This conference call transcript was computer generated and almost certianly contains errors. This transcript is provided for information purposes only.EarningsCall, LLC makes no representation about the accuracy of the aforementioned transcript, and you are cautioned not to place undue reliance on the information provided by the transcript.
spk09: Greetings and welcome to the WW Grainger fourth quarter and full year 2022 earnings call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. Please note that this conference is being recorded. I will now turn the conference over to our host, Kyle Bland, Vice President of Investor Relations. Thank you. You may begin.
spk12: Good morning. Welcome to Grainger's fourth quarter and full year 2022 earnings call. With me are D.G. McPherson, Chairman and CEO, and D. Merriweather, Senior Vice President and CFO. As a reminder, some of our comments today may include 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 our corresponding GAAP measures are found in the tables at the end of this presentation and in our Q4 earnings release, both of which are available on our investor relations website. This morning's call will focus on fourth quarter and full year 2022 adjusted results, which exclude the gain related to the divestiture of Cromwell's enterprise software business, which was sold in the fourth quarter. We will also share results related to Monotaro. Please remember that Monotaro is a public company and follows Japanese GAAP. which differs from US GAAP and is reported in our results one month in arrears. As a result, the numbers disclosed will differ somewhat from Monotaro's public statements. Now, I'll turn it over to DG.
spk13: Thanks, Kyle. Good morning, and thank you for joining us today. I'm going to discuss some of our key accomplishments from 2022, and then I'll pass it to D to walk through the specifics of our fourth quarter performance and our outlook for 2023. Turning to slide four, the Grainger Edge framework has been instrumental in guiding our work in 2022. We know that when we live our principles, focus on the things that matter, and serve our customers well, we can achieve great things. Our customer base is very broad. I've been with customers that are seeing positive economic signs like aerospace, and I've also been with other customers like some retailers that are seeing some concerning economic signs. But in general, our customers continue to be busy. And Grainger has and will remain their trusted partner by providing value to their operations every day. As we look to 2023 and beyond, we are excited to continue living out the Grainger edge, starting with the customer and serving as their valued partner through any cycle. In 2022, the Grainger team stayed relentlessly focused on what matters most, providing our customers exceptional service, supporting each other, and making a positive impact on our communities and the environment. In both models, we made strategic investments to support customers and build the business for the future. This included adding supply chain capacity, including a new bulk warehouse in the U.S. and the startup of the Inagawa Distribution Center in Japan, expanding our digital and data capabilities, including progress with our customer and product information systems and our high-touch business and improved account management tools and our endless assortment model, and executing against our merchandising and marketing initiatives, including Tant Search and Recommendation, functionality. During the year, we also continue to strengthen our purpose-driven culture by ensuring Grainger is a place where our team members can be their true selves and have a fulfilling career. We continue to receive external recognition for our workplace culture, but what means the most to me and the rest of the leadership team is the positive feedback from team members about why they choose to build their career at Grainger. And finally, we continue to make progress with our environmental, social, and governance objectives. both internally and in supporting our customers to help them achieve their own ESG goals. The result of this focus was an outstanding year of profitable growth, and we are extremely proud of our results, which surpassed our own expectations throughout the year. Turning to slide six, we finished the year with over $15.2 billion in sales, up 16.5% on a daily basis, or 19.3% in daily constant currency, as demand across the business remained strong. In our high-touch business in North America, we focused on our growth engines and achieved approximately 775 basis points of U.S. market outlook growth in 2022, far exceeding our updated target of 400 to 500 basis points. In the endless assortment model, both Zorro and Monotaro made progress to achieve high teens growth in local currency and local days. During the year, we drove 250 basis, 15 basis points of gross margin improvement, which, when coupled with 40 basis points of SG&A leverage resulted in 255 basis points of operating margin expansion and a nearly 50% increase in adjusted EPS. We also generated over $1.3 billion in operating cash flow, an increase of 42% over 2021, and returned $949 million to Grainger shareholders through dividends and share repurchases. We accomplished this while also improving our ROIC by 870 basis points to 40.6%. The strong 2022 financials were the result of staying focused throughout the year on what truly matters to our customers, our suppliers, and our team members, and we are well positioned to continue this momentum into 2023. With that, I will turn it over to Dee to discuss the details of the fourth quarter and our outlook.
