Greetings, and welcome to the W.W. Grainger Fourth Quarter and Full Year 2022 Earnings 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, Kyle Bland, Vice President of Investor Relations. Thank you. You may begin.

Good morning. Welcome to Grainger's fourth quarter and full year 2022 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 with their corresponding GAAP measures are found in the tables at the end of this presentation and in our Q4 earnings release, both of which are available on our Investor Relations website. This morning's call will focus on fourth quarter and full year 2022 adjusted results, which exclude the gain related to the divestiture of Cromwell's enterprise software business, which was sold in the fourth quarter. We will also share results related to MonotaRO. Please remember that MonotaRO was 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 disclosed will differ somewhat from MonotaRO's public statements. Now I'll turn it over to D.G.

Thanks, Kyle. Good morning and thank you for joining us today. I'm going to discuss some of our key accomplishments from 2022, and then I'll pass it to Dee to walk through the specifics of our fourth quarter performance and our outlook for 2023. Turning to Slide 4. The Grainger Edge framework has been instrumental in guiding our work in 2022. We know that when we live our principles, focus on the things that matter and serve our customers well, we can achieve great things. Our customer base is very broad. I've been with customers that are seeing positive economic signs like aerospace, and I've also been with other customers like some retailers that are seeing some concerning economic signs. But in general, our customers continue to be busy, and Grainger has and will remain the trusted partner of providing value to their operations every day. As we look to 2023 and beyond, we are excited to continue living out the Grainger Edge starting with the customer and serving as their valued partner through any cycle. In 2022, the Grainger team stayed relentlessly focused on what matters most, providing our customers exceptional service, supporting each other and making a positive impact on our communities and the environment. In both models, we made strategic investments to support customers and build the business for the future. This included adding supply chain capacity, including a new bulk warehouse in the U.S. and the start-up of the Anegawa distribution center in Japan, expanding our digital and data capabilities, including progress with our customer and product information systems, in our high-touch business, improved account management tools, and our endless assortment model, and executing against our merchandising and marketing initiatives, including temp search and recommendation functionality. During the year, we also continued to strengthen our purpose-driven culture by ensuring Grainger is a place where our team members can be their true selves and have a fulfilling career. We continue to receive external recognition for our workplace culture. But what means the most to me and the rest of the leadership team is the positive feedback from team members about why they choose to build their career at Grainger. And finally, we continue to make progress with our environmental, social and governance objectives, both internally and in supporting our customers to help them achieve their own ESG goals. The result of this focus was an outstanding year of profitable growth, and we are extremely proud of our results, which surpassed our expectations throughout the year. Turning to Slide 6. We finished the year with over $15.2 billion in sales, up 16.5% on a daily basis or 19.3% in daily constant currency as demand across the business remains strong. In our high-touch business in North America, we focused on our growth engines and achieved approximately 775 basis points of U.S. market outgrowth in 2022, far exceeding our updated target of 400 to 500 basis points. In the endless assortment model, both Zoro and MonotaRO made progress to achieve high-teens growth in local currency and local days. During the year, we drove 215 basis points of gross margin improvement, which, when coupled with 40 basis points of SG&A leverage, resulted in 255 basis points of operating margin expansion and a nearly 50% increase in adjusted EPS. We also generated over $1.3 billion in operating cash flow, an increase of 42% over 2021 and returned $949 million to Grainger shareholders through dividends and share repurchases. We accomplished this while also improving our ROIC by 870 basis points to 40.6%. The strong 2022 financials were the result of staying focused throughout the year on what truly matters to our customers, our suppliers and our team members, and we are well positioned to continue this momentum into 2023. With that, I will turn it over to Dee to discuss the details of the fourth quarter and our outlook.

