Greetings, welcome to the W.W. Grainger, Inc. third quarter 2019 earnings conference call. At this time, all participants are in 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 0 on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Irene Holman, Vice President, Investor Relations. Please go ahead.
Good morning. Welcome to Grainger's Q3 earnings call. With me are D.G. Macpherson, Chairman and CEO, and Thomas Okray, CFO. As a reminder, some of our comments may be forward-looking, based on our current view of future events. 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 mentioned on today's call with their corresponding GAAP measures are 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. Now I'll turn it over to D.G.
Thanks, Irene. Good morning. Thank you for joining us today. I'm gonna discuss our Q3 results and share an update on the U.S. and Endless Assortment Growth Initiatives that we introduced earlier this year. Tom will provide details on the quarter, and we'll open it up for questions. We have had solid results so far this year as we manage through the uncertainty of the current environment. Despite softening global demand, we have accelerated our sequential share gain in the U.S. business and continue to invest for growth in our Endless Assortment business, Zoro. We've also been diligent in partnering with our suppliers to manage cost and have driven expense leverage across our U.S. and Canadian businesses. Year to date, total company operating margin is up 30 basis points, and we've driven incremental margin of 26%.
We've also maintained the guidance that we set on the Q4 call in January for total company gross profit margin, operating margin, and earnings per share. I wanna commend our team members for all the work they've done to strive during this environment. From my recent U.S. customer visits, it's clear that demand has slowed, but it's also clear that things are not falling off a cliff, and that we have great opportunities to continue to gain share. Earlier this month, I spent time with a large manufacturer in the Southeast. They have seen strong growth due to their ability to innovate. Our team members have built solid relationships with their leadership and operations staff and are delivering solutions that matter. This customer views Grainger as providing exceptional service for a part of their operation.
We have leveraged our KeepStock inventory management system to make it easy for this customer to have what they need when they need it. We only have a portion of this customer spend today. Because of our reliable partnership and our ability to deliver real value, we're exploring ways to expand our offer. This means finding ways for this customer to save more money by ensuring that they are using the right products at the right cost and managing usage and inventory effectively. When we do these things well, we gain share. I rarely visit a customer where the opportunity to create value and gain share is not significant. We do this across our business through two models. Through our high-touch solutions model, we provide relevant products and services to customers to drive efficiencies and to save them money.
Through our endless assortment model, we provide value through an expansive assortment that is easily accessed through a streamlined search experience. In these challenging times, we continue to focus on what matters. We're investing for growth in both business models. Our strong balance sheet allows us to invest in good times and bad, and we are rigorous in our expense management. We have already achieved roughly $200 million in savings the last two years and have expectations for continued productivity moving forward. With that, let's take a closer look at our performance in the U.S. in Q3. Similar to what we are seeing from economic indicators, we estimate that U.S. market growth decelerated from approximately 2% to 2.5% in Q1 and approximately 1% in Q2 to about flat in Q3. We are seeing softness across most end markets, including heavy manufacturing, natural resources, contractors, and in pocket site manufacturing.
We have seen some of our customers, particularly in heavy manufacturing and natural resources, slow production. The healthcare market remains quite strong, and we are seeing flat to modest growth in government and retail end markets. U.S. segment share gain accelerated sequentially in the third quarter with 250 basis points of outgrowth versus the market. U.S. large business grew 2% and 10% on a two-year stack, and U.S. midsize grew 5% and 23% on a two-year stack. Let me spend a few minutes providing an update on our U.S. growth initiatives, which we introduced in May of this year. As previously communicated, these initiatives fall into two buckets. The first are improvements to our foundation that ensure that we stay competitive. This includes improving the quality of our product and customer data, embedding our KeepStock offer, and enhancing the customer experience.
Second bucket of initiatives are incremental investments that contribute to our long-term goal of 300 to 400 basis points of growth above market. Our initiatives are beginning to take hold, as evidenced by our 250 basis points of share gain in the quarter. Our merchandising efforts are showing strong incremental revenue lift, driven by our comprehensive category review process. About half a billion dollars of product revenue has been re-merchandised and we're seeing good results. We expect to get through about a billion dollars for our assortment by year-end. Our return on these investments has steadily improved throughout the year, which has exceeded our expectations. We have made solid progress in improving the customer experience and have increased the effectiveness of our order to cash processes the beginning of this year.
