Good morning. Welcome to Grainger's Third Quarter 2020 Earnings Call. With me are D.G. Macpherson, Chairman and CEO; and Tom Okray, SVP and CFO. As a reminder, some of our comments today may be forward-looking statements. 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 with their corresponding GAAP measures are found in the tables at the end of this slide presentation and in our Q3 press release, both of which are available on our IR website. This morning's call will focus on adjusted results for the third quarter of 2020, which exclude restructuring and other items that are outlined in our earnings release. Now I'll turn it over to D.G.

Thanks, Irene. Good morning, and thank you for joining us today. Market conditions remained challenging in the third quarter as the pandemic conditions improved but continued to weigh on many of our customers. Amidst these challenges, Grainger performed well, continuing to demonstrate our resilience and strength. I'm so proud of how Grainger team members have responded to the challenges of 2020, staying relentlessly focused on further deepening relationships with our customers and supporting each other. I've shared with you our Grainger edge framework, which includes our purpose, aspiration, strategy and the principles that define the behaviors we expect from all team members. These principles, including starting with the customer, acting with intent and competing with urgency, provide clarity and focus as we continue to execute on our purpose to keep the world working. And we'll continue to leverage the Grainger edge in all that we do throughout this pandemic and beyond. So let me start off with a brief business update and an overview of our third quarter performance before turning it over to Tom to dive into the details. On the business side, we continue to serve our customers well to support the needs and safety of our team members and ensure we remain in a strong financial position. A quick update on each point. Grainger has operated effectively throughout the pandemic, first in support of essential businesses and now in serving all businesses. Each of our customers has a unique story on how they have been impacted by and managed through the pandemic. We have been there for all of them. Sales to healthcare, government and e-commerce businesses remained strong in the quarter, and we saw improving trends with manufacturing and commercial customers. I'll address the pattern of revenue in a moment. Our world-class integrated supply chain organization, which supports both our North American high-touch businesses and our Zoro endless assortment platform, has helped find and secure products to meet customer demand. We have successfully worked down our backlog of orders for most pandemic-related products, including masks, and continue to work with suppliers to catch up on a few categories that remain scarce, including some gloves and hand sanitizers. The team remains laser-focused on maintaining our high level of customer service. Customer feedback has been strong and improving throughout the pandemic. For our team members, we continue to take steps to support not only their safety but their overall well-being during this uncertain time. To date, we have managed the challenges of 2020 without major layoffs and currently have roughly 1% of our workforce still on furlough. Importantly, we've maintained a strong financial position. We've been diligent in controlling costs while balancing the need to continue to serve our customers, support our team members and invest where it matters most. Our strong performance over the last 2 quarters, together with our solid cost containment, have enabled us to relax a number of our short-term cash preservation actions. We exited the quarter with approximately $2.1 billion in available liquidity. We continue to make strong progress on our strategic growth priorities during the short-term uncertainty. We have continued to execute our transform merchandising process to drive significant user experience improvements to grainger.com, including our search and visualization capabilities and enriched product descriptions and content. By the end of 2020, we expect to have remerchandised $2.8 billion in product through this new process, including $1.6 billion in the year alone. We intend to further accelerate these efforts moving forward as a result of our new product information management system that launched in the third quarter. Customer feedback on our website has improved significantly over the past 6 quarters. Marketing has been a large contributor to our U.S. share gain over the last few years. We have improved effectiveness in both media advertising and paid search and plan to further invest in marketing given these strong returns. We continue to deepen relationships with our customers through our large customer multisite growth initiative, enhancements to our KeepStock offering and improvements to our sales strategy and effectiveness. We know that when we embed one or more of our service offerings with our customers, we foster deeper and longer-lasting relationships. Over 60% of our U.S. revenue is generated from customers with one or more embedded solutions. And lastly, within our endless assortment model, we are executing the successful MonatoRO playbook at Zoro here in the U.S. and are making strides in marketing effectiveness, customer analytics and SKU additions. This year alone, we have added 1.5 million SKUs to Zoro, pushing its assortment to roughly 5 million products. Turning to our quarterly performance, we produced strong operating results in the third quarter. Organic daily sales finished up 4.6% in the quarter, underpinned by growth in our U.S. high-touch business and the continued impressive performance of our endless assortment model. In the U.S., we realized strong outgrowth to the broader MRO market as a whole, which was down 5% to 6% in the quarter. Our gains were supported by pandemic-related demand, sales to new customers, and improved sales of non-pandemic products as we started to see some stabilizing trends in underlying business activity. Overall business activity still trails pre-pandemic levels as some customers remain disrupted by COVID. The endless assortment model continues to deliver with 20% growth in the third quarter while also generating meaningfully improved margins. We remain very excited about the future of this business as we continue to adopt learnings from MonatoRO to drive growth and profitability. At the total company level, we expanded adjusted operating margins by 90 basis points as gross margin stabilized sequentially and we demonstrated strong cost control. Tom will detail this in a bit. The business continues to produce a durable cash flow stream with operating cash flow of $311 million and free cash flow of $252 million. Looking at Slide 6, I thought it would be important to again show this chart to highlight the underlying trends with pandemic and non-pandemic products based on our current categorization of SKUs. Our characterization goes beyond traditional safety products to include product categories with substantial volume increases during the pandemic. Flexiglass barriers will be an example. As you can see, while sales of pandemic-related products have decreased since May, continued demand for key products, including masks, gloves, and cleaning supplies, has kept pandemic sales elevated year-over-year. This heightened demand has continued to come from a multitude of new and existing customers across numerous industries as businesses reopen and adjust to the new operating protocols. On the non-pandemic side, sales have improved since bottoming out in April, with non-pandemic sales now down about 7% year-over-year. This improvement has been seen across most industries with some of the obvious industries remaining the furthest below their pre-pandemic levels. These include airlines, hotels, and cruise lines. Based on month-to-date performance, we forecast October sales to finish up around 2% for the U.S. segment on continued trends in pandemic and non-pandemic performance. Predicting the recovery over the next few quarters is very challenging. The path of the virus will have a big impact on whether the recent improvements continue, level off, or reverse, but we feel well positioned to compete in any environment that comes our way. With that, I will turn it over to Tom to talk us through the quarter's results in detail. Tom?

