固安捷 (GWW) 2017 Q4 法說會逐字稿

Greetings, and welcome to the Grainger Fourth Quarter 2017 Earnings Conference Call. (Operator Instructions) And as a reminder, this conference is being recorded.

I'd now like to turn the conference over to Laura Brown, Senior Vice President, Communications and Investor Relations. Thank you. Please go ahead.

Thank you. Good morning, everyone. Welcome to Grainger's Q4 Earnings Call. With me are DG MacPherson, Chairman and 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 the slide presentation and in our Q4 press release, which is available on our Investor Relations website.

DG will be covering the performance for the quarter as well as give an update on our 2018 guidance. After that, we'll open for questions. DG, to you.

Thanks, Laura. Good morning, and thank you for joining us today. We know it's a busy earnings days, and we appreciate you being on the call.

So 2017 was an important year for Grainger. We took action to become more relevant to our customers and to compete more aggressively in the market. We also saw the market grow for the first time since 2014.

In 2017, we announced a significant change to our pricing structure in the U.S. Pricing had been a barrier to our growth both with large and mid-sized customers. This was a very complex change that required a lot of work, a lot of collaboration and great execution to pull off. I'm extremely proud of our team members for executing the way that they have this year, and the results show clearly in the fourth quarter 2017 numbers. We saw our performance accelerate through the back half of the year, which is very encouraging.

We executed a pricing change while continuing to focus on making sure we create value for our customers.

In 2017, we also launched our new R&D website called Gamut with a new way to think about product search. Given the positive early customer feedback, we plan to combine the capabilities of Gamut with those of our industry-leading website, grainger.com, to create the most powerful industrial website in the market.

In Canada, we led the foundation for a complete business model reset, and that began in late 2017. We are improving our service to customers through more consistent direct-to-customer shipping. We are improving Canada's cost structure through branch reductions and the creation of North American centers of excellence. And we are improving our profitability to price increases and improve large customer solutions. We are now starting to see the benefits of that work, which I'll discuss later in the call.

Finally, in 2017, we announced a plan to take $150 million to $210 million of cost out of the business from 2018 and 2019. We continue to make strong progress on that plan.

The actions and execution in 2017 reflect the culture we are reenforcing at Grainger. Everything we do is focused on delivering value to our customers in the most efficient and effective way possible. We are entering 2018 with a solid foundation.

With that, let's take a look at our results for the year.

2017 reported results included adjustments resulting in a $112 million impact to operating earnings and $1.44 impact EPS. This morning's call will focus on adjusted results, which includes the items outlined in our press release.

Looking at our total company adjusted results, sales increased 3% versus the prior year and gross profit dollars were flat. Operating expenses increased 3%. Operating earnings were down 8%, and operating cash flow increased 3% for the year.

Turning to the quarter. Our adjusted results for the quarter were better than expectations. Total company sales in the quarter were up 7%. That was made up of volume of 11% that was partially offset by price, which is down 3%. We also had a 1% decline due to our specialty business divestiture in the U.S.

Gross profit dollars increased 4% as volume growth outpaced price deflation. Gross profit margin was better than expected due to U.S. performance and Canada price increases. We also realized expense leverage on higher volume. Operating expenses increased 4% on volume of 11%. All of that led to operating earnings growth of 4% in the quarter.

I'll start by covering our Other Business category first. Other Businesses include our online model and our international businesses. Sales were up 16%, which is almost entirely volume. Our online businesses, which include Zoro in the U.S. and MonotaRO in Japan, continue to drive strong growth and profitability.

Our international businesses performed in line with our expectations as a group and contributed to operating margin expansion in the quarter.

Turning to Canada. Sales were up 5% or flat in local currency. We introduced price increases in the second half of the quarter, and we're happy with the response. Price was up 4% for the quarter, volume was down 4% for the quarter. Volume was down due to price increases and branch closures in the quarter. Overall revenue was slightly better than our own expectations.

Operating expenses increased 2% in local currency versus the prior year as we made investments initiating the turnarounds in Canada. Operating margin was better than expected in the quarter due primarily to a higher gross profit rate as a result of the price increases and a benefit from inventory adjustments.

As you know, we are in the midst of a substantial transformation of the business in Canada. We are moving very quickly to reset the business. We're closing unproductive branches. We're leveraging the U.S. business more through North American centers of excellence. We're improving service by leveraging our distribution network in Canada and the U.S. We're improving our large customer contact performance.

I would say we're making strong progress on all of these initiatives. We remain committed to the plan we laid out in November for our 2018 for the business. We did get more benefit earlier than expected in the quarter.

