Hello, and welcome to the W. W. Grainger Third Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen only mode. 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 Hohman, VP, Investor Relations. Please go ahead.
Good morning. Welcome to Grainger's Q3 2020 earnings call. With me are D. J. McPherson, Chairman and CEO and Tom Ocray, 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 Q3 of 2020, which exclude restructuring and other items that are outlined in our earnings release. Now I'll turn it over to BG.
Thanks, Irene. Good morning and thank you for joining us today. Market conditions remain challenging in the Q3 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. 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 Q3 performance before turning it over to Thanh 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 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 remained 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 Zoro endless 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, 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 $2,100,000,000 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 transformed 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 remerchandised $2,800,000,000 in product through this new process, including $1,600,000,000 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 Q3.
Customer feedback on our website has improved significantly over the past 6 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 KeepStock offering and improvements to our sales strategy and effectiveness. We know that when we embed 1 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 1 or more embedded solutions.
And lastly, within our endless assortment model, we are executing the successful Monotro playbook at Zoro here in the U. S. And are making strides in marketing effectiveness, customer analytics and SKU additions. This year alone, we have added 1,500,000 SKUs to Zorro, pushing its assortment to roughly 5,000,000 products. Turning to our quarterly performance, we produced strong operating results in the 3rd 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 Q3, while also generating meaningfully improved margins. We remain very excited about the future of this business as we continue to adopt learnings from Monotro to drive growth and profitability. At the total company level, we expanded adjusted operating margins by 90 basis points as gross margin 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 311,000,000 free cash flow of $252,000,000 Looking at Slide 6, 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 during the pandemic. Flexiglass 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 date 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, D. G. Starting on Slide 8, 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 2nd 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 unit business unit mix impact as we experienced significant growth in our endless assortment business. Our SG and A came in at $700,000,000 for the 3rd quarter, better than our communicated range of $715,000,000 to $730,000,000 SG and A cost was down $60,000,000 year over year and we captured 2 60 basis points of SG and A leverage in the period. This result stems from prudent cost reduction actions across our high touch solutions model, including cost lower costs as a result of our Fabry divestiture and leverage gains with our endless assortment business.
This SG and 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 swings from quarter to quarter. We generated operating cash flow of $311,000,000 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 percent of net adjusted earnings and year to date adjusted return on invested capital is over 29%.
Given our solid results over 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 4th quarter. While we $100,000,000 to work on repurchases in Q4, we will monitor market conditions and optimize the amount accordingly. 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 midsized 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 percent was down 160 basis points compared to the Q3 of 2019, but improved sequentially from the 310 basis point year over year decline we saw in the Q2 of 2020. The unfavorable variance in gross margin was driven by mainly by 2 factors that were similar to the 2nd 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 Q4. 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 points 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 Q4. From an SG and A perspective, we gained 160 basis points of leverage with cost decreasing approximately $22,000,000 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 and 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% 6% in the 3rd 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 1st 9 months of 2020. Moving to our other businesses, organic daily sales increased 12.5 percent or 12.3% on a constant currency basis. The endless assortment business grew at approximately 20%, fueled by strong results at both Monatro and Zoro during the quarter. Zoro 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 2nd 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 and 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 Monotro. 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 continued 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 mix headwinds, which were offset partially by lower freight costs in the quarter. Cost management remained strong with savings of $5,000,000 year over year, resulting in 110 basis points of SG and 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 of quarters, I want to give you a sense of how we are thinking about things in the Q4. 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 continue as the pandemic related impacts and tariff fueled cost inflation headwinds will persist into the Q4. The one time freight tailwind we realized in the Q3 will fall off.
Further, we anticipate year over year cost headwinds in the 4th 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 and A, we expect to see sequential increases in a couple of areas, primarily related to some incremental technology investments to support growth in the U. S. And at Monotro, which will push our estimated SG and A to between $725,000,000 to $740,000,000 for the Q4.
