W.W. Grainger, Inc.

Hello, and welcome to the WW Granger third quarter 2020 earnings conference call. At this time, all participants are in a listen-only mode. If anyone should require operator assistance, please press star zero on your telephone keypad. A question and answer session will follow the formal presentation. As a reminder, this conference is being recorded. It's now my pleasure to turn the call over to your host, Irene Holman, VP Investor Relations. Please go ahead.

Good morning. Welcome to Granger's Third Quarter 2020 Earnings Call. With me are D.J. McPherson, Chairman and CEO, and Tom Okre, SVP and CFO. As a reminder, some of our comments today may be forward-looking statements. 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 their corresponding GAAP measures are found in the tables at the end of this slide presentation and in our Q3 press release, both of which are available on our IR website. This morning's call will focus on adjusted results for the third quarter of 2020, which exclude restructuring and other items that are outlined in our earnings release. Now I'll turn it over to DG.

Thanks, Irene. Good morning, and thank you for joining us today. Market conditions remain challenging in the third quarter as the pandemic conditions improved, but continued to weigh on many of our customers. Despite these challenges, Grainger performed well, continuing to demonstrate our resilience and strength. I'm so proud of how Grainger team members have responded to the challenges of 2020, staying relentlessly focused on further deepening relationships with our customers and supporting each other. I've shared with you our Grainger Edge framework, which includes our purpose, aspiration, strategy, and the principles that define the behaviors we expect from all team members. These principles, including starting with the customer, acting with intent, and competing with urgency, provide clarity and focus as we continue to execute on our purpose to keep the world working. And we'll continue to leverage the greater edge in all that we do throughout this pandemic and beyond. So let me start off with a brief business update and an overview of our third quarter performance before turning it over to Tom to dive into the details. On the business side, we continue to serve our customers well, support the needs and safety of our team members, and ensure we remain in a strong financial position. A quick update on each point. Grainger has operated effectively throughout the pandemic, first in support of essential businesses and now in serving all businesses. Each of our customers has a unique story on how they have been impacted by and managed through the pandemic. We have been there for all of them. Sales to healthcare, government, and e-commerce businesses remain strong in the quarter, and we saw improving trends with manufacturing and commercial customers. I'll address the pattern of revenue in a moment. Our world-class integrated supply chain organization, which supports both our North American high-touch businesses and our Zorro endless assortment platform, has helped find and secure products to meet customer demand. We have successfully worked down our backlog of orders for most pandemic-related products, including masks, and continue to work with suppliers to catch up on the few categories that remain scarce, including some gloves and hand sanitizers. The team remains laser focused on maintaining our high level of customer service. Customer feedback has been strong and improving throughout the pandemic. For our team members, we continue to take steps to support not only their safety, but their overall well-being during this uncertain time. To date, we have managed the challenges of 2020 without major layoffs and currently have roughly 1% of our workforce still on furlough. Importantly, we've maintained a strong financial position. We've been diligent in controlling costs, while balancing the need to continue to serve our customers, support our team members, and invest where it matters most. Our strong performance over the last two quarters together with our solid cost containment have enabled us to relax a number of our short-term cash preservation actions. We exited the quarter with approximately $2.1 billion in available liquidity. We continue to make strong progress on our strategic growth priorities during the short-term uncertainty. We have continued to execute our transform merchandising process to drive significant user experience improvements to Grainger.com, including our search and visualization capabilities and enriched product descriptions and content. By the end of 2020, we expect to have re-merchandised $2.8 billion in product through this new process, including $1.6 billion in the year alone. We intend to further accelerate these efforts moving forward as a result of our new product information management system that launched in the third quarter. Customer feedback on our website has improved significantly over the past six quarters. Marketing has been a large contributor of our U.S. share gain over the last few years. We have improved effectiveness in both media advertising and paid search and plan to further invest in marketing given these strong returns. We continue to deepen relationships with our customers through our large customer multi-site growth initiative, enhancements to our keep stock offering, and improvements to our sales strategy and effectiveness. We know that when we embed one or more of our service offerings with our customers, we foster deeper and longer-lasting relationships. Over 60% of our U.S. revenue is generated from customers with one or more embedded solutions. And lastly, within our endless assortment model, we are executing the successful Monotro playbook at Zorro here in the U.S. and are making strides in marketing effectiveness, customer analytics, and SKU additions. This year alone, we have added 1.5 million SKUs to Zorro, pushing its assortment to roughly 5 million products. Turning to our quarterly performance, we produced strong operating results in the third quarter. Organic daily sales finished up 4.6% in the quarter, underpinned by growth in our U.S. high-touch business and continued impressive performance of our endless assortment model. In the U.S., we realized strong outgrowth to the broader MRO market as a whole, which was down 5% to 6% in the quarter. Our gains were supported by pandemic-related demand, sales to new customers, and improved sales of non-pandemic product as we started to see some stabilizing trends in underlying business activity. Overall business activity still trails pre-pandemic levels as some customers remain disrupted by COVID. The endless assortment model continues to deliver with 20% growth in the third quarter while also generating meaningfully improved margins. We remain very excited about the future of this business as we continue to adopt learnings from Minotro to drive growth and profitability. At the total company level, we expanded adjusted operating margins by 90 basis points as gross margins stabilized sequentially, and we demonstrated strong cost control. Tom will detail this in a bit. The business continues to produce a durable cash flow stream with operating cash flow of $311 million and free cash flow of $252 million. Looking at slide six, I thought it would be important to again show this chart to highlight the underlying trends with pandemic and non-pandemic products based on our current categorization of SKUs. Our characterization goes beyond traditional safety products to include product categories with substantial volume increases during the pandemic. Plexiglass barriers will be an example. As you can see, while sales of pandemic-related products have decreased since May, continued demand for key products, including masks, gloves, and cleaning supplies, has kept pandemic sales elevated year over year. This heightened demand has continued to come from a multitude of new and existing customers across numerous industries as businesses reopen and adjust to the new operating protocols. On the non-pandemic side, sales have improved since bottoming out in April, with non-pandemic sales now down about 7% year over year. This improvement has been seen across most industries, with some of the obvious industries remaining the furthest below their pre-pandemic levels. These include airlines, hotels, and cruise lines. Based on month-to-day performance, we forecast October sales to finish up around 2% for the U.S. segment on continued trends in pandemic and non-pandemic performance. Predicting the recovery over the next few quarters is very challenging. The path of the virus will have a big impact on whether the recent improvements continue, level off, or reverse. But we feel well-positioned to compete in any environment that comes our way. With that, I will turn it over to Tom to talk us through the quarter's results in detail. Tom.

