Zoro businesses around the world. So we're really excited about the path of the endless assortment business. On the right side, you'll see some principles. I would say that we have always been a very highly ethical company and one that really worked hard to work with our customers to get great results. We are dialing up our intensity around a number of issues, I would say, starting with the customer, embracing curiosity, making sure we act with intent so we're focusing on what really matters, competing with urgency. Those are all things that we're really trying to ramp up and make sure that in everything we do, we are focused on winning and winning the right way. And so this is new, relatively new for our team. We are working every day to reinforce these principles. They're going to be part of everything we do in our talent management system, everything we do every day in our business to make sure that we get the right behaviors with each other, with our customers and with our suppliers. So that's the Grainger edge. I thought I'd spend a minute just talking about the coronavirus. There's -- it's a pretty multifaceted problem, as you might realize. So let me talk a little bit about sort of the customer impact and the immediate customer impact. We are -- we believe -- I think this is accurate, we are the largest safety distributor in the world. So in the first week of the coronavirus, we took a lot of orders, as you might guess. I mean, a lot of them, like decades worth of supply in some cases. And so we are bound by our own ethics to make sure that we provide products to health care institutions and government institutions that could do the most good. So we did not ship all those products. We took the orders. We prioritized and then we started allocating them out. And so things like masks, which really are not in supply anywhere at this point, that's what we did. And so we saw, obviously, a huge bump in mask sales, as an example. We continue to work with our customers to do the best we can to supply those products. And I think we've done a really nice job, and our customers keep coming to us for help as much as we can provide. As you probably know and you probably read, much of the production for things like masks now are more geared towards the government, which they should be at this point. And so that sort of has run its course. So we don't have of extra pandemic products lying around at this point, in case you were wondering. You can't order them on the website. You'll see that they are on hold. So that's kind of number one. The implication of that is we have seen sort of a nice start to the year from a demand perspective. Pandemic sales will increase revenue for -- through today. If I said what had happened through today, our revenue would be higher due to pandemic sales, and our gross margins would be slightly lower because they're sold into government and health care agencies that are in contract. So net-net, it's not a huge impact, but that's just where we're at today. There's the second question, which is around supply of other stuff. We got a little bit of a break here because the pandemic happened right at Chinese New Year. So we had obviously brought in a whole bunch of stuff in November and December to get out in front of Chinese New Year. And so we have very strong availability on all of our products still. So we don't see a short-term supply problem. Most of the manufacturing plants that we work with in China are back and running. It varies. It's all over the board, but probably 60% is a good number to think about now, maybe 70% capacity. And we started to see some scheduling of shipments in, so that's a good sign. This will all depend on how fast that everything gets up and going. By now, we're not concerned. We don't think we have a problem in the next month or 2. If it goes longer, though, then obviously, everybody would have a problem. We feel like we have the ability to manage this as well or better than anybody. We are on it. We've placed a bunch of other orders. We generally don't have many items coming out of Asia that don't have alternative sources to other places. But the reality today is that the supply chain is so global that there's components that go into everything that come from all over the place. So it's going to be very complicated, and it's all going to depend on how fast the world can get up and working. The last thing I'd say about the coronavirus is from our own emergency response. We have a team that's working constantly, trying to figure out we do as a business to make sure that we keep our team members safe. And that is building a bunch of contingency plans. And so we have contingency plans for almost everything. The nice thing about -- if it was obviously a pandemic across the U.S., that would be a problem at the same time. But the nice thing about the way we operate is if one of our distribution centers had a problem, we can close it down for a few days and point volume at other buildings and keep operating. We aren't sort of single-threaded because we have 11 or 12 distribution centers in the U.S. But we're thinking very hard about how we manage through this, and it's not -- it's a little bit of a different problem than most of us are used to seeing, to be honest. So we're working very hard to make sure we're out in front of it. So other than that, we feel good about our ability to gain share. We've talked about the 2 models. Our high-touch solutions model, our goal is 300 to 400 basis points of share every year. And we started hitting that in the fourth quarter, and we feel strongly that we can continue to gain share with that model. And then the endless assortment model, we think, can grow roughly 20% a year for the next several years. And so we think that's a really nice growth path for us at this point. So with that, maybe, Sam, I'll turn it over to you. Thanks.

From an ironic timing standpoint, just this morning, I saw my first Grainger ad for coveralls as it relates to the virus. So it's -- clearly, it's front and center. Beyond the viral impacts on business near term, obviously, Grainger is a great proxy for overall commercial and corporate spending. I think 1 out of every 12 hours or so, that spend in the U.S. for MRO is fed through Grainger. How would you characterize the tone of business here early in the year? I know there's been some easy weather comparisons because of the lack of ice storms last year. How would you -- how's business?

