W.W. Grainger Q4 2022 Earnings Call Transcript

Quartr
Provided by Quartr
February 2, 2023

There are 12 speakers on the call.

Operator

Greetings, and welcome to the W. W. Grainger 4th 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.

Operator

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.

Speaker 1

Good morning. Welcome to Grainger's 4th quarter and full year 2022 earnings call. With me are D. G. Macpherson, Chairman and CEO and Dean Merriwether, Senior Vice President As a reminder, some of our comments today may include forward looking statements.

Speaker 1

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 our 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 Q4 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 Q4. We will also share results related to Monotaro. Please remember that Monotaro is a public company and follows Japanese GAAP, which differs from U.

Speaker 1

S. GAAP and is reported in our results 1 month in arrears. As a result, the numbers disclosed will differ somewhat from Monotaro's public statements. Now, I'll turn it over to DG.

Speaker 2

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 Q4 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, Focused on the things that matter and serve our customers well, we can achieve great things.

Speaker 2

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 their trusted partner by 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, and build the business for the future.

Speaker 2

This included adding supply chain capacity, including a new bulk warehouse in the U. S. And the start up of the Inagawa Business and improved account management tools and our endless assortment model and executing against our merchandising and marketing initiatives, including 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, 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 surpassed our own expectations throughout the year.

Speaker 2

Turning to Slide 6, we finished the year with over $15,200,000,000 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 Hi 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 Monitaro made progress to achieve high teens growth in local currency and local days.

Speaker 2

During the year, we drove 250 basis 15 basis points of gross margin improvement, which when coupled with 40 basis points of SG and A leverage resulted in 2 55 basis points of operating margin expansion and a nearly 50% increase and adjusted EPS. We also generated over $1,300,000,000 in operating cash flow, an increase of 42% over 2021 and returned $949,000,000 to Grainger shareholders through dividends and share repurchases. We accomplished this while also Our ROIC by 8 70 basis points to 40.6 percent. The strong 2022 financials were the result of staying focused throughout the year on what

Speaker 3

Thanks, DG. Turning to our Q4 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.

Speaker 3

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. HiTouch business and high teens growth in local currency across Total company gross profit margin in the quarter was 39.6%, Expanding 230 basis points over the prior year 4th quarter, driven by increases in both segments and 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 decrease in SG and A leverage in the quarter.

Speaker 3

We continue to invest in our strategic initiatives and also incurred an aggregate 35,000,000 Non recurring items in the quarter. This included a one time bonus to most hourly employees within Hightouch to recognize their significant contributions towards our 2022 performance. Excluding these one time non recurring items, Total company SG and 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 Q4, representing a 31% increase versus the Q4 2021, another strong quarter of performance.

Speaker 3

In our Hi Tec Solutions segment, we continue to see strong growth with daily sales up 16.8% compared to the Q4 of 2021. We saw continued positive growth in all major customer end markets across 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 continued strong price realization over 11% in the quarter.

Speaker 3

Canadian daily sales were also strong, up 7% or 17.2% in local days and local currency. For the segment, GP margin finished the quarter at 41.9 percent, 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 lapped the unfavorable LIFO adjustment from the prior year period and also recorded a positive 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.

Speaker 3

Price cost spread in the quarter was also Roughly neutral. Moving to SG and 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 $29,000,000 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 and A, we still expanded operating margins by 100 and 90 basis points year over year finishing with a 15.5% operating margin for the segment. This was a strong finish for our Hightouch team.

Speaker 3

Looking at market outgrowth on Slide 10, We estimate that the U. S. MRO market, including volume and price inflation, grew between 9% 10%, implying we outpaced the market by roughly 800 basis points in the quarter. This strong finish helped us deliver 7 75 basis points of market outgrowth for the full year 2022. We continue to have great success in gaining share as we point 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.

Speaker 3

Moving to our illness 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, Monitaro 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 Monitaro.

Speaker 3

Gross margin for this segment expanded 170 basis points versus the Q4 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 Monitaro in the quarter. Segment operating margin declined 180 basis points as favorable gross margin was more than offset by heightened SG and A costs. While Zoro's operating margins were roughly flat in the quarter, Monitaro was impacted by startup costs at the new Inagawa DC as well as non recurring asset retirement costs related to the upcoming closure of the Amagasaki facility. As we lap these DC transition costs and ramp the new facility to peak efficiency, We expect profitability will begin trending towards more normal levels as we move through 2023.

