UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2008

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ______ to _______

Commission file number 1-5684

W.W. Grainger, Inc.
(Exact name of registrant as specified in its charter)

UNITED STATES

Illinois		36-1150280

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2007

OR

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from

to

Commission file number 1-5684

W.W. Grainger, Inc.

(Exact name of registrant as specified in its charter)

Illinois

36-1150280

(State or other jurisdiction of incorporation or organization)

(I.R.S. Employer Identification No.)

100GraingerParkway,LakeForest,Illinois

60045-5201

(Address of principal executive offices)

(Zip Code)

(847)535-1000

(Registrant’s telephone number including area code)

NotApplicable

(Former name, former address and former fiscal year; if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by 

Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for 

such shorter period that the registrant was required to file such reports), and (2) has been subject to 

such filing requirements for the past 90 days. 


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes

Yes

X

X

No

No


Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a 

non-accelerated filer. See definition of ”accelerated filer and large accelerated filer” in Rule 12b-2 of

the Exchange Act. (Check One):

Large accelerated filer

T

X

Accelerated filer

£

Non-accelerated filer

£

Smaller reporting company £


Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the 

Exchange Act).

Yes		NoX

There were 76,067,844 shares of the Company’s Common Stock outstanding as of September 30, 2008.
1

Yes

No

X

There were 79,244,196 shares of the Company’s Common Stock outstanding as of September 30, 2007.

TABLEOFCONTENTS

Page No.

PART I

FINANCIAL INFORMATION

Item 1.

Financial Statements (Unaudited)

Condensed Consolidated Statements of Earnings 

for the Three Months and Nine Months Ended

September 30, 20072008 and September 30, 2006

2007

3

Condensed Consolidated Statements of Comprehensive

Earnings for the Three Months and Nine Months Ended

September 30, 20072008 and September 30, 2006

2007

4

Condensed Consolidated Balance Sheets

as of September 30, 20072008 and December 31, 2006

2007

5 - 6

Condensed Consolidated Statements of Cash Flows

for the Nine Months Ended September 30, 20072008 and 

September 30, 2006

2007

7 - 8

Notes to Condensed Consolidated Financial Statements

9 - 15

17

Item 2.

Management’s Discussion and Analysis of Financial

Condition and Results of Operations

16 - 25

18 – 29

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

26

30

Item 4.

Controls and Procedures

26

30

PART II

OTHER INFORMATION

Item 1.

Legal Proceedings
30
Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

27

31

Item 6.

Exhibits

28

31

Signatures

29

32

EXHIBITS

Exhibit 11

Computations of Earnings Per Share

Exhibits 31 & 32

Certifications



2
PART I – FINANCIAL INFORMATION

Item 1.  Financial Statements (Unaudited)

W.W. Grainger, Inc. and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS

(In thousands of dollars, except for per share amounts)

(Unaudited)

 

 

Three Months Ended

September 30,

 

Nine Months Ended

September 30,

 

 

2007

 

2006

 

2007

 

2006

 

 

 

 

 

 

 

 

 

Net sales

 

$    1,658,592 

 

$    1,519,499 

 

$    4,806,261 

 

$    4,421,496 

 

 

 

 

 

 

 

 

 

Cost of merchandise sold

 

999,003 

 

920,412 

 

2,874,119 

 

2,668,777 

 

 

 

 

 

 

 

 

 

Gross profit

 

659,589 

 

599,087 

 

1,932,142 

 

1,752,719 

 

 

 

 

 

 

 

 

 

Warehousing, marketing and
    administrative expenses

 

485,257 

 

447,774 

 

1,428,650 

 

1,322,445 

 

 

 

 

 

 

 

 

 

Operating earnings

 

174,332 

 

151,313 

 

503,492 

 

430,274 

 

 

 

 

 

 

 

 

 

Other income and (expense):

 

 

 

 

 

 

 

 

Interest income

 

3,144 

 

5,571 

 

11,182 

 

16,311 

Interest expense

 

(721)

 

(485)

 

(1,817)

 

(1,480)

Equity in income of unconsolidated

entities – net

 

470 

 

480 

 

353 

 

2,549 

Gain on sale of unconsolidated entity

 

– 

 

– 

 

– 

 

2,291 

Unclassified – net

 

(41)

 

(75)

 

(53)

 

95 

Total other income and (expense)

 

2,852 

 

5,491 

 

9,665 

 

19,766 

 

 

 

 

 

 

 

 

 

Earnings before income taxes

 

177,184 

 

156,804 

 

513,157 

 

450,040 

 

 

 

 

 

 

 

 

 

Income taxes

 

68,034 

 

52,310 

 

197,429 

 

165,574 

 

 

 

 

 

 

 

 

 

Net earnings

 

$       109,150 

 

$        104,494 

 

$       315,728 

 

$       284,466 

 

 

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

 

 

 

Basic

 

$             1.33 

 

$             1.20 

 

$             3.78 

 

$             3.21 

 

 

 

 

 

 

 

 

 

Diluted

 

$             1.29 

 

$             1.16 

 

$             3.67 

 

$             3.11 

 

 

 

 

 

 

 

 

 

Weighted average number of shares  outstanding:

 

 

 

 

 

 

 

 

Basic

 

82,233,231 

 

87,258,559 

 

83,437,184 

 

88,746,312 

 

 

 

 

 

 

 

 

 

Diluted

 

84,864,258 

 

89,682,032 

 

86,119,670 

 

91,423,719 

 

 

 

 

 

 

 

 

 

Cash dividends paid per share

 

$             0.35 

 

$             0.29 

 

$             0.99 

 

$             0.82 


  
Three Months Ended
September 30,
  
Nine Months Ended
September 30,
 
  2008  2007  2008  2007 
             
Net sales $1,839,475  $1,658,592  $5,257,377  $4,806,261 
                 
Cost of merchandise sold  1,097,127   999,003   3,129,218   2,874,119 
                 
Gross profit
  742,348   659,589   2,128,159   1,932,142 
                 
Warehousing, marketing and
administrative expenses
  510,891   485,257   1,526,044   1,428,650 
                 
Operating earnings
  231,457   174,332   602,115   503,492 
                 
Other income and (expense):                
Interest income
  1,602   3,144   3,642   11,182 
Interest expense
  (4,393)  (721)  (9,591)  (1,817)
Equity in net income (loss) of
unconsolidated entities
  755   470   2,835   353 
Unclassified – net
  (731)  (41)  569   (53)
Total other income and (expense)
  (2,767)  2,852   (2,545)  9,665 
                 
Earnings before income taxes
  228,690   177,184   599,570   513,157 
                 
Income taxes  88,667   68,034   232,130   197,429 
                 
Net earnings
 $140,023  $109,150  $367,440  $315,728 
                 
                 
Earnings per share:                
                 
Basic
 $1.84  $1.33  $4.78  $3.78 
                 
Diluted
 $1.79  $1.29  $4.65  $3.67 
                 
Weighted average number of shares
outstanding:
                
Basic
  75,967,774   82,233,231   76,813,709   83,437,184 
                 
Diluted
  78,279,422   84,864,258   79,085,640   86,119,670 
                 
Cash dividends paid per share $0.40  $0.35  $0.40  $0.99 

The accompanying notes are an integral part of these financial statements.

3

W.W. Grainger, Inc. and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE EARNINGS

(In thousands of dollars)

(Unaudited)

 

 

Three Months Ended

September 30,

 

Nine Months Ended

September 30,

 

 

 

2007

 

2006

 

2007

 

2006

 

 

 

 

 

 

 

 

 

Net earnings

 

$       109,150

 

$        104,494

 

$       315,728

 

$       284,466

 

 

 

 

 

 

 

 

 

Other comprehensive earnings:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign currency translation

adjustments, net of tax

(expense) benefit of $(4,181),

$70, $(9,229) and $(2,160),

respectively

 

24,317

 

184

 

52,552

 

10,938

 

 

 

 

 

 

 

 

 

Comprehensive earnings

 

$       133,467

 

$       104,678

 

$       368,280

 

$       295,404


  
Three Months Ended
September 30,
  
Nine Months Ended
September 30,
 
  2008  2007  2008  2007 
             
Net earnings $140,023  $109,150  $367,440  $315,728 
                 
Other comprehensive earnings (losses):                
                 
Foreign currency translation adjustments, net of tax benefit (expense) of $2,534, $(4,181), $4,133, and $(9,229), respectively  (18,636)  24,317   (26,075)  52,552 
                 
Comprehensive earnings $121,387  $133,467  $341,365  $368,280 


The accompanying notes are an integral part of these financial statements.


4

W.W. Grainger, Inc. and Subsidiaries

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands of dollars, except for per share amounts)

(Unaudited)

ASSETS

 

Sept. 30, 2007

 

Dec. 31, 2006

CURRENT ASSETS

 

 

 

 

Cash and cash equivalents

 

$               89,366 

 

$              348,471 

Marketable securities at cost,

 

 

 

 

which approximates market value

 

19,833 

 

12,827 

Accounts receivable (less allowances for doubtful

 

 

 

 

accounts of $21,204 and $18,801, respectively)

 

674,787 

 

566,607 

Inventories

 

889,166 

 

827,254 

Prepaid expenses and other assets

 

51,861 

 

58,804 

Deferred income taxes

 

53,705 

 

48,123 

Total current assets

 

1,778,718 

 

1,862,086 

 

 

 

 

 

PROPERTY, BUILDINGS AND EQUIPMENT

 

1,961,920 

 

1,827,104 

Less accumulated depreciation and amortization

 

1,101,285 

 

1,034,169 

Property, buildings and equipment – net

 

860,635 

 

792,935 

 

 

 

 

 

DEFERRED INCOME TAXES

 

60,644 

 

48,793 

 

 

 

 

 

INVESTMENT IN UNCONSOLIDATED ENTITY

 

9,164 

 

8,492 

 

 

 

 

 

GOODWILL

 

232,498 

 

210,671 

 

 

 

 

 

OTHER ASSETS AND INTANGIBLES – NET

 

118,286 

 

123,111 

 

 

 

 

 

TOTAL ASSETS

 

$           3,059,945 

 

$           3,046,088 



ASSETS Sept. 30, 2008  Dec. 31, 2007 
CURRENT ASSETS      
Cash and cash equivalents
 $364,417  $113,437 
Marketable securities at cost,
        
which approximates market value  –   20,074 
Accounts receivable (less allowances for doubtful
        
accounts of $29,345 and $25,830, respectively)
  721,387   602,650 
Inventories
  961,094   946,327 
Prepaid expenses and other assets
  63,028   61,666 
Deferred income taxes
  61,395   56,663 
Total current assets
  2,171,321   1,800,817 
         
PROPERTY, BUILDINGS AND EQUIPMENT  2,116,796   2,004,276 
Less accumulated depreciation and amortization
  1,188,300   1,125,931 
Property, buildings and equipment – net
  928,496   878,345 
         
DEFERRED INCOME TAXES  72,760   54,658 
         
INVESTMENT IN UNCONSOLIDATED ENTITIES  23,089   14,759 
         
GOODWILL  231,945   233,028 
         
OTHER ASSETS AND INTANGIBLES – NET  108,830   112,421 
         
TOTAL ASSETS $3,536,441  $3,094,028 



5

W.W. Grainger, Inc. and Subsidiaries

CONDENSED CONSOLIDATED BALANCE SHEETS (Continued)

