W.W. GRAINGER, INC. (GWW) FY 2023 MD&A

Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations

Objective

The following Management’s Discussion and Analysis (MD&A) of Financial Condition and Results of Operations is intended to help the reader understand the results of operations and financial condition of W.W. Grainger, Inc. (Grainger or Company) as it is viewed by the Company. The following discussion should be read in conjunction with the Consolidated Financial Statements and accompanying notes included in Part II, Item 8: Financial Statements and Supplementary Data of this Form 10-K. This section of this Form 10-K generally discusses 2023 and 2022 items and year-to-year comparisons between 2023 and 2022. Discussions of 2021 items and year-to-year comparisons between 2022 and 2021 are not included in this Form 10-K, and can be found in MD&A of Financial Condition and Results of Operations in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2022.

Percentage figures included in this section have not been calculated on the basis of such rounded figures but on the basis of such amounts prior to rounding. For this reason, percentage amounts in this section may vary slightly from those obtained by performing the same calculations using the figures in the Company's Consolidated Financial Statements or in the associated text.

Overview

W.W. Grainger, Inc. is a broad line distributor of maintenance, repair and operating (MRO) products and services with operations primarily in North America, Japan and the United Kingdom (U.K.). Grainger uses a combination of its high-touch solutions and endless assortment businesses to serve its customers worldwide, which rely on Grainger for products and services that enable them to run safe, sustainable and productive operations.

Strategic Priorities

The Company’s continued strategic aspiration for 2024 is to relentlessly expand Grainger’s leadership position by being the go-to partner for people who build and run safe, sustainable, and productive operations. To achieve this, each Grainger business has a set of strategic growth drivers to drive top-line revenue and MRO market outgrowth. In the High-Touch Solutions North America (High-Touch Solutions N.A.) segment, businesses are focused on three areas: advantaged MRO solutions, differentiated sales and services, and unparalleled customer service. In the Endless Assortment segment, businesses are focused on product assortment expansion and innovative customer acquisition and retention capabilities. Additionally, all Grainger businesses are focused on continuously enhancing our operational processes to improve service and cost through customer experience, technology and supply chain infrastructure which ultimately delivers long-term returns for shareholders.

Recent Events

Inflationary Cost Environment and Macroeconomic Pressures

The global economy continues to experience volatile disruptions including to the commodity, labor and transportation markets, arising from a combination of geopolitical events and various economic and financial factors. These disruptions have affected the Company's operations and may continue to affect the Company's business, financial condition and results of operations.

The Company continues to monitor economic conditions in the U.S. and globally, and the impact of macroeconomic pressures, including repercussions from changes in interest rates, currency exchange fluctuations, inflation and a potential recession on the Company’s business, customers, suppliers and other third parties. As a result of continued inflation, the Company has implemented strategies designed to mitigate certain adverse effects of higher costs while also remaining market price competitive. Historically, the Company’s broad and diverse customer base and the nondiscretionary nature of the Company’s products to its customers has helped to insulate it from the effects of recessionary periods in the industrial MRO market. The full extent and impact of these conditions are uncertain and cannot be predicted at this time.

For further discussion of the Company's risks and uncertainties, see Part I, Item 1A: Risk Factors of this Form 10-K.

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Results of Operations

In this section, Grainger utilizes non-GAAP measures where it believes it will assist users of its financial statements in understanding its business. Non-GAAP measures exclude certain items affecting comparability that can affect the year-over-year assessment of operating results and other one-time items that do not directly reflect ongoing operating results. For further information regarding the Company's non-GAAP measures including reconciliations to the most directly comparable GAAP measures, see below "Non-GAAP Measures."

The following table is included as an aid to understanding the changes in Grainger's Consolidated Statements of Earnings for the twelve months ended December 31, 2023 and 2022 (in millions of dollars).

The following table is included as an aid to understanding the changes of Grainger's total net sales, daily net sales and daily organic constant currency net sales from the prior period for the twelve months ended December 31, 2023 (in millions of dollars):

Net sales of $16,478 million for the year ended December 31, 2023 increased $1,250 million, or 8%, and on a daily, organic constant currency basis, net sales increased 10% compared to the same period in 2022. Both High-Touch Solutions N.A. and the Endless Assortment segments contributed to sales growth in 2023. For further discussion on the Company's net sales, see the Segment Analysis section below.

Gross profit of $6,496 million for the year ended December 31, 2023 increased $647 million, or 11%, and gross profit margin of 39.4% increased 100 basis points compared to the same period in 2022. Both segments contributed to margin expansion in 2023. For further discussion on the Company's gross profit, see the Segment Analysis section below.

