What drove Grainger's sales and earnings growth in 2006?

Sales growth came from broad strength in commercial, government and manufacturing customers, with heavy manufacturing up almost double digits, plus contributions from the U.S. market expansion program (about 2 points of segment growth) and the new product line expansion (about 2 points). Operating earnings grew faster than sales because gross margin improved, while operating expenses rose 8.1%, largely from stock-based compensation and profit sharing.

Is the margin improvement sustainable?

Part of the improvement came from one-time or mix-related factors. Winding down low-margin integrated supply and automotive contracts lifted gross margin and reduced sales growth by about 2 points in the Grainger Branch-based segment. Management also cited inflation recovery and global sourcing. Lab Safety's margin actually fell 0.3 points on freight costs and lower-margin Rand products, so gains are not uniform across segments.

How is management returning cash to shareholders, and can it keep doing so?

In 2006 Grainger bought back 6.95 million shares for about $473 million and paid $97.9 million in dividends, funded by $437 million of operating cash flow and the company's existing cash balance. About 7.7 million shares remained under the repurchase authorization at year-end. Cash fell to $348 million, so the pace of buybacks in 2007 will depend on continued operating cash generation, which management expects to stay strong while funding capex of $150-$175 million.

What are the key risks an investor should monitor?

Key risks include a slowdown in economic activity, since sales correlate with industrial production and payroll growth; competitive pressure in a fragmented market; the timing and results of the multiyear market expansion and product line programs; dependence on key suppliers and information systems; and retention of key employees. The asbestos and silica litigation (about 3,100 plaintiffs) is considered unlikely to be material, though it is not fully predictable. The 2007 tax rate guidance of 38.5% is also a headwind to net earnings growth versus 2006's 36.4%.

GWW 10-K FY2006 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed February 27, 2007. Cited figures are marked; the original filing is the authoritative source.

W.W.

Grainger's fiscal 2006 10-K shows a company performing well on the top and bottom line. Net sales rose 6.5% to $5.88 billion^a, with daily sales up 6.9%, driven by strong demand from commercial, government and manufacturing customers and by the U.S. market expansion program. Gross margin improved 0.9 points to 40.0%, largely from mix shifts away from low-margin integrated supply and automotive contracts and from global sourcing.

Operating earnings grew 11.4% to $578.1 million^b, and diluted EPS rose 12.2% to $4.24, even after roughly $0.14 of dilution from the adoption of SFAS 123R stock-based compensation expensing. Net earnings were $383.4 million, and the 36.4% reported tax rate included one-time benefits worth about $0.15 per share. Balance sheet and capital allocation were central themes.

Management repurchased about 6.95 million shares for roughly $473 million^c, versus 2.4 million shares in 2005, and paid $97.9 million in dividends, with the quarterly dividend raised to $0.29 from $0.24 during the year. Cash fell to $348 million from $545 million as buybacks and capital spending (about $137 million, with 2007 guidance of $150 to $175 million) absorbed cash flow from operations of $437 million. Total debt was minimal at roughly 0.4% of capitalization, and the company holds an S&P AA+ long-term rating.

Working capital was $1.16 billion^d and the current ratio was 2.6. The main watch items are the cadence of the multiyear market expansion and product line programs, which management expects to drive 2007 growth, the wind-down of low-margin integrated supply contracts, a higher expected 2007 effective tax rate of 38.5%, and the ongoing asbestos and silica litigation involving about 3,100 plaintiffs, which management does not expect to be material. The filing reflects a company that is growing faster than its market, expanding margins and returning substantial capital to shareholders.

02—Key points

Key Highlights

Net sales rose 6.5% to $5.88 billion; daily sales grew 6.9% across commercial, government and manufacturing customers.
Gross margin expanded 0.9 points to 40.0%, driven by mix (less low-margin integrated supply and automotive business) and global sourcing.
Operating earnings increased 11.4% to $578.1 million; operating margin reached 9.8%.
Diluted EPS of $4.24 rose 12.2%, despite a roughly $0.14 SFAS 123R stock-compensation drag and a $0.15 one-time tax benefit.
Repurchased 6.95 million shares for about $473 million and paid $97.9 million in dividends; quarterly dividend stepped up to $0.29 from $0.24.
Balance sheet remains conservative: total debt about 0.4% of capitalization, S&P AA+ rating, $250 million of undrawn committed credit lines.
2007 outlook includes capex of $150-$175 million and a projected 38.5% effective tax rate, with growth expected from market expansion and product line programs.

03—Questions

Frequently Asked Questions

What drove Grainger's sales and earnings growth in 2006?
Sales growth came from broad strength in commercial, government and manufacturing customers, with heavy manufacturing up almost double digits, plus contributions from the U.S. market expansion program (about 2 points of segment growth) and the new product line expansion (about 2 points). Operating earnings grew faster than sales because gross margin improved, while operating expenses rose 8.1%, largely from stock-based compensation and profit sharing.
Is the margin improvement sustainable?
Part of the improvement came from one-time or mix-related factors. Winding down low-margin integrated supply and automotive contracts lifted gross margin and reduced sales growth by about 2 points in the Grainger Branch-based segment. Management also cited inflation recovery and global sourcing. Lab Safety's margin actually fell 0.3 points on freight costs and lower-margin Rand products, so gains are not uniform across segments.
How is management returning cash to shareholders, and can it keep doing so?
In 2006 Grainger bought back 6.95 million shares for about $473 million and paid $97.9 million in dividends, funded by $437 million of operating cash flow and the company's existing cash balance. About 7.7 million shares remained under the repurchase authorization at year-end. Cash fell to $348 million, so the pace of buybacks in 2007 will depend on continued operating cash generation, which management expects to stay strong while funding capex of $150-$175 million.
What are the key risks an investor should monitor?
Key risks include a slowdown in economic activity, since sales correlate with industrial production and payroll growth; competitive pressure in a fragmented market; the timing and results of the multiyear market expansion and product line programs; dependence on key suppliers and information systems; and retention of key employees. The asbestos and silica litigation (about 3,100 plaintiffs) is considered unlikely to be material, though it is not fully predictable. The 2007 tax rate guidance of 38.5% is also a headwind to net earnings growth versus 2006's 36.4%.

04—Continue

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