Thanks, D.G. Starting on Slide 8, you can see we delivered strong results in the quarter. Organic daily sales, which adjust for the divestitures of Fabory in China, were up 4.6% on a constant currency basis. This increase was primarily driven by share gains in our U.S. segment and continued impressive growth in our endless assortment business, which was up over 20% in the quarter. These gains more than offset pandemic-related softness in our Canada and Cromwell businesses, where we saw meaningfully higher sales sequentially but still remain well below pre-pandemic levels. Gross margin for the total company was down 170 basis points versus the prior year quarter, but represented a 120 basis point improvement from the second quarter year-over-year decline. Margin pressure continues to be driven by pandemic-related headwinds, primarily in our U.S. segment, as well as continued business unit mix impact as we experienced significant growth in our endless assortment business. Our SG&A came in at $700 million in the third quarter, better than our communicated range of $715 million to $730 million. SG&A cost was down $60 million year-over-year, and we captured 260 basis points of SG&A leverage in the period. This result stems from prudent cost reduction actions across our high-touch solutions model, including lower costs as a result of our Fabory divestiture and leverage gains with our endless assortment business. This SG&A performance more than overcame gross margin headwinds to drive a 90 basis point improvement in total company operating margins for the quarter, a tremendous result in this environment. Incremental margins were up 50% in the quarter. As mentioned last quarter, the utility of the incremental and decremental margin calculation is diminished in this uncertain environment as the metric can vary significantly given the magnitude of top-line swings from quarter-to-quarter. We generated operating cash flow of $311 million, which we used to continue to invest in the business, build appropriate inventory to support our customers and return capital to shareholders. Operating cash flow was 126% of net adjusted earnings, and year-to-date adjusted return on invested capital is over 29%. Given our solid results of the last couple of quarters, combined with stabilizing trends in underlying business activity, we fully repaid our revolving credit facility, increased our dividend payment, and are announcing today our intent to restart our share repurchase program in the fourth quarter. While we anticipate putting several hundred million dollars to work on repurchases in Q4, we will monitor market conditions and optimize the amount accordingly. The favorable trends over the last several months give us confidence that this is the right time to move forward with these actions. Turning to our U.S. segment. Daily sales increased 3.1% in the quarter, driven primarily by volume, which is net of unfavorable product mix. On the product side, sales of pandemic-related products remained elevated, up 53% in the quarter, but as shown earlier, have tapered off from the peak in March. Non-pandemic products were down around 8% in the quarter, but continued to show meaningful improvement from April lows. We've also seen a significant uptick in new customer acquisitions with some really encouraging signs of repeat buying. From a customer perspective, we saw improved growth with both large and midsized customers, with the latter growing 6% in the quarter, an improvement from the 6% decline year-over-year we saw in Q2 2020. Gross margins of 36.4% was down 160 basis points compared to the third quarter of 2019, but improved sequentially from the 310 basis point year-over-year decline we saw in the second quarter of 2020. The unfavorable variance in gross margin was driven mainly by 2 factors similar to the second quarter: pandemic-related product headwinds and tariff-fueled cost inflation. Pandemic-related headwinds contributed about 140 basis points of the gross margin decline, as we continue to see unfavorable product and customer mix due to elevated sales of lower-margin pandemic products. Beyond the pandemic impact, we continue to face pressure in the quarter due to the lapping of year-over-year cost inflation, which was driven partially by tariffs that went into effect in 2019. This drove approximately 80 basis points of year-over-year margin decline. Based on what we know now, we expect that both of these gross margin headwinds will continue into the fourth quarter. It should be noted that we anticipate the tariff headwinds will fully subside as we move into 2021. Offsetting these two factors in the quarter was a 60 basis points tailwind related to favorable freight costs driven by nonrecurring shipping efficiencies and timing. We do not expect these freight dynamics to continue in the fourth quarter. From an SG&A perspective, we gained 160 basis points of leverage with cost decreasing approximately $22 million year-over-year. The reduction was driven primarily by decreased travel expenses, lower labor-related costs, and general operating efficiencies. Operating margin remained flat to the prior year quarter at 15.1% as SG&A leverage offset gross margin headwinds. Return on invested capital was a very healthy 38%. Drilling into our U.S. sales performance on Slide 10. While we estimate the U.S. MRO market declined between 5% and 6% in the third quarter, Grainger was able to capture roughly 850 basis points of outgrowth, fueled by pandemic-related sales, selling to new customers, and improving sales of non-pandemic products. Despite the challenges of 2020, U.S. segment daily sales are up 2.1% year-to-date, and we have outgained the broader MRO market by over 900 basis points through the first 9 months of 2020. Moving to our Other Businesses. Organic daily sales increased 12.5% or 12.3% on a constant currency basis. The endless assortment business grew at approximately 20%, fueled by strong results at MonatoRO and Zoro during the quarter. Zoro continues to execute the MonatoRO playbook with improvements to marketing effectiveness, discounting strategies, and better cost leverage, all helping to drive improved performance. Although we saw significant sequential improvement compared to the second quarter, our international high-touch businesses continue to be impacted by pandemic-related shutdowns, with both Mexico and Cromwell seeing year-over-year declines. Operating margins for Other Businesses are up 190 basis points, with 35 basis points driven by the divestiture of our Fabory and China businesses, which produced below system average profitability in the prior year. The remaining operating margin favorability was driven by significant SG&A leverage across the portfolio, most notably within our endless assortment business, which continues to do a nice job leveraging its cost base. This leverage was only partially offset by gross profit headwinds from incremental freight costs at MonatoRO. Turning to Slide 12. In Canada, daily sales decreased 9.9% or 9.1% in constant currency. The decline is comprised of roughly 8% decline in volume and price headwinds, including customer mix of approximately 1%. While volumes in Canada continued to be impacted by the pandemic-driven economic slowdown, the business did improve sequentially and is gaining traction with hospitals, manufacturing, and higher-education customers. As the Canadian business continues to integrate and leverage our U.S. resources, we are making progress with our customer diversification efforts and are pleased with the trajectory of this business going forward. Gross profit margin at Grainger Canada declined 35 basis points year-over-year, driven by pandemic-related mix headwinds, which were offset partially by lower freight costs in the quarter. Cost management remains strong with savings of $5 million year-over-year, resulting in 110 basis points of SG&A leverage. Total operating margins were up 75 basis points versus prior year despite the top-line challenges. Before I turn it back to D.G., similar to the last couple of quarters, I want to give you a sense of how we're thinking about things in the fourth quarter. From a sales perspective, month-to-date trends support our estimate for October year-over-year sales growth to be up over 4% at the total company level on an organic constant currency basis. This October month-end estimate is reflective of continued solid growth in our U.S. segment, coupled with strong performance in endless assortment. From a gross margin perspective, as I previously mentioned, we anticipate gross margin pressure will continue as the pandemic-related impacts and tariff-fueled cost inflation headwinds will persist into the fourth quarter. The onetime freight tailwind we realized in the third quarter will fall off. Further, we anticipate year-over-year cost headwinds in the fourth quarter as the already stretched global shipping providers pass through freight surcharges during the busy holiday season. Given these factors and based on what we are currently seeing, we anticipate gross margins will be down over 200 basis points year-over-year. With respect to SG&A, we expect to see sequential increases in a couple of areas, primarily related to some incremental technology investments to support growth in the U.S. and at MonatoRO, which will push our estimated SG&A to between $725 million to $740 million for the fourth quarter. As always, we remain focused on managing near-term headwinds while continuing to invest in long-term growth, particularly in people, processes, and technology where and when it makes sense. With that, I'll turn it back to D.G. for some final thoughts.

