固安捷 (GWW) 2017 Q2 法說會逐字稿

Greetings, and welcome to the W.W. Grainger's Second Quarter 2017 Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Ms. Laura Brown, Senior Vice President of Communications and Investor Relations. Thank you, Ms. Brown. You may begin.

Thank you very much. Good morning, everyone, and welcome to Grainger's Q2 Quarterly Earnings

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(inaudible) again.

Good morning. This is Laura Brown, and welcome to Grainger's Q2 Quarterly Earnings Call. With me are DG MacPherson, CEO; and Ron Jadin, Senior Vice President and CFO.

As a reminder, some of our comments today may be forward looking based on our current view of future events. Actual results may differ materially as a result of various risks and uncertainties, including those detailed in our SEC filings. Reconciliations of any non-GAAP financial measures mentioned on today's call with their corresponding GAAP measures are at the end of this slide presentation and in our Q2 press release, which are available on our Investor Relations website.

DG will begin by making some opening comments regarding the performance of the company with an update on our pricing actions in the U.S. and expense management. After that, we will open the call for questions. DG, to you.

Thanks, Laura. So this quarter was about staying focused on creating value for customers while executing our pricing initiatives in the U.S. and improving the economics of the portfolio.

Before I go into detail on these activities, I'll discuss overall company results. We'll start with our reported results on page -- on Slide 4, which were significantly impacted by restructuring.

We began winding down the Colombia business in the quarter, which resulted in restructuring charges of $42 million. This business has struggled with sustaining profitability, and we are moving quickly to ensure we have businesses with competitive advantage and strong returns in the portfolio.

In the quarter, we also took steps to transform our Canadian business. We announced the closure of 59 branches and eliminated poorly performing assets, resulting in $20 million in restructuring for the quarter. I'll discuss Canada in more detail in a few minutes.

This morning's call will focus on adjusted results, which exclude items outlined on Page 2 of our press release.

So turning to our adjusted results. Our adjusted results were in line with expectations. Total company sales were up 2%. Volume for the company was up a healthy 7%, as many end markets strengthened and our pricing actions started to take hold. Price was down 3% as expected and consistent with the first quarter.

Gross profit declined 110 basis points, in line with expectations that we had discussed in April. And we continue to get operating expense leverage on higher volume as operating expense as a percentage of COGS was 50 basis points better than last year.

Let me start with our other businesses. For our other businesses, which include our online model and our international businesses, sales were up 11%. That included a 3% headwind from currency, largely due to the British pound. The online businesses, which include Zoro in the U.S. and MonotaRO in Japan, continued to deliver strong sales growth of 23% and expanded operating margins 50 basis points in the quarter.

The other businesses operating margin decline was largely driven by lower-than-expected performance in the U.K. due to economic conditions and the devaluation of the pound related to Brexit. We also completed the supply chain initiatives in Cromwell, which enabled us to improve service and the cost structure of that business going forward, but those changes impacted H1 results in Cromwell.

Mexico, Fabory and China make up the bulk of the rest of the international portfolio, and all of those showed nice growth during the quarter.

In Canada, we saw sales decline 3%, but sales were up 2% in local currency. We see trends improving in Canada, and we continue to manage expenses resulting in improved performance and a smaller loss than last year. As I've previously mentioned, we are closing 59 of 144 branches in Canada. To be clear, we are in the midst of a substantial transformation in the business. This business has scale and should be quite profitable. We are still on track to exit 2017 in a breakeven run rate. We will discuss our longer-term aspirations for the business as we move through the balance of the year.

Turning to the U.S. The U.S. business performance in the quarter was heavily influenced by our pricing actions. Sales were up 1 per 7 -- 1%, which was driven by -- which was a result of strong volume growth of 5% and price deflation of 4%. For those of you who look at the EPG documents, you'll notice that for the large customers, our volume went down slightly. That was all driven by government performance, which slowed in June and affected our results. The slowdown was really driven by government spending delays in local and state budgets and in federal civilian funding. Other than that, we saw continued good trends in terms of volume.

Operating expenses in the U.S. were up 2%, again demonstrating leverage on volume growth of 5%. Operating margin declined 160 basis points driven by the gross profit impact of our pricing actions.

Other operating metrics around service. Competitive position continued to be strong in the U.S. The U.S. team is focused on executing the price changes and selling the value that we provide to customers through our on-site services, advantage fulfillments and focus on saving customers' time and money.

So I wanted to take a little closer look at the volume response to our pricing actions in the quarter. I would point out a few things. First, we are seeing positive signs where we want to see positive signs, most notably reversing trends with midsized customer volume and large customer spot buy volume. This is critical to moving from an unfavorable customer mix to a favorable mix over time.

Second, we are hearing very positive comments from all customer groups about the changes we are making. Customers recognize that we still have a premium price, but that we will be more competitive. That makes sense to customers given the value that we provide.

Finally, these results are off of small volumes in some cases, but our margin of volumes give us a lot of confidence in the path we're on. We continue to get more comfortable with the fact that these changes are working.