spk01: Thanks, D.D. Turning to our fourth quarter 2022 results for the total company, it was a solid quarter to finish out this year. And while you'll notice some noise as we walk through the financials, at the end of the day, we delivered great results. Sales growth in the quarter was 13.2% or 17.2% on a daily constant currency basis, which normalizes for the impact of the depreciating yen. Our results this quarter included strong growth in both segments as we continue to execute well against our strategic priorities. This includes approximately 800 basis points of share gain in the U.S. high-touch business and high-teens growth in local currency across endless assortment. Total company gross profit margin in the quarter was 39.6%, expanding 230 basis points over the prior year fourth quarter, driven by increases in both segments and including a favorable year-over-year impact from year-end inventory adjustments, which I'll detail in a moment. The strong gross margin performance was partially offset by a decrease in SG&A leverage in the quarter. We continued to invest in our strategic initiatives and also incurred an aggregate $35 million in non-recurring items in the quarter. This included a one-time bonus to most hourly employees, within High Touch to recognize their significant contributions towards our 2022 performance. Excluding these one-time non-recurring items, total company SG&A as a percentage of sales would have been roughly flat year over year. Despite these non-recurring costs, we still finished the quarter with operating margin up 135 basis points over the prior year period. This profitable growth resulted in diluted EPS of $7.14 for the fourth quarter, representing a 31% increase versus the fourth quarter 2021, another strong quarter of performance. In our high tech solution segment, we continue to see strong growth with daily sales up 16.8% compared to the fourth quarter of 2021. We saw continued positive growth in all major customer end markets across the segment, including over 20% growth in natural resources, transportation, and heavy manufacturing. The daily sales increase in the U.S. of over 17% was fueled by mid-single digit volume growth and continued strong price realization over 11% in the quarter. Canadian daily sales were also strong of 7% or 17.2% in local days and local currency. For the segment, GP margin finished the quarter at 41.9%, achieving 225 basis points of margin expansion. During the quarter, the segment benefited from lower freight costs and continued improvement in product mix. Margin was also favorably impacted by year-end inventory adjustments as we lapped the unfavorable LIFO adjustment from the prior year period and also recorded a positive net inventory adjustment in the current year period. The net impact of these inventory adjustments was around 130 basis points for the segment. Price-cost spread in the quarter was also roughly neutral. Moving to SG&A. The segment delevered by about 35 basis points, which was driven by continued investments in marketing and headcount to support growth. In addition, the segment incurred $29 million in non-recurring items in the period, including the one-time bonus payment previously discussed and some accounting true-ups to close the year. While we did modestly delever SG&A, we still expanded operating margins by 190 basis points year over year, finishing with a 15.5% operating margin for the segment. This was a strong finish for our high-touch team. Looking at market outgrowth on slide 10, we estimate that the U.S. MRO market, including volume and price inflation, grew between 9% and 10%. implying we outpaced the market by roughly 800 basis points in the quarter. This strong finish helped us deliver 775 basis points of market outgrowth for the full year 2022. We continue to have great success in gaining share as we execute against our strategic growth engines in our high-touch models. We remain confident in our ability to deliver the 400 to 500 basis points of annual outgrowth going forward and are excited to continue partnering with our customers and our suppliers to drive value for all parties each and every day. Moving to our endless assortment segment, reported and daily sales increased 0.9% or 18.2% on a daily constant currency basis after normalizing for the significant impact of the depreciating yen. In local currency and local days, Monotaro achieved 19.4% growth, and Zorro U.S. was up 19.5%. Revenue growth continues to be driven by strong new customer acquisition and repeat business for the segment, as well as enterprise customer growth at Monotaro. Gross margin for this segment expanded 170 basis points versus the fourth quarter of 2022 as we saw strong price realizations coupled with continued freight efficiencies as average order values have increased year over year. We also benefited from favorable business unit mix as Zorro grew faster than Monotaro in the quarter. Segment operating margin declined 180 basis points as favorable gross margin was more than offset by heightened SG&A costs. While Zorro's operating margins were roughly flat in the quarter, Monotaro was impacted by startup costs at the new Inagawa DC, as well as non-recurring asset retirement costs related to the upcoming closure of the Amagasaki facility. As we lap these DC transition costs and ramp the new facility to peak efficiency, We expect profitability will begin trending towards more normal levels as we move through 2023. On slide 12, we can continue to see positive results with our key endless assortment operating metrics. Total registered users are tracking nicely with Zorro and Monotaro combined up 17% over the prior year. On the right, we show the continued growth of Zorro's SKU portfolio, now at over 11 million SKUs, and in 2022, the team successfully delivered on our stated goal to add 2 million SKUs per year over the next several years. In summary, a great job of spinning the Endless Assortment Flywheel by both Zorro and Monotauro in 2022. I also want to acknowledge the exciting news that our Zorro US business surpassed $1 billion in annual sales in 2022, the first time they've exceeded that threshold in their history. It's been an amazing success story since we launched this business back in 