W.W. Grainger, Inc. Q4 FY2020 Earnings Call

Greetings, and welcome to the W.W. Grainger Fourth Quarter 2020 Earnings Conference Call. Please note that this conference is being recorded. I will now turn the conference over to our host, Irene Holman, Vice President of Investor Relations. Thank you. You may begin.

Good morning. Welcome to Grainger's Fourth Quarter and Full Year 2020 Earnings Call. With me are D.G. Macpherson, Chairman and CEO; and Deidra Merriwether, Senior Vice President 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 Q4 earnings release, both of which are available on our IR website. This morning's call will focus on adjusted results for the fourth 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. I'm excited that our new CFO, Dee Merriwether, is here with me. Dee brings a wealth of financial and operational expertise and a deep understanding of Grainger's business that will serve us well. She has been with Grainger for 8 years in finance, pricing, and sales leadership roles. It's great to have her as our new CFO. For the call today, I'd like to provide an overview of 2020, highlighting accomplishments and challenges. Clearly, much of the year has been shaped by the pandemic, but I'll also highlight our progress on key strategic initiatives. Then I'll turn it over to Dee to review the details of our fourth quarter results. I'll close by discussing how we will resegment the business to more closely reflect how we think about the company, and we'll also touch on our high-level opportunities and priorities for both the high-touch and endless assortment businesses. 2020 was obviously one of the most challenging and intense years in history. Through it all, we demonstrated agility, resilience, and a steadfast focus on supporting our customers and team members. At the start of the pandemic, we laid out 3 basic priorities: to serve our customers well, support our team members, and ensure we remain strong financially. I can confidently say we've been able to accomplish all 3, and I'm proud of how the team has continued to execute on our purpose to keep the world working by living our principles every day. Over the last year, we persevered through the pandemic while continuing to deliver an exceptional customer experience. We've deepened relationships with existing customers and developed new relationships, many of which have returned for multiple purchases. We helped our customers secure product, manage their inventory, and solve their problems as we further embed KeepStock and our other solutions in their facilities. Grainger was sometimes the only vendor our customers allowed on their sites to support their operations; a testament to our deep customer relationships. Another priority was to support our team members. We operated with the perspective that the pandemic would be challenging and longer in duration than we had anticipated, but that it would eventually end. As such, we maintained a stable workforce, deployed personnel to safely and effectively serve customers, and supported team members to ensure their safety and well-being. The pandemic is, first and foremost, a humanitarian crisis, and supporting our team members has remained a huge priority. Finally, we have remained very strong financially, generating over $1.1 billion in operating cash flow in this difficult year. As it became clear that our business model would be resilient throughout the pandemic, we reverted from a temporary focus on cash preservation to our longer-term strategic priority of growing the business profitably. The Grainger team has been active in serving our communities during this time of need. We have great team members who value giving back to others. As a company, we provided monetary and product donations to organizations like the Red Cross and the Children's First Fund to support the pandemic response. Key leadership challenge this year was balancing our pandemic response while continuing to build the company for the future. Throughout, we remain focused on executing against our strategic initiatives. Within our high-touch solutions model, we improve the way customers find the products they need. We know this is core to our growth. In 2020, we launched our product information management system, which provides the foundation for our merchandising efforts. We now have over $2.8 billion of our product assortment remerchandised, with $1.6 billion completed in 2020 alone. We also made enhancements to our search functionality and mobile app, resulting in a better user experience. We added features like a search by image, where you can take a picture of the product you're looking for and get accurate matches to relevant items quickly and easily. We took a significant step forward with our marketing capabilities in 2020. We brought more capabilities in-house to develop the competitive advantage of industry-specific knowledge. These efforts helped us gain share and increase customer acquisition with the Grainger brand. We developed new capabilities to support on-site inventory management, including vending solutions and technology, allowing us to remotely upgrade or alter installations to better serve customers during the pandemic. We also opened a new distribution center in Louisville earlier this year, now our largest facility, with the capacity to stock 700,000 products in a strategic geographic location. We leveraged the building to test product expansion on a set of new categories with very strong results. We also made strong progress with our endless assortment businesses. Zoro continued to expand its product portfolio, adding 2.5 million items in 2020 to bring the total SKUs to over 6 million. Zoro also improved its marketing capabilities, resulting in improved ROI and higher customer repeat rates. They are leveraging the MonotaRO playbook to improve the fundamental growth and profitability of the business. MonotaRO continued its exceptional growth and profitability performance. All in all, a great year for the endless assortment team. Now before I review our 2020 results, I think it's helpful to step back and take a look at the impact the pandemic has had on our operating performance. From a revenue perspective, we started to see a shift to pandemic-related products starting in mid-February of last year. In late March, as pandemic product demand surged, we saw a significant decline in other non-pandemic product as lockdowns took hold. Since that point, we have seen continued strong sales of pandemic products, which has ebbed and flowed based on the virus, including another surge in the fourth quarter, which mirrored the increase in case counts. Non-pandemic products are slowly coming back, and while not yet at pre-pandemic levels, they have improved quite a bit from April lows. We expect the pandemic to continue to impact revenue through at least the first half of 2021 and then start to moderate as vaccinations take hold. Steve will detail our forward-looking thoughts in a bit. The pandemic has also had a significant impact on gross profit, driven by 2 main factors: First, we were impacted by product and customer mix. Pandemic products are generally lower-margin, and we sold large quantities to health care and government customers, which typically receive more favorable pricing. This was exacerbated early on as we initially prioritized product allocation to those most in need, like health systems and those on the front lines. Thus, sell-through margins have been negatively affected by these mix impacts. The second driver is that we have been aggressive in supporting our customers by trying to anticipate the needs they might have. As a result, we placed large orders for certain products in Q2 of last year. As we have gone through the pandemic surges, the supply-demand situation has changed rapidly for some products, forcing us to revalue our inventory to reflect this reality. The vast majority of our purchases have worked well, though a few have not. We have reverted to our normal purchasing processes and will continue to monitor market dynamics as the situation unfolds. Looking ahead, our gross profit will improve sequentially as we move through 2021 with anticipations of exiting as high or higher than we started in Q1 2020. We expect U.S. gross profit to improve sequentially and to exit 2021 at high or higher than we began in Q1 2020. Finally, as we look at SG&A, overall net costs were lower despite some increased costs for enhanced safety protocols and workforce disruptions. The team was able to tightly control costs while also continuing to invest for the long term. Despite these unique and challenging circumstances, we were still able to deliver strong overall performance in 2020. A few of the highlights: We delivered organic constant currency daily sales growth of 3.5% at the total company level, driven by our above-market growth of 800 basis points in the U.S. due in part to pandemic-related sales. Also, we achieved over 18% daily sales growth in the endless assortment businesses. We delivered an operating margin of 11.2%, reflecting strong SG&A leverage, which helped to offset the previously mentioned pandemic-related gross profit headwinds. We generated over $1.1 billion in operating cash flow while returning $939 million to shareholders in dividends and buybacks. We remained disciplined in our capital deployment, maintaining a strong adjusted ROIC of over 28% for the company. In order to focus on our core high-touch and endless assortment businesses, we divested Fabory and China, 2 non-core businesses abroad. Overall, I am confident in the direction we are heading and very excited about the future. We have gained significant share and strong capabilities. We are in a very good position to deliver strong performance this year and for years to come as the pandemic loses its grip. With that, I will turn it over to Dee to take us through the fourth quarter results. Dee?

