PART I – FINANCIAL INFORMATION

 

Item 1. Financial Statements (Unaudited)

 

W.W. Grainger, Inc. and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS

(In thousands of dollars, except for per share amounts)

(Unaudited)

 

 

The accompanying notes are an integral part of these financial statements.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE EARNINGS

(In thousands of dollars)

(Unaudited)

 

 

 

The accompanying notes are an integral part of these financial statements.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands of dollars, except for per share amounts)

(Unaudited)

 

 

 

 

 

 

W.W. Grainger, Inc. and Subsidiaries

CONDENSED CONSOLIDATED BALANCE SHEETS (Continued)

(In thousands of dollars, except for per share amounts)

(Unaudited)

 

 

 

 

The accompanying notes are an integral part of these financial statements.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands of dollars)

(Unaudited)

 

 

 

 

 

W.W. Grainger, Inc. and Subsidiaries

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

(In thousands of dollars)

(Unaudited)

 

 

 

The accompanying notes are an integral part of these financial statements.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

W.W. Grainger, Inc. distributes facilities maintenance products and provides services and related information used by businesses and institutions in North America. In this report, the words “Company” or “Grainger” mean W.W. Grainger, Inc. and its subsidiaries.

 

The Condensed Consolidated Financial Statements of the Company and the related notes are unaudited and should be read in conjunction with the consolidated financial statements and related notes for the year ended December 31, 2007, included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (SEC).

 

The Condensed Consolidated Balance Sheet as of December 31, 2007, has been derived from the audited consolidated financial statements at that date, but does not include all of the disclosures required by accounting principles generally accepted in the United States of America for complete financial statements.

 

The unaudited financial information reflects all adjustments (primarily consisting of normal recurring adjustments) which, in the opinion of management, are necessary for a fair presentation of the statements contained herein.

 

 

NEW ACCOUNTING STANDARD

 

In March 2008, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 161, “Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133” (SFAS No. 161). SFAS No. 161 amends and expands the disclosure requirements related to derivative instruments and hedging activities which will enable investors to better understand the effects on an entity’s financial statements, financial position and cash flows. The statement is effective for fiscal years beginning after November 15, 2008. The Company does not expect the adoption of SFAS No. 161 to have a material effect on its results of operations or financial position.

 

In April 2008, the FASB issued Staff Position FSP 142-3, “Determination of the Useful Life of Intangible Assets” (FSP 142-3). FSP 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142, “Goodwill and Other Intangible Assets.” FSP 142-3 is effective for financial statements issued after December 15, 2008. The Company does not expect the adoption of FSP 142-3 to have a material effect on its results of operations or financial position.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

In May 2008, the FASB issued Statement of Financial Accounting Standards No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (SFAS No. 162). SFAS No. 162 is intended to improve financial reporting by identifying a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with US GAAP for nongovernmental entities. The FASB believes that the GAAP hierarchy should be directed to entities because it is the entity (not its auditor) that is responsible for selecting accounting principles for financial statements that are presented in conformity with GAAP. The Company does not expect the adoption of SFAS No. 162 to have a material effect on its results of operations or financial position.

 

In June 2008, the FASB issued Staff Position EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities” (FSP 03-6-1). FSP 03-6-1 states that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method. Upon adoption, a company is required to retrospectively adjust its earnings per share data presentation to conform with the FSP 03-6-1 provisions. FSP 03-6-1 is effective for financial statements issued after December 15, 2008. The Company is currently evaluating the impact that adoption may have on its results of operation and financial condition.

 

 

On June 6, 2008, Acklands - Grainger Inc., a wholly owned subsidiary of the Company, acquired substantially all of the assets and assumed certain liabilities of Excel F.I.G. Inc. (Excel). Excel is a business-to-business broad line distributor of maintenance, repair and operating supplies. In 2007, Excel had sales of approximately Canadian $14 million (approximately US$12 million). The purchase price and costs of the acquisition were US$6.9 million in cash and US$0.7 million in assumed liabilities. The estimated goodwill recognized in the transaction amounted to US$4.4 million and is expected to be partially deductible for tax purposes. The results of Excel are included in the Company’s consolidated results from the date of acquisition. Due to the immaterial nature of this transaction, disclosure of pro forma results were not considered necessary.