Turning to the U.S. We continue to see strong volume response through our pricing actions, and we continue to see an improved demand environment. Sales were up 5%. This included volume growth of 11% and price deflation of 5%. The demand environment has been consistently strong the last few months.

Operating expenses in the U.S. were up 2%, showing leverage on 11% volume growth. Operating margin was better than expected in the quarter as expense leverage partially offset the decline in the GP rate.

Turning to more specifics in the U.S. We're continuing to see that our value proposition resonates with both large and mid-sized customers when we remove pricing as a barrier. U.S. large customer volume increased 8% versus the prior year and 300 basis points sequentially. We ended 2017 having renegotiated about 80% of our contract revenue. We will continue to work on the remaining contracts in 2018. As planned, the remaining contracts will be negotiated as renewals come up.

Large customers spot buy and large noncontract customers both had stronger volume growth than the average for large customers in the quarter. U.S. mid-sized customers continue to exceed our expectations. Mid-sized customer volume increased [26%] (corrected by company after the call) over the prior year and 800 basis points sequentially. We're seeing progress with our marketing efforts and progress against all mid-sized customer groups. We are further penetrating existing customers, we are reengaging lapse customers, and we are acquiring new customers. For the first time in a long time, we're seeing significant mid-sized volume growth at attractive margins.

Overall, we remain quite optimistic for the U.S. business heading into 2018.

I wanted to briefly remind you of our expectations for driving productivity in the business while improving the customer experience. As I mentioned earlier, we continue to get strong expense leverage in the quarter, driven by strong volume performance and our diligence in managing expenses. We continue to be focused on improving our cost structure and focusing on the things that matter the most.

Our targets for cost takeout have not changed. We continue to expect cost takeout and productivity of [$90 million] (corrected by company after the call) and $120 million in the U.S., $50 million to $70 million in Canada and $10 million to $20 million in the other areas of the business. Based on our performance in 2017 and our momentum, we are on track to achieve our productivity targets going forward.

Now, let's take a look at 2018 guidance. I'll talk about the midpoint of guidance on this slide. If you recall, we shared at the Analyst Day in November on the left side on the chart, from 2017 to 2018, at that point, we expected 5% sales growth, 5% operating earnings growth and 5% EPS growth.

As we discussed, our 2017 actual results exceed expectations. That, coupled with tax reform, has altered our outlook for 2018. We still expect sales growth of 5%, but now, we anticipate operating earnings growth of 2%. That's due to 2 things: The first is our decision to increase our digital investments with the portion of the excess cash that will result from a lower tax rate, and the second is our decision to maintain our expectations for Canada's 2018 operating margin despite better performance in the fourth quarter. Just too early to build in that benefit in 2018.

The bottom line is that we expect both higher sales and earnings dollars and a higher operating margin in 2018 than we'd suggested in November given the momentum that we're seeing. In addition, our EPS is now expected to grow 18% versus prior year.

In the appendix, you will find a slide that outlines the new revenue recognition accounting standards that require us to reclassify certain service costs from operating expense to cost of goods sold beginning in 2018. There is no impact to operating margin as a result of that change.

Taking a closer look. A little bit more detail on our operating margin and EPS guidance for 2018 compared to what we showed in November. If you look at our 2017 performance, our outperformance in the second half of Q4 resulted in a 0.4% benefit to operating margin and an almost $0.60 benefit to EPS. As I mentioned, we decided to maintain our expectations for Canada's operating margin despite our strong performance in the quarter. That results in an operating margin of 11% and an EPS of $11.70.

From there, we factored other incremental items that will occur in 2018. We are expecting a lower tax benefit from our clean energy investments in 2018 than what was originally anticipated. That will be roughly $0.10 negative impact. That will raise our base tax rate from 35% to 36%. So our corporate tax rate on that base is expected to go from 36% to 24.5% at the midpoint as a result of the new U.S. tax legislation. That results in a $2.15 benefit to EPS. We also, as I mentioned, plan to increase our investments in digital. We will accelerate actions to combine Gamut capabilities with grainger.com and accelerate our progress with our digital offering overall. That has a negative 0.2% impact on operating margin and a negative $0.26 impact to EPS.

Finally, we expect to have a $0.06 EPS benefit from additional share repurchases.

At the end of all those adjustments, we expect 2018 operating margin to be 10.8% and earnings per share to be $13.55.

Given the changes to the tax rate, we're updating our cash flow projections for 2018. We now expect to generate $1.1 billion to $1.18 billion of operating cash flow. As I mentioned, we'll use some of that excess cash to make investments in our digital portfolio. The remainder will be used to purchase additional shares, which reflects our confidence in our strategy going forward.