Thanks, D.G. Turning to our quarterly performance. Organic daily sales, which adjust for the divestitures of Fabory and China, finished up 5.6% on a constant currency basis in the fourth quarter. Underpinned by growth in our U.S. segment and continued impressive performance in our endless assortment businesses. In the U.S., we realized strong outgrowth to the broader MRO market, which contracted about 1.5% to 2% versus the prior year. Our gains were driven by pandemic-related demand, which remains at elevated levels, sales to new customers, and growth with midsized customers. The endless assortment model continues to deliver with 20% growth in daily sales again in the fourth quarter, while also generating improved operating margins. We remain very excited about the future of this business, and we'll discuss our plans to provide further transparency as we introduce our new GAAP reportable segments for 2021. At the total company level, margin pressure continues to be driven by pandemic-related headwinds, primarily in the U.S. segment. I will detail the pandemic mix more in a few slides. In addition, we continue to see business unit mix impacts as we experienced significant growth from our endless assortment businesses. SG&A costs were favorable by $42 million year-over-year as we captured 235 basis points of SG&A leverage in the period through prudent cost controls in the U.S. and Canada, and we gained strong expense leverage in our endless assortment businesses. This resulted in Q4 operating margin at 10%, down 75 basis points from the fourth quarter last year. From a cash flow perspective, the business continues to produce robust cash flow, with operating cash flow of $336 million at 170% of net adjusted earnings, and free cash flow of $291 million. We restarted our share repurchase program in the fourth quarter and completed $500 million of repurchases in the period. Finally, we delivered strong return on invested capital at over 28% for the full year. Turning to our U.S. segment. Daily sales increased 3.7% in the quarter compared to the fourth quarter of 2019. On the product side, sales of pandemic-related products remain elevated, up 49% in the quarter but have tapered off from the peak in the second quarter. We continue to see meaningful improvement in our non-pandemic product trends, which have improved to down 7% in the quarter, exiting the year with December at the lowest decline, down 5%. We've also seen a significant uptick in new customer acquisitions month-over-month with encouraging signs of repeat buying. From a customer perspective, we see improved growth with both large and midsized customers, with the latter growing about 6% in the quarter, continuing to show signs of improvement from earlier in the year. Gross margin of 35.7% was down 290 basis points compared to the fourth quarter of 2019. The unfavorable variance in gross margin was driven most notably by pandemic-related headwinds, which accounted for nearly 90% of the GP decline. The pandemic impact was driven by continued product and customer mix and mark-to-market inventory adjustments, which D.G. outlined earlier, as well as freight-related surcharges, net of pass-through shipping charges to customers. In the second half of 2020, we started getting solid traction on price realization, which nearly offset continued cost headwinds as we exited the year. From an SG&A perspective, we gained 155 basis points of leverage with costs decreasing approximately $14 million year-over-year. The reduction was driven primarily by decreased travel expenses, lower depreciation, and general operating efficiencies. Operating margin declined to 12.8% in the fourth quarter as the pandemic impact of gross margin weighed more heavily than the SG&A leverage gained. Adjusted return on invested capital was a very healthy 36.5% for the full year of 2020. Now looking at pandemic product trends. While sales of pandemic-related products decreased from the second quarter through October, continued demand for key products, including masks, gloves, and cleaning supplies, has kept pandemic sales elevated year-over-year. We saw this pick up again in the last few months of the year as cases spiked heading into winter. We've also seen customers across industries prepare for vaccine distribution, which may require different products like those needed to work in refrigerated storage units. January sales remain elevated and have tapered off from Q4. Looking at share gain, we estimate the U.S. MRO market declined between 1.5% to 2% in the fourth quarter, showing strong improvement from the mid-teens decline we saw in the second quarter. Grainger was able to capture roughly 550 basis points of outgrowth, fueled by pandemic-related sales and our growth initiatives. On a full-year basis, we estimate that we have outgrown the broader MRO market by roughly 800 basis points. This outgrowth was aided by significant pandemic-related volume, some of which, particularly in the second and third quarters, was related to large onetime orders that are unlikely to reoccur. We estimate that approximately 250 basis points of the market growth in 2020 was a result of these non-repeating pandemic transactions. Accordingly, as we move into 2021 and lap these pandemic sales spikes, we expect to see some volatility in our year-over-year share gain metric. That being said, we are confident in our ability to serve new and existing customers during these challenging times. We believe we are doing the right things in merchandising, marketing, and sales effectiveness to drive repeat purchases and produce 300 to 400 basis points of sustainable outgrowth in our U.S. high-touch business. Moving to our other businesses. Organic daily sales increased 14.6% or 13% on a constant currency basis. The endless assortment business grew at an approximately 20%, with strong results in both MonotaRO and Zoro during the quarter. For our international