Our midsized customer volume continued to accelerate throughout the quarter. Now about 50% of our midsized customer volume is on more competitive pricing, and the midsized customer volume was positive for the quarter for the first time in more than 5 years.

With large customers, we've seen more volume coming through without discounts. These prices are lower than before the changes, but this volume is important to support the profitability of the business going forward. We are continuing to renegotiate our large customer contracts, and we are ready to go for August 1. The vast majority of contracts will be renegotiated by August 1, and the remainder will fall on normal renewal cycles.

As a reminder, the actions on August 1 will result in all prices for all customers being more competitive. This will speed up customer retention efforts, accelerate the acquisition of new customers as we accelerate marketing spend and simplify our pricing to make it much easier for customers to understand. These actions are critical to achieving our 2019 operating margin objectives.

Turning to expenses. A key component to achieving our 2019 goals is expense management. As a reminder, in the second quarter, we announced that we would take out $100 million to $125 million of costs by 2019. $80 million to $95 million of that net of marketing investment will come out of the U.S. business and corporate. We've already identified approximately 75% of the actions, and much of that work is underway. We will share more information as we announce actions internally.

In Canada, we announced $20 million to $30 million of cost takeout, largely driven by the closure of the 59 branches that I mentioned earlier.

Taking a closer look at the U.S. from 2017 to 2019, we're assuming annual volume growth of 6% to 8%, resulting in incremental volume variable expense of approximately $60 million to $90 million. We're expecting inflationary expenses of approximately 80 to 90 -- $80 million to $85 million, which is about 2% of the base annually. And that's going to be partially offset by cost takeout of $80 million to $95 million net of the marketing investment. These actions result in significant operating expense leverage as we continue to focus on improving the customer experience and driving productivity and profitable growth.

Given what we've seen so far with the pricing actions and the impact on gross profit, these expense reductions result in operating earnings aligned with the 2019 objectives we discussed last November and in April.

Turning to guidance. We are reiterating our 2017 adjusted guidance issued in April. Q2 performance was as expected, and we anticipate continued positive response to our pricing actions in the second half of the year.

Looking at our 2019 targets. Our long-term operating margin guidance remains unchanged from our November 2016 Analyst Meeting.

In the U.S., we are confident in our ability to gain share profitably. We provide exceptional service to our customers. With our pricing actions and marketing activities, we will gain share at a faster pace. And we will continue to take costs out of the business while improving the customer experience.

In Canada, we are on track to exit 2017 at a breakeven run rate. Our long-term guidance for Canada at 2% to 4% is not good enough. We know that. We're working towards returning to double-digit operating margin on a faster path.

In other businesses, we continue to be encouraged by the growth and profit improvement of our online businesses and our international portfolio.

So before we take questions, in closing, we performed as expected in the quarter. We're seeing growth from the pricing actions in the places that will help us grow profitably in the future, most notably midsized customers and large customers spot buy. We're focused on simplifying our portfolio and making sure we have profitable growth as evidenced by the wind-down of our Colombian business. Our actions in Canada are intended to speed the path to double-digit profitability for the business, and we will provide frequent updates for you along the way. And we continue to believe that we are well positioned to improve the customer experience with more relevant pricing, superior service and an unmatched digital experience.

Today, we also announce that Ron is retiring at the end of the year. He will stick around and close out the financials for 2017, and we have started a search for his replacement. I want to thank Ron for his many contributions to Grainger in the past 20 years. We greatly appreciate all that he's done for Grainger. Thanks, Ron.

Thanks, DG.

So now I'll open it up for questions.

(Operator Instructions) Our first question comes from the line of David Manthey with Robert W. Baird.

First off, have you been able to isolate the outgrow from pricing efforts versus the growth that would be driven by an improving market? And whether that's looking at your growth versus comps or some other benchmark, how do you know that the growth you're seeing right now is due to the pricing actions and not just the backdrop getting better?

It's a great question. Thanks. Let me just start by saying that we think the market has grown this year, and we have seen strengthening in many segments. And so part of the growth was certainly -- part of the volume growth was certainly driven by strengthening to the market -- of the marketplace. When we look at the pricing actions, we see growth that is significantly higher than we've seen in the past in areas that are directly affected by pricing, and that's what gets us comfortable, particularly in midsized customers where we were double-digit negative last year, and now we're positive; large local customers that are not on contracts, which have turned positive and have been negative for a long time; and then just the spot buy with manufacturing commercial customers, which has turned positive as well. And so we see very strong growth in those areas, and that gives us confidence that what we're doing is working. And we've estimated the market to be drawing a couple of percent this year, and with volume of 5% in the U.S., certainly, we feel like we're gaining volume share. And most of that is a probably a reaction to our pricing at this point.

Okay. And then the follow-up would be as it relates to the progression, does the lack of momentum into June concern you at all given the backdrop and sort of what the competitors have been reporting? And I know you mentioned government, but anything else we should know about there?

No. That is really all government. In fact, government's 100% of the slowdown. We saw state and local government holding funds. We saw federal government holding funds in many cases. There are rumors that, that is easing up, but we have to wait and see if that plays out. So it has been all government during the quarter.