 

 

On July 30, 2008, the Company’s Board of Directors declared a quarterly dividend of 40 cents per share, payable September 1, 2008, to shareholders of record on August 11, 2008.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

 

The Company generally warrants the products it sells against defects for one year. For a significant portion of warranty claims, the manufacturer of the product is responsible for the expenses associated with this warranty program. For warranty expenses not covered by the manufacturer, the Company provides a reserve for future costs based on historical experience.

 

The warranty reserve activity was as follows:

 

 

 

On May 6, 2008, the Company entered into a four year term loan of $500 million. Proceeds were used to pay down short-term debt, fund additional share repurchases and for general corporate purposes.

 

At the election of the Company, the term loan shall bear interest at the Base Rate plus the Applicable Margin or the LIBOR Rate plus the Applicable Margin as defined within the contract. At June 30, 2008 the Company has elected a one month LIBOR Interest Period. The weighted average interest rate during the period outstanding was 3.33%.

 

The Company may prepay the loan in whole or in part at its option. The scheduled loan repayment of the outstanding principal amount is as follows:

 

 

The Company’s debt instruments include only standard affirmative and negative covenants that are normal in debt instruments of similar amounts and structure. The Company’s debt instruments do not contain financial or performance covenants restrictive to the business of the Company. The Company is in compliance with all debt covenants for the six months ended June 30, 2008.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

 

The Company has a postretirement healthcare benefits plan that provides coverage for a majority of its retired employees and their dependents should they elect to maintain such coverage. Covered employees become eligible for participation when they qualify for retirement. Participation in the plan is voluntary and requires participants to make contributions, as determined by the Company, toward the cost of the plan.

 

The net periodic benefit costs charged to operating expenses, which are valued at the measurement date of January 1 and recognized evenly throughout the year, consisted of the following components:

 

 

The Company has established a Group Benefit Trust to fund the plan and process benefit payments. The funding of the trust is an estimated amount, which is intended to allow the maximum deductible contribution under the Internal Revenue Code of 1986 (IRC), as amended. There are no minimum funding requirements and the Company intends to follow its practice of funding the maximum deductible contribution under the IRC. During the three and six months ended June 30, 2008, the Company contributed $1.2 million and $2.1 million, respectively, to the trust.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

 

The three reportable segments are Grainger Branch-based, Acklands - Grainger Branch-based (Acklands - Grainger) and Lab Safety Supply, Inc. (Lab Safety). Grainger Branch-based is an aggregation including the following: Grainger Industrial Supply, Grainger, S.A. de C.V. (Mexico), Grainger Caribe Inc. (Puerto Rico) and Grainger China LLC (China). Acklands - Grainger is the Company’s Canadian branch-based distribution business. Lab Safety is a direct marketer of safety and other industrial products. Following is a summary of segment results (in thousands of dollars):

 

 

 

 

 

 

W.W. Grainger, Inc. and Subsidiaries

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

 

 

 

 

 

 

 

W.W. Grainger, Inc. and Subsidiaries

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

Following are reconciliations of segment information with the consolidated totals per the financial statements (in thousands of dollars):

 

 

 

Unallocated expenses and unallocated assets primarily relate to the Company headquarters’ support services, which are not part of any business segment. Unallocated expenses include payroll and benefits, depreciation and other costs associated with headquarters-related support services. Unallocated assets primarily include non-operating cash and cash equivalents, certain prepaid expenses, deferred income taxes and non-operating property, buildings and equipment – net.

 

The increase in unallocated expenses for the three and six months ended June 30, 2008 is primarily attributed to a $6.0 million legal reserve the Company recognized in the second quarter of 2008. This expense is related to the settlement of the “qui tam” action regarding allegations involving sourced items and the Trade Agreement Act compliance under the Company’s United States General Services Administration (GSA) contract. Discussions with the Department of Justice relating to the Company’s compliance with its disclosure obligations and the contract’s pricing provisions are ongoing.

 

The increase in unallocated assets as of June 30, 2008 is primarily due to the Company’s higher cash balance.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

 

The following table sets forth the computation of basic and diluted earnings per share:

 

 

 

As previously reported, the Company received a letter in December 2007 from the Commercial Litigation Branch of the Civil Division of the Department of Justice (DOJ) regarding the Company’s contract with GSA. The letter suggested that the Company had not complied with its disclosure obligations and the contract’s pricing provisions, and had potentially overcharged government customers under the contract. As also reported, the DOJ subsequently intervened in a previously filed civil “qui tam” action alleging non-compliance with the pricing provisions for “sourced” items under the contract and with the country of origin provisions of the Trade Agreement Act.