So overall, to summarize, we're very pleased with our progress. We have executed our pricing changes in the U.S. and are seeing strong growth with gross margin rates at our expectations. We are moving fast in Canada and starting to see some early signs of progress.

Our online model continues to drive strong revenue growth and margin expansion. We are laser-focused on driving performance in our core business. We continue to get strong expense leverage across the business.

Our team members have demonstrated throughout this year their ability to create value for our customers even in the midst of what has been a very complicated pricing change. And while we still have the financial challenge of lapping our price changes in 2018, we are well-positioned to gain share and improve our economics going forward.

So with that, I will open it up to questions.

(Operator Instructions) Our first question comes from the line of Ryan Merkel with William Blair.

So first question, the 11% volume growth really stands out. You've been talking about 6% to 8%. So two-part question. First, do you view the upside as more a response to your price cuts versus the macro? And then secondly, are you just being conservative by not changing the sales guidance for 2018 at this early stage?

Right. So thanks, Ryan. I would answer those in succession. So when we look at the 11% growth in the U.S., certainly, a part of that is an improving demand environment. It's a meaningful part, but not the majority. The majority is our own pricing and marketing actions driving that. So certainly, there's some demand tailwinds, which are great, but a lot of this is just the changes we've made.

The second part of that is we're not going to change our projections at this time. We're still 4 months in, 5 months in understanding what's going on with the volume response. And so we're going to keep to our projections at this time.

Fair enough. But would you also say there's no reason, you see nothing out there that the 11% or something near that wouldn't be sustainable based on what you're seeing today?

What I would say is that the demand environment has been very consistent the last 3 months heading into this year, and so there's nothing to suggest things are changing.

Okay. And then just second question on gross margin, the outlook there down 70 basis points excluding the accounting. Is there any upside from improved price cost? Are you starting to see some inflation from your suppliers?

Yes. So yes, we are starting to see some inflation from suppliers and we expect to have some price costs. We've already built that into the projections. I think a lot of what happens with GP rate in the U.S. will be determined by the mix of growth that we get. If we continue to see the midsized customers and the large noncontract customers grow faster than the average, we may have some upside, but we're just going to wait and see.

Our next question comes from the line of Christopher Glynn with Oppenheimer.

Just wanted to ask another one on gross margin. With commodities and supplier inflation on an uptick here. In the context of your repricing strategies, is pricing to inflation at odds with continuing to execute the volume response side of pricing?

No, not really. We would separate those 2. So the pricing actions we've taken, we really are tagging to the market and making sure we are market competitive. And then if market prices increase, we will be able to realize that as well if it's based on inflation. So we view them as independent. We're focused on being competitive. But certainly, as inflation comes, we would expect to realize that as well.

Okay. So you're not nervous about a squeeze there even if it's short-lived, it doesn't sound like. And then just housekeeping item. Does the 2018 tax rate guidance reflect the full impact of the bill? Or is there a more mature run rate that we would pencil in for 2019?

Yes. We are calling this provisional at this point. This is the best, to our knowledge, at this point, and we think we've captured the key elements in the rate.

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

I was hoping you could give us some more color on the acceleration and sales growth with the medium-sized customers that you saw. Could you share any data on the active customer count, the reengagement that you had with customers that have fallen off? Has there been any change in the average order sizes? Just a little bit more detail so we can better understand the moving pieces there.

Yes. So I won't provide too much detail on that. I will say that if you recall, we have a fairly small portion of midsized customers as customers today. The price changes had more impact with the existing midsized customers early days, but we are starting to acquire new customers. I would say our customer acquisition is still pretty nascent. So it's really been mostly around existing customers buying more and then what we would call lapse customers, people who knew Grainger rebuying, but we are starting to acquire some new customers as well.

Okay. And then, DG, could you comment on what you're seeing so far in your January sales? There's been some difficult weather and government shutdown impacts. Maybe how we should be thinking about the quarter and the cadence as we move through the year?

Yes. I mean, it's too early to comment much about January. We don't feel like the government shutdown is going to have much impact if it gets funded going forward. Obviously, if there's another shutdown, that would change things. And the weather events are normal for this time of year. I think certainly, we've had days when there's been some impact. But overall, we don't expect any of that to have a huge impact at this point.

Our next questions come from the line of David Manthey with Baird.

DG, your plan seems to be coming together better than most. I believe that it would. When you look at the current quarter outperformance, what do you feel were the biggest contributors to that outperformance relative to your expectations going in?