Thanks, D.G. Turning to our fourth quarter 2022 results for the total company, it was a solid quarter to finish out this year. And while you'll notice some noise as we walk through the financials, at the end of the day, we delivered great results. Sales growth in the quarter was 13.2% or 17.2% on a daily constant currency basis, which normalizes for the impact of the depreciating yen. Our results this quarter included strong growth in both segments as we continue to execute well against our strategic priorities. This includes approximately 800 basis points of share gain in the U.S. high-touch business and high-teens growth in local currency across endless assortment. Total company gross profit margin in the quarter was 39.6%, expanding 230 basis points over the prior year fourth quarter driven by increases in both segments including a favorable year-over-year impact from year-end inventory adjustments, which I'll detail in a moment. The strong gross margin performance was partially offset by a decrease in SG&A leverage in the quarter. We continue to invest in our strategic initiatives and also incurred an aggregate $35 million in non-recurring items in the quarter. This includes a one-time bonus to most hourly employees within high-touch to recognize their significant contributions towards our 2022 performance. Excluding these one-time non-recurring items, total company SG&A as a percentage of sales would have been roughly flat year-over-year. Despite these non-recurring costs, we still finished the quarter with operating margin up 135 basis points over the prior year period. This profitable growth resulted in diluted EPS of $7.14 for the fourth quarter, representing a 31% increase versus the fourth quarter 2021, another strong quarter of performance. In our High-Touch Solutions segment, we continue to see strong growth with daily sales up 16.8% compared to the fourth quarter of 2021. We saw continued positive growth in all major customer end markets across the segment, including over 20% growth in natural resources, transportation and heavy manufacturing. The daily sales increase in the U.S. of over 17% was fueled by mid-single-digit volume growth and continued strong price realization of over 11% in the quarter. Canadian daily sales were also strong, up 7% or 17.2% in local days in local currency. For the segment, GP margin finished the quarter at 41.9%, achieving 225 basis points of margin expansion. During the quarter, the segment benefited from lower freight costs and continued improvement in product mix. Margin was also favorably impacted by year-end inventory adjustments as we lap the unfavorable LIFO adjustment from the prior year period and also recorded a positive net inventory adjustment in the current year period. The net impact of these inventory adjustments was around 130 basis points for the segment. Price/cost spread in the quarter was also roughly neutral. Moving to SG&A. The segment delevered by about 35 basis points, which was driven by continued investments in marketing and headcount to support growth. In addition, the segment incurred $29 million in non-recurring items in the period, including the one-time bonus payment previously discussed and some accounting true-ups to close the year. While we did modestly delever SG&A, we still expanded operating margins by 190 basis points year-over-year, finishing with a 15.5% operating margin for the segment. This is a strong finish for our High-Touch team. Looking at market outgrowth on Slide 10, we estimate that the U.S. MRO market, including volume and price inflation, grew between 9% and 10%, implying we outpaced the market by roughly 800 basis points in the quarter. This strong finish helped us deliver 775 basis points of market outgrowth for the full year 2022. We continue to have great success in gaining share as we execute against our strategic growth engines in our High-Touch model. We remain confident in our ability to deliver the 400 to 500 basis points of annual outgrowth going forward and are excited to continue partnering with our customers and our suppliers to drive value for all parties each and every day. Moving to our Endless Assortment segment, reported and daily sales increased 0.9% or 18.2% on a daily constant currency basis after normalizing for the significant impact of the depreciating yen. In local currency and local days, MonotaRO achieved 19.4% growth and Zoro U.S. was up 19.5%. Revenue growth continues to be driven by strong new customer acquisition and repeat business for the segment as well as enterprise customer growth at MonotaRO. Gross margin for this segment expanded 170 basis points versus the fourth quarter of 2022 as we saw strong price realization, coupled with continued freight efficiencies as average order values have increased year-over-year. We also benefited from favorable business unit mix as Zoro grew faster than MonotaRO in the quarter. Segment operating margin declined 180 basis points as favorable gross margin was more than offset by heightened SG&A costs. While Zoro's operating margins were roughly flat in the quarter, MonotaRO was impacted by start-up costs at the new Anegawa DC as well as non-recurring asset retirement costs related to the upcoming closure of the Amagasaki facility. As we lap the DC transition costs and ramp a new facility to peak efficiency, we expect profitability will begin trending towards more normal levels as we move through 2023. On Slide 12, we continue to see positive results with our key Endless Assortment operating metrics. Total registered users are tracking nicely with Zoro and MonotaRO combined, up 17% over the prior year. On the right, we show the continued growth of Zoro SKU portfolio, now at over 11 million SKUs. And in 2022, the team successfully delivered on our stated goal to add 2 million SKUs per year over the next several years. In summary, a great job of spending the Endless Assortment flywheel by both Zoro and MonotaRO in 2022. I also want to acknowledge the exciting news that our Zoro U.S. business surpassed $1 billion in annual sales in 2022, the first time they exceeded that threshold in their history. It's been an amazing success story since we launched this business back in 2011, and we remain excited about what Masaya, Kevin and the rest of the Zoro team will accomplish going forward.