Thanks, Tom. So I'm proud of our results for the quarter, and I want to thank our team members for their commitment to safety and customer service. We have gained share, improved our merchandising and marketing capabilities, deepened our customer relationships, expanded our assortment while improving margins at Zoro and have significant financial flexibility to support the business moving forward. We remain committed to fulfilling our purpose of keeping the world working throughout this pandemic as well as continuing to execute our strategy, so we can achieve this purpose for years to come. And with that, we will open up the line for questions.

Our first question today is coming from Chris Glynn from Oppenheimer.

I was curious, you mentioned the customer acquisition trend still going strong and conversions to some regular customer dynamics are going well. Just wondering if you could further dive into that topic and how it informs the early view of share outperformance for '21?

Thank you, Chris. As you may have noticed, due to our inventory levels, we've attracted a significant number of new customers to Grainger, Zoro, and MonatoRO during this time of increased customer acquisition. The positive aspect is that the rate of repeat customers has improved considerably compared to the past. While repeat rates remain similar to previous levels, we now have a larger pool of customers, many of whom are becoming regular purchasers. This trend indicates strong customer acquisition lately, which we believe is a positive sign for the future. We are confident in our expectation of 300 to 400 basis points outgrowth for our U.S. business and 20% growth for the endless assortment, and we see no reason to adjust these projections at this time. This year, we have actually exceeded those figures in the U.S., and we aim to maintain that performance and continue to grow from there.