 

In March 2008, the Company began the process of meeting with the DOJ to discuss the DOJ’s allegations and damage estimates. In May 2008, counsel for the parties arrived at the terms of a proposed settlement agreement relating to the “qui tam” action and in July, the parties executed an agreement pursuant to which the Company paid $6.0 million to the government but did not admit any violations. The “qui tam” action was dismissed on July 25, 2008.

 

Discussions relating to the Company’s compliance with its disclosure obligations and the contract’s pricing provisions are ongoing. The timing and outcome of these discussions are uncertain and could include settlement or civil litigation by the DOJ to recover, among other amounts, treble damages and penalties under the False Claims Act. While this matter is not expected to have a material adverse effect on the Company’s financial position, an unfavorable resolution could result in material payments by the Company. The Company continues to believe that it has complied with the GSA contract in all material respects.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

 

 

On July 10, 2008, Lab Safety, a wholly owned subsidiary of the Company acquired substantially all of the assets of Highsmith, Inc. (Highsmith), located in Fort Atkinson, Wisconsin for approximately $27 million. Highsmith is a direct marketing company in the library equipment, furniture and supplies market and had sales of $64 million in 2007. Allocation of the purchase price has not yet been finalized. The integration of Highsmith into existing operations should be completed over the next six months.

 

Effective July 21, 2008, the Company acquired a 49.9% interest in Asia Pacific Brands India Ltd. (Asia Pacific) an industrial, electrical and appliances distributor in India for an investment and capital infusion of $6.5 million. Asia Pacific had revenue of US$47 million for its fiscal year ended March 31, 2008. The Company will use the equity method to account for this investment.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

 

Item 2.

 

Overview

General

Grainger is the leading broad-line supplier of facilities maintenance and other related products in North America. Grainger distributes a wide range of products used by businesses and institutions to keep their facilities and equipment up and running. Grainger uses a multichannel business model to provide customers with a range of options for finding and purchasing products through a network of branches, sales representatives, direct marketing including catalogs, and a variety of electronic and Internet channels. Grainger serves customers through a network of more than 600 branches, 18 distribution centers and multiple Web sites.

 

Grainger’s three reportable segments are Grainger Branch-based, Acklands - Grainger Branch-based (Acklands - Grainger) and Lab Safety Supply, Inc. (Lab Safety). Grainger Branch-based is an aggregation including the following business units: Grainger Industrial Supply, Grainger, S.A. de C.V. (Mexico), Grainger Caribe Inc. (Puerto Rico) and Grainger China LLC (China). Acklands - Grainger is the Company’s Canadian branch-based distribution business. Lab Safety is a direct marketer of safety and other industrial products.

 

Business Environment

Several economic factors and industry trends shape Grainger’s business environment. Historically, Grainger’s sales tended to correlate positively with industrial production growth, particularly manufacturing output, as well as employment growth, particularly non-farm payrolls. According to the Federal Reserve, overall industrial production increased 0.3% from June 2007 to June 2008. Manufacturing output decreased 0.6% from June 2007 to June 2008, and manufacturing employment levels declined approximately 2.5%. Non-farm employment was essentially flat from June 2007 to June 2008. Grainger’s sales to manufacturing customers continue to show improvement, though at a slower rate than the second quarter of 2007. Current economic growth projections for 2008 industrial production and GDP are 0.1% and 1.5%, respectively.

 

For the first six months of 2008, the Company had $109.9 million of capital expenditures, of which $29.3 million related to its U.S. market expansion program. The Company expects to complete its investments in the U.S. market expansion program in 2008.