Moving to our outlook. Despite the economic uncertainty heading into 2023, our high-level earnings algorithm remains intact. Within our High-Touch segment, over the longer-term economic cycle, we target growing 400 to 500 basis points faster than the U.S. MRO market and remain confident in our ability to do so. In our Endless Assortment segment, we expect to continue our track record of strong growth, both in the U.S. and in Japan. At the total company level, we target generally stable gross margin performance over time while sticking to our core pricing tenant, and as we strive to grow SG&A slower than sales to help expand operating margin. Combine this with our balanced and consistent approach to capital allocation, and we can drive attractive returns over the long term as we've done especially well over the last few years. So what does this mean for 2023? At the total company, we expect revenue between $16.2 billion and $16.8 billion, with daily sales growth between 7% and 11%, driven by strong top-line performance in both segments. Note that this range is 40 basis points lower on a reported basis when factoring in one less selling day in 2023. Within our High-Touch Solutions segment, we expect daily sales growth between 5% and 9.5%. In the U.S., we're planning for MRO market growth between 1% and 5%, comprised of a volume range of flat to down 3% coupled with price inflation between 4% and 5%, largely representing the wrap of 2022 price increases. On top of a 1% to 5% market, we expect to continue executing against our strategic growth engines to achieve 400 to 500 basis points of U.S. market outgrowth in 2023. In the Endless Assortment segment, we anticipate daily sales to grow between 16% and 18% or roughly 17% to 19% in daily constant currency when factoring in 100 basis points of foreign exchange headwind at the segment level from the Japanese yen. Zoro is anticipated to grow within the segment range, reflecting further SKU expansion and a continued focus on acquiring and retaining high-value business customers. MonotaRO is also expected to grow within the segment range and local currency as they continue to grow with both small businesses and large enterprise customers. Moving to our margin expectations. We expect strong performance in both segments with stable to expanding performance in High-Touch Solutions and improving profitability in Endless Assortment. In the High-Touch Solutions segment, we expect gross profit in the year to be flat to slightly down as we anticipate some of the price/cost favorability experienced in 2022 to unwind as we trend back to neutrality over the long term. We expect this headwind will be partially offset by freight favorability given the improvement in container cost and the current outlook for diesel prices. On the SG&A side, we will continue to make incremental investments toward our strategic initiatives as we fuel our growth algorithm. We will also have some tailwinds as we lap the non-recurring items that hit in the fourth quarter and variable compensation resets in the new year. Overall, we expect SG&A leverage to be favorable, and therefore, when combined with our top-line growth expectations, we anticipate operating margin of 16.3% to 16.8% in High-Touch for 2023. In the Endless Assortment segment, we expect MonotaRO's operating margins to improve year-over-year as they continue to benefit from favorable freight efficiencies and strong price realization. At Zoro, we expect operating margins to continue to ramp as they gain leverage on their cost base. Overall, this represents operating margin for the segment between 8.6% and 9%, an improvement of 60 to 100 basis points compared to 2022. Growing this up for total company, we expect to gain SG&A leverage of 30 to 60 basis points to offset a modest decline in gross margin, resulting in operating margin between 14.4% and 14.9% for the full year.

