Greetings, and welcome to the W.W. Grainger Third Quarter 2023 Earnings Conference Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Kyle Bland, Vice President of Investor Relations. Thank you. You may begin.

Good morning. Welcome to Grainger's third quarter 2023 earnings call. With me are D.G. Macpherson, Chairman and CEO; and Dee Merriwether, 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 Q3 earnings release, both of which are available on our IR website. This morning's call will focus on our third quarter 2023 results, which are consistent on both a reported and adjusted basis for all periods presented. 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'll provide an overview of our third quarter performance and then pass it to Dee to walk through our results in detail. As I typically do, I'd like to start today's call with some reflections on how our Grainger Edge framework continues to drive our success. Unlike last year, our results in 2023 have not benefited from outsized macro tailwinds and we don't expect this to change for the remainder of the year as MRO market volume growth remained slightly negative. This means we must emphasize the value we bring through our customer experience and supply chain network to drive profitable share gain. I've recently had the opportunity to spend time with several manufacturing and government customers in California. While I was there, it was clear that our advantaged supply chain, strong digital capabilities and ability to solve complex problems are adding value for these customers. All of this is helping us to continue to gain share. Before we get into the results, I want to share a few examples of how our team members continually deliver our principles and improve the communities where we operate. Last month, our team members assembled more than 4,000 buckets to help natural disaster victims across the U.S. These buckets were strategically placed in regions vulnerable to hurricanes and flooding to ensure residents are prepared to quickly respond when a crisis hits. For the second year in a row, Grainger has been recognized as one of Fortune's Best Places to Work for Women. This recognition is based on team member responses to key questions based on trust, respect, credibility, fairness, pride and camaraderie. We know that when team members are heard and recognized, we unlock the full potential of our team and the full potential of our business. Now let's dive into the quarter. On Slide 5, you can see we had another strong quarter as demand stayed reasonably steady as we continue to provide strong service and deliver tangible value to our customers. We finished the quarter with sales growth of 6.7% or 8.7% on a daily constant currency basis. Results again were driven by positive performance in both segments, most notably within the High-Touch Solutions segment, where we continue to drive profitable share gain. Total company operating margin was 15.9%, an increase of 60 basis points over the prior year, with improved gross margin performance driven by continued freight and supply chain efficiencies, along with a favorable product mix, largely falling to the bottom line. Combine this with our strong top-line performance, and we delivered another quarter of robust EPS growth, record operating cash flow and strong ROIC of over 44%. We also returned a total of $287 million to Grainger shareholders in the quarter through dividends and share repurchases. In the High-Touch Solutions segment, we are advancing our five key growth engines as we continue to leverage our technology and data assets to unlock further value for customers. We remain focused on extending our service advantage and officially broke ground on our previously announced distribution center outside of Portland which we expect will help enhance our service performance in the Pacific Northwest. Within the Endless Assortment business, while we continue to see a softer demand environment, we remain focused on acquiring new customers and improving repeat purchase rates across the segment driving long-term profitable growth. Overall, 2023 is shaping up to be another great year as we follow the Grainger Edge, make progress on our strategy and drive value for customers. We remain on track to deliver over 20% earnings growth for shareholders. And with that, I'll pass it to Dee to go through the details.