high-touch business in both Mexico and Cromwell, we saw continued sequential improvement. However, both businesses remain impacted by pandemic-related shutdowns. Overall, operating margins for other businesses were up 210 basis points. The favorability was driven by significant SG&A leverage and endless assortment, notably at Zoro, which lapped heavy investment spending in the prior year period. Zoro continues to execute the MonotaRO playbook and deliver low single-digit results for the year. Turning to the Canadian market, it has seen an overall economic slowdown during the pandemic, which has notably impacted our natural resource and export customers. Throughout the pandemic, our team in Canada has remained focused on serving new and existing customers well while also accelerating our customer diversification efforts. In Canada, daily sales decreased 3.2%, or 4.4% on a constant currency basis. Volumes in Canada reflect the pandemic-driven slowdown. However, the business continued to improve sequentially. We have seen positive sales growth in the month of December, and we believe the business is well suited for post-pandemic growth. Gross margin at Grainger Canada declined 1,040 basis points year-over-year. This is primarily driven by lapping significant onetime supply chain efficiencies, and to a lesser extent, the impact of pandemic-related headwinds. Cost management and the benefit of pandemic-related subsidies resulted in 315 basis points of SG&A leverage. Given the continued uncertainty surrounding the pandemic and the subsequent path of economic recovery, we will not be providing formal guidance at this time. The picture remains fluid, as does the shape of the pandemic and the customer demand for pandemic products. Similar to the last few quarters, we want to continue providing some insights into how we're thinking about the current quarter's performance. From a sales perspective, our preliminary results for January show year-over-year sales of about 9% at the total company level on a daily organic constant currency basis. While this is a strong start to the quarter, we faced more difficult comparisons in February and March when pandemic sales started to spike. With this, we expect daily sales to moderate and end the first quarter up between 3% and 5% organically. Note, we'll also have 1 less selling day this quarter. From a gross margin perspective, we expect GP improvement of around 50 to 100 basis points sequentially versus Q4 2020. This anticipated lift is underpinned by a slowdown in pandemic product demand, continued price cost recovery, and the lapping of freight headwinds experienced in Q4 2020. On a year-over-year basis, this would imply GP will be down between 150 to 200 basis points in the quarter. With respect to SG&A, we expect costs will inch up sequentially as business activity progresses and if things like variable compensation reset with the start of the new year. With this, we anticipate SG&A of between $730 million to $750 million for the first quarter of 2021. While this is up slightly compared to Q4 2020, we will still be down meaningfully year-over-year. As always, we remain focused on managing near-term headwinds while continuing to invest in the business for the long term. From a capital allocation perspective, we remain committed to our balanced framework. For 2021, we anticipate investing between $225 million and $275 million back into the business. These CapEx investments include DC expansion in Japan, continued IT and KeepStock investments in the U.S., and normal levels of maintenance capital. Beyond that, we anticipate executing a similar dividend and share repurchase strategy, putting between $600 million to $700 million to work on repurchases in 2021. Although we are not providing 2021 guidance, I thought it might be helpful to provide some insights as to how a post-pandemic recovery could play out through the year. As it's the largest portion of our business and one of the most impacted by the pandemic, we have charted our U.S. segment to give you some context. As we have seen continued progress on vaccine distribution and a return to near full economic activity as we enter the second half of 2021, we would expect our results to trend back towards more normalized levels. On the pandemic/non-pandemic sales chart, the quarter-to-quarter sales spikes from pandemic-related products are most pronounced in the second quarter, which remained elevated through the year, and finished up $835 million or 54% in 2020. This drove pandemic product mix as a percent of total sales to 28%, a large increase compared to 19% in 2019. Conversely, non-pandemic sales were down dramatically in the second quarter and remained depressed throughout the year, finishing down $540 million or 8% in 2020. These trends improved sequentially. In 2021, we expect to face lapping headwinds as pandemic sales continue to moderate from the spikes we saw last year. That being said, it's important to remember that more than 70% of our sales come from non-pandemic products, and as the economy recovers and these sales rebound, it should more than offset the headwinds from pandemic-related products. This will also help normalize our product mix back towards pre-COVID levels. Accordingly, we would expect to see year-over-year growth in 2021, but the magnitude will be determined by the pace of the economic recovery. Related to gross profit margin, as product mix trends towards pre-pandemic levels, we would expect to see improved GP rates throughout the year. This includes sequential improvement from Q4 2020, beginning in Q1 2021. We expect to exit the year with U.S. GP rates as high or higher than Q1 2020 levels. I want to reiterate, while this commentary relates to the U.S. business, I showcase it because it represents more than 70% of the total company results and was the most heavily impacted by the pandemic. With that, I will turn it back over to D.G.