Speaker 3

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 Monitaro combined up 17% over the prior year. On the right, we show the continued growth of Zoro's SKU portfolio, now at over 11,000,000 SKUs. And in 2022, the team successfully delivered on our stated goal to add 2,000,000 SKUs per year over the next several years. In summary, a great job of spinning the endless assortment flywheel by both Zoro and Monitaro in 2022.

Speaker 3

I also want to acknowledge the exciting news that our Zoro U. S. Business surpassed $1,000,000,000 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 This is back in 2011, and we remain excited about what Messiah, Kevin and the rest of the Zorro team will accomplish going forward. Moving to our outlook.

Speaker 3

Despite the economic uncertainty heading into 2023, Our high level earnings algorithm remains intact. Within our HiSET 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.

Speaker 3

S. And in Japan. At the total company level, we target generally stable gross margin performance over time while sticking to our core pricing tenets. And as we strive to grow SG and A slower than sales to help expand operating margin. Couple 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.

Speaker 3

So what does this mean for 2023? At the total company, we expect revenue between $16,200,000,000 $16,800,000,000 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 Hi Tec Solutions segment, we expect daily sales growth between 5% and 9.5%. In the U.

Speaker 3

S, we're planning for MRO market growth between 1% 5%, comprised of a volume range A flat to down 3%, coupled with price inflation between 4% 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 18% and 18% or roughly 17% to 19% in daily constant currency when factoring in 100 basis Monitaro is also expected to grow within the segment range in local currency as they continue to grow with both small businesses and large enterprise customers.

Speaker 3

Moving to our margin expectations. We expect strong performance in both segments with stable to expanding performance in Hi Tec Solutions and improving profitability in endless assortment. In the Hijet Solutions segment, we expect gross profit in the year to be flat to slightly down as we anticipate some of 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 costs and the current outlook for diesel prices. On the SG and A side, we will continue to make incremental investments toward our strategic initiatives as we fuel our growth algorithm.

Speaker 3

We will also have some tailwinds as we lap the non recurring items that hit in the 4th quarter Certain expenses like variable compensation reset in the New Year. Overall, in total, we expect SG and 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% and HiTouch for 2023. In the Endless Assortment segment, we expect Monitaro's At Xero, 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% 9%, an improvement of 60 to 100 basis points compared to 2022. Growing this up for total company, We expect to gain SG and A leverage of 30 to 60 basis points to offset a modest decline in gross margin, resulting in operating margin between 14.4% 14.9% for the full year.

Speaker 3

Turning now to capital allocation. We expect the business will continue to generate strong cash flow in the year with an expected range of $1,450,000,000 to $1,650,000,000 an increase of over $215,000,000 at the midpoint period 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 Capital spending in the range of $450,000,000 to $525,000,000 in 2023. This includes DC capacity investments to expand our service advantage in the U.

Speaker 3

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 investments 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 $550,000,000 to $700,000,000 and a strong Cash dividend, which we've increased consistently for the past 51 years and expect to do so again here in 2023.

Speaker 3

Summarizing the high level points on Slide 17, you can see these revenue, profitability and capital allocation translate to adjusted EPS of $32 to $34.50 per share, We are off to a really strong start in January with preliminary total company daily sales up 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 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 watermark in the 1st quarter and sequential declines in the 2nd and third quarters, We anticipate SG and A will be reasonably consistent over the course of the year. With that, I'll turn it back to DG for some closing remarks.

Speaker 2

Thank you, Dee. Before I open it up for questions, I want to 1st 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, deliver a flawless experience and drive profitable growth over the long haul. With Hakim's continued commitment to focusing on the things that matter, we are well poised to deliver in any macro environment.

Speaker 2

With that, we will open up the line for questions.

Operator

Thank you. And at this time, we will conduct our question and answer session. Our first question comes from Tommy Moll with Stephens. Please state your question.

Speaker 4

Good morning and thanks for taking my questions.

Speaker 2

Good morning.

Speaker 4

I'll ask 2 both on high touch. Let's start on pricing there. It looks like For 2023, 4 to 5 points of growth on price and Dee, I think you heard 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?

Speaker 3

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 his 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% to total market.

Speaker 3

We believe that volume will be down 3 to flat. And as you noted, price Up 4 to up 5. We have more visibility into our pricing than anyone. And In 2022 and their full impact to 2023. So we still see a little bit more price Coming our way, so it takes that 3 ish percent up to about 4% to 5% from the for the price outlook.

Speaker 2

Yes, Tommy, I would say most of the if there's deflationary pressure, it's mostly due to commodities. So there are We have we've taken prices up and down across the assortment and the ones that are down are almost always very commodity intensive. So they're very steel intensive or very some specific commodity intensive. So we do see that broad market pressures. We don't see that much.