Thanks, DG. Starting on slide eight, you can see we delivered strong results in the quarter. Organic daily sales, which adjust for the divestitures of Fabry in China, were up 4.6% on a constant currency basis. This increase was primarily driven by share gains in our U.S. segment and continued impressive growth in our endless assortment business, which was up over 20% in the quarter. These gains more than offset pandemic-related softness in our Canada and Cromwell businesses. We saw meaningfully higher sales sequentially, but still remain well below pre-pandemic levels. Gross margin for the total company was down 170 basis points versus the prior year quarter, but represented 120 basis point improvement from the second quarter year-over-year decline. Margin pressure continues to be driven by pandemic-related headwinds, primarily in our U.S. segment, as well as continued business unit mix impact as we experienced significant growth in our endless assortment business. Our SG&A came in at $700 million for the third quarter, better than our communicated range of $715 to $730 million. SG&A cost was down $60 million year over year, and we captured 260 basis points of SG&A leverage in the period. This result stems from proven cost reduction actions across our high-touch solutions model, including lower costs as a result of our Fabry divestiture and leverage gains with our endless assortment business. This SG&A performance more than overcame GP headwinds to drive a 90 basis point improvement in total company operating margins for the quarter, a tremendous result in this environment. Incremental margins were up 50% in the quarter. As mentioned last quarter, the utility of the incremental and decremental margin calculation is diminished in this uncertain environment as the metric can vary significantly given the magnitude of top line swings from quarter to quarter. We generated operating cash flow of $311 million, which we used to continue to invest in the business, build appropriate inventory to support our customers, and return capital to shareholders. Operating cash flow was 126% of net adjusted earnings and year-to-date adjusted return on invested capital is over 29%. Given our solid results of the last couple of quarters, combined with stabilizing trends and underlying business activity, we fully repaid our revolving credit facility, increased our dividend payment, and are announcing today our intent to restart our share repurchase program in the fourth quarter. While we anticipate putting several hundred million dollars to work on repurchases in Q4, we will monitor market conditions and optimize the amount accordingly. The favorable trends over the last several months give us confidence that this is the right time to move forward with these actions. Turning to our U.S. segment, daily sales increased 3.1% in the quarter, driven primarily by volume, which is net of unfavorable product mix. On the product side, sales of pandemic-related products remained elevated, up 53% in the quarter, but as shown earlier, have tapered off from the peak in March. Non-pandemic products were down around 8% in the quarter, but continued to show meaningful improvement from April lows. We've also seen a significant uptick in new customer acquisitions, with some really encouraging signs of repeat buying. From a customer perspective, we saw improved growth with both large and mid-sized customers, with the latter growing 6% in the quarter, an improvement from the 6% decline year-over-year we saw in Q2 2020. Gross margins of 36.4% was down 160 basis points compared to the third quarter of 2019, but improved sequentially from the 310 basis point year-over-year decline we saw in the second quarter of 2020. The unfavorable variance in gross margin was driven by mainly by two factors that were similar to the second quarter, pandemic-related product headwinds and tariff-fueled cost inflation. Pandemic-related headwinds contributed about 140 basis points of the gross margin decline, as we continue to see unfavorable product and customer mix due to elevated sales of lower margin pandemic product. Beyond the pandemic impact, we continue to face pressure in the quarter due to the lapping of year over year cost inflation, which was driven partially by tariffs that went into effect in 2019. This drove approximately 80 basis points of year over year margin decline. Based on what we know now, we expect that both of these gross margin headwinds will continue into the fourth quarter. It should be noted that we anticipate the tariff headwinds will fully subside as we move into 2021. Offsetting these two factors in the quarter was a 60 basis point tailwind related to favorable freight costs driven by non-recurring shipping efficiencies and timing. We do not expect these freight dynamics to continue in the fourth quarter. From an SG&A perspective, we gained 160 basis points of leverage with cost decreasing approximately $22 million year over year. The reduction was driven primarily by decreased travel expenses, lower labor-related costs, and general operating efficiencies. Operating margin remained flat to the prior year quarter at 15.1% as SG&A leverage offset gross margin headwinds. Return on invested capital was a very healthy 38%. Drilling into our U.S. sales performance on slide 10, while we estimate the U.S. MRO market declined between 5 and 6% in the third quarter, Grainger was able to capture roughly 850 basis points of outgrowth fueled by pandemic-related sales, selling to new customers and improving sales of non-pandemic product. Despite the challenges of 2020, U.S. segment daily sales are up 2.1% year-to-date, and we have outgained the broader MRO market by over 900 basis points through the first nine months of 2020. Moving to our other businesses, organic daily sales increased 12.5% or 12.3% on a constant currency basis. The endless assortment business grew at approximately 20% fueled by strong results at both Monatro and Zorro during the quarter. Zorro continues to execute the Monatro playbook with improvements to marketing effectiveness, discounting strategies and better cost leverage, all helping to drive improved performance. Although we saw significant sequential improvement compared to the second quarter, our international high touch businesses continue to be impacted by pandemic related shutdowns with both Mexico and Cromwell seeing year over year declines. Operating margins for other businesses are up 190 basis points, 35 basis points, which is due to the divestiture of our Fabry and China businesses, which produced below system average profitability in the prior year. The remaining operating margin favorability was driven by significant SG&A leverage across the portfolio, most notably within our endless assortment business, which continues to do a nice job levering its cost base. This leverage was only partially offset by gross profit headwinds from incremental freight costs at Monatro. Turning to slide 12, in Canada, daily sales decreased 9.9% or 9.1% in constant currency. The decline is comprised of roughly 8% decline in volume and price headwinds, including customer mix of approximately 1%. While volumes in Canada continue to be impacted by the pandemic-driven economic slowdown, the business did improve sequentially and is gaining traction with hospitals, manufacturing, and higher education customers. As the Canadian business continues to integrate and leverage our U.S. resources, we are making progress with our customer diversification efforts and are pleased with the trajectory of this business going forward. Gross profit margin at Grainger Canada declined 35 basis points year over year, driven by pandemic-related mixed headwinds, which were offset partially by lower freight costs in the quarters. Cost management remains strong with savings of $5 million year over year, resulting in 110 basis points of SG&A leverage. Total operating margins were up 75 basis points versus prior year, despite the top line challenges. Before I turn it back to DG, similar to the last couple quarters, I want to give you a sense of how we're thinking about things in the fourth quarter. From a sales perspective, month-to-date trends support our estimate for October year-over-year sales growth to be up over 4% at the total company level on an organic, constant currency basis. This October month-end estimate is reflective of continued solid growth in our U.S. segment coupled with strong performance and endless assortment. From a gross margin perspective, as I previously mentioned, we anticipate gross margin pressure will continue as the pandemic-related impacts and tariff-fueled cost inflation headwinds will persist into the fourth quarter. The onetime freight tailwind we realized in the third quarter will fall off. Further, we anticipate year-over-year cost headwinds in the fourth quarter as the already stretched global shipping providers pass through freight surcharges during the busy holiday season. Given these factors and based on what we are currently seeing, we anticipate gross margins will be down over 200 basis points year over year. With respect to SG&A, we expect to see sequential increases in a couple of areas, primarily related to some incremental technology investments to support growth in the US and at Minotro, which will push our estimated SG&A to between $725 to $740 million for the fourth quarter. As always, we remain focused on managing near-term headwinds while continuing to invest in long-term growth, particularly in people, processes, and technology where and when it makes sense. With that, I'll turn it back to DG for some final thoughts.