Thanks, D.G. On Slide 7, you can see the high-level results for the total company, including strong sales growth of 8.7% on a daily constant currency basis driven by growth across both segments. This is a relatively stable growth rate compared to the second quarter, even as price contribution declined as we wrap inflation pass in the prior year period. Total company operating margin was up 60 basis points, primarily due to expanded gross margin in High-Touch, which more than offset lower EA gross margin and slight SG&A deleverage across the business. In total, we delivered diluted EPS for the quarter of $9.43, which was up over 14% versus the third quarter of 2022. Moving on to segment level results. The High-Touch Solutions segment continues to perform well, with sales up 8.5% in daily constant currency underpinned by growth across all geographies. Volume accelerated sequentially and contributed 6 percentage points of growth, excluding price contribution for the first time in five quarters. In the U.S., we continue to drive year-over-year growth in all customer segments with government and transportation growing faster. Canadian daily sales were strong, up 9.1% in local currency. For this segment, gross profit margin finished the quarter at 41.7%, up 110 basis points versus the prior year. We continue to benefit from improved product availability, which drove freight and supply chain efficiencies in the quarter. Product mix also remained a tailwind, partially driven by an outsized number of project-related value-added services in the current year period, a level which we don't expect to repeat going forward. As expected, price/cost spread was negative as the timing favorability captured in 2022 continues to unwind. This price/cost trend will continue in the fourth quarter, and we anticipate finishing nearly neutral on a two-year stack for the full year 2022 and 2023 combined. At the operating line, we saw improvement of 70 basis points year-over-year as GP favorability was partially offset by continued marketing and headcount investments to drive long-term growth. SG&A leverage was further impacted by one less selling day in the current year period. Overall, it was another strong quarter for the High-Touch Solutions North American segment. Looking at market outgrowth on Slide 9, we estimate that the U.S. MRO market grew between 2.5% and 3.5%, indicating that we achieved roughly 550 basis points of outgrowth for the High-Touch Solutions U.S. business in the quarter. Performance remains above our annual target to outgrow the market by 400 basis points to 500 basis points, driven by consistent execution across our five growth engines. We continue to remain confident in our ability to achieve our annual outlook target through any economic cycle. Moving to our Endless Assortment segment. Sales increased 4.3% or 9.2% on a daily constant currency basis, which adjusts for the impact of the depreciated Japanese yen. Zoro U.S. was up 1.2%, while MonotaRO achieved 12.6% growth in local currency. At the business level, while we're seeing some signs of macro-related softness at MonotaRO, the business still drove strong growth with new and enterprise customers and remains focused on growing repeat business with its core B2B customer. At Zoro, results reflect a continuation of headwinds discussed last quarter with tough prior year comps, decline in noncore B2C volume and a slowing macro environment all contributing to more muted top-line growth. Noncore B2C customer performance was down nearly 20% year-over-year as we continue to focus our growth efforts on stickier B2B customers. Core B2B customer growth remains in the high single digits for the quarter and continues to reflect a slower macro for small businesses and in end markets where Zoro is more skewed. We expect these pressures to persist for at least the balance of the year. From a profitability perspective, gross margin for the segment declined 20 basis points versus the prior year as MonotaRO favorability was offset by year-over-year declines at Zoro. MonotaRO results reflect continued freight efficiencies and strong price realization in the quarter while the Zoro decline was driven by negative product mix and the impact of unfavorable timing from prior year price increases. These gross margin headwinds coupled with the continued demand generation investments in softer Zoro top line drove a 70 basis point decline in operating margins for the segment. On Slide 11, we continue to propel the Endless Assortment flywheel as we add new users and grow our SKU count. Total registered users were up 15% across the segment, and we continue to grow our assortment at Zoro, having added roughly 600,000 SKUs in the quarter, pushing the portfolio total to over 12.8 million products offered. Now looking forward to the rest of the year, you can see that we've narrowed our guidance ranges for the full year 2023. The new outlook includes total company daily sales growth between 8.5% and 9.5% and an EPS range between $36 and $36.60. These updated figures imply a Q4 daily sales growth between 4.5% and 8.5%, which includes 4% month-to-date growth in October, which is in line with our expectations and reflects a total comparison given hurricane-related sales in the prior year. This month-to-date growth is roughly 100 basis points higher in constant currency. From a margin perspective, we are raising the lower end of our ranges and now expect operating margin for the full year to be between 15.6% and 15.7%, a record year for the total company. The new range implies fourth quarter operating margin will be lower sequentially as we anticipate product mix to normalize with fewer value-added service engagements and SG&A margin to deleverage in line with typical seasonality in the fourth quarter. Supplemental guidance covering cash flow and share repurchase expectations, which have also been increased can be found in the appendix of the presentation. All told, we're pleased to achieve full year results that includes the absorbed price for sales, profitability and cash flow further strengthening our track record of delivering strong returns for Grainger shareholders. With that, I'll turn it back to D.G. for closing remarks.

