Greetings, and welcome to the W.W. Grainger's Second Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note that this conference is being recorded. I will now turn the conference over to our host, Irene Holman, VP of Investor Relations. Thank you. You may begin.

Good morning. Welcome to Grainger’s second quarter 2021 earnings call. With me are D.G. Macpherson, Chairman and CEO; and Dee Merriwether, Senior Vice President and CFO. As a reminder, some of our comments today may include 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 and their corresponding GAAP measures are found in the tables at the end of this slide presentation and in our Q2 earnings release, both of which are available on our IR website. This morning’s call will focus on adjusted results, 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 I’ll provide an overview of our second quarter results and progress toward our goals as the economy recovers. Before we get into details on the quarter, I'd like to spend a moment highlighting our Grainger Edge framework. Two years ago, we launched this framework that defines who we are, why we exist, and where we're going. It covers our purpose, aspiration, strategy and the principles that drive our actions. It all starts with our purpose. We keep the world working. We shared this with all team members across the company in 2019, while the concepts weren’t new and many were already part of our operational DNA, the framework provided clarity on who we are and what we do, as well as a common language for our team members. The Grainger Edge has guided us through the pandemic, and I'm proud of how the Grainger team has continued to embrace it. It's also been a strong foundation for how we serve our customers and helped us through the challenges of the last 18 months. Speaking of challenges, 2021 has provided plenty. The year has been characterized by strong demand, but a very challenging supply chain environment. Raw material shortages, labor shortages and transportation challenges have been the norm, particularly in the second quarter. These challenges are industry-wide. And while we're not immune to them, we are uniquely positioned to leverage our scale and navigate through these ongoing difficulties. Importantly, this year, the supply chain has become a competitive sport. And while we've had obstacles and things are messier than normal, our customer research suggests we are navigating the obstacles well and providing very strong relative service during this time. We are actively leveraging our network. For example, for a customer located in New York, we would typically fulfill their entire order from our Northeast DC. Due to supply constraints or product delays, now part of the order may only be available in Louisville. In this case, the order may be fulfilled from Louisville, adding an extra day and incremental cost to the order. But we are able to leverage our network to provide and protect our great service. We are also leveraging our branches for more shipping in this environment. In addition, we have accelerated the ramp of our Louisville DC, which has helped alleviate capacity constraints. This building is a great asset for Grainger, and will continue to ramp capacity through the next 18 months. The good news is that we still have very high availability in our network even if the product comes from an alternate location. I've had the opportunity to be in the field quite a bit this past quarter and have been excited to spend time with the customers and hear their feedback. I'm hearing consistently that while we may be delivering a bit differently than the past, we are serving our customers better than the competition. We have validated this feedback on our recent customer service and a vast majority said we were doing better than distributors right now. We are also investing in non-pandemic inventory and partnering closely with our suppliers to work through any supply constraints, inbound lead time challenges and any potential cost increases. Additionally, the shortage in the labor market have had a significant impact for all companies this year. In response, we have increased our wages to attract and retain talent, especially in our distribution centers. We've implemented robust training programs to onboard new team members and train existing team members to work throughout our buildings. We have made great progress in closing staffing gaps and will continue to do so over the third quarter. Finally, transportation has been very challenging. That is clearly linked to the product and labor shortages. While we have always prioritized optimal routes and cost efficiencies, over the last few months, we have partnered with our carriers in new ways to ensure we are meeting customer expectations. We have also added new partners to our carrier mix to handle our volume and provide us flexibility. It's important to note that the overall freight market is volatile and uncertain. While we are confident in our current plans to manage these challenges, there are a lot of moving pieces and constraints across all modes, parcel, LTL and ocean freight. For example, the ocean freight market has been uncertain as the pandemic surges again in Asia and container costs fluctuate. We are ready to respond to any of these dynamics. We expect the supply chain challenges to last through the end of the year and likely well into next year. I have no doubt, as we continue to live the Grainger Edge and follow our principles, we'll not only get through these challenges, but will deliver strong results and take market share. Turning to our financial highlights. The bottom line is that our performance has been in line with our expectations and what we communicated on our last earnings call. The only exception that this has been gross profit impacted primarily by the changes in May to the CDC mask guidelines halfway through the quarter. Heading into the second quarter, all external factors were pointing to a reopening in the U.S. around or sometime after the 4th of July, giving us a full quarter to sell through as much of our remaining pandemic inventory as possible. Based on our internal scenario planning, we thought that potential adjustments in Q2 would fall somewhere between $45 million and $50 million. We shouldn’t predict precisely how the demand curve has fallen and when. Then when a CDC mask guidance change in mid-May, we saw demand for pandemic products, especially in masks, decline rapidly. As a result of the sudden weakening in demand, we had more pandemic inventory remaining than expected, and we took a $63 million adjustment, about $15 million more than our internal scenario planning. We believe this completes any material pandemic-related inventory adjustments. Without this incremental change, we would have been roughly flat sequentially. We understand the CDC has just changed guidance again this week. While the situation is fluid, we do not expect any material change in our outlook as a result of this change. Shifting to the other financial results. We achieved strong organic daily sales growth of 15% for the company on a constant currency basis within our guided range. When compared to 2019, Q2 was up about 14% on a daily organic basis, a positive indicator of our strong performance and recovery beyond the pandemic. Our High-Touch Solutions North America segment grew 12.7% on a daily constant currency basis. In the U.S., we lapped the most extreme volatility of 2020. Looking at the 2-year average in the second quarter of 2021, we drove approximately 275 basis points of average market outgrowth. We remain very confident in our ability to grow 300 to 400 basis points faster than the market on an ongoing basis. We expect the volatility of 2020 and 2021 to average out and get back to normal heading into 2022. Our Canadian business drove positive operating earnings growth for the quarter and managed expenses as well. We are seeing continued momentum in targeted end markets, especially heavy manufacturing and higher education as schools prepare to reopen in the fall. And we continue to diversify the business beyond natural resources. The Endless Assortment model had another impressive quarter with 23.9% daily sales growth on a constant currency basis, fueled by strong customer acquisition. Lastly, we generated $269 million in operating cash flow and achieved strong ROIC of 29.2%. Turning to our quarterly results for the company. I've discussed most of what's on this slide, but I wanted to point out two additional items. First, our SG&A was $790 million, in line with the guided range provided on our first-quarter call. As expected, we increased SG&A for the quarter as we continue to invest in marketing and in our people through increased variable compensation and wage rates in the DCs. This resulted in total company operating margin of 10.4%, down 70 basis points compared to the prior year. Excluding the impact of the $15 million incremental inventory adjustment, gross profit would have been roughly flat sequentially and operating margin would have been 10.9%. Resulting EPS would have been around $4.50. With that, I will turn it over to Dee to take us through more detail on our two segments.