Thanks, Tom. So I'm proud of our results for the quarter, and I want to thank our team members for their commitment to safety and customer service. We have gained share, improved our merchandising and marketing capabilities, deepened our customer relationships, expanded our assortment while improving margins at Zorro, and have significant financial flexibility to support the business moving forward. We remain committed to fulfilling our purpose of keeping the world working throughout this pandemic, as well as continuing to execute our strategies so we can achieve this purpose for years to come. And with that, we will open up the line for questions.

Thank you. We'll now be conducting a question and answer session. If you'd like to be placed in the question queue, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing star one. One moment, please, while we poll for questions. Our first question today is coming from Chris Glynn from Oppenheimer. Your line is now live.

Hey, thanks. I was curious. You mentioned the customer acquisition trend still going strong and conversions to some regular customers. dynamics are going well. Just wondering if you could further dive into that topic and how it informs early view of share out performance for 21.

Great. Thanks, Chris. So, yeah, so we've had, you know, as you might guess, given inventory positions, we have had a whole bunch of new customers sample Grainger and Zorro and Minotro, frankly. As we've had elevated customer acquisitions through this period, the good news is that those who have repeated the numbers much higher than in the past, the repeat rates are similar to the past, but we have a much bigger funnel, and we're starting to get those customers to be regular purchasing customers. So we've seen really nice, attractive customer acquisition through this period, and we think that really helps build well for the future. You know, we feel very confident in our 300 to 400 basis point outgrowth in the U.S. business in the 20% growth expectations for the endless assortment, and we have no reason to change those right now. This year, we've obviously been higher than that number in the U.S. We would expect to be in that range and shoot for higher, but be in that range moving forward.

Okay, and then for follow-up, I think the Would you anticipate that 3Q pandemic sales using October as a proxy might approximate the sustainable run rates as long as workplaces are very germaphobic, or is that still way to influx?

I think that's a very interesting question, and I don't think anybody has the answer. What we're seeing right now is elevated pandemic sales. We expect that to continue, and certainly as as case rates rise, which we've seen recently, we would expect that to continue through the fall. You know, what happens when we have better treatments and a vaccine is probably a question that is all in our minds and is probably impossible to answer. We would expect some of that to moderate, but we do think people are going to be more conscious of safety and cleanliness for some period after that as well. But for now, we're seeing similar trends to what we've seen in the past. We would expect that to continue in the fall, given the given the rate of transmission.

Thanks, DJ.

Thank you.

Thank you. Our next question today is coming from Chris Dankert from Longbow Research. Your line is now live.