Yes. I would say that almost all of the outperformance came in 2 places, one is the U.S. and the other is Canada. So that contributed about $0.60 of the outperformers. Obviously, given the U.S. size, most of it was there. I would say a little bit of that outperformance would be the market strengthening, and the rest would really be around price and marketing and some of our sales activities with large local customers that are really getting traction. And so that's where we would see most of the outperformance right now. And then Canada was -- there's the rest of that, and that was getting some traction on price increase, which was really important.

And just to be clear, did you say that the price increase was in the second half of the quarter, or...

Yes, (inaudible). Yes, it was.

Okay. Okay, and then a follow-up question. Was there something about the operating outperformance that you saw, that $0.50 or so in the fourth quarter, that leads you to believe it was unsustainable into 2018? The reason I ask is that given that all that outperformance was concentrated into 1 quarter, it just seems like the guidance might have stepped up by more than the $0.50, assuming that outperformance would've been spread out more evenly in 2018 than it was in 2017. So is there anything about it? Or are you just being cautious here as you look out to 2018 and everything that's going on?

Yes. And I think short term, we would expect, like I mentioned the demand environment continues to be strong. A lot of uncertainty, of course, in what happens throughout the year. And so we built in the outperformance from the U.S. into the guidance, but we didn't assume that all of that continues throughout the entire year.

Our next question comes from the line of Robert McCarthy with Stifel.

So I think 2 questions or 2 sub-questions or however you want to typify it. I think the first question is building on what David asked about. I mean, clearly, perhaps your conservatism could be due to the fact that the back half of 2018 will provide a very interesting compare environment, because you'll be anniversarying the price comps and the volume response. So is that really where the basis of your caution with respect to raising the guidance further is really the rubber hits the road in the back half of '18 and we'll have a better sense then, because then, you'll start to anniversary some of these actions?

Well, I think as I mentioned before, if you look at midsized customers, for example, most midsized customers have not yet engaged with us. So I think there is probably a longer runway than just through the end of July to grow with midsized customers, and we would expect to continue to grow there. I think if we're being cautious, it's just we don't have enough time -- history here to know exactly how this is going to play out. And so we are -- we've got our targets and we're holding to our targets, and that's what we're going to do.

And then on the '19 targets, I mean, any thoughts about how your cadence and how that's looking there? Is there any source of potential upside from those targets? Or do you at least expect those targets to remain very firm?

Yes, we're still very comfortable with those targets. We don't change long-term guidance at the quarter, and we'll continue to talk about that, certainly, in November (inaudible).

The final question, obviously, given the stock move and the fundamental performance improvement, the CFO job is looking increasingly attractive. Is there any updates when we will see a new CFO put in place?

I would say the process has moved along very, very well, and we are deep into that process at this point. We'll let you know.

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

The first question is just around the portfolio. And the question really is, does repatriation or tax reform longer term make you take a fresh look at the portfolio, whether it's the MonotaRO business or any other pieces of the business just in terms of whether they belong or don't belong, or whether the tax rules sort of change your view on monetization longer term?

So I think the first thing, I think, Hamzah, thanks for the question, is that we have gone through a lot of work over the last 3 years to get our portfolio to be where we think it needs to be. And so the business that we have that remain, we think, can be very successful. It's still early in the tax reform cycle to understand whether there will be significant implications throughout the portfolio. But right now, we think the portfolio we have is the right one. We think we have competitive advantage in the places we are. We think we can grow the businesses and grow them profitably, and that's where we're focused on.

Got it. And just a follow-up question. If you could just remind investors on your government business and how that did. And clearly, the shutdown was only 3 days. But since it's tropical and we saw some impact in 2013 in your business. I know (inaudible) is a smaller piece. But just any of view on how that government business did and what we should be thinking about?

Yes. So I think our government business is very strong. When you think about the government -- if you're talking about the government shutdown, typically, certain parts of the government stay open. And so as the military continues to buy and has continued to buy, they're a big part of our federal government. It has some impact. But for us, if there's a shut down that's short-lived, it won't have tremendous impact. If it's long-lived, of course, all bets are off. But it's a fairly small -- the part that was affected by the most recent shutdown was a pretty small portion of our portfolio.

Our next question comes from the line of Deane Dray with RBC.

Was hoping to get some more color on the capital allocation decisions that you're making here with the -- with regard to the benefits of tax reform. So start with the spending on digital. Was this in a plan before tax reform? And maybe just give some color as to where and how this money will be spent.

Sure. So for us as a company, the most important thing for us is to be successful and drive success over the long term. We take a look at the tax, the tax bill and took a look at where we might accelerate investment to ensure that we are successful. There's a host of things around digital. We've certainly developed a lot of capabilities. This is really moving things forward in the cycle. And so accelerating things that we probably would've done over a longer time horizon, and we feel like now is the time to do that and there will be no regrets for making these investments and they're important to creating a competitive advantage long term, and so we decided to pull this forward.