Thanks D.G. Turning to our High-Touch Solutions segment, we continue to see a robust recovery with daily sales up 13.7% compared to the second quarter of 2020 and up 9.5% compared to the second quarter of 2019. In the U.S., we saw strong growth in our non-pandemic product category with product mix returning to more normal levels. For the segment, gross profit finished the quarter at 36.9%, down 125 basis points versus the prior year. I think it's important to note that without the $63 million of inventory adjustment, gross profit would have been up 125 basis points year-over-year. This 250 basis point swing demonstrates that our underlying gross profit rate would have otherwise been a healthy 39.4%. Coupled with our focus on achieving price/cost neutrality, we are confident that our run rate gross profit remains strong. SG&A in the segment ramped as expected to $640 million, lapping the lowest point of SG&A spend in the second quarter of 2020. Canada continues to make solid progress and expanded operating margins, approximately 315 basis points year-over-year. Consistent with last quarter, we have included a chart with details on the U.S. and the Canadian businesses on the first page of the appendix. On Slide 10, looking at pandemic product trends, I want to highlight two things before we dive into the Q2 numbers. First, we left the extreme growth experience last year and saw decreased demand for PPE products. Accordingly, pandemic sales declined approximately 28% versus 2020. However, that's an impressive 27% increase versus 2019. We estimate July 2021 will be down about 28% over July 2020, in line with what we saw in the second quarter of this year. More importantly, we see the trend in our non-pandemic sales as a positive sign of economic recovery. During the quarter, we grew 31% versus 2020 and up 7% versus 2019. We're seeing end markets like commercial, which include our severely disrupted customers in hospitality, along with heavy manufacturing, make a significant comeback. We estimate that for the month of July 2021, non-pandemic sales growth of about 22%. As it relates to pandemic product mix, while we expected it to taper off to near pre-pandemic levels at about 20% by year-end, we're seeing this happen more quickly now at about 22% of sales. In total, our U.S. High Touch Solutions business is up about 12% for the second quarter of 2021 and up 10% over 2019. Looking at market outgrowth on slide 11, we are lapping the highest concentration of large pandemic purchases of the prior year. At this time, the market declined between 14% and 15% and we saw outsized share gains of roughly 1,200 basis points. For Q2 2021, we're seeing the opposite effect. We estimate the U.S. MRO market grew between 18.5% and 19.5%. The U.S. High-Touch business grew 12.4%, about 650 basis points lower than the market. To normalize for the volatility, we calculated the two-year average share gain to be 275 basis points over the market. There's some noise in the market number because across industrials, given the dynamics and fluctuations over the last two years. Therefore, the two-year average is a better estimate of what's really going on. As I previously noted, our U.S. High-Touch business is up 10% over 2019. As the impact of the pandemic subsides, coupled with our strong progress on key initiatives, and our return on investments like marketing, we remain confident in our ability to achieve our share gain goals. Now let's cover our U.S. gross profit rate. As previously discussed, our second quarter gross profit decline resulted from the $63 million inventory adjustment. This adjustment lowered U.S. gross profit by 270 basis points. Without this, our underlying U.S. gross profit rate is 39.8% in the second quarter. As we look to the remainder of 2021, it is important to note, we are operating in a very challenging and fluid environment. We're doing everything within our control to exit the year with a Q4 gross profit rate at or above the Q1 2020 levels or 40.1%. We remain confident in our ability to achieve this target for a few reasons. First, as noted earlier, we anticipate no further material pandemic-related inventory adjustments. Excluding the inventory impact, our gross profit rate is nearing this level already. As we discussed on slide 10, our pandemic product mix is close to pre-pandemic levels, and we expect this to fully normalize in the second half. And we've seen evidence that we can continue to maintain price/cost neutrality. On the cost side, we have a robust process to partner with our suppliers and understand the specific raw material impacts as well as other conditions that may result in increased costs. As it relates to price, our goal is to continue to maintain competitiveness in the market and pass what is applicable. In the first half, we were slightly above neutrality. And as we expect to take additional price increases in the second half to offset what we're expecting in costs. Even in this inflationary environment, we are confident we will be able to execute and achieve neutrality through the remainder of the year. Moving to our Endless Assortment segment. Daily sales increased 23% or 23.9% on a constant currency basis driven by continued strength in new customer acquisitions at both Zoro and MonotaRO as well as growth of larger enterprise customers in MonotaRO. We did have 75 basis points year-over-year, driven by positive trends in both businesses and operating margins finished up 95 basis points over the prior year. I'll go into more detail on the next slide, as we provide further transparency on the results of both of these businesses. Moving to Slide 14, please remember that MonotaRO is a public company, and follows Japanese GAAP, which differs from U.S. GAAP and is reported in our results one month in arrears. As a result, the numbers we disclose will differ somewhat from MonotaRO’s public statements. In local currency, and using Japan's local selling days which occasionally differ from U.S. selling days, MonotaRO's daily sales grew 16.7%. gross profit finished the quarter at 26.4%, 25 basis points above the prior year. Operating margin decreased 15 basis points to 12% as they continue to ramp up operations at the Ibaraki DC. Again, another strong quarter for MonotaRO. Switching to Zoro U.S., daily sales grew 32.6% as it laps its softest quarter of 2020. Zoro gross profit grew 95 basis points to 31.5% and achieved 320 basis points of operating margin expansion through substantial SG&A leverage in the quarter. All in all, very impressive results. Moving to Slide 15. In addition to the strong financial performance, we're seeing positive results with our key operating metrics. As you saw in the first quarter, we've listed total registered users for both businesses, an important driver of top-line performance. Both MonotaRO and Zoro have shown progress and are up over 20% over the second quarter last year. On the right, Zoro continues to actively add SKUs to the portfolio. At the end of the second quarter of 2021, we had a total of 7.5 million SKUs available online. Our goal was 8 million for the year. We remain encouraged by our progress with SKU additions beyond traditional MRO. Now I'll provide commentary as it relates to the upcoming quarter and our expectations for the full year. For the third quarter, on a total company level, we expect our revenue growth to be between 10% and 11% on a daily organic basis. We believe any material pandemic-related inventory adjustments are complete, and we expect gross profit to be up between 100 and 120 basis points year-over-year and to improve sequentially. SG&A is anticipated to fall between $805 million and $815 million as we continue to invest in marketing and wages in the DCs to remain competitive. Transitioning to our total company guidance, I'd like to provide some brief commentary on how we're trending so far. We expect strong sales to continue, while gross profit operating margin and EPS will face pressure as a result of the incremental inventory adjustments and freight costs, along with increased DC wages and marketing. While we are maintaining our guidance, we expect results to trend towards the low end of our range with the exception of revenue. We expect revenue to be near the midpoint. As it relates to our segment operating margins, we think that some of the supply chain challenges as well as the first half inventory adjustment will weigh more heavily on the High-Touch Solutions segment, and therefore, High-Touch operating margin may trend at the low end of the range. At the same time, we believe Endless Assortment, driven by strong performance and improving margins may end the year at the high end, both helping to support delivery of total company results. We are not adjusting guidance as we are confident in our ability to deliver results within our guidance ranges. As we learn more, we'll continue to keep you apprised of any changes. With that, I'll turn it back over to D.G. for some closing remarks.