All right, DG. Ron, congratulations.

Thanks, Dave.

Our next question comes from the line of Ryan Merkel with William Blair.

So my first question is have you seen margins come under pressure for the who cares items like lights and batteries and cleaning supplies? And I ask this because investors are concerned that you know that you're going to see margin pressure on these items, and I just wonder if there's any evidence of it yet.

No. I guess, the short answer to that, Ryan, is not really. I mean, I think the industry is seeing pressure on margins across the board the last few years. And certainly, product and price transparency has increased as more customers Google items. I have actually 2 customers yesterday. We were talking about our price changes, and their response was, "That's fantastic because we don't feel like we need to be negotiating every item with you." And if you're in the ballpark, you already get the business given the service that you provide. And so really, we're seeing very strong response at very strong margins where we're getting the new price programs in place. So there hasn't been a real change in the competitive environment necessarily on those items where we're competitive.

Okay. And then for my follow-up question just on gross margin and pricing for the third quarter just to calibrate everyone, how much will U.S. prices be down in the third quarter? I was thinking down 5%, but I wanted to check. And then sequentially, maybe just help us, how much will gross margins be down sequentially into the third quarter?

So let me handle pricing first, and then maybe I'll turn it over to Ron to handle gross profit. So we would expect July to be similar to what we've seen thus far this year because there's no change in July. For the rest of the year, we would expect to be price down -- price to be down roughly 6%, so we would expect kind of 5% to 6% in the quarter on price. And you asked GP as well, Ryan, is that right?

Yes, just sequentially, just to help us. I assume it will be down. I just was thinking, just trying to help calibrate as how much.

Yes, I would say somewhere in the 100 basis points, probably, range, 100 to 130 sequentially.

Our next question comes from the line of Adam Uhlman with Cleveland Research.

I was wondering, DG, could you spend a little bit more time about what you're hearing in your large customer price negotiations that you've gone through the spot buy? Sales declines have gotten smaller, but they're still down year-over-year. So maybe you could just give us a little bit more color about how those are going, how many contracts are you retaining versus losing, that'd be helpful.

We -- so we really haven't lost any contracts that are meaningful through the negotiations. The negotiations have gone exceptionally well. I would say that we still have to date a very small portion of those contracts on the new pricing because most of that flips in the next month. So what you're seeing was spot buy is encouraging, but it's off a relatively small base still, and we would expect to see better results as time moves on. So -- but so far, we haven't had -- the conversations have gone well. Customers understand what's going on, what's going on in the marketplace. They really value the service that we provide, the services we provide, in many cases, and so the conversations have gone very, very well. And we're going to create more value for customers and ourselves through this process.

Okay. Got you. And then could you talk to the branch closings in Canada? How should we think about the revenue impact from that here in the near term?

Yes. So there will be some revenue impact, obviously, when we close branches. Typically, we see revenue impact in the 20%, roughly, range. Many of these branches -- so to give you a sense, in the U.S., we have 250 branches. In Canada, we have 144 and the volumes at 10%. So we are over-stored in Canada right now, and so we are closing branches that are unprofitable. There'll be some revenue impact, but it's going to be positive OE impact. And we've taken a very close look at where we want branches to be and where there's foot traffic where we can use those branches to offer service to customers that they will stay open, and we'll continue to provide, actually, better service to customers as product ships directly to customers and still provide services at the customer's place of business. So some revenue loss. Certainly, we are really focused on getting the business reset to a place where it can grow profitably. That's our focus right now.

Our next question comes from Robert McCarthy with Stifel.

So first question, just in terms of these trends you've been seeing, how do you think about just modeling for competitive response? I mean, obviously, a lot of times, you're dealing with a local or you're losing out to a local mom-and-pop or a local competitor on pricing. And obviously, lowering your price is going to help your volume. But how you think about an environment maybe if, obviously, not across the board, but...

Rob?

Yes?

We are having trouble hearing you. Sorry. Can you -- I'm not sure why.

Okay. Can you hear me now?

You're just breaking up.

You're just breaking up. I'm not sure. But okay, let's try again. I'm sorry.

Can you hear me now?

Yes.

Yes. Okay. Sorry about that. So the question very simply is how do you take into account competitive response in terms of your modeling for the back half of '17?

(inaudible) to our model.

Yes. And so I think the question is how do you take a better response to the model? I would say we're in an industry in the U.S. where the market is roughly $125 billion, and competitors compete in very, very different ways. I was at a customer in Milwaukee yesterday. And we were there, and a lot of our competitors were there serving different volume in different ways. And we have not seen direct response to the changes yet. It's not obvious given that some compete as specialists, some compete online, some don't compete online. It's not obvious how competitors will respond, and we feel like when we get within range of the prices that we're going to be very strong in terms of our growth. For the mom-and-pops, it's not obvious that there's a lot of room to respond really in terms of profit margins as well. So we'll watch that closely. We're watching it closely, and we will see what happens. But we haven't seen much response yet.