Okay. For a follow-up, do you expect that the pandemic sales in the third quarter, using October as an indicator, might be close to the sustainable run rates as long as workplaces remain very cautious about germs? Or is that still too uncertain?

I think that's a very interesting question, and I don't think anybody has the answer. What we're seeing right now is elevated pandemic sales. We expect that to continue. And certainly, as case rates rise, which we've seen recently, we would expect that to continue through the fall. What happens when we have better treatments and a vaccine is probably a question that is all in our minds, and it's probably impossible to answer. We would expect some of that to moderate, but we do think people are going to be more conscious of safety and cleanliness for some period after that as well. But for now, we're seeing similar trends to what we've seen in the past. We would expect that to continue in the fall, given the rate of transmission.

Our next question today is coming from Chris Dankert from Longbow Research.

I guess, first off, what's the status of investment in Zoro? I mean in the past, we'd mentioned you had $50 million of investment in '19. It largely rolls off this year, I guess. Are we still on pace to get to mid-single-digit EBIT margin plus in the Other Business in '21? Just thoughts on investment there would be really helpful, I think.

Sure. So we had a very heavy investment period in the back half of '18 and '19 with Zoro. Many of those investments took several forms. One was technology. Another was people in getting the talent to be able to have their own destiny in terms of product adds and the like. And so we made those investments. Those investments are behind us. We're starting to see those leverage themselves now. This year, we're getting improved operating margins in Zoro. We think the long-term path for Zoro from a margin perspective is as we've discussed. We'll talk about next year in January, but we have no reason to believe the positivity that we've seen won't continue, and we still think that is going to be a high single-digit operating margin business in the next several years. And so that's the path for that business.

Got it. Got it. And then thinking about SG&A, I mean, compared to what the guidance was, again, coming in below that range. My apologies if I missed it, but just what were the key moving parts on what helps you kind of cut that SG&A number even lower in the third quarter here?

Yes. Thanks.

Tom, do you want to take that?

Yes, sure. Thanks, Chris. First of all, there was a little bit that was win dated just with the Fabory divestiture, and that takes the $60 million down to about $40 million. But then we just had real good efficiency across the board. Everything from travel and entertainment, professional services, cleaning supply, security, just a real good focus by the team in terms of efficiency and cost control. And one of the great things with the pandemic is we've always been cost-conscious, but I think we've really upped our game. And I think it's going to continue going forward where we're really in this mode of operating this way. So just to summarize, really good cost control across the board while continuing to spend in advertising and technology, which are important for us.

Got it. Glad to hear it that it's a broad-based savings, certainly. So congrats again on the quarter.

Our next question today is coming from Adam Uhlman from Cleveland Research.

Sticking with the SG&A question, I guess the freight dynamics that you pointed out for the third quarter and the fourth quarter are pretty interesting. As the surcharge rate kind of transitions into base rate increases, I'm wondering if you could help us ballpark just how meaningful of a headwind that could be for 2021? Or perhaps it's not a headwind, and you have some other levers to pull to offset that? And maybe you could just remind us about how you charge customers for freight. I believe most customers don't pay, but maybe discuss that as well.

It's a great question. Most of our largest and contract customers typically do not pay for parcel services; they usually pay for LTL or large shipments. The surcharge mentioned is focused on large packages during peak season, and we will implement charges for some of that. We anticipate recovering a portion of those costs, but not all. This won't heavily influence our projections for next year, which we will discuss after this quarter. The freight business has certainly faced challenges due to increased shipments to homes. We have encountered some pressure, but the surcharges from the fall may not impact our future operations in the same way, and we will address that. We believe we have strategies to alleviate these pressures moving forward, and we will discuss those details at the end of the year.

Okay. Great. That's good to hear. And then secondly, the company has been building up inventory. And I was curious, one, if you could talk about your inventory and working capital assumptions here in the medium term? And then secondly, if you are concerned at all of absorbing losses on any pandemic inventory that you might be taking if we have some good luck and the pandemic starts to roll off and market pricing deteriorates further?

Yes, let me address that. Tom, feel free to add if I miss anything. Regarding inventory, we've focused on two main areas where we've been increasing our stock, and we plan to continue doing this for the rest of the year. The first area is standard practice as we ramp up the Louisville distribution center in 2021. We are in the process of stocking that facility, which is partially complete now and will be fully stocked as we progress. The second area concerns pre-purchases for pandemic-related products. In response to your question about potential losses from excess inventory, our pandemic-related gross profit already includes some write-downs. To ensure customer service during the pandemic peak, we invested in a variety of products. While some prices have fluctuated, and movement has been seen in many cases, some have remained stable. Throughout this process, we've managed to serve our customers effectively, which is reflected in the gross profit rates. Overall, we are confident about our position. Most of our inventory buildup has been through pre-purchasing low-risk products we are familiar with and which we know will sell, preparing for potentially challenging fall and winter seasons. Therefore, most of our inventory exposure is not riskier than usual. However, some of the speculative buys made during the peak of the pandemic have already impacted our gross profit.

