In the first nine months of 2004, Grainger’s net sales of $3,784.8 million increased 7.8% compared with sales of $3,512.6 million for the comparable 2003 period. The growth over the prior year was due to an increase in daily sales, up 7.2% from the first nine months of 2003, as well as to the one additional sales day included in the 2004 year-to-date period. The increase in net sales was realized across all three segments of the business.
Gross profit margin for the nine months ended September 30, 2004, improved 0.9 percentage point to 36.6% principally due to lower product costs, favorable product mix and selected price increases. This improvement was partially offset by unfavorable changes in selling price mix. Operating earnings of $315.1 million for the first nine months of 2004 increased 13.1% over the comparable period of 2003. Increases in operating earnings occurred across all three segments of the business, partially offset by higher operating expenses at headquarters related to variable compensation, benefits and spending for the Company’s initiatives, particularly for information technology and market expansion. The first quarter of 2004 also included increased payroll costs for severance and benefits related to organizational changes. Increases in operating expenses were partially offset by the benefit from the subsidy associated with the Medicare Act, which was recognized in the third quarter of 2004.
For the year-to-date period ended September 30, 2004, net earnings increased by 19.1% to $196.9 million from $165.2 million in 2003. The growth in net earnings for the year was due to the improvement in operating earnings, higher interest income and a reduced tax rate. Diluted earnings per share of $2.15 in the first nine months of 2004 were 20.1% higher than $1.79 for the first nine months of 2003.
W.W. Grainger, Inc. and Subsidiaries
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Branch-based Distribution
Net sales of $3,377.2 million increased $242.1 million, or 7.7%, in the first nine months of 2004 compared to net sales of $3,135.1 million in the comparable nine months of 2003. Daily sales were up 7.2% over the prior period of 2003.
Sales in the United States were up 7.4% due to a stronger economy and an additional sales day. Daily sales in the United States increased 6.8%. Increases were realized across all customer segments, with strong sales in the manufacturing and commercial sectors. Within these customer segments, national account sales were up 10% in the year-to-date period. Sales to government accounts were up 4% for the nine months ended September 30, 2004, primarily due to increased sales to the federal government and the U.S. Postal Service. However, sales to the military and local and state governments have trended downward in recent periods. Sales processed through the grainger.com Web site were $454.3 million for the first nine months of 2004, an increase of 27.4% on a daily basis over the first nine months of 2003 sales of $354.7 million.
Net sales in Canada during the first nine months of 2004 were 10.2% higher than the comparable 2003 period, benefiting from a favorable exchange rate. On a daily basis, sales were up 9.6%. In local currency, daily sales increased 2.1%. The driver of this year-to-date increase was the stronger Canadian economy in the third quarter fueled by its natural resources industry. Partially offsetting this increase was a decline in safety product sales compared to 2003, which had benefited from sales related to the SARS epidemic. Sales in Mexico increased 15.1% in the year-to-date period ended September 30, 2004, or 14.5% on a daily basis, driven by increased telesales, an improving local economy and two branch expansions.
The gross profit margin increased 1.1 percentage points in the first nine months of 2004 over the comparable period of 2003. Lower product costs, favorable product mix and selected price increases, partially offset by unfavorable changes in selling price category mix, contributed to the gross profit margin improvement.
Operating expenses for the Branch-based Distribution businesses increased 9.0% for the nine months ended September 30, 2004. The increase in operating expenses was principally driven by higher payroll and benefits costs. The increase in payroll and benefits resulted from additional sales commissions and higher accruals for profit sharing and bonuses, as well as increases in stock-based compensation. The benefit from the recognition of the subsidy related to the Medicare Act in the third quarter of 2004 helped offset increases in these operating expenses.
Operating earnings of $326.9 million in the first nine months of 2004 increased 16.5% compared with $280.5 million for the comparable period of 2003. The earnings improvement resulted from higher sales, as well as from improved gross profit margin and warehouse productivity.