 

Matters Affecting Comparability

Grainger’s operating results for the first six months of 2008 include the operating results of the acquisition made by Lab Safety in May 2007. Since the acquisition date, those results have been included in the Lab Safety segment. See the Segment Analysis in the following Management’s Discussion and Analysis.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

 

Results of Operations – Three Months Ended June 30, 2008

The following table is included as an aid to understanding the changes in Grainger’s Condensed Consolidated Statements of Earnings:

 

 

Grainger’s net sales of $1,756.9 million for the second quarter of 2008 increased 9.7% compared with sales of $1,601.0 million for the comparable 2007 quarter. An increase in net sales was realized in two of the three segments of the business: Grainger Branch-based and Acklands Grainger Branch-based. Net sales at Lab Safety were essentially flat versus the second quarter of 2007. The overall increase in net sales was led by low double-digit growth in the government sector and high single-digit growth in the light manufacturing and commercial sectors. Approximately 5 percentage points of the sales growth came from Grainger’s ongoing strategic initiatives, market expansion and product line expansion, with another 1 percentage point from foreign exchange. As the Easter holiday fell in March during 2008 and in April during 2007, the sales growth for the second quarter of 2008 was positively affected by approximately 1 percentage point. For the quarter, sales were positively affected by price by approximately 2 percentage points. Prices were increased to offset cost inflation. Refer to the Segment Analysis below for further detail of sales and ongoing strategic initiatives.

 

Gross profit of $705.9 million for the second quarter of 2008 increased 10.2%. The gross profit margin during the second quarter of 2008 increased 0.2 percentage point when compared to the same period in 2007, primarily due to positive inflation recovery partially offset by unfavorable selling price category mix.

 

Operating expenses of $521.0 million for the second quarter of 2008 increased 10.0%. Operating expenses grew slightly faster than the sales growth. During the quarter Grainger recognized a $6.0 million provision for a legal reserve. This expense is related to the settlement of the “qui tam” action regarding allegations involving sourced items and the Trade Agreement Act compliance under Grainger’s United States General Services Administration (GSA) contract. Discussions with the Department of Justice relating to Grainger’s compliance with its disclosure obligations and the contract’s pricing provisions are ongoing. Excluding this charge, operating expenses were up 8.7%.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

 

Operating earnings for the second quarter of 2008 totaled $184.8 million, an increase of 11.0% over the second quarter of 2007. This earnings growth exceeded the sales growth primarily due to an improvement in gross profit margin.

 

Net earnings for the second quarter of 2008 increased by 8.0% to $113.2 million from $104.8 million in 2007. The growth in net earnings for the quarter primarily resulted from the improvement in operating earnings, partially offset by lower interest income, higher interest expense and a higher income tax rate versus 2007. Diluted earnings per share of $1.43 in the second quarter of 2008 were 18.2% higher than the $1.21 for the second quarter of 2007, including a $0.05 provision for a legal reserve. This improvement was higher than the percentage increase for net earnings due to lower shares outstanding primarily due to the Company’s share repurchase program.

 

Segment Analysis

The following comments at the segment level refer to external and intersegment net sales. Comments at the business unit level include external and inter- and intrasegment net sales. See Note 8 to the Condensed Consolidated Financial Statements.

 

Grainger Branch-based

Net sales were $1,450.8 million for the second quarter of 2008, an increase of $117.9 million, or 8.8%, when compared with net sales of $1,332.9 million for the same period in 2007.

 

Sales in the United States were up 8.6%, with growth in all customer end markets. The increase in net sales was led by low double-digit growth in the government sector and high single-digit growth in the light manufacturing and commercial sectors. Sales growth in the segment was positively affected by approximately 1 percentage point due to the timing of the Easter holiday. There was minimal effect from sales of seasonal products in the quarter. Market expansion and product line expansion added approximately 6 percentage points to overall growth in the quarter.

 

Results for the market expansion program were as follows:

 

 

A large order benefited the Los Angeles market (Phase 2) during June 2008. In the 2007 second quarter, the Company benefited from a large government order for safety products in the Washington D.C. market (Phase 4) that did not repeat this year. The Company is on track for completion of

 

 

 

W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

 

phases 5 and 6 in 2008 and expects to see continued incremental sales growth from the program for another five years.

 

The 2008 catalog includes a total of 183,000 products. The U.S. branch-based business has added more than 35,000 new products in 2008 which will be featured in the February 2009 catalog but are already for sale on grainger.com. The Company expects to add more products throughout the year.

 

Sales in Mexico increased 25.1% in the second quarter of 2008 versus 2007, positively affected by approximately 5 percentage points due to the timing of the Easter holiday. In local currency, sales were up 19.9% driven primarily by the ongoing branch expansion program.