Our customer feedback suggests that we provide the best experience in our space. We have re-energized our corporate account work and have seen improvements in share gain with this group of customers. Finally, we are on track to start receiving inbound shipments to our Louisville DC in the fourth quarter. We are encouraged by our ability to accelerate sequential share gain in the U.S., and we remain fully committed to 300-400 basis points of outgrowth versus the market on an ongoing basis. I also want to spend a few minutes on our growth initiatives at Zoro U.S. You've heard us talk about expanding the product assortment at Zoro. Our goal is to add 10 million items over the next three to five years. In the third quarter, we added about 350,000 SKUs, which brings us to 800,000 SKUs for the year.
These product adds are driving incremental revenue growth on a per-SKU basis that is similar to what we've seen historically at MonotaRO. Our investment in systems and people to help drive this growth are also going well. We launched a new marketing campaign in September, the results are promising, although early. We are optimistic about the trajectory of Zoro going forward. The bulk of our investments in this business will be completed by the end of this year, we expect strong growth and profitability moving forward. The natural tendency would be to cut back on these type of investments during a soft market. We are focused on long-term growth of our business and will continue to make prudent investments while driving productivity. I'll turn it over to Tom Okray, who will discuss the quarter's results in more detail.
Thanks, D.G. Looking at our total company adjusted results for the quarter, daily sales were up 2.5%. Volume grew 2.5%, both price and the impact of FX were flat to the prior year. Two of our businesses, AGI and Cromwell, are not only facing challenging end markets, but are also in the middle of turnarounds. Their results are adversely impacting the company's performance. For perspective, the U.S. segment and endless assortment businesses combined were up 4.5% in the quarter and 5% year-to-date versus the prior year. Moving to gross profit, our total company gross profit margin declined 80 basis points versus the prior year. The decline in gross profit margin was driven primarily by the timing of U.S. price adjustments during the year, which resulted in negative price cost spread in the U.S. in the third quarter.
Lower gross profit margin of our endless assortment businesses also contributed to the decline. Year to date, our total company gross profit margin is down 40 basis points versus the prior year. For the fourth quarter, we expect the company's gross profit margin to be higher than the third quarter. We drove operating earnings growth of 2% in the quarter. Our operating margin, however, declined 20 basis points versus the prior year, due primarily to the investments we're making to drive growth at Zoro. Excluding the investments in Zoro, SG&A leverage completely offset the gross profit margin decline in the quarter. As expected, SG&A grew at half the rate of sales. As an organization, we will continue to rigorously manage expenses while ensuring we're providing the absolute best experience for our customers. Year to date, operating margin has expanded 30 basis points, and we've driven incremental margin of 26%.
We are also focused on generating strong cash flow. While operating cash flow in the quarter decreased 8%, driven primarily by unfavorable timing of supplier payments, operating cash flow was up 3.5% year to date and close to 100% of reported net income. Year to date, we've returned $842 million to shareholders through $242 million in dividends and $600 million in share buybacks. We expect to continue to buy back shares in the fourth quarter. Let's turn to our performance in the U.S. The demand environment has slowed throughout the year, and the market was flat in the third quarter. Daily sales were up 2.5%, comprised of volume growth of 2.5%, flat price inflation, a 0.5% increase of intercompany sales to Zoro, and a 0.5% decline in specialty brands.
In the quarter, we grew 250 basis points faster than the market, driven by strong execution of our U.S. growth initiatives. U.S. gross profit margin declined 80 basis points in the quarter versus the prior year, driven primarily by product cost inflation outpacing price inflation, partially offset by favorability in the supply chain. At the beginning of 2019, we wanted to ensure that our pricing was sufficient to cover product cost increases related to tariffs and general inflation. In retrospect, we were a little too aggressive. To ensure that our pricing was market-based, we dialed pricing back in the second quarter. While third quarter gross profit margin was a little below our expectations, we estimate that gross profit margin will be higher in the fourth quarter than the third quarter. The results for the entire year will be consistent with the expectations set at the start of the year.
