Greetings, and welcome to the W.W. 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. [Operator Instructions] 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.

Good morning. Welcome to Grainger's fourth quarter and full year 2022 earnings call. With me are D.G. Macpherson, Chairman and CEO; and Dee Merriwether, 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 their 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 was a public company and follows Japanese GAAP, which differs from U.S. GAAP and is reported in our results 1 month in arrears. As a result, the numbers disclosed will differ somewhat from MonotaRO's public statements. Now I'll turn it over to D.G.

Thanks, Kyle. Good morning and thank you for joining us today. I'm going to discuss some of our key accomplishments from 2022, and then I'll pass it to Dee to walk through the specifics of our fourth quarter performance and our outlook for 2023. Turning to Slide 4. The Grainger Edge framework has been instrumental in guiding our work in 2022. We know that when we live our principles, 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 the trusted partner of 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 start-up of the Anegawa distribution center in Japan, expanding our digital and data capabilities, including progress with our customer and product information systems, in our high-touch business and improved account management tools and our endless assortment model, and executing against our merchandising and marketing initiatives, including temp search and recommendation functionality. During the year, we also continued to strengthen our…

Thanks, D.G. 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 continue to invest in our strategic initiatives and also incurred an aggregate $35 million in non-recurring items in the quarter. This includes 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-Touch Solutions segment, we continue to see strong growth with daily sales up 16.8% compared to the fourth…

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, the liver follows experience to 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.

Thank you. And at this time, we will conduct a question-and-answer session. Please limit yourself to one question and one follow-up question. [Operator Instructions] Our first question comes from Tommy Moll with Stephens. Please state your question.

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. Dee, I think you heard -- I think I heard you say that most, but maybe not all of that is a wrap, but if you could comment there on the wrap versus any new initiatives? And then also just a related point, are there any areas of pricing pressure? That's something that's been picked up in the marketplace this quarter elsewhere. And I just wonder if you've seen any of that in your business.

So I'll start with the first part and then maybe D.G. can add in a little bit on what he's hearing from -- what he's hearing from some customers on the visit. So, yes, when we look at the market outlook, it includes both price and volume. And so the sum of that, we believe, will be somewhere in the range of 1% to 5% of the total market. We believe that volume will be down 3% to flat. And as you know, at price, up 4% to up 5%, we have more visibility into our pricing than anyone. And so when we look at price, we are also taking into account our wrap, 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 three-ish percent up to about 4% to 5% from for the price outlook.

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

That's helpful. And then I wanted to follow up on the volume -- the volume outlook for High-Touch flat to down three. And D.G., you mentioned at least one area of strength in aero 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.

Yes. We're really sticking to what the market projections are at this point. In terms of -- you heard the January results. We aren't seeing a lot of weakness to be fair at this point. We do expect in the back half, there to be more challenges from a volume perspective. What I would say is every customer we have has a COVID-fueled story about what's happened to their volume over the past few years and where they've been determines whether they're facing pressures now or whether they're seeing optimism. So obviously, with aerospace, they -- we shut down the airlines for a long time and they now have orders. So they're starting to build up. And that's going to take a couple more years to actually get the full speed, we think, with aerospace. With some, they may have forward loaded some of their volume because they were selling things that were very important during the pandemic, and now they're faced with situations where things are slowing down. So, I would say every customer has their own story, net-net, that we're not seeing any real softness as of yet, and that's showing in the numbers.

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

Nice quarter. I wanted to start with a couple of questions on price cost. Just wanted to dig in a little bit more. So last quarter, I think price cost 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.

Well, if you're specifically focused on GP in the U.S., our gross margins have expanded, if you look over a longer period of time here. And as it relates to price cost, just want to reiterate, when we talk about neutrality, we do talk about that over time. And we have continued to speak about the fact that price cost just like GP is lumpy. We have a cost cycle, which we have traditionally had for years that really didn't hold last year because of how fast cost inflation was coming 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. It's 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.

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?

Yes. Maybe I'll cover that. First of all, I think that the way you measure price inflation is probably not common across everybody. So you dive into the details that we don't really know how others are talking about price 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 how 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 pricing.

Our next question comes from Deane Dray with RBC Capital Markets. Please state your question.

Could we touch on freight for a second? It looked like that rate efficiencies helped you on price cost, if I read that correctly, but it still sounds like there's freight inflation. So where does that stand today?