Yes. And just to add a little bit more color on inventory and cash. One of the things that we've been very efficient on is our management of cash, and you've seen that in this quarter. More specifically, our cash conversion cycle, our DSO is actually down year-over-year a couple of days. And our DPO is actually favorable by more than a few days, which has allowed us to keep an overall cash conversion cycle that is very healthy versus last year and invest in the inventory. So we can play our role as an essential business and support the customers the way we need to. So you're right. Inventory is up since the beginning of the year, 8% at $1.78 billion. We've invested in working capital. It's up $220 million. And we did put pandemic inventory spend in the quarter of approximately $300 million. And as D.G. said, I mean, you're not going to bat 1,000 on all of that. So we go through the normal E&O process. And I guess the way I would describe it is we're very aggressive operationally, but very conservative financially. So doing the right thing to reserve. So thanks for the question.

Our next question today is coming from Chris Snyder from UBS.

I just wanted to follow-up on endless assortment margins. I understand there's like a longer-term kind of high single-digit target out there for Zoro. But with the back-office investment slowing, what kind of incremental margins could we expect for this business as the top line continues to ramp?

Yes. It's a good question. We really don't look at incremental margins specifically on the endless assortment business just because the supply chain is so intertwined and the synergies with the broader business. So we really look at the business as the incremental margin for the overall entity.

I mean, Tom, I would just add. I mean, if you look at incremental margins with MonatoRO, typically, you're talking about a 15% to 20%, which is just GP minus the variable marketing cost. And so I would expect us to get to something like that over time at Zoro. But that's typically what we see in MonatoRO, I think.

Appreciate that. And then just following up on MonatoRO. So like the stock is like 100% year-to-date in Tokyo last I checked. Can you just talk about how you kind of view that business strategically at Grainger?

So we view both the endless assortment and the high-touch solutions model as absolutely core to what we do. Masaya Suzuki, who's the leader of that business now, also leads Zoro. We are sharing best practices and analytics and working together to ensure that we're actually making progress across those 2 businesses and our Zoro business in the U.K. as well. So we view it as absolutely core to what we do right now. And we're getting a whole lot of leverage from that MonatoRO team in terms of learnings and building the business in Zoro for the future. So we are running those very, very tightly together at this point.

Our next question today is coming from Deane Dray from RBC Capital Markets.

I was hoping to get more clarity on the gross margin guidance for the fourth quarter, which is down 200 basis points. Can you break down what the sales from the pandemic would be compared to non-pandemic sales? We're trying to understand the core gross margin trajectory.

Yes. I think the way to look at it, Deane, is we said the pandemic impact is 140 basis points for this quarter, and the cost other is 80 basis points unfavorable bad guy, and we had the onetime freight of 60. So if you remove the 60 from the 140 and the 80, you get to 220. Now we think that the pandemic will likely improve. Obviously, it's very volatile. Say you get roughly a 20% improvement on your cost inflation as well as your pandemic, that gets you to around 200-ish. And then you throw in the freight headwinds that we think we might experience at the end of the year, as D.G. discussed, with the surcharges, and that gets you above 200.

That's real helpful. And then I was hoping to get some additional color on the October sales. Just to the extent that you can, anything that you think would be helpful regarding geographic, customer sizes, anything else about the mix, that would be a big help here.

If you examine the sales revenue performance from July through October, you would struggle to find significant differences among those months. We have noticed a slight decline in pandemic-related sales and a minor increase in non-pandemic sales. Overall, the trends have been quite consistent throughout these months. Therefore, the trends and performance observed in the second quarter seem to be continuing into October.

Got it. And just lastly, an observation. I've certainly heard the Grainger spot ads on business radio pretty frequently in the brand building. So I guess pretty effective.

Our next question today is coming from Nigel Coe from Wolfe Research.

I want to pick up on that 4Q gross margin guidance. So roughly 200 basis points down from 38% last quarter gets it to about 36%, which would be up from this quarter. So I just wanted to make sure that, that math kind of still holds that we're looking for what would be a fairly normal sequential pickup in gross margin percentage from 3Q.

Tom, do you want to take that one?

I think another way to look at it is our absolute gross margin should be very similar to Q3. And then when you just look at the comparison to prior year, it's going to bump it over 200. So that's the other way I would look at it.

The growth among midsize customers was quite impressive and a noticeable improvement from last quarter. I'm curious if we're observing a shift from a high-touch distribution model, commonly used by many competitors, particularly smaller ones and a couple of larger ones, to potentially a more low-touch, direct ship e-commerce sales approach alongside some supply consolidation. Is there anything you can identify in the current market?

Well, yes, I would say we've certainly seen more digital sales through the pandemic. I think we've seen that in almost every industry, and ours has been no different. What I would say is that we are seeing improvements in midsize customer growth from digital actions but also from inside sales actions. So that is more of a touch, but we're seeing nice growth across both of those contact points. And so yes, I would say it's fair to characterize as more digital, but not all digital. We're also seeing some nice growth through some of our other actions that are more high touch.

Our next question today is coming from Josh Pokrzywinski from Morgan Stanley.

