固安捷 (GWW) 2018 Q4 法說會逐字稿

Greetings, and welcome to W.W. Grainger's Fourth Quarter 2018 Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Irene Holman, Vice President, Investor Relations. Thank you. You may begin.

Good morning. Welcome to Grainger's Q4 earnings call. With me are DG MacPherson, Chairman and CEO; and Tom Okray, 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 IR website.

Looking at reported results for the year, we had adjustments resulting in $186 million impact to operating earnings and a $2.97 impact to EPS. Adjustments included $139 million of noncash impairment charges related to the Cromwell business and restructuring, primarily related to Canada.

This morning's call will focus on adjusted results, which exclude the items outlined in our press release.

Now I'll turn it over to DG to discuss our 2018 performance. DG, to you.

Thanks, Irene. Good morning. Thanks all of you for joining us this morning. 2018 was a strong year for Grainger, both in terms of our performance and in building the path for our long-term success. I'm extremely proud of our team members and what they accomplished. Across the business, we remained laser-focused on enhancing our relationships with customers, which has put us in a better position to consistently gain share moving forward.

Let's take a look at what we accomplished in 2018. We drove significant share gains across large and midsize customers in the U.S. as our value proposition continue to resonate on more relevant pricing. Our strong sales performance and favorable customer mix helped drive gross margin performance that was better than expected for the year, and our diligence in managing costs resulted in significant operating expense leverage.

We continued to enhance the customer experience with the Grainger brand in the U.S. through better search capabilities, best-in-class fulfillment and by improving the end-to-end customer experience from order to delivery. Feedback from customers has been very strong and improving over the last 2 years.

In Canada, the structural reset of the business is complete, and we exited the year with a profitable fourth quarter. This has been a tough road for our team members in Canada. I want to acknowledge all the work that they and our team members in the U.S. put in to get Canada to profitability. We still have work ahead of us to stabilize volume performance, which I will talk about in a minute.

Our single-channel businesses, mainly MonotaRO and Zoro, continued to drive profitable growth. Daily sales grew 23% for our single-channel model in 2018.

For our international businesses, the portfolio performed well and contributed to operating margin expansion in the year. Across the business, we drove strong operating expense leverage. We achieved $130 million in cost savings and productivity, net of digital investments, which was above our target of $80 million to $120 million. For the year, operating expenses grew at half the rate of sales.

Last January, we mentioned our plan to make incremental digital investments to accelerate progress with our offering in the U.S. Since then, we've combined our Gamut and grainger.com capabilities and made incremental investments in digital marketing. We also invested in our Zoro business to build out our endless assortment model.

At our 2016 analyst meeting, we shared 2019 operating margin guidance of 12% to 13%, and we reiterated that target at early 2017 when we announced the acceleration of our pricing actions. We hit that target a year early with operating margin of 12% for the year, and we will build off this momentum moving forward.

Now I want to remind everyone of the 2018 expectations we set for the U.S. business when we announced the acceleration of our move to market-based pricing. We said that we expected to achieve 6% to 8% annual volume growth in both 2018 and 2019 with expected market volume growth of 2% to 3% in each year. We expected price deflation of 2% and gross profit margin to decline approximately 120 basis points in 2018.

Our results were better than that. U.S. volume grew 8%, at the high end of our guide, versus U.S. market volume growth of about 3.5%. Price was flat and contributed to GP margin being down only 20 basis points after normalizing for the revenue recognition change.

Price deflation related to the reset was offset by positive customer mix and market-based price increases. More importantly, we're having -- not having to deeply discount infrequently purchased items as customers are more comfortable with our pricing.

When I speak with customers and team members, I'm hearing that price is no longer the primary part of the conversation, and the focus is squarely on how we can add value and help our customers solve problems. Our volume performance with both large and midsize customers remained strong throughout 2018. The fourth quarter was our first quarter having fully lapped the pricing changes, and this was our strongest quarter of results to date on a 2-year stack after adjusting for the holiday timing in December, which Tom will address later in this call.

U.S. large customer volume grew 6% in the fourth quarter and 14% on a 2-year stack. For the year, our U.S. large volume grew 12% on a 2-year stack. U.S. midsize customer volume grew 16% in the fourth quarter and 42% on a 2-year stack. For the year, our midsize customers grew to 31% on a 2-year stack. We are very happy with our performance in the U.S. in 2018.

I want to spend a few minutes reminding everyone of our strategy and performance expectations going forward. Our strategy is to create value for customers through 2 business models. The first model is the high-touch, high-service model that serves customers with complex needs. Our Grainger U.S., Canada and Mexico businesses plus Cromwell and Fabory all fit within this model.

The second model is the endless assortment model focused on customers with less complex needs, which we sometimes call the single-channel online model.

In our high-touch, high-service model, we have 3 priorities for every business to create more value for our customers. Our first is to make sure that we have advantaged MRO solutions. That means understanding more about our products and our customers than anyone and building solutions that create value for our customers.

Our second is differentiated sales and services. The battle in our space with complex customers largely occurs at their place of business. Our sellers and our service teams build relationships and provide services that customers value.