Speaker 2

It's more specific Commodities that we're seeing right now.

Speaker 4

Thank you. That's helpful. And then I wanted to follow-up on the volume outlook for HiTouch Flat to down 3%. And D. G, you mentioned at least one area of strength in aero and one area of relative weakness in retail.

Speaker 4

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.

Speaker 2

Yes. We're really sticking to what The market projections are at this point. In terms of you heard the January results. We aren't seeing a lot of weakness to be fair At this point, we do expect in the back half there to be more challenges from a volume perspective. What I would say is Every customer we have has a COVID fueled story about what's happened to their volume over the past few years and where they've been determines Whether they're facing pressures now or whether they're seeing optimism.

Speaker 2

So obviously, with Aerospace, they we shut down The airlines for a long time and they now have orders. So they're starting to build up and that's going to take them a couple more years to actually get to full speed we think with aerospace. With some, they may have forward loaded some of their volume because they were selling things that were very important during the pandemic, and now they're faced with situations where things are slowing down. So I would say every customer has their own story. As of yet, and that's showing in the numbers.

Operator

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

Speaker 5

Thanks and 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 helped by 60 basis points and then in the 4th quarter, it was Flat. I'm just curious why does it move around so much?

Speaker 5

And then I think you're managing the price cost being neutral, 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?

Speaker 3

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 into 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 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 costs actually come through.

Speaker 3

And that's why our Focus is doing that over a period of time and when it makes sense both for our supply base as well as for our customer base.

Speaker 5

Okay, that makes sense. And then my follow-up, I think you had 9% price mix in 'twenty two. 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 Granger have more price in 2022 than the market? And if so, why?

Speaker 2

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 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 it's 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 History, you might understand why we would do that. And so we are more wired on our reprice competitive.

Speaker 2

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 price.

Operator

Thank you. Our next question comes from Deane Dray with RBC Capital Markets. Please state your question. Thank you. Good morning, everyone.

Speaker 2

Good morning. Good morning.

Speaker 6

Hey, could we

Speaker 2

touch on freight for a second? It looked like that freight 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. So our price cost does not include freight the way we define it for you.

Speaker 2

So freight is a separate issue. Obviously, we consider freight In everything we do, like everybody, we saw huge freight increases during 2021 2022, that has certainly moderated. It's still above 2019 levels fairly substantially, and we have That come down quite a bit. So and we talked about for this year, we expect it to be a benefit in terms of some of the moderating prices. And some of that is sort of obvious places and containers from overseas are a lot cheaper than they were 6 months ago, quite a bit.

Speaker 2

They're still Relatively higher than 2019, but beginning closer. Other parts of the market are still tight. So net net, we still feel like it will be a small benefit this year for sure. That's helpful. And then the follow-up on the supply chain, just where does it stand today in efficiencies?

Speaker 2

What kind of lead times are you seeing and expectations about returning to normal? Yes. I mean, it's a great question. So what I would say is that, from our perspective, once we have the product When customers get at that part of the supply chain, it's all good. We're basically clean every night barring a Storm in Dallas or something that we've seen in the last couple of days where people won't pick up.

Speaker 2

But in general, the supply chain on the outbound side, both in our buildings and then our Freight Partners is very, very good. On the inbound side, we still have some elongated supply chain that's gotten much better in the past 4 or 5 months, and we expect to Continue to get better. At normal, I think I'd probably say in quotes now. I do expect it to get closer to 2019 lead times, but maybe not Quite all the way there as the year progresses, but we do expect it to continue to get better. Thank you.

Operator

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

Speaker 7

Thank you. 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.

Speaker 7

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 over Pricing 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 out price the smaller regional competitors who do not offer that. Thank you.

Speaker 2

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 may get modest benefits over time.

Speaker 2

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 basis point 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.

Speaker 2

But for now, we're not changing that. That's our expectation going forward.

Speaker 7

Thank you. 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.

Speaker 7

Thank you.

Speaker 2

Yes. So we have a favorable mix. Mix for us generally means product mix here. And so You can imagine during 2020 2021, in particular, we had a very negative mix because we had We were selling any mask in the world we could find we were selling it and that is a lower margin product. I would say we are more back to normal now in terms of the industrial Products that we have typically sold and that's been a favorable mix for us.

Speaker 2

And certainly, we are working hard to make sure that we can compete with Technical products or industrial products and that will be a focus for us going forward. Most of the mix benefit has been getting really getting back to normal is the way I describe it.