Okay. And then, Ron, congratulations on your career at Grainger. I guess, the question I have, in terms of launching for a new CFO search, it sounds like it's external. Could you just comment on what you're looking for and why there's no internal candidates being vetted?

Our business has become more complex, and we are -- have looked at sort of the spec we want for a CFO, and we feel like we should cast a wide net. So we're going to look externally and find somebody who can handle the complexity, the regulatory environment. Things have changed pretty substantially. And so we feel like that's the right thing to do, to look for the best candidate, and we will find the best candidate we can find anywhere.

Our next question comes from Andrew Buscaglia with Crédit Suisse.

Can you update us on your free cash flow guidance? I don't -- I didn't see an update there. I would think that it would have to come down relative to the restructuring charges you're taking.

I'll take this one. This is Ron. Our free cash flow continues to be strong, and it is kind of counter intuitive, I suppose. There's -- a lot of the restructuring that we're doing that probably 80% of it is noncash. So Colombia is a great example of that. So that doesn't really affect our cash flow. And so while operationally, there's some pressure because of performance, there's also a fair amount of cash flow we're generating through the sale of the branches that we closed over the last 2 years. So we expect free cash flow to continue to be strong, and it's up 10% as we speak.

Okay. So no real change then, I guess?

No. To give you a sense, though, the Colombia is a $42 million charge, and over $30 million of it is actually noncash. So that's -- it's not as big of a cash event as it is an earnings event.

Okay. Okay. And then just as it relates to the whole industry, I know there's definitely some skepticism in terms of where your pricing is relative to your competition. Can you give us, I don't know, some details or some confidence in that you're not -- you're still not going to be the lowest pricer in the industry? I don't know what it takes. It doesn't seem to me -- the market doesn't seem to be believing that, that's the case. But at what point does the -- do the price cuts stop, I guess, is what we're trying to gain confidence in?

So I can tell you, we're looking at the competitive environment very closely. We are not setting our web prices to be near the bottom on the stat. One thing I would say is we actually spent a little bit of marketing money for the quarter on customer acquisition. At those -- for items that we already changed on web prices and we had a very good response on a small volume. And so I think we've shown and proved to ourselves that we can acquire customers at a price that is not low. It's competitive, but it's not low. And so we don't feel like we're going to have to -- we know we're not going to have to be the lowest price, and we feel like we're positioning the price towards (inaudible)

Our next question comes from Matt Duncan with Stephens Inc.

This is Will Steinwart, on the call for Matt. On the relative success you're getting with the medium customer volume response versus the large customer, was the 1-point sequential volume pickup with the large group in line with your expectations for the quarter as we've seen the backdrop improve throughout the last 3 months and the year overall?

Yes, it was in line with our expectations. So keep in mind that large customers, most of their prices have always been competitive, and so the price changes will have less of an impact initially with large customers as they will with midsize. And so we would expect shifts in midsize to be much bigger than they are with large customers, and so it was right at our expectations for the quarter.

Our next question comes from the line of Chris Belfiore with UBS.

So guys, I just wanted to kind of go back to some of the earlier comments on -- in terms of the trends in the quarter. But just kind of looking in the back of the slide, you've kind of put the sales by end market. I mean -- and I understand like you're saying that government kind of fell off, but it says it was flat for the quarter. In some of the other pieces that are similar size were even lower. So I'm just kind of curious like can you -- is there -- can you kind of provide some cadence on like how government -- like what government actually did from month-to-month? And then how light -- how something like light manufacturing -- it sounds like it got better because you're saying that government was kind of the most -- the biggest laggard in the quarter. But it was still down for the -- the light manufacturing was still down for the quarter.

Yes. So the back half of the quarter, the government was down and everything else, the trends stayed stable effectively, is the way to think about. I think that's your question is we saw a significant year-over-year down government as state, local and federal, in some cases, health funding, but everything else has kind of continued on similar trends.

I think government was up low double digit in the first half of the quarter, I believe. So as the...

Yes. It was the big change...

Second half.

Government started the quarter very strongly and ended very, very slowly. And these are all -- keep in mind, these are all very large contracts that we have with the government. So it's completely independent of our pricing action and really what they chose to spend or not spend.

Okay. And then just on the marketing that you guys will be able to do more thoroughly once you -- all the SKUs are kind of on a web pricing in the second half of the year. Just a lot of the sales are going through eCommerce, so I'm just kind of curious like if there are some kind of examples of like kind of what Grainger -- the kind of marketing kind of Grainger is like looking to do in terms of the stuff like click-through rate, in terms of like searches by customers and addressing kind of like that kind of part of the business?

Yes. So we have a lot of examples of doing this very well, particularly with the online model with MonotaRO and Zoro. So a lot of this is marketing spent online, whether it's paid search or product listing ads. The dynamic we've had in the U.S. for a long time is that if we had customers click through as we pay -- use paid search advertising, they would click through a price that was -- where they'd see a price, a visible price that was much higher than the competition. So the difference now is when they click through, they'll see something that is reasonable, and that marketing will have a much higher return than it's had historically. We haven't had great returns in the U.S. but particularly on new customer acquisition with marketing where we have with MonotaRO, for example. And so as we think about this, we're going to spend marketing spend to acquire customers and then to acquire contacts within existing customers. And the return on that should be much better than we've seen in the past because of our pricing.