I would say that before the coronavirus hit, we would have said that manufacturing had been pretty slow the last couple of quarters. But generally, the business environment is decent. Heavy manufacturing had been struggling little bit. But generally, in most of our segments, we'd seen decent growth. And as I mentioned, the coronavirus has actually probably helped that in the short term. And so the underlying business environment right now feels okay. It doesn't feel like it's either really good or really bad, I'd say. It feels okay.

Let's talk about margins for a few questions. Your guidance for this year is down at the midpoint, about 80 basis points on a gross margin basis. How should we think of that first half, second half? And why does it play out timing-wise as it is?

Yes. So there's several components to that. One is endless assortment growth has an impact on margins, for sure, because that grows at lower margins. We have the large customer business, we've seen some significant growth and some wins in the back half of the year that will drive growth in the business but at lower-than-average margins. And then I would say, in terms of -- across the year, last year in the first half of 2019 and the first half of the year, we took price early on, probably more than -- trying to estimate the tariffs, probably outpaced ourselves a little bit. And so you're probably going to see worse performance in the first half of the year from a margin -- relative margin basis than you will in this back half of the year. We think this is all short term, frankly. We think it's just how the tariffs have layered in, what's happened with some customer wins, what's going on with the current business environment. We feel like, over time, we should be much closer to more stable margins in the U.S. other than -- other than the endless assortment shift, which will continue to be a thing as it continues to grow. So that's what you should expect.

I mean can you give us a sense of scale? I mean it wouldn't be fair to think that our earnings per share might be down in the first quarter or 2 and then meaningfully higher in the back half. Is that how we should think of the cadence?

Well, we have -- we don't guide the quarters. We talked about, I think, 3% to 11% earnings per share growth, something in that range. We expect to grow earnings at that level at this point still. So we don't have any change in that.

Got you. Your stock tends to correlate real closely with EBITDA margin, at least your relative performance versus the market. Talk to us -- you're going to have mixed pressures for the foreseeable future. Talk to us about what the proper expectation should be for EBITDA margins or incremental margins, however you want us to look at it, in the out-years, beyond 2020.

Yes. So our expectation is that incremental margins post -- in the out-years should be roughly 25%. Our expectation is that we might get a slight compression in gross profit over time. It won't be as much as we've talked about this year. We'll get SG&A leverage. And we've talked about if we can grow the business 2%, 2.5%, we would expect the EBITDA margins to stay flat. Anything beyond that, so if we get a 1% or 2% market growth, we would expect to grow 4% or 5%, and we would expect expansion at that point. So we've built our business around managing SG&A such that we can grow margins if there's really any market growth and if we grow 3% or 4% or 5%. That's our expectation.

You have a U.K. business, Cromwell, that you've announced. That is, I guess, either officially or unofficially on the clock. Talk about, tactically, over the next 12, 18 months or so, what initiatives you have in place to rightsize that cost structure. And then strategically, how does it fit in the portfolio?

Yes. So a couple of things about the U.K. business. We call it Cromwell. Cromwell is actually providing the back end for the Zoro U.K. business. The Zoro U.K. business is actually doing really well. It should be profitable end of this year, early next year, which will be the fastest time to profitability for endless assortment model. And what that means is that the assortments and the service coming out of Cromwell is actually pretty good. And the Zoro U.K. business, they're giving -- customers are giving five-star ratings. And so generally, the core of that business in terms of do you have the right products and can you provide good service is pretty good. We had a number of things happened in the Cromwell business. Brexit was a component. We did some things that frankly backfired and created some challenges on the revenue line in the core Cromwell business. We actually took a bunch of action in the fourth quarter to rightsize the business. We took over GBP 10 million out of the cost structure. We've seen service go from bad to really good over the last 9 months, and the team has done a nice job. And that's the most important thing in our business, is getting service right. And we're starting to see signs that we're winning customer business again. And the pace of wins of customer business and how much that comes back is going to determine the path. So we just have to grind on winning business with customers, and the sales team is working very hard to do that. We're also doing some things with digital to expand sales and grow sales. But in general, the service is good. The cost structure is where it needs to be. Whether or not we can grow the business is going to be a key.

Canada. Canada, discuss.