Turning now to capital allocation, we expect the business will continue to generate strong cash flow in the year with an expected range of $1.45 billion to $1.65 billion, an increase of over $215 million at the midpoint compared to 2022. We expect to use this cash to invest in the business and return capital to shareholders. As discussed at our Investor Day in September, we plan to invest in our DC network over the next few years to support strong growth and to maintain industry-leading service levels. With this, we anticipate capital spending in the range of $450 million to $525 million in 2023. This includes DC capacity investments to expand our service advantage in the U.S. as well as the start of a new DC project in Tokyo. We are also continuing to invest in technology to further our customer and product information advantage, and we'll continue spending on accretive ESG investment across the portfolio. We expect to continue to return a significant amount of cash to shareholders in line with our historical approach. This will include share repurchases to the tune of $550 million to $700 million and a strong cash dividend, which we've increased consistently for the past 51 years and expect to do so again here in 2023.

Summarizing the high-level points, you can see these revenue, profitability and capital allocation expectations translate to adjusted EPS of $32 to $34.50 per share, a 7.9 to 16.3 percentage increase over 2022, and nearly double our pre-pandemic 2019 adjusted EPS of $17.29. We are off to a really strong start in January with preliminary total company daily sales of 16% or around 19% in daily constant currency. We do expect growth rates will be stronger in the first half as results will benefit from a more pronounced price wrap. In the second half, we will face tougher comps and have modeled a slower economic cycle. On profitability, while every year is different, we do expect gross margins will generally follow our traditional seasonal pattern with a high water mark in the first quarter and sequential declines in the second and third quarters. We anticipate SG&A will be reasonably consistent over the course of the year. With that, I'll turn it back to D.G. for some closing remarks. Thank you, Dee. Before I open it up for questions, I want to first and foremost, thank the Grainger team as well as our customers and supplier partners who have helped to drive such a successful year. We truly kept the world working in 2022 and in turn achieved outstanding results for the year, both financially and operationally. I am excited for what is to come in 2023 and remain confident in Grainger's ability to create tangible value and drive profitable growth over the long haul. With our team's continued commitment to focusing on the things that matter, we are well poised to deliver in any macro environment. With that, we will open up the line for questions.

Thank you. And at this time, we will conduct a question-and-answer session. Please limit yourself to one question and one follow-up question. Our first question comes from Tommy Moll with Stephens. Please state your question.

I'll ask two, both on High-Touch. Let's start on pricing there. It looks like for 2023, four to five points of growth on price. Dee, I think I heard you say that most, but maybe not all of that is a wrap, but if you could comment there on the wrap versus any new initiatives? And then also just a related point, are there any areas of pricing pressure? That's something that's been picked up in the marketplace this quarter elsewhere. And I just wonder if you've seen any of that in your business.

So I'll start with the first part and then maybe D.G. can add in a little bit on what he's hearing from some customers on the visit. So, yes, when we look at the market outlook, it includes both price and volume. And so the sum of that, we believe, will be somewhere in the range of 1% to 5% of the total market. We believe that volume will be down 3% to flat. And as you know, at price, up 4% to up 5%, we have more visibility into our pricing than anyone. And so when we look at price, we are also taking into account our wrap, which is basically the price increases that we took in 2022 and their full impact to 2023. So, we still see a little bit more price coming our way. So, it takes that three-ish percent up to about 4% to 5% for the price outlook.

Yes, Tommy, I would say that if there is any deflationary pressure, it primarily comes from commodities. We have adjusted prices both up and down across our product range, and the items that have decreased in price are typically those that are highly dependent on specific commodities like steel. We are observing some broad market pressure, but it seems to be more related to particular commodities at this time.

That's helpful. And then I wanted to follow up on the volume outlook for High-Touch flat to down three. And D.G., you mentioned at least one area of strength in aero and one area of relative weakness in retail. But I'm just curious, as you roll it all up into that full year outlook, are there other areas of weakness you're already seeing? Or is it more just potentially some conservatism around the back half? Anything you could provide there would be helpful.