(In thousands of dollars, except for per share amounts)

(Unaudited)

LIABILITIES AND SHAREHOLDERS' EQUITY

 

Sept. 30, 2007

 

Dec. 31, 2006

 

 

 

 

 

CURRENT LIABILITIES

 

 

 

 

Short-term debt

 

$              144,214 

 

$                        – 

Current maturities of long-term debt

 

4,590 

 

4,590 

Trade accounts payable

 

377,315 

 

334,820 

Accrued compensation and benefits

 

151,238 

 

140,141 

Accrued contributions to employees’

 

 

 

 

profit sharing plans

 

94,044 

 

113,014 

Accrued expenses

 

94,613 

 

106,681 

Income taxes payable

 

11,493 

 

7,077 

Total current liabilities

 

877,507 

 

706,323 

 

 

 

 

 

LONG-TERM DEBT (less current maturities)

 

4,895 

 

4,895 

 

 

 

 

 

DEFERRED INCOME TAXES

 

24,590 

 

6,235 

 

 

 

 

 

ACCRUED EMPLOYMENT-RELATED BENEFITS

 

168,717 

 

151,020 

 

 

 

 

 

SHAREHOLDERS' EQUITY

 

 

 

 

Cumulative Preferred Stock – $5 par value –

12,000,000 shares authorized; none issued

nor outstanding

 

– 

 

– 

Common Stock – $0.50 par value –

300,000,000 shares authorized;

issued 109,657,938 shares

 

54,829 

 

54,829 

Additional contributed capital

 

527,065 

 

513,667 

Retained earnings

 

3,239,438 

 

3,007,606 

Unearned restricted stock compensation

 

(58,759)

 

(35,213)

Accumulated other comprehensive earnings

 

55,983 

 

3,431 

Treasury stock, at cost –

30,413,742 and 25,590,311 shares, respectively

 

(1,834,320)

 

(1,366,705)

 

 

 

 

 

Total shareholders' equity

 

1,984,236 

 

2,177,615 

 

 

 

 

 

TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY

 

$          3,059,945 

 

$          3,046,088 



LIABILITIES AND SHAREHOLDERS' EQUITY Sept. 30, 2008  Dec. 31, 2007 
       
CURRENT LIABILITIES      
Short-term debt
 $16,431  $102,060 
Current maturities of long-term debt
  12,923   4,590 
Trade accounts payable
  314,445   297,929 
Accrued compensation and benefits
  164,524   182,275 
Accrued contributions to employees’
        
profit sharing plans
  110,566   126,483 
Accrued expenses
  99,386   102,607 
Income taxes payable
  16,589   10,459 
Total current liabilities
  734,864   826,403 
         
LONG-TERM DEBT (less current maturities)  496,562   4,895 
         
DEFERRED INCOME TAXES AND TAX UNCERTAINTIES  23,531   20,727 
         
ACCRUED EMPLOYMENT-RELATED BENEFITS  153,393   143,895 
         
SHAREHOLDERS' EQUITY        
Cumulative Preferred Stock – $5 par value –
12,000,000 shares authorized; none issued
nor outstanding
  –   – 
Common Stock – $0.50 par value –
300,000,000 shares authorized;
issued 109,659,219 shares
  54,830   54,830 
Additional contributed capital
  555,410   475,350 
Retained earnings
  3,593,931   3,316,875 
Accumulated other comprehensive earnings
  46,096   72,171 
Treasury stock, at cost –
33,591,375 and 30,199,804 shares, respectively
  (2,122,176)  (1,821,118)
         
Total shareholders' equity
  2,128,091   2,098,108 
         
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY
 $3,536,441  $3,094,028 


The accompanying notes are an integral part of these financial statements.


6

W.W. Grainger, Inc. and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands of dollars)

(Unaudited)

 

 

Nine Months Ended Sept. 30,

 

 

2007

 

2006

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

Net earnings

 

$            315,728 

 

$            284,466 

Provision for losses on accounts receivable

 

7,824 

 

3,047 

Deferred income taxes

 

(7,437)

 

1,410 

Depreciation and amortization:

 

 

 

 

Property, buildings and equipment

 

75,113 

 

71,568 

Capitalized software and other intangibles

 

18,486 

 

12,804 

Stock-based compensation

 

28,988 

 

27,380 

Tax benefit of stock incentive plans

 

2,820 

 

4,624 

Net gains on sales of property, buildings and equipment

 

(5,433)

 

(7,673)

Gain on sale of unconsolidated entity

 

– 

 

(2,291)

(Income) from unconsolidated entities

 

(353)

 

(2,549)

Change in operating assets and liabilities – net of business acquisitions:

 

 

 

 

(Increase) in accounts receivable

 

(105,145)

 

(92,428)

(Increase) decrease in inventories

 

(39,532)

 

24,357 

Decrease in prepaid expenses and other assets

 

7,410 

 

7,608 

Increase in trade accounts payable

 

39,188 

 

22,460 

(Decrease) in other current liabilities

 

(16,324)

 

(44,580)

Increase (decrease) in current income taxes payable

 

3,598 

 

(7,333)

Increase in accrued employment-related benefits

 

17,697 

 

12,314 

Other – net

 

(4,876)

 

(2,202)

 

 

 

 

 

Net cash provided by operating activities

 

337,752 

 

312,982 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

Additions to property, buildings and

equipment – net of dispositions

 

(128,744)

 

(85,561)

Additions to capitalized software

 

(5,726)

 

(5,167)

Cash paid for business acquisitions

 

(4,684)

 

(13,859)

Proceeds from sale of marketable securities

 

12,765 

 

– 

Purchase of marketable securities

 

(17,079)

 

(13,062)

Proceeds from sale of unconsolidated entity

 

– 

 

27,413 

Other – net

 

(405)

 

(1,714)

 

 

 

 

 

Net cash used in investing activities

 

(143,873)

 

(91,950)


  Nine Months Ended Sept. 30, 
  2008  2007 
CASH FLOWS FROM OPERATING ACTIVITIES:      
Net earnings
 $367,440  $315,728 
Provision for losses on accounts receivable
  11,867   7,824 
Deferred income taxes and tax uncertainties
  (18,432)  (7,437)
Depreciation and amortization:
        
Property, buildings and equipment
  81,507   75,113 
Capitalized software and other intangibles
  19,258   18,486 
Stock-based compensation
  36,655   28,988 
Tax benefit of stock incentive plans
  1,612   2,820 
Net gains on sales of property, buildings and equipment
  (4,760)  (5,433)
(Income) losses from unconsolidated entities – net
  (2,835)  (353)
Change in operating assets and liabilities – net of business acquisitions
        
(Increase) in accounts receivable
  (125,936)  (105,145)
(Increase) in inventories
  (17,360)  (39,532)
Decrease in prepaid expenses
  645   7,410 
Increase in trade accounts payable
  13,069   39,188 
(Decrease) in other current liabilities
  (42,191)  (16,324)
Increase in current income taxes payable
  6,466   3,598 
Increase in accrued employment-related benefits cost
  9,498   17,697 
Other – net
  (1,186)  (4,876)
         
Net cash provided by operating activities
  335,317   337,752 
         
CASH FLOWS FROM INVESTING ACTIVITIES:        
Additions to property, buildings and
equipment – net of dispositions
  (125,020)  (128,744)
Additions to capitalized software
  (6,570)  (5,726)
Cash paid for business acquisitions
  (33,995)  (4,684)
Proceeds from sale of marketable securities
  19,627   12,765 
Purchases of marketable securities
  –   (17,079)
Investments in unconsolidated entities
  (6,486)  – 
Other – net
  (416)  (405)
         
Net cash used in investing activities
 $(152,860) $(143,873)



7

W.W. Grainger, Inc. and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(In thousands of dollars)

(Unaudited)

 

 

Nine Months Ended Sept. 30,

 

 

2007

 

2006

CASH FLOWS FINANCING ACTIVITIES:

 

 

 

 

Net increase in short-term debt

 

$            144,428 

 

$                      – 

Stock options exercised

 

103,465 

 

47,251 

Excess tax benefits from stock-based compensation

 

27,050 

 

5,954 

Purchase of treasury stock

 

(647,293)

 

(319,163)

Cash dividends paid

 

(84,766)

 

(73,136)

 

 

 

 

 

Net cash used in financing activities

 

(457,116)

 

(339,094)

 

 

 

 

 

Exchange rate effect on cash and cash equivalents

 

4,132 

 

522 

 

 

 

 

 

NET (DECREASE) IN CASH AND CASH EQUIVALENTS

 

(259,105)

 

(117,540)

 

 

 

 

 

Cash and cash equivalents at beginning of year

 

348,471 

 

544,894 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$              89,366 

 

$           427,354 


  Nine Months Ended Sept. 30, 
  2008  2007 
CASH FLOWS FROM FINANCING ACTIVITIES:      
Net (decrease) in commercial paper
 $(95,356) $– 
Net increase in short term debt
  –   144,428 
Borrowings under line of credit
  19,136   – 
Payments against line of credit
  (8,799)  – 
Proceeds from issuance of long-term debt
  500,000   – 
Stock options exercised
  41,103   103,465 
Excess tax benefits from stock-based compensation
  11,733   27,050 
Purchase of treasury stock
  (307,552)  (647,293)
Cash dividends paid
  (90,384)  (84,766)
         
Net cash provided by (used in) financing activities
  69,881   (457,116)
         
Exchange rate effect on cash and cash equivalents  (1,358)  4,132 
         
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS  250,980   (259,105)
         
Cash and cash equivalents at beginning of year  113,437   348,471 
         
Cash and cash equivalents at end of period $364,417  $89,366 


The accompanying notes are an integral part of these financial statements.


8

W.W. Grainger, Inc. and Subsidiaries

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.

BACKGROUND AND BASIS OF STATEMENT PRESENTATION


1.  BACKGROUND AND BASIS OF PRESENTATION
W.W. Grainger, Inc. distributes facilities maintenance products and provides services and related information used by businesses and institutions in North America.  In this report, the words “Company” or “Grainger” mean W.W. Grainger, Inc. and its subsidiaries.


The Condensed Consolidated Financial Statements of the Company and the related notes are unaudited and should be read in conjunction with the consolidated financial statements and related notes for the year ended December 31, 2006,2007, included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (SEC).


The Condensed Consolidated Balance Sheet as of December 31, 20062007, has been derived from the audited consolidated financial statements at that date, but does not include all of the disclosures required by accounting principles generally accepted in the United States of America for complete financial statements.


The unaudited financial information reflects all adjustments (consisting(primarily consisting of normal recurring adjustments) which, in the opinion of management, are necessary for a fair presentation of the statements contained herein. Certain prior period amounts have been reclassified to conform to the current year’s presentation.

2.


2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

NEW ACCOUNTING STANDARDS

In July 2006,March 2008, the Financial Accounting Standards Board (FASB) issued Financial Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes.” The Company adopted the provisions of FIN 48 on January 1, 2007. As a result of the implementation of FIN 48, the Company recognized a decrease of approximately $0.9 million in the liability for tax uncertainties, which resulted in an increase to the January 1, 2007 balance of Retained earnings.

The Company’s liability for tax uncertainties was $15.8 million, including $0.6 million for interest and penalties, at January 1, 2007. The Company classifies this liability in Deferred income taxes. Included in this amount is $4.3 million of tax positions for which the ultimate deductibility is highly certain but for which there is uncertainty about the timing of such deductibility. Because of the impact of deferred tax accounting, other than interest and penalties, the disallowance of the shorter deductibility period would not affect the annual effective tax rate but would accelerate the payment of cash to the taxing authority to an earlier period.