And the third is our flawless order-to-cash process. Creating value for our customers means our order-to-cash process has to be the absolute best in our space. We are very strong here, and we have continued to make good progress.

Our fourth priority with our high-touch, high-service model is to continue the turnaround in Canada. While we have made great progress, we have not yet met our expectations. With the cost structure changes behind us, we are now focused on stabilizing volume and driving profitable growth. Our team is working on expanding our product assortment and building the demand generation engine through improved website functionality, effective digital marketing and a high-performing sales and services team. This is an attractive market where we are one of the largest players. Our long-term goal remains to achieve double-digit operating margin and consistent share gain for this business.

In terms of the endless assortment model, we have several priorities. Given the success of our Zoro business, coupled with our learnings from MonotaRO, we have made the decision to invest in Zoro to accelerate their product expansion efforts. This means investments in systems and people. In addition, we are leveraging our knowledge of MonotaRO to improve our marketing and analytics capability in our Zoro U.S. operation. These 2 changes will require some incremental investment in 2019 that will lower margins in the Zoro business. We are confident that these investments will improve both our growth rate and margins for Zoro in the next several years.

Now executing against these priorities will put us in a position to accomplish the following in 2019 and beyond: We expect U.S. revenue to grow 300 to 400 basis points faster than the market. We expect Canada volume to stabilize in 2019 and for profitable growth to follow. We expect accelerated growth of the endless assortment model. We expect continued strong operating expense leverage, and the company expects to have operating margin expansion in 2019.

Now I'll turn it over to Tom for detail on our 2018 performance and our 2019 guidance.

Thanks, DG. I'll start with a recap of our 2018 total company-adjusted results then move to the fourth quarter results by segment. For the full year, revenue was up 8%, 7% on a daily basis, driven entirely by volume. Our normalized gross profit rate was down 20 basis points versus the prior year after adjusting for revenue recognition, consistent with the U.S. businesses.

We continue to realize operating expense leverage on higher volume. For the full year, operating expenses normalized for revenue recognition grew 3% on 8% revenue growth. Our strong sales growth, gross margin performance and diligence in driving operating expense leverage resulted in incremental margin of 25%, operating earnings growth of 17% and an operating margin of 12%, which is 100 basis points higher than the prior year. EPS grew 46% for the year. We generated operating cash flow of $1.1 billion, representing 110% of net earnings after adjusting for the noncash impairment for the Cromwell business. This result was flat to the prior year as positive earnings were offset by higher working capital, primarily driven by the timing of trade and other payables, which we do not expect to repeat; and the investment in inventory, including some opportunistic prebuys.

In addition, we returned $741 million in cash to shareholders through dividends and share repurchases.

Looking at the quarter. Sales increased 5%, including a 1% unfavorable impact from foreign exchange. On a constant currency basis, sales grew 6%, 4% on a daily basis. Sales were comprised of volume growth of 4% and price inflation of 1%, partially offset by a 1% impact for holiday timing. Our normalized gross profit margin was down 20 basis points as margin growth in the U.S. and Canada was more than offset by gross profit declines in our Other Businesses, driven primarily by Cromwell and freight increases in Japan.

Operating expenses, normalized for revenue recognition, increased 3%. The increase was driven by 3 factors: First, incremental digital investments, including website enhancements and marketing spend for our U.S. business as well as investments in the growth of our Zoro business; second, incentive compensation versus the prior year, reflecting our strong performance in 2018; and third, expenses which were onetime in nature and are not expected to repeat.

Overall, operating earnings were up 10%, resulting in operating margin of 11.2%, which is up 50 basis points from the prior year. Earnings per share increased 35% in the quarter versus the prior year due to strong operating performance and a lower tax rate.

Looking at our other segment results. I'll start with our Other Businesses, which include our single-channel online model and our international businesses. Sales were up 11% on a constant currency basis due primarily to volume. Operating earnings increased 28% for the quarter, with a 70 basis point improvement in operating margin. In Canada, we finished the quarter profitably, something we haven't been able to say for the past 11 quarters. Sales were down 25% on a daily basis and down 22% daily in constant currency.

We've made a lot of changes in a short period of time to improve the business, and that has impacted volume more than we expected. The volume decline was offset by 8% price inflation.

Moving to profit. Our gross margin was up 160 basis points versus the prior year after normalizing for revenue recognition. Price inflation and lower freight were partially offset by product cost inflation and lapping favorable inventory adjustments in 2017 fourth quarter. Operating earnings increased 134% versus prior year. Operating margin improved 330 basis points, driven by the initiatives from our turnaround plan.

In the U.S., sales grew 6%, 5% on a daily basis and 6% after normalizing for holiday timing. In 2018, Christmas Eve and New Year's Eve fell on a Monday versus on a Sunday in 2017. We were open for business both days to serve our customers. However, revenue on those days was significantly lower than normal. That lower revenue effectively offset the benefit of the additional sales day.

Excluding holiday timing, it was our strongest quarter on a 2-year stack since announcing the pricing reset. We feel good about our sales momentum heading into 2019.

Gross profit margin was up 20 basis points after normalizing for revenue recognition as price inflation outpaced cost inflation in the quarter. Higher supplier rebates on strong volume performance also contributed to the favorable GP rate in the quarter.