Thank you, Dee. Before I open it up to questions, I wanted to share two recent company accomplishments. First, I'm proud to announce that earlier this month, Grainger was certified as a Great Place to Work, a true testament to the exceptional team member experience we've built and an important milestone in advancing the Grainger Edge. Second is our 10th year of publicly reporting our ESG efforts. I wanted to share highlights from our new corporate responsibility report. At Grainger, we embrace our obligation to operate sustainably and with a long-term fact-based view of critical issues regarding the environment, society at large, and corporate governance. For example, in 2012, we became the first industrial distributor to publicly disclose our carbon footprint. In 2013, we became the first in our industry to set a public greenhouse gas emissions reduction target, which we achieved two years early. We just set a new goal last year to reduce the absolute Scope 1 and 2 greenhouse gas emissions by 30% by 2030. We're also committed to helping our customers achieve their ESG goals through our products and services. We now offer more than 100,000 environmentally friendly products. Through this portfolio, we're able to help customers maintain sustainable facilities, enhance efficient energy management, water conservation, waste reduction, and improved indoor air quality. In 2017, Grainger signed the Chicago Network Equity Pledge focused on achieving 50% representation of women in leadership positions by 2030. And this year, we formed the ESG Leadership Council, which I chair. The council is comprised of Grainger leaders who provide strategic direction and oversight on our ESG efforts. You can find the new report at graingeresg.com. With that, we will open up the line for questions.