24
W.W. Grainger, Inc. and Subsidiaries
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Lab Safety
Lab Safety net sales were $258.3 million for the first nine months of the year, an increase of $28.2 million, or 12.3%, when compared with $230.1 million for the same period in 2003. The increase in sales was driven by growth in sales of maintenance, material handling, safety and labware products. Also contributing to the year-over-year increase were incremental sales from Gempler’s, acquired on April 14, 2003. Daily sales for the first nine months of 2004 were up 11.7% over 2003. Excluding Gempler’s, daily sales were up 5.6%.
The gross profit margin declined 0.6 percentage point in the year-to-date period ended September 30, 2004, when compared with the same period of 2003. Contributing to this decline were incremental sales of Gempler’s products through the first four months of the year, which had lower margins resulting from a customer loyalty program and the negative effect of selling price category mix earlier in the year.
Operating expenses for the nine months ended September 30, 2004, were $6.5 million higher than the comparable period of 2003 due to increased investment in media to strengthen Lab Safety’s customer file, higher benefits expenses resulting from increases in healthcare costs and incremental costs associated with the acquisition of Gempler’s.
Operating earnings of $36.4 million were up 11.7% in the first nine months of 2004 over 2003, resulting primarily from the increase in sales, offset slightly by the lower gross profit margin and higher operating expenses.
Integrated Supply
Net sales of $163.1 million for the first nine months of 2004 were up 1.8% when compared with the same period of 2003. Daily sales were up 1.3% over the prior period. Incremental sales at ten customer locations, added since the third quarter of 2003, were partially offset by disengagements of two large customers late in 2003, lower volumes from existing customers and lower management fees. Sales include both product sales, which are passed through to the customer at cost, and management fees.
The gross profit margin for Integrated Supply declined due to higher product sales combined with lower management fees. Operating expenses decreased 6.8% in the year-to-date period versus 2003 due to a reduction in data processing costs and the bad debt provision.
Operating earnings of $3.5 million through September 30, 2004, increased $0.8 million, or 29.8% versus the prior year, resulting primarily from the reduction in operating expenses.
25
W.W. Grainger, Inc. and Subsidiaries
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Other Income and Expense
Other income and expense was $2.3 million of income for the nine months ended September 30, 2004, compared with $1.9 million of expense in the nine months ended September 30, 2003. The following table summarizes the components of other income and expense:
| Nine Months Ended Sept. 30,
|
|---|
| 2004
| 2003
|
|---|
| (In thousands of dollars) |
|---|
| Other income and (expense) | | | | | | | | |
| Interest income (expense) — net | | | $ | 423 | | $ | (2,282 | ) |
| Equity in income (loss) of unconsolidated | | |
| entities — net | | | | 303 | | | (1,880 | ) |
| Gain on sale of unconsolidated entity | | | | 750 | | | -- | |
| Unclassified — net: | | |
| Gains on sales of investment securities | | | | 50 | | | 1,208 | |
| Gains on sales of fixed assets — net | | | | 709 | | | 3,056 | |
| Write-down of investments | | | | -- | | | (1,614 | ) |
| Other | | | | 24 | | | (355 | ) |
|
| |
| |
| Net other income and (expense) | | | $ | 2,259 | | $ | (1,867 | ) |
|
| |
| |
The improvement in other income and expense for the first nine months of 2004 over the same period of 2003 was primarily attributable to higher net interest income in 2004 versus net interest expense in 2003, as well as a $2.2 million increase in the results of unconsolidated entities. The results for 2003 also included a $1.6 million write-down of investment securities, offset by $3.1 million in gains principally related to the sale of two facilities and $1.2 million in gains on the sales of investment securities.
Income Taxes
Grainger’s effective tax rate was 38.0% for the nine months ended September 30, 2004, and 40.3% for the comparable period of 2003. Excluding the effect of equity in unconsolidated entities, which is recorded net of tax, the effective income tax rate declined two percentage points versus 2003, adding $0.07 per share to diluted earnings per share for the nine months ended September 30, 2004. The reduction in the tax rate in 2004 was primarily driven by a lower tax rate in Canada and the realization of tax benefits related to operations in Mexico and to capital losses. These tax loss benefits were previously unrecognized due to the uncertainty of their realization.