And as a result, we'll spend significantly more than we have in the past on that area.

Yes. It makes more sense to spend more. The return should be much better.

Our next question comes from Patrick Baumann with JPMorgan.

Just a question on volume. Just curious what your volume expectations are for the U.S. segment in the back half of the year. What kind of pick-up you have embedded in the guidance? I'm getting to kind of high single digits versus the 5% you did in the second quarter and would look like maybe 4% in June. Just curious if that's in the range. And then you mentioned July. You're seeing some of the government issues loosen up, and just curious how July to date is trending on volume for U.S. segment.

Yes. In the back half of the year, we're expecting 6% to 8% of volume growth, and so a fairly strong volume growth based on the price changes and some marketing ads. I think the government is probably a wildcard still in terms of what happens. We've heard rumors of things easing up, but we will need to see it. So we'll see what happens with the government.

And in July, how are things trending?

We are not talking about months at this point.

Okay. And second question would be just any update on the 2018 plus kind of margin progression for both gross and operating margins. Just a lot moving around as we exit this year with the price downs overlapping into next year and just trying to get a feel for the path to the 12% to 13% you still expect for 2019.

Yes. We are very focused on executing the price -- the pricing changes effectively on improving our cost structure. We will provide 2018 guidance at the Analyst Day in November.

Our next question comes from Deane Dray with RBC Capital Markets.

My congrats to Ron also. My question is a bit to address your longer-term growth expectations in light of the new pricing. So if this quarter, we learned 4% down price drives 5% in volume, how do you hit a 6% to 8% revenue growth target out in 2018, 2019 without the benefit of further discounting? So is it a flat pricing environment? How do you get flat pricing environment and -- to drive 6% to 8% volume growth?

Well, when your prices are -- your visible prices are much higher than the competition and you do things like digital marketing, you don't get the returns that you get. So this will enable us to spend on marketing dollars for midsized customers for customer acquisition like we haven't been able to do before. I would also say that when you sit down and talk with our customers, customers, as recently as yesterday, they are very excited if we are reasonably priced to give us a whole bunch of more volume. And so we're pretty excited about, they're pretty excited about the prospect of not having to come to us for negotiations for SKU level decisions. So we feel like that's going to change the game pretty substantially. Thus far, we've only changed partial prices, and so what you've seen so far is a partial response to the pricing changes, and that will change starting in August.

What portion of your SKUs have had the reprice to web pricing? Can you size it by -- either by customer base or by percent of SKUs?

So percent of SKUs online, it's been 400-some thousands, so it's been 25% to 35% have been repriced -- were repriced at the beginning of the year, and that will be all of them soon. And the percentage of volume, I think that the most important thing to recognize, it was large customer volume, large customer pricing was already competitive, so the impact has been fairly small thus far on large customers. We renegotiated a bunch of contracts in the last 60 days that will change that dynamic. But so far, large customer price has really haven't been all that different this year than they've been in the past, in many cases.

Got it. And then just last question for me is on the buyback program. What would cause you to put the program on hold? And just the thought here is do you see risk in continuing to lever up the balance sheet to fund buybacks when the business model is in such a state of change right now?

Yes, Deane, that's a great question. I guess, I'd go back to the strength of our cash flow generation. Through cycles, it's very strong. As you know, we reinvest about 1/3 of our cash back in the business, and the other 2/3 get back to shareholders, so there's a lot of excess cash. So that's not a real concern of ours at all. We buy through the cycles. We'll continue to buy back shares as we've given a guidance in the past. We'll continue on that same path.

Our next question comes from the line of Chris Dankert with Longbow Research.

I guess, just first off, you mentioned Cromwell was having some issues just given the Brexit concerns and rolling out the new initiatives. I guess, any update on what the growth rate looked like there in the quarter? And just kind of where profitability is at? I think last we knew, it was near breakeven. Is that still the case?

This is for which business? Are you trying to refer to Cromwell?

Cromwell, yes.

Yes. So we think we gained a little bit of share in the first half of the year. The market down slightly. We're up slightly. So that's our volume growth -- our sales growth in Cromwell. The business is right around breakeven now from an earnings perspective. Keep in mind that, that includes fairly significant investments we've made in the supply chain over the last 9 months to go more to a direct-to-customer model. And we feel like that business will bounce back profitability-wise fairly quickly and positive next year. So we aren't concerned about the long-term health of the business. We -- but it has been a market challenge. And the other thing that's been a challenge is the currency change with the British pound has caused us to chase some price increases on -- and the GP line has suffered.

Got it. And then just any update on the status of the ERP transition in Canada? I mean, has that been more of a hindrance on trying to get those branches realigned? Or is that actually kind of helping you identify opportunity at this point?