In an environment with uncertainty around tariffs and market demand, quarterly noise is commonplace. The year-to-date picture is often more useful in evaluating performance. For perspective, on a year-to-date basis, excluding the write-down of remaining contract negotiations, our price cost spread is favorable. We continue to effectively manage product cost inflation related to both tariffs and general inflation. In the quarter, both improved sequentially, and we expect that trend to continue in the fourth quarter. U.S. operating earnings increased 4% in the quarter. U.S. operating margin was flat versus the prior year, as lower gross profit margin was completely offset by SG&A leverage. SG&A was flat on sales growth of 4%. In Canada, daily sales declined 14.5% on a constant currency basis. Price inflation was 1% in the quarter and volume declined 15.5%. Volume remains the main issue in Canada.
While optimization of the cost structure is strong, it's taking time for us to stabilize top-line performance. Operating margin was positive in the third quarter for the first time in 2019, driven by improvement to gross profit margin and continued diligence on the SG&A line. Gross profit margin improved 50 basis points versus the prior year, largely due to supply chain efficiencies offsetting negative price cost spread. Moving to other businesses, which includes our endless assortment model and our international portfolio. Daily sales were up 9% in the third quarter on a constant currency basis due to revenue growth from our endless assortment model. Together, MonotaRO and Zoro daily sales grew 19.5% in the quarter. Gross profit margin for the other businesses declined 130 basis points, driven by promotional activities at Zoro and freight headwinds at both Zoro and MonotaRO.
Operating margin declined 220 basis points for the other businesses, primarily driven by long-term growth investments in Zoro U.S. and performance at Cromwell. As we've mentioned in the past, the Cromwell business is facing operational challenges while also experiencing a difficult economic climate. The business is taking action to improve service and the customer experience to drive top-line growth while also improving the cost structure. Page 14 covers our guidance for 2019. At the total company level, we are reiterating all of our guided metrics. At the segment level, we expect the U.S. segment and other businesses to be within their guided ranges. For AGI, we now expect to finish the year below the guided range. Now I'll turn it back to D.G. for closing remarks.
Thanks, Tom. Our performance so far this year has been solid, even in a slower growth environment and with the added uncertainty around tariffs. While AGI and Cromwell continue to be challenged, customer feedback is much better in both businesses. We have done a lot of work to get the cost structure and service right at AGI and Cromwell, and are well positioned to grow in the future. I was at Cromwell earlier this month, and even with the economic challenges, customers were pleased with our improved service, and we are exploring how to expand these relationships. We are happy with the growth of our endless assortment businesses and the progress we're seeing with our U.S. growth initiatives. We've driven strong incremental margin year to date and are maintaining our total company guidance. We are committed to delivering strong performance over the short term and long term.
Our performance expectations remain the following. We expect our initiatives in the U.S. to drive 300 to 400 basis points of outgrowth versus the market on an ongoing basis. We believe Canada is an attractive market for Grainger, and we will continue our work to drive profitable growth in that business. We expect to accelerate growth with our endless assortment model through the strength of MonotaRO in Japan and the investments we're making in Zoro U.S. Overall, we expected our strong SG&A leverage and operating margin improvement for the year, resulting in incremental margin of 20%-25%. Now we'll open it up for questions.
Thank you. We'll now be conducting a question and answer session. If you'd like to be placed into question queue, please press *1 on your telephone keypad. We ask that you please ask one question and one follow-up, then return to the queue. You may press *2 if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing *1. Once again, ladies and gentlemen, that's *1 to ask a question. We ask that you please ask one question and one follow-up, then return to the queue. One moment, please, while we poll for questions. Our first question today is coming from David Manthey from Baird. Your line is now live.
Thank you. Good morning. You mentioned the long-term goal of growing SG&A at half the rate of sales growth. You've obviously done a great job of that over the past several years. Clearly, that equation is a lot easier when you're growing 8% than when you're growing two, but you've actually done it in both environments. What I'm wondering is, as we go forward here, we're looking ahead to the next year or so. Do you have a specific plan in place that'll keep that expense leverage going? At some point, do we just see natural low single-digit inflation return to the cost stack in any case?