Yes, we are adhering closely to the current market projections. Regarding the January results, we are not observing significant weakness at this time. However, we do anticipate additional challenges in the latter half of the year related to volume. Each of our customers has a unique story influenced by COVID that has affected their volume over the past few years, which determines whether they are currently experiencing pressures or feeling optimistic. For instance, in the aerospace sector, the airlines were shut down for an extended period, but they now have orders and are beginning to ramp up production. We believe it will take a couple more years for them to reach full capacity. Some customers may have accelerated their volume due to high demand during the pandemic, but now they are facing slower conditions. Overall, while each customer has their own individual circumstances, we are not currently seeing any significant softness, and this is reflected in our numbers.

Our next question comes from Ryan Merkel of William Blair. Please state your question.

Nice quarter. I wanted to start with a couple of questions on price cost. Just wanted to dig in a little bit more. So last quarter, I think price cost held by 60 basis points. And then in the fourth quarter, it was flat. I'm just curious, why does it move around so much? And then I think you're managing the price cost being neutral. But typically in the past, when there's a lot of inflation, right, your gross margins would expand. I'm curious how you're sort of managing to that price cost neutral.

Well, if you're specifically focused on GP in the U.S., our gross margins have expanded, if you look over a longer period of time here. And as it relates to price cost, just want to reiterate, when we talk about neutrality, we do talk about that over time. And we have continued to speak about the fact that price cost just like GP is lumpy. We have a cost cycle, which we have traditionally had for years that really didn't hold last year because of how fast cost inflation was coming in to suppliers. So that makes the cost piece of that a little bit lumpier. And then if you recall, we have the opportunity based upon our percentage of revenue, highly contracted. We have the right to introduce price at different periods during the time. We also have web price, which is also a good portion of our business, and we can pass price on web at any particular time. So that is the lumpiness. It's the timing of when we can actually price plus the timing of when cost actually comes through. And that's why our focus is doing that over a period of time and when it makes sense for both our supply base and for our customer base.

Okay. That makes sense. And then my follow-up, I think you had 9% price mix in '22. And my question is, is that 9% also included in your definition of the MRO market? And really what I'm getting at is, did Grainger have more price in '22 than the market? And if so, why?

Yes. Maybe I'll cover that. First of all, I think that the way you measure price inflation is probably not common across everybody. So you dive into the details that we don't really know how others are talking about price inflation, so we wouldn't comment on that. I think the thing I would point to is, to Dee's point, we generally think of price as pricing to the market, and we are very confident that what we have now is market competitive, and we look at that very, very, very closely, given our history, you might understand why we would do that. And so we are more wired on how we price competitive. As you said, there's really a lot of lumpiness. We may have taken price later than others or some may have taken earlier who knows. But the reality is that we are very competitive now and feel like we're in a good position on pricing.

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

Could we touch on freight for a second? It looked like that rate efficiencies helped you on price cost, if I read that correctly, but it still sounds like there's freight inflation. So where does that stand today?

Yes, our price cost does not factor in freight the way we define it. Freight is a separate issue, and we do consider it in all our decisions. Like many others, we experienced significant freight increases during 2021 and 2022, but that has moderated. Although it's still considerably higher than 2019 levels, we have observed a notable decrease. For this year, we anticipate it will provide some benefits due to moderating prices. It's evident that container costs from overseas are much lower than they were six months ago. While they remain relatively higher than 2019, they are getting closer. However, other areas of the market are still tight. Overall, we believe it will be a small benefit this year.

That's helpful. And then a follow-up on the supply chain. Just where does it stand today in efficiencies? What kind of lead times are you seeing and expectations about returning to normal?

Yes, it's a great question. From our perspective, once we have the product until it reaches our customers, that part of the supply chain is operating well. We generally have everything sorted out each night, except for unusual events like a storm in Dallas that can affect pickups. Overall, the outbound supply chain, including our facilities and freight partners, is performing very well. On the inbound side, we still face some delays, but things have improved significantly over the past four to five months, and we anticipate further improvements. I would say we expect lead times to get closer to those of 2019, although they may not fully reach those levels as the year goes on.