I would say for about a year, it was a big hindrance to doing anything because we had a bunch of service problems in the business. We are now stable. Service is good in the business, and we're able to take a fresh look and really get after improving the fundamental operations and profitability of the business. It actually helps us now. We have more visibility into where there are -- where there's profit and profitable portions of the business; where there isn't. So right now, it's working well and stable.

Our next question comes from Nigel Coe with Morgan Stanley.

Just going back to the government swing between the first portion of 2Q and the latter portion. Understanding that there are some budget pressures in certain states, but any sense on what would cause such a big swing? And also, just to clarify, does that impact the spot purchases because my impression always was that the government sector had less spot purchases?

I don't think in this case it had much impact on spot purchases in the aggregate. So we have a very clear view to the pipeline and many of our government customers. And so the pipeline has looked pretty good, but the money didn't release at the end of the second quarter. And that was -- you can tie it to very specific state and local governments and very specific federal agencies that just did not release any money. So in this case, it's pretty easy to see what's going on. And assuming that you release the money, it'll come back. But it's very easy to see what's going on from a pipeline perspective.

Okay. Just to clarify that. The government sector did impact the slowdown in spot purchases between 2Q and the first half of 2Q?

It would have been a little bit of a hindrance for that, sure. Yes. Absolutely.

Okay. Okay. Understood. And maybe a follow-on maybe for Ron, the accounts receivable seems quite high in relation to historical norms in 2Q. Anything driving that higher AR bounce?

No, nothing unusual. Volume's up a fair amount. It's just timing of collections and when the year-end closes off versus kind of the first half of the year, just had a -- it's really just timing. There's nothing unusual with DSO, the underlying DSO. That's been -- that's remained stable.

Our next question comes from Christopher Glynn with Oppenheimer.

Ron, congrats on your coming transition. I had a question on the gross margin performance relative to the magnitude of the price resets is pretty impressive. I'm wondering, was there any reallocation of how costs get put into COGS versus G&A along the way?

No. No. We see some COGS deflation, but there's no reallocation. That's just the actual performance.

Our next question comes from Scott Graham with BMO Capital Markets.

Congratulations, Ron. My first question is simply, if we can go to Chart 10. I'm trying to understand what's sort of on the other side of the equal sign here. So we've got incremental expenses 2017 to '19 listed. The cost takeout obviously goes the other way. Are you expecting mix to be the entire gap filler between what's written here and the plus 100 basis points of operating margin expectation in '19?

No. There's a fair amount of volume leverage as well.

Yes. So what should happen is in '19, our price should stabilize until that volume growth in '19 actually is positive for GP dollars. And then this -- when you put this -- the expense picture below it, you get to the earnings guidance we've had before.

Okay. So what we're saying here is that the WMA percent of sales should start to more meaningfully come down than we saw in this quarter?

Yes.

Yes. Percent of sales should absolutely, yes. And I just wanted to make a comment earlier about the sequential GP rate. There is -- there's nothing unusual in the quarter GP rate. But sequentially, to the first quarter, there is an anomaly in the first quarter, and I'll just suggest you go back to the press release from that because it's there every year. And it's how our national sales meeting is accounted for, and there's some costs that are moved between expenses and GP. So that does create a sequential difference from the first quarter to the second. And -- but it's just accounting-related. It's not operational.

My follow-up was simply, is it at all possible that the U.S. June slowdown was maybe a function of customers may be sitting on their hands a little bit waiting for more price actions?

No, we don't believe we've seen that behavior. And talking to customers, that doesn't appear to be a behavior. Customers typically just buy. I mean, they're not stockpiling inventory in our business, and they buy when they need it. So given that it's kind of $300 at a time, we don't expect to see much of that.

Our next question comes from the line of Hamzah Mazari with Macquarrie Capital.

Just first question, could you maybe give us some color as to what sort of a service premium you think on pricing is justified both your repricing actions? Is it 10%? 15%? And then what are customers paying for? Is it product availability? It seems like technical support maybe a little bit in your portfolio, but just help us with some of that.

Yes. So Hamzah, I won't talk about a specific percentage. I don't -- not sure that's appropriate to talk about publicly. But -- so let me tell you about the customer conversations we had. Yesterday, I was talking with a customer, and their perspective was they get things, the product availability, a wide range of products that comes quickly. But their perspective was also that we provide them with a whole lot of support around safety service, around inventory management services. We have embedded ourselves to help them manage their inventory. We understand how their business runs. We help them. I talked to somebody who places the orders. We talked to about 6 people in the organization, and his view was, "Your orders are the easiest to place, they're easiest to get resolved because you understand how our business operates and you link with our processes very, very well." So there's a whole range of the way we operate, which will allow us to command a premium in the market as long as that premium isn't so visible and so large.

And just to follow on, could you maybe update us on the current structure of the sales force? How much is inside sales now? And is there any opportunity on sales force efficiency remaining in -- at the company?