Our first question comes from Christopher Glynn with Oppenheimer. Please go ahead with your question.

Good morning. Congratulations on no adjustments, a rare thing these days. I'm curious about the large customer contracts, you talked about having good price/cost trends overall. Just curious how that works with the large customer contracts.

Dee, why don't you take that one?

Sure. So as we've discussed in the past, we have about 70% of our business in the U.S. with large customers, and that business runs through their contracts. We have the right to pass on price increases to those customers at different times in the year. And so as you can imagine, our cost increases coming in from our suppliers and the timing of when we can pass on price increases to those contract customers do not always line up perfectly. So it ends up having some lumpiness as it relates to gross profit. But overall, those actions that we're taking with those customers are going well. And we have been able to pass on cost increases to those customers. I'd also like to remind you that the rest of the business, about 30%, is on a wet price, which we have the ability to change in line with the market. And we do that to remain competitive with others in the market that have visible prices.

The only thing I'd add to that, Chris, and thanks for the question, is that we have a very - as Dee said, a very robust process in terms of managing costs. This is an environment right now where everybody is raising price on everything. And we are effectively working with our suppliers to mitigate the cost. And so the conversations with customers are well understood and expected at this point. So I would say if we continue to do both of those things well, we feel like we can be in good shape.

Okay. Thanks for that. And on the guidance, kind of, separately heard at the low end in the slide, and then towards the low end. I don't know about other people, I read those a little bit differently. Just want to clarify your intent?

So I think if you go back to our prepared remarks, we expect revenue to remain strong and fall within the range. And while gross profit operating margin and EPS will be pressured primarily due to some of the inventory adjustments that we have taken this year, we're happy to be back past that. But because of that, and some other pressures related to some wage increases and things like that that D.G. noted, we're saying now that gross profit operating margin and EPS will fall at the lower end of the guidance range that we provided in the first quarter. So we are maintaining our guidance and giving color related to revenue, gross profit, operating margins, and EPS.

Our next question comes from Chris Snyder with UBS. Please state your question.

So the company has demonstrated a pathway to get back to pre-pandemic gross margin, and when we see the inventory adjustments, we're almost already there. But I guess what's the outlook for either 2022, or 2022 and beyond once we get back there? Is the expectation that we can get to pre-pandemic levels and hold it? Or should we expect moderation thereafter on competition? Or is there an opportunity to improve it, given what we're seeing with outgrowth from midsized customers?

So thanks for the question. I think if you step back, I think we find that comparisons to 2019 or early 2020 are probably better than last year at this point because there's so much messiness in the year-over-year numbers. But our general thinking is, we will exit the year with having gained significant share and in a better spot from an economic perspective with similar gross profit and better SG&A leverage. And that's kind of the model going forward. We feel like we're priced competitively. We feel like we can hold gross profit in each of our business units fairly consistently over time and get some SG&A leverage. And so our whole model is based on consistent share gain and slightly expanding operating margins. Typically, we would expect gross profit to hold relatively flat as a percentage moving forward with some SG&A leverage.