During the nine months ended September 30, 2007, the Company recognized an additional $2.4 million of income tax expense for the current year positions partially offset by a $2.1 million reduction related to prior periods. The current year expense includes $0.4 million for interest and penalties. The Company recognizes interest expense and penalties in the provision for income taxes.


W.W. Grainger, Inc. and Subsidiaries

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

The Company regularly undergoes examination of its federal income tax returns by the Internal Revenue Service (IRS). The Company and the IRS have settled tax years through 2004. Additionally, the Company is routinely involved in state and local income tax audits, and on occasion, foreign jurisdiction tax audits. The Company’s tax years 2002 – 2006 remain subject to state, local and foreign audits. The Company expects to resolve these audits within the amounts paid and/or reserved for these liabilities.

NEW ACCOUNTING STANDARDS

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159161, “Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133” (SFAS No. 159), “The Fair Value Option for Financial Assets and Financial Liabilities.”161).  SFAS No. 159 provides companies with an option to report selected financial assets161 amends and liabilities at fair value. It also establishes presentation andexpands the disclosure requirements related to facilitate comparisons between companies using different measurement attributes for similar types of assetsderivative instruments and liabilities.hedging activities which will enable investors to better understand the effects on an entity’s financial statements, financial position and cash flows.  The statement is effective for the first fiscal yearyears beginning after November 15, 2007. The Company is currently evaluating the impact that adoption of SFAS No. 159 may have on its results of operations or financial position.

In June 2007, the Emerging Issues Task Force (EITF) reached a consensus with respect to EITF Issue No. 06-11 (Issue No. 06-11), “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards.” Under Issue 06-11, a realized income tax benefit from dividends or dividend equivalents that are charged to retained earnings and paid to employees for equity classified nonvested equity shares, nonvested equity share units, and outstanding equity share options should be recognized as an increase to additional paid-in capital (APIC). The amount recognized in APIC should be included in the pool of excess tax benefits available to absorb tax deficiencies on share-based payment awards. A tax benefit recognized from a dividend on an award that is subsequently forfeited or is no longer expected to vest would be reclassified from APIC to the income statement, if sufficient excess tax benefits are available in the pool of excess tax benefits in APIC. Issue 06-11 is to be applied prospectively to the income tax benefits of dividends on equity-classified employee share-based payment awards that are declared in fiscal years beginning after December 15, 2007 with early application permitted.2008.  The Company does not expect the adoption of Issue 06-11SFAS No. 161 to have a material effect on its results of operations or financial position.

3.

ACQUISITION


In April 2008, the FASB issued Staff Position FSP 142-3, “Determination of the Useful Life of Intangible Assets” (FSP 142-3).  FSP 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142, “Goodwill and Other Intangible Assets.”  FSP 142-3 is effective for fiscal years beginning after December 15, 2008.  The Company does not expect the adoption of FSP 142-3 to have a material effect on its results of operations or financial position.


9

W.W. Grainger, Inc. and Subsidiaries
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


In May 2008, the FASB issued Statement of Financial Accounting Standards No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (SFAS No. 162).  SFAS No. 162 is intended to improve financial reporting by identifying a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with US GAAP for nongovernmental entities.  The FASB believes that the GAAP hierarchy should be directed to entities because it is the entity (not its auditor) that is responsible for selecting accounting principles for financial statements that are presented in conformity with GAAP.  The Company does not expect the adoption of SFAS No. 162 to have a material effect on its results of operations or financial position.

In June 2008, the FASB issued Staff Position EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities” (FSP 03-6-1).  FSP 03-6-1 states that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method.  Upon adoption, a company is required to retrospectively adjust its earnings per share data presentation to conform with the FSP 03-6-1 provisions.  FSP 03-6-1 is effective for fiscal years beginning after December 15, 2008.   The Company is currently evaluating the impact that adoption may have on its results of operation and financial position.


3.  ACQUISITIONS

Effective July 21, 2008 the Company acquired a 49.9% interest in Asia Pacific Brands India Ltd. (Asia Pacific Brands) from its sole shareholder.  Asia Pacific Brands, one of India's largest industrial and electrical wholesale distributors, is headquartered in Mumbai, India.  With 27 locations and more than 6,200 dealer relationships across India, Asia Pacific Brands had revenue of US$47 million for its fiscal year ended March 31, 2008.  The Company paid $5.4 million for its ownership interest.  In addition, the Company and its joint venture partner each made a $1.1 million capital infusion which is intended to help grow the business.  The Company is using the equity method to account for this investment.

On May 31, 2007,July 10, 2008, Lab Safety Supply, Inc. (Lab Safety), a wholly owneddirect marketing subsidiary of the Company, acquired substantially all of the assets and assumed certain liabilities of McFeely’s Square Drive Screws (McFeely’s). McFeely’sHighsmith Inc. (Highsmith), located in Fort Atkinson, Wisconsin.  Highsmith is a business-to-business direct marketermarketing leader in the library equipment, furniture and supplies market and had sales of specialty fasteners, hardware and tools for the professional woodworking industry. McFeely’s had more than $9$64 million in sales in 2006.2007.  The purchase price and costs of the acquisition were $4.7$27.0 million in cash and $0.3$6.1 million in assumed liabilities.  The estimated goodwill recognized in the transaction amounted to $1.2$4.1 million and is expected to be fully deductible for tax purposes.  The integration of Highsmith into existing operations should be completed by the end of the year.  As part of the integration Lab Safety is discontinuing the contract sales group of Highsmith which represented approximately $19 million of sales in 2007.  The results of McFeely’sHighsmith are included in the Company’s consolidated results from the date of acquisition.  Due to the immaterial nature of this transaction, disclosure of pro forma results were not considered necessary.


10

W.W. Grainger, Inc. and Subsidiaries

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

4.

MARKETABLE SECURITIES



On June 6, 2008, Acklands - Grainger Inc., a wholly owned subsidiary of the Company, acquired substantially all of the assets and assumed certain liabilities of Excel F.I.G. Inc. (Excel).  Excel, located in Granby, Quebec, Canada, is a business-to-business broad line distributor of maintenance, repair and operating supplies.  In 2007, Excel had sales of approximately US$12 million.  The Company’s investmentspurchase price and costs of the acquisition were US$6.9 million in marketable securities consist of commercial papercash and US$0.7 million in assumed liabilities.  The estimated goodwill recognized in the transaction amounted to US$4.4 million and is expected to be held to maturity.partially deductible for tax purposes.  The investmentsresults of Excel are issuedincluded in the Company’s consolidated results from high credit quality issuers. The marketable securities are recorded at cost which is considered to approximate fair value. These investments have an original maturitythe date of more than 90 days.

acquisition.  Due to the immaterial nature of this transaction, disclosure of pro forma results were not considered necessary.

5.

DIVIDEND



4.  DIVIDEND

On October 31, 2007,29, 2008, the Company’s Board of Directors declared a quarterly dividend of 3540 cents per share, payable December 1, 20072008, to shareholders of record on November 12, 2007.

10, 2008.

6.

WARRANTY RESERVES



5.  WARRANTY RESERVES

The Company generally warrants the products it sells against defects for one year.  For a significant portion of warranty claims, the manufacturer of the product is responsible for the expenses associated with this warranty program.  For warranty expenses not covered by the manufacturer, the Company provides a reserve for future costs based on historical experience.

The warranty reserve activity was as follows:

 

Nine Months Ended Sept. 30,

 

 

2007

 

2006

 

(In thousands of dollars)

 

 

 

 

 

Beginning balance

 

$            4,651 

 

$            3,763 

Returns

 

(9,266)

 

(8,550)

Provision

 

8,630 

 

8,762 

Ending balance

 

$            4,015 

 

$            3,975 

7.

SHORT-TERM DEBT

The increase in short-term debt was primarily the result of short-term borrowings used to fund an accelerated share repurchase program in August 2007. At September 30, 2007, there was commercial paper outstanding of $133.9 million. Refer to Note 8 for further discussion of the Company’s share repurchase program.

In June 2007, the Company entered into a revolving short-term line of credit related to Grainger China LLC. The maximum loan amount of the line of credit is US$21.0 million or the equivalent Chinese Renminbi. Grainger China LLC utilizes the line of credit to meet its business expansion and operating needs. As of September 30, 2007, US$10.3 million of the line of credit had been utilized.


  Nine Months Ended September 30,  
  2008  2007
  (In thousands of dollars)  
      
Beginning balance $3,442  $4,651 
Returns  (10,218)  (9,266)
Provision  10,495   8,630 
Ending balance $3,719  $4,015 

11

W.W. Grainger, Inc. and Subsidiaries

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

8.

REPURCHASE OF COMMON STOCK



6.  LONG-TERM DEBT

On August 17, 2007, the Company’s Board of Directors authorized the restoration of the share repurchase program to 10 million shares. The program, which has no stated expiration date, replaced the existing 10 million share program that was authorized in October 2006. A total of 4,010,200 shares had been acquired under the prior program.

On August 20, 2007,May 6, 2008, the Company entered into an accelerateda four year term loan of $500 million.  Proceeds were used to pay down short-term debt, fund additional share repurchase (ASR) agreement with Goldman, Sachs & Co. (Goldman) to purchase $500 millionrepurchases and for general corporate purposes.


At the election of itsthe Company, the term loan shall bear interest at the Base Rate plus the Applicable Margin or the LIBOR Rate plus the Applicable Margin as defined within the contract.  At September 30, 2008 the Company has elected a one month LIBOR Interest Period.   The weighted average interest rate during the period outstanding common stock. was 3.26%.

The Company paid Goldman $500 million on August 23, 2007may prepay the loan in exchange for an initial delivery of 5,316,007 shares.whole or in part at its option.  The exact number of shares bought back will be determined at the conclusionscheduled loan repayment of the agreement, which could take upoutstanding principal amount is as follows:

Year Payment Amount 
2009 $16.7 million 
2010 $45.8 million 
2011 $50.0 million 
2012 $387.5 million 

The Company’s debt instruments include only standard affirmative and negative covenants that are normal in debt instruments of similar amounts and structure.  The Company’s debt instruments do not contain financial or performance covenants restrictive to eightthe business of the Company.  The Company is in compliance with all debt covenants for the nine months to complete. At the end of this period, the Company may receive from or be required to pay to Goldman a price adjustment based upon the volume weighted average priceended September 30, 2008.


12

W.W. Grainger, Inc. and Subsidiaries
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)

7.  EMPLOYEE BENEFITS

Retirement Plans
A majority of the Company’s shares duringemployees are covered by a noncontributory profit sharing plan.  This plan provides for annual employer contributions based upon a formula related primarily to earnings before federal income taxes, limited to a percentage of total eligible compensation paid to all eligible employees.  Retroactive to January 1, 2008, the purchase period. The price adjustment, if any, may be settled, atplan was amended on July 30, 2008 to establish a minimum contribution of 8% and a maximum contribution of 18% of total eligible compensation paid to all eligible employees.  Previously, there was no minimum percentage and the Company's option, in shares of its common stock or cash. Grainger does not expect to make any additional share repurchases until the ASR is complete. The Company estimates the ASR will have a benefit of $0.01 per share for the remainder of 2007.

maximum percentage was 25%.