Thank you, Dee. Turning to our new GAAP reporting structure, I am excited to announce changes that will better align our financial disclosure to the way we manage the company, while also providing increased transparency for the investment community. Beginning in 2021, we will shift our segments to high-touch North America and endless assortment. Thinking about these businesses under two new segments is consistent with our strategic priorities for each segment and how our teams are organized internally. Our new high-touch North America segment comprises our Grainger-branded businesses in the U.S., Canada, Mexico, and Puerto Rico. This further solidifies the work we have done over the last couple of years to create a consistent go-to-market approach across the region while also merging the commercial functions of these businesses into a single organization. It reflects the fact that we run the supply chain as one entity across the region. We feel confident that these businesses are well situated to support our customers with quicker, more coordinated decisions to drive profitable share gain and exceptional customer solutions across North America. Given the growing size and importance of our endless assortment model, the timing is right to begin providing stand-alone disclosures for this important business. Our endless assortment segment will consist of our MonotaRO and Zoro businesses, which operate primarily in Japan, Korea, the U.S., and the U.K. We continue to align the operations of these businesses more closely, taking a lead from the success we've had at MonotaRO. Alongside these changes, we will also take the opportunity to simplify our corporate cost allocation and intercompany sales methodologies to better align with industry best practices. Given this amount of change, we wanted to preview the resegmentation this morning in preparation for shifting to the new structure, starting with our first-quarter 2021 results. Between now and our Q1 earnings call, the team will be working to file our 2020 10-K in the normal course under our historical presentation. Shortly thereafter, we expect to file an 8-K with three-year recast summary financials reflecting the new segmentation, including quarterly information for the 2020 period. On March 9, we plan to host a modeling call to help you fully understand the change and answer any additional questions that you may have. This should position us well for our Q1 call on April 30, which I would point out is a week later than normal. Going forward, given our new endless assortment reportable segment, we will be pushing back our earnings call calendar to align with MonotaRO's schedule. Shifting gears, we continue to execute against our business priorities. In our high-touch solutions model, we remain focused on remerchandising our product line to ensure customers and team members can find the right solutions quickly. We know that remerchandised categories see increased sell-through rates while also significantly improving the user experience, so this work is an important pillar in our share gain efforts. We expect to remerchandise an additional $1.5 billion of product in 2021. This process has become embedded in the way we work and will be a constant moving forward. We will continue to invest in and improve our marketing efforts, which supports all customers and has delivered proven share gain over the past few years. We'll continue to deepen customer relationships with KeepStock and further strengthen our KeepStock offer to create more value for customers and ensure we have a competitive advantage. We will continue to improve our offer and sales strategy with both large, multisite customers, as well as midsized customers. And lastly, we will continue to improve the path that we are on with our Canada operations as part of the North America Grainger business unit. Our improved cost position, exceptional service, and early success in expanding into new customer segments gives us confidence that we are on the right path in Canada. We will update you on Canada's performance as part of the high-touch North America segment. In our endless assortment model, we expect to add over 2 million items to Zoro in the U.S. in 2021, pushing us to over 8 million SKUs on the site. We will work to continue improving profitability through enhanced marketing efforts and further leverage analytics to refine our customer acquisition funnel and improve customer repeat rates at Zoro. MonotaRO flexed its resilience in 2020, and we'll look to continue momentum in 2021. The business expects to launch new product and order management systems in the first half of the year to further improve internal processing and shorten lead times. Additionally, work continues on 2 new fulfillment centers, with the Ibaraki facility expected to be completed in mid-2021. There's a lot of great work being done across the organization, and I am excited about the opportunities in front of us in 2021 and beyond. On Slide 19, I just wanted to reiterate our earnings growth algorithm. As we have shed non-core businesses over the last few years and moved forward with more streamlined reportable segments, the path to long-term growth comes into clearer focus. On the operational side, we feel we are well situated to gain share profitably in our North America high-touch business. This includes 300 to 400 basis points of sustainable annual outgrowth in the U.S., improving top line performance in Canada, and operating margin expansion as GP rates recover, and we continue to gain SG&A leverage. In the endless assortment, we expect to continue to produce 20% annual top-line growth while also ramping margins at Zoro U.S. into the mid to high single digits over the next 3 to 5 years. These strong growth drivers, alongside a business that generates consistent free cash flow and has significant capital allocation flexibility, give us confidence in our ability to deliver strong returns for our shareholders. I'm proud of our results for the quarter and the full year and want to thank our team members for their commitment to safety and customer service. I also want to thank our customers and suppliers who have been great partners throughout this challenging time. We have needed to work together more than ever over the past year, and those relationships have been crucial. We have gained share, improved our merchandising and marketing capabilities, deepened our customer relationships, and expanded our assortment while improving margins at Zoro. We are in a strong financial position to grow the business profitably 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 the lineup for questions.