I appreciate that. And then I wanted to follow up on the U.S. 2-year outgrowth, which fell to 275 bps a bit below the 300 to 400 the company was targeting. Is there anything specific there to call out? Or is that just quarter-to-quarter lumpiness? And then I guess what gives you confidence that we'll get back into that 300, 400 bp range, at least on a multiyear basis into the back half and then thereafter?

Yes. For the year, we're still within our expectation. Now I would say, just to be frank, a lot of the comparisons, we had the market growing 18% to 19% in the second quarter. It's tough to find sort of any peers that have grown that way. Relative to peers, we think we're doing good. And we look at both our own metric, which is based on industrial production, and we look at peers. And so we feel very strong about our performance. We also feel, and the returns we're seeing. We're tracking everything, and we feel very good. We think right now what you're seeing for the second quarter is a lot of messiness in metrics and pandemic-driven sort of ups and downs. But through the cycle, we're very confident we're going to be able to achieve our target.

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

And I also join Chris in saying it's great to see that you did flow through that inventory write-down through your operating results. So we appreciate the transparency there. And just - and D.G., you did say this is a fluid environment. We recognize that, and there are some regions that are going to return to mask mandates. Would there be any potential scenario where this inventory could eventually be sold? So are you still carrying that inventory? Because I think the way the accounting works, it would be sold at all profits since you've now taken the costs out. Is that the correct understanding?

Yes. So to be clear, our accounting for the quarter was what happened at the end of the quarter and through a couple of weeks after that when we actually put the results together, working with our team and our external accountants. And we just follow our process, the mask change that happened in the last couple of days, I will say that every single external announcement in the pandemic has driven behavior. So we are expecting in the short term to get some increased mask sales. We haven't flown that through. You're right, there's a potential, but it's so early, 48 hours' worth of revenue wouldn't give us any indication. And things are so fluid and change so fast, it's really hard to tell. Obviously, if we went into full lockdown with full mask usage, what you described could in fact be true. But it's just really uncertain right now.

Of course, I appreciate that. And then I may have missed the explanation, but MonotaRO, the margin pressure this quarter was the 15 basis points. Is that pandemic related? What's the explanation there?

I think Dee talked about it. But basically, starting at the Ibaraki DC, which was an expected cost is a big part of that. So, given their growth, they have put significant investments in the distribution centers and that has added some costs. They're still very, very profitable and still seeing very good growth relative to what has been a pretty challenging market in Japan.

And our next question comes from David Manthey with Baird. Please go ahead. David Manthey, your line is open, please unmute yourself.

First off, I'm trying to understand the guidance as you put it to the low end, not the lower end of the range. When I run the numbers here, if I'm doing this right, $15 million is maybe $0.20 after-tax and relative to $1.50 range. I mean, if you're originally at the midpoint, now you're maybe $0.1950 something, I'm just wondering that excluding this write-down, have your expectations for the second half changed in the past 90 days? I know you said it's fluid, but it seems like to immediately go to the low end of the range seems a little bit much relative to the inventory adjustment that was unexpected.

Yes, I'll start and then maybe D.G. can add on if he wants to add any more color. A couple of things have happened since the last time we talked. And we talked about it in our prepared remarks related to the messiness of the market and industry supply chain challenges, being able to make sure that we can hire and retain the right people in our DCs, which is critical to our business. And so we're seeing some labor inflation that wasn't projected at that time. So, that plays into it along with additional marketing spend to continue to focus on our brand and improve our web conversion with our customers as well. So, we talked about some of those things in our stated remarks as well. And so, again, we're guiding to the low end of the range as it relates to that plus the inventory actions we've taken.

Our next question comes from Ryan Merkel with William Blair. Please go ahead.

My first question is on freight. How much will freight hurt margins in 2021? And then how are the conversations going with customers where you're asking some of them to pay freight where they have been getting free freight in the past?

So, starting last year, as you can imagine trying to work through somewhere north 2,000 type customers with conversations with large customers. Those conversations have been going well. But there's two things I think you have to take into account. Either there are some freight rate changes that have come from some visible partners that are easier to talk through. And so those things have gone extremely well and continue to go well. So, no problems up to this point with being able to pass on some freight costs to our customers.

I would add, Ryan, there's a number of factors. One is freight rates. The other is just the service challenges, and we are - we've certainly added some costs. We are going to recoup certainly some of that, if not all of that. But just to be able to make sure that we have delivery assurance they can actually get product to customers right now is not as trivial as it historically has been. So we're having to prioritize loads more than we've ever prioritized loads, containers coming from Asia or the cost is way, way up. And that, trying to avoid taking too much cost increase while still providing great service. So it's challenging. And certainly, there's some uncertainty. We do think that ultimately, it will balance out. But for right now, it's relatively chaotic in the freight market.