9.

EMPLOYEE BENEFITS


Postretirement Benefits
The Company has a postretirement healthcare benefits plan that provides coverage for a majority of its retired employees and their dependents should they elect to maintain such coverage.  Covered employees become eligible for participation when they qualify for retirement.  Participation in the plan is voluntary and requires participants to make contributions, as determined by the Company, toward the cost of the plan.


The net periodic benefit costs charged to operating expenses, which are valued at the measurement date of January 1 and recognized evenly throughout the year, consisted of the following components:

 

Three Months Ended

September 30,

 

Nine Months Ended

September 30,

 

2007

 

2006

 

2007

 

2006

 

(In thousands of dollars)

 

 

Service cost

$          2,714 

 

$          2,434 

 

$        8,142 

 

$        7,302 

Interest cost

2,243 

 

1,900 

 

6,730 

 

5,700 

Expected return on assets

(1,012)

 

(697)

 

(3,037)

 

(2,092)

Amortization of transition asset

(36)

 

(36)

 

(107)

 

(108)

Amortization of unrecognized losses

523 

 

726 

 

1,570 

 

2,178 

Amortization of prior service cost 

(109)

 

(214)

 

(328)

 

(643)

Net periodic benefit costs

$          4,323 

 

$          4,113 

 

$      12,970 

 

$      12,337 


W.W. Grainger, Inc. and Subsidiaries

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

  Three Months Ended September 30, Nine Months Ended September 30,
  2008  2007  2008  2007 
  (In thousands of dollars) 
    
Service cost $2,425  $2,714  $7,275  $8,142 
Interest cost  2,373   2,243   7,118   6,730 
Expected return on assets  (1,117)  (1,012)  (3,349)  (3,037)
Amortization of transition asset  (36)  (36)  (108)  (107)
Amortization of unrecognized losses  328   523   984   1,570 
Amortization of prior service credits  (304)  (109)  (912)  (328)
Net periodic benefit costs
 $3,669  $4,323  $11,008  $12,970 

The Company has established a Group Benefit Trust to fund the plan and process benefit payments.  The funding of the trust is an estimated amount, which is intended to allow the maximum deductible contribution under the Internal Revenue Code of 1986 (IRC), as amended.  There are no minimum funding requirements and the Company intends to follow its practice of funding the maximum deductible contribution under the IRC.  During the three and nine months ended September 30, 2007,2008, the Company contributed $0.5$1.0 million and $1.6$3.1 million, respectively, to the trust.


10.

SEGMENT INFORMATION

13

W.W. Grainger, Inc. and Subsidiaries
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)

8.  SEGMENT INFORMATION

The three reportable segments are Grainger Branch-based, Acklands –- Grainger Branch-based (Acklands –- Grainger) and Lab Safety Supply, Inc. (Lab Safety).  Grainger Branch-based is an aggregation ofincluding the following: Grainger Industrial Supply, Grainger, S.A. de C.V. (Mexico), Grainger Caribe Inc. (Puerto Rico) and, Grainger China LLC (China) and Grainger Panama S.A. (Panama).  Acklands –- Grainger is the Company’s Canadian branch-based distribution business.  Lab Safety is a direct marketer of safety and other industrial products.

 

 

Three Months Ended September 30, 2007

 

Grainger Branch-based

 

Acklands – Grainger Branch-based

 

Lab Safety

Total

 

(In thousands of dollars)

Total net sales

$       1,385,278 

 

$                    163,519 

 

$             111,199 

 

$       1,659,996 

Intersegment net sales

(487)

 

– 

 

(917)

 

(1,404)

Net sales to external

customers

$       1,384,791 

 

$                    163,519 

 

$             110,282 

 

$       1,658,592 

 

 

 

 

 

 

 

 

Segment operating

earnings

$          173,115 

 

$                      10,243 

 

$               14,213 

 

$          197,571 

 

 

 

 

 

 

 

 

  Following is a summary of segment results (in thousands of dollars):

 

 

Three Months Ended September 30, 2006

 

Grainger Branch-based

 

Acklands – Grainger Branch-based

 

Lab Safety

Total

 

(In thousands of dollars)

Total net sales

$       1,274,219 

 

$                    141,586 

 

$             104,671 

 

$       1,520,476 

Intersegment net sales

(329)

 

– 

 

(648)

 

(977)

Net sales to external

customers

$       1,273,890 

 

$                    141,586 

 

$             104,023 

 

$       1,519,499 

 

 

 

 

 

 

 

 

Segment operating

earnings

$          149,260 

 

$                        5,122 

 

$               13,625 

 

$          168,007 

 

 

 

 

 

 

 

 


  
Three Months Ended September 30, 2008
 
  
Grainger
Branch-based
  Acklands - Grainger Branch-based  Lab Safety  Total 
    
Total net sales $1,523,543  $190,754  $127,321  $1,841,618 
Intersegment net sales  (1,021)  (127)  (995)  (2,143)
Net sales to external customers $1,522,522  $190,627  $126,326  $1,839,475 
                 
Segment operating earnings $226,602  $14,168  $12,212  $252,982 
                 

  
Three Months Ended September 30, 2007
 
  
Grainger
Branch-based
  Acklands - Grainger Branch-based  Lab Safety  Total 
    
Total net sales $1,385,278  $163,519  $111,199  $1,659,996 
Intersegment net sales  (487)  –   (917)  (1,404)
Net sales to external customers $1,384,791  $163,519  $110,282  $1,658,592 
                 
Segment operating earnings $173,115  $10,243  $14,213  $197,571 
                 


14

W.W. Grainger, Inc. and Subsidiaries

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

 

Nine Months Ended September 30, 2007

 

Grainger Branch-based

 

Acklands – Grainger Branch-based

 

Lab Safety

Total

 

(In thousands of dollars)

Total net sales

$       4,014,522 

 

$                    464,851 

 

$             330,653 

 

$       4,810,026 

Intersegment net sales

(1,211)

 

– 

 

(2,554)

 

(3,765)

Net sales to external

customers

$       4,013,311 

 

$                    464,851 

 

$             328,099 

 

$       4,806,261 

 

 

 

 

 

 

 

 

Segment operating

earnings

$          505,027 

 

$                      29,710 

 

$               43,191 

 

$          577,928 

 

 

 

 

 

 

 

 

 

Nine Months Ended September 30, 2006

 

Grainger Branch-based

 

Acklands – Grainger Branch-based

 

Lab Safety

Total

 

(In thousands of dollars)

Total net sales

$       3,684,934 

 

$                    427,528 

 

$             311,823 

 

$       4,424,285 

Intersegment net sales

(989)

 

– 

 

(1,800)

 

(2,789)

Net sales to external

customers

$       3,683,945 

 

$                    427,528 

 

$             310,023 

 

$       4,421,496 

 

 

 

 

 

 

 

 

Segment operating

earnings

$          433,923 

 

$                      12,070 

 

$               42,324 

 

$          488,317 

 

Grainger Branch-based

 

Acklands – Grainger Branch-based

 

Lab Safety

Total

Segment assets:

(In thousands of dollars)

September 30, 2007

$       2,098,756 

 

$                    491,433 

 

$             212,533 

 

$       2,802,722 

 

 

 

 

 

 

 

 

December 31, 2006

$       1,938,270 

 

$                    394,707 

 

$             215,515 

 

$       2,548,492 

 

 

 

 

 

 

 

 



  
Nine Months Ended September 30, 2008
 
  
Grainger
Branch-based
  Acklands - Grainger Branch-based  Lab Safety  Total 
    
Total net sales $4,346,857  $565,924  $350,032  $5,262,813 
Intersegment net sales  (2,330)  (127)  (2,979)  (5,436)
Net sales to external customers $4,344,527  $565,797  $347,053  $5,257,377 
                 
Segment operating earnings $596,411  $41,856  $40,596  $678,863 
                 

  
Nine Months Ended September 30, 2007
 
  
Grainger
Branch-based
  Acklands - Grainger Branch-based  Lab Safety  Total 
    
Total net sales $4,014,522  $464,851  $330,653  $4,810,026 
Intersegment net sales  (1,211)  –   (2,554)  (3,765)
Net sales to external customers $4,013,311  $464,851  $328,099  $4,806,261 
                 
Segment operating earnings $505,027  $29,710  $43,191  $577,928 
                 


  
Grainger
Branch-based
  Acklands - Grainger Branch-based  Lab Safety  Total 
    
Segment assets:
   
September 30, 2008 $2,225,971  $506,897  $240,572  $2,973,440 
                 
December 31, 2007 $2,107,408  $502,414  $212,627  $2,822,449 
                 


15

W.W. Grainger, Inc. and Subsidiaries

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)



Following are reconciliations of segment information with the consolidated totals per the financial statements:

statements (in thousands of dollars):

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

2007

 

2006

 

2007

 

2006

Operating earnings:

 

(In thousands of dollars)

Total operating earnings for reportable

segments

 

$      197,571 

 

$      168,007 

 

$      577,928 

 

$      488,317 

Unallocated expenses and eliminations

 

(23,239)

 

(16,694)

 

(74,436)

 

(58,043)

Total consolidated operating earnings

 

$      174,332 

 

$      151,313 

 

$      503,492 

 

$      430,274 


 

 

September 30,

2007

 

December 31,

2006

Assets:

(In thousands of dollars)

Total assets for reportable segments

$           2,802,722

 

$           2,548,492

Unallocated assets

257,223

 

497,596

Total consolidated assets

$           3,059,945

 

$           3,046,088


  
Three Months Ended
September 30,
  
Nine Months Ended
September 30,
 
  2008  2007  2008  2007 
Operating earnings:
   
Total operating earnings for reportable
segments
 $252,982  $197,571  $678,863  $577,928 
Unallocated expenses and eliminations  (21,525)  (23,239)  (76,748)  (74,436)
Total consolidated operating earnings
 $231,457  $174,332  $602,115  $503,492 

  
Sept. 30,
2008
 Dec. 31, 2007
Assets:
   
Total assets for reportable segments $2,973,440  $2,822,449 
Elimination of intersegment assets  (34,579)  (167)
Unallocated assets  597,580   271,746 
Total consolidated assets
 $3,536,441  $3,094,028 


Unallocated expenses and unallocated assets primarily relate to the Company headquarters’ support services, which are not part of any business segment.  Unallocated expenses include payroll and benefits, depreciation and other costs associated with headquarters-related support services.  The unallocated expense increase was primarily driven by payroll and benefits due to increased incentive compensation as a result of the Company’s performance. Unallocated assets primarily include non-operating cash and cash equivalents, certain prepaid expenses, deferred income taxes and non-operating property, buildings and equipment – net.

The decreaseincrease in unallocated assets wasas of September 30, 2008 is primarily driven by the decrease in non-operating cash and cash equivalents primarily relateddue to the Company’s ongoing share repurchase program.

higher cash balance.