Our first question comes from Ryan Merkel with William Blair.

So first off, can you explain Slide 14 in the deck a little bit more? How much are you assuming pandemic sales to be down in '21? And I guess I'm just trying to get a sense of what the safety surge headwind could be for 2021?

The headwind will largely depend on the duration of the pandemic. Considering around 10 months of pandemic sales, we generated about $100 million in additional pandemic product sales. We believe that pandemic sales are currently very strong and will continue to be so. For the year, we expect the headwind to be several hundred million. However, we anticipate that we will more than recover that in non-pandemic sales.

Okay. That's helpful. And then the next slide, the gross margin framework, is really helpful. I guess my question is on 250 basis points of ramp from 4Q '20, do you expect it to be gradual like you're showing? Because I would think in 2Q, you could see a bigger jump based on the comps. And then as part of the answer, can you just tell us how to think about freight and inventory adjustments? Because I would think those impacts would be falling off?

We anticipate that the freight impacts will begin to decrease in the first quarter and continue reducing in the second quarter. However, the freight environment remains tight. As you may know, more people are ordering products for home delivery than ever before, which has resulted in a fairly constrained freight market. Nevertheless, we do not expect to be significantly affected by this. Regarding inventory adjustments, I want to clarify that in the second quarter of 2020, we implemented several measures to ensure product availability for our customers to maintain service levels. Some of those measures were successful, while others did not perform as expected, and we primarily received that product in the third quarter. Each week, we gain more insights, and we plan to align our inventory with actual pandemic-related sales as we learn. Therefore, we expect to continue making inventory adjustments in the first half of the year, but we anticipate that they will gradually diminish afterward. So the ramp we projected is more aligned with our expectations.

Our next question comes from David Manthey with Baird.

So in the fourth quarter, you reported 70 basis points of sequential degradation in gross margin. I think your outlook was more for a flat outcome. Can you quantify approximately the material factors that affected the fourth quarter gross margin working from the third quarter levels?

Yes, sure. I'll turn it over to Dee. Roughly, the surge in pandemic had a modest impact. The inventory adjustments had a bigger impact and were a large part of that. So Dee, do you want to provide a little bit of color?

Yes, thank you, D.G. If we focus on the U.S. segment, particularly regarding Slide 15, I would note that more than 90% of the sequential impact from Q3 to Q4 was driven by pandemic-related challenges. D.G mentioned this, and I also touched on our mark-to-market adjustments. Although you asked about the sequential changes, it's important to highlight that about half of our total pandemic impact for the full year was due to inventory adjustments.

With a bigger portion in the fourth quarter?

Correct.

Okay. And then second, as the fourth quarter gross margin didn't play out exactly as you expected relative to your outlook last quarter, when you look at the gross margin outlook here, what factors could prevent you from achieving the anticipated levels that you have outlined here for 2021?

Well, I mean, I think that most of what we have is pretty well understood and known at this point. So if we get to a point where the vaccinations work and the third quarter starts to look better economically and there's less pandemic product, that's generally the shape of how it will play out. Obviously, if the pandemic doesn't get better and we're still in a really elevated pandemic state, and pandemic is still a huge portion of our business, it would be somewhat less. It'd still improve over the year, but there'll be somewhat less as we exit the year than is shown in that slide.

Our next question comes from Christopher Glynn with Oppenheimer.

Welcome, Dee. Congrats on the new role.

Thank you.

