Welcome to the W.W. Grainger Q2 2019 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. Please note this conference is being recorded. I will now turn the conference over to our host, Irene Holman, Vice President of Investor Relations. Thank you. You may begin.
Good morning. Welcome to Grainger's Q2 earnings call. With me are D.G. Macpherson, Chairman and CEO, and Tom 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 Q2 press release, which is available on the IR website. Reported results in the Q2 included a $3 million benefit to operating earnings and a $0.03 benefit to EPS, primarily related to a reduction in lease obligations in Canada. This morning's call will focus on adjusted results, which exclude items outlined in our press release.
Please also note within our comments, we have removed the variable timing impact of the North American sales meeting from gross profit margin and operating margin. The sales meeting had a positive 20 basis point impact on total company gross profit margin and operating margin, and a positive 25 basis point impact on U.S. gross profit margin and operating margin. I'll turn it over to D.G.
Thanks, Irene. Good morning, and thank you all for joining us today. I'm gonna discuss our first half and Q2 results and share an overview of what we're doing to drive growth in the U.S. and through our endless assortment model. Tom will provide details on the quarter, and we'll open it up for questions. The demand environment has softened throughout the year. Having said that, our strategy is grounded in having a value proposition that resonates through economic cycles.
Through our high-touch solutions model, we provide services and products to customers that help save them money. We help them consolidate MRO spend, we manage their inventory, we provide solutions to simplify their purchasing process, we offer product substitution recommendations, we enable standardization across sites, and we help them keep their operations running and their people safe.
In times of slower growth, we partner with our customers to lower their costs, which strengthens our relationships. We're confident in our ability to gain share in both up and down cycles with this model. With our Endless Assortment Model, customers value our streamlined search experience and expansive assortment. We're investing for growth through this model and are bullish on the path ahead.
Turning to our performance so far this year, we delivered strong operating results in the first half of 2019, despite a slower global economy and significant investment in our Endless Assortment Model. Year-to-date total company operating margin was 13%, up 50 basis points, and we've driven incremental margin of 42%. Operating cash flow through the first half of 2019 is up 14%.
We're through much of the heavy lifting on our cost take-out initiatives and are now focused squarely on driving profitable growth through our U.S. and endless assortment businesses. At AGI, the top-line recovery has been slower than we anticipated. We made multiple changes in a short amount of time that caused disruption to our customer base, and we've seen more volume loss than we expected. Revenue dollars were stable from the Q1 to the Q2 .
Service is now once again strong, and we've started to win new business for the first time in a couple of years. We expect to see better performance in the second half of 2019. At Cromwell, we have made many changes to position the business for growth. We redesigned the distribution center and launched Zoro UK, leveraging the Cromwell supply chain.
Performance has lagged in the short term resulting from market conditions and our actions in the region. Performance at Zoro UK has been very strong. We remain committed to this market. Our 2019 total company outlook remains the same for gross profit margins, operating margin, and EPS based on our strong operating performance so far this year.
We are lowering our estimate for market growth to -1% to 2% and lowering our revenue guidance to 2%-5% growth due to the weaker demand environment and performance at AGI and Cromwell. Moving to the quarterly sales performance in the U.S., the U.S. MRO market growth decelerated from 2%-2.5% in Q1 to approximately 1% in Q2. We estimate U.S. market growth included about one point in price. As a reminder, these are internal estimates of market growth.
The factors that determine market growth are finalized over the next 60 days. We expect the slow market growth to continue in the second half of 2019. In the quarter, market growth slowed across all of our end markets, with the exception of healthcare. The core Grainger business grew about 150 basis points faster than the market. U.S. large customer daily sales growth was 2% and 11% on a two-year stack. U.S. mid-sized customer growth was 5% and 25% on a two-year stack.
We got off to a slower start in the first half of the year for two reasons. First, as we've noted, we've seen a meaningful decline in the U.S. market growth from 2018. Second, we've implemented new initiatives to drive growth in 2019 and beyond, and these activities take time to yield results. 1 example of this is our merchandising initiatives.
We've completely revamped our category review process to include the voice of the customer more to ensure that we have the right assortment and that it is presented in the right way to our customers. This will lead to strategic product ads and improved product presentation. To date, we've implemented this approach on a small portion of our assortment, and the early results are very promising.
We expect to be through about $1 billion worth of the assortment in the second half of the year and to accelerate these changes in 2020. We are confident in our ability to accelerate our share gain in the remainder of the year.
Our updated sales guidance for 2019 implies U.S. share gain of about 300 basis points in the second half, and we are fully committed to 300 to 400 basis points of outgrowth versus the market on average over the next several years. Let me spend a few minutes discussing our U.S. growth initiatives in the context of our value proposition.
While we are in the early innings of these initiatives, which I first shared in May, we are encouraged by the results and remain committed to their implementation to drive the business forward. We generally think about them in 2 buckets. The first are improvements to our foundation that ensure that we stay competitive, and the second are incremental investments that contribute to our long-term goal of 300 to 400 basis points of growth above market.