Thanks, Dave. I would say that we are constantly working on improving our expenses and our cost structure. We have built in an expectation that the functions in the business will cover things like merit going forward, and we're working through plans for next year right now, as you might guess. We feel pretty confident that we can continue to get cost productivity throughout the business, and we'll work hard to make sure that we continue to deliver the performance we've been delivering.
Okay, thanks. DG, when you said that you expect a return to strong profitability in the endless assortment business or something along those lines, improved profitability, I'm just wondering if you can help us define that. Historically, when you look at segment contribution margins following periods of investment, you've gotten as high as maybe the mid or higher teens. Is that what we should be thinking about for contribution margins in the other business segment going forward?
I would say that if you look at the online businesses, which are part of the other segment, our expectation is we will return Zoro to profitability, and we'll begin the migration over the next several years up to very strong profitability like we see in MonotaRO. I think, the MonotaRO P&L gives you a sense for where we hope to be able to get with the Zoro business. That's our objective, and it'll take several years to get there as we come out of these investments, but we're pretty confident we can continue to grow profit.
Thank you. Our next question today is coming from Ryan Merkel from William Blair. Your line is now live.
Hey, thanks. A couple of questions. First, I just want to clarify why gross margins are going to improve in the fourth quarter versus the third quarter. I apologize if I missed it.
Gross margins typically improve sequentially Q3 versus Q4. This year, Q4 versus Q3, they typically will improve. This quarter is going to be no different going into Q4. We are seeing general inflation and tariff inflation going down, and that's the main driver for the gross profit going up in Q4.
Got it. Okay. You mentioned a price adjustment in the second quarter. Can you just tell us how much did you lower prices, maybe on average, and was it broad-based across all the SKUs, or was it more targeted?
It was more targeted. Obviously, we're working on this on a continuous basis. As we said in the prepared remarks coming out to Q1, we thought we overshot a little bit, so we went back and really scrubbed. Some SKUs we raised, some SKUs we lowered. Overall, though, we lowered.
Got it. Okay. I'll pass it on. Thanks.
One other comment related to the first question on gross margin. We also expect some favorability in supply chain to help us out related to Q4. We see softening in the supply chain area, the transportation area. We expect that to also be a factor in Q4.
Thank you. Our next question is coming from Christopher Glynn from Oppenheimer. Your line is now live.
Hey, thanks. Good afternoon out there. A lot of emphasis on the 300-400 basis points of long-term sustainable outgrowth. I wanted to narrow that down into medium, get a little more detail on traction on your initiatives and prospects to kind of inflect that growth higher. I think last quarter you talked about things like assortment, sales coverage, and digital experience. Wondering how you're seeing those kind of discrete drivers kind of ramp on the ground level.
Yeah. Thanks, Chris. We continue to expect our mid-size customer growth and share gain to be higher than the overall U.S. share gain. We continue to see that. Given the way we cover and interact with customers, things like merchandising and marketing have an outsized impact. They impact all of our customers, but they have an outsized impact on the mid-size customers, and that has continued to play out. Our expectation is that we will continue to grow significantly faster in the next several years with mid-size customers than with the whole. The initiatives are playing out pretty much as expected at this point.
Okay. With Canada, I think you talked a little bit more about sales stabilization in prior quarters. Just wondering, where's the cross-section between the customer re-engagement you've talked about with stabilized service levels versus kind of softening macro up above?
I'd say that we have a number of our sales leaders in, and we interact with them frequently, and I've been talking to them and hearing from customer feedback. We are now having conversations and getting permission to grow with our customers, and it's been several years, frankly, since that's been the case. It feels like we're right at the precipice now of being able to start climbing again and grow based on the work we've done, and it's been a long haul, but we feel like we're having the right conversations now. We're a lot more confident now than we've been in several years.
Okay, thank you.
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. Hey, I know you're not in the giving of 2020 guidance yet, just could you talk qualitatively what you're expecting the U.S. MRO market to look like? One of the other big industrial distributors talked about flattish expectations for the first half. How do you think the operating environment for MRO will be? Related to that, what caused you to step up into that 300-400 basis points of outgrowth, and what might the timeframe be for that? Two-part question. Thanks.