I was curious, Dee, you kind of left off with affirming the 3% to 4% outgrowth as your long-term algorithm. For '21, is it reasonable to net the kind of 2.5% of large pandemic orders against that as a thought as we kind of model out the year?

Yes. In the U.S., I think the way to think about it is we gained 800 basis points of share in 2020. 250 of that, we think, is non-repeating. So you'd say 550 is what we think is real share gain. If we gained 400 basis points of real share gain ex those orders, you'd subtract 250 from that, and we'd be at 150 in the year, and across the 2 years, we'd be 950. I think the two-year story, the main point here is that, and I hear it from customers every time I talk to them, and I talk to customers every week at a minimum, we are viewed very favorably in terms of how we've handled this. And certainly, we took extra risks with inventory, and it certainly impacted our gross profit. But we are in a great position from a relationship perspective. And we will have a very strong two-year share gain period, and we will exit those 2 years with very strong economics. And so for us, that's really the main point.

Okay. That makes sense. And then on the again to kind of affirming exit pitch there. The high single-digit margin at Zoro, if you said it, I missed it. But where was that in 2020? And directionally, does Zoro scale profitability a bit in '21?

Yes, we expect it to go. It was low single digits, so we expect closer to mid-single digits in 2021 and high single digits in 3 to 5 years.

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

Add my congrats to Dee in her new role.

Thank you.

D.G., I would like to hear a description of the product category, specifically what product purchases didn't succeed or which categories faced challenges. That was a particularly difficult period, and I know you were trying to secure PPE. I'm curious about what went wrong there, almost as a history lesson.

Yes, a lot did go right, but there are certain categories where supply and demand have changed dramatically since then. When you wanted to buy products for your customers, you had to pay large quantities at inflated costs. I would say there's a very narrow range of SKUs that fall into that category, all of which are PPE and are the reason for the inventory restatement. It's not like there are hundreds of SKUs; it's just a very limited set. If you ask me whether I would do it again, I would say yes, as I think it was the right decision. Many of those products were sold to customers and helped keep them safe. However, you are certainly seeing the impact in terms of inventory adjustments at this point.

I understand, and that was the response I anticipated. That was related to PPE. My second question is whether we are starting to gain a better understanding of the post-pandemic sales ramp-up. I'm trying to gauge how this recovery will differ from past recoveries following recessions, where we usually see a significant restocking phase, as customers deplete their own inventories. It seems like this time might not follow that pattern. Any insights on your expectations for the ramp-up would be appreciated.

Yes. I think it's not going to happen that way, primarily because it's not a broad-based sort of all-segment impact. So I think what you're going to see is certain segments turn on; we've already seen manufacturing come back relatively strongly as the year progressed and into 2021. So we've certainly seen some restock. We don't get a lot of restock given what we sell, but we certainly have seen volumes pick up with manufacturing. We still are in a very challenged state with hospitality, airlines, cruise lines, and those types of things. And so I think what's going to happen is certain segments seem to turn on as we recover here, and they don't all turn up at once. So you probably don't see a huge sort of restock; you see more of a phased restock as we go. That would be my expectation.

Our next question comes from Chris Dankert with Longbow Research.

And congratulations again, Dee. I guess, D.G., I know we've gone over this territory before. But I guess with the resegmentation happening now, just again, can we come back to Canada? It's been about 5 years since it's really been a positive contributor here. What's the logic in keeping it around? What's the long-term prospect for getting the thing back to a real contributor to growth and profitability for Grainger here?

Yes. I mean, I'd say we expect to provide as much transparency into Canada as we did before the resegmentation. It's quite easy to provide you with the numbers you need to understand what's going on in Canada. Secondly, though, I would say the performance in Canada last year was pretty good. We've seen growth now in December, and January was good for Canada, which is the first time we've seen that in 4 or 5 years. We have very good customer feedback when I talk to customers there. The feedback is very, very good. Our cost structure is in the right place. We have stabilization in gross profit ex some of the inventory efficiency issues we talked about this quarter, which are not operational. So we feel like the business was roughly breakeven last year in the midst of a pandemic. We actually think it's on a very good path. And we think in the next several years, it's going to be a profitable, growing part of the portfolio. We've taken all the hard action now, and we aren't losing contracts anymore. I mean, it just feels very, very different. And I think we've also built some deep customer relationships through the pandemic. So it's going to be a profitable part of the North America portfolio, albeit not as big as it once was, but it will start growing now, is our expectation.

Got it. Got it. And then again, just thinking about price mix in the U.S. specifically, pretty nice results in the fourth quarter. I know we're not guiding, but just how do you think about pricing in the new year as we started to see a good number of vendors really come out with pretty significant increases? Just any commentary on the pricing environment as we move into '21?

Yes, I think it's important to analyze the different segments. Some categories have experienced significant supply-demand disruptions due to the pandemic, leading to substantial cost increases, and we are adjusting prices in those areas as well. Overall, inflation remains relatively low, and we believe the price-cost mix will remain neutral over time, with a potential for improvement based on our initial position. While we are witnessing significant cost hikes in certain categories, we're also observing modest price inflation in others, along with early indications of a favorable price-cost mix.