Thanks, Dee. Before we close out, I wanted to quickly reflect on the tremendous progress that we've made over the years since our Investor Day last fall. As you may recall, we outlined an earnings framework that got us to some attractive three-year targets that included delivering strong top line growth, ramping to record operating margins and producing double-digit EPS growth through 2025. With the 2023 guidance you just outlined, even if you were to normalize for some of the one-time benefits elevating our margins this year, we are trending favorably towards the 2025 targets. As we look beyond 2023, the core tenets of this earnings framework remain intact. We will continue to focus on maximizing earnings dollar generation by delivering strong top line growth, maintaining healthy gross margins, which we expect are going to stabilize after adjusting for the one-time benefits we realized in 2023, and gaining expense leverage by growing SG&A slower than sales. Executing against this framework positions us well to deliver attractive returns and consistently produce double-digit EPS growth for our shareholders. With that, we will open up the line for questions.

And our first question comes from Ryan Merkel with William Blair.

Nice quarter. I wanted to start with a high-level question on gross margin, if I could. I think your guidance for gross margin '25 is 37% and you're a good bit above that here, 39% plus. Can you tell us why your gross margins are so much higher than the expectation you laid out at the Investor Day?

Ryan, this is Dee. Thanks for your question. If you think back to where we were about a year ago, we were in the midst of coming out of the pandemic. Product availability was not exactly where we wanted it to be, even though our relative performance was quite good. We were expecting to get back in line with product availability much later in this year. That snapped forward really quickly in Q1, and it helped us significantly improve our margins. That's one piece. The other piece I will point you to is that we target price-cost neutrality over time. Last year, around that time, we expected costs to come in a lot sooner than they did this year. We had passed price earlier last year in anticipation of that cost. Costs are now flowing through GP as we expected. So a lot of things are timing related. We are performing better than what we had anticipated at that time, but really it's due to product availability, price-cost timing as we continue to focus on neutrality. Additionally, we've continued to do very well in terms of freight and supply chain efficiencies. That was also another timing element.

Got it. Okay. That's helpful. And then just a question on trends. Government looks like it's performing very well, transport, same thing, maybe just unpack what the drivers are there? And then can you put a fine point on the October, I think you mentioned 4% month-to-date growth, and that's down from September that's closer to 9%? Just what's going on there?

Yes. So government has been very strong across the board. We have won some new contracts that have helped us this year, and so that has been certainly a tailwind. When we say transportation, I think we mean aerospace there. Aerospace has been very strong. I think the aerospace companies can't build enough airplanes now, so we're benefiting from that. The market in general remains stable. There are puts and takes, but those two have been certainly on the plus side for us. In terms of the 4% growth seen through October, several factors are at play. Our market share gain is expected to be strong in October, but we did have Hurricane Ian, which generated a lot of sales last year for us. So that comparison makes the month look a little worse than it actually is. The underlying volumes are quite good.

As it relates to the second part of your question about October month-to-date top line growth at 4% versus our implied Q4 being in the range of 4.5% to 8.5%, I will point to one thing. This time last year, we supported the sale-through of products for recovery related to Hurricane Ian, and now we're cycling a tougher comp. As the quarter progresses, these comparisons will get easier, so we feel pretty good about the range we've laid out for the quarter.

Our next question comes from Tommy Moll with Stephens.