And then for my follow-up, just a question on gross margins. It sounds like you expect neutral price/cost in the second half for the High-Touch business, at least. So I'm just curious, how much confidence can we have in that? I mean it's a crazy environment right now. Would you say there's sort of above-average risk versus normal that there could be some downside? Or do I have it wrong and you feel pretty confident based on what you know?

I would say, and Dee can add to this if she'd like. I would say we're pretty confident in that. We've actually had conversations through the summer with most of our suppliers about cost expectations, and we've already been managing those negotiations and getting to a place that we think makes sense. And we have price set for some increases in the back half of the year. So, most of that is already set. There are surprises that happen and are likely to happen this year. But typically, we're able to manage those and either push those out or find ways to mitigate those. So we're pretty confident that we're going to be within that sort of price/cost neutrality range.

Our next question comes from Nigel Coe with Wolfe Research. Please go ahead.

Just a bit more detail on the 3Q guide. I think this is for Dee. So I think you said 110 or so basis points of gross margin expansion Q-to-Q, so that gets us flat year-over-year. Number one, is that correct? And I think the comment was 4Q exit rate kind of consistent with Q1 '20. It feels like that's now pushing to the right, just maybe confirm that? And the final comment, the SG&A in 3Q, the 810, it seems like your full year guidance seems that, that committee go it bit higher in 4Q. Is that the right way to read it? Thanks.

Yes. So if you look at - I think I'll start with your question just around the gross profit for our total company, the guide was that we expect that to be up 100 to 120 basis points. And so that's really being driven by a little bit of the conversation we just had. Achieving price/cost neutrality, we're slightly above neutrality through the first half, but we think that we're going to maintain that and be neutral for the full year. And we believe that because of the pricing actions, as D.G. noted, that we expect to continue to take, our cost rigor with our supply base, gives us confidence in what we've been able to do up to this point this year. And as it relates to SG&A, the range of 8.05 to 8.15 is pretty solid in our mind on a go-forward basis, and it looks similar for Q4.

And then longer term, the customer base is, for both the MonotaRO and Zoro are now very similar. The ARPU is 2x for MonotaRO versus Zoro. I understand MonotaRO is a much more mature business. Is there any reason why Zoro's ARPU can't get closer to MonotaRO over time?

You're talking about operating earnings, Nigel?

I'm talking about revenue per customer.

Got you. So there's a couple of things that will make that be different going forward. And I would expect MonotaRO to have much higher sales per customer. One is, in the Japanese market, there is no industrial distributors - broadline industrial distributors like there are in the U.S. that direct to customer. So, actually, the MonotaRO business is starting to build a pretty strong enterprise customer solution, and they're having some success there. We don't expect Zoro to do that because the competition in the U.S. is much more stiff on that front. And so, they have some larger customers that Zoro doesn't have. Zoro is focused on that small business more fully and really focused there. So I think that's probably the primary difference, and I would expect that difference to continue. We expect the growth rates to be strong in both businesses, and we expect the margins to improve to high single digits in Zoro over the next couple of years. And so, we feel like it's a great story. But I would expect that metric to be slightly different.

Our next question comes from Tommy Moll with Stephens. Please go ahead.

Just wanted to follow up on the point you just made about the continued margin progression for Zoro. Your leverage at the operating income line in the second quarter was impressive. Can you take us through some of the drivers there? And then looking forward, how sustainable some of those might be?

Yes. We think they're very sustainable. So just as a sort of reminder, we made - a couple of years back, we made pretty significant investments to give that business more independence. And there were really two types of investments being made. One was in systems to allow them to have their own - for example, their own product management system. So they're pretty much clean now in terms of their own systems infrastructure. And the second one is building teams that could do things like add millions and millions of products a year, improving their marketing and data analytics capabilities, improving their IT team. A lot of those were one-time investments. And now, as we grow, we're starting to see the leverage, and we expect to see that leverage moving forward. We feel like the gross profit is in a good place, and we think that price points are in a good place. So we don't see concerns there. And we just see a role where we can continue to grow the business fairly quickly and leverage the investments that we've made.

Following up on your High-Touch business for the gross margin trajectory versus what you talked about a quarter ago. It sounds like there's some incremental marketing spend that's in the budget now. What were the factors that changed over the last 90 days where you decided to go ahead and lean in heavier there? And as you look forward to Q4, does it feel like - or I should say, just the rest of the year? Does it feel like you've now got pretty good grip on what the budget looks like? Or could it shift higher again potentially?

Yes. We've got a really good handle on what the budget is going to look like on marketing. We just look at returns on a periodic basis, and the returns we're getting were really strong. And we've been running a number of tests and those tests came back positive. Some did not. But the ones that came back positive, we decided to push on. And so that's what drove that incremental money.