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Selling, general, and administrative (SG&A) expenses of $3,931 million for the year ended December 31, 2023 increased $297 million, or 8%. Adjusted SG&A of $3,905 million increased $250 million, or 7%, compared to the same period in 2022 driven by higher marketing and payroll expenses. Adjusted SG&A leverage improved 30 basis points in 2023.

Operating earnings of $2,565 million for the year ended December 31, 2023 increased $350 million, or 16%. Adjusted operating earnings of $2,591 million increased $397 million, or 18%, compared to the same period in 2022 due to higher gross profit dollars, partially offset by increased SG&A consistent with sales growth in 2023. Adjusted operating margin improved 130 basis points in 2023.

Income tax expense of $597 million and $533 million represents effective tax rates of 23.9% and 24.8% for the years ended December 31, 2023 and 2022, respectively. The Company's effective tax rate was positively impacted by increased benefits related to stock compensation in 2023.

Diluted earnings per share was $36.23 for the year ended December 31, 2023. Adjusted diluted earnings per share was $36.67 for the year ended December 31, 2023, an increase of 24% compared to $29.66 for the same period in 2022.

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Non-GAAP Measures

Grainger utilizes non-GAAP measures where it believes it will assist users of its financial statements in understanding its business. Non-GAAP measures exclude certain items affecting comparability that can affect the year-over-year assessment of operating results and other one-time items that do not directly reflect ongoing operating results. Organic net sales results exclude the impact of changes in foreign currency exchange rates and results of certain divested businesses in the comparable prior year period post date of divestiture. Adjusted results including adjusted SG&A, adjusted operating earnings, adjusted net earnings and adjusted diluted EPS exclude certain non-recurring items, including restructuring charges, asset impairments, gains and losses associated with business divestitures and other non-recurring, infrequent or unusual gains and losses from the Company’s most directly comparable reported U.S. generally accepted accounting principles (GAAP) results. The Company believes its non-GAAP measures provide meaningful information to assist investors in understanding financial results and assessing prospects for future performance as they provide a better baseline for analyzing the ongoing performance of its businesses by excluding items that may not be indicative of core operating results. Grainger’s non-GAAP financial measures should be considered in addition to, and not as a replacement for or as a superior measure to its most directly comparable GAAP measure and may not be comparable to similarly titled measures reported by other companies.

Business Divestitures

In the fourth quarter of 2023, Grainger divested E & R Industrial Sales, Inc. (E&R) and recorded a one-time pre-tax loss on the divestiture of $26 million in SG&A. In the fourth quarter of 2022, Grainger divested Cromwell's wholly owned software business in the U.K. and recorded a one-time pre-tax gain on the divestiture of $21 million in SG&A. The Company does not expect these business exits to have a material effect on its future results of operations.

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The following table provides a reconciliation of reported net sales growth from the prior year period in accordance with GAAP to the Company's non-GAAP measures daily net sales and daily, organic constant currency net sales for the twelve months ended December 31, 2023 (in millions of dollars):

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The following tables provide a reconciliation of reported SG&A expenses, operating earnings, net earnings attributable to W.W. Grainger, Inc. and diluted earnings per share determined in accordance with GAAP to the Company's non-GAAP measures adjusted SG&A, adjusted operating earnings, adjusted net earnings attributable to W.W. Grainger, Inc. and adjusted diluted earnings per share for the twelve months ended December 31, 2023 and 2022 (in millions of dollars):

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Segment Analysis

In this section, Grainger utilizes non-GAAP measures where it believes it will assist users of its financial statements in understanding its business. For further information regarding the Company's non-GAAP measures including reconciliations to the most directly comparable GAAP measures, see above "Non-GAAP Measures." For further segment information, see Note 13 of the Notes to Consolidated Financial Statements in Part II, Item 8: Financial Statements and Supplementary Data of this Form 10-K.

High-Touch Solutions N.A.

The following table shows reported segment results (in millions of dollars):

Net sales of $13,267 million for the year ended December 31, 2023 increased $1,085 million, or 9% compared to the same period in 2022. The increase was due to volume of 5% and price, which includes customer mix, of 4%.

Gross profit of $5,546 million for the year ended December 31, 2023 increased $595 million, or 12%, and gross profit margin of 41.8% increased 120 basis points compared to the same period in 2022. The increase was driven by freight and supply chain efficiencies in 2023.

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SG&A of $3,212 million for the year ended December 31, 2023 increased $244 million, or 8%, and adjusted SG&A of $3,186 million increased $218 million, or 7% compared to the same period in 2022. The increase was primarily due to higher marketing and payroll expenses. Adjusted SG&A leverage improved 30 basis points compared to the same period in 2022.