 

The segment gross profit margin increased 0.3 percentage point in the 2008 second quarter over the comparable quarter of 2007, due to positive inflation recovery partially offset by unfavorable selling price category mix.

 

Operating expenses in this segment were up 7.9% in the second quarter of 2008 versus the second quarter of 2007. Operating expenses grew at a slower rate than sales due primarily to non-payroll operating expenses.

 

For the segment, operating earnings of $194.0 million for the second quarter of 2008 increased 13.0% over the $171.7 million for the second quarter of 2007. This earnings improvement exceeded the sales growth rate due to improved gross profit and positive operating expense leverage. Included in these results were lower profits in Mexico primarily due to branch expansion related expenses and ongoing losses in China.

 

Acklands - Grainger Branch-based

Net sales at Acklands - Grainger were $197.9 million for the second quarter of 2008, an increase of $38.6 million, or 24.2%, when compared with $159.3 million for the same period in 2007. The timing of the Easter holiday had a positive impact of approximately 2 percentage points. In local currency, sales increased 14.4% due to sales to mining, petroleum and government customers, partially offset by weakness in the forestry sector.

 

The gross profit margin was flat in the 2008 second quarter versus the second quarter of 2007.

 

Operating expenses were up 17.8% in the second quarter of 2008. The segment achieved positive operating expense leverage as operating expenses increased 8.4% in local currency.

 

Operating earnings of $16.0 million for the second quarter of 2008 were up $5.5 million, or 52.2%. The earnings improvement was primarily a result of the sales increase and operating expenses growing at a slower rate than sales.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

 

Lab Safety

Net sales at Lab Safety were $109.9 million for the second quarter of 2008. Sales were essentially flat when compared with $110.4 million for the same period in 2007. Sales from an acquisition made during May 2007 contributed approximately 2 percentage points to sales. Excluding this acquisition the rest of the business was down 2%.

 

The gross profit margin increased 0.5 percentage point in the second quarter of 2008 from the second quarter of 2007. Gross profit margin was up as a result of positive inflation recovery and product mix, partially offset by selling price category mix.

 

Operating expenses were up 3.7% in the second quarter of 2008, primarily due to higher payroll as a result of increased headcount and professional services.

 

Operating earnings of $13.6 million for the second quarter of 2008 decreased 5.5% over the same period in 2007. Operating earnings decreased due to an increase in operating expenses, partially offset by a higher gross profit margin.

 

Other Income and Expense

Other income and expense was an expense of $0.5 million in the second quarter of 2008 compared with $3.7 million of income in the second quarter of 2007. This decrease was primarily attributable to lower interest income and higher interest expense in 2008 due to lower cash on hand and increased borrowings.

 

Income Taxes

Grainger’s effective tax rate was 38.6% and 38.4% for the second quarter of 2008 and 2007, respectively. Excluding the effect of equity in net income of unconsolidated entities, the effective income tax rate was 38.9% for the second quarter of 2008 and 38.5% for the second quarter of 2007.

 

Results of Operations – Six Months Ended June 30, 2008

The following table is included as an aid to understanding the changes in Grainger’s Condensed Consolidated Statements of Earnings:

 

 

 

 

 

W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

 

Grainger’s net sales of $3,417.9 million for the first six months of 2008 increased 8.6% compared with sales of $3,147.7 million for the comparable 2007 period. An increase in net sales was realized in all three segments of the business. The increase in net sales was led by high single-digit sales growth in the government sector and mid single-digit growth in the light manufacturing and commercial sectors. Approximately 3 percentage points of the sales growth came from Grainger’s ongoing strategic initiatives, market expansion and product line expansion, with another 1 percentage point from foreign exchange. Refer to the Segment Analysis below for further detail of sales and ongoing strategic initiatives.

 

Gross profit of $1,385.8 million for the first six months of 2008 increased 8.9%. The gross profit margin during the first half of 2008 increased 0.1 percentage point when compared to the same period in 2007 primarily due to positive inflation recovery, partially offset by unfavorable selling price category mix.

 

Operating expenses of $1,015.2 million for the first six months of 2008 increased 7.6%. Operating expenses grew at a slower rate than sales due primarily to non-payroll operating expenses.