Good. Thanks, Deane. I think, we don't have any crystal ball that's different than others are seeing. We are planning for a wide range of potential market growth outcomes for next year and building plans around a wide range. I think flattish is not a bad place to start, probably, but anybody's guess. That would not be certainly a wrong estimate at this point, but we are planning for a fairly wide range. We have a set of initiatives that we've talked about that we believe are starting to build to getting us to that 300-400 basis points. If you look at the quarter, on a volume basis, we were significantly higher than 300 basis points of growth, actually.
We are starting to get confident that we have the right initiatives in place to grow 300, 400 basis points, and the things we've been talking about with merchandising, marketing, adding sellers, corporate account growth, re-energizing things like our KeepStock program. We feel like we've got the right initiatives, and we're starting to get some of that traction right now.
Terrific. Just as a follow-up, is there any update on Gamut? Looks like that website is in transition. You talked a bit about how that might be happening, and then maybe some update on the improvement of the search capability, and the rollout there. Appreciate it. Thank you.
Gamut is no longer a customer-facing website. All those learnings have been built into the Grainger processes. We're building a new product information system that will be live in the fourth quarter. When we talk about remerchandising half a billion dollars so far this year, a lot of the insights from Gamut are actually in those remerchandising. If you look at the categories that we've gone through, you see a lot of the lessons there. We've effectively built what we've learned from Gamut into grainger.com. We continue to get improved feedback from customers, and that will only get better and better as we continue to build out more categories and improve the product information. We're pretty excited about the path we are on in terms of our search experience right now.
Thank you. Our next question is coming from Robert Barry from Buckingham Research. Your line is now live.
Hey, everyone. Good morning.
Morning, Ryan.
Just a quick follow-up on Ryan's question. I think, Tom, you mentioned seeing inflation going down. Was that just a comment on freight, or was that broader comment?
It's broader. I mean, sequentially, if you look at what we've experienced in Q3 versus Q2, we saw both tariff-related inflation and general inflation go down. We expect that to continue in Q4 as well.
Okay. Do you expect to be price-cost positive in 4Q?
Didn't say that. We'll come back to what we said for the entire year. We expect to be price-cost neutral, excluding our pricing write-downs that we've done.
Got it. It just seems a little counterintuitive because the tariff headwinds seem to be growing.
Actually, if you look at the tariffs, how we've experienced them throughout the year, they've been fairly constant, and now that we're starting to lap some of the tariffs, we're seeing improvement there. The other thing is you have to reconcile between stated tariffs and what we're actually able to negotiate in terms of realized tariffs. We've got two buckets we work on. One is our own imported parts, which come largely from China, which are impacted directly, and the other one is our national brands, which we work with our supplier partners. Stated versus actually realized is a factor as well.
Got it. Just lastly, so does that mean in that context, maybe seeing price at zero is less of a concern to you, given you've been able to negotiate some of this deflation?
I think what I would say is where we're at in terms of our share growth objectives and our share growth initiatives, seeing flat pricing for the quarter doesn't get us overly exercised. As D.G. mentioned, from a volume basis, we grew share quite a bit, and at this point where we're trying to get traction on our share gain initiatives, that doesn't concern us that one quarter we're priced flat. If you look at the entire year, we're price cost neutral when you adjust for the reset from the strategic write-downs, and we're happy with that. It's what our objective was at the beginning of the year.
Thank you. Our next question today is coming from Joshua Pokrzywinski from Morgan Stanley. Your line is now live.
Hi, good morning, guys.
Morning.
Just want to follow up, given that we're now fully past the price reset, just any observation with some of those customers, what percentage have kind of converted to being more core customers versus those who were maybe transactional during the process? I would imagine you got a better grasp on that today than maybe you did six or 12 months ago. How satisfied are you with that? I guess, we'll just leave that as the first question.
Josh, I will answer the question and interpret it. Tell me if I'm not answering correctly. We tend to look at, with our large customers for sure, we had a lot of relationships that were not transactional relationships before. We still have a lot of those, and we've expanded some of those. I think the biggest shift has been with mid-size customers, where we now have a whole lot more mid-size customers who are buying frequently based on the price reset. The price reset was largely to make sure we were growing across the entire customer base consistently. We have liked the results we've seen with mid-size customers. We still have a long way to go to acquire and turn many of those customers into regular purchasing customers. We have made great progress with mid-sized customers.