Is there any way you can give us some examples of what time of spending in the lines of digital?

So we're not going to talk about specifics today. But we have a plan. We are likely to talk about that more around the EPG timeframe.

Got it. And just last question. Can you provide specifics on what the adjustments were to -- or the add-backs to adjusted gross margin?

Add-backs to adjusted?

What are -- what are you...

So I know you exclude restructuring. Is there anything else?

Yes. The only -- most of it's in op expense. The ones that affect cost of goods sold or GP would be the ones that have to do with inventory primarily. So as we go to close the branch, we'll increase reserve because some of the inventory that we would have sold over time now, we have to accelerate that process. So we end up taking a hit to cost of goods sold as we increase that provision. That's predominantly what it would be. So most of it's an expense out of that $112 million we talked about. Well, you can do the math on it, but it's -- I think it's $10 million, $15 million that would be COGS.

Our next question comes from the line of Matt Duncan with Stephens.

So first question I've got. DG, I was hoping maybe you could give us just a little bit more granularity on the acceleration of volume that you saw with U.S. large customers. You did mention that the spot buy volume and the noncontracted large customer volume both grew faster than the average. Could you put some numbers on that by chance and sort of help us gauge what the acceleration was from the third quarter to fourth quarter in those 2 categories?

Yes. I think the important point there, Matt, is that those 2 pieces of volume had been shrinking for several years. And now, they're actually contributing to the growth. And so both were -- they were slightly better than the average, but that's a big jump sequentially from what we've been seeing with both large local and spot buy. So we saw, I think, spot buy grow roughly 10 and large local grow roughly -- close to 10, a little less than 10. So those are the numbers we saw.

Okay, that's very helpful. And then another one on gross margin. Sorry to keep beating you over the head with this. But just on the supplier price increases that you're seeing, what are those sort of on average? And then historically one thing that I've thought you guys have always done well over time is used inflation to help get a little bit of gross margin. Now that seems like a strange conversation to have right now. Is there any chance that you might benefit a little bit as you sort of time how you increase your pricing around inflation? Or is that just not the way we need to be thinking about it given the dynamics in your business right now?

No, I think it is the way to think about it. I think net of the repricing, we do believe that we will be able to benefit from inflation. To your question about what we're seeing from suppliers, it's all over the map depending on what type of supplier they are, but most single digit inflation is kind of where we're -- what we're seeing at this point and on average. And so we would expect to benefit some from that.

And our next question comes from the line of Sam Darkatsh with [MRC].

From Raymond James, hopefully. So 2 questions, if I could. Your original guidance for pricing in North America or -- I'm sorry, in the U.S. was down 6% for both 3Q and 4Q, and it ended up being down 5% in both quarters. Was that due to a change in the pricing strategy or effects? Or was that you being conservative? Or what was the reason for the delta between your actual pricing in the U.S. and what you originally guided for?

It's pretty much all customer mix. So or type and buy mix. So when spot buy and large local and midsize grow as fast as they have, then that's the benefit.

Got you. And then second question. You still have $250 million in debt paydown anticipated for 2018. I'm trying to understand why that is preferable over share repurchase given the fact that your debt-to-EBITDA is still only about 1/3 or so. Why is that an attractive use or a source of use of cash?

Sam, it's Ron. I have to apologize. That's a short-term debt in Other. And by the end of next year, it's really Other. Our short-term debt at the end of this year is less than $50 million. I think it's about $40 million. And by the end of next year, it's a similar, very small number. So really, that $250 million, probably $200 million of it is cash -- it's excess cash. So that could be applied to many things. In November, I mentioned that, that number was about $100 million. So that number is growing in part because of improved performance and tax change. So we're reinvesting $40 million of that in CapEx as DG said and $80 million in share repurchase, and there's more that we could do with the excess cash that's still there, assuming we deliver on that plan.

Our next question comes from the line of Robert Barry with Susquehanna.

I just wanted to follow up on the comments about benefiting from inflation. Do you think you'll actually be pricing ahead of seeing it? Or is that a comment more due to timing of inventory turns or something like that?

So historically, we've seen benefits from our ability to manage COGS better than the inflation that we've seen. And so I think that's probably the source of the benefit that we typically have historically.

That you think will occur again?

In fact, I just want to add, DG mentioned before low single digit inflation on the items where we're seeing inflation, but our plan for the next -- for this year is still negative 0.5% deflation. Given all the actions we take and continue to take to reduce cost with other supplies, we're not seeing inflation.