2011, and we remain excited about what Messiah, Kevin, and the rest of the Zorro team will accomplish going forward. Moving to our outlook. Despite the economic uncertainty heading into 2023, our high-level earnings algorithm remains intact. Within our high-tech segment, over the longer-term economic cycle, we target growing 400 to 500 basis points faster than the U.S. MRO market and remain confident in our ability to do so. In our endless assortment segment, we expect to continue our track record of strong growth both in the U.S. and in Japan. At the total company level, we target generally stable gross margin performance over time while sticking to our core pricing tenets. And as we strive to grow SG&A slower than sales to help expand operating margins. Couple this with our balanced and consistent approach to capital allocation, and we can drive attractive returns over the long term, as we've done especially well over the last few years. So what does this mean for 2023? At the total company, we expect revenue between $16.2 and $16.8 billion, with daily sales growth between 7% and 11% driven by strong top line performance in both segments. Note that this range is 40 basis points lower on a reported basis when factoring in one less selling day in 2023. Within our high-tech solution segment, we expect daily sales growth between 5% and 9.5%. In the U.S., we're planning for MRL market growth between 1% and 5%, comprised of a volume range of flat to down 3%, coupled with price inflation between 4% and 5%, largely representing the wrap of 2022 price increases. On top of a 1% to 5% market, we expect to continue executing against our strategic growth engines to achieve 400 to 500 basis points of U.S. market outgrowth in 2023. In the endless assortment segment, we anticipate daily sales to grow between 16% and 18%, or roughly 17% to 19% in daily constant currency when factoring in 100 basis points of foreign exchange headwind at the segment level from the Japanese end. Zorro is anticipated to grow within the segment range, reflecting further skew expansion and a continued focus on acquiring and retaining high-value business customers. Monetario is also expected to grow within the segment range and local currency as they continue to grow with both small businesses and large enterprise customers. Moving to our margin expectations, we expect strong performance in both segments with stable to expanding performance and high-tech solutions and improving profitability and endless assortment. In the high jet solution segment, we expect growth profit in the year to be flat to slightly down as we anticipate some of the price cost favorability experienced in 2022 to unwind as we trend back to neutrality over the long term. We expect this headwind will be partially offset by freight favorability given the improvement in container costs and the current outlook for diesel prices. On the SG&A side, we will continue to make incremental investments toward our strategic initiatives as we fuel our growth algorithm. We will also have some tailwinds as we lap the non-returning items that hit in the fourth quarter and as certain expenses like variable compensation reset in the new year. Overall, in total, we expect SG&A leverage to be favorable, and therefore, when combined with our top-line growth expectations, We anticipate operating margin of 16.3 to 16.8% and high touch for 2023. In the endless assortment segment, we expect Monotiro's operating margins to improve year over year as they continue to benefit from favorable freight efficiencies and strong price realization. At Xero, we expect operating margins to continue to ramp as they gain leverage on their cost base. Overall, this represents operating margin for the segment between 8.6 and 9%, an improvement of 60 to 100 basis points compared to 2022. Rowing this up for total company, we expect to gain SG&A leverage of 30 to 60 basis points to offset a minus decline in gross margin, resulting in operating margin between 14.4% and 14.9% for the full year. Turning now to capital allocation, we expect the business will continue to generate strong cash flow in the year with an expected range of $1.45 to $1.65 billion, an increase of over $215 million at the midpoint compared to 2022. We expect to use this cash to invest in the business and return capital to shareholders. As discussed at our investor day in September, we plan to invest in our DC network over the next few years to support strong growth and to maintain industry-leading service levels. With this, we anticipate capital spending in the range of $450 to $525 million in 2023. This includes DC capacity investments to expand our service advantage in the U.S., as well as the startup of a new DC project in Tokyo. We are also continuing to invest in technology to further our customer and product information advantage, and we'll continue spending on accretive ESG investments across the portfolio. We expect to continue to return a significant amount of cash to shareholders in line with our historical approach. This will include shared repurchases to the tune of $550 to $700 million and a strong cash dividend, which we've increased consistently for the past 51 years and expect to do so again here in 2023. Summarizing the high-level points on slide 17, You can see these revenue, profitability, and capital allocation expectations translate to adjusted EPS of $32 to $34.50 per share, a 7.9 to 16.3 percentage increase over 2022, and nearly double our pre-pandemic 2019 adjusted EPS of $17.29. We are off to a really strong start in January with preliminary total company daily sales of 16% or around 19% in daily constant currency. We do expect growth rates will be stronger in the first half as results will benefit from a more pronounced price wrap. In the second half, we will face tougher comps and have modeled a slower economic cycle. On profitability, While every year is different, we do expect gross margins will generally follow our traditional seasonal pattern with a high watermark in the first quarter and sequential declines in the second and third quarters. We anticipate SG&A will be reasonably consistent over the course of the year. With that, I'll turn it back to DG for some closing remarks.