Got it. Yeah, that was a mid-size customer question.
Okay.
Definitely.
I see where you're coming from. Sure. Yeah.
Right, yeah. Large wouldn't make as much sense. Then I guess on the price cost dynamic from here, is there anything that happens as a function of the calendar in terms of customers kind of reevaluating the start of year where the progression kind of post 4Q inflex or deflex one way or another? I think from a cost perspective there's probably equal measures deflation and inflation, but probably a bit more deflation on the inputs. Just trying to understand how that conversation evolves over time on the pricing front and if there's anything that changes with the calendar flip.
Well, we have a long history of working with our customers, a lot of our contract customers to lock in prices at the beginning of the year. We go through a process that we are going through now to make sure we've got the right competitive prices and that process always happens. There's always a sort of beginning of the year reset that happens and you see that in our results historically and that will be the same this year.
Thank you. Our next question today is coming from John Inch from Gordon Haskett. Your line is now live.
Hi, good morning. It's Caroline dialing in for John. I just want to clarify on the 3Q gross margin dynamic. It sounded like, given you said price inflation has sequentially come down, essentially all of that gross margin degradation is coming from product pricing. I guess part of it, maybe you can confirm that the 5% of large accounts that still needs to get price adjusted and is that done over the quarter? Is the rest of the pricing degradation coming from more broad-based pricing adjustments?
Yes, it's largely done. We'll see a little bit in Q4. We won't have any in 2020.
Okay. Yeah, it just sounds like, I guess given the magnitude of the pricing and gross margin decrease, more of that has to do with a broader-based pricing adjustment. Maybe just follow up on that point. I guess you guys have adjusted pricing since the start of the year, I guess a couple of times. As you go through this exercise, are you seeing sequentially similar, well, I guess the ideal volume response that you would hope for? As you go through these pricing exercises, are you starting to see throughout the year like a bit of a more diminishing return?
No, I think we're seeing good pricing response. Again, I'll go back to we see a flat MRO market in the third quarter. Included in that flat market is a little over 1% in price offset by a little bit over 1% in volume deterioration. We were up 2.5%. That puts us well above 350 bps. There's also some weather issues related to the hurricanes last year that we didn't put in our prepared remarks and some government lapping differences. Yeah, if you look at that, we're very happy with our volume response.
Yeah, I would just add that if you think about some of the pricing dynamic, Tom talked about this. We talked about being price cost neutral before the reset for the year. We are effectively where we expect to be in aggregate, and we are careful. We make pricing changes all the time, but we're very careful not to disrupt customers with large customers, particularly with changing prices around. We are a little bit more careful with how many times we change with large customers. Overall, we've seen the exact response we expected this year.
Thank you. Our next question today is coming from Adam Uhlman from Cleveland Research Company. Your line is now live.
Hey, good morning, guys.
Morning.
Morning.
I had a few questions on Zoro. I guess when should we expect the incremental investment spend to wrap up? Are we fully lapping that as we head into the first quarter and should expect profitability to recover there early in the year? Is this going to take a little bit more time than?
We expect profitability to recover some in the first quarter. We did start investing pretty heavily in the first quarter of this year. Profitability will grow from there. We will get some improvement in the first quarter is our expectation.
Okay. Of the 800,000 SKUs that have been added so far this year, and as we add some more going forward, I'm just wondering if you could comment about if the gross margin profile of the business is changing, how you look at the categories that you're adding in? Is that more of a build-out of the existing one, or are there new product categories that are getting you into higher or lower margin categories?
Yeah. I think that we are, first of all, adding a whole bunch of categories that we haven't had before. There's a mix of adding new categories and expanding the offering existing categories. In general, we are creating a fairly distinct value proposition for Zoro, and Zoro will become less reliant on the Grainger supply chain moving forward. Most of those products will be drop shipped. For the financials, the GP is lower when you have drop shipped items, so is the expense. You'll see that impact the GP slightly over time. We expect most of those items that we're adding, if we talk about $10 million over the next 3-5 years, we expect most of those items to be third-party shipped. We're not going to be stocking most of those at Grainger.
Thank you. Our next question today is coming from Chris Dankert from Longbow Research. Your line is now live.