16

W.W. Grainger, Inc. and Subsidiaries
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)


9.  EARNINGS PER SHARE

The following table sets forth the computation of basic and diluted earnings per share:

  Three Months Ended Sept. 30,  Nine Months Ended Sept. 30, 
  2008  2007  2008  2007 
             
             
Net earnings $140,023,000  $109,150,000  $367,440,000  $315,728,000 
                 
Denominator for basic earnings per share –
weighted average shares
  75,967,774   82,233,231   76,813,709   83,437,184 
Effect of dilutive securities –
stock-based compensation
  2,311,648   2,631,027   2,271,931   2,682,486 
Denominator for diluted earnings per share –
weighted average shares adjusted for
dilutive securities
  78,279,422   84,864,258   79,085,640   86,119,670 
                 
Basic earnings per common share $1.84  $1.33  $4.78  $3.78 
Diluted earnings per common share $1.79  $1.29  $4.65  $3.67 


10.  LEGAL PROCEEDINGS

As previously reported, the Company received a letter in December 2007 from the Commercial Litigation Branch of the Civil Division of the Department of Justice (the “DOJ”) regarding the Company’s contract with the United States General Services Administration (the “GSA”).  The letter suggested that the Company had not complied with its disclosure obligations and the contract’s pricing provisions, and had potentially overcharged government customers under the contract. 

Discussions relating to the Company’s compliance with its disclosure obligations and the contract’s pricing provisions are ongoing.  The timing and outcome of these discussions are uncertain and could include settlement or civil litigation by the DOJ to recover, among other amounts, treble damages and penalties under the False Claims Act.  While this matter is not expected to have a material adverse effect on the Company’s financial position, an unfavorable resolution could result in material payments by the Company.  The Company continues to believe that it has complied with the GSA contract in all material respects.

17

W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS


Item 2.


Overview

General

Grainger is the leading broad-line supplier of facilities maintenance and other related products in North America.  Grainger distributes a wide range of products used by businesses and institutions to keep their facilities and equipment up and running.  Grainger uses a multichannel business model to provide customers with a range of options for finding and purchasing products through a network of branches, sales representatives, direct marketing including catalogs, and a variety of electronic and Internet channels.  Grainger serves customers through a network of more than 600 branches, 18distribution centers and multiple Web sites.


Grainger’s three reportable segments are Grainger Branch-based, Acklands –- Grainger Branch-based (Acklands –- Grainger) and Lab Safety Supply, Inc. (Lab Safety).  Grainger Branch-based is an aggregation ofincluding the following business units:  Grainger Industrial Supply, Grainger, S.A. de C.V. (Mexico), Grainger Caribe Inc. (Puerto Rico) and, Grainger China LLC (China) and Grainger Panama S.A. (Panama).  Acklands –- Grainger is the Company’s Canadian branch-based distribution business.  Lab Safety is a direct marketer of safety and other industrial products.


Business Environment

Several economic factors and industry trends shape Grainger’s business environment.  Historically, Grainger’s sales tendtrends have tended to correlate positively with industrial production growth, particularly manufacturing output, as well as employment growth, particularly non-farm payrolls.  According to the Federal Reserve, overall industrial production increased 1.9%decreased 4.5% from September 20062007 to September 2007.2008.  Manufacturing output increased 1.6%decreased 4.8% from September 20062007 to September 2007, although2008, and manufacturing employment levels declined approximately 1.6%3.2%.  Non-farm employment levels grew 1.2%was essentially flat from September 20062007 to September 2007.2008.  Grainger’s sales to manufacturing customers, continueas well as to show improvement overmost other customer-end markets, continued to grow in the prior year, though at a slower rate.third quarter of 2008.  This reflects the success of Grainger’s on-going market expansion and product line expansion initiatives, as well as Grainger’s growing diversification into markets other than manufacturing.  Current economic growth projections for 20072008 industrial production and GDP are 2.1%(0.4%) and 2.0%1.4%, respectively.


For the first nine months of 2007,2008, the Company had $142.7$142.0 million of capital expenditures, of which $62.4$35.3 million related to its U.S. market expansion program.  The Company expects to completeis targeting completion of its investments in the U.S. market expansion program in 2008.

The Company continues to look for ways of improving its productivity and efficiency. During


Matters Affecting Comparability
There were 64 sales day in the fourththird quarter of 2007, the Company identified up2008 compared to 125 positions in information technology that can be eliminated. As a result, the Company anticipates incurring up to a $6 million charge63 sales days in the fourththird quarter of 2007 and reducing costs2007.  There were 192 sales days in the first nine months of up2008 compared to $12 million191 sales days in 2008.

the first nine months of 2007.

W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Matters Affecting Comparability

Grainger’s operating results for the first nine months of 20072008 include the operating results of the acquisitionsHighsmith acquisition made by Lab Safety in 2007 and late 2006.July 2008.  Since the respective acquisition dates,date, those results have been included in the Lab Safety segment.  See Note 3 to the Condensed Consolidated Financial Statements and Segment Analysis in the following Management’s Discussion and Analysis.

There was a lower tax rate in the three



18

W.W. Grainger, Inc. and nine months ended September 30, 2006 as a result of a 2004 tax audit settlement. The Company benefited $8.5 million or $0.09 per share from the settlement in the three and nine months ended September 30, 2006.

Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS


Results of Operations – Three Months Ended September 30, 2007

2008

The following table is included as an aid to understanding the changes in Grainger’s Condensed Consolidated Statements of Earnings:

 

Three Months Ended September 30,

 

Items in Condensed Consolidated

Statements of Earnings

 

As a Percent of Net Sales

 

Percent Increase (Decrease)

2007

 

2006

Net sales

100.0%

 

100.0%

 

9.2%

Cost of merchandise sold

60.2

 

60.6

 

8.5

Gross profit

39.8

 

39.4

 

10.1

Operating expenses

29.3

 

29.5

 

8.4

Operating earnings

10.5

 

9.9

 

15.2

Other income

0.2

 

0.4

 

(48.1)

Income taxes

4.1

 

3.4

 

30.1

Net earnings

6.6

 

6.9

 

4.5

 Three Months Ended September 30, 
 Items in Condensed Consolidated Statements of Earnings 
       
 
 
 As a Percent of Net Sales   
   2008 2007 
Percent Increase 
(Decrease)
 
 Net sales  100.0%  100.0%  10.9%
 Cost of merchandise sold    59.6   60.2   9.8 
 Gross profit  40.4   39.8   12.5 
 Operating expenses  27.8   29.3   5.3 
 Operating earnings  12.6   10.5   32.8 
 Other income (expense)     (0.2)  0.2   (197.0)
 Income taxes  4.8   4.1   30.3 
 Net earnings  7.6%  6.6%  28.3%

Grainger’s net sales of $1,839.5 million for the third quarter of 2008 increased 10.9% compared with sales of $1,658.6 million for the third quarter ofcomparable 2007 increasedquarter.  Daily sales were up 9.2% compared with sales of $1,519.5 million for the comparable 2006 quarter. Third quarter 2007 sales benefited from ongoing strategic initiatives such as market expansion and product line expansion. Partially offsetting these improvements was the negative effect of the wind-down of low margin integrated supply contracts..  An increase in net sales was realized in all three segments of the business.

  The overall increase in net sales was led by low double-digit growth in the government sector and high single-digit growth in the reseller sector.  Approximately 3 percentage points of the sales growth came from Grainger’s ongoing strategic initiatives, market expansion and product line expansion.  For the quarter, sales were positively affected by price increases of approximately 4 percentage points and there was minimal effect from foreign exchange. Sales were negatively affected by 1 percentage point due to a decline in the sales of seasonal products.  Prices were increased to offset cost inflation.  Refer to the Segment Analysis below for further detail of sales and ongoing strategic initiatives.


Gross profit of $742.3 million for the third quarter of 2008 increased 12.5%.  The gross profit margin improved 0.4 percentage point to 39.8% induring the third quarter of 2008 increased 0.6 percentage point when compared to the same period in 2007, from 39.4% in the comparable period of 2006. The primary driver of the gross profit margin improvement wasprimarily due to positive inflation recovery partially offset by unfavorable customerselling price category mix.


Operating expenses of $485.3$510.9 million for the third quarter of 20072008 increased 8.4%5.3%.  ExpensesOperating expenses grew at a slower rate than the sales growth primarily due to non-payroll operating expenses including lower severance costsadvertising expenses, and a lower provision for bad debts due to reduced contract labor costs associated withimproved collection effectiveness.  Comparisons also benefited from one extra sales day which increased the Company’s system installation in 2006.

leverage on fixed costs.


Operating earnings for the third quarter of 20072008 totaled $174.3$231.5 million, an increase of 15.2%32.8% over the third quarter of 2006.2007.  This earnings improvementgrowth exceeded the sales growth rate due to an improvedimprovement in gross profit margin and positive operating expenses which grew at a slower rate than sales.

expense leverage.


19

W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS



Net earnings for the third quarter of 20072008 increased by 4.5%28.3% to $140.0 million from $109.1 million from $104.5 million in 2006.2007.  The growth in net earnings for the quarter primarily resulted from the improvement in operating earnings, partially offset by lower interest income, higher interest expense and a higher income taxestax rate versus 2006.2007.  Diluted earnings per share of $1.29$1.79 in the third quarter of 20072008 were 11.2%38.8% higher than the $1.16$1.29 for the third quarter of 2006.2007.  This improvement was higher than the percentage increase for net earnings due to the effectlower shares outstanding primarily a result of the Company’s share repurchase program. The 2006 third quarter included an $8.5 million or $0.09 per share benefit from the settlement of a 2004 tax audit. Excluding this benefit, net earnings increased 13.7% and diluted earnings per share increased 20.6% percent for the 2007 third quarter.


Segment Analysis

The following comments at the segment level refer to external and intersegment net sales.  Comments at the business unit level include external and inter- and intrasegment net sales.  See Note 108 to the Condensed Consolidated Financial Statements.


Grainger Branch-based

Net sales were $1,385.3$1,523.5 million for the third quarter of 2007,2008, an increase of $111.1$138.2 million, or 8.7%10.0%, when compared with net sales of $1,274.2$1,385.3 million for the same period in 2006.

2007.  Daily sales were up 8.3%.


Sales in the United States were up 8.6%,9.6%.  Daily sales were up 7.9% with growth in all customer end markets except retail, which was flat.  The increase in net sales was led by low double-digit growth in the government sector and commercial sectors. The wind-down ofhigh single-digit growth in the Company’s low margin integrated supply contracts reduced sales growthreseller sector.  Sales were negatively affected by approximately 1 percentage point. Thepoint due to a decline in the sales growth benefited from the Company’s two strategic initiatives: marketof seasonal products.  Market expansion and product line expansion.

Market expansion contributedadded approximately 13 percentage pointpoints to overall growth in the sales growth for the segment. quarter.


Results for the market expansion program were as follows:

 

 

2007 Third Quarter

 

 

 

Sales

Increase

 

Percent

Complete

 

Phase 1 (Atlanta, Denver, Seattle)

 

16%

 

100%

 

Phase 2 (Four markets in Southern California)

 

7%

 

100%

 

Phase 3 (Houston, St. Louis, Tampa)

 

14%

 

95%

 

Phase 4 (Baltimore, Cincinnati, Kansas City,
                Miami, Philadelphia, Washington D.C.)

 

8%

 

95%

 

Phase 5 (Dallas, Detroit, New York City, Phoenix)

 

8%

 

75%

 

Work on the last phase, Phase

  2008 Third Quarter 
  
Sales
Increase
 
Percent
Complete
 
Phase 1 (Atlanta, Denver, Seattle) 11% 100% 
Phase 2 (Four markets in Southern California)   5% 100% 
Phase 3 (Houston, St. Louis, Tampa) 10% 100% 
Phase 4 (Baltimore, Cincinnati, Kansas City,
Miami, Philadelphia, Washington D.C.)
 4% 100% 
Phase 5 (Dallas, Detroit, Greater New York, Phoenix) 5%   95% 
Phase 6 (Chicago, Minneapolis, Pittsburgh,
San Francisco)
 7%   95% 
The Company is targeting completion of phases 5 and 6 (Chicago, Minneapolis, Pittsburghin 2008 and San Francisco), is expectedexpects to be completed in 2008.