D.G., you described the demand environment as reasonably steady. Can you elaborate on that and provide any relevant anecdotes? The revenue guidance appears to have a slightly lower midpoint. I don't want to overemphasize this, but is there a specific reason for that adjustment, or could it be attributed to foreign exchange fluctuations or something else?

The reality is that the volume this year has been near zero pretty much all year. So our volume share gain has been all volume pluses. That will continue. The biggest difference moving through the fourth quarter is that we had price increases last year that elevated our revenue line for the first three quarters, but we lapped that going into the fourth quarter. We don't see any changes and nothing to be made up. This is how we predicted the year to play out, and it's playing out exactly as expected. We are not concerned about the revenue line.

Great. And then shifting back to gross margins and specifically around the High-Touch segment. I know 40% is still the official long-term anchor there, and it may be prudent to wait to revise that. But could you even walk us maybe qualitatively from the 41.7% that you just reported in 3Q to how that may progress for 4Q and even into early next year?

Sure. You are right, it feels a little early for us to start resetting things. At this point, which I've reiterated the last couple of quarters. However, related to High-Touch, if you compare Q3 to where we think we will go sequentially in Q4, I will call out that our service-related product mix happened as a benefit both in Q2 and Q3. We don't expect that to continue into Q4. Additionally, there are pieces that fall into the price-cost related to rebates last year. Both years, we're doing very good in volume as D.G. noted, but again, volume was really strong last year, still very strong, which reset some of the rebates. So, there will be a slight drop from Q3 to Q4.

Our next question comes from Jacob Levinson with Melius Research.

Just touching on the margins. I know you talked about some favorable items you have this year, and you're certainly trending well above those 2025 targets that you laid out, but D.G. or Dee, for that manner, maybe you can just give us a sense of how you're thinking about operating leverage in the business going forward because I would think at least that the growth is there that you're probably not going to see margins contracting meaningfully, even if mix was a little bit worse or price/cost is a little bit worse?

What I would say is that the adjustments that once you take out are trending positively. The High-Touch model will be relatively stable moving forward, and we are trending favorably to the targets as discussed. The earnings model is share gain, stable gross margins and growing SG&A slower than sales. That formula is not going to change, and we expect to be able to continue to do that moving forward.

Okay. That's helpful. And just switching gears, I think your balance sheet is probably the least levered since you took over D.G., is that reflecting some conservatism on the macro? Or is there appetite for more aggressive share buybacks or special dividend or otherwise returning more cash to shareholders?

You are correct. We are fortunate to have a strong balance sheet. At this time, we don't see a significant need to further leverage the business, which you term conservatism. You can use that word, but we don't see a big need right now for that. Based on our cash flow generation and access to capital, if there ever becomes a need for that, we feel like we are well positioned to go into the capital markets to help us. Right now, based on our operating cash flow and conversion, we feel like we're in a good place with leverage.

Your next question comes from Christopher Glynn with Oppenheimer.

I was curious on HTS price/cost dynamics. What was price in the quarter? And then is it holding well? Are we looking fine on market competitive pricing to expect neutral price/cost margin impact in '24 like the algorithm?

To answer your first question, the price/cost for High-Touch was 2.5% in the quarter. We take a longer-term view of price competitiveness, remaining price competitive. Due to the lumpiness of all the components of price and costs impacting the business, if you look at a two-year stack, we expect to be close to neutral if you accrue '22 and '23. We would not change that position looking ahead. We are targeting price-cost neutrality over time, and when we get to early next year and set the 2024 guide, we'll talk in more detail about 2024.

The only thing I'd add is that we are not seeing a lot of product cost pressure relative to what we've seen in the last few years. While there are puts and takes, we are not expecting significant product cost inflation heading into the new year.

Okay. And then on Zoro and MonotaRO, just curious how you're thinking about the path back to the kind of 16% to 18% long-term top-line targets?