Hey, morning, guys. Thanks for taking my question. I guess, first off, what's the status of investment in Zorro? I mean, in the past, we've mentioned that $50 million of investment in 2019 largely rolls off this year, I guess. Are we still on pace to get to mid-single-digit EBIT margin plus in the other business in 21? Just thoughts on investment there would be really helpful, I think.

Sure. So we had a very heavy investment period in the back half of 18 and 19 with Zorro. Many of those investments took several forms. One was technology. Another was people and getting the talent to be able to have their own destiny in terms of product ads and the like. And so we made those investments. Those investments are behind us. We're starting to see those leverage themselves now. This year we're getting improved operating margins in Zorro. We think the long-term path for Zorro from a margin perspective is as we've discussed. We'll talk about it next year in January, but we have no reason to believe the positivity that we've seen will continue And we still think that is going to be a high single-digit operating margin business in the next several years. And so that's the path for that business.

Got it, got it. And then thinking about SG&A, I mean, compared to what the guidance was, again, coming in below that range, my apologies if I missed it, but just what were the key moving parts on what helps you kind of cut that SG&A number even lower in the third quarter here?

Yeah, thanks.

Tom, do you want to take that? Yeah, sure. Thanks, Chris. First of all, there was a little bit that was wind-aided just with the Fabry divestiture, and that takes the $60 million down to about $40 million. But then we just had real good efficiency across the board, everything from travel and entertainment, professional services, cleaning supplies, security, just a real good focus by the team in terms of efficiency and cost control. And one of the great things with the pandemic is, you know, we've always been cost conscious, but I think we've really upped our game. And I think it's going to continue going forward where we're really in this mode of operating this way. So, you know, just to summarize, really good cost control across the board while continuing to spend in advertising and technology, which are important for us.

Got it. Glad to hear it. It's a broad-based savings, certainly. So, well, congrats again on the quarter, and thanks for my question again. Thank you.

Thanks, Chris.

Thank you. Our next question today is coming from Adam Ullman from Cleveland Research. Your line is now live.

Hey, guys. Good morning. Morning. Sticking with the SG&A question, I guess the freight dynamics that you pointed out for the third quarter and the fourth quarter are pretty interesting. As the surcharge rate kind of transition into base rate increases, I'm wondering if you could help us ballpark just how meaningful of a headwind that could be for 2021, or perhaps it's not a headwind and you have some other levers to pull to offset that. And maybe you could just remind us about how you charge customers for freight. I believe most customers don't pay, but maybe discuss that as well.

So I would say that it's a great question. Our largest customers and contract customers often don't pay for parcel. They often pay for LTL or large shipments. The surcharge that Tom was referring to is really around large packages during the peak season. And we will charge for some of that. We expect to recoup some of that. We don't expect to recoup all of that. And that doesn't have much to do with what happens into next year. So we'll talk about next year, obviously, after this quarter. I would say certainly the freight business, given the number of shipments going to people's houses, has become strained, and we've seen some pressure. That does not mean, though, that the surcharges that happen in the fall necessarily translate going forward, and so we'll talk about that. And we think we've got initiatives and actions to help mitigate that moving forward. But we'll talk about that at the end of the year.

Okay, great. That's good to hear. And then secondly, you know, the company has been building up inventory, and I was curious, one, if you could talk about your inventory and working capital assumptions here in the medium term. And then secondly, if you are concerned at all of – absorbing losses on any pandemic inventory that you might be taking if we have some good luck and the pandemic starts to roll off and market pricing deteriorates further.

Thanks. Yeah, so let me take those, and, Tom, you can add to them if you think I miss anything. So in terms of inventory, there's really two areas where we've built inventory and will continue to do so through the latter part of the year. The first one is sort of normal, which is we are starting the Louisville, D.C. full up in 2021. And so as that comes on, we obviously stock that building. That's partially stocked now but becomes more fully stocked as we go through, and that's a part of what you've seen. The other part is pre-buys for pandemic-related product. I would say to your question about do we have risk on excess obsolescence with that product, Part of what you see with us in terms of pandemic GP already embeds some write-downs. We obviously, to make sure we could serve our customers, took positions in a whole bunch of products in the height of the pandemic. And some of those, the price-cost has changed. Some of those, we haven't seen movement. A lot of those, we've seen movement, and it's gone very well. But in that messiness to serve customers, which we think has been really, really important, you're already seeing that in some of the GP rates that you're seeing as us take that. We think that we're in good position. Most of the inventory build, to be clear, has been pre-buys on products that is very low risk. We know suppliers, we know product, we know product that will sell in any case. But trying to get out ahead of that in case the fall and the winter's really, really bad. And so most of that is not higher risk than normal. but certainly in some of the speculative buys and things we took in the heart of the pandemic, you've already seen some of that come through in terms of GDP.

Yeah, just to add a little bit more color on inventory and cash, one of the things that we've been very efficient on is our management of cash, and you've seen that in this quarter. More specifically, our cash conversion cycle, our DSO is actually down year over year a couple of days, and our DPO is actually favorable by more than a few days, which has allowed us to keep an overall cash conversion cycle that is very healthy versus last year and invest in the inventory so we can play our role as an essential business. and support the customers the way we need to. You know, so you're right. Inventory is up since the beginning of the year, 8% at 1.78 billion. We've invested in working capital. It's up 220 million. And, you know, we did put pandemic inventory spend in the quarter of approximately 300 million. And as DG said, I mean, you're not going to bat a thousand on all of that. So we go through the normal process. you know, E&O process. And I guess the way I would describe it is we're very aggressive operationally, but very conservative financially. So doing the right thing to reserve. So thanks for the question.

Thank you. Our next question today is from Chris Snyder from UBS. Your line is now live.