Product line expansion contributed approximately 3 percentage points to thesee continued incremental sales growth from the program for the segment. Over the past two years, the Companyanother five years.



20

W.W. Grainger, Inc. and Subsidiaries
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS


The U.S. branch-based business has added approximately 70,00060,000 new products in 2008 which will be featured in the plumbing, fastener, material handling and security product lines as partFebruary 2009 catalog but are currently for sale on grainger.com.  The 2008 catalog includes a total of its ongoing product line expansion initiative.

183,000 products.


Sales in Mexico increased 24.3%16.8% in the third quarter of 20072008 versus 2006.2007.  Daily sales were up 15.0%. In local currency, daily sales were up 24.5%8.2% primarily driven primarily by increased market share coming from the ongoing branch expansion programprogram.  Daily sales were led by growth to the natural resources sector of the economy, partially offset by weakness in manufacturing and an improved economy.

hospitality.

W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

The segment gross profit margin increased 0.20.8 percentage point in the 20072008 third quarter over the comparable quarter of 2006,2007, primarily driven bydue to positive inflation recovery partially offset by unfavorable selling price category mix.


Operating expenses in this segment were up 6.6%3.6% in the third quarter of 2008 versus the third quarter of 2007.  ExpensesOperating expenses grew at a slower rate than the sales growth primarily due to non-payroll operating expenses including lower severance costsadvertising expenses, and a lower provision for bad debts due to reduced contract labor costs associated withimproved collection effectiveness.  Comparisons also benefited from one extra sales day which increased the Company’s system installation in 2006.

leverage on fixed costs.


For the segment, operating earnings of $226.6 million for the third quarter of 2008 increased 30.9% over the $173.1 million for the third quarter of 2007 increased 16.0% over the $149.3 million for the third quarter of 2006.2007.  This earnings improvement exceeded the sales growth rate due to improved gross profit margin and positive operating expense leverage.  Included in these results were lower profits in Mexico primarily due to branch expansion related expenses, ongoing losses in China and start up expenses related to the new branch in Panama.

Acklands - Grainger Branch-based
Net sales at Acklands - Grainger were $190.8 million for the third quarter of 2008, an increase of $27.3 million, or 16.7%, when compared with $163.5 million for the same period in 2007.  On a daily basis sales increased 14.8%.  There was minimal effect from foreign exchange as sales increased 16.2% in local currency, or 14.4% on a daily basis.  The results benefited from continued strength from sales to oil sands, natural gas, construction, government, mining, and agriculture customers, partially offset by weakness in the forestry sector.

The gross profit margin increased 0.7 percentage point in the 2008 third quarter versus the third quarter of 2007, primarily due to positive inflation recovery, partially offset by increased freight and handling costs.

Operating expenses were up 14.9% in the third quarter of 2008.  The segment achieved positive operating expense leverage as operating expenses increased 14.4% in local currency.

Operating earnings of $14.2 million for the third quarter of 2008 were up $3.9 million, or 38.3%.  The earnings improvement was primarily a result of an improved gross profit margin and operating expenses which grew at a slower rate than sales.

Acklands –


21

W.W. Grainger, Branch-based

Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS


Lab Safety
Net sales at Acklands – GraingerLab Safety were $163.5$127.3 million for the third quarter of 2007,2008, an increase of $21.9$16.1 million, or 15.5%14.5%, when compared with $141.6 million for the same period in 2006. In local currency,2007.  Daily sales increased 7.7% due to strongerwere up 12.7%.

Sales from the Highsmith acquisition made in July 2008 contributed all of the sales ingrowth for the mining and oil and gas industries, partially offset by weakness inquarter.  Excluding this acquisition sales growth for the forestry and manufacturing industries.

remainder of the business was down 4.6% on a daily basis.


The gross profit margin increased 1.8 percentage points in the 2007 quarter over the third quarter of 2006. The improvement in the gross profit margin was primarily due to positive inflation recovery and higher supplier funding.

Operating expenses were up 12.4%decreased 1.7% in the third quarter of 2008 from the third quarter of 2007.  Expenses grew at a slower rate than salesGross profit margin was down primarily due to product mix, as the Highsmith acquisition negatively impacted margins due to lower margin rates, and from a negative selling price category mix.


Operating expenses were up 20.2% in the third quarter of 2008, primarily due to costs associated with the Highsmith acquisition.  Excluding Highsmith, operating expense leverage,expenses were down 1.3% for the resultthird quarter of improved cost management.

2008.


Operating earnings of $10.2$12.2 million for the third quarter of 2007 were up $5.1 million or 100%. This2008 decreased 14.1% over the same period in 2007.  Operating earnings improvement exceeded the sales growth ratedecreased due to an improveda decline in gross profit margin and operating expenses which grew at a slowerhigher rate than sales.

Lab Safety

Net sales at Lab Safety were $111.2 million for the third quarter of 2007, an increase of $6.5 million, or 6.2%, when compared with $104.7 million for the same period in 2006. Sales from acquisitions made during 2007 and late 2006 contributed approximately 7 percentage points to the growth.

The gross profit margin decreased 0.2 percentage point in the third quarter of 2007 from the third quarter of 2006. Gross profit margin was down as a result of increased freight costs and unfavorable selling and product mix, partially offset by positive inflation recovery.

Operating expenses were up 6.5% in the quarter primarily driven by higher acquisitions costs and higher benefits due to increased healthcare costs.


W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Operating earnings of $14.2 million for the third quarter of 2007 increased 4.3% over the same period in 2006. This earnings improvement was less than the sales growth rate due to a lower gross profit margin and operating expenses which grew at a slightly faster rate than sales.

Other Income and Expense

Other income and expense was incomean expense of $2.9$2.8 million in the third quarter of 20072008 compared with $5.5$2.9 million of income in the third quarter of 2006.2007.  This decrease was primarily attributable to lower interest income due to lower interest rates and higher interest expense in 2007.

2008 due to increased borrowings.


Income Taxes

Grainger’s effective income tax rate wasrates were 38.8% and 38.4% and 33.4% for the third quarter of 2008 and 2007, and 2006, respectively.  The third quarter rate of 2006 includes the benefit from the settlement of a 2004 tax audit, which increased earnings $8.5 million or $0.09 per share. Excluding this benefit and the effect of equity in net income of unconsolidated entities, which is recorded net of tax, the effective income tax rate was 38.9% for the third quarter of 2008 and 38.5% for the third quarter of 20072007.

22

W.W. Grainger, Inc. and 38.9% for the third quarter of 2006. The full year 2006 rate was 36.4% and benefited from the resolution of uncertainties related to the audit of the 2004 tax year and from a reduction of deferred tax liabilities related to property, buildings and equipment.

Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS


Results of Operations – Nine Months Ended September 30, 2007

2008

The following table is included as an aid to understanding the changes in Grainger’s Condensed Consolidated Statements of Earnings:

 

Nine Months Ended September 30,

 

Items in Condensed Consolidated

Statements of Earnings

 

As a Percent of Net Sales

 

Percent

Increase

(Decrease)

2007

 

2006

Net sales

100.0%

 

100.0%

 

8.7%

Cost of merchandise sold

59.8

 

60.4

 

7.7

Gross profit

40.2

 

39.6

 

10.2

Operating expenses

29.7

 

29.9

 

8.0

Operating earnings

10.5

 

9.7

 

17.0

Other income

0.2

 

0.4

 

(51.1)

Income taxes

4.1

 

3.7

 

19.2

Net earnings

6.6

 

6.4

 

11.0

 Nine Months Ended September 30, 
 Items in Condensed Consolidated Statements of Earnings 
       
 
 
 
As a Percent of Net Sales
   
   2008 2007 
Percent
Increase
(Decrease)
 
 Net sales  100.0%  100.0%  9.4%
 Cost of merchandise sold    59.5   59.8   8.9 
 Gross profit  40.5   40.2   10.1 
 Operating expenses  29.0   29.7   6.8 
 Operating earnings  11.5   10.5   19.6 
 Other income (expense)     (0.1)  0.2   (126.3)
 Income taxes  4.4   4.1   17.6 
 Net earnings  7.0%  6.6%  16.4%
Grainger’s net sales of $4,806.3$5,257.4 million for the first nine months of 20072008 increased 8.7%9.4% compared with sales of $4,421.5$4,806.3 million for the comparable 20062007 period.  The first nine monthsDaily sales benefited from ongoing strategic initiatives such as market expansion and product line expansion. Partially offsetting these improvements was the negative effect of the wind-down of low margin integrated supply contracts.were up 8.8%.  An increase in net sales was realized in all three segments of the business.

  The increase in net sales was led by low double-digit sales growth in the government sector and mid single-digit growth in the light manufacturing, commercial and reseller sectors.  Approximately 3 percentage points of the sales growth came from Grainger’s ongoing strategic initiatives, market expansion and product line expansion, with another 1 percentage point from foreign exchange.  For the first nine months of 2008, sales were positively affected by price increases of approximately 3 percentage points.  Sales were negatively affected by approximately 1 percentage point due to a decline in the sales of seasonal products.  Refer to the Segment Analysis below for further detail of sales and ongoing strategic initiatives.


Gross profit of $2,182.2 million for the first nine months of 2008 increased 10.1%.  The gross profit margin forduring the first nine months ended September 30, 2007 improved 0.6of 2008 increased 0.3 percentage point when compared to 40.2% from 39.6%the same period in the comparable period of 2006. The improvement in the gross profit margin was2007 primarily driven bydue to positive inflation recovery, partially offset by unfavorable selling price category mix.


W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Operating expenses of $1,428.7$1,526.0 million for the first nine months of 20072008 increased 8.0% over the prior year. Expenses6.8%.  Operating expenses grew at a slower rate than sales due primarily to lower severance costsnon-payroll operating expenses including advertising and to reduced contract labor costs associated withprofessional services.  Comparisons also benefited from one extra sales day which increased the Company’s system installation in 2006.

leverage on fixed costs.


Operating earnings for the first nine months ended September 30, 2007of 2008 totaled $503.5$602.1 million, an increase of 17.0%19.6% over the first nine months of 2006.2007.  This earnings improvementgrowth exceeded the sales growth rate due to an improvedimprovement in gross profit margin and positive operating expenses which grew at a slower rate than sales.

expense leverage.


23

W.W. Grainger, Inc. and Subsidiaries
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS


Net earnings for the first nine months ended September 30, 2007of 2008 increased by 11.0%16.4% to $367.4 million from $315.7 million from $284.5 million in 2006.2007.  The growth in net earnings for the first nine months ended September 30, 2007 primarily resulted from the improvement in operating earnings, partially offset by lower interest income, higher interest expense and no counterpart to a gain on the sale of Acklands – Grainger’s interest in the USI-AGI Prairies joint venture in 2006.higher income tax rate versus 2007.  Diluted earnings per share of $3.67$4.65 in the first nine months of 20072008 were 18.0%26.7% higher than the $3.11$3.67 for the first nine months of 2006.2007.  This improvement was higher than the percentage increase for net earnings due to the effectlower shares outstanding primarily a result of the Company’s share repurchase program. In addition, the first nine months of 2006 included an $8.5 million or $0.09 per share benefit from the settlement of a 2004 tax audit. Excluding this benefit, net earnings increased 14.4% and diluted earnings per share increased 21.5% percent for the first nine months of 2007.