Yes. So our price cost does not include freight the way we define it for you. So freight is 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's still above 2019 levels fairly substantially, but we have seen that come down quite a bit. So -- and we talked about for this year, we expect it to be a benefit in terms of some of the moderating prices. And some of that is sort of obvious places the containers from overseas or a lot cheaper than they were six months ago, quite a bit. They're still relatively higher than 2019, but getting closer. Other parts of the market are still tight. So net-net, we still feel like it will be a small benefit this year for sure.

That's helpful. And then a follow-up on the supply chain. Just where does it stand today in efficiencies? What kind of lead times are you seeing and expectations about returning to normal?

Yes. I mean, it's a great question. So what I would say is that -- from our perspective, once we have the product to -- when customers get it, that part of the supply chain is all good. We were basically clean every night, barring a storm in Dallas or something that we've seen in the last couple of days where people won't pick up. 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. At normal, I think I'd probably say in quotes now. I do expect it to get closer to 2019 lead times, but maybe not quite all the way there as the year progresses, but we do expect it to continue to get better.

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

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.

Yes. I mean I guess I would say just from a core sort of principle for us, we think of outgrowth in terms of volume, we expect price to be relatively neutral. You're right, we make it 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, we've done a little better than that. But for now, we're not changing that. That's our expectation going forward.

And then for my follow-up, I wanted to talk about the High-Touch favorable mix during the quarter, typically mixed screens as transitory. But on the last call, the Company talked about the mix benefit coming from an increased focus on technical products. And just given the strategic nature of that, it sounds more structural, so just hoping for more color on how to think about mix going forward.

Yes. So we have a 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 had -- we were selling any mask in the world we could find, we're 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. But most of the mix benefit has been getting -- really getting back to normal is the way I describe it.

And our next question comes from Jake Levinson with Melius Research. Please go ahead.

D.G., are you guys still experiencing any kind of labor issues either at the factory level or otherwise? Just thinking about kind of the mix signals we're seeing in the labor market. You still got wage inflation at the lower end and seemingly a lot of competition and warehouses and factories and whatnot, but just curious what -- how that translates for you guys.

Yes. Well, I mean -- so a couple of things. One is we certainly, we had wage labor challenges 18 months ago, a year ago. We have made adjustments in wages for our team members. I would say we are in a much, much better position. Our churn rates are back to normal basically in most parts of the business. And we are in a much more stable staffing pattern than we've been. And I mentioned some of the outbound, 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.

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 Grainger brand over some of the marquee brands, if you will.

You know, not. We aren't seeing a big shift there. I would say that most customers, when they're buying industrial products, they need the product for the application they're using it for. And so if our private brand works that we use it and they always have. But generally, we aren't seeing certainly a down shift to lower cost products. That's not what we're seeing right now.

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

So I think last quarter, another topic that came into the improved mix discussion for HTS was the result of the merchandising initiatives. So drilling into that, is that trend kind of in the input there full throttle now or still ramping up? And is that kind of expected to be a good guide driver for an indefinite number of years?

Yes, it's the latter, Chris. So we've -- we started this initiative three or four years ago. We've worked through sort of some initial category reviews. We keep getting better at them. What we've discovered is that we've learned a ton as we've gone, and we're just getting better and better at it and there's still a lot of improvement to be made. 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, it's kind of what we do. So getting better at that seems to have a good result, and we're going to continue to really push hard on that.

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

No. We are -- I would say we are agnostic to what the -- not agnostic to the economics, but agnostic to sort of identifying higher-value products. We're trying to make it super easy for 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.

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

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. I just if you could go through the mechanics of that, I'd appreciate it.

Sure, sure, Dave. So I'll go back to last year, you just start with that because there was two things. We're lapping last year's -- it was unfavorable last year, favorably this year adjustment. And if you recall last year, we had a sharp increase in cost, and then we had an outsized amount of inventory kind of get delivered in the 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 an inflationary period as it relates to cost and we saw costs still coming in. From our suppliers, we worked on improving our processes, tightening our processes, making sure that we were booking entries and looking at the process, not just from the financials, but with the chain leaders to ensure our inventory valuation was staying up to par as we move through the year. So I feel like we did a much better job there. However, when you look at the inventory that was sold through in the last quarter of the year, it required us to take a favorable LIFO adjustment to correct for that. Because if something has an increase for those that don't know, something has an increase in the quarter, it 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 in Q4 resulted in about 130 basis points, a net 130 basis point year-over-year impact to GP for the High-Touch business.