Thank you for the question. I just wanted to follow up on endless assortment margins. I understand, you know, there's like a longer term, you know, kind of high single digit target out there for Zorro. But, you know, with the back office investment slowing, what kind of incremental margins could we expect for this business as the top line continues to ramp?

Yeah, it's a good question. We really don't look at incremental margins specifically on the endless assortment business just because the supply chain is so intertwined and the synergies with the broader business. So we really look at the business as the incremental margin for the overall entity.

Yeah, I mean, Tom, I would just add, if you look at incremental margins with Minotro, typically you're talking about 15% to 20%. which is just GP minus the variable marketing cost. And so I would expect us to get to something like that over time at Zorro. But that's typically what we see at Minotro, I think.

I appreciate that. And then just following up on Minotro, so like the stock is up like 100% year-to-date in Tokyo last I checked. Can you just talk about how you kind of view that business strategically at Grainger? Sure.

Well, we view, sure, so we view both the endless assortment and the high-tech solutions model as absolutely core to what we do. Masaya Suzuki, who's the leader of that business now, also leads Zorro. We are sharing best practices and analytics and working together to ensure that we're actually making progress across those two businesses and our Zorro business in the UK as well. So we view it as absolutely core to what we do right now. and we're getting a whole lot of leverage from that Minotro team in terms of learnings and building the business in Zorro for the future. So we are running those very, very tightly together at this point.

Appreciate that. Thank you for the time.

Thank you. Our next question today is coming from Dean Dre from RBC Capital Markets. Your line is now live.

Thank you. Good morning, everyone. I was hoping we'd get some color on the additional color on the gross margin guidance for the fourth quarter down 200 bps. Is there any way you can parse out what the pandemic sales would be versus non-pandemic sales? We're just trying to get a sense of what the core gross margin trajectory might be. Thanks.

Yeah, I think the way to look at it, Dean, is we said the pandemic impact is 140 basis points for this quarter, and the cost other is 80 basis point, you know, unfavorable bad guy. And we had the one-time freight of 60. You know, so if you remove the 60 from the 140 and the – the 80, you get to 220. Now, we think that the pandemic will likely improve. Obviously, it's very volatile. You know, say you get roughly a 20% improvement on your cost inflation as well as your pandemic. That gets you to around 200-ish. And then you throw in the freight headwinds that we think we might experience at the end of the year, as DG discussed with the surcharges. and that gets you above 200.

That's real helpful. And then I was hoping you could get some additional color on the October sales, just the extent that you can. Anything that you think would be helpful regarding geographic, customer sizes, anything else about the mix, that would be a big help here. Thank you.

I think, Dean, if you – looked at sales revenue performance July, August, September, October, you'd be hard-pressed to see much of a difference across those months. We've seen a little tail-off in pandemic and a little improvement in non-pandemic, but pretty much the trend has been very, very similar across all of those months. So the trends we've seen and the performance we saw in the second quarter really just appears to be – the third quarter appears to be continuing in October at this point.

Got it. And just lastly, an observation. I've certainly heard the Grainger spot ads on business radio pretty frequently in the brand building. So I think it's pretty effective. Thank you.

Thanks, Dean.

Thanks, Dean.

Thank you. Our next question today is coming from Nigel Coe from Wolf Research. Your line is now live.

Oh, thanks. Good morning. Thanks for the question. I want to pick up on that 4Q gross margin guidance. So roughly turn-based points down from 38% last quarter gets to about 36%, which would be up from this quarter. So I just wanted to make sure that that map kind of still holds that we're looking for what would be a fairly normal sequential pickup in gross margin percentage from 3Q.

Tom, do you want to take that one?

Yeah, sorry, I was on mute. Nigel, I think another way to look at it is our absolute gross margin should be very similar to Q3. And then when you just look at the comparison to prior year, it's going to bump it over 200. You know, so that's the other way I would look at it.

Okay, so that's fair. And then, you know, the midsize customer growth was pretty impressive. And I swing from what we saw last call. And I'm just curious, are we seeing, you know, obviously a lot of your competitors, especially, you know, the small competitors and one or two larger ones, you know, have employed a very high touch, you know, distribution model. And I'm wondering if we're seeing a switch towards perhaps more low touch direct ship, you know, e-commerce type sales. and maybe some supply consolidation? I mean, anything you see in there in the market?

Yeah, I would say we've certainly seen more digital sales through the pandemic. I think we've seen that in almost every industry, and ours has been no different. You know, what I would say is that, you know, we are seeing improvements in midsize customer growth. from digital actions but also from inside sales actions. So that is more of a touch, but we're seeing nice growth across both of those contact points. And so, yeah, I would say it's fair to characterize as more digital but not all digital. We're also seeing some nice growth through some of our other actions that are more high touch.

Okay, that's helpful. Thanks.

Thank you. Our next question today is coming from Josh Pokerzwinski from Morgan Stanley. Your line is now live.

Hi, good morning, guys. Good morning.

Good morning.

Just a couple of questions. We've covered a lot of ground already, but one thing I want to be sure on, if you don't mind, Tom, on Endless Assortment, clearly some good leverage happening there, but just wondering if anything is happening inside of Zorro or Monotaro, for that matter, with MIX. obviously in the middle of pandemic we can talk about like pandemic mix and safety products but i guess just more broadly are people buying different stuff than that is normally tuned up for and does that have some benefit positive or negative that that may not look like the ongoing model yeah i i think the only thing that i would say and then dg please please add is uh

we're probably seeing more B2C customers than B2B customers in the pandemic. But other than that, nothing out of the ordinary.