Yes. Yes. So the good news is Canada is -- you can see -- if you look over the last 2 years, their month -- year-over-year growth rate by month, the last couple have been -- the last 3 or 4 have been the best we've seen. So you are starting to see business come back in Canada. We've got the right cost structure there. We expect this year to be roughly breakeven, but we do see a path that we can get to 8% over the next 3 or 4 years of operating margins. So we feel like what we're seeing now gives us a lot of confidence. We are -- we just changed -- we actually just changed the brand name to Grainger Canada from Acklands. That was just this week. The team is very excited about that. It's sort of a fresh start for the business, and we're seeing a lot of momentum. I don't think I've seen the sales team as excited as they are now in maybe 10 years there. So I think we've got the right things in place to start growing the business. And when we do that, we're going to be very profitable there. I think we've built it to be sustainable. So while I haven't been thrilled with the past, for sure, I don't think any of us have, we feel like we're in a better place now than we've been in a long time. And we feel pretty good about the path. I'll see it when -- I believe when I see it, I'd say, is kind of my view on this one.

You've done, over the last couple of years, a lot of terrific, impactful initiatives regarding the midsized customer element of your business. I think over the last -- and many folks know this. Over the last 3 quarters or so, it looks like growth is right around the mid-single-digit range for midsized. Beyond what happens in macro, what reaccelerates the growth of that customer contingent for you?

Yes. I think most of that comes with our acquisition funnel. And so we've -- with the Grainger brand, we've added some marketing funding and changed some of the way we're doing marketing. We've seen some nice results. We expect that we should be probably more like high single digits within the midsized customer base this year and moving forward. The nice thing is for a decade, it shrunk so fast that it was a huge drag on GP. We feel like, at this point, for those of you who don't know the business well, midsized customers have higher gross profit. And we're seeing nice growth. We've seen nice growth throughout. Our expectation is kind of high single digits for midsized customers through the cycle.

You just talked about customer acquisition. Let's talk about M&A as a counter. You've had some really good experiences. You've had some challenges with M&A. How do you view the pipeline? How do you view your appetite? Do you toggle between where Grainger's overall stock valuation is versus what prospective M&A valuations might look like? Talk to us about the process, if you could.

So I think you're kind to say we've had some good experiences. I think we've had mostly bad experiences, to be honest. I think that we are really focused. I know we are really focused on being an organic growth company. We think that's the best thing to do for our business. So while we wouldn't be afraid of large M&A, our experience would suggest that the companies you buy have their own secret sauce in the way they go to market, in many cases, and you have to retain that. And retaining that within the Grainger family has proven to be challenging at times. And so I think that for us to think we can go do a lot of M&A successfully would be folly at this point. And so we are really focused on organic growth. We -- obviously, any large deal, we'll see. But generally, we're really focused on organic growth at this point.

And then you mentioned during -- in your prepared remarks, MonotaRO and the $6 billion market cap. There's a fair amount of folks that when they look at Grainger, they try and do a sum-of-the-parts analysis with the endless assortment on one side and then the legacy Grainger business on the other. Is that an appropriate way, in your view, to view the stock? And why or why not?

Well, I mean, I think any analysis is appropriate to do. So I wouldn't say it's not appropriate to do analyses like that. I think from our perspective, having Masaya Suzuki run the Zoro business, so I think we're going to learn a whole lot over the next year about what could happen with the Zoro businesses. I think they've been running together in the sense of sharing best practices for a long time, and I think what we're going to see now is just an acceleration of the benefits from being part of that portfolio. And I think we'll take a look at that and see where that goes. But I'm pretty excited about what I'm seeing.

Questions here from the audience? We have 2, 3 minutes left. Here he is.

How do you manage potential conflicts of interest with minority shareholders in MonotaRO as [indiscernible]?

So the question is, how do we manage potential conflicts of interest with the minority shareholders in MonotaRO when setting strategy. The reality is that Grainger doesn't have much to say about MonotaRO's strategy. We share strategy, we don't set it. So that business has their own Board, has their own governance structures and makes their own decisions. And we keep that distinct so that we don't have those conflicts of interest. And we think that's very important. Thanks.

Any other questions here? Right here, yes?

The 300 to 400 basis points of growth...

Share gain, yes.

So who are the share donors?

Who are the share donors? Yes, a lot of it -- I'd say a lot of it is smaller distributors. We do feel like we need to gain share from some of our competitors as well, but certainly, most of that. Historically, if you look kind of at a 40-year history, the larger companies have gotten larger over that 40 years at a fairly consistent, fairly slow rate. And they're still -- but there's still a lot of small distributors out there. And we feel like if we do the right things, we can continue to gain share consistently.

We'll continue this in the breakout. Thank you, D.G.