Operating earnings of $2,334 million for the year ended December 31, 2023 increased $351 million, or 18%, and adjusted operating earnings of $2,360 million increased $377 million, or 19% compared to the same period in 2022.

Endless Assortment

The following table shows reported segment results (in millions of dollars):

Net sales of $2,916 million for the year ended December 31, 2023 increased $129 million, or 5%, and on a daily constant currency basis, increased 10% compared to the same period in 2022. The increase was due to sales growth of 10%, driven by customer acquisition for the segment and enterprise growth at MonotaRO, partially offset by declining sales at Zoro and non-core, consumer-like customers for the segment. Sales growth was offset by unfavorable currency exchange of 5% due to changes in the exchange rate between the U.S. dollar and the Japanese yen.

Gross profit of $864 million for the year ended December 31, 2023 increased $47 million, or 6%, and gross profit margin of 29.6% increased 30 basis points compared to the same period in 2022. The increase was driven by freight efficiencies at MonotaRO partially offset by unfavorable product mix at Zoro in 2023.

SG&A of $631 million for the year ended December 31, 2023 increased $37 million, or 6%, compared to the same period in 2022. The increase was primarily due to higher marketing and payroll and benefit expenses to support the continued growth of the segment in 2023. SG&A leverage decreased 30 basis points compared to the same period in 2022.

Operating earnings of $233 million for the year ended December 31, 2023 increased $10 million, or 4%, compared to the same period in 2022. The increase was due to higher gross profit dollars, partially offset by higher SG&A in 2023.

Liquidity and Capital Resources

Grainger believes its current balances of cash and cash equivalents, marketable securities and availability under its revolving credit facilities will be sufficient to meet its liquidity needs for the next twelve months. The Company expects to continue to invest in its business and return excess cash to shareholders through cash dividends and share repurchases, which it plans to fund through cash flows generated from operations. Grainger also maintains access to capital markets and may issue debt or equity securities from time to time, which may provide an additional source of liquidity.

Sources of Liquidity

Cash and Cash Equivalents

As of December 31, 2023 and 2022, Grainger had cash and cash equivalents of $660 million and $325 million, respectively. The increase in cash was primarily due to cash flows from operations and favorable year-over-year working capital, partially offset by higher capital expenditures and higher volume of share repurchases. The Company had approximately $1.9 billion in available liquidity as of December 31, 2023.

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Cash Flows

The following table shows the Company's cash flow activity for the periods presented (in millions of dollars):

Net cash provided by operating activities was $2,031 million and $1,333 million for the year ended December 31, 2023 and 2022, respectively. The increase compared to the prior year period was due to higher earnings and favorable changes in year-over-year working capital largely driven by sales growth, inventory management and timing of cash receipts and payments.

Net cash used in investing activities was $422 million and $263 million for the year ended December 31, 2023 and 2022, respectively. The increase compared to the prior year period primarily reflects increased U.S. supply chain investments including capacity, automation and sustainability initiatives, as well as technology enhancements across the Company.

Net cash used in financing activities was $1,278 million and $972 million for the year ended December 31, 2023 and 2022, respectively. The increase compared to the prior year period was primarily due to higher treasury stock repurchases.

Debt

Grainger maintains a debt ratio and liquidity position that provides flexibility in funding working capital needs and long-term cash requirements. Grainger has various sources of financing available. For further information regarding the Company's debt instruments and available financing sources, see Note 5 of the Notes to the Consolidated Financial Statements in Part II, Item 8: Financial Statements and Supplementary Data of this Form 10-K.

Total debt as a percent of total capitalization was 40.1% and 45.9%, as of December 31, 2023 and 2022, respectively.

Credit Ratings

Grainger receives ratings from two independent credit ratings agencies: Moody's Investor Service (Moody's) and Standard & Poor's (S&P). Both credit rating agencies currently rate the Company's corporate credit at investment grade.

The following table summarizes the Company's credit ratings as of December 31, 2023:

Uses of Liquidity

Internally generated cash flows are the primary source of Grainger's working capital and growth initiatives, including

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capital expenditures. The Company expects to continue to return excess capital to shareholders through share repurchases and dividends.

Working Capital

Working capital as of December 31, 2023 was $3,078 million, an increase of $214 million compared to $2,864 million as of December 31, 2022. The increase was primarily due to sustained sales growth and inventory management driven by supply chain efficiencies compared to the prior year period. As of December 31, 2023 and 2022, the ratio of current assets to current liabilities was 2.8 and 2.5, respectively.