Yeah, I mean, so one of the things that I would say that's muddled the pandemic a little bit in terms of results has been with so many people working from home, sometimes the business and the consumer tends to blur. You know, I've listened to a bunch of contact center calls and It's fascinating that there's a lot of people at home maybe buying things for businesses, but also sometimes delivering to their home. We think we've had more consumer acquisition than normal. We don't re-market to consumers, whether in Zorro or Grainger. What we do know is that the business customer acquisition has been very solid, very strong. and the attractiveness of those customers has been every bit as strong as we've seen in the past. So we're happy with, besides having to sort of sift through consumer business, the business that we're sure is business has been very strong, and that's been sort of key for us.

Got it. That's helpful. And then it sounds like Dean's going to be a future customer here based on the effectiveness in that marketing, so maybe you can close that lead.

He's not the target segment.

I can assure you that. Okay. um understood and then just on the uh the inventory question yeah i know someone asked earlier about you know the the inventory bill there um anything on kind of a seasonally uncommon liquidation in the fourth quarter that you're planning that that may be dragging uh that down or impacting that at all um you know just thinking about historically you usually build a little inventory in the fourth quarter sequentially is that something that happened earlier Is that playing into that dynamic at all on the gross margin?

It's playing into it. It's playing into it a little bit. As we said on the previous question, we've been very aggressively operationally from an inventory perspective because it's the right thing to do and we want to have the product available for our customers. But on the other hand, we've been conservative financially. So Part of the gross margin deterioration that you've seen in Q3 is an E&O headwind, cleaning up some of the buys that didn't exactly thread the needle. So we've tried to do most of that in Q3. We'll see a little bit in Q4 as well. And then we believe that that's going to be behind us going into 2021. We'll have the right product to serve our customer. And then if anything, we'll have a tailwind as we unwind some of those reserves when the products that we have reserved potentially will be available for sale.

Got it. That's helpful. Thanks so much.

Thank you.

Thank you. Our next question today is coming from John Inch from Gordon Haskett. Your line is now live.

Thank you. Good morning, everybody. Hey, assuming that PPE sales which you would assume, right, to happen as the market's been saturated, naturally continued to trend lower. As we roll into 2021, what kind of a, you know, kind of an absolute sales headwind could this prospectively represent? And you guys have had very strong OpEx control. I don't think I've heard this in the discussion thus far. I mean, what kind of costs are you thinking about are going to have to come back next year as you sort of flip from PPE to kind of a more normalized volume trajectory for other products?

Well, I think there's a lot in that question, John. I would say that it's really difficult to project the PPE trend. What we've seen since April, in April we saw PPE up almost 100%. pandemic product, what we call pandemic that includes more than PPE, we saw sort of normal volumes down 20% in April. And what we've seen is those two sort of just come together consistently since that time. And there's lots of puts and takes with that. So if PPE comes down and we get a little bit better non-pandemic product, it helps GP, probably doesn't have any impact on SG&A, frankly. We think we can control SG&A in any environment. And one of the good things about the pandemic, and there haven't been many, is it really forces a business to focus. And I think we've really been focused on what matters, and I think that's something that we definitely need to take forward, is how do we continue to focus on the few things that really matter, which helps drive results, but also helps you manage your SG&A. So we think we're going to be able to do that going forward. I can't give you a crystal ball answer as to what's going to happen with PPE, you know, because it just all depends on the timing of the virus and people's behavior, and we've never seen anything like this before.

Right. Do you have any sense, DG, of what maybe the SG&A – I'm sorry, Tom. What sort of SG&A headwinds you're facing kind of on a quantifiable basis? Because you do have the 1% people that are furloughed. Presumably you're going to have to bleed back a little bit of travel and – you know, some merit increases and stuff like that. Is it too early to tell at this point, or are you thinking about it?

No, I mean, we'll talk about that certainly at year end as we talk about forward looking. You know, we had merit increases this year, you know, so that's not yet. Clearly, we have costs that will come back into the business. Travel will be modest, we think, for the next six months, given what we're seeing with the virus at some point, that can come back. You know, but I think the headline for me would be we've seen nice growth. GP's been depressed given pandemic sales has been so elevated. SG&A's been down. I think over time, as that moderates, you get better GP and a little bit of cost back added into the business. And there's just a dynamic there that we can talk about later.

Yeah, the only thing that I – I'm sorry, the only thing that I would reinforce is, you know, as DG said, we're always going to be about SG&A efficiency and control. And, you know, we'll handle that. The upside that I see, which DG mentioned, is we're going to see the gross margin pop from as the pandemic goes down. And also, I think on the sales front, as the broader economy opens up, we're going to be well positioned to ride that wave as well. And I would have to imagine, obviously, it's speculation that there's going to be a lot of PP&E product that's going to come into those businesses opening up as well. So, you know, I see it more as a tailwind than any sort of a headwind.

DG, just lastly, implicit in your answer on Monotoro and monetizing Monotoro, you indicated that Zorro, it's still pretty important to the Zorro business. It's intertwined and so forth. At what point Can Zorro, do you think, stand on its own where you might strategically be in a position to say, hey, we don't need to own half of Monotoro. The stock has done fantastic. Let's take our position down to 20%, 30%, something like that, or even to zero?

Well, I'd say a couple things to that. One is it's probably, you know, timing, you probably need three more years, you know, given what we're projecting to get Zorro to where we'd like to get it. So it's really got the... the connective tissue to be a really strong performer for a long time. And so that's what we're shooting for. At that point, you know, obviously we could do things. There's all kinds of tax implications of that, John, and so we need to think through all that at that point. For now, you know, for the next three years, we're thinking of it as, you know, we need to get Zorro business performing well. We're really excited about the Minotro path, and we think that's the right focus for us.