Our next question comes from Josh Pokrzywinski with Morgan Stanley. Please state your question.

So, D.G., just on kind of your own commercial initiatives getting out in front of customers, things like that with the markets being a little bit more open to receptive, how do you expect some of those outgrowth metrics to sort of snap back from here? I know that there's some - a bit of a contortion in the metric right now because of the pandemic sales stuff. But are you able to kind of commercialize or get out in the field more than you were 90 days ago? And is that kind of bearing any fruit here in the medium term?

Yes. So, it's a great question. The answer is yes, we're getting out to our customers more. If our customers are accepting visits from us, we are going. That would be the answer to that question. I would say that the vast majority are. And as you know, our service team members have been there every day of the pandemic, basically. We've been able to visit customers to fill inventory bins and do the things that we do from a servicing side. But in terms of customer discussions, we are pretty much running like normal. There are some customers that don't allow visits, but I've been in front of probably 10 to 15 customers in the last six, seven weeks. And those conversations feel very normal, and we're talking about how to expand the business, really leveraging the work we've done to help them stay up and running in the pandemic and keep their people safe to try to improve the relationship and grow. And I think that's going to be a positive story moving forward.

And then I guess sort of related to that, I think there's a whole litany of end markets and business activities that are sort of post-COVID change. Is it - whether it's a customer group or end market, where do you see sort of the biggest difference in that interaction, someone buying differently, wanting you to handle a bigger scope of what they're doing? Because I would imagine that we go through 2020 and even early 2021 and the recovery, everyone is just sort of too busy to make big sleeping structural changes, but maybe now with maybe the smoke clearing a bit more. Anything you've seen out there where someone used to said, here's how we're running this process differently. Again, it could be an end market, could be kind of a customer practice, but just curious high level where you guys have seen the biggest change.

Yes, I think the customer changes or trend changes, there are two I would point to. One is the pandemic did teach a lot of our customers that having a digital solution is pretty important. And the other is having an inventory solution is pretty important. And so almost every conversation you have with customers now centers on how can we install processes so that it's really easy to order and that we can help them manage inventory and keep inventory levels where they need to be. Those are the two biggest changes. Those are really across all customers. Obviously, there's differences by segment. There are still some segments that are pretty significantly disrupted and some that are ranging. But I think from a customer interest standpoint, helping them manage their inventory and getting on the right digital solution are the two things that are even more intense even though they've always been important, they're really intense right now.

Our next question comes from Michael McGinn with Wells Fargo. Please go ahead.

Thank you. I just wanted to go back to the SG&A and digital marketing that you were discussing earlier. If I'm looking at the Q3 guidance, SG&A is going to take a 15% uptick year-over-year here, and that is about 500 bps greater than the sales growth you're guiding to. Can you just give us an update on what the structural SG&A savings that were discussed last quarter? And how much of that is going to roll into 2022 and what those initiatives look like?

Well, first, and I'll turn it over to Dee. I think that we expect to have better SG&A leverage in the third quarter than we do in the second quarter, but I'll turn it over to Dee to talk about the details.

Yes, I'd agree. So when we talked about, at the highest level, daily revenue expectation of 10 to 11 in Q3, that implies SG&A leverage will improve. And so we expect that. But again, we just talked about the fact that we are going to continue to invest in marketing spend as well as continue to see some uptick in the full quarter's worth of the - some of the DC labor changes and transportation changes that have happened. We are working on a number of mitigating factors to continue to see how much we can offset that over time. But we have laid into Q3 as far as providing color and expectations that that's where we're going to get to when you take into account those increases.

And on the freight conversation, I guess my assumption is that anything small standard would go on the contract rate. You guys are probably using your legacy relationships in the new carriers. Are you pushing the nonstandard product to those new channels, because there are more market spot-based freight costs? And is this something that you're going to lean into long term? Or how should we think about that nonstandard product shipments?

Well, the vast majority of our shipments do go parcel. And for those, we have obviously very big contracts and contract rates. And so that is correct. In terms of alternatives right now, the LTL market is probably the most challenged from a service perspective, from a driver shortage perspective, and as a result, from a cost perspective. And so there, we've developed new solutions. We're working with some new carriers, working with some existing carriers in trying to find the right solution. That would be where it is most messy right now, I would say. The other place would be on ocean freight, which is mostly a container cost issue and a capacity issue right now, where we're prioritizing more than we ever had to make sure that we get our contracted rates and don't have to get outside those because if you get outside of this right now, that's very expensive.