Operating expenses in the U.S. were up 8% after normalizing for revenue recognition and one additional payroll day. For the year, after normalizing for revenue recognition, operating expenses grew 5% on 8% revenue growth, providing significant operating leverage. However, there were some lumpiness throughout the year.

In the quarter, the lumpiness related to 3 main factors. First, we made planned incremental digital investments in the U.S. Second, we had higher incentive compensation versus the prior year, reflecting strong performance in 2018. And the third piece was related to items that we do not expect to recur. Overall, operating earnings grew 5%, resulting in a 14.6% operating margin for the U.S., which was down 20 basis points in the quarter.

Moving to our cost takeout and productivity targets. Everything we do is focused on delivering value to our customer in the most efficient and effective way possible. Our goal was to drive $150 million to $210 million of cost savings and productivity net of digital investments over a 2-year period. In 2018, we achieved cost savings of $130 million and are now more than halfway to our 2-year target.

In the U.S., we realized $70 million in savings, driven by a handful of items, including sales productivity from increased revenue per seller and on-site service efficiencies; supply chain productivity, as we practice continuous improvement in our DCs; and completing the contact center consolidation. For Canada, we realized $45 million in savings related to our turnaround efforts.

And for our Other Businesses, we realized $15 million in savings, primarily related to closure of unprofitable businesses.

Our 2019 cost takeout target is to achieve $65 million to $85 million in savings. Improving our cost structure has been and continues to be an important part of driving profitable growth in the future. We are confident in our ability to achieve our 2019 targets.

To recap 2018, our performance was strong throughout the year. We gained share profitably, beat our expectations on operating margin and earnings per share and achieved our 2019 operating margin target a year early.

Now let's take a look at 2019 guidance. As a reminder, we changed our guidance philosophy in 2018. We now set guidance in January and plan to update it if we expect to be materially outside the range.

In 2019, we expect to deliver the following for the total company: 4% to 8.5% sales growth, driven by continued share gains for the U.S. segment and the single-channel businesses.

Total company gross margin is expected to be down 60 basis points to flat versus the prior year. This is due to the timing of our contract pricing negotiations and freight headwinds, partially offset by price increases and customer mix.

Operating margin is expected to improve 20 to 100 basis points, driven by strong sales growth and continued expense leverage.

We're investing in the areas that matter most to our customers. This includes incremental digital investments in the U.S. segment and investments to accelerate growth with Zoro. Our goal is to drive 2019 incremental margin of 20% to 25%.

Finally, we expect earnings per share growth of 2% to 12%.

We expect to have a higher tax rate in 2019 versus the prior year due to the wind-down of our clean energy investment at the end of 2018. As a result, there will be no EPS benefit due to clean energy in 2019. We have also not assumed any stock-based compensation impact to the tax rate in 2019, which helped the tax rate in 2018.

Moving to our segment-level projections for 2019. In the U.S. segment, we expect operating margin of 15.5% to 16.1%, driven by expense leverage on strong sales growth, partially offset by gross profit margin headwinds. U.S. revenue growth is expected to be driven by customer acquisition and increasing share of wallet. We continue to expect this business to grow 300 to 400 basis points faster than the market, with expected market growth of approximately 1% to 4%, which includes 1% of price.

Moving to gross profit margin. U.S. GP rate is expected to be down slightly to flat due to a few factors. First, we expect to pass through both general and tariff-related cost inflation. In an inflationary environment, we feel confident in our ability to pass through price.

Second, increased freight costs. We have strategic partnerships with freight carriers that significantly mitigated our exposure to increases in 2018. We continue to effectively manage freight costs and expect 2019 freight increases to be materially less than the market.

Finally, we will complete the contract negotiations related to the pricing reset in 2019. We have approximately 10% of large contract revenue to go.

In Canada, we expect operating margin of 1% to 5%. Our 2018 volume performance was below expectations. And as a result, our operating margin guide for 2019 is slightly lower than our original target.

As DG mentioned, most of the cost structure initiatives are behind us, and we are now focused on stabilizing volume and driving profitable growth. Our 2019 actions will include: expanding our product assortment, including leveraging the U.S. assortment where it makes sense; improving our digital capabilities, including website functionality and online marketing; and building a high-performing sales and service team.

Canada is an attractive market for Grainger, and we're committed to getting this business to long-term profitable growth.

For Other Businesses, we expect 6% to 8% operating margin. Single-channel businesses' operating margin growth is expected to slow due to investments in product expansion and technology to support the growth of our endless assortment model. As we commented earlier, we are confident these investments will improve both our growth rate and margins for Zoro over the next several years.

On Slide 20, we outline our cash flow projection. In 2018, we generated $1.1 billion in operating cash flow. In 2019, we expect operating cash flow to be between $1.1 billion and $1.3 billion, driven by strong earnings growth and working capital improvements. We plan to use $300 million to $350 million of our cash to reinvest in the business. This includes investment in a DC to support the growth of MonotaRO. We will also make investments to support the growth of our Zoro business, improve our IT infrastructure and enhance our U.S. distribution center network. Development of our Louisville DC is progressing as planned, and we are on track to start outbound shipping in early 2020. We expect to use $450 million to $600 million for share repurchases, which reflects confidence in our strategy going forward. The remainder will be used for dividends.