spk13: Thank you, Dee. Before I open it up for questions, I want to first and foremost thank the Grainger team as well as our customers and supplier partners who have helped to drive such a successful year. We truly kept the world working in 2022 and in turn achieved outstanding results for the year, both financially and operationally. I am excited for what is to come in 2023 and remain confident in Grainger's ability to create tangible value, deliver a flawless experience, and drive profitable growth over the long haul. With our team's continued commitment to focusing on the things that matter, we are well poised to deliver in any macro environment. With that, we will open up the line for questions.
spk09: Thank you. And at this time, we will conduct our question and answer session. Please limit yourselves to one question and one follow-up question. To ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate that your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. One moment, please, while we poll for questions. Our first question comes from Tommy Maul with Stevens. Please state your question.
spk08: Good morning, and thanks for taking my questions.
spk10: Good morning.
spk08: I'll ask two, both on high touch. Let's start on pricing there. It looks like for 2023, four to five points of growth on price. And Dee, I think I heard you say that most, but maybe not all of that is a wrap. But if you could comment there on the wrap versus any new initiatives. And then also just a related question. point, are there any areas of pricing pressure? That's something that's been picked up in the marketplace this quarter elsewhere, and I just wonder if you've seen any of that in your business.
spk01: So I'll start with the first part, and then maybe DG can add in a little bit on what he's hearing from some customers on his visit. So Yeah, when we look at the market outlook, it includes both price and volume. And so the sum of that, we believe, will be somewhere in the range of 1% to 5%, the total market. We believe that volume will be down 3% to flat. And as you noted, price up 4% to up 5%. You know, we have more visibility into our pricing than anyone. And so when we look at price, we are also taking into account our RAP, which is basically the price increases that we took in 2022 and their full impact to 2023. So we still see a little bit more price coming our way. So it takes that 3-ish percent up to about 4% to 5%. for the price outlook.
spk13: Yeah, Tommy, I would say, you know, most of the, if there's deflationary pressure, it's mostly due to commodities. So there are, you know, we have, we've taken prices up and down across the assortment, and the ones that are down are almost always very commodity intensive. So they're very steel intensive or very, you know, some specific commodity intensive. So we do see that. Broad market pressures, we don't see that much. It's more specific commodities that we're seeing right now.
spk08: Thank you. That's helpful. Then I wanted to follow up on the volume outlook for high touch, flat to down three. DG, you mentioned at least one area of strength and arrow and one area of relative weakness in retail, but I'm just curious as you roll it all up into that full year outlook, are there other areas of weakness you're already seeing, or is it more just potentially some conservatism around the back half? Anything you could provide there would be helpful.
spk13: Yeah, you know, we're really sticking to what the market projections are at this point. You know, you heard the January results. We aren't seeing a lot of weakness, to be fair, at this point. We do expect in the back half there to be more challenges from a volume perspective. You know, what I would say is, you know, every customer we have has a COVID-fueled story about what's happened to their volume over the past few years and where they've been determines whether they're facing pressures now or whether they're seeing optimism. So obviously with aerospace, we shut down the airlines for a long time and they now have orders. So they're starting to build up and that's going to take a couple more years to actually get to full speed, we think, with aerospace. But with some, they may have forward loaded some of their volume because they were selling things that were very important during the pandemic, and now they're faced with situations where things are slowing down. So I would say every customer has their own story, net-net, that we're not seeing any real softness as of yet, and that's showing in the numbers.
spk09: Thank you. Our next question comes from Ryan Merkel of William Blair. Please state your question.