Understood. Thanks very much.

Thank you. Thank you. Our next question is coming from David Manthe from Bayer. Your line is now live.

Thank you. Good morning, everyone. Tom, I'll have to go back and review your commentary, but when you were talking about gross margin and you said above 200, I'm confused. Was that a fourth quarter statement or were you walking into 2021? Fourth quarter, Dave.

You know, the way I'm looking at it is just simple math. If you look at Q3, 160 bad guy on gross margin with a 60 bps one-time freight. So if you just take the 60 bps up, that gets you to 220. Now, we assume the pandemic is going to get better as is cost inflation. You know, so bring that down to 200 or a little bit below. But then going back to the freight surcharges we see during the holiday season, that'll get us back above 200, which is the framework that we talked about in the prepared remarks for Q4. Now, having said that, I mean, it's very fluid. It's hard to predict. But we're just trying to give you guys some framework for your model.

Okay, yeah, that's very helpful. And so I'll ask the question. Gross margin is obviously extremely hard to model these days. And if we're just thinking big picture moving parts from where we'll wind up in 2020, which looks like, I don't know, low 36s, If you just were thinking big picture, what are the main moving parts as we go from 2020 to 2021 that could move that up or down?

Yeah, we'll have a lot more to say about that going forward. I think, though, just to give you a couple of things to think about, you know, one would be how long is the pandemic going to last? Because obviously the longer the pandemic lasts, the more we're going to be depressed with pandemic-related mix and the type of customers we're selling to. So that's number one. Number two, we should see a natural tailwind in terms of we will have fully lapped the tariff-related cost inflation, as well as we'll probably see less spikes in terms of cost inflation related to the pandemic product. Um, you know, so those are, those are the two big ones to think about and, and both of them, you know, should be tailwinds for 2021. But again, it's, it's premature to talk in detail. We'll have plenty of time for that later.

Got it. That's, that's a great color. And then second on, um, on KeepStock and these embedded solutions, um, that you talk about making up 60% of revenues. Just to put that in context, what percentage of customers would that represent? And then recognizing that those customers obviously buy from via several mechanisms that you provide, could you talk about what percentage of sales are directly via the embedded solutions today?

Well, so let me try to take that. So most of our largest complex customers will have embedded solutions, and typically they'll have both a KeepStock inventory management solution and an EDIE Pro sort of connected digital solution as well. And so, you know, EDIE Pro and KeepStock would make up over 30% of our direct revenue, I believe. Don't quote me on it, something like that. I don't have that in the numbers right in front of me, something like that. In terms of number of customers, obviously our mid-sized customers have fewer of those solutions. They're more into buying on Grazer.com. And, by the way, that can be pseudo-embedded, although we would call it embedded because they can have their own pricing. They may have their own workflow on Grazer.com. But typically they wouldn't have inventory management. And so from a customer count, the number of customers will be much fewer in that 60% than those in there. But the largest complex customers will all have an embedded solution in general.

Okay, that's great. Thanks, DG.

Thank you. Our next question today is coming from Michael McGinn from Wells Fargo. Your line is now live.

Thanks. If I could just move to the low-touch segment. Can you talk about the sell-through rate of per-site visit or any other tangible improvement for SKU recommendations, substitute or frequent package products, and SKU count and what that's What's been the most impactful so far and what will be going forward?

Are you talking about the Endless Assortment business, the Zorro business? Yeah, the Endless Assortment, yeah. Yeah, so I'd say there's three things that have been really impactful. One is SKU count. So we look at the productivity of every SKU ad, and we look over kind of the last six, seven years as we've added SKUs. We've now hit the 5 million point. The ads we've made in the last six months are as productive and it looks like maybe even more productive than those that we've made in the past. That bodes pretty well for future growth. That's probably the most important piece of the growth. The other one is customer analytics and marketing. Getting customers, customer acquisition, the funnel is pretty big, but then getting customers to repeat is really the key. And we're doing all kinds of things there with analytics and marketing to get that second, third, fourth order and starting to get real traction there. So those are far and away the two most important things with the unless it's sort of business that we track. And we're seeing progress on both of those.

And how does it correlate to sales per site visit? What's kind of been the trend there?

Sales per site visit. You mean customers coming onto the website and what's the revenue per site visit?

Yeah. I guess what industry metrics are you benchmarking to within that endless assortment model? And what's been the improvement with this level of investment?

So we look at things that other businesses would look at to return on ad spend. That is interesting but not sufficient. The most important thing is looking at customer value and so looking at customer acquisition and the customer lifetime value. And so we look at new customer acquisition rates, repeat rates, and we link all that to a customer value model to understand the NPV of each customer ad. And so that's what we track all the time.

Got it. All right, on my second question, CapEx, is there a normalized level of CapEx that you would be targeting in the out years as you transition from and less from branches, more to endless assortment. I mean, it looks like you're trending pretty well this year. Just wondering if you underspent this year and there's a catch-up into next year or beyond.

Go ahead, Tom. Yeah, I don't think there's going to be any big catch-up. I mean, even if you look at, we spent roughly $60 million in the quarter, which was similar to last year. You know, when the pandemic first hit, we tightened our belt a little bit and deferred some things. But, you know, given the confidence that we've had in the cash generation, we're back to normal spend levels. So I don't see any big wave, you know, coming in future years that would be anything out of the ordinary. Got it. Thank you.

Thank you. Our next question today is coming from Hamza Mazzari from Jeffries. Your line is now live.