Yes, I think the principle we always have is we price the market and then we get the best cost and service we can. And so if the market is increasing price and we're able to manage COGS better, that's the benefit that we've seen historically that people resort to.

Got it. And then you said the stronger performance on the top line was mostly on your actions, the price cuts, the marketing. But anything you'd call out in terms of end markets that did get notably better? And maybe in that commentary, you could speak specifically about resellers just because it's especially strong?

Yes. I mean, I think the strength is across the board, and I think you're always looking at sort of what's happened in the past year. I think heavy manufacturing was strong. Resellers were strong. It's still a pretty small portion of our overall mix, though. So I wouldn't really point to anything that unusual within the end markets.

Our next question comes from the line of Justin Bergner with Gabelli.

First question just relates to understanding sort of the breakout between the -- among the $0.50 of sort of better-than-expected earnings that Grainger delivered in the fourth quarter. I'm just trying to sort of decompose that a bit. I mean, it seems about half of that is coming from the better sales growth, maybe some from mix, some from Canada. Are those sort of the right buckets and the right general proportions? And are there other drivers in that $0.50 beat versus your own expectations that I should be thinking about?

Yes. Most of that comes -- the bulk of that comes from the U.S. It's volume and expense leverage, so strong drop-through rates on the volume, and then it's Canada, the Canada GP improvement. Those are the primary levers.

And then was mix also beneficial given the medium customers are accelerating?

Yes. Mix is beneficial on the gross profit line for sure, yes.

Okay. Another question I had is as you think about the acceleration of large customers and medium customers and higher share of wallet from your pricing changes, do you have a sense as to who you're increasingly taking share from? Is it sort of a mom-and-pops and regionals? Or is it larger national players that you think are the share donors?

Yes. I mean, I think historically, and I think it's probably no different today, we're still in a very, very fragmented market. And so when we're gaining share, typically, it's from a very fragmented set, whether it's mom-and-pops or midsized distributors or others. With midsized customers, I think it's even probably more diverse in a sense that there's -- they use retail sometimes, and so if we're able to get that business, then we might be taking it from other sources. But it's very fragmented.

Okay, great. And then just finally, quick clarification question. So between the P&L investments in digital and increased CapEx, which seems mainly digital-related as well, your spending sort of an additional $50 million to $60 million on digital in '18 versus where you expected to be before?

No, just the $40 million that we talked about.

Okay. So the P&L impact of the increased investment is non-digital, or...

Yes. So -- I'm sorry, so the $40 million is capital. Probably more like $15 million of expenses. And then the depreciation on the $40 million is -- gets you the $20 million impact.

Next question comes from the line of John Inch with Deutsche Bank.

DG and Ron, the gross margins were better in the fourth quarter. And I was wondering if there's perhaps a more favorable benefit from, say, the rebates. And the reason I ask that is the question is because it's the fourth quarter, does it cause for some sort of a true-up for the year? So if you're getting more rebates, do you have to actually recognize disproportionately more gross margin benefit because you have to average it over the course of the year. Does that makes sense?

Yes. No, it's a great question. It's certainly, with the addition of volume, we'd be getting additional rebates. But that volume is brought into inventories, so those rebates are capitalized. We'd see those rebates drop in the P&L next year.

Okay. So there's no -- so in other words, the gross margin improvement in the fourth quarter was all volumetric. There wasn't any other -- some sort of accrual accounting impact that would not repeat?

No. No, no.

Okay. Pricing was better. Sort of down 5 versus down 6. Why was that again? Was it just mix? I mean, I think you've answered a couple of questions saying it's mix. But was there some any other phenomenon in the way the quarter played out?

No, just customer mix and volume mix.

Okay. One more question for me. It looks like the trajectory of transportation costs, UPS, freight and the like, it seems to be sort of heading significantly higher in the short term. How do you -- just describe Grainger, like, how do you actually pass through those costs to customers? I know that you sort of bill UPS on top. But maybe if you could just explain sort of what's going to be the impact of these costs and how you manage it?

Yes. So I think we're actually doing quite a good job with managing our transportation cost in aggregate. And I won't go into details of where we expect those to go now. Now in general to your question, it just depends on the customer. For many customers, we actually take the burden of transportation costs and it's included in their contract. Some do pay freight. We feel that's the best environment because we feel we can manage those costs as well or better than anyone. And that's what we're focused on there.

Just one last, last thing. Government, I mean, you've basically said, DG, government's pretty strong or was pretty strong. MSC called out weak government in December. It sounds like you did not [indiscernible quite what their excuse was, but it doesn't sound like you experienced that.