 

Operating earnings for the first six months of 2008 totaled $370.7 million, an increase of 12.6% over the first six months of 2007. This earnings growth exceeded the sales growth primarily due to positive operating expense leverage.

 

Net earnings for the first six months of 2008 increased by 10.1% to $227.4 million from $206.6 million in 2007. The growth in net earnings for the first six months primarily resulted from the improvement in operating earnings, partially offset by lower interest income, higher interest expense and a higher income tax rate versus 2007. Diluted earnings per share of $2.86 in the first six months of 2008 were 20.2% higher than the $2.38 for the first six months of 2007. This improvement was higher than the percentage increase for net earnings due to lower shares outstanding primarily due to the Company’s share repurchase program.

 

Segment Analysis

The following comments at the segment level refer to external and intersegment net sales. Comments at the business unit level include external and inter- and intrasegment net sales. See Note 8 to the Condensed Consolidated Financial Statements.

 

Grainger Branch-based

Net sales were $2,823.3 million for the first six months of 2008, an increase of $194.1 million, or 7.4%, when compared with net sales of $2,629.2 million for the same period in 2007.

 

Sales in the United States were up 7.2%, with growth in all customer end markets, except the retail customer market, which was flat. The increase in net sales was led by high single-digit sales growth in the government sector, and mid single-digit growth in the light manufacturing and commercial sectors. There was minimal effect from sales of seasonal products. Market expansion and product line expansion added approximately 4 percentage points to overall growth for the first six months of 2008.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

 

Results for the market expansion program were as follows:

 

 

The Company is on track for completion of phases 5 and 6 in 2008 and expects to see continued incremental sales growth from the program for another five years.

 

The 2008 catalog includes a total of 183,000 products. The U.S. branch-based business has added more than 35,000 new products in 2008 which will be featured in the February 2009 catalog but are already for sale on grainger.com. The Company expects to add more products throughout the year.

 

Sales in Mexico increased 21.5% in the first six months of 2008 versus 2007. In local currency, sales were up 17.6% driven primarily by the ongoing branch expansion program.

 

The segment gross profit margin increased 0.2 percentage point in the first half of 2008 over the comparable 2007 period, primarily driven by positive inflation recovery, partially offset by unfavorable selling price category mix.

 

Operating expenses in this segment were up 6.2% in the first six months of 2008. Operating expenses grew at a slower rate than sales due primarily to non-payroll operating expenses.

 

For the segment, operating earnings of $369.8 million for the first six months of 2008 increased 11.4% over the $331.9 million for the first six months of 2007. This earnings improvement exceeded the sales growth rate due to a slightly improved gross profit margin and positive operating expense leverage. Included in these results were lower profits in Mexico primarily due to branch expansion related expenses and ongoing losses in China.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

 

Acklands - Grainger Branch-based

Net sales at Acklands - Grainger were $375.2 million for the first six months of 2008, an increase of $73.9 million, or 24.5%, when compared with $301.3 million for the same period in 2007. In local currency, sales increased 10.8% due to sales to mining, petroleum and government customers, partially offset by weakness in the forestry sector.

 

The gross profit margin increased 0.3 percentage point in the first half of 2008 over the first half of 2007. The increase was driven by positive inflation recovery and lower freight costs.

 

Operating expenses were up 21.8% in the first six months of 2008. The segment achieved positive operating expense leverage as operating expenses increased 8.2% in local currency. The increase in operating expenses was primarily due to payroll and benefits as a result of increased headcount and merit increases, and other operating expenses.

 

Operating earnings of $27.7 million for the first six months of 2008 were up $8.2 million, or 42.2%. This earnings improvement exceeded the sales growth rate primarily due to a slightly improved gross profit margin and positive operating expense leverage.

 

Lab Safety

Net sales at Lab Safety were $222.7 million for the first six months of 2008, an increase of $3.2 million, or 1.5%, when compared with $219.5 million for the same period in 2007. Sales from an acquisition made during May 2007 contributed approximately 2% to the growth. Excluding this acquisition, the rest of the business was down approximately 1%.

 

The gross profit margin increased 0.2 percentage point in the first half of 2008 from the first half of 2007. Gross profit margin was up as a result of positive inflation recovery, partially offset by unfavorable selling price category mix.