I have a couple of questions. I know we've covered a lot already, but I want to clarify something, if that's okay. Tom, regarding the endless assortment, it seems like there's some good leverage there. However, I’m curious if there are any developments with Zoro or MonatoRO related to product mix. During the pandemic, we discussed the mix of safety products, but more generally, are customers purchasing different items than usual? And does this create any positive or negative effects that might not fit the ongoing model?

Yes. I think the only thing that I would say, and then, D.G., please add, is we're probably seeing more B2C customers than B2B customers in the pandemic. But other than that, nothing out of the ordinary.

One factor that has affected our results during the pandemic is the blending of business and consumer activities, as many people are working from home. I've listened to several contact center calls, and it's interesting to note that individuals at home may be purchasing items for their businesses while also having them delivered to their residences. Consequently, we believe we have attracted more consumers than usual. We do not actively market to consumers, whether through Zoro or Grainger. However, we have seen very robust business customer acquisition, and these customers continue to be just as appealing as those we have attracted in the past. Overall, we are pleased with the strength of our business, despite the need to navigate the overlap between consumer and business transactions.

Got it. That's helpful. And then it sounds like Deane is going to be a future customer here based on the effect of this marketing, so maybe you can close that lead.

He's not the target segment, I can assure you that.

Understood. And then just on the inventory question. I know someone asked earlier about the inventory build there. Anything on kind of seasonally uncommon liquidation in the fourth quarter that you're planning that may be dragging that down or impacting that at all? Just thinking about historically, usually, you build a little inventory in the fourth quarter sequentially. Is that something that happened earlier? And is that playing into the dynamic at all on the gross margin?

It's playing into it a little bit. As we said on the previous question, we've been very aggressively operationally from an inventory perspective because it's the right thing to do, and we want to have the product available for our customers. But on the other hand, we've been conservative financially. So part of the gross margin deterioration that you've seen in Q3 is an E&O headwind, cleaning up some of the buys that didn't exactly thread the needle. So we've tried to do most of that in Q3. We'll see a little bit in Q4 as well. And then we believe that that's going to be behind us going into 2021, we'll have the right product to serve our customer. And then if anything, we'll have a tailwind as we unwind some of those reserves when the products that we have reserved potentially will be available for sale.

Our next question today is coming from John Inch from Gordon Haskett.

Assuming that PPE sales are expected to decline as the market has become saturated, what kind of absolute sales headwind could this represent as we move into 2021? You have maintained strong control over operating expenses. I don't think this has been addressed in the discussion so far. What costs do you anticipate will need to be reinstated next year as you transition from PPE to a more normalized volume trajectory for other products?

I think there are many factors in that question, John. It's challenging to predict the PPE trend. Since April, we've experienced PPE nearly doubling due to pandemic-related products, which encompass more than just PPE. In April, normal volumes decreased by 20%. Since then, we've seen these two trends align consistently. There are many variables at play. If PPE declines and we see improvements in non-pandemic products, it benefits gross profit, though it likely won't affect selling, general, and administrative expenses. We believe we can manage SG&A in any situation. One positive aspect of the pandemic, though there haven't been many, is that it has compelled businesses to focus, and we have concentrated on what truly matters. This focus is something we need to maintain moving forward to drive results and also manage SG&A. While I can't provide a definitive answer about PPE's future, it ultimately depends on the virus's timing and people's behavior, and we haven't encountered anything like this before.

Do you have any idea, D.G., about the SG&A challenges you're encountering on a measurable level? Considering that 1% of the workforce is furloughed, you might need to reduce travel and implement some merit increases. Is it too early to assess this, or what are your thoughts?

No. We'll discuss that further at year-end when we consider our future outlook. We implemented merit increases this year, so we do have costs that will return to the business. We expect travel to be modest for the next six months due to the current situation with the virus. At some point, that may pick up again. However, the key point for me is that we've experienced solid growth. Gross profit has been impacted as pandemic sales have been unusually high. Selling, general, and administrative expenses have decreased. Over time, as these conditions stabilize, we anticipate improvements in gross profit and some costs returning to the business. There's a dynamic here that we'll address later.

Yes. I'm sorry, the only thing that I would reinforce is, as D.G. said, we're always going to be about SG&A efficiency and control, and we'll handle that. The upside that I see which D.G. mentioned is we're going to see the gross margin pop from as the pandemic goes down. And also, I think on the sales front, as the broader economy opens up, we're going to be well positioned to ride that wave as well. And I would have to imagine, obviously it's speculation, that there's going to be a lot of PP&E product that's going to come into those businesses opening up as well. So I see it more as a tailwind than any sort of a headwind.

D.G., just lastly, implicit in your answer on MonatoRO and monetizing MonatoRO, you indicated that Zoro is still pretty important to the Zoro business. It's intertwined and so forth. At what point can Zoro do you think stands on its own where you might strategically be in a position to say, hey, we don't need to own half of MonatoRO, the stock has done fantastic, let's take our position down to 20%, 30%, something like that or even to 0%?