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 Zoro 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 strategy 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 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 trends still going strong and conversions to some regular customer dynamics are going well. Just wondering if you could further dive into that topic and how it informs early view of share outperformance for 2021?
Great. Thanks, Chris. So yes, we've had, as you might guess, given inventory positions, we have had a whole bunch of new customers sample Granger and Zoro and the Notro 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.
We think that really helps bode well for the future. 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 the 3Q pandemic sales using October as a proxy might approximate the sustainable run rates as long as workplaces are very germophobic 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 case rates rise, which we've seen recently, we would expect that to continue through the fall. What happens when we have better treatments in 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 rate of transmission. Thanks, D. J.
Thank you.
Thank you. Our next question today is coming from Chris Dankert from Longbow Research. Your line is now live.
Hey, good morning guys. Thanks for taking my question. I guess first off, what's the status of investment in Zoro? I mean, in the past, we'd mentioned that $50,000,000 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 any other business in 2021? Just thoughts on investment there would be really helpful, I think.
Sure. We had a very heavy investment period in the back half of 2018 2019 with Zoro. 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 start to see those starting to see those leverage themselves now. This year, we're getting improved operating margins in Zoro. We think the long term path for Zoro from a margin perspective is as we've discussed.
We'll talk about 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. I didn't think about SG and 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 helped you cut that SG and A number even lower in the Q3 here?
Yes. Thanks, Tom.
Do you want to take that?
Yes, sure. Thanks, Chris. First of all, there was a little bit that was wind aided just with the Fabry divestiture and that takes the $60,000,000 down to about $40,000,000 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, 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 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. Technology, which are important for us.
Got it. Glad to hear it.
It's a broad based savings, certainly. So 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 Uhlman from Cleveland Research. Your line is now live.
Hey, guys. Good morning. Good morning. Sticking with the SG and A question, I guess, the freight dynamics that you pointed out for the Q3 and the Q4 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. Most customers, 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, 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, the company has been building up inventory and I was curious, 1, 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 observing 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.
Yes. So let me take those and Tom you can add to them if you think I missed anything. So in terms of inventory, there's really two areas where we've built inventory and we'll 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 DC full up in 2021. And so as that comes on, we obviously stock that building.
That's partially stock now, but becomes more fully stocked 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 in terms of 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 in 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 product 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 is 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 GP.
Yes. 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 So you're right, inventory is up since the beginning of the year, 8% at $1,780,000,000 We've invested in working capital, it's up $220,000,000 And we did put pandemic inventory spend in the quarter of approximately 300,000,000 dollars And as D. G.
Said, I mean, you're not going to bat $1,000 on all of that. So we go through the normal E and 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 coming from Chris Snyder from UBS. Your line is now live.
Thank you for the question. I just wanted to follow-up on Enlistosaurin margins. I understand there's like a longer term kind of high single digit target out there for Zoro. But with the back office investments slowing, what kind of incremental margins could we expect for this business as the top line continues to ramp?
Yes, 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.
Yes, I mean, Tom, I would just add. I mean, if you look at incremental margins with Monotro, 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 Zoro. But that's typically what we see in Monotro, I think.
I appreciate that. And then just following up on Monotro. 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?
Well, we view, sure. So we view both the endless assortment and the high touch solutions model as absolutely core to what we do. Masaya Suzuki, who is the leader of that business now, also leads Zoro. We are sharing best
So we view it as absolutely core to what we do right now.
So we view it as absolutely core to what we do right now. And we're getting a whole lot of leverage from that Monotro team in terms of learnings and building the business at 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 Deane Dray from RBC Capital Markets. Your line is now live.
Thank you. Good morning, everyone. I was hoping we get some color on the additional color on the gross margin guidance for the 4th quarter down 200 bps. Is there any way you can parse out what the pandemic sales would be versus non pandemic sales? I'm just trying to get a sense of what the core gross margin trajectory might be.
Thanks.