26
W.W. Grainger, Inc. and Subsidiaries
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Financial Condition
At September 30, 2004, working capital of $1,049.5 million increased by $122.8 million over the working capital at December 31, 2003. The ratio of current assets to current liabilities was 2.6 at September 30, 2004, versus 2.3 at December 31, 2003.
Net cash flows provided by operating activities of $305.3 million and $233.1 million for the nine months ended September 30, 2004 and 2003, respectively, continued to serve as the primary source of funding operations including growth initiatives and capital expenditures, as well as the payment of long-term debt, the repurchase of shares and the payment of cash dividends. Net earnings of $196.9 million, up $31.6 million over the first nine months of 2003, and continued improvement in working capital management, were the primary drivers of the increase in cash flow from operations. Changes in operating assets and liabilities – net of business acquisition, resulted in a net source of cash of $8.8 million for the first nine months of 2004. Trade accounts payable increased due to higher inventory purchases in September compared to the 2003 year end. Increases in variable compensation were the principal driver of the increase in other current liabilities. Accounts receivable increased due to higher September sales. Current income taxes payable decreased due to the reduction in the effective tax rate, tax benefits associated with increased stock option exercise activity, and the timing and amount of estimated tax payments.
Net cash used in investing activities was $74.2 million and $89.5 million for the nine months ended September 30, 2004 and 2003, respectively. Grainger spent $66.1 million during the first nine months of 2004 on property, buildings and equipment, and $17.3 million on capitalized software, for a total of $83.4 million. In the comparable period of 2003, $57.6 million was expended for property, buildings and equipment and $5.9 million for capitalized software. Grainger also funded $36.7 million in the second quarter of 2003 to purchase Gempler’s, which is included as part of the Lab Safety segment. The results of Gempler’s operations have been included in the consolidated financial statements since the acquisition date of April 14, 2003. Also during the first nine months of 2003, Grainger used a total of $8.1 million for investments in or loans to unconsolidated entities.
Net cash used in financing activities was $240.0 million and $61.9 million for the nine months ended September 30, 2004 and 2003, respectively. During the third quarter, Grainger liquidated its cross-currency swap and paid off $140.8 million in long-term debt. Purchases of treasury stock were $75.5 million higher in the first nine months of 2004 as Grainger repurchased 1,884,000 shares, compared with 474,700 shares in the same period of 2003. As of September 30, 2004, approximately 7.2 million shares of common stock remained available under Grainger’s repurchase authorization. Dividends paid to shareholders were $53.2 million and $50.4 million for the first nine months of 2004 and 2003, respectively. Partially offsetting these cash outlays were proceeds from stock options exercised of $50.8 million and $13.9 million for the nine months ended September 30, 2004 and 2003, respectively.
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 provides 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. As a result of the liquidation of the cross-currency swap and related commercial paper, total debt as a percent of total capitalization was 0.5% at September 30, 2004, compared to 7.5% at December 31, 2003.
Commitments and Other Contractual Obligations
Grainger has contractual obligations for long-term debt, operating leases, purchase obligations and projected postretirement benefit obligations that were summarized in the table of contractual obligations in Grainger’s Annual Report on Form 10-K for the year ended December 31, 2003. Management is not aware of any material changes outside the ordinary course of business since December 31, 2003. The following are changes identified in commitments and other contractual obligations: (1) long-term debt payments totaling approximately $141 million were made in conjunction with the liquidation of the cross-currency swap, (2) additional future minimum rental commitments totaling approximately $12 million have been entered into and are due ratably over the next 2 – 10 years as a result of the market expansion project, (3) branch construction commitments for uncompleted additions to property, buildings and equipment of approximately $9million and (4) payments totaling approximately $10 million due periodically over the next 4 years for information technology commitments.
28
W.W. Grainger, Inc. and Subsidiaries
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
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 highly 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 description of Grainger’s critical accounting policies, see the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.