No. So I think that some of that question goes to what we saw over November and December. And for us, the demand environment has been very, very consistent. 2016 was a little unusual in the sense that November, I think, was bad for everybody and December was good for everybody. So the compares can make you think that December wasn't as good, when, in fact, relative to our forecast and expectation, December was every bit as strong if not stronger than November. And so we didn't see anything from shut down that caused any problems for us.

Our next question comes from the line of Patrick Baumann with JPMorgan.

Quick question on the segment margins for the U.S. Exiting the year, you guys are at 15%. And I don't think you've changed the 2018 guide for U.S. segment margins. I think it's still 14.7%, I guess, at the midpoint. This is just another question trying to get the conservatism in the guide and while you're just following through the 4Q beat the 2018 ops guide. So just looking historically, the first quarter margin typically improves versus the fourth quarter in the U.S. segment. Can you remind me why that is and is there any reason this year will be different from previous years?

No. I mean, so I'm just trying to understand your question. So are you asking a historical question on why the first quarter margin is typically higher?

No, (inaudible). Yes, I mean (inaudible). What's that?

That's relating to price increase cycles, typically. So often, we take -- we don't take in price increases early in the year. And so that has typically been the pattern that we've seen. This year, we would -- the pattern will be similar to (inaudible) price increases. But you also have the opposite, which is the price reset that we're going through.

Got it. Got it. Makes sense. And then also, where is the digital investment? Is that in Other Businesses? Will that show up there?

No, that's in the U.S. Yes. We're putting it in the U.S.

Okay, got it. And then last question for me. Just the volume pickup for midsized and large spot and noncontract that you saw through the quarter. I mean, versus what you said at the mid-November investor meeting, it seems like, I guess, you had it growing 6% for large and 15% to 20% I think for midsized, and it was 8% for large and 26% for midsized. Was that just being conservative at the November meeting? Was that just you guys being conservative? Or was the growth -- the pickup really back-half-weighted in the quarter, so it just surprised you there.

Well, it's been better than our expectations. And in November, we had very short time horizon of working at that data. And so I think we're starting to get a better sense for what's going on now.

Our next question comes on the line of Andrew Buscaglia with Crédit Suisse.

I just want to dig in to Canada a little bit more. I mean, definitely better than expected. What end markets are really driving that? And I think you mentioned things are still strong, just generally on a monthly basis, but it pulled back in December. Is that just the comp? And remind us what the comp -- why that was strong last year at this time?

Yes. So I think for the second part question, you're asking, I think you're asking overall. Last year, there seemed to be -- people are talking about budget selections, such things. It seemed like customers last year spent a lot money at the end of the year. And I don't know that we know exactly why that happened, but it made November -- November was not strong, December was very strong. So for us, that compares the only reason December looks like it's slightly slower at this point. In terms of Canada, we -- I think the turnaround effort we're talking about probably is independent of end market segments. It's more making sure that we have the right service model, the right pricing, the right cost structure. So the improvement wasn't because we saw great things in any specific end-user segment, it was because we focused on providing good service at the lowest cost and improving our pricing.

Okay, got it. So more Grainger-specific. And then one other question I had was part of your strategy, I think, with Gamut was learning more about the market and then -- I think your plan was to roll that into grainger.com. Can you tell us where you stand with that? Is that going to be part of the additional investments you plan to make?

Yes. And so we are developing more detailed plans as we speak. We will provide more updates later in the year, probably, as I mentioned before, probably the EPG timeframe.

Our next questions comes from the line of Joe Ritchie with Goldman Sachs.

This is Evelyn Chow on for Joe. I want to touch first on Canada. I understand the prudence in maintaining the guide right now for 2018, but just curious to understand, you had great price increases, your expense leverage in 4Q was very impressive. What more do you kind of need to see out of this business, either from the market or your own strategic actions, to make you confident that this could turn profitable in 2018?

Yes. And I think we've got a plan that basically lays out what to expect to get that quarter, and we're on that plan. And we have a set of initiatives that we're executing with high intensity. And if we continue to execute as we started to execute, I think we're going to be in good shape. So we are watching things very closely as you might suggest, and we're going to make sure that we execute as well. But there is no structural reason why the Canadian business cannot be very profitable and get back to growth once we get through the reset.

That makes sense. And then maybe just an almost conceptional question. I think a lot of skeptics that sort of look at the benefits from tax reform, not just for your business but across distributors in general, kind of points to the idea what if these tax benefits can get competed away. I guess, I would infer from your increased digital investments that you believe these are benefits that are here to stay. I'd just be curious to understand your response to that kind of pushback both for the industry and for your business in particular.