Operator

Thank you. And our next question comes from Jake Levenson with Melius Research. Please go ahead.

Speaker 8

Good morning, everyone.

Speaker 2

Good morning.

Speaker 8

Hi, T. G, are you guys still experiencing any kind of labor issues either at the factory Level or otherwise, just thinking about kind of the mixed signals we're seeing in the labor market, you've still got wage inflation at the lower end And seemingly a lot of competition in warehouses and factories and whatnot, but just curious what how that translates for you guys?

Speaker 2

Yes. Well, I mean, so a couple of things. One is, we certainly, we had wage labor challenges 18 months ago, a year ago, we have made adjustments in wages for our team members. I would say we are in a much, much better Our churn rates are back to normal basically in most parts of the business. And we are in a much more stable Staffing pattern that we've been and I mentioned sort of the outbound, our DCs are performing well, our call centers are performing well.

Speaker 2

We don't have Near as much churn as we did at the peak and we're really close to back to normal at this point.

Speaker 8

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

Speaker 2

No, 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 They're using it for. And so if our private brand works, they will use it and they always have. But generally, we aren't seeing certainly a downshift a lower cost products. That's not what we're seeing right now.

Operator

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

Speaker 9

Thanks. Good morning, guys. So, I think last quarter, another topic that came into the improved mix discussion And for HTS was the result of the merchandising initiative. 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 guy driver for an indefinite number of years.

Speaker 2

Yes, it's the latter, Chris. We started this initiative 3 or 4 years ago. We've worked through sort of some initial category reviews. We keep getting better at them. What we've discovered is that We've learned a ton as we've gone and we're just getting better and better at it and there's still a lot of improvement to be made.

Speaker 2

It will be a consistent Benefit for us, we believe going forward for the foreseeable future. So that mid term 3 to 5 year timeframe, we still see a lot of benefit from Improving the way we merge. It's good to quarter what we do. I mean, helping customers have confidence that they found the right product is kind of what we choose. So getting better at that seems to have good results and we're going to continue to really push hard on that.

Speaker 9

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

Speaker 2

No, we are I would say we are agnostic to What the not agnostic to the economics, but agnostic to sort of identifying higher value products. We're trying to make it super easy for And so it's really all about do we have the right assortment? Can we present it in a way that makes it really easy for customers to find? So they can have a lot of confidence They're getting the product that they need to use for the right application.

Speaker 5

Okay. Thank you.

Operator

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

Speaker 6

Thank you. Good morning. 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 year to year, if you could go through the mechanics of that, I'd appreciate it.

Speaker 3

Sure, Dave. So I'll go back to last year, so we just start with that because there was 2 things. We're lapping last year's It was unfavorable last year and favorable this year adjustment. And if you recall last year, we had a sharp increase in cost. And then we had an outsized amount of inventory kind of get delivered in the Q4.

Speaker 3

And that combination of those two factors At the same time, resulted in us recording a meaningful LIFO adjustment To our Q4 adjustments in 2021. Now looking at that and understanding that we were still in a Inflationary period as it relates to cost and we saw cost still coming in. From our suppliers, We worked on improving our processes, tightening our processes, making sure that we were booking Entries and looking at the process not just from the financials but with the supply chain leaders To ensure inventory valuation was staying up to par as we move through the year. So I feel like we did a much better job there. However, when you look at the inventory that was sold through in the last quarter of the year, it required us to take a Favorable adjust LIFO adjustment to correct for that, because if something has an increase, For those that don't know, something hasn't increased in the quarter and you haven't sold it or the price change in that quarter from when it changed early in the year, The LIFO adjustment causes you to refactor all of those sales to the latest cost.

Speaker 3

So that adjustment was favorable for us. The combination of those 2 year over year in Q4 resulted in about 130 basis points A net 130 basis points year over year impact to GP for the Hi Touch business.

Speaker 6

Okay. Thank you. And second, the share gains that you've been seeing have clearly been terrific. Could you The balance that you're seeing between new customer adds and selling more to existing customers, I would imagine there's a difference between high touch and Endless assortment, but could you just give us some color on that? Yes.

Speaker 2

I mean, in high touch so I would just say that in high touch that The vast majority of our share gain is existing customers. The reality is that the Grainger brand sells something to most large and midsize customers, Business customers in a year and so vast majority of those are the share gains we're seeing are actually share of wallet as opposed to new customer acquisitions. In the endless assortment, it's more balanced. We're seeing in Japan, we're seeing a mix of new customers, but also Significant growth with existing customers. And at Zoro, we're seeing nice retention rates.