Now I'll turn it back to DG for closing remarks.

Thanks, Tom. We're very pleased with our performance in 2018. More importantly, we're excited about the actions we've taken to position us for success moving forward. We look forward to maintaining this momentum in 2019 and beyond.

Now we will open it up for questions.

(Operator Instructions) Our first question is from Ryan Merkel with William Blair.

So first of all, U.S. EBIT margin guidance for 2019, up 10 basis points at the midpoint. I guess, 2-part question. First, just to clarify, you're thinking about flat gross margins, and then, it is offset by investment. Is that why there's not more margin expansion? And then -- well, I'll let you answer that then I'll ask the second part.

Thanks, Ryan. This is DG. So a couple of things. One is on the gross profit line, our expectation is that we will be down 60 basis points; two, flat for the year. There's a couple things going on there. One is we talked about being roughly flat in 2019 before. What has happened is some of our contracts have not actually been implemented yet, so we got some benefit in 2018. And that benefit will turn into a slight negative in 2019. So at the midpoint, we're slightly down. We still expect to get strong operating leverage in the year. We are making some additional investments in digital capability certainly, but we still expect to get strong operating leverage and slightly down GP at the midpoint, and that's because of that contract timing.

Okay, got it. All right. And then are we through some of these one-off items, sticking with U.S. EBIT margin, in the fourth quarter. I guess, what I'm asking is, once we get in the first quarter 2019, does year-over-year operating margin in the U.S. start to expand again? Or is this something that might be more of a second half progression?

Yes. Let me take this. This is Tom. As we alluded to in our prepared remarks, there's 3 main items there. Let me give you a little bit more granularity to help you size that. For the U.S. segment in Q4, SG&A expenses grew 6%. We said 5%. That's related to the additional payday. If you normalize for 3 buckets, which is variable compensation, the additional payroll day and items that aren't expected to recur, the 6% increase actually goes to flat, or 9% associated with revenue recognition goes to a 3% increase. This clearly had a material impact on our Q4 U.S. segment on the operating margin, and we don't expect this profile to be representative going forward.

(Operator Instructions) Our next question comes from David Manthey with Baird.

First off, as it relates to your outlook, it appears to contemplate something of a soft landing. Could you just talk about the 1% to 4% market growth? What of that do you assume is price versus volume for the market? And then are you assuming that Grainger is going to be in the same ballpark of maybe a low single-digit growth rate of price?

Yes. So we have 1% price in there. We have volume of 0% to 3%. We would expect to be somewhere in that ballpark generally. So yes, that's what we've embedded in there. And it is a bit of a soft landing. We don't have any -- we've got the same economic advisers that everybody else does, and so we're hearing the same thing as you are. So that's where we are right now.

Okay. Sounds good, DG. And then on these investments in the digital in the Other Businesses, including Zoro, could you talk about the nature of those investments? Broadly, what type of investments those are? And then if you could talk about maybe by how much those investments depressed the EBIT margin forecast that you've given us.

Sure. So the investments are largely -- if you think about our business in MonotaRO, which has been so successful, they now have 20 million items on their website. And we are making investments in Zoro to be able to expand our offering dramatically over the next several years. Those investments are in systems and people to make sure that we can be successful in doing that. We're also investing in analytics capabilities and marketing capabilities and really taking the lessons we learned from MonotaRO to go ahead and push that. Those investments are significant for Zoro. The business will remain profitable through the transition, and most of those investments will be done by the end of the year. So we should be in better shape going into 2020 from a margin perspective, but we expect several hundred basis points or more to be down relative to where we were this year.

Our next question is from Christopher Glynn with Oppenheimer.

I just wanted to ask a little bit about the sequential momentum and the medium strategy. In terms of your path to get back above 5% share long term, obviously, good momentum right now. Wondering if there are any market penetration levers that are just getting started there and how that compounding sensitivity is shaping up. You're introducing new levers at Zoro. Sounds interesting. How would you describe how you sustain the compounding at the medium?

Sure. So with midsize customers, and we've talked about some of these before, we've seen growth both with existing customers -- we've reengaged some last customers and we've acquired new customers. I would say the new customer acquisition has been very solid over the last quarter, and we expect that to continue. So most of that is acquiring new customers digitally and then getting -- building a relationship with those customers. We still have a fairly small customer file with midsize customers relative to the entire universe. So with the Grainger brand, midsize customers, we expect consistent strong growth over the next couple of years at a minimum. And a lot of that's going to be new customer acquisition in addition to some of the existing customer growth.

Okay, great. And I just want to get a better understanding of the impact of the contract negotiations on U.S. gross margin outlook because the U.S. large revenue base is about 80% of the segment, and you're talking about 10% of those, so maybe 8% of the U.S. segment. It doesn't seem like that approach is the magnitude of mix that would have such a pronounced impact on your gross margin outlook given volume and mix should be good, guys.