Segment Analysis

The following comments at the segment level refer to external and intersegment net sales.  Comments at the business unit level include external and inter- and intrasegment net sales.  See Note 108 to the Condensed Consolidated Financial Statements.


Grainger Branch-based

Net sales were $4,014.5$4,346.9 million for the first nine months of 2007,2008, an increase of $329.6$332.4 million, or 8.9%8.3%, when compared with net sales of $3,684.9$4,014.5 million for the first nine months of 2006.

same period in 2007.  Daily sales were up 7.7%.


Sales in the United States were up 8.9%,8.0%.  Daily sales were up 7.5% with growth in all customer end markets, except the retail customer market, which was flat.  The increase in net sales was led by low double-digit sales growth in the government sector, and mid single-digit growth in the light manufacturing, commercial and reseller sectors.  The wind-down of the Company’s low margin integrated supply contracts reduced sales growthSales were negatively affected by approximately 1 percentage point. Thepoint due to a decline in the sales growth benefited from the Company’s two strategic initiatives: marketof seasonal products.  Market expansion and product line expansion.

Market expansion contributedadded approximately 24 percentage points to the salesoverall growth for the segment. first nine months of 2008.


Results for the market expansion program were as follows:

 

 

2007 Year-to-Date

 

 

 

Sales

Increase

 

Percent

Complete

 

Phase 1 (Atlanta, Denver, Seattle)

 

14%

 

100%

 

Phase 2 (Four markets in Southern California)

 

6%

 

100%

 

Phase 3 (Houston, St. Louis, Tampa)

 

13%

 

95%

 

Phase 4 (Baltimore, Cincinnati, Kansas City,
                Miami, Philadelphia, Washington D.C.)

 

10%

 

95%

 

Phase 5 (Dallas, Detroit, New York City, Phoenix)

 

9%

 

75%

 


  2008 Year-to-Date 
  
Sales
Increase
 
Percent
Complete
 
Phase 1 (Atlanta, Denver, Seattle) 11% 100% 
Phase 2 (Four markets in Southern California)   8% 100% 
Phase 3 (Houston, St. Louis, Tampa) 12% 100% 
Phase 4 (Baltimore, Cincinnati, Kansas City,
Miami, Philadelphia, Washington D.C.)
 4% 100% 
Phase 5 (Dallas, Detroit, Greater New York, Phoenix) 6%   95% 
Phase 6 (Chicago, Minneapolis, Pittsburgh,
San Francisco)
 8%   95% 

The Company is targeting completion of phases 5 and 6 in 2008 and expects to see continued incremental sales growth from the program for another five years.

The U.S. branch-based business has added approximately 60,000 new products in 2008 which will be featured in the February 2009 catalog but are currently for sale on grainger.com.  The 2008 catalog includes a total of 183,000 products.

24

W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

Work on the last phase, Phase 6 (Chicago, Minneapolis, Pittsburgh and San Francisco), is expected to be completed in 2008.

Product line expansion contributed approximately 2 percentage points to the sales growth for the segment. Over the past two years, the Company has added approximately 70,000 new products in the plumbing, fastener, material handling and security product lines as part of its ongoing product line expansion initiative.



Sales in Mexico increased 23.5%19.8% in the first nine months of 20072008 versus 2006.2007.  Daily sales were up 19.2%.  In local currency, daily sales were up 23.8%14.3% primarily driven by increased market share coming from the ongoing branch expansion program and an improved economy.

program.


The segment gross profit margin increased 0.50.4 percentage point in the first nine months of 20072008 over the comparable 20062007 period, primarily driven by positive inflation recovery, partially offset by unfavorable selling mix.

price category mix and increased freight and handling costs.


Operating expenses in this segment were up 7.6%5.3% in the first nine months of 2007. Expenses2008.  Operating expenses grew at a slower rate than sales due primarily to lower severance costsnon-payroll operating expenses including advertising and to reduced contract labor costs associated withprofessional services.  Comparisons also benefited from one extra sales day which increased the Company’s system installation in 2006.

leverage on fixed costs.


For the segment, operating earnings of $596.4 million for the first nine months of 2008 increased 18.1% over the $505.0 million for the first nine months of 2007 increased 16.4% over the $433.9 million for the first nine months of 2006.2007.  This earnings improvement exceeded the sales growth rate due to an improved gross profit margin and positive operating expense leverage.  Included in these results were lower profits in Mexico primarily due to branch expansion related expenses, which grew at a slower rate than sales.

ongoing losses in China and start up expenses related to the new branch in Panama.


Acklands –- Grainger Branch-based

Net sales at Acklands –- Grainger were $464.9$565.9 million for the first nine months of 2007,2008, an increase of $37.4$101.0 million, or 8.7%21.7%, when compared with $427.5$464.9 million for the same period in 2006.2007.  Daily sales were up 21.1%.  In local currency, daily sales increased 5.8% due12.0%   The results benefited from continued strength from sales to stronger sales in thegovernment, construction, oil sands, natural gas, mining and oil and gas sectors,agriculture customers, partially offset by weakness in the forestry and manufacturing sectors.

sector.


The gross profit margin increased 2.10.4 percentage pointspoint in the first nine months of 20072008 over the first nine months of 2006. 2007.  The improvement in the gross profit marginincrease was primarily due todriven by positive inflation recovery and higher supplier funding, partially offset by higher freight costs.

recovery.


Operating expenses were up 3.7%19.3% in the first nine months of 2007. Expenses grew at a slower rate than sales due to2008.  The segment achieved positive operating expense leverage theas operating expenses increased 10.3% in local currency.  The increase in operating expenses was primarily due to payroll and benefits as a result of improved cost management.

increased headcount and merit increases, and other operating expenses.


Operating earnings of $29.7$41.9 million for the first nine months of 20072008 were up $17.6$12.1 million, or 146%40.9%.  This earnings improvement exceeded the sales growth rate primarily due to an improved gross profit margin and positive operating expenses which grew at a slower rate than sales.

expense leverage.


25

W.W. Grainger, Inc. and Subsidiaries
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS


Lab Safety

Net sales at Lab Safety were $330.7$350.0 million for the first nine months of 2007,2008, an increase of $18.9$19.3 million, or 6.0%5.9%, when compared with $311.8$330.7 million for the same period in 2006. Sales2007.  Daily sales were up 5.3%.  Excluding sales from the acquisitions made during 2007 and late 2006 contributedHighsmith acquisition, sales growth for the remainder of the business was down approximately 7 percentage points to the growth.

1%.

W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

The gross profit margin decreased 0.5 percentage point in the first nine months of 2007 over2008 from the first nine months of 2006.2007.  Gross profit margin was down as a result of increased freight costs and unfavorable selling price category mix and product mix partially offset by positive inflation recovery.


Operating expenses were 6.0% higherup 9.2% in the first nine months of 20072008.  Expenses grew at a faster rate than sales primarily driven by higher acquisitions costs.

due to the costs associated with the Highsmith acquisition.  Excluding Highsmith, operating expenses were up approximately 2% for the first nine months of 2008.


Operating earnings of $43.2$40.6 million for the first nine months of 2007 were up 2.0% over 2006. This2008 decreased 6.0% versus the same period in 2007.  Operating earnings improvement was less than the sales growth rate primarilydecreased due to a lowerdecline in gross profit margin.

margin and operating expenses which grew at a higher rate than sales.


Other Income and Expense

Other income and expense was an expense of $2.5 million in the first nine months of 2008 compared with income of $9.7 million in the first nine months of 2007 compared with $19.8 million in the first nine months of 2006.2007.  This decrease was primarily attributable to lower interest income due to lower interest rates and lower average cash balances and higher interest expense in 2007 and no counterpart2008 due to a gain on the sale of Acklands – Grainger’s interest in the USI-AGI Prairies joint venture in 2006. In addition, there was a decrease in earnings on equity of unconsolidated entities in 2007 versus 2006 primarily driven by the absence of earnings relating to the sale of the joint venture.

increased borrowings.


Income Taxes

Grainger’s effective tax rate was 38.5% and 36.8% for the first nine months of 2007 and 2006, respectively. The rate for the first nine months of 2006 includes the benefit from the settlement of a 2004 tax audit, which increased earnings $8.5 million or $0.09 per share. Excluding this benefit and the effect of equity in income of unconsolidated entities, which is recorded net of tax, the effective income tax rate wasrates were 38.7% and 38.5% for the first nine months of 2008 and 2007, andrespectively.  Excluding the effect of equity in net income of unconsolidated entities, the effective income tax rate was 38.9% for 2006. The full year 2006 rate was 36.4%the first nine months of 2008 and benefited from38.5% for the resolutionfirst nine months of uncertainties related to the audit of the 2004 tax year2007.


26

W.W. Grainger, Inc. and from a reduction of deferred tax liabilities related to property, buildings and equipment.

Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS


Financial Condition

For the nine months ended September 30, 2007,2008, working capital of $901.2$1,436.5 million decreasedincreased by $254.6$462.1 million when compared to $1,155.8$974.4 million at December 31, 2006.2007.  The increase in working capital primarily relates to increases in cash and receivables and the replacement of short-term borrowings with long-term debt.  The ratio of current assets to current liabilities was 2.03.0 at September 30, 2007,2008, versus 2.62.2 at December 31, 2006. The decrease in working capital and reduction in the ratio of current assets to current liabilities primarily relates to the decrease in cash and cash equivalents as a result of the Company’s share repurchase program.

2007.


Net cash provided by operating activities was $337.8$335.3 million and $313.0$337.8 million for the nine months ended September 30, 20072008 and 2006,2007, respectively.  Net cash flows from operating activities serve as the Company’sGrainger’s primary source to fund its growth initiatives.  Contributing to cash flows from operations were net earnings in the first nine months ended September 30, 20072008 of $315.7$367.4 million and the change ineffect of non-cash itemsexpenses such as stock-based compensation, and depreciation and amortization.  Partially offsetting these amounts were Changeschanges in operating assets and liabilities, – net of business acquisitions, which resulted in a net use of cash of $93.1$155.8 million for the first nine months of 2007.2008.  The principal operating uses of cash were increases in accounts receivable and inventory, as well as a reduction of other current liabilities.  The increase in receivables was due to a higher


W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

sales volume.  The increase in inventories was due to the product line expansion initiative and higher inventories to improve customer service through better product availability. Other current liabilities declined primarily due to the timing of annual cash payments for profit sharing and bonuses.  Partially offsetting these uses in cash was an increase in trade accounts payable.


Net cash used in investing activities was $143.9$152.9 million and $92.0$143.9 million for the nine months ended September 30, 2008 and 2007, and 2006, respectively. In the first nine months of 2007, Grainger continued funding the Company’s market expansion initiative and acquired the McFeely’s business.  Cash expended for additions to property, buildings, equipment and capitalized software was $140.5 million in the first nine months of 2008 versus $143.5 million in the first nine months of 20072007.  Capital expenditures included the continued funding of the market expansion initiatives in the United States and Mexico.  Cash expended for business acquisitions was $34.0 million for the first nine months of 2008 versus $102.3$4.7 million in the first nine months of 2006. The first nine months of 2006 included the sale of Acklands – Grainger’s interest in the USI-AGI Prairies joint venture for $27.4 million in cash.