So we have -- we're mostly outside sellers calling on large complex customers. We have an inside sales team calling on midsized customers, but most of the numbers are in outside sales. We -- there's a couple of things going on. One is we think pricing will allow those sellers to grow revenue, have better conversations and more conversations without having to talk about price as much, and we feel like the revenue per seller should increase. We should get more penetration at those accounts. So we look at revenue per seller pretty closely. Our expectation is we will get significant improvements based on the pricing actions, based on the tools we're providing sellers, based on a number of factors, and we are confident we will start to get more productivity out of the sales organization.

Our next question comes from Robert Barry with Susquehanna Financial Group.

Great. Lots of ground covered. So we're halfway through the year. It sounds like the quarter was as expected. Should we be thinking the midpoint of the range is where you're tracking at this point? Still a pretty wide range out there.

Based on the quarter, that would be a reasonable assumption. I would say that well, the quarter was as expected, given the changes going on in the business, given what's going to happen August 1, we're very confident in the path, but there's no reason to alter our guidance at this point. We feel like we're on the right path.

Kind of tracking to the middle. Okay, and then just I guess a question on price cost. What are you seeing in terms of COGS inflation on kind of a like-for-like product basis? It seems like we're increasingly in a inflationary environment. And then what's happening to pricing outside of spot buys and medium? Is there any place you think outside of those areas that you're able to raise price? What's the thought there?

Yes. So we are -- our COGS this year are likely going to be on the 0.5%, and we are not seeing huge inflationary pressure moving through. There's a little bit, but not much. If in fact, we got inflation, we would be able to get price in a number of places in a number of customers. It looks we'll have to wait to see whether that happens, but we're not -- we have not seen any inflation in our COGS at this point.

Okay. It seems like a little bit of an outlier because a lot of the others have been talking about starting to see inflation and having some challenges getting priced. But I mean, any reason why you're not seeing inflation or actually seeing deflation?

Well, I think we have a -- we have worked very hard to put in processes to manage COGS. We work -- we've put in new processes to really understand the competitive environment, understand what product should cost and build that into our work with suppliers. I think we've done a nice job of managing it.

Our next question comes from Joe Ritchie with Goldman Sachs.

And congratulations, Ron, as well. My first question, I guess, just going back to Nigel's question earlier on spot, it sounds like the government business didn't really impact the spot performance as the quarter went on. So what specifically led to kind of weaker performance at spot as we progressed through 2Q?

No, government business did impact it, and we saw for large customers spot buy, x government was pretty stable throughout the quarter.

Got it. Maybe thinking about spot longer term, how -- DG, how are you thinking about the, like, mix of business moving forward? Did spot remain 30% of your large customer base? Or is -- does that number just trend down over time?

We actually hope it trends up. I think when we're talking to customers now about the new pricing structure, both us and they would like to get out of this situation where we have to negotiate every item. And so our hope is as we grow midsized customers, as we grow long-contract customers, as we get the new contracts and with-contract customers that actually spot buy will grow, and we feel like we can make that happen.

Got it. And maybe one quick follow-up here. Just thinking about the guidance for the year, you guys have alluded to the price down sort of coming in the second half to, call it, 5 to 6 points price downs. How are we -- how are you guys thinking about the gross margin year-over-year change in the second half? I think the guidance for the full year is still down 160. What does that imply for 2H in your guidance?

It's down just a little bit more significantly third and fourth quarter over the prior years than it is in the first half, so it's worsening, but we haven't given guidance on that per se. We've kind of stayed with the whole year. I think our total year guidance is still good. Just until obviously a little bit worse in the second half than the first half on a year-over-year comp.

Okay. And maybe even more specifically then, in terms of offsetting the pricing declines, like I know that you're thinking about 6% to 8% type volume growth. What other items should we be thinking about as potential offsets to the pricing?

Product mix. Product mix continues to be favorable for us. And what I mean by that is it's not offsetting GP rate, but it's at least mitigating some of it. And that's the growth we're seeing with the medium-sized customers in particular and the products they're buying that even though their price reduced, they're still at margins above the company average. And so that does provide a partial mix offset.

Our next question comes from Justin Bergner with Gabelli & Company.

On Cromwell, I'm trying to understand, looks like it was a pretty sizable operating profit hit year-on-year in terms of dollars. Could you -- is that going to disappear as we move into the second half of the year? Or is that a permanently sort of rebased margin for Cromwell?

Well, it's not a permanently rebased margin. A lot of that has to do with the currency and the currency shift having an impact on GP rate. And so we are working through pricing changes as a result of that. But when that happens, typically, we ride that, and so we have to make that up. We're also working on the plans to get back to where we need to be starting in 2018, so it's not a permanent change. It's just a pretty significant change given the currency translation.

And why did that mainly kick in the second quarter and not the first quarter on Cromwell?

I think it's the lag of the -- price lags, right?

Price lags, yes.

I mean, commodity inflation, we can often see, right? We have negotiations with suppliers. We can increase prices when we see true commodity inflation. But when a currency changes overnight, there's always a lag effect of us going back to customers and repricing.

Okay. And then just one last question. When we get to August and sort of the second round of pricing changes, I'm just -- would love some clarity as to what's going to sort of change for large customers versus what's going to differentially change for medium customers come August.