Speaker 2

So we are seeing more balance between new customer Position volume and existing customer volume in the end of the assortment model.

Operator

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

Speaker 2

Hey, good morning, guys. Good morning.

Speaker 10

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

Speaker 3

So, if you're looking at our guide, the guide is implying 30 to 60 basis Point of SG and A leverage for next year. And as I think about that, Let's remember a couple of things. We're continuing to invest in demand generation And we had some one time costs this year that we don't expect to impact us next year. And I would say one of the last things to consider is going into a new year, we get to reset our Variable costs like variable costs such as variable compensation back to 100% of our plan. And then we have some modest productivity that we build into the plan because we focus our organization on looking at driving standard work, Automation and productivity every day, so we don't have to have huge events.

Speaker 3

We do that in times when things are going really well and we can scale and Also when things are tightening up. So those are the numbers that I had related to the type of SG and A leverage we're looking to gain and remember that's in the midst of us continuing to invest.

Speaker 5

That's helpful.

Speaker 10

For my follow-up here, it does look like inventories took a decent step up from the Q3 to Q4, which makes sense given the sales guide increase. Could you just provide some color on what's embedded in the operating cash guide for how inventories and working capital trend throughout the year?

Speaker 3

Can you repeat that question again?

Speaker 2

What's going to happen to inventory levels next year and working capital

Speaker 3

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 And working capital, as far as it is not diminishing as much as it has 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.

Operator

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

Speaker 1

Hey, morning. Thanks for taking the question. I guess looking at the margin guide for analyst assortment, Pretty impressive expansion in 'twenty three 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 'twenty four and beyond maybe as we think about an assortment

Speaker 2

Yes. So, I mean, the 2 biggest portions of the analysts are Zuora U. S. And Monotaro. Monotaro, their profitability in the last year was deflated by operating 2 buildings at once In the Osaka area, that goes away, so they'll see some improvement next year.

Speaker 2

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've talked a lot about Zoro U. S.

Speaker 2

We expect that to get a high single digit operating margins over the next several years. And so that combination gets you to sort of that long term

Speaker 5

Well, good. And just to put

Speaker 1

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 Operating 2 facilities at once whenever that investment comes through?

Speaker 3

So we expect So the Inagala DC that went up and getting out of Amagasaki in 2023, there's the first half they will They'll be incurring some costs as well as wrapping up to their full efficiency. In the midst of that, they're also launching Phase 2 of the Inagala DC, which has additional costs. So our expectation is that they will end the year in 2023 Or exit that year with op margin rate similar to what you saw prior to both projects?

Speaker 2

I think Chris was asking a bit different You're 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 Okay. That's like that's 3 or 4 years out.

Operator

Thank you. And our next question comes from Pat Baumann with JPMorgan. Please go ahead and state your question. Hi, good

Speaker 11

morning. Thanks for taking my questions. A quick one, I think you're expecting on gross margin For the Q4 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.

Speaker 11

So I'm not sure if that's like The entire bridge to that 39.6%. I know it's 130 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 any color on that? Thanks.

Speaker 3

Sure. So admittedly, we did end stronger than what we 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.

Speaker 3

As we look to implement Some wet prices, we implemented some wet 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 of Something that wasn't anticipated. So that inventory valuation adjustment that we booked in the quarter that was favorable, that was the 3rd piece.

Speaker 11

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

Speaker 3

I would say you take all 3, it was about a third, a third and a third from a value perspective.

Speaker 11

Great. And then my follow-up is just on it's also on gross margin, just the guide for 2023. Just wondering what the assumptions are kind of behind that modest contraction for some of these moving parts. Like is it Is price cost negative, which is offset by freight kind of those washout and then kind of the decline is like just kind of segment mix related or Is there anything in there for kind of the inventory adjustment dynamics to think about? Just wondering that year over year guide, how to think about the moving parts for that?

Speaker 3

Well, I think you said it exactly right. I can repeat what you said, but we have some price cost 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

Operator

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.

Speaker 2

Yes. Thanks for joining us today. Really appreciate you jumping on the call. Hopefully, you get the sense that we feel pretty good about We've had a really good year, but we're more excited about the future and driving things to help So with that, I'll just say thanks for joining again and hope you stay safe. You're going to get cold, I think, in the Northeast.

Speaker 2

So Hopefully, you don't ice up too much because that does affect us too. But have a great rest of the week. Thank you.

Operator

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

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Earnings Conference Call
W.W. Grainger Q4 2022
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