spk05: Thanks, and nice quarter. I wanted to start with a couple questions on price-cost. Just wanted to dig in a little bit more. So last quarter, I think price cost held by 60 basis points, and then in the fourth quarter, it was flat. I'm just curious, why does it move around so much? And then I think you're managing the price cost being neutral, but typically in the past when there's a lot of inflation, right, your gross margins would expand. I'm curious how you're sort of managing to that price cost neutral.
spk01: Well, if you're specifically focused on GDP in the U.S., Our gross margins have expanded, if you look over a longer period of time here. And as it relates to price costs, I just want to reiterate, when we talk about neutrality, we do talk about that over time. And we have continued to speak about the fact that price costs, just like GP, is lumpy. You know, we have a cost cycle, which we have traditionally had for years that really didn't hold last year because of how fast cost inflation was coming in to suppliers. So that makes the cost piece of that a little bit lumpier. And then, if you recall, we have the opportunity, based upon our percentage of revenue, highly contracted. We have the right to introduce price at different periods during the time. We also have web price, which is also a good portion of our business, and we can pass price on web at any particular time. So that is the lumpiness is the timing of when we can actually price plus the timing of when cost actually comes through, and that's why our focus is doing that over a period of time and when it makes sense both for our supply base as well as for our customer base.
spk05: Okay, that makes sense. And then my follow-up, I think you had 9% price mix in 22. And my question is, is that 9% also included in your definition of the MRO market? And really what I'm getting at is, did Grainger have more price in 22 than the market? And if so, why?
spk13: Yeah, maybe I'll cover that. First of all, I think that the way you measure price inflation is probably not common across markets. across everybody, so you dive into the details. We don't really know how others are talking about price inflation, so we wouldn't comment on that. I think the thing I would point to is, to Dee's point, we generally think of price as pricing to the market, and we are very confident that what we have now is market competitive, and we look at that very, very, very closely. Given our history, you might understand why we would do that. And so we are more wired on are we price competitive As you said, there's really a lot of lumpiness. We may have taken price later than others or some may have taken earlier. Who knows? But the reality is that we are very competitive now and feel like we're in a good position on price.
spk09: Thank you. Our next question comes from Dean Dre with RBC Capital Markets. Please state your question.
spk11: Thank you. Good morning, everyone. Good morning. Good morning. Can we touch on freight for a second? It looked like that Freight efficiencies helped you on price costs, if I read that correctly, but it still sounds like there's freight inflation. So where does that stand today?
spk13: Yeah, so our price cost does not include freight the way we define it for you. So freight's a separate issue. Obviously, we consider freight in everything we do. Like everybody, we saw huge freight increases during 2021 and 2022. That has certainly moderated it. It's still above 2019 levels fairly substantially, but we have seen that come down quite a bit. So, you know, and we talked about for this year, we expect it to be a benefit in terms of some of the moderating prices. And, you know, some of that is sort of obvious places. Containers from overseas are a lot cheaper than they were six months ago, quite a bit. They're still, you know, relatively higher than 2019, but getting closer. other parts of the market are still tight. So net-net, we still feel like it'll be a small benefit this year for sure.
spk11: That's helpful. And then to follow up on the supply chain, just where does it stand today in efficiencies? You know, what kind of lead times are you seeing and expectations about returning to normal?
spk13: Yeah, I mean, it's a great question. So, you know, what I would say is that from our perspective, once we have the product to when customers get it, that part of the supply chain is all good. We're basically clean every night, barring a storm in Dallas or something that we've seen the last couple of days where people won't pick up. But in general, the supply chain on the outbound side, both in our buildings and then our freight partners, is very, very good. On the inbound side, we still have some elongated supply chains. It's gotten much better in the past four or five months, and we expect to continue to get better. You know, normal is a thing I'd probably say in quotes now. I do expect it to get closer to 2019 lead times, but maybe not quite all the way there as the year progresses. But we do expect it to continue to get better.
spk09: Thank you. And our next question comes from Chris Snyder with UBS. Please go ahead.
spk03: Thank you. And congrats on a really great year. Market outgrowth for the U.S. high-touch business has continued to improve despite presumably better product availability across your smaller competitors. So it seems like the strategic initiatives are certainly taking hold. So I guess my question with that, does this change the way you think about the 400 to 500 basis points of outgrowth? And Should we think about price as part of that outgrowth? It sounds like a lot of the questioning seems to suggest that you guys are overpricing the market, but it just feels like with the digital divide we're seeing and the increased importance that brings to customers, I would suspect you guys should be able to outprice the smaller regional competitors who do not offer that. Thank you.