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

My first question was on the outgrowth. I realize there's some squishiness to the market growth rate upon, which your outgrowth statistic was calculated. But just generally speaking, as we think about the 300 to 400 basis point sort of outgrowth target, everything else being equal, should the supply chain challenges favor Grainger being on the high end of that range simply because you have more capabilities to meet customer demand in a supply chain-challenged environment than some of your competitive set?

Yes. I think that's absolutely right. And I think that if we didn't have sort of our distribution center capacity right now, things would be a lot more difficult finding customer solutions. So we feel like the investments we've made which have been substantial over the last 12 years to get the network we have, is really helping us now make sure we can serve customers. And we think that's giving us a pretty significant advantage in the marketplace.

And then just a question on sort of free cash flow. Is it still the case that sort of you're going to be focused on deploying the vast majority of your free cash flow to dividends and repurchases? Or has anything sort of changed there?

So thanks for the question. No, nothing has really changed related to our capital allocation strategy. And so we're still sticking exactly to what we have said in the past.

Our next question comes from Patrick Baumann with JPMorgan. Please go ahead.

Thank you for taking my question. On the Zoro growth, I mean, it looked really strong to me in the quarter. I'm not sure what the comp was. So I'm just kind of curious if you could tell us what it looked like on a tier stack basis? And then how should we think about growth there in the second half of the year?

Yes. So I don't remember the 2-year stack number at Zoro. But what I will say is there is going to be a lot of lumpiness in every quarter-to-quarter comparison this year for reasons that mostly have to do with supply. So last year in the second quarter, we prioritized supply for healthcare and government customers of pandemic products. And so we turned off a whole bunch of volume that Zoro probably could have sold. So Zoro did not have the kind of growth last year that certainly it was used to. In this year, we're very pleased with the trajectory they're on. They're ahead of plan and doing very well. But this year's number in the second quarter, I wouldn't assume that that's going to be the number we see going forward because that is off of a very low number, given the supply decisions that we made last year. We still have a lot of confidence in Zoro's ability to grow 20% going forward, but there's going to be some lumpiness in the back half of the year. There's going to be bad compares. In the summer last year, we had a bunch of consumer business as we were the only ones that have product that we're going to compare against still be strong growth but may not be quite as much as you're used to seeing. That will all work its way out, and we expect very consistent strong growth in our business.

And then my follow-up is can you remind us where your freight costs are recognized? I'm not sure, if it's inbound or outbound or different areas of the P&L or maybe part of it is - SG&A part of it in COGS. If it's in COGS when you say price/cost neutrality does this include freight? And then also, does the neutrality mean keeping profits neutral or margin rate neutral? I know there was a bunch of questions in there, but I just wanted to fit them all in.

So the freight costs are included in gross profit for us. And what was the - you were talking so fast? Can you repeat the second and third question again for me? Sorry.

Yes. So I was saying, if it's in the gross profit, which it is when you talk about price/cost neutrality, does this include freight in that comment? And then when you talk about price/cost neutrality also, does it mean keeping profits neutral? Or is it keeping the margin rate neutral?

So, yes. So when we talk about price/cost neutrality, it doesn't include the freight portion. And then to answer the second question, we're talking about rate, gross profit rate not run rate.

And our next question comes from Kevin Marek with Deutsche Bank. Please go ahead.

Maybe just one on Cromwell quickly where gross margins have improved this quarter. Can you talk about what's driving that and how sustainable the improvement is? I'm kind of wondering if we should still think about Cromwell losses being halved for the full year versus last year? Thanks.

Yes. So we do think Cromwell is going to roughly have losses from last year to this year. The market in Cromwell in the UK has been challenged as most people are aware. But that business has done a really nice job of improving service and starting to see some growth now, which is great. And they're starting to bounce back a little bit, and they're in a good position from a cost perspective and from a service perspective. So we still have some of our expectations that we had at the beginning of the year for how that business will shake out through the balance.

Thank you. There are no further questions in queue. I'll turn it back to D.G. Macpherson for closing remarks.

Great. Thanks. Thanks, everyone, for joining the call. I really appreciate it. The one thing I'll just leave you with is, as we think about what has been a very strange period the last 18 months, our focus is clearly on the future. And we keep saying this, but I will continue to repeat this. Our goal this period is to exit the pandemic in better shape than we started, and that means consistent share gain. We believe we will have done that, and that means having better economics as we exit, and we believe we will be there as well as we exit the year and head into, hopefully, we put the pandemic behind us, although, of course, that's no guarantee. But that is our goal. And we continue to focus on making sure we deliver a great customer experience and manage the business for long-term share gain and long-term margin expansion. So we're going to continue to do that. And we feel really good about where we're at. And so I appreciate the time, and look forward to talking to you soon. Thank you.

Thank you. That concludes today's conference. All parties may disconnect. Have a great day.