Well, I'd say a couple of things to that. One is it's probably timing, you probably need 3 more years, given what we're projecting to get Zoro to where we would like to get it. So it's really got the connected tissue to be a really strong performer for a long time. And so that's what we're shooting for. At that point, obviously, we could do things. There's all kinds of tax implications of that, John. And so we need to think through all that at that point. For now, for the next 3 years, we're thinking of it as we need to get Zoro business performing well. We're really excited about the MonatoRO path, and we think that's the right focus for us.

Our next question is coming from David Manthey from Baird.

Tom, I'll have to go back and review your commentary. But when you were talking about gross margin and you said above 200, I'm confused, was that a fourth quarter statement? Or were you walking into 2021?

Fourth quarter, Dave. The way I'm looking at it is just simple math. If you look at Q3, 160 bad guy on gross margin with a 60 bps of onetime freight. So if you just take the 60 bps up, that gets you to 220. Now we assume the pandemic is going to get better as is cost inflation, so bring that down to 200 or a little bit below. But then going back to the freight surcharges we see during the holiday season, that will get us back above 200, which is the framework that we talked about in the prepared remarks for Q4. Now having said that, I mean, it's very fluid. It's hard to predict. But we're just trying to give you guys some framework for your model.

Gross margin is challenging to predict at the moment. If we consider the overall changes from 2020, where we were in the low 36s range, what are the key factors that could influence that margin as we transition into 2021?

Yes. We'll have a lot more to say about that going forward. I think, though, just to give you a couple of things to think about. One would be how long is the pandemic going to last? Because obviously, the longer the pandemic lasts, the more we're going to be depressed with pandemic-related mix and the type of customers we're selling to. So that's number one. Number two, we should see a natural tailwind in terms of we will have fully lapped the tariff-related cost inflation as well as we'll probably see less spikes in terms of cost inflation related to the pandemic product. So those are the 2 big ones to think about, and both of them should be tailwinds for 2021. But again, it's premature to talk in detail. We'll have plenty of time for that later.

Got it. That's great information. Now, regarding KeepStock and the embedded solutions that contribute to 60% of our revenues, can you share what percentage of our customers that represents? Also, since these customers utilize several purchasing mechanisms you offer, could you explain what portion of sales is currently made directly through the embedded solutions?

Let me address that. Most of our largest complex customers utilize embedded solutions, typically combining the KeepStock inventory management system with the EDI Pro connected digital solution. I believe these two solutions account for over 30% of our direct revenue, though I don't have the exact figures in front of me. For our midsized customers, they tend to have fewer of these solutions and often purchase through grainger.com. This can be seen as pseudo-embedded since they might have their own pricing and workflows on the site, but generally, they wouldn't implement inventory management. Consequently, while the number of customers in this group is fewer, the largest complex customers will generally have an embedded solution.

Our next question today is coming from Michael McGinn from Wells Fargo.

Could you provide insight into the sell-through rate per site visit in the low-touch segment, as well as any measurable improvements regarding SKU recommendations, substitutes or frequently packaged products, and SKU count? What has been the most significant impact so far, and what do you foresee going forward?

Are you talking about the endless assortment business, the Zoro business?

Yes. Yes, the endless assortment.

I'd say there are three key factors that have had a significant impact. First is SKU count. We assess the productivity of each SKU we add, reviewing the past 6 to 7 years as we increased SKUs. We have now reached 5 million points, and the additions we've made in the last 6 months are proving to be at least as productive, if not more so, than previous ones. This is a positive sign for future growth and is likely the most crucial aspect. Secondly, customer analytics and marketing play a vital role. While we have a large customer acquisition funnel, encouraging those customers to make repeat purchases is essential. We are implementing various strategies in analytics and marketing to boost second, third, and fourth orders, and we are seeing tangible progress in that area. These two elements are by far the most significant factors in our endless assortment business, and we are making headway on both fronts.

And how does it correlate to sales per site visit and what's kind of been the trend there?

Sales per site visit. You mean customers coming on to the website and what's the revenue per site visit?

Yes. I guess what industry metrics are you benchmarking to within that and this assortment model? And what's been the improvement with this level of investment?

So we look at things that other businesses would look at. The return on ad spend, that is interesting, but not sufficient. The most important thing is looking at customer value. And so looking at customer acquisition and the customer lifetime value. And so we look at new customer acquisition rates, repeat rates, and we link all that to a customer value model to understand the NPV of each customer ad. And so that's what we track all the time.

Got it. On my second question, what is the targeted level of capital expenditure in the coming years as you shift away from branches towards an endless assortment? It seems like you're doing well this year, but I'm curious if you spent less than expected this year, and whether there will be a catch-up in spending for next year or beyond.

Yes. I don't...

Go ahead, Tom.

I don't anticipate any significant catch-up in spending. We invested about $60 million this quarter, which is comparable to last year. When the pandemic began, we reduced our expenditures and postponed some initiatives. However, due to our confidence in cash generation, we have returned to our typical spending levels. Therefore, I do not expect any substantial increases in future years that would be unusual.

Our next question today is coming from Hamzah Mazari from Jefferies.

My question was just in the other segment, if you take out the endless assortment business, are those other businesses losing money today? Or are they profitable? And then is the endless assortment business now over 10% of revenue, where you have to sort of resegment that? Or is that not the right way to look at that?