Yes. 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 unfavorable bad guy and we had the one time freight of 60. So if you remove the 60 from the 140 and the 80, you get to 220. Now we think that the pandemic will likely improve. Obviously, it's very volatile.
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 really helpful. And then I was hoping to 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 Q2 really just appears to be in the Q3, it 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 Wolfe Research. Your line is now live.
Thanks. Good morning. Thanks for the question. Just want to pick up on that 4Q gross margin guidance. So roughly 20 basis 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?
Bob, do you want to take that one?
Yes, 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. So that's the other way I would look at it.
Okay. That's fair. And then the midsize customer growth was pretty impressive and a nice swing from what we saw last quarter. And I'm just curious, are we seeing obviously, a lot of your competitors, especially the small competitors and 1 or 2 larger ones, have employed a very high touch distribution model. And I'm wondering if we're seeing a switch towards perhaps more low touch direct ship, e commerce type sales and maybe some supply consolidation?
I mean anything you see in there in the market?
Yes, 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. What I would say is that we are seeing improvements in midsized 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 yes, I would say it's fair to characterize as more digital, but not all digital.
We're 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 Pokrzywinski from Morgan Stanley. Your line is now live.
Hi, good morning guys.
Good morning. Good morning.
Just a
couple of questions. I was covered on the 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 Zoro 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?
Does that have some benefit positive or negative that may not look like the ongoing model?
Yes. I think the only thing that I would say and then, BG, please add is, we're probably seeing more B2C customers and B2B customers in the pandemic, but other than that, nothing out of the ordinary.
Yes. 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. 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. And so we think we've had more consumer acquisition than normal. We don't remarket to consumers, whether in Zoro or Granger.
And 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 the sort of key for us.
Got it. That's helpful. And then it sounds like Dean is going to be a future
Understood. And then just on the
Understood. And then just on the inventory question, I know someone asked earlier about the inventory build there. Anything on kind of a seasonally uncommon liquidation in the Q4 that you're planning that may be dragging that down or impacting that at all. Just thinking about historically, you usually build a little inventory in the Q4 sequentially. Is that something that happened earlier?
Is that playing into the dynamic at all on the gross margin?
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 and 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 continue to trend lower. As we roll into 2021, what 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 we it's hard it's really difficult to project the PPE trend. What we've seen since April, in April we saw PPE up almost 100 100%, pandemic product, what we call pandemic that includes more than PPE. We saw sort of normal volumes down 20 percent in April. And what we've seen is those 2 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 and A, frankly. We think we can control SG and 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 it's 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 a few things that really matter, which helps drive results, but also helps you manage your SG and 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, 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.
But do you have any sense, TG, of what maybe the SG and A headwinds or I'm sorry, Tom, what sort of SG and 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 some merit increases and stuff like that. Is it too early to tell at this point or how are you thinking
about that?
No, I mean, we'll talk about that certainly at year end as we talk about forward looking. We took we had merit increases this year. So that's not yes, clearly, we have costs that will come back into the business. Travel will be modest, we think for the next 6 months given what we're seeing with the virus. At some point, that can come back.
But I think the headline for me would be we've seen nice growth. GP has been depressed given pandemic sales has been so elevated. SG and A has 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.
Yes.
The only thing that I would reinforce is, as D. G. Said, we're always going to be about SG and A efficiency and control, and we'll handle that. The upside that I see, which D. G.
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 and E product that's going to come into those businesses opening up as well. So I see it more as a tailwind than any sort of a headwind. D.
G, just lastly, implicit in your answer on Monitoro and monetizing Monitoro, you indicated that Zoro is still pretty important to the Zoro business. It's intertwined and so forth. At what point can Zoro 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 0.
Well, I'd say a couple of things to that. One is, it's probably timing, you probably need 3 more years given what we're projecting to get Zoro to where we'd like to get it. So it's really got 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, 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, for the next 3 years, we're thinking of it as we need to get Zoro business performing well. We're really excited about the Monocchio 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 Manthey from Baird. Your line is now live.