Well, for large customers, the biggest change will be more competitive prices in the items that they don't buy frequently. So they will have -- we will have renegotiated contracts. In many cases, they will be more competitive in the tail of their purchases. For midsized customers, we will have prices that will allow us to acquire customers that will be very, very new. So that will be very different than we've had historically. Now we talk about 50% of our volume at competitive prices for midsize customers. That's part of the story. We don't actually have business with most midsized customers in the U.S., so we have a big football field to go out and try to acquire customers now. We're going to go after that, so that will be very, very different.

And the change in the pricing book for large customers against what you described as fairly competitive pricing for more regular purchases, that's all taken effect for large customers by now, for the most part?

It will by August 1 for the most part. There are still some contracts that are having -- holding the same contracts because they have renewals coming up in the next year. But for the most part, it will have taken place.

And our final question comes from the line of John Inch with Deutsche Bank.

And Ron, I don't -- I forget if you mentioned this, but I know you guys typically have this customer-sponsored trade show in the first quarter. Did you get -- were the reimbursement benefits that helped gross profit kind of second quarter versus first quarter versus last year? Is it...

Yes. Yes, John, there was. And I was trying to -- I probably didn't say it well, but our national sales and service meeting in the first quarter is funded by suppliers. And so a lot of that expense gets moved up to COGS, and so that does create an anomaly for us between the first quarter and the second quarter for sequential GP rate. And I would just suggest you go back to how we explained it in the first quarter. I don't have that information with me, but it should be in our press release. And actually, it's in the first quarter and a little bit in the second quarter, actually, where we have to account for that but...

I guess my question, Ron, is was there any timing difference of the reimbursement year-over-year that benefited your GP in the second quarter versus the last year? And so in other words, last year, you got more reimbursement in the first quarter than this year you got in the second quarter.

Just a few million dollars, nothing material, plus year-over-year variance.

Okay. Could be a lot of questions around the growth. This is sort of a big-picture question. Ron and DG, how do you know that Zoro isn't actually cannibalizing purchasing at Grainger or sales at Grainger in some manner to kind of -- well, obviously, on an indirect basis. But is there any way to kind of prove or disprove that hypothesis?

Yes. So we do a lot of analysis on Zoro, and the vast majority of the Zoro volume comes from small businesses that Grainger have not had a relationship with. So most of the customer file, we have no business with at all at the Zoro customer file. There's a little bit of cannibalization, but it's very, very small. I would also say, when you visit large customers, you really don't hear Zoro come up at all. It is not a discussion point, so. We don't -- we know that cannibalization rate is very, very small.

Okay. And then just finally, you had mentioned that 80% of these charges, right, were noncash. Why is that? Like what's -- can you give me an example of what would be the nature of some noncash write-downs? And what would be the payback of the cash component of the $1.29 of charges or of the cash component of that?

So, and DG alluded to Colombia before, a big noncash item there is foreign exchange. So cumulative translation adjustment is on the balance sheet, and it has to get flushed through the P&L. That currency has weakened substantially in the last 5 years, and so that's a -- like $16 million by itself. That's a pretty big noncash item. So the thing that typically would be cash, would be severance, right, things like that. I would say a little bit of it is writing down some inventory, had branches that we're closing up in Canada. Most of the inventory we move, that becomes an opportunity to dispose of some of the very slow-moving items as opposed to handling it again and moving it to another branch. So it's some of that, some of that we sell. We actually generate cash on some of those, but we take some book accounting hits.

But sounds like this would probably benefit your free cash next year then, all else equal?

Yes. For the branches that we own, I mean, this all depends on the market, right, the real estate market. But in the U.S., certainly, it has helped us. Now just to be clear, from a P&L perspective, we have some gains, and we pulled that out, so that the gains and/or losses, but it's been gains, because gains are removed just like the restructuring costs are removed. So when we talk about year-over-year adjusted results, none of that is in there, right? So it's an apples-to-apples comparison. But it has helped us a little bit on cash flow the last couple of years and probably will next year as well.

Thank you. There are no further questions at this time. I would like to turn the call back over to DG MacPherson for closing remarks.

So thanks for joining us this morning. Just to reiterate, we performed as we expected during the quarter. I think the exciting points are that we're starting to see growth in places that are really important for our long-term profitability, most notably midsized customers and large customers spot buy. We are continuing to make the portfolio stronger, making sure that the businesses we have are profitable and have profitable growth. Our actions in Canada, we are taking an eye towards improving profitability much faster there and took some significant actions in the quarter. And we'll keep talking to you about what we're doing there. And we really believe that we are very well positioned with -- to improve the customer experience. The conversations we've had with customers around pricing have been fantastic. There's been no balking by customers. They're very happy with what -- the direction we're taking. They understand that we have great service. They understand that we have a strong digital experience. They understand that we have a strong on-site experience. We're going to continue to leverage those things to grow the business, and we're really excited about the path we're on.

So with that, thanks for joining us, and take care.

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.