In terms of what we call advantaged MRO solutions, we are investing in our foundation to allow us to offer better solutions for our customers. We are improving our product and customer information and building new data platforms so that we can suggest more relevant solutions online, over the phone, at the branch, and through our sellers. We expect to start reaping the benefit of these efforts in early 2020. We are also investing in our website to make the search process easier.
Feedback from our customers is positive and improving, and we will continue to make enhancements to our website throughout the back half of 2019. To accelerate our growth, we are making incremental investments in marketing and merchandising. I've already talked about our merchandising initiatives. Our marketing investments are focused on both digital and media.
This spend is spread evenly throughout 2019, we're seeing strong returns from these efforts. Moving to our second pillar, differentiating sales and services. From a foundation perspective, we are investing to refine our customer relationship management processes, increasing our efforts to serve specific markets more effectively, and improving salesforce effectiveness. In terms of inventory management, we've done some heavy lifting to realign our offer to drive profitability.
KeepStock, which is the core piece of this offer, is now profitable and ready to drive growth. Sales through this service represent 10% of net revenue in 2018, total sales of these customers represent about 30% of U.S. revenue. Over the long term, we expect sales through KeepStock to grow much faster than the overall business.
From an incremental perspective, we are expanding our service offering, which includes partnering with suppliers and utilizing our safety and other technical experts to help customers manage total costs and keep their facilities up and running and their people safe. We're also looking at targeted expansion of our sales force where it makes sense. We're planning to strategically add sellers to address changes in how customers buy and to be more relevant in select segments.
With corporate accounts, we have been very focused the last two years on communications around the price changes. We are now in a position to deepen those relationships to drive significant growth. These relationships stretch from the plant floor to the C-suite, and we have a significant opportunity to gain share with these customers based on the service and the capabilities that we can provide. Our last pillar is unparalleled customer service.
Our first priority is always to deliver a seamless customer experience. We are known for this in the market and are focused on retaining this advantage through our order-to-cash work. We have implemented a number of initiatives in the past year that have resulted in an improved customer experience. Our metrics have improved, and customer feedback is at an all-time best and getting better.
In terms of fulfillment, we now have 600,000 products stocked in the U.S. It's very likely that when a customer places an order, we will have the products available for delivery next day and all in one box. We are adding capacity and capability with the addition of our distribution center in Louisville, which we expect to go online in early 2020.
Louisville will have the most capacity in our network and will enable us to stock up to 800,000 SKUs in the U.S. with potential for more. When we add stock to items, we tend to see significant lift in revenue. Historically, outside of the pricing reset, we've had anywhere from slightly negative share gain to up to 300 basis points.
When we've had a share gain on the higher end, it's been by adding customer touches or products. The initiatives I've shared do both. Increased marketing, improved product assortment and navigation, expanded services and sales force additions, and the opening of our Louisville DC is expected to allow us to grow 300-400 basis points faster than the market over the midterm.
I also want to spend a few minutes on the investments we're making in Zoro US to drive long-term profitable growth. You've heard us talk about expanding the product assortment. We plan to add 1 million new items to the Zoro assortment this year. We've already added 400,000. Overall, we plan to add 10 million items over the next three to five years. The product adds are driving revenue growth similar to what we've seen historically at MonotaRO.
Our investments in systems and people to help drive this growth are also going well. We are going live with the new product information management system for Zoro this year, which will allow Zoro to add products at their own pace and to become less reliant on Grainger's supply chain. We're also improving our analytics platform, which will help us better market our assortment to customers online.
We are investing in Zoro for success. We expect the bulk of the infrastructure investments to be complete this year. We are optimistic on the trajectory of this business going forward. Now I'll turn it over to Tom, who will discuss the quarter's results in more detail.
Thanks, D.G. Macpherson. Looking at our total company adjusted results for the quarter, sales were up 1% daily and up 2% on a constant currency basis. Volume was up 1.5% and price was up 0.5%. Year-to-date, price is up 1%. For perspective, our U.S. and endless assortment businesses, which represent approximately 90% of total revenue, were up 5%, but were offset by headwinds at AGI and Cromwell.
Moving to gross profit, our GP rate declined 35 basis points. The decline in GP rate versus the prior year was primarily driven by the other businesses. We drove operating earnings growth of 5% in the quarter. Our operating margin grew 30 basis points versus the prior year due to gross margin in the U.S., our cost takeout initiatives at AGI, and cost discipline in the U.S. and at the corporate level.
For the quarter, we generated incremental margin of 39%. Operating cash flow was $323 million in the Q2 of 2019, up 30%, driven by better operating earnings and favorable working capital versus the prior year period. Now let's look at our performance in the U.S. As DG mentioned, the demand environment slowed sequentially from Q1 to Q2. Daily sales were up 2%, composed of volume growth of 1.5% and price inflation of 0.5%.
Intercompany sales to Zoro contributed 0.5%, which were completely offset by the decline in specialty brands. Our GP rate increased 10 basis points. Excluding the remaining contract implementations, price-cost spread was neutral. Gross profit margin also included a benefit from supply chain costs, primarily related to freight and inventory optimization and positive mix.