Yes. I think over the very long term, I think we don't know what benefits will be sticking. Right now, certainly, it's a benefit to us and we're going to continue to invest in things that make us successful, that help us compete, differentiate us from our competitors, create value for our customers. And that's really our focus. I won't comment or speculate on what happens with the benefit of tax over the long haul.

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

So just to -- so I understand that Grainger has historically been able to pass inflation through at a higher rate, but the competitive environment has changed. So do you have a sense of the (inaudible) of the higher prices of the U.S. customers given that they may have other options and then all the pricing actions you guys went through this year?

Yes. So as I mentioned. We tend to think of managing price as a market competitiveness effort. So we will look very closely at what happens with market prices. Historically, we've seen inflation passed through to customers. We don't really see any reason or anything different in the market price structure now than we did 2 years ago. Most of the changes, all of the changes we made have been because of our own structure, not really because market prices have been increasing or decreasing. And so I don't think the dynamics actually changed all that much. We don't have any evidence that it's changed all that much. And so I don't know why we would think that it's an inflationary environment, and we manage COGS where we wouldn't get some benefit.

Okay. And then just going up to Canada. With regard to the volume price relationship there, was there any demand weakness? Or was it just a function of lower volumes on higher pricing?

Well, I think the low volume is only partially because of the pricing. Lower volumes also because we've removed a bunch of branches. So we will go from 170 branches to 35 or something like that over the course of 2 years. And that is taking away some unprofitable volume, but certainly taking away a little bit of volume.

Our next question comes from the line of Ryan Cieslak with Northcoast.

My first question. DG, you mentioned that with regard to the midsized customers, the new customer acquisition is still is early innings and maybe somewhat slow. But at this point, with most of the pricing actions have been -- having been taken. What do you need to do, or what you think is the trigger to really start to see some new customers come through to the model?

Yes. Just to be clear, we are seeing some new customers come through, but it's a smaller portion initially than existing or lapse customers. So we have a lot of experience of acquiring new customers in some of the online businesses. It just takes time. You just keep acquiring, acquiring, acquiring. And so we're not going to -- the reality is the customers that aren't Grainger customers, you have to get to them through, usually, through digital solutions. And if you -- if they find that the prices are competitive and they get the service that we provide, they often come back. And so we're really focused on acquiring new attractive business customers, and I think that will just continue to build over time.

Okay. And then for my follow-up question. And going back to the question and the comments about passing along inflation for you guys and some of the supplier inflation that you're already seeing, have you already started to pass that along and then successful? I just want to be clear there. And if not, when does that actually -- or do you start to do that? Is that something you're going to wait a quarter or 2 to do? Or is that something you guys are already starting to implement and progress through here in the first quarter?

We've already started it very recently, but we're able to change price multiple times during the year. We've already started that process, so we will start to see some of that benefit in the first quarter.

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

Just thinking about digital strategy, obviously, that's doing quite well. But are you willing to comment on the success of kind of your endless selection strategy versus something more approaching Gamut and grainger.com. Is there any kind of difference in trends that we should be thinking about that?

I think we'll talk a lot about this in May. I think that the differences might include some subtleties. I would say that the endless sort of model tends to be attractive to smaller customers, less complex customers. And the solutions that we provide on grainger.com, Gamut, tend to be more attractive for certainly more industrial customers and our bigger customers, our more complex customers. So we see acquisition and growth rates that are different across the customer base across those 2 solutions, typically.

Got you. I'll wait until EPG, I guess. And then thinking about Cromwell, with that getting digital, getting online, there was a big focus when that was brought onboard. I guess any comment on how that progress is going?

Yes. So we have -- we've replumbed the website for the Cromwell core business and started Zoro U.K. Zoro U.K. is certainly early days but starting to get some traction. Too early to tell how fast that's going to grow, but we're certainly starting to see some growth in U.K. The market seems to be there for that offer, so we're pretty excited about what we're seeing there.

That concludes our question-and-answer session. I'd like to turn the floor back to DG MacPherson for closing comments.

All right. I'll just -- I'll close very quickly here. Thank you for your time and attendance today. As I mentioned overall, we're very pleased with our progress. I think we've done a lot of heavy lifting this year to get not only pricing right, but to get our portfolio to be as clean as possible. And we are really focused now on creating value for customers in U.S., turning around Canada, continuing to accelerate growth with the online model. And given all the changes, given our team member's efforts this year, we feel like we're much better positioned than we were certainly a year ago. And so we're pretty optimistic about where we're heading. And really, (inaudible) execution, so that's what we're going to focus on.

So thanks for your time and thanks for following us.

This concludes today's conference. You may disconnect your lines at this time, and thank you for your participation.