2007.


Net cash used inprovided by financing activities was $457.1 million and $339.1$69.9 million for the nine months ended September 30, 20072008, versus net cash used of $457.1 million for the nine months ended September 30, 2007.  For the nine months ended September 30, 2008, cash provided by financing activities included proceeds from long-term borrowings of $500 million, and 2006, respectively. Grainger’sproceeds and excess tax benefits realized from stock options exercised of $52.8 million in 2008 versus $130.5 million in 2007.  Amounts used in financing activities included treasury stock purchases of $647.3$307.6 million were $328.1 million higher infor the first nine months of 20072008 versus 2006, as$647.3 million for the first nine months of 2007.  Grainger repurchased 7.14.3 million shares compared to 4.77.1 million shares in the first nine months of 2006.2007.  As of September 30, 2007,2008, approximately 4.78.8 million shares of common stock remained available under Grainger’s repurchase authorization.  See Note 8Grainger also used cash in financing activities to the Condensed Consolidated Financial Statements for further discussion of the Company’s accelerated share repurchase program. Dividends paidpay dividends to shareholders were $84.8of $90.4 million and $73.1$84.8 million for the first nine months of 2008 and 2007, respectively, and 2006, respectively. Partially offsetting these financing cash outlays were proceeds and excess tax benefits realized from stock options exercisedpaid off $85.0 million of $130.5short-term borrowings in the first nine months of 2008 versus an increase of $144.4 million in 2007 versus $53.2 million in 2006.

the first nine months of 2007.


27

W.W. Grainger, Inc. and Subsidiaries
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS


Grainger maintains a debt ratio and liquidity position that provide flexibility in funding working capital needs and long-term cash requirements.  In addition to internally generated funds, Grainger has various sources of financing available, including commercial paper sales and bank borrowings under lines of credit.  Total debt as a percent of total capitalization was 7.2%19.8% at September 30, 20072008, and 0.4%5.0% at December 31, 2006.2007.  The increase in total debt as a percent of total capitalization was primarily the result of short-term borrowings used to fund an accelerated share repurchase program.long-term borrowings.  See Note 86 to the Condensed Consolidated Financial Statements for further discussion of the Company’s share repurchase program.

additional borrowings detail.



Critical Accounting Policies and Estimates

The preparation of financial statements, in conformity with accounting principles generally accepted in the United States of America, requires management to make judgments, estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses in the financial statements.  Management bases its estimates on historical experience and other assumptions, which it believes are reasonable.  If actual amounts are ultimately different from these estimates, the revisions are included in Grainger’s results of operations for the period in which the actual amounts become known.


Accounting policies are considered critical when they require management to make assumptions about matters that are uncertain at the time the estimate is made and when different estimates than those management reasonably could have made have a material impact on the presentation of Grainger’s financial condition, changes in financial condition or results of operations.  For a


W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

description of Grainger’s critical accounting policies see the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

2007.



28

W.W. Grainger, Inc. and Subsidiaries
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS


Forward-Looking Statements

This document may contain forward-lookingForm 10-Q contains statements under the federal securities laws. The forward-looking statements relate to Grainger’s expectedthat are not historical in nature but concern future financial results and business plans, strategies and objectives and are not historical facts. They are oftenother matters that may be deemed to be “forward-looking statements” under the federal securities laws.  Grainger has generally identified such forward-looking statements by qualifiersusing words such as “will,” “believes,” “intends,” “intended,” “tends"continued incremental sales growth, continues to correlate,” “expect,” “expected,” “isbelieve it complies, could, expect, expected,” “anticipate,” “estimates,” “estimated,” “assumption,” “may,” “contingent,” “projection,” “percent expects, intended, intends, is targeting, may, percent complete,” “scheduled,” “goals,” “target,” “trends” projections, should be completed, timing and outcome are uncertain, and will" or similar expressions. There

Grainger cannot guarantee that any forward-looking statement will be realized although Grainger does believe that its assumptions underlying its forward-looking statements are reasonable. Achievement of future results is subject to risks and uncertainties the outcome of which could cause Grainger’s results to differ materially from what is projected.

those which are presented.


Factors that may affectcould cause actual results to differ materially from those presented or implied in a forward-looking statementsstatement include, the following:without limitation: higher product costs or other expenses; a major loss of customers; increased competitive pricing pressure on Grainger’s businesses;pressures; failure to develop or implement new technologies or other business strategies; the outcome of pending and future litigation andor governmental or regulatory proceedings; changes in laws and regulations; disruption of information technology or data security systems; general industry or market conditions; general economic conditions; labor shortages; facilities disruptions or shutdowns; higher fuel costs or disruptions in transportation services; natural and other catastrophes; and unanticipated weather conditions;conditions.

Caution should be taken not to place undue reliance on Grainger’s forward-looking statements and other difficulties in achievingGrainger undertakes no obligation to publicly update the forward-looking statements, whether as a result of new information, future events or improving margins or financial performance.

Trends and projections could also be affected by general industry and market conditions, gross domestic product growth rates, general economic conditions, including industrial production, interest rate and currency rate fluctuations, global and other conflicts, job creation and employment levels in manufacturing, non-farm and other sectors, and other factors.

otherwise.

29

W.W. Grainger, Inc. and Subsidiaries



PART I – FINANCIAL INFORMATION


Item 3.

Item 3.       Quantitative and Qualitative Disclosures About Market Risk


For quantitative and qualitative disclosures about market risk, see “Item 7A: Quantitative and Qualitative Disclosures About Market Risk” in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006.

2007.

Item 4.       Controls and Procedures

Controls and Procedures


Disclosure Controls and Procedures


Grainger carried out an evaluation, under the supervision and with the participation of its management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of Grainger’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15.  Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that Grainger’s disclosure controls and procedures were effective as of the end of the period covered by this report.


Changes in Internal Control Over Financial Reporting


There were no changes in Grainger’s internal control over financial reporting that occurred during the third quarter, that have materially affected, or are reasonably likely to materially affect, Grainger’s internal control over financial reporting.


W.W. Grainger, Inc. and Subsidiaries

PART II – OTHER INFORMATION


Items 1, 1A, 3, 4 and 5 not applicable.


Item 1.       Legal Proceedings

As previously reported, the Company received a letter in December 2007 from the Commercial Litigation Branch of the Civil Division of the Department of Justice (the “DOJ”) regarding the Company’s contract with the United States General Services Administration (the “GSA”). The letter suggested that the Company had not complied with its disclosure obligations and the contract’s pricing provisions, and had potentially overcharged government customers under the contract. 

Discussions relating to the Company’s compliance with its disclosure obligations and the contract’s pricing provisions are ongoing.  The timing and outcome of these discussions are uncertain and could include settlement or civil litigation by the DOJ to recover, among other amounts, treble damages and penalties under the False Claims Act.  While this matter is not expected to have a material adverse effect on the Company’s financial position, an unfavorable resolution could result in material payments by the Company.  The Company continues to believe that it has complied with the GSA contract in all material respects.


30

W.W. Grainger, Inc. and Subsidiaries


Item 2.

Item 2.       Unregistered Sales of Equity Securities and Use of Proceeds


Issuer Purchases of Equity Securities – Third Quarter

Period

Total Number of

Shares Purchased

(A)

Average Price

Paid per Share

(B)

Total Number of Shares

Purchased as Part of

Publicly Announced Plans

or Programs (C)

Maximum Number of

Shares that May Yet be

Purchased Under the

Plans or Programs

 

 

 

 

 

 

July 1 – July 31

-

-

-

5,989,800

shares

 

 

 

 

 

 

Aug. 1 – Aug. 31

5,316,007

$84.65 (D)

5,316,007

4,683,993

shares

 

 

 

 

 

 

Sept. 1 – Sept. 30

-

-

-

4,683,993

shares

 

 

 

 

 

 

Total

5,316,007

$84.65

5,316,007

 

 

PeriodTotal Number of Shares Purchased (A)Average Price Paid per Share (B)
Total Number of Shares
Purchased as Part of
Publicly Announced Plans
or Programs (C)
Maximum Number of
Shares that May Yet be
Purchased Under the
Plans or Programs
      
July 1 – July 31350,000$83.38350,0008,811,100shares
      
August 1 – August 313,375$89.15–8,811,100shares
      
Sept. 1 – Sept. 30–––8,811,100shares
      
Total353,375$83.44350,000  

(A)  

(A)

There were no3,375 shares withheld to satisfy tax withholding obligations in connection with the vesting of employee restricted stock awards.

(B)  

(B)

Average price paid per share includes any commissions paid and includes only those amounts related to purchases as part of publicly announced plans or programs.  Activity is reported on a trade date basis.

(C)  

(C)

During the first six months of 2007, purchasesPurchases were made pursuant to a share repurchase program approved by Grainger’s Board of Directors on October 16, 2006. A total of 4,010,200 shares were acquired under this authorization. Effective August 17, 2007 theDirectors.  On April 30, 2008, Grainger announced that its Board of Directors granted authority to restore the repurchase programup to 10 million shares.

  The program has no specified expiration date.  No share repurchase plan or program expired or was terminated during the period covered by this report.

On August 20, 2007, Grainger announced that it entered into an accelerated share repurchase (ASR) agreement with Goldman, Sachs & Co. (Goldman) to purchase $500 million of its outstanding common stock. Grainger paid Goldman $500 million on August 23, 2007 in exchange for an initial delivery of 5,316,007 shares. At the conclusion of the ASR, Grainger may receive additional shares or be required to pay additional shares of its common stock or cash (at Grainger’s option), based on the volume-weighted average price during the term of the agreement. The ASR will conclude in April 2008, although in certain circumstances the termination date may be accelerated at Goldman’s option.


(D)

Represents the initial purchase price paid for shares repurchased under the ASR and is subject to adjustment as described in (C) above and Note 8 to the Condensed Consolidated Financial Statements.


W.W. Grainger, Inc. and Subsidiaries

Item 6.

Exhibits

(a)

(a)Exhibits (numbered in accordance with Item 601 of Regulation S-K)

(10)

(31)

Material Contract

(11)

Computations of Earnings per Share

(31)

Rule 13a – 14(a)/15d – 14(a) Certifications

(a)

Chief Executive Officer certification pursuant to Section 302 of the

Sarbanes-Oxley Act of 2002.

(b)

Chief Financial Officer certification pursuant to Section 302 of the

Sarbanes-Oxley Act of 2002.

(32)

Section 1350 Certifications

(a)

Chief Executive Officer certification pursuant to Section 906 of the

Sarbanes-Oxley Act of 2002.

(b)

Chief Financial Officer certification pursuant to Section 906 of the

Sarbanes-Oxley Act of 2002.




31

SIGNATURES



Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


W.W. Grainger, Inc.

(Registrant)

Date: November 1, 2007

October 30, 2008

By:

/s/ P. O. Loux

P. O. Loux, Senior Vice President, Finance and Chief Financial Officer

Date: November 1, 2007

By:

/s/ R. L. Jadin

R. L. Jadin, Senior Vice President

and Chief Financial Officer
Date: October 30, 2008
By:
/s/ G. S. Irving
G. S. Irving, Vice President
and Controller

29