And our next question comes from Chris Snyder with UBS. Please go ahead.

And congrats on a really great year. Market outgrowth for the U.S. High-Touch business has continued to improve despite presumably better product availability across your smaller competitors. So it seems like the strategic initiatives are certainly taking hold. So I guess my question with that, does this change the way you think about the 400 to 500 basis points of outgrowth? And should we think about price as part of that outgrowth? It sounds like a lot of the questioning seems to suggest that you guys are overpricing the market. But it just feels like with the digital divide we're seeing and the increased importance that brings to customers, I would suspect you guys should be able to outprice the smaller regional competitors who do not offer that.

Yes. I mean I guess I would say just from a core sort of principle for us, we think of outgrowth in terms of volume, we expect price to be relatively neutral. You're right, we make it modest benefits over time that can happen. But certainly, what we're talking about is volume outgrowth. The position from last year, certainly, we got some benefit from supply chain fairly modest. And what we do is we sort of decouple that analytically and look at what our initiatives are doing, and that's how we came up with the 400 to 500 basis point target at the Analyst Day, we're still sticking with that. I mean, obviously, we've done a little better than that. But for now, we're not changing that. That's our expectation going forward.

And then for my follow-up, I wanted to talk about the High-Touch favorable mix during the quarter, typically mix screens as transitory. But on the last call, the Company talked about the mix benefit coming from an increased focus on technical products. And just given the strategic nature of that, it sounds more structural, so just hoping for more color on how to think about mix going forward.

We have a favorable product mix now. During 2020 and 2021, we faced a negative mix as we were selling any masks we could find, which are lower margin products. Now, we are closer to normal with the industrial products we usually sell, which has improved our mix. We are also working hard to compete with technical and industrial products, which will continue to be a focus for us. The main benefit we've seen from the mix has been returning to normal.

Our next question comes from Jake Levinson with Melius Research. Please go ahead.

D.G., are you still dealing with any labor issues at the factory level or elsewhere? Considering the mixed signals in the labor market, there's ongoing wage inflation at the lower end and significant competition in warehouses and factories. I'm interested to know how this affects your operations.

Yes, we faced challenges with labor 18 months ago and a year ago. We have made wage adjustments for our team members and are now in a considerably better position. Churn rates have returned to normal in most areas of the business, and our staffing is much more stable than it has been. Our distribution centers and call centers are performing well, and we are experiencing significantly less churn compared to the peak, getting very close to normal now.

That's helpful. And just switching gears, I guess, as a consumer when you get a lot of inflation, you see people switching from the premium product to the private label brand. Are you seeing that kind of trend in your business where customers that might want to prefer your Grainger brand over some of the marquee brands, if you will?

You know, not. We aren't seeing a big shift there. I would say that most customers, when they're buying industrial products, they need the product for the application they're using it for. And so if our private brand works that we use it and they always have. But generally, we aren't seeing certainly a down shift to lower cost products. That's not what we're seeing right now.

And our next question comes from Christopher Glynn with Oppenheimer. Please state your question.

So I think last quarter, another topic that came into the improved mix discussion for HTS was the result of the merchandising initiatives. So drilling into that, is that trend kind of in the input there full throttle now or still ramping up? And is that kind of expected to be a good guide driver for an indefinite number of years?

Yes, it's the latter, Chris. We started this initiative three or four years ago and have worked through some initial category reviews, continually improving. We've discovered a lot along the way and are consistently getting better, though there's still room for improvement. We believe this will provide ongoing benefits for us in the midterm, over the next three to five years. We continue to see advantages from enhancing our merging process, which is central to our mission of helping customers feel confident they have found the right product. Therefore, we are committed to pushing hard on this initiative.

And to be clear, that's just highlighting higher value-add products within categories for the most part?