Zoro grew, MonotaRO grew to about 13% in the quarter. The Japanese market has not been strong, and we've been dealing with some inflation for the first time in memory there. I have confidence that the team is on the right track to continue delivering strong growth, whether that's approaching 20% like they've done over the last 20 years or something less than that is debatable. But I have no concerns about the performance of that business. In Zoro, we've seen some competitors actually go negative in the last couple of quarters in terms of revenue, which has impacted us. The market has certainly had an impact on Zoro. Core B2B sales are up in the high single digits, which is not where we want to be, but still not horrible. There are many factors at play, particularly with the consumer business falling off, which we want. We are focusing on getting repeat business out of customers, and the team is working to improve that.

Our next question comes from David Manthey with Baird.

My question was along the same lines on Zoro. It sounds like what you're seeing there is primarily cyclical in nature. You're not concerned about the strategy there. However, you also mentioned that you're implementing strategic moves to grow that business. Could you outline a couple of those for us so we know what the drivers are?

There are two pieces to growth for Zoro. One is acquiring customers, and Zoro has always been good at that. The other is developing repeat business from those customers, to become the place of choice for shopping. We've had success with that. However, we recognize we need to improve the customer repeat business aspect. We are testing various alterations to figure out how to improve that part of the business. This will be a major focus going forward.

Okay. And then on the High-Touch side, product and customer information tools have really been key drivers of the outperformance there. Can you update us on the Salesforce's use of those tools or if you've added any new capabilities lately to those applications?

We are building some of our software for the first time in a long time, focusing on customer information and product information. Specifically, here's a system we've developed to help the website optimize customer activity, which drives growth through marketing and merchandising. The customer information system supports marketing as well as seller coverage, enabling us to refine our strategies. Both areas have been major drivers of growth and we continue to enhance our capabilities in these areas.

Our next question comes from Nigel Coe with Wolfe Research.

Looking at the fourth quarter margin, Dee, I believe you called out about 50 basis points of sequential margin change from Q3 to Q4. Is that correct? How does that break down between High-Touch and Endless Assortment?

Yes. Total company is about 60 basis points. The favorability we saw in Q2 and Q3 relates to some services and project-related revenue that is accretive to the business. At a total company level, that's about 40 basis points, and for High-Touch, that's about 60 basis points. The remaining piece is related to smaller headwinds concerning price/cost and rebates, which contributes about another 20 basis points at the total company level, rounding up similarly at the High-Touch level.

To clarify your comments about price/cost normalization, we're no longer looking at 40% gross margin in High-Touch. Are you thinking you can maintain a higher plateau than that?

What we've said is that some one-time benefits, if you look at this year, include freight accrual-related benefits and supplier rebate benefits that we won't see going forward, along with the project benefit. Additionally, we expect to see about a 40 basis point headwind year-over-year. But outside of those, we expect to maintain relatively stable gross margins.

Our next question comes from Steve Volkmann with Jefferies.

I wanted to go back to something you said, D.G. You mentioned you didn't expect any cost increases or pressures in '24. Are we indeed thinking that cost and price are rather flat in '24?

We haven't really talked about that yet. Generally, we are not seeing as much product cost pressure as we've seen in the last two years. There are certain categories where costs will be down and others will be up, but generally, we're not expecting a lot of cost pressure. We'll address price/cost and actual numbers at the end of the year for next year.

Fair enough. You talked about leveraging SG&A, but we didn't do that this quarter. I assume we're making some investments. Do those continue for a number of quarters? How should we think about the trajectory there?

Yes. We're going to continue to invest in the business, but we believe we will have SG&A leverage over time. In any quarter, you may not see it, but we expect this strategy to result in improvements that will show in the longer term.

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

I hate to keep asking about Zoro, but I'm curious about whether there is any friction in that system that needs to be addressed. What can we do to really ramp up customer acquisition? Given SKU count has been moving up, what else needs to happen within the system to make improvements?