In response to your second question, we are considering the need for any segmentation and will discuss our stance on that at the end of this year or early next year. We are assessing this and collaborating with our auditors to fully understand the requirements. There are various types of businesses within the other segment, excluding endless assortment, but there aren't many. Mexico is profitable, as is Puerto Rico. Cromwell is currently unprofitable, but it has been performing well in terms of customer service and experience, and it is losing less money this year compared to last. Overall, I think these businesses are slightly unprofitable as a group, with two being profitable and one not performing as well, but we are addressing that situation.

Our next question is coming from Justin Bergner from G. Research.

Quick clarification question, then a more open-ended question. The medium-sized customer growth going from negative 6% to 6%, how much of that related to those businesses sort of being closed in the second quarter or being unable to get pandemic-related product and then sort of catching up in the third quarter?

So there are two things going on. One is some of those businesses were more impacted and may have been closed. I think the bigger issue was in the heat of the pandemic in April, May, in particular, given the way product supply happened for pandemic products and the customers we needed to funnel that product to, we didn't have product available for those customers. And in the summer, we relaxed that constraint as pandemic products became more available and we were able to open that up to that customer base. And so we've seen very strong growth since that happened. And I think that's probably the bigger issue is just being able to release the product for midsized customers, and we've seen nice growth as a result.

Great. And then the open-ended question. Looking at it from a sort of customer grouping point of view, Grainger showed nice acceleration in the government and the retail channels. Maybe you could just sort of talk about anything unusual or potentially recurring that is going to sustain that trend and maybe in the context of just general outgrowth levers that may be materializing anew as you look towards the end of this year and into 2021?

Yes, it's important to understand that retail primarily consists of distribution centers that serve customers directly. We don't engage much in walk-in retail. Instead, we focus on distribution centers that have significant safety and other requirements. This sector has been growing, especially during the pandemic, and we have supported our customers throughout this time. We believe this trend will continue as we move forward. What was the other segment you mentioned?

Government accelerating, which would sort of be surprising in light of pandemic sales being decelerating.

Well, yes, the government sales have been strong, and a lot of that has been pandemic as governments try to find product to support their communities during this time. And so that's a lot of state government business. Military has been okay as well for federal. But certainly, state governments have been very, very busy as each of them has tried to fight the pandemic, and we've been there trying to help as much as possible.

Our next question today is coming from Patrick Baumann from JPMorgan.

I have a couple of quick questions. I'm curious if you can provide an estimate of the revenue from pandemic-related sales that might pose a challenge for next year. It sounds like you anticipate solid market share gains, estimating between 300 to 400 basis points. I just want to confirm if there are any significant concerns regarding pandemic sales affecting next year.

Well, I think we're definitely going to talk about that in January with our results, like I said before. Right now, and as we head into the winter, given what we're seeing with case counts, we expect pandemic sales to be elevated through the fall and into the winter. That would be our expectation. We will reevaluate as we go forward to really understand what the puts and takes are. But if pandemic sales go down, we think non-pandemic sales will go up because that would mean the pandemic isn't as much of a problem. And again, that helps our gross profit when that happens and probably overall profitability rates. So we don't really know. I think it's impossible to tell what's going to happen with pandemic products. At some point, it will be a headwind, but other things then won't be a headwind, and that's our expectation.

Yes. Makes sense. And then last one real quick on Zoro. Are the added SKUs year-to-date, is that all third-party related? And since you're skewing mix more in that direction, I just want to check and see if there are any big differences in how you report the revenue or the margin or the type of margin you get when you ship third-party versus Grainger owned inventory.

Yes. Many of the new product additions are from third parties, with some coming through the Grainger supply chain. Third-party items usually have lower selling, general and administrative expenses and slightly lower gross margins. However, we typically collaborate with high-quality companies that have strong fulfillment capabilities. This is important as we build partnerships that enhance our product range. While our reporting remains unchanged, this will increasingly influence our operations moving forward. We will keep adding third-party shippers, which is a significant component of our strategy.

Yes. The only thing I would add, Patrick, is the accounting difference is whether you're an agent or not when you're doing third party, but that's a minor nuance. So thanks for the question.

We've reached the end of our question-and-answer session. I'd like to turn the floor back over to management for any further or closing comments.

All right. So this is D.G. So thanks, everyone, for joining us. Really appreciate it. We feel good about our results in the quarter. We feel really good about our forward prospects. Obviously, there's a ton of uncertainty in terms of how the market is going to evolve. And probably more than anybody, we'd like for the pandemic to be behind us, but we know it's not. And so we're going to make sure we continue to support our customers through this. That's the first and most important thing we're going to do. And we're going to make sure we take care of our team members, and we're going to make sure we do things that are prudent, both for the current performance of the business but for the long term. And we feel like we're taking the right actions and in really good position to succeed both during the pandemic and beyond. So thanks for joining us today, and hope you all stay safe.

Thank you. That does conclude today's teleconference. You may disconnect your lines at this time, and have a wonderful day. We thank you for your participation today.