Yes. So it actually does approach the number that we're talking about if -- that's going to be in the 10s of basis points of impact for next year if we're down 60 to flat. If that were not the case, we'd be sort of centered much closer to 0 for next year. So that's the impact. And a lot of this is just implementation of contracts that are already signed, and in particular, one very, very large contract that still needs to be implemented fully.

Our next question comes from Stephen Volkmann with Jefferies.

I wonder if we could go back to the midsize sort of large customer breakdown. And obviously, the midsize is growing a lot faster. Great to see that. I assume that has some positive margin implications. And I'm curious if you could ballpark sort of how much tailwind that gives you and then sort of what's offsetting that to leave us with sort of flat to down gross margin.

Yes. I mean, like we said, it's an impact. It's certainly 10 to 20 basis points roughly of an impact in terms of mix that we've seen if we continue to grow midsize customers much faster than large. So it's a small impact but a real one.

Okay. All right. That's helpful. And then just with respect to -- I think you laid in a little bit extra inventory, and I'm curious if that benefits maybe the first half of 2019 on sort of a price/cost basis.

Yes. We added inventory, as you saw, including some opportunistic prebuys that we made in Q4 preparing us for what we expect to be strong growth in 2019.

Our next question is from Hamzah Mazari with Macquarie Group.

Mario Cortellacci filling in for Hamzah. Actually, just kind of hitting on the medium customers again. I mean, could you walk us through what kind of market share you think you guys could get in the medium customers? And maybe you could talk about how your go-to-market or your sales strategy is different from that of large customers or maybe it's the same.

No, it's fairly significantly different. So we have less than 2% market share today. At our peak, we had significantly more than that. Without contemplating a specific number, we know we've got a lot of runway with midsize customers. In terms of how we go to market, we acquire customers, typically digitally with the midsized customer group. We then develop a relationship. In some cases, that will stay digital; in some cases, that becomes an inside seller relationship, where there will be someone on the phone that talks to them on a consistent basis. We provide significant technical product support to that group, which is a big value to that group. And what we find is that those customers really value what Grainger has to offer: the technical product support, the products themselves, the quality of the products and the fulfillment all mean a whole lot to that midsize customer group. So we're seeing great response as we acquire new customers and build those relationships.

Great. And just a quick follow-up. I mean, could you talk about, I guess, how you guys differ from Amazon industrial supply in your distribution or your products or even your service levels, and maybe where you guys bump up with them head to head and -- just competition-wise?

So I'm assuming you're talking about Amazon Business, is it?

Yes, yes.

Yes, okay. So I would say that we are skewed very much more industrial. We develop personal relationships with customers. We provide services with customers. We provide on-site services with customers. We have sellers. Our fulfillment is designed to make sure that we get complete orders to customers next day, so our buildings are a completely different design. I would say on almost every dimension, we are different. And so without going into too much detail on the call, we built our machine to be able to really be very attractive to industrial businesses, and that's our customer base, and that's what we're trying to gain share with.

Our next question is from Patrick Baumann with JPMorgan.

I just had a couple of questions here. First one is just on SG&A growth. The profile through 2019 sounds pretty similar to what you did in 2018. Just curious as you look beyond 2019 what this might look like on more of a normalized basis after you're through with all your cost savings plans.

I would just say that we have, we think, built a muscle and a process to make sure that we are very disciplined with SG&A going forward. Our expectation is that we will continue to get SG&A leverage through 2020 and beyond. So without talking about specific numbers, our expectation is that the process we've built, the way we look at our expenses, the way we drive improvement throughout the business, efficiency and effectiveness, we'll continue to do -- to perform well going forward.

Okay. On Zoro, what did the business grow in the quarter and through the year? And just curious if you could provide some context on what's driving the change in kind of the assortment strategy there. Is the growth kind of slowing down a little bit or are you guys just...

No. The Zoro business continued to grow very, very strongly throughout the year. If you look at the history of our business in Japan, about this time in the history, they really stepped on the accelerator with the assortment strategy. And we're at the point now where creating some real differentiation with the Zoro business in the marketplace we think is important, and we think we've got an opportunity to do that based on what we've learned. And so we're investing for the future. It doesn't mean that he have seen slower growth at Zoro at this point.

Got it. And the last one, just really quick, on the restructuring expense for 2019. Do you guys expect any restructuring? I haven't seen anything on the slides or the press release.

Yes. We expect our restructuring expenses, obviously, to go down with most of the heavy lifting in U.S. and Canada behind us. So it will be significantly less than we've seen the past couple of years.

Our next question is from Robert Barry with The Buckingham Research Group.

I apologize. I was dropped from the call for the first couple of questions, so if you touched on this already, we can skip it. But could you talk about what you've assumed in the guide vis-à-vis the tariffs versus what you outlined at 3Q? Any change there?

No change at all. And just to clarify, our contemplation and the guide assume the 10% tariff being at 25%, so that's already included in the guide.

Got it. So if it stays at 10%, then there'll be some upside there, I guess.

Correct.

Yes.

Got it. And then just, I wanted to follow up on the question about -- I think there was a question about the U.S. operating margin. I think it's implied about flattish. Is that right? And I'm just curious what's driving that, especially because it sounds like you'll be lapping some headwinds in 3Q and 4Q that seems to be nonrecurring.