spk13: Yeah, I mean, I guess I would say just from a core sort of principle for us, We think of outgrowth in terms of volume. We expect price to be relatively neutral. You're right, we may get modest benefits over time. That can happen. But certainly what we're talking about is volume outgrowth. The position from last year, certainly we got some benefit from supply chain, fairly modest. And what we do is we sort of decouple that analytically and look at what our initiatives are doing, and that's how we came up with the 400 to 500 basis point target. at the analyst day, we're still sticking with that. I mean, obviously, you know, we've done a little better than that, but for now, we're not changing that. That's our expectation going forward.
spk03: Thank you. And then for my follow up, I wanted to talk about the high touch favorable mix during the quarter, you know, typically mixed screens as transitory. But on the last call, the company talked about the mixed benefit coming from an increased focus on technical products. And just given the strategic nature of that, it sounds more structural. So just hoping for more color on how to think about mix going forward. Thank you.
spk13: Yeah, so we have had favorable mix. Mix for us generally means product mix here. And so you can imagine during 2020 and 2021 in particular, we had a very negative mix because we were selling, you know, any mask in the world we could find, we were selling it, and that is a lower margin product. I would say we are more back to normal now in terms of the industrial products that we have typically sold, and that's been a favorable mix for us. And certainly we are working hard to make sure that we can compete with technical products or industrial products, and that will be a focus for us going forward. Most of the mixed benefit has been really getting back to normal is the way I describe it.
spk09: Thank you. And our next question comes from Jake Levinson with Mellius Research. Please go ahead.
spk00: Good morning, everyone.
spk01: Good morning.
spk00: DG, are you guys still experiencing any kind of labor issues, either at the factory level or otherwise, just thinking about kind of the mixed signals we're seeing in the labor market? You've still got wage inflation at the lower end and seemingly a lot of competition in warehouses and factories and whatnot, but just curious how that translates for you guys.
spk13: Yeah, well, I mean, so a couple things. One is, you know, we certainly we had wage labor challenges, you know, 18 months ago, a year ago. We have made adjustments in wages for our team members. I would say we are in a much, much better position. Our churn rates are back to normal, basically, in most parts of the business. And, you know, we are in a much more stable staffing pattern than we've been. And I mentioned sort of the outbound. Our Our DCs are performing well. Our call centers are performing well. We don't have as much churn, near as much churn as we did at the peak, and we're really close to back to normal at this point.
spk00: That's helpful. And just switching gears, I guess as a consumer, when you get a lot of inflation, you see people switching from the premium product to the private label brand. Are you seeing that kind of trend in your business where customers that might want to prefer your range of brand over some of the marquee brands, if you will?
spk13: You know, we aren't seeing a big shift there. I would say that most customers, when they're buying industrial products, they need the product for the application they're using it for. And so if our private brand works, they will use it, and they always have. But generally, we aren't seeing certainly a downshift to lower-cost products. That's not what we're seeing right now.
spk09: Thank you. And our next question comes from Christopher Glenn with Oppenheimer. Please state your question.
spk06: Thanks. Good morning, guys. So I think last quarter another topic that came into the improved mix discussion for HTS was the result of the merchandising initiative. So drilling into that, is that trend kind of in the input there full throttle now or still ramping up? And is that kind of expected to be a
spk13: good guy driver for an indefinite number of years yeah it's the latter Chris so we've you know we started this initiative three or four years ago we've worked through sort of some initial category reviews we get keep getting better at them and what we've discovered is that we've learned a ton as we've gone and we're just getting better and better at it and there's still a lot of improvement to be made it will be a consistent benefit for us, we believe, going forward for the foreseeable future, sort of that midterm three- to five-year time frame. We still see a lot of benefit from improving the way we merge. And it's core to what we do. I mean, helping customers have confidence that they found the right product is kind of what we do. So getting better at that seems to have good results, and we're going to continue to really push hard on that.
spk06: And to be clear, that's just highlighting higher value-add products within categories for the most part?
spk13: No, I would say we are agnostic to what – not agnostic to the economics, but agnostic to sort of identifying higher value products. We're trying to make it super easy for customers to find what they need. And so it's really all about do we have the right assortment, can we present it in a way that makes it really easy for customers to find, so they can have a lot of confidence that they're getting the product that they need to use for the right application. Thank you.
spk09: Our next question comes from David Manthe with Baird. Please state your question.