No. I would say we are open to various products, not the economic aspects but to identifying higher-value items. Our goal is to make it very easy for customers to find what they need. It's really about having the right assortment and presenting it in a way that allows customers to easily locate the products they require for the correct application.

Our next question comes from David Manthey with Baird. Please state your question.

First off, I'm interested in understanding how you capture a LIFO benefit when both inventories and the LIFO reserve are up quarter-to-quarter and year-to-year. I just if you could go through the mechanics of that, I'd appreciate it.

Sure, I’ll start by referencing last year because there are a couple of important points to consider. We are comparing to a less favorable situation from last year, which has turned into a favorable adjustment this year. If you remember, last year we experienced a significant rise in costs, along with an unusually high amount of inventory delivered in the fourth quarter. The combination of these two factors led us to record a substantial LIFO adjustment for our fourth quarter adjustments in 2021. As we look at the current situation, we understand that we are still facing inflationary pressures regarding costs, as we continue to see costs coming from our suppliers. We focused on enhancing our processes and ensuring accuracy in our inventory valuation throughout the year. I believe we managed this much better this time around. However, when examining the inventory sold in the last quarter, it necessitated a favorable LIFO adjustment to account for it. For those unfamiliar, if there’s an increase in costs within a quarter that hasn't been sold, and the prices change in that quarter compared to earlier in the year, the LIFO adjustment requires us to recalculate all those sales to reflect the most recent costs. This adjustment benefited us. Altogether, these factors year-over-year in Q4 led to about a 130 basis point improvement in gross profit for the High-Touch business.

In High-Touch, most of our share gain comes from existing customers. The Grainger brand typically sells to most large and midsized business customers each year. Therefore, the share gains we're experiencing are mainly from existing customers, representing an increase in share of wallet rather than new customer acquisitions. In contrast, the Endless Assortment shows a more balanced approach. In Japan, we're observing a combination of new customers and significant growth with existing ones. At Zoro, we're seeing strong retention rates, indicating a balance between acquiring new customers and increasing volume from existing customers in the Endless Assortment model.

And our next question comes from Ken Newman with KeyBanc Capital Markets. Please state your question.

I think the midpoint of guide implies SG&A leverage of, call it, high teens for 2023 at the midpoint. Just remind me how much of the SG&A spend is fixed versus variable at this point? And should we think about high teens as kind of the right way for SG&A leverage to progress if sales stay at this at or above mid-single-digit growth going forward?

If you're looking at our guide, it suggests 30 to 60 basis points of SG&A leverage for next year. We are continuing to invest in demand generation, and we had some one-time costs this year that we do not expect to affect us next year. Additionally, as we enter a new year, we can reset our variable costs, such as variable compensation, back to 100% of our plan. We have also incorporated some modest productivity improvements into our plan by focusing our organization on driving standard work, automation, and productivity daily. We do not rely on large events for productivity; instead, we work to improve in both thriving and tightening circumstances. These are the figures relating to the SG&A leverage we aim to achieve, keeping in mind that we will continue to invest.

That's helpful. For my follow-up here, it does look like inventories took a decent step up from the third quarter to fourth quarter, which makes sense given the sales guide increase. Can you just provide some color on what's embedded in the operating cash guide for how inventories and working capital trend throughout the year?

Can you repeat that question again?

What can happen to have inventory levels next year and working capital next year?

So with that investment, it also includes some investments in DC capacity. So we expect to continue to build inventory as we stand up some of those new buildings. We do expect to see some slight improvement in working capital as far as it is not diminishing as much as it has in the last couple of years because we were investing much more significantly in inventory, say, last year, and we're starting to see some improvement and our accounts receivable execution as well.

Our next question comes from Chris Dankert with Loop Capital Markets. Please state your question.

I guess looking at the margin guide for Endless Assortment, pretty impressive expansion in '23 expected here. How do we think about kind of the long-term path towards that 11% margin guide? I mean does the DC investment in Tokyo, what else should we be thinking about in terms of cost and investments in '24 and beyond maybe as we think about Endless Assortment profitability over time here?