Hey, good morning. My question was just in the other segment, if you take out the endless assortment business, are those other businesses losing money today or are they profitable? And then is the endless assortment business now over 10% of revenue where you have to sort of resegment that or is that not the right way to look at that? So

On your second question, we are evaluating the need to think about any segmentation and we'll talk about that and our position on that at the end of the year or with next year. So we are evaluating that and we work with our auditors to make sure we understand requirements. So that's still to come. So there's different types of businesses that are in other when you take out endless assortment, but there's not a lot of them. So there's Mexico. That's profitable. There's Puerto Rico. That's profitable. And there's Cromwell. Cromwell is unprofitable now. But having a pretty good year in terms of customer service and experience, and they're losing less money this year than last. So in total, I believe those would be slightly unprofitable. But two of them are profitable and one is not, and working on that one.

Got it. I know we're at the hour, so I'll just leave it there. I appreciate it.

All right. Thanks, Andre.

Thank you.

Thank you. Our next question is coming from Justin Berger from G Research. Your line is now live.

Good morning, DG. Good morning, Tom. Thanks for fitting me in.

Good morning.

Good morning, Justin. Good morning. Quick clarification question, then more open-ended question. The medium-sized customer growth going from negative 6% to 6%, how much of that related to those businesses sort of being closed in the second quarter or being unable to get pandemic-related product and then sort of catching up in the third quarter?

So two things there, two things going on. One is some of those businesses were more impacted and may have been closed. I think the bigger issue was in the heat of the pandemic in April, May in particular, given the way product supply happened for pandemic products and the customers, we needed to funnel that product to you. We didn't have product available for those customers. And in the summer, we relaxed that constraint as pandemic products became more available and we were able to open that up to that customer base. And so we've seen very strong growth since that happened, and I think that's probably the bigger issue is just being able to release the product for mid-sized customers, and we've seen nice growth as a result of that.

Great. And then the open-ended question, looking at it from a sort of customer grouping point of view, Grainger showed nice acceleration in the government and the retail channels. Maybe you could just sort of talk about anything unusual or potentially recurring that is going to sustain that trend and maybe in the context of just general outgrowth levers that, you know, may be materializing anew as you look towards the end of this year and into 2021?

Yeah, I think it's important to understand what retail is. Retail is mostly distribution centers that go direct to customer. We don't do a lot of sort of walk-in retail business. We're more sort of the distribution centers that obviously have more safety needs and other needs. So that has obviously been growing as an industry as the pandemic has happened, and so we've been there supporting our customers through that. So that is a trend that we believe will continue as we move forward. What was the other segment you mentioned?

Government accelerating, which would sort of be surprising in light of pandemic sales being decelerating.

Well, yes, but government sales have been – have been strong, and a lot of that has been pandemic as governments try to find product to support their communities during this time. And so that's a lot of state government business. Military has been okay as well for federal, but certainly state governments have been very, very busy as each of them has tried to fight the pandemic, and we've been there trying to help as much as possible.

Great. Thank you.

Thank you. Our next question today is coming from Patrick Bowman from J.P. Morgan. Your line is now live.

Hi, D.J. I just have a couple quick ones here. What next year? I'm just wondering if there's a way for you to quantify the amount of revenue from pandemic that could be a headwind to next year. It sounds like you still expect pretty good share gains. You said 300 to 400 basis points, but I just wanted to check to see if there's any major issues on that front in terms of the pandemic sales into next year.

Well, I think we're definitely going to talk about that in January with our results. Like I said before, right now and as we head into the winter season, Given what we're seeing with case counts, we expect pandemic sales to be elevated through the fall and into the winter. That would be our expectation. We will reevaluate as we go forward to really understand what the puts and takes are. But if pandemic sales go down, we think non-pandemic sales will go up because that would mean the pandemic is much of a problem. And, again, that helps our gross profit when that happens and probably over our profitability rates. So, you know, we don't really know. I think it's impossible to tell what's going to happen with pandemic products. At some point, it will be a headwind, but other things then won't be a headwind, and that's our expectation.

Yep, makes sense. And then last one real quick on Xero. Are the added SKUs here today, is that all third-party related? And since you're skewing mix more in that direction, I just want to check and see if there are any big differences in how you report the revenue or the margin or the type of margin you get when you ship third-party versus grain-drawn inventories.

Yeah, so a lot of the new product ads are third-party. Some are through the Granger supply chain. Third-party items tend to be lower SG&A and slightly lower gross margin. But most of the time, we're working with high-quality companies that have very good fulfillment capabilities. And so that's one of our important sorts as we develop partners that actually add to our assortment. So it's really no difference in how we report it. but it is going to be a bigger factor for us going forward. We're going to continue to add third-party shippers, and that's a big part of what we're doing.

Yeah, the only thing I would add, Patrick, is the accounting difference is whether you're an agent or not when you're doing third-party, but that's a minor nuance. So thanks for the question.

Thank you. We've reached the end of our question-and-answer session. I'd like to turn the floor back over to management for any further or closing comments.

All right, so this is DG. So thanks, everyone, for joining us. Really appreciate it. We feel good about our results in the quarter. We feel really good about our forward prospects. Obviously, there's a ton of uncertainty in terms of how the market's going to evolve, and probably more than anybody we'd like for the pandemic to be behind us, but we know it's not. And so we're going to make sure we continue to support our customers through this. That's the first and most important thing we're going to do. We're going to make sure we take care of our team members and And we're going to make sure we do things that are prudent both for the current performance of the business but for long-term. And we feel like we're taking the right actions and in a really good position to succeed both during the pandemic and beyond. So thanks for joining us today and hope you all stay safe.

Thank you. That does conclude today's teleconference. You may disconnect your line at this time and have a wonderful day. We thank you for your participation today.