Hi, thanks for taking my question. You guys have given some really great color on gross margin. I guess, moving down to SG&A, typically, we see a bit of a step up into the fourth quarter here, but your reiteration of the guidance suggests maybe you can hold that flat into the fourth quarter. Is that the right way to be thinking about SG&A, and just maybe you can highlight some of the puts and takes that are in that line?
I think you're thinking about it the right way. Year to date, on a total company level, we're 70 basis points favorable for SG&A. We expect that percentage to increase for the entire year. We do have a favorable lap related to variable compensation, in addition to just a number of other cost productivity ideas and implementation that'll hit in Q4.
Got it. Thank you. Then thinking about some of the rollback of the investment in the other business in Zoro and MonotaRO. I think you guys had called out rolling back the vast majority of that into 2020. Is that still the plan?
Yeah, that's still the plan, Chris. If you think about it, a number of the investments have been system investments. We're going live with a new product information system, for example. We get through those this year, and those do not repeat next year. We have most of the investments behind us. We have added people, analytics talent, marketing talent that will remain, obviously. A lot of the investments are one-timers that they're going to be gone this year.
Yeah.
As you saw in the charts, we're really happy with the sales growth of both Zoro and MonotaRO. MonotaRO on a constant local currency basis was up over 23%, and Zoro was up big double digits. Very happy with that.
Thank you. Our next question today is coming from Justin Bergner from G.research. Your line is now live.
Good morning, D.G. Good morning, Tom.
Morning.
Just quickly on Zoro, did I hear you say earlier in the call that Zoro is currently running unprofitable, below breakeven?
No, they actually made money in the quarter, just not as much as they will make on an ongoing run rate basis.
Okay. Is any of the investment price investment, or is this all mainly on the SG&A side?
It's both. There are promotional spending, which we're undertaking when we're adding new SKUs and going into new verticals.
Okay.
On a dollar basis, most of it is expense.
Sure
as opposed to the GP price investment.
Okay, great. My other question was just around the, I guess, price action you took that affected price cost in the third quarter. Was that price action taken in the second quarter such that you kind of expected the results that you ended up just reporting, or was some of that taken in the third quarter, and was that all sort of to correct for some of the pricing you took in the earlier part of the year, or was some of that more in response to current market conditions?
It was taken in the second quarter.
Thank you. Our next question today is coming from Nigel Coe from Wolfe Research. Your line is now live.
Thanks. Good morning. I wanted to just come back to the gross margin sequential guidance you gave. Certainly, when you go back in history, there's a very profound seasonal uplift in 4Q. Can you just remind us, though, what drives that? Is this a mixed impact? Because normally revenues are slightly down. Just curious what drives that. The second part of that question is, with the tariffs, List 3, 25% rolled in from May onwards and then List 4 from September. I think you talked about 10% of your U.S. sales, List 3, 10% List 4. I'm just curious why we're not seeing some inflationary pressures coming from tariffs and perhaps that's offset by other deflationary impacts. Maybe just address that as well, please.
Okay. Well, let me take the first one, and I might have to get you to repeat the second one. It was breaking up on our phone here. There are many levers that we can pull in terms of gross margin for Q4. Why it historically goes up? Traditionally, I think what we've seen is we've seen cost inflation work its way down throughout the year, and we have better opportunities in terms of related to pricing terms, in terms of vendor rebates, customer support, those types of things, which are quarter-end settlements. We count those as cost, obviously. Our pricing environment is fairly static throughout the year, as DG mentioned, with the big pricing happening throughout the year. The main driver in Q4 is really our vendor volume rebates and our customer rebate settlements that we have in Q4.
If I could get you to repeat the second question, please.
Yeah. It's really just about the impact of the tariff. The step up from 10% to 25% on the list three tariff, which was effective early May, and then list four, which was, I think, September. I think you previously disclosed that 10% of your U.S. sales are list three, 10% are list four. I'm just wondering why we're not facing some inflationary pressures, going into Q4 that would need to be offset with price.