Yes. So I mean the two biggest portions of the Endless Assortment are on our Zoro U.S. and MonotaRO. MonotaRO, their profitability in the last year was deflated by operating two buildings at once in the Osaka area. That goes away. So they'll see some improvement next year. They will be investing in a building in the Tokyo region in the next several years. But generally, I think the pattern for them will be getting closer back to where they were prior to the dual DC Osaka situation. So, we would expect them to improve over time. And then we talked a lot about Zoro U.S. We expect that to get to kind of high single-digit operating margins over the next several years. And so that combination gets you to sort of that long-term guidance.

Okay. And just to put a finer point on that last piece about Tokyo. I mean, will that have a similar impact as the stand of Osaka did in terms of operating two facilities that at once whenever that investment comes through?

We expect that the Anegawa DC, which became operational in Amagasaki in the first half of 2023, will continue to incur some costs as it reaches full efficiency. During this period, they are also launching Phase 2 of the Anegawa DC, which will involve additional costs. Our expectation is that they will finish 2023 with an operating margin rate comparable to what you observed before both products.

I think Chris was asking a different question, which you were asking about Tokyo, whether it's going to be a similar issue with Tokyo when that comes on board. The answer is who knows. It depends on the pattern of the timing and when things open. It may or may not be as impactful, but we'll comment on that as we get closer to that's three or four years out.

And our next question comes from Pat Baumann with JPMorgan. Please go ahead and state your question.

A quick one, I think you're expecting on gross margin for the fourth quarter, like 38% to 34%. Can you just walk from what you were expecting to that 39.6% that you reported kind of like what surprised you? You called out LIFO benefit, but that's like a year-over-year impact. So I'm not sure if that's like the entire bridge to that 39.6%. I know, it's 1/3 year-over-year, but I'm not sure that that's like the difference in kind of where you came in at versus what you expected. So maybe color on that.

Sure. So admittedly, we did end stronger than what we expected as we continue to execute well. And a number of things as you kind of note went our way. So we talked about one of them earlier. We got some tailwind from freight efficiencies with both fuel and container costs coming down over the last couple of months. In addition to that, we did get some price/cost timing benefits as we look to implement some web prices, we implemented some web prices in the quarter ahead of our January price increases, so that helped us a bit. And then if you break away the inventory valuation adjustment this year from what we saw last year that was more something that wasn't anticipated. So that inventory valuation adjustment that we booked in the quarter that was favorable, that was the third piece.

Okay. Is it kind of like in that order in terms of like the magnitude of difference?

I would say, if you take all three, it was about 1/3, 1/3 and 1/3 from a value perspective.

Great. My follow-up is regarding gross margin guidance for 2023. I'm curious about the assumptions behind the modest contraction due to various factors. Is it primarily due to negative price/cost dynamics offset by freight, leading to a washout, or is the decline mainly related to segment mix? Additionally, should we consider any inventory adjustment dynamics that could impact year-over-year guidance? I'm interested in understanding how to analyze these moving parts.

No, I think you said it exactly right. I can repeat what you said, but we have some price/cost benefit timing. Some of that may fall away. We may have some freight efficiencies. Those may or may not cover that completely up. And then you've got the business unit mix between Endless Assortment and High-Touch and the fact that Endless Assortment is going to grow faster. So it has a negative impact.

And we have reached the end of our question-and-answer session today. I will now turn the call over to D.G. Macpherson for closing remarks.

Yes. Thanks for joining us today. I really appreciate you joining the call. Hopefully, you get a sense that we feel pretty good about the path we're on. We've had a really good year, but we're more excited about the future and driving things to help our customers operate better and help them succeed. So with that, I'll just say thanks for joining again, and hope you stay safe. If you're going to get cold, I think, in the Northeast. So, hopefully, you don't ice up too much. That does affect us too. But have a great rest of the week. Thank you.

Thank you. And this concludes today's conference. You may disconnect your lines at this time. Thank you all for your participation.