Our next question comes from Nigel Coe with Wolfe Research.

So we've been talking about the inventory mark-to-market a fair bit. I'm just wondering if there's any way you could quantify, in dollar terms, how much inventory still kind of being held, just to try and help us think about the divestment. I think my real question is more on the growth algorithm for non-pandemic sales in '21, and you obviously provided some detail on Slides 14, 15. But if we think about it as a proxy for MRO, let's call it, 4% to 5% recovery in '21, you expect to grow 300 basis points over that number. Is that the right framework?

Yes, that is generally the right framework. However, we will have some year-over-year limitations due to certain one-time orders that resulted in a 250 basis point increase. But yes, that reflects the long-term framework. Regarding your earlier question, the curve displayed on Slide 15 incorporates our assessment of the risks related to any inventory, which is already factored into that curve.

Okay. And then just on Zoro operating margin improvements and the remerchandising. Just so I understand this kind of model. Do you basically earn a commission on the remerchandising sales? So essentially, the more volumes you're remerchandising, the better your fixed cost absorption, SG&A absorption, and that's what drives the margin expansion?

Well, let me clarify a few things there, and I think I can answer the question in the process. So when we've talked about remerchandising as a priority, that is mostly in the Grainger brand. So that is mostly making sure that we have very highly curated product data so it is easier for our customers and team members to find the product than anybody else on the roughly 2 million items we would have in the U.S. With Zoro, we are expanding the offer. You don't have as much curation with that model. You couldn't possibly, given the number of SKUs we have. What happens when you add SKUs is you get growth. And you get customer acquisition first, and then you're able to get repeat buy. And that does not add much expense to the business. So you do, as you grow, get fixed cost leverage with that investment in product SKUs. That isn't the full story. Part of the full story is we're also growing with existing customers and getting repeat buy, and that adds to some of the fixed cost leverage as well. Hopefully, that answers the question, Nigel.

Our next question comes from Adam Uhlman with Cleveland Research.

Congratulations, Dee. I wanted to start by discussing SG&A expenses and thank you for the detailed information on the first quarter; it’s very helpful. I understand that you're expecting a significant decline in the first quarter. However, we will soon be comparing against easier prior savings. Could you clarify how we should consider the remainder of the year? How substantial is the reset of incentive compensation? Additionally, as we anticipate travel in the second half of the year, should we expect a considerable increase in Grainger's expenses associated with that? Could you elaborate on the SG&A outlook?

Yes. I will pass it over to Dee shortly. Overall, we do not anticipate a significant increase throughout the year. The comparisons may seem unfavorable. As a reminder, we approached this situation believing that the virus would last longer than we hoped, but we knew we would eventually need to continue operations. Therefore, we did not implement drastic measures. We focused on prioritizing our actions, which has helped reduce some costs. While some of our travel budget may return in the second half of the year, it is difficult to predict at this point. However, not all of it will come back. We believe we will maintain strict cost control and still achieve leverage. Dee, would you like to add anything?

Yes. I think you said most of it there, but I would just say, generally, I think our long-term view is to have SG&A be at half the rate of sales will be the continued focus. But this year is going to be kind of wait and see. And as D.G. noted, we're very focused on being very prudent with our costs. And I think it's all going to really depend upon how this pandemic progresses. But I think we would slowly start to see expenses tick up as we get closer to normal levels of activity in the overall market with our customers. But if we don't see us getting back to normal, we will still be very prudent with our expenses.

Okay. Got you. And then, I guess, D.G., you were mentioning the kind of new customer wins, it sounds like a lot of more sticky relationships. Is there any way that you can dimension the retention of new customers that you've got, like repeat buyers, folks you haven't done business with? Or any data you could share on active account growth that could help us better understand the market outgrowth that you delivered this past year?

Yes, in terms of revenue contribution, I would say that new customers and repeat rates have performed well. They currently make up a relatively small part of our growth, but we believe this gives us an opportunity. We have certainly increased our customer base. While we usually do not share specific information about that for Grainger, I can say that our customer file has expanded significantly, and we have a higher number of repeat customers who made their first purchases in 2020 compared to previous years. Additionally, we are starting to understand what this means and how to consistently convert these new customers into repeat buyers. However, it is still too early to fully grasp the long-term effects of this trend.

Our next question comes from Chris Snyder from UBS.

So just following up on safety or pandemic. This was a very sizable $1.6 billion business prior to the pandemic. So I guess my question is, how did this legacy business trend in 2020? Just so we can try to separate out the underlying business from the surge or new business that came online over the last year just to help model out the trajectory. Because I would assume that the underlying business carries more leverage to the industrial economy than the surge business that came on.