On the customer acquisition piece, the increasing product breadth really helps. We have achieved success here, but beyond that, we are focusing on getting those customers to become repeat buyers. This is where we've had success in some cases, but we need to enhance that part of the model. Our goal is to make our products appealing enough to attract new customers and then to ensure those customers come back for repeat business.

And our next question comes from Deane Dray with RBC Capital Markets.

Question on destocking. Is that at all impacting your volumes?

No, that never comes up in customer visits. For our types of products, customers generally don't have too much inventory; they buy when they need it. A lot of our value proposition is helping them not have too much inventory. We ensure that customers have what they need to keep their business running.

Good to hear that. Is there a bigger push on brand building, both in advertising, television and radio? I'm certainly hearing it more. How do you measure the returns on that?

Yes, we've stated that marketing has played a significant role in helping us gain share. We measure returns primarily through A/B tests in specific markets to understand actual pull-through results. Our marketing efforts are measured keenly, allowing us to see what's effective.

And our next question comes from Chris Snyder from UBS.

I wanted to ask about project-related value-added services. Was that a 60 basis point boost to High-Touch gross margin in Q3? Could you detail what those services entail and why they're considered one-time or transitory?

We go to market with our customers to help them solve problems, using a combination of products and services. We have over 400 what we classify as value-added service providers who assist in resolving customer issues. While these services provide ongoing revenue, a larger number of projects this quarter and in Q2 that are unlikely to be repeated drove the boost we saw. Such projects include lighting retrofits, roofing projects, and safety certifications, ensuring our customers are investing in the right products to pass safety audits.

Was that right? You mentioned earlier that it provided a 60 basis point boost in Q3 to High-Touch gross margin?

Yes, that is correct.

Thank you. D.G., you talked a lot about the value-added services offered. Do you view those services as a way to sustain pricing even in a stagnant cost environment or as a means to support mid-single-digit volume outperformance?

I'd frame this differently. We are primarily a product company. We help simplify the purchasing process for nearly every customer while also managing their inventory. To that extent, we deliver a combination of product and service value, though value-added services form a minority part of the business. These services are crucial when customers require them. There were large projects this quarter that are likely not to repeat, but our fundamental value proposition remains focused on helping customers run their operations smoothly.

Our next question comes from Patrick Baumann with JPMorgan.

A lot of numbers are being discussed regarding gross margins. Just to clarify, the 40 basis points you mentioned on gross margins, was that on an annual basis?

Yes, that's correct if you're thinking about normalizing '23 for gross margins on a go-forward basis.

Right. So all else equal, that's a baseline adjustment for your '23 number?

Correct.

And it seems like 2024 might present a more typical pricing environment based on your comments regarding product cost pressure. Assuming that is the case and looking at gross margins coming down slightly, do you see SG&A inflation slowing to enable bottom-line margin expansion? It appears your fourth quarter guidance was flat year-over-year, but perhaps there were one-time SG&A costs last year that inflated prior results. Could you provide some insight?

When examining our quarter-over-quarter results, a couple of timing factors are at play. We will continue to invest in demand generation to enhance our long-term market outgrowth specifically in the U.S. In Q4 last year, we had a LIFO benefit that we will cycle. Overall, we intend to invest in sustainable demand generation and work on offsetting as much of that through continuous improvement. Our algorithm discussed during Investor Day targets 400 to 500 basis points outgrowth, and we still expect to achieve this.

There are no further questions at this time. I'll hand the floor back to D.G. Macpherson for closing remarks.

Thanks, everyone. We recognize that today is a very busy day for all of you in terms of the number of people that are releasing results, and I appreciate you spending time with us. Yes, I would just reiterate that we feel really good about how the year has played out. It's played out pretty similar to what we expected. We continue to invest in the business to drive profitable share gain. That is our primary focus, and we continue to invest not only that but in our team and in making sure that our customers are successful. So appreciate you joining us. I hope you have a great day. Thank you.

Thank you. This concludes today's conference. All participants may disconnect.