Capital Expenditures

In fiscal 2023, the Company's capital expenditures were $445 million and $256 million for the years ended December 31, 2023 and 2022, respectively. Capital project spending for 2024 is expected to be in the range of $400 and $500 million. This includes continued supply chain capacity expansion and technology enhancements across the Company. With Grainger's strategic plan to expand its distribution network, the Company completed land purchases in Oregon and Texas in the second and fourth quarters of 2023 for construction of approximately 500,000 and 1,200,000 square foot distribution centers (DC), respectively.

Share Repurchases

For the years ended December 31, 2023 and 2022, Grainger repurchased shares of its common stock in the open market for $850 million and $603 million, respectively. Share repurchases are executed at prices the Company determines appropriate subject to various factors, including market conditions and the Company's financial performance and may be affected through accelerated share repurchase programs, open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. Share repurchases for 2024 are expected to be in the range of $900 and $1,100 million.

Dividends

For the years ended December 31, 2023 and 2022, Grainger declared and paid $392 million and $370 million, respectively, in dividends to holders of the Company's common stock.

Commitments and Other Contractual Obligations

The Company's material cash requirements include the following commitments and other contractual obligations.

Debt

As of December 31, 2023, the Company had outstanding debt obligations with varying maturities for an aggregate principal amount of $2,337 million, with $34 million payable within 12 months. Total future interest payments associated with the Company's outstanding debt obligations was $1,729 million, with $87 million payable within 12 months.

Purchase Obligations

Grainger had purchase obligations of approximately $1,453 million as of December 31, 2023, which includes approximately $1,175 million payable within 12 months. Grainger's purchase obligations primarily include commitments to purchase inventory, uncompleted additions to property, buildings and equipment and other goods and services. Purchase obligations are made in the normal course of business to meet operating needs and are primarily noncancelable.

Leases

The Company has lease arrangements for certain properties, buildings and equipment (including branches, warehouses, DCs and office space). As of December 31, 2023, the Company had fixed operating lease payment obligations of $492 million, with $87 million payable within 12 months.

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Critical Accounting Estimates

The preparation of Grainger’s Consolidated Financial Statements and accompanying notes are in conformity with GAAP and the Company’s discussion and analysis of its financial condition and operating results require the Company’s management to make assumptions and estimates that affect the reported amounts. The Company considers an accounting policy to be a critical estimate if: (1) it involves assumptions that are uncertain when judgment was applied, and (2) changes in the estimate assumptions, or selection of a different estimate methodology, could have a significant impact on Grainger’s consolidated financial position and results. While the Company believes the assumptions and estimates used are reasonable, the Company’s management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances. Note 1 of the Notes to Consolidated Financial Statements in Part II, Item 8: Financial Statements and Supplementary Data of this Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s Consolidated Financial Statements.

Inventories

Company inventories primarily consist of merchandise purchased for resale and are valued at the lower of cost or market value. The majority of the Company’s inventory is accounted for using the last-in, first-out (LIFO) method. Market value is based on an analysis of inventory trends including, but not limited to, reviews of inventory levels, sales and cost information and on-hand quantities relative to the sales history for the product and shelf-life. The Company's methodology for estimating whether adjustments are necessary is continually evaluated for factors including significant changes in product demand, liquidation or disposition history values and market conditions such as inflation and other acquisition costs, including freight and duties. If business or economic conditions change, estimates and assumptions may be adjusted as deemed appropriate.

Goodwill and Other Intangible Assets

The Company evaluates goodwill and indefinite-lived intangible assets for impairment annually during the fourth quarter and more frequently if impairment indicators exist. The fair value of reporting units is calculated primarily using the discounted cash flow method and utilizing value indicators from a market approach to evaluate the reasonableness of the resulting fair values. The Company’s indefinite-lived intangible assets are primarily trade names. The fair value of trade names is calculated primarily using the relief-from-royalty method, which estimates the expected royalty savings attributable to the ownership of the trade name asset.

The estimates used to calculate the fair values of reporting units and indefinite-lived intangible assets involve the use of significant assumptions, estimates and judgments and changes from year to year based on operating results, market conditions, macroeconomic developments and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and impairment for each reporting unit and indefinite-lived intangible asset. For further information on the Company's goodwill and other intangible assets, see Note 4 of the Notes to Consolidated Financial Statements in Part II, Item 8: Financial Statements and Supplementary Data of this Form 10-K.

Contingencies and Legal Matters

The Company is subject to various claims and legal proceedings that arise in the ordinary course of business, the outcomes of which are inherently uncertain. The Company accrues for costs relating to litigation claims and other contingent matters when it is probable that a liability has been incurred and the amount of the assessment can be reasonably estimated. For further information on the Company's contingencies and legal matters, see Note 14 of the Notes to Consolidated Financial Statements in Part II, Item 8: Financial Statements and Supplementary Data of this Form 10-K.

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