You're referring to the guide for '19 for the U.S. segment?

Yes, the 15.5% to 16.1%. I think it came in, what, at 15.7%, yes, at 15.7% for the year.

Yes. Sure. No. And as DG mentioned earlier, maybe you were dropped off the call. Our GP, we expect to be flat to minus 60 down, and with the big impact there being freight as well as the contracts, which still have to be closed for this year or implemented for this year. So yes, we've got opportunity on the high end to grow 100 bps in terms of operating margin, but we're being prudent on the low end given the uncertainty we see in terms of the freight issues as well as the overall economic environment.

Got it, got it. Just finally, what is the messaging on the end market demand in your momentum? I mean, the 4% adjusted in December looks like a deceleration. And I think the 4Q overall is a deceleration versus recent quarters. Just any color on what you're seeing out there and the demand from the demand perspective.

Yes. I'd point you to a couple of things. One is, certainly, the market growth was still reasonably stronger in the fourth quarter, a little less than it was in Q2 and Q3, it appears. That said, we think our performance was very similar on a comparison basis to the market in the fourth quarter. We talked a little bit about the last week of the year being very slow, but fortunately, people showed up, back up to work to start the year. And so our expectation is that there's going to be very modest growth at this point. That's our expectation, and it will continue to gain share at a similar the pace to what we've done.

Our next question is from Nigel Coe with Wolfe Research.

DG, could you maybe just kind of just go back to your comments on tariffs? Because you expressed confidence in your ability to price through both the inflation and tariffs. So if we end up with a 10% or [0 on less 3] compared to 25% in your plan, should we assume that's a wash with pricing a little less than you would have otherwise gone with?

So I think your -- Nigel, I think your question is what happens if the tariffs stay at -- go back to 10%? Is that your question?

Yes, and therefore pricing. Would pricing not be as great as it would otherwise have been?

Over time, that would be the case. I mean, typically, if that were to happen, there would be some lags so there might be some benefit during that lag period. It's what we typically have seen historically. But generally, our philosophy is we want to make sure we're pricing to market and getting the best cost we can. And so presumably, the market price would adjust at some point in the future as well.

Okay. And then I hate to ask you this question, but can you maybe just touch on your government sales? Obviously, still very strong through 4Q, but with the shutdown, how is that tracking? And maybe just remind us in terms of your exposure to state versus federal and the proportion of sales.

Yes. Great. So we're about 70% state local, about 30% federal. The federal business for us tends to skew industrial. And by that, we mean things like the military. Some of those are funded. So far, I would say the impact on has been – certainly it's calculable but not big. It's a small impact for us right now. I would say we get a little more concerned if the shutdown goes longer because it has knock-on effects to other things. But for us, the shutdown in its current form, we don't have huge volume with customers that are shut down right now. So it's a pretty small impact on us so far. That said, obviously, if it goes longer, we get concerned about some other things.

And then total government is about 14% of your sales or so?

Yes, that's about right.

Our next question is from Chris Dankert with Longbow Research.

I guess, just to take another slice at medium. Kind of what gives you confidence in maintaining, it looks like medium -- mid-teens growth in that business? I mean, anything you can share with us, whether it's your number of new customer acquisitions, new users' size? But is there any other metrics we can see as far as giving you confidence in maintaining that growth rate?

Yes. We haven't shared the specifics. I would say that the new customer acquisition rate gives us confidence. I would say that the last customer return rate continues to be strong. We continue to get customers who have been customers before. And just our numbers through the fourth quarter give us confidence that there's still a lot of momentum to go as we lap the pricing decreases.

Got it, got it. And then thinking about productivity and cost savings beyond 2019 here. Obviously, you already commented on Zoro and the single channel kind of getting a little bit improvement from lower investment. I guess, any other way of thinking about normalized incremental margins for the U.S. and the Other Businesses here?

I'm sorry. You're talking about in 2019 or beyond 2019?

Beyond, once we kind of get the cost cuts fully?

Yes. So our expectation has been that we'll grow expenses at about half the rate we grow sales, and that's been kind of our expectation. We don't see anything that would change that at this point going forward. We still feel like we've got a lot of opportunity to improve our cost structure going forward.

Our next question is from Evelyn Chow with Goldman Sachs.

I wanted to touch on Canada for a moment. I know Tom, we met back in November. You had said there's some potential green shoots in the volume inflection in that business. Could you just give us an update on what you're seeing on the ground and how the market is progressing? And any line of sight you have into your own inflection?

Yes. So just to clarify, we had a really hard reset of that business. I think when you look at the cost takeout numbers, they're bigger than what we had talked about taking. And as we got into it, we felt like we need to reset pretty much everything in the business. That has had a fairly significant impact on volume in the business. We are now doing some things to improve the customer experience that we think are going to help us grow going forward, adding products to the assortment. Again, we're training our sellers and really working on getting a high-performing sales and services team in that business. Our fulfillment performance is actually pretty good. We're hearing from customers that it's pretty good. And we're starting to see a few wins for the first time in a long time there, I think, where we're starting to get some volume. Now it's going to take a while. The reality is this was a very hard reset, and that's why we were backing off of the margin targets for 2019 because it's going to take a little bit longer than we had hoped. It's been a very complicated and challenging process. I would say we're still confident in the underlying market. The market has been performing reasonably well. We have a business that's sort of separate out there that we know has been performing reasonably well. So the market has been growing, and most of this has been us resetting that business.