Well, we've got part one and part two, which arguably are a lower amount of our COGS, which are lapping in Q4, so we'll see less of an impact there. Q3, you're right, is moving from 10% to 25%, or did move from 10% to 25% in May. Again, I will take you back to the actual stated tariff number versus the realized. We are experiencing much less than the stated tariff number on an actual basis. It's hard to just look at what's stated and look at the actual results. You really have to focus on the actual realized results. Our team's doing a very good job of working with our supplier partners to mitigate those increases.
Okay. I'll leave it there. Thank you very much.
Thank you. Our next question today is coming from Patrick Baumann from JPMorgan. Your line is now live.
Hi, D.G. Hi, Tom. Thanks for taking my question. On the Zoro business, if you could put a finer point on, you said it's making money. Is it making money this year? Is it kind of like a mid-single digit type operating margin? I know MonotaRO is in the low double digits. Want to have a better sense of what the runway is there over the next several years, what the base is this year.
Yeah, we're not going to go into specific breakout of Zoro. Let's leave it at it's making a small amount of money this year.
Okay. Fair enough. How should we think about the Louisville facility coming online in the fourth quarter here and then into next year, both from, I guess, or what are your expectations for it, I guess, from a market outgrowth or cost perspective? I know you mentioned supply chain favorability that you expect in the fourth quarter. I don't know if that's part of it or if that's something else. Just curious any color on that.
Yeah, I think I would answer that two ways. One is long-term. The Louisville facility provides capacity and helpful capacity in a couple of ways. The first thing it does is it allows us to stock probably 200,000 more items in the network because it's a very good backup for Chicago, Greenville, New Jersey, and even Dallas to some degree. It allows us to stock more items and have more breadth, which provides better customer experience. Typically that does drive growth. The other thing it does is it's next to the Worldport, it gives you overnight capability for tail items, slow-moving items in the network to get to customers who need them, that's a service that we will offer to our customers. We are working through exactly how to bring the building up. We're starting to receive in the fourth quarter.
We'll talk more about that at the end of the fourth quarter in terms of what we're using the building for exactly next year and how we're bringing that building up. It's huge, and it's going to take a couple of years to get to full capacity for sure. We're going to leverage that building to provide better service to customers next year, and improve our cost structure a bit as well. We'll talk about that at the end of the year.
Thank you. Our next question is coming from Michael McGinn from Wells Fargo. Your line is now live.
Thanks a lot for the time. I could switch gears to more of a long-term fundamental question regarding the endless assortment model. Having visited your new New Jersey D.C., there was a distinct concerted effort on what shows up in a red box versus what shows up in a blue box. Just wondering, long-term, what kind of thresholds are you putting on the third-party market to maintain branding? Are they going to get national account freight pricing? How does that feed into your supplier rebate discussions longer term? You could just answer those quick questions, it'd be great.
As we build out the endless assortment, we will have partners that provide distinct Zoro branding. Whether or not it's in a blue box or a label is probably up for discussion at this point still. The idea is we will make sure we retain the Zoro branding. Zoro will have more ownership for its own space. It will still leverage freight contracts that we have at Grainger. It will leverage some things at Grainger, but in general, it will be more independent, the value proposition will be independent, and the business will be more independent.
The growth of that business, does that feed into the general Grainger supplier rebate conversation, or is that something separate?
For stuff that we stock jointly, it definitely will. For stuff that we don't, it will not.
Thank you. We've reached the end of our question and answer session. I'd like to turn the floor back over to D.G. Macpherson for any further closing comments.
Terrific. Thanks for joining us this morning. I'll just reiterate what we feel are really important about our expectations moving forward. In our U.S. business, we feel that scale really, really matters, and gaining share is incredibly important. Our expectation is that we are gonna grow revenue 300 to 400 basis points faster than the market. We feel like we have a great opportunity to do that with relatively stable gross profit and continuing leverage on the SG&A line going forward. In Canada, we have improved the customer experience. We are reengaging customers in a positive way. If we can get volume back into the business, which is our entire focus right now, we're going to be in a place to drive profitable growth. We're excited about the endless assortment model, the investments we're making into Zoro, excited about the growth path there.
We feel really, really good about a lot of the initiatives we have and the customer experience we're providing. Appreciate the time today, and look forward to talking to you soon. Thank you.
Thank you. That does conclude today's teleconference. You may disconnect your line at this time, and have a wonderful day. We thank you for your participation today.