 

Operating expenses were up 3.6% in the first six months of 2008. Expenses grew at a faster rate than sales primarily due to higher payroll as a result of increased headcount, higher benefit expenses related to increased medical claims and increased charge card fees as a result of increased credit card sales volume.

 

Operating earnings of $28.4 million for the first six months of 2008 decreased 2.0% versus the same period in 2007. This earnings decrease was a result of operating expenses which grew at a faster rate than sales.

 

Other Income and Expense

Other income and expense was income of $0.2 million in the first six months of 2008 compared with $6.8 million in the first six months of 2007. This decrease was primarily attributable to lower interest income and higher interest expense in 2008 due to lower cash on hand and increased borrowings.

 

Income Taxes

Grainger’s effective tax rate was 38.7% and 38.5% for the first six months of 2008 and 2007, respectively. Excluding the effect of equity in net income of unconsolidated entities, the effective income tax rate was 38.9% for the first six months of 2008 and 38.5% for the first six months of 2007.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

 

Financial Condition

For the six months ended June 30, 2008, working capital of $1,371.6 million increased by $397.2 million when compared to $974.4 million at December 31, 2007. The increase in working capital primarily relates to increases in cash and receivables, the replacement of short-term borrowings with long term debt and a reduction in liabilities due to annual cash payments for profit sharing and bonuses. The ratio of current assets to current liabilities was 3.1 at June 30, 2008, versus 2.2 at December 31, 2007.

 

Net cash provided by operating activities was $118.7 million and $180.3 million for the six months ended June 30, 2008 and 2007, respectively. Net cash flows from operating activities serve as Grainger’s primary source to fund its growth initiatives. Contributing to cash flows from operations were net earnings in the first six months ended June 30, 2008 of $227.4 million and the effect of non-cash expenses such as stock-based compensation, and depreciation and amortization. Partially offsetting these amounts were changes in operating assets and liabilities, which resulted in a net use of cash of $193.2 million for the first six months of 2008. The principal operating uses of cash were increases in accounts receivable and inventory, as well as a reduction of other current liabilities. The increase in receivables was due to a higher sales volume. The increase in inventories was due to the product line expansion initiative and higher inventories to improve customer service through better product availability. Other current liabilities declined primarily due to annual cash payments for profit sharing and bonuses. Partially offsetting these uses in cash was an increase in trade accounts payable.

 

Net cash used in investing activities was $89.2 million and $68.1 million for the six months ended June 30, 2008 and 2007, respectively. Cash expended for additions to property, buildings, equipment and capitalized software was $108.3 million in the first six months of 2008 versus $83.2 million in the first six months of 2007. Capital expenditures included the continued funding of the market expansion initiative.

 

Net cash provided by financing activities was $122.3 million for the six months ended June 30, 2008, versus net cash used of $75.6 million for the six months ended June 30, 2007. For the six months ended June 30, 2008, Grainger offset financing cash outlays with proceeds from long term borrowings of $500 million. Also offsetting financing cash outlays were proceeds and excess tax benefits realized from stock options exercised of $41.3 million in 2008 versus $119.5 million in 2007. Grainger’s treasury stock purchases of $271.0 million were $123.7 million higher in the first six months of 2008 versus 2007 as Grainger repurchased 3.5 million shares compared to 1.7 million shares in the first six months of 2007. As of June 30, 2008, approximately 9.2 million shares of common stock remained available under Grainger’s repurchase authorization. Dividends paid to shareholders were $59.4 million and $54.1 million for the first six months of 2008 and 2007, respectively, and short-term borrowings decreased $88.6 million in the first six months of 2008 versus an increase of $6.2 million in the first 6 months of 2007.

 

Grainger maintains a debt ratio and liquidity position that provide flexibility in funding working capital needs and long-term cash requirements. In addition to internally generated funds, Grainger has various sources of financing available, including commercial paper sales and bank borrowings under lines of credit. Total debt as a percent of total capitalization was 20.3% at June 30, 2008, and 5.0% at December 31, 2007. The increase in total debt as a percent of total capitalization was primarily the

 

 

 

W.W. Grainger, Inc. and Subsidiaries

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

 

result of long-term borrowings. See Note 6 to the Condensed Consolidated Financial Statements for additional borrowings detail.