spk02: Thank you. Good morning. First off, I'm interested in understanding how you capture a LIFO benefit when both inventories and the LIFO reserve are up quarter to quarter and year to year. It's easy to go through the mechanics of that. I'd appreciate it.
spk01: Sure, sure, Dave. So I'll go back to last year. So we'll just start with that because there were two things. We're laughing last year's unfavorable, it was unfavorable last year, favorable this year adjustment. And if you recall last year, you know, we had a sharp increase in costs. And then we had an outsized amount of inventory kind of get delivered in the fourth quarter. And that combination of those two factors happening at the same time resulted in us recording a meaningful LIFO adjustment to our fourth quarter adjustments in 2021. Now, looking at that and understanding that we were still in a... inflationary period as it relates to cost, and we saw a cost bill coming in. From our suppliers, we worked on improving our processes, tightening our processes, making sure that we were booking entries and looking at the process, not just from the financials, but with the chain leaders to ensure inventory valuation was was staying up to par as we moved through the year. So I feel like we did a much better job there. However, when you look at the inventory that was sold through in the last quarter of the year, it required us to take a favorable LIFO adjustment to correct for that. Because if something has an increase, for those that don't know, if something has an increase in the quarter, haven't sold it or the price change in that quarter from when it changed early in the year, the LIFO adjustment causes you to refactor all of those sales to the latest cost. So that adjustment was favorable for us. The combination of those two, year-over-year and Q4, resulted in about a net 130 basis points year-over-year impact to GP sales. for the high touch business.
spk02: Okay, thank you. And second, the share gains that you've been seeing have clearly been terrific. Could you discuss the balance that you're seeing between new customer ads and selling more to existing customers? I would imagine there's a difference between high touch and endless assortment, but could you just give us some color on that?
spk13: Yeah, I mean, in high touch, so I would just say that in high touch that The vast majority of our share gain is existing customers. The reality is that the Grainger brand sells something to most large and mid-sized customers, business customers in a year, and so the vast majority of the share gains we're seeing are actually share of wallet as opposed to new customer acquisitions. In the endless assortment, it's more balanced. We're seeing in Japan, we're seeing a mix of new customers but also significant growth with existing customers. And at Zorro, we're seeing nice retention rates, so we are seeing more balance between new customer acquisition volume and existing customer volume in the endless assortment model.
spk09: Thank you. And our next question comes from Ken Newman with KeyBank Capital Markets. Please state your question.
spk04: Hey, good morning, guys. Good morning. Dee, I think the midpoint of guide implies SG&A leverage of high teens for 2023 at the midpoint. Can you just remind me, how much of the SG&A spend is fixed versus variable at this point? And, you know, should we think about high teen as kind of the right way for SG&A leverage to progress if they'll stay at this, you know, at or above mid-single-digit growth going forward?
spk01: So if you're looking at our guide, the guide is implying 30 to 60 basis points of SG&A leverage for next year. And as I think about that, let's remember a couple of things. You know, we're continuing to invest in demand generation. And we had some one-time costs this year. that we don't expect to impact us next year. And I would say one of the last things to consider is going into a new year, we get to reset our variable costs, like variable costs such as variable compensation, back to 100% of our plan. And then we have some modest productivity that we build into the plan because we focus our organization on looking at driving standard work, automation and productivity every day so we don't have to have huge events. We do that in times when things are going really well and we can scale and also when things are tightening up. So, you know, those are the numbers that I had related to the type of SG&A leverage we're looking to gain. And remember, that's in the midst of us continuing to invest.
spk04: That's helpful. For my follow-up here, it does look like inventories took a decent step up from the third quarter to fourth quarter, which makes sense given the sales guide increase. Could you just provide some color on what's embedded in the operating cash guide for how inventories and working capital trend throughout the year?
spk01: Can you repeat that question again?
spk13: What could happen to inventory levels next year and working capital next year?
spk01: Oh, so, you know, with that investment, it also includes some investments in VC capacity. So, We expect to continue to build inventory as we stand up some of those new buildings. We do expect to see some slight improvement in working capital as far as it is not diminishing as much as it has the last couple years because we were investing much more significantly in inventory, say, last year, and we're starting to see some improvement and our accounts receivable execution as well.
spk09: Thank you. Our next question comes from Chris Dankert with Loop Capital Markets. Please state your question.