That's a great question and largely difficult to answer. Let me provide some customer examples for context. When the pandemic struck in the second quarter of 2020, we were the largest supplier of industrial safety products, typically selling items like N95 masks, which historically have not been significant for hospitals. N95s were usually used in settings like grain elevators and harsh manufacturing processes. Suddenly, all our products were redirected to hospitals and governments. We have returned to a more balanced mix of what we refer to as pandemic products than we had before, but there remains a lot of uncertainty. Many customers in the industrial sector have not fully returned to using safety products at previous levels due to reduced activity. This makes it a complex question to address. Additionally, many hospital systems have achieved remarkable outcomes in protecting and saving lives this year, but they have been unable to carry out a lot of the standard safety maintenance tasks they typically would have. They are focused primarily on COVID, resulting in a backlog of necessary actions that still need funding. Therefore, it's a compelling question that is challenging to respond to accurately. I apologize for providing anecdotal evidence, but I have numerous examples that suggest there is pent-up demand for regular pandemic products.

No. I appreciate all of that. And then just kind of following up, could you provide some color or numbers around the margin difference between pandemic and the non-pandemic revenues? Just as we try to model out this margin trajectory into 2021 as that shift normalizes?

Yes, I can say that we haven't provided specific numbers for that. The $0.5 billion shortfall in non-pandemic revenue from 2020 likely reflects our usual incremental and decremental figures. On the other hand, the $800 million in pandemic sales above normal would have significantly lower incremental margins, possibly less than half, which contributes to the slight decline in our overall operating earnings for the year. This might help you consider how to analyze the situation.

Our next question comes from Patrick Baumann with JPMorgan.

You covered a lot of ground on the short term. I just wanted to move on to the long-term growth and algorithm for a second, where you're targeting, I think, low double-digit earnings growth and high single-digit revenue growth. Can you give us a high-level view on the moving parts margins within this, particularly how we should think about gross margins over the medium term once this mix dynamic from pandemic normalizes? And then just kind of the puts and takes within that?

Yes. For the company, we expect the U.S. business's high-touch model to maintain fairly consistent margins over time. We anticipate SG&A growing at half the rate of growth. This forms the basis of the earnings algorithm for that model. We expect our growth to exceed the average significantly, around 20%. While our gross profits are lower than the average, this will influence the overall margins by approximately 20 basis points. You might notice a slight decline in overall gross profits and a slight decline in overall SG&A, considering that this business has lower SG&A as well, but it should stabilize once we move past this phase.

And then as a follow-up to that. Go ahead, Dee. I'm sorry.

No. Again, I was just going to add to D.G. that I would agree with that. And that coming out of the pandemic, I think we would look for a much more stable and potentially more accretive margins on the high-touch than what we've seen over the pandemic.

I’m a bit surprised that you would expect the high-touch to perform well, considering some of the growth initiatives like KeepStock and on-site, where margins are typically lower. Could you discuss how you are positioned competitively to expand those areas of the business and maintain your gross margins?

Yes. I would like to highlight that we continue to achieve very strong results from our midsized customers, even in the last quarter. Although there may be some pressure from large customers, we anticipate that the growth of midsized customers will continue to outperform that, which should also benefit us.

And they use fewer services like KeepStock and similar offerings.

Higher GP, fewer services, and so, higher margins.

Our next question comes from Hamzah Mazari with Jefferies.

Just sticking with the medium customer initiative, D.G., maybe you could talk about sort of what kind of growth to expect in 2021? I know I guess it was 6% in Q4. And whether that's sort of baked into your gross margin assumption of exiting sort of at pre-pandemic levels in Q4 2021. I guess just what's baked into your assumption on medium customer growth within that gross margin sort of trajectory?

Yes, I believe there are a few factors to consider. In 2020, especially in the second quarter, we focused on supporting health care systems and governments, which resulted in less product being available for midsized customers. As a result, our business with midsized customers experienced a decline. Additionally, more midsized businesses were closed during that period. We have seen a gradual recovery, although it hasn’t fully returned to normal yet. We anticipate reaching normalcy with midsized customers and have incorporated significant share gains from that group into our projections. We do not expect substantial growth in 2021 as the pandemic will still influence the first half of the year, but we believe that by the end of the year, we will see midsized customers growing at a faster rate than in March, which is factored into our gross profit assumptions.

Got it. And just my follow-up question, and congrats, Dee, again on the new role. Just on Zoro U.K., is that a business that can scale up? I know we talk a lot about Zoro U.S., but just any thoughts there.

Yes. I mean, I'd say yes, is the answer. The business has done well in terms of customer acquisition and revenue path. It's got a healthy gross profit for a business that's relatively new. And Masaya and the team are working hard to make that a scalable business, and we still have some positive expectations there that that's going to be a success story. As you know, the U.K. market was probably more impacted this year than some others. But certainly, we've seen continued growth through this cycle with our U.K. business and a lot of good signs. Well, thanks. I really appreciate everybody's questions. I'll just close by reiterating: We're viewing the pandemic as a likely two-year event, and we expect to gain a lot of share during those two years, and we expect to have very strong economics exiting out of that. I want to thank our team members and our customers for all we've worked together on to really put ourselves in a good position to have great relationships moving forward, and it's been an all hands-on-deck effort. So thanks to everybody. I hope you stay safe, and I hope to see you, at some point, in person. Thanks.

Thank you. This concludes today's conference. All parties may disconnect. Have a good day.