That makes sense. And then thanks for framing the gross margin guidance with your comments on contract negotiations and tariffs. It sounds like freight is the other big piece of that. So any sense of the magnitude that's baked into the guide currently?

Well, obviously, freight market has been tight. I think a lot of the uncertainty on where we land probably is freight going into the year, whether or not that market stays as tight or gets tighter or gets looser. It builds in some of the uncertainty. We feel like we are effectively managing freight. We feel like we've got a really good process to improve both our operational freight cost and our overall freight cost. So I would say it's modest impact but it is an impact.

Our next question is from Ryan Cieslak with Northcoast Research.

My first question, I think you'd mentioned that supplier rebates had a positive impact on your gross margins within the U.S. business in '18. Is there any way you can maybe quantify that or provide some directional color of how much of an impact that was? And then what does the 2019 guidance for your gross margins in the U.S. segment assume for the supplier rebate dynamic certainly relative to what you guys saw in 2018?

So our supplier rebates are largely based on volume. We don't disclose how much of -- what the magnitude of those are. And I would say that our supplier rebates for 2019 bake in an assumption around our volume, which you see in there, so they're linked to the revenue expectations for the business.

Is it fair to say, DG, though, that the supplier rebate benefit is smaller than what you saw in '18?

To the extent that our volume is slightly smaller, that would be fair to say.

And then when you think about the ability to maintain the medium-sized customer growth, I know this question was asked a couple different ways, but is there anything specific that you guys are going to do differently this year as it relates to digital actions or some sort of investments that you're making that would potentially be a catalyst or recatalyze sort of where the level is? Or are you saying basically you're seeing good momentum and you expect that momentum to continue here into 2019?

I think it's both. We're seeing good momentum, and we're actually increasing our digital investments to acquire more customers. So we are doing both. That's part of the digital investment that Tom talked about earlier.

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

I just want to make sure I understand how you could get to the higher end of your 2019 sales guidance. Just from what I see you coming out of the fourth quarter, exit rate is a bit softer. You're baking in some soft landing assumptions here. Maybe we'll see how long the government shutdown pinches you, at least for the first quarter. But based upon that, where do you get an acceleration of growth? And might you have to go and consider further price cuts?

Well, first of all, let me address the price cut issue first. Our prices are competitive from a market-based perspective. So that -- no is the answer to that question. Our perspective is we don't actually see a shift in the share gain we have. So the way I think about it is if our -- the market growth rate is at the top end of what we're saying, then we feel like we will be at the top end of that revenue perspective. And so there's all kinds of opinions out there about what happens with market activity. Some of them actually have a little bit of a slowdown now and an acceleration later. I don't know whether any of that is true. But certainly, there are projections out there that are at the top end of our range. If that comes true, then we will be at the top end of our sales range.

Got it. And then for Tom, just some color around the tax for the fourth quarter, a lot lower. We've heard some companies discuss further clarity on tax reform. Was there any dynamic there? And what was it that drove the decision to exit your clean energy tax program?

Yes. I mean, first of all, on the tax rate, if you put in the stock-based compensation, then that puts us squarely at the low end of our guide. So that's the story on that. In terms of exiting the clean energy, it was a nice $0.09 per share pickup for this year, and we just made the decision that we're going to conclude it.

So that was at your discretion. It's not that the program went away?

That's correct.

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

As you look at sort of your outgrowth going forward, and I realize you're only guiding to 2019 today. But just generally speaking, is it going to shift more towards medium customers driving your outgrowth? I know that large customers have also been a strong contributor. But as medium customers become a larger base, is that going to become a larger contributor to your outgrowth? Or is it going to stay a large contribution as well?

Well, over the next couple of years, we expect midsize customers to grow faster than large, but we expect the dollar impact of large customer growth to be much higher given the base of large customer revenue. So we don't feel like we are close to maxed out with any customer segment. We feel like we have strong opportunity really with all customer groups. But we would expect the percentage growth with midsize customers to be higher this year, next year, probably for the next 3 years at a minimum.

Okay. And then I'm surprised that price is only modeled or expected to be 100 basis points. Just to help me understand why all sort of the inflationary and tariffs headwinds don't require greater than 1% price to sort of keep up with cost pressures.

Yes. Well, just to clarify, in the 1% to 4% market growth, we've got 1% assumed in that, so it would be 0% to 3% in terms of volume. With respect to our own range and our guide, we've got 1% to 2%.

The next question is from Scott Graham with BMO Capital Markets.