 

Critical Accounting Policies and Estimates

The preparation of financial statements, in conformity with accounting principles generally accepted in the United States of America, requires management to make judgments, estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses in the financial statements. Management bases its estimates on historical experience and other assumptions, which it believes are reasonable. If actual amounts are ultimately different from these estimates, the revisions are included in Grainger’s results of operations for the period in which the actual amounts become known.

 

Accounting policies are considered critical when they require management to make assumptions about matters that are uncertain at the time the estimate is made and when different estimates than those management reasonably could have made have a material impact on the presentation of Grainger’s financial condition, changes in financial condition or results of operations. For a description of Grainger’s critical accounting policies see the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.

 

Forward-Looking Statements

This Form 10-Q contains statements that are not historical in nature but concern future results and business plans, strategies and objectives and other matters that may be deemed to be “forward-looking statements” under the federal securities laws. Grainger has generally identified such forward-looking statements by using words such as "continued incremental sales growth, continues to believe it complies, continues to show improvement, could, expect, expected, expects, intended, intends, may, on track, projections, should be completed, timing and outcome are uncertain, and will" or similar expressions.

 

Grainger cannot guarantee that any forward-looking statement will be realized although Grainger does believe that its assumptions underlying its forward-looking statements are reasonable. Achievement of future results is subject to risks and uncertainties which could cause Grainger’s results to differ materially from those which are presented.

 

Factors that could cause actual results to differ materially from those presented or implied in a forward-looking statement include, without limitation: higher product costs or other expenses; a major loss of customers; increased competitive pricing pressures; failure to develop or implement new technologies or business strategies; the outcome of pending and future litigation or governmental or regulatory proceedings; changes in laws and regulations; disruption of information technology or data security systems; general industry or market conditions; general economic conditions; labor shortages; facilities disruptions or shutdowns; higher fuel costs or disruptions in transportation services; natural and other catastrophes; and unanticipated weather conditions.

 

Caution should be taken not to place undue reliance on Grainger’s forward-looking statements and Grainger undertakes no obligation to publicly update the forward-looking statements, whether as a result of new information, future events or otherwise.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

 

PART I – FINANCIAL INFORMATION

 

 

For quantitative and qualitative disclosures about market risk, see “Item 7A: Quantitative and Qualitative Disclosures About Market Risk” in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2007.

 

 

Disclosure Controls and Procedures

 

Grainger carried out an evaluation, under the supervision and with the participation of its management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of Grainger’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that Grainger’s disclosure controls and procedures were effective as of the end of the period covered by this report.

 

Changes in Internal Control Over Financial Reporting

 

There were no changes in Grainger’s internal control over financial reporting that occurred during the second quarter, that have materially affected, or are reasonably likely to materially affect, Grainger’s internal control over financial reporting.

 

PART II – OTHER INFORMATION

 

Items 1A, 3, 4 and 5 not applicable.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

 

 

As previously reported, the Company received a letter in December 2007 from the Commercial Litigation Branch of the Civil Division of the Department of Justice (DOJ) regarding the Company’s contract with the United States General Services Administration (GSA). The letter suggested that the Company had not complied with its disclosure obligations and the contract’s pricing provisions, and had potentially overcharged government customers under the contract. As also reported, the DOJ subsequently intervened in a previously filed civil “qui tam” action alleging non-compliance with the pricing provisions for “sourced” items under the contract and with the country of origin provisions of the Trade Agreement Act.

 

In March 2008, the Company began the process of meeting with the DOJ to discuss the DOJ’s allegations and damage estimates. In May 2008, counsel for the parties arrived at the terms of a proposed settlement agreement relating to the “qui tam” action and in July, the parties executed an agreement pursuant to which the Company paid $6 million to the government but did not admit any violations. The “qui tam” action was dismissed on July 25, 2008.

 

Discussions relating to the Company’s compliance with its disclosure obligations and the contract’s pricing provisions are ongoing. The timing and outcome of these discussions are uncertain and could include settlement or civil litigation by the DOJ to recover, among other amounts, treble damages and penalties under the False Claims Act. While this matter is not expected to have a material adverse effect on the Company’s financial position, an unfavorable resolution could result in material payments by the Company. The Company continues to believe that it has complied with the GSA contract in all material respects.

 

 

 

W.W. Grainger, Inc. and Subsidiaries

 

 

Issuer Purchases of Equity Securities – Second Quarter

 

 

 

 

 

 

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.