01—Abstract
Summary
Summary of the 10-K filed March 10, 2004. Cited figures are marked; the original filing is the authoritative source.
W.W.
Grainger's fiscal 2003 10-K shows a company with flat top-line performance but improving gross margins and a fortress balance sheet. Net sales were $4,667.0 milliona, essentially flat versus $4,643.9 million in 2002, as weak U.S. manufacturing employment weighed on demand, partly offset by government account growth (up to 17% of sales from 13% in 2001) and Canadian currency tailwinds. Gross margin rose to 35.1% from 34.4% on favorable product mix and selected price increases, but operating earnings fell 1.5% to $387.3 million because operating expenses rose to 26.8% of sales, driven by higher severance and healthcare costs.
Diluted EPS increased to $2.46b from $2.24, though the prior-year comparison was depressed by a $23.9 million goodwill write-down; excluding that, earnings growth was more modest. The company ended 2003 with $402.8 million in cash, long-term debt of only $4.9 million (with $144.1 million reclassified to current due to a cross-currency swap maturing in 2004), and shareholders' equity of $1.85 billion. Operating cash flow improved to $394.1 million, aided by inventory reduction from the redesigned logistics network.
Management plans to more than double capital expenditures to $200 to $225 millionc in 2004, targeting branch expansion, IT upgrades, and completion of the distribution network, which is a meaningful step-up that will pressure free cash flow in the near term. Key watch items for investors include the continued dependence on U.S. manufacturing employment, the rising operating expense base, the 2004 capex ramp, and the accounting change requiring vendor allowances to be reclassified from operating expenses to cost of merchandise sold (a $55.2 million reclassification in 2003 terms, with no net earnings effect). The company's AA+ credit rating and low leverage give it significant flexibility to fund these initiatives.
02—Key points
Key Highlights
- Net sales of $4,667.0 million, essentially flat (+0.5%) versus 2002, reflecting weak U.S. manufacturing demand
- Gross profit margin expanded 70 basis points to 35.1% from 34.4% on product mix and selected price increases
- Operating earnings declined 1.5% to $387.3 million as operating expenses rose to 26.8% of sales from 25.9%
- Diluted EPS of $2.46 versus $2.24 in 2002, with 2002 burdened by a $23.9 million after-tax goodwill write-down
- Operating cash flow rose to $394.1 million, with cash and equivalents reaching $402.8 million at year-end
- Long-term debt was just $4.9 million excluding a $144.1 million current maturity tied to a cross-currency swap; S&P rating AA+
- 2004 capital expenditures guided to $200 to $225 million, more than double recent levels, to fund branch network, IT, and logistics projects
03—Questions
Frequently Asked Questions
Why did Grainger's sales stay flat in 2003 despite a larger branch network?
Sales were pressured by weakness in the U.S. economy, particularly manufacturing, where job losses reduce demand for Grainger's products. U.S. sales declined about 1%, with government accounts (up roughly 11%) offsetting declines in manufacturing and other commercial segments. Canada's 15.4% sales increase was mostly due to a favorable exchange rate; in local currency growth was only 2.7%.
Is Grainger's earnings growth in 2003 sustainable?
The 2003 EPS increase is partly flattered by the absence of the 2002 goodwill write-down. Operating earnings actually fell 1.5%, and segment results were mixed: Branch-based Distribution earnings dropped 1.2%, Lab Safety fell 11.1%, and Integrated Supply declined sharply. Sustained growth will depend on a sales recovery and controlling the higher operating expense base, which rose on severance and healthcare costs.
What is the impact of the change in vendor allowance accounting?
Under EITF Issue 02-16, Grainger will classify most vendor-provided advertising allowances as a reduction of cost of merchandise sold rather than an offset to operating expenses. This shifts reported gross margin and operating expense ratios but does not change net earnings. In 2003 the reclassification affected $7.9 million, and the company estimates it would have reduced 2003 cost of merchandise sold by $55.2 million on a full-year basis.
Does Grainger face material debt or liquidity risk?
Not significantly. Apart from the $144.1 million current debt, which is mainly a commercial paper position backing a cross-currency swap maturing in September 2004, the company's debt is minimal and carries no restrictive financial covenants. Total debt was 7.5% of total capitalization, and the company held $265.4 million in committed credit lines. Management has not yet decided whether to renew the swap, but the company states it can refinance the underlying obligation.
What are the main litigation risks disclosed?
Grainger is a defendant in asbestos and silica lawsuits involving about 3,300 plaintiffs, based on alleged exposure to products it distributed. Around 275 cases were dismissed in 2003 for lack of product identification. Management believes most claims are covered by insurance and that the ultimate outcome will not have a material adverse effect, though it cannot predict results and is still negotiating coverage with its carriers.
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