Similar to a -- I think it was a question at the top about the 2019 guidance range for the U.S. I guess, I was expecting to hear a tinge of conservatism, and I don't think I'm hearing that from you all. And if I'm wrong in that, please let me know. And by extension, that does mean that the Other Businesses, that goal of 6% to 8% with a midpoint of 7%, that's roughly 100 basis points on a 6% margin from '18 is a pretty big needle move on a business whose margins have really not moved even though we've kind of targeted higher. So it does seem that if, in fact, the U.S. margin range is kind of going to be what it's going to be, that there's a lot of reliance in an area where we haven't seen a lot of success in reaching to a higher level of margin. Can you maybe give us what the drivers are behind that business to give us some comfort on that?

Sure. So just to be clear, we have seen pretty significant margin expansion in our other category over the last couple of years. And what gives us more confidence is we've actually closed some unprofitable businesses. That portfolio is now much more squarely attuned to the online model, and the margins there are much higher than that 6% in aggregate. So as we go forward, we would expect to have continued margin expansion, even with the investments in Zoro that we're going to make, largely just the math of having a much stronger portfolio at this point. So we expect that. I would also say we do expect slight margin expansion in the U.S. although it's modest, at least for the guide.

Okay. And we are talking to the as-reported 6%, right? Not the sort of stripped-down version, right?

I'm not sure -- Scott, I'm not sure...

In other words, the business is -- I think you were referring -- they're through your other – [you’re into] segment, you run some things that could potentially change the dynamic of the Other Businesses margin. We are talking about the Other Businesses margin as reported, right?

Sure, yes, yes. Absolutely, absolutely we are. Yes.

Okay, okay. Secondly, I know it was some time ago that you set forth your 2019 margin goals. Any reason why now that we're in '19, we don't maybe take a look out a couple of years and kind of go to higher aspirations?

Well, I mean, I would assume that we have higher aspirations. We have not -- right now, we're just talking about 2019. If we decide to put out margin guidance going forward, we would do that separately. But yes, I mean, obviously, we're not saying that we're going to stop.

No. For sure, I would definitely be hearing that message. Last question is this: the slowdown that we maybe saw in the fourth quarter, could you maybe give us a little bit of a feel for the tone of business in January so far?

Well, like I said, I mean, it was -- we're happy to see that people came back to work in January, and we feel good about our ability to gain share in any market. There's obviously a lot of uncertainty. Most of that is uncertainty around things that we don't control, and I don't think we know where to land. I would say that the fourth quarter, up until sort of the last week of December, things we're very, very, very good. And so the slowdown was a very, very short period of time. And so we were looking to see if people came back to work, and they did, which is good.

Our next question is from John Inch with Gordon Haskett.

I want to ask you just about the national accounts. If you go back prior to your pricing initiatives, they would traditionally drag gross margins. And I'm curious, if we were to normalize for these contract sort of implementation to 10%, are they still relatively dragging year-over-year on the trend? Or are they flat, up? Like what's going on there?

So are you asking about -- I think you're asking the question on national account. Are their GPs flat year-over-year? Or are you talking about their impact on the company's GP?

Yes, yes. No, are they flat year-over-year? And just -- I guess if were to normalize for the contracts...

Yes, with the exception of the contract resets that we've talked about, the answer is yes, they're pretty stable.

They are pretty stable. Okay. And that's a change, right, from what...

Yes, it is actually, post reset. What we've seen with all of our large customers is a bit of an opportunity to simplify pricing. They are more willing to buy spot buys at the prices that they see because they're competitive. And so that's simplifying things as well.

Okay. The other question I had is, it goes back to tariffs. If the tariffs are rolled back or we actually achieve a trade deal, I mean, what actually happens to pricing? Does pricing have to get reversed? And how do you guys think about this dynamic over the next few months?

Well, so for us, we actually separate price/cost in terms of how we think about it. We're pricing to the market, and we try to get the best cost we can. I think I mentioned this before. Typically, when there's been things like that, that have happened, price will change, but there may be some lag. So there might be some period where you have some short-term benefit. Ultimately, you would expect if tariffs will roll back, that prices would eventually sort of moderate. But typically, we get some period of benefit then.

You mean, in Grainger prices moderate, so you would actually have to take your list prices down? Is that -- or your contract pricing down or whatever?

Over -- well, so over time, the market price will change, and we will be aligned in the marketplace.

Understood. Just lastly, your Zoro investments, I think you said that you were expanding your SKUs. What are the SKUs now? And how much do they expand? And I'm curious, are there -- is there an impact if Zoro gets bigger with respect to potentially cannibalizing medium accounts? Or do you really think they can sort of stick to discrete tracks?

Yes. They're pretty discrete today. There is very little cannibalization. Actually, today, there's several million SKUs that Zoro has. We will go to double-digit million SKUs eventually. Doing that actually creates a little bit more differentiation between a Grainger model, which is very industrial, very MRO-focused versus what Zoro has. And we feel that, that will actually mitigate cannibalization to some degree as well. But obviously, there's some, but it's very minimal today.

Ladies and gentlemen, we've reached the end of the question-and-answer session. I'd now like to turn the call back to DG MacPherson for closing comments.

All right. Thanks, everyone, again, for joining us. I would just reiterate a couple of points. One is, we're very happy with the performance that we had in 2018. I think we've focused on the right things, our results were strong, and we've got a lot of momentum heading into the future. So I really appreciate all your time, and I hope you are off to a great new year. Thank you.

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