Thank you. Good morning, everyone.
Tom, I'll have
to go back and review your commentary. But when you're talking about gross margin and you said above 200, I'm confused. Was that a 4th quarter statement or were you walking into 2021?
4th quarter, Dave. 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 onetime freight. So if you just take the 60 bps up, that gets you to 2 20. Now we assume the pandemic is going to get better as is cost inflation.
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 will 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. Yes, 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, 30 below 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?
Yes. We'll have a lot more to say about that going forward. I think so, just to give you a couple of things to think about, one would be how long is the pandemic 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 1.
Number 2, we should see a natural tailwind in terms of we will fully lap the tariff related cost inflation, as well as we'll probably see less spikes in terms of cost inflation related to the pandemic product. So those are the 2 big ones to think about and both of them should be tailwinds for 2021. But again, it's premature to talk in detail. We'll have plenty of time for that later.
Got it. That's great color. And second, on KeepStock and these embedded solutions 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, EDIE Pro and KeepStock would make up over 30% of our direct revenue, I believe. Don't I to 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 grainger.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 recommendation, substitute or frequent packaged products and SKU count and what's been the most impactful so far and what will be going forward?
Are you talking about the endless assortment business, the Zoro business? Yes,
yes, the endless assortment, yes.
Yes. So I mean, I'd say there's 3 things that have been really impactful. 1 is SKU count. So we look at the productivity of every SKU add and we look over kind of the last 6, 7 years as we've added SKUs. We're now we've now hit the 5,000,000 point.
The ads we've made in the last 6 months are as productive, and it looks like maybe even more productive than those that we've made in the past. So that bodes pretty well for future growth. So that's probably the most important piece of the growth. The other one is customer analytics and marketing. So getting 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, 3rd, 4th order and starting to get real traction there. So those are far and away the 2 most important things with the unlisted assortment 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 visits. You mean customers coming on to the website and what's the revenue per site visit?
Yes.
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 like 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 acquisition rates, repeat rates and we link all that to a customer value model to understand the NPV of each customer add. 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 be targeting in the out years as you transition less from branches more to endless assortment? I mean, it looks like you're trending pretty well this year. Just wondering if there's if you underspent this year and there's a catch up into next year or beyond?
Go ahead, Tom.
Yes. I don't think there's going to be any big catch up. I mean, even if you look at we spent roughly $60,000,000 in the quarter, which was similar to last year. When the pandemic first hit, we tightened our belt a little bit and deferred some things. But 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 coming in future years that would be anything out of the ordinary.
Our next question today is coming from Hamzah Mazari from Jefferies. 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 losing less money this shoot them last. So in total, I believe those would be slightly unprofitable, but 2 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, Hamzah.
Thank you. Thank you. Our next question is coming from Justin Bergner from G. Research. Your line is now live.
Good morning, DG. Good morning, Tom. Thanks for fitting me in. Good morning.
Good morning, Jeff.
Yes, 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 Q3?
So two things there, two things going on. One is that 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 Tandemics products and the customers we needed to funnel that product to, 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 midsized customers and we see nice growth as a result of that.
Great. And then the open ended question, looking at it from 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 may be materializing anew as you look towards the end of this year and into 2021?
Yes. 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, the government sales 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. Thank you. Our next question today is coming from Patrick Baumann from JPMorgan. Your line is now live.
Hi, DJ. I had time. Just have a couple of quick ones here. For next year, 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 that you said 300 basis points 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, 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 for our profitability rates. So 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.
Yes, makes sense. And then last one real quick on Zoro. Are the added SKUs year to date, 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 3rd party versus a Granger owned inventory?
Yes. So a lot of the new product adds are 3rd party from or through the Grainger supply chain. 3rd party items tend to be lower SG and A and slightly lower margin 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 3rd party shippers and that's a big part of what we're doing.
The only thing I would add, Patrick, is the accounting difference is whether you're an agent or not when you're doing 3rd 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.
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 is 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, 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