Okay. And the second, the share gains that you've been seeing has clearly been terrific. Could you discuss the balance that you're seeing between new customer adds and selling more to existing customers? I would imagine there's a difference between High-Touch and Endless Assortment. But could you just give us some color on that.

Yes. I mean in High-Touch, so I would just say that in High-Touch that the vast majority of our share gain is the existing customers. The reality is that the Grainger brand sells something to most large and midsized customers' business customers in a year. And so a vast majority of those are -- the share gains we're seeing are actually share of wallet as opposed to new customer acquisitions. In the Endless Assortment, it's more balanced. We're seeing in Japan, we're seeing a mix of new customers, but also significant growth with existing customers. And at Zoro, we're seeing nice retention rates. So we are seeing more balance between new customer acquisition and volume and existing customer volume in the Endless assortment model.

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

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

So the -- 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. 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 will say the -- one of the last things to consider is going into a new year, we get to reset our variable cost like variable costs such as variable compensation back to a 100% of our plan. And then we have some modest productivity that we built 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, 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.

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. Can you just provide some color on what's embedded in the operating cash guide for how inventories and working capital trend throughout the year?

Can you repeat that question again?

What can happen to have inventory levels next year and working capital next year?

So with that investment, it also includes some investments in DC capacity. So we expect to continue to build inventory as we stand up some of those new buildings. We do expect to see some slight improvement in working capital as far as it is not diminishing as much as it has in the last couple of years because we were investing much more significantly in inventory, say, last year, and we're starting to see some improvement and our accounts receivable execution as well.

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

I guess looking at the margin guide for analyst assortment, pretty impressive expansion in '23 expected here. How do we think about kind of the long-term path towards that 11% margin guide? I mean does the DC investment in Tokyo, what else should we be thinking about in terms of cost and investments in '24 and beyond maybe as we think about Endless Assortment profitability over time here?

Yes. So I mean the two biggest portions of the Endless Assortment are on our Zoro U.S. and MonotaRO. MonotaRO, 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 talked a lot about Zoro U.S. 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 guidance.

Okay. And just to put a finer point on that last piece about Tokyo. I mean, will that have a similar impact as the stand of Osaka did in terms of operating two facilities that once whenever that investment comes through?

So, we expect -- so, the Anegawa 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 2 of the Anegawa DC, which has additional cost -- so our expectation is that they will end the year in 2023 or exit that year with op margin rate similar to what you saw prior to both product.

I think Chris was asking a 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 that's three or four years out so.

And our next question comes from Pat Baumann with JPMorgan. Please go ahead and state your question.

A quick one, I think you're 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 bridge to that 39.6%. I know, it's 1/3 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 color on that.

Sure. So admittedly, we did end stronger than what we expected as we continue to execute well. And a number of things as you kind of note went our way. So we talked about one of them earlier. We got some tailwind from freight efficiencies with both fuel and container costs coming down over the last couple of months. In addition to that, we did get some price/cost timing benefits as we look 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. And then if you break away the inventory valuation adjustment this year from what we saw last year that was more something that wasn't anticipated. So that inventory valuation adjustment that we booked in the quarter that was favorable, that was the third piece.

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

I would say, if you take all three, it was about 1/3, 1/3 and 1/3 from a value perspective.

Great. And then my follow-up is just on -- it's also on gross margin, just to guide for '23. Just wondering what the assumptions are kind of behind that modest contraction for some of these moving parts? Like is it price/cost negative which is 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.

No, I think you said it exactly right. I can repeat what you said, but we have some price/cost benefit timing. Some of that may fall away. We may have some freight efficiencies. Those may or may not cover that completely up. And then you've got the business unit mix between Endless Assortment and High-Touch and the fact that Endless Assortment is going to grow faster. So it has a negative impact.

And we have reached the end of our question-and-answer session today. I will now turn the call over to D.G. Macpherson for closing remarks.

Yes. Thanks for joining us today. I really appreciate you jumping on the call. Hopefully, you get a sense that we feel pretty good about the path we're on. We've had at 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. If you're going to get cold, I think, in the Northeast. So, hopefully, you don't ice up too much. That does affect us too. But have a great rest of the week. Thank you.

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