Forward-Looking Statements
This document contains forward-looking statements under the federal securities laws. The forward-looking statements relate to Grainger’s expected future financial results and business plans, strategies and objectives and are not historical facts. They are often identified by qualifiers such as: “believes,” “estimated,” “intends,” “projected,” “expected,” “assumptions,” “estimates,” “future,” “expects,” “reasonably likely” or similar expressions. There are risks and uncertainties the outcome of which could cause Grainger’s results to differ materially from what is projected.
Factors that may affect forward-looking statements include the following: higher product costs or other expenses; a major loss of customers; increased competitive pricing pressure on Grainger’s businesses; failure to develop or implement new technologies or other business strategies; the outcome of pending and future litigation and governmental proceedings; changes in laws and regulations; facilities disruptions or shutdowns; disruptions in transportation services; natural and other catastrophes; unanticipated weather conditions; and other difficulties in achieving 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 interest rate and currency rate fluctuations, global and other conflicts, job creation and employment levels, and other factors.
29
W.W. Grainger, Inc. and Subsidiaries
PART I — FINANCIAL INFORMATION
| Item 3. | | Quantitative and Qualitative Disclosures about Market Risk |
| | For a description of additional market risks of Grainger, 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, 2003. |
| Item 4. | | Controls and Procedures |
| | (a) | Evaluation of 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. |
| | (b) | Internal control over financial reporting |
| | | There were no changes in Grainger’s internal control over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, Grainger’s internal control over financial reporting. |
30
W.W. Grainger, Inc. and Subsidiaries
PART II — OTHER INFORMATION
Item 1. Legal Proceedings
On September 28, 2004, the U.S. Environmental Protection Agency (EPA) filed an administrative complaint against Grainger seeking a civil penalty of $0.4 million for alleged violations of federal clean-air law and regulations. The complaint alleges that Grainger sold a “non-essential” wheel chock product which contained and/or was manufactured with an ozone-depleting substance (ODS). The complaint also alleges that Grainger sold aerosol cleaning fluids containing an ODS without displaying proper notification where the products were sold. According to the complaint, Grainger sold the cleaning fluids to persons who did not provide proof that they were commercial purchasers and failed to verify that such persons were commercial purchasers. Grainger does not believe that the resolution of this matter will be material to Grainger’s results of operations or financial condition.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Issuer Purchases of Equity Securities
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 | | | | 179,600 | | $ | 53.42 | | | 179,600 | | | 7,926,200 shares | |
Aug. 1 — Aug. 31 | | | | 559,345 | | $ | 51.75 | | | 556,400 | | | 7,369,800 shares | |
Sept. 1 — Sept. 30 | | | | 199,980 | | $ | 53,20 | | | 172,100 | | | 7,197,700 shares | |
|
|
|
|
|
| Total | | | | 938,925 | | $ | 52.38 | | | 908,100 | | | 7,197,700 shares | |
| | (A) | | The total number of shares purchased includes Grainger’s withholding of 30,825 shares to satisfy tax withholding obligations in connection with the vesting of employee restricted stock awards. |
| | (B) | | Average price paid per share includes any commissions paid. Activity is reported on a settlement date basis. |
| | (C) | | Purchases were made pursuant to a share repurchase program approved by Grainger’s Board of Directors. As reported in Grainger’s Form 10-Q for the quarter ended September 30, 2002, which was filed on November 11, 2002, authority under the program was restored to 10 million shares on October 30, 2002. The program has no specified expiration date. No share repurchase plan or program expired, or was terminated, during the period covered by this report. |
Items 3, 4 and5 not applicable.
31
W.W. Grainger, Inc. and Subsidiaries
| | (a) | Exhibits (numbered in accordance with Item 601 of Regulation S-K) |
| | | (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 |
32
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 3, 2004 |
By: |
/s/ P. O. Loux
P. O. Loux, Senior Vice President,
Finance and Chief Financial Officer |
Date: November 3, 2004 |
By: |
/s/ J. E. Andringa
J. E. Andringa, Vice President
and Controller |
33