spk10: Hey, morning. Thanks for taking the question. I guess looking at the margin guide for endless assortment, pretty impressive expansion, 23 expected here. How do we think about the long-term path towards that 11% margin guide? I mean, there's a DC investment in Tokyo. What else should we be thinking about in terms of, you know, costs and investments in 24 and beyond maybe as we think about, you know, analyst assortment profitability over time here?
spk13: Yeah, so I mean, the two biggest portions of the analyst assortment are Zorro US and Monotaro. Monotaro, you know, their profitability in the last year was deflated by operating two buildings at once in the in the Osaka area. That goes away, so they'll see some improvement next year. They will be investing in a building in the Tokyo region in the next several years. But generally, I think the pattern for them will be getting closer back to where they were prior to the dual DC Osaka situation. So we would expect them to improve over time. And then we've talked a lot about Zorro US. We expect that to get a kind of high single-digit operating margins over the next several years, and so that combination gets you to sort of that long-term guy.
spk10: Well, guys, and just to put a finer point on that last piece about Tokyo, I mean, will that have a similar impact as the stand-up of Osaka did in terms of operating two facilities at once whenever that investment comes through?
spk01: So, you know, we expect – So the Inagawa DC that went up and getting out of Amagasaki in 2023, the first half, they will still be incurring some costs as well as wrapping up to their full efficiency. In the midst of that, they're also launching phase two of the Inagawa DC, which has additional costs. So our expectation is that they will end the year in 2023 or exit that year was at margin rate similar to what you saw prior to both projects?
spk13: I think Chris was asking a bit different question, which you were asking about Tokyo, whether it's going to be a similar issue with Tokyo when that comes on board. The answer is who knows. It depends on the pattern of the timing and when things open. It may or may not be as impactful, but we'll comment on that as we get closer to it. That's three or four years out. Okay.
spk09: Thank you. And our next question comes from Pat Bauman with JP Morgan. Please go ahead and state your question.
spk07: Hi, good morning. Thanks for taking my questions. A quick one. I think you were expecting on gross margin for the fourth quarter, like 38 to 34%. Can you just walk from what you were expecting to that 39.6 that you reported, kind of like what surprised you? You called out LIFO benefit, but that's like a year over year impact. So I'm not sure if that's like the entire, you know, bridge to that 39.6. I know it's 130 year over year, but I'm not sure that that's like the difference in kind of where you came in at versus what you expected. So maybe you can call her on that. Thanks.
spk01: Sure. So admittedly, we did end stronger than what we expected, you know, as we continue to execute well. And a number of things, as you kind of note, went our way. So we talked about one of them earlier. You know, we got some tailwind from freight efficiencies with both fuel and container costs coming down over the last couple months. In addition to that, we did get some price-cost timing benefits as we looked to implement some web prices. We implemented some web prices in the quarter ahead of our January price increases, so that helped us a bit. If you break away the inventory valuation adjustment this year from what we saw last year, that was more of something that wasn't anticipated. So that inventory valuation adjustment that we booked in the quarter that was favorable, that was the third piece.
spk07: Okay. Is it kind of like in that order in terms of like the magnitude of difference?
spk01: I would say if you take all three, it was about a third, a third, and a third from a value perspective.
spk07: Great. And then my follow-up is just on, it's also on gross margin, just the guide for 23. Just wondering what the assumptions are kind of in the, behind that modest contraction for some of these moving parts, like is it, is price cost negative, which is, you know, offset by freight kind of those wash out and then kind of the decline is like just kind of segment mix related, or is there anything in there for kind of the inventory adjustment dynamics to think about just wondering that year-over-year guide, how to think about the moving parts for that.
spk01: I think you said it exactly right. I can repeat what you said, but, you know, we have some price-cost benefit timing. Some of that may fall away. We may have some freight efficiencies. You know, those may or may not cover that completely up. And then you've got the business unit mix between endless assortment and high touch and the fact that endless assortment is going to grow faster. So it has a negative impact.
spk09: Thank you. And we have reached the end of our question and answer session today. I will now turn the call over to DG McPherson for closing remarks.
spk13: Yeah, thanks for joining us today. Really appreciate you jumping on the call. You hopefully get the sense that we feel pretty good about the path we're on. We've had a really good year, but we're more excited about the future and driving things to help our customers operate better and help them succeed. So with that, I'll just say thanks for joining again and hope you stay safe. You're going to get cold, I think, in the northeast, so hopefully you don't ice up too much because that does affect us too. But have a great rest of the week. Thank you.
spk09: Thank you. And this concludes today's conference. You may disconnect your lines at this time. Thank you all for your participation.
Disclaimer