With respect to the remaining contract implementation, we are on track to complete this work in 2019, with only 5% remaining. In the quarter, we passed through a majority of tariff and non-tariff related cost inflation while ensuring that our pricing was market-based. We still expect price cost to be neutral for the year, excluding the remaining contract implementations, and we've taken the following approach to mitigate any headwinds associated with price cost.
With price, one of the main objectives of the reset was to ensure our pricing was market competitive. We can move web price fluidly throughout the year to ensure that we are priced appropriately. With contract customers, we can adjust price a few times during the year, and we manage these relationships in terms of total cost ownership to ensure that customers are getting the most value.
On the cost side, we've been very happy with our ability to navigate the tariff environment. As a reminder, we have a cross-functional team that meets regularly and has worked to minimize the impact. You may recall we originally expected about 2% COGS inflation related to tariffs. Our actual exposure through working with our supplier partners has proven to be much less.
More specifically, we've leveraged our scale and maintained strong relationships with our suppliers, allowing us to better predict and manage cost headwinds. We continuously evaluate our product portfolio to ensure we have the best product at the best cost, which includes optimizing sources of supply. Moving to operating earnings. Operating margin was up 60 basis points in the U.S. SG&A was flat on sales growth of 2%.
Our continued cost discipline has enabled us to maintain SG&A while growing revenue. We remain fully committed to growing SG&A at half the rate of sales on an ongoing basis. In Canada, daily sales were down 23% and down 20% on a constant currency basis. Price was up 3% and volume was down 23%. Volume decline primarily resulted from the customer disruptions related to the turnaround activities we took last year.
Gross profit margin was down 150 basis points in the quarter due to negative price-cost spread. While we were able to pass through price in the quarter, cost was unfavorable due primarily to lower vendor rebates on softer volume and the foreign exchange impact of U.S.-denominated product purchases. SG&A was down 26% versus the prior year, driven by the cost takeout initiative.
Operating margin was down 30 basis points in the quarter, reflecting lower gross profit margin, partially offset by favorable SG&A rate. We expect performance in Canada to improve in the second half of the year. Late in the quarter, we saw encouraging data showing that service levels and web sales were improving. As DG mentioned, daily sales were flat from Q1 to Q2, indicating signs of stabilization on the top line.
Recall that most of the significant volume decline associated with the turnaround actions occurred in the second half of 2018. Therefore, we will have easier top-line comparisons in the second half of 2019. Moving on to other businesses. As a reminder, other businesses include our endless assortment model and our international portfolio.
Daily sales were up 6.5% in the Q2 and up 9.5% on a constant currency basis due to strong revenue from our endless assortment model. MonotaRO continues to grow significantly, and we're making good progress with our growth initiatives at Zoro. Gross profit margin for the other businesses declined 220 basis points, driven by promotional activities at Zoro, unfavorable customer mix at Cromwell, and freight headwinds in Japan.
Operating margin declined 290 basis points for the other businesses, primarily driven by investments in Zoro US to drive long-term growth and performance at Cromwell. Page 15 covers our guidance for 2019. At the total company level, we are reiterating our gross profit margin, operating margin, and EPS guidance for the year.
Our U.S. segment operating performance is strong and is more than offsetting slower performance at AGI and Cromwell. We expect U.S. segment operating margin to be at the high end of the guidance range, while AGI is expected to be towards the low end of the range.
For other businesses, we are updating our operating margin guidance from 6%-8% to 4%-6% due primarily to performance at Cromwell. Moving to our sales expectations. Our view of the MRO market has also changed from April. Instead of 1%-4% growth, we now expect -1% to +2% market growth for 2019.
Due to the slower demand environment, uncertain economic conditions, the early stages of our U.S. growth initiatives, and performance at both AGI and Cromwell, we are lowering our top-line guidance from 4%- 8.5% to 2%- 5%. Now I'll turn it back to DG for closing remarks.
Thanks, Tom. I would like to close by reminding you of our long-term performance expectations. We expect our initiatives in the U.S. to allow us to grow revenue 300-400 basis points faster than the market on average over the next several years. We believe Canada is an attractive market for Grainger to be in. It can grow faster than the market and be a double-digit operating margin business over the next five years.
We expect continued strong 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 expect to drive strong SG&A leverage and continued operating margin improvement resulting from incremental margin of 20%-25%. Now I will open up for questions.
Thank you. At this time, we will be conducting a question-and-answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate that your line is in the question queue. You may press star two if you would like to remove your question from the queue. Please limit yourself to one question and one follow-up question.
For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Our first question comes from David Manthey with Baird. Please state your question.
Oh, hi. Thank you. Good morning. Initially, you were targeting double-digit growth within the U.S. medium customer set, and now we're down to sort of a mid-single-digit growth rate this quarter. You mentioned the fluidity of pricing. I'm just wondering if there's anything you can talk about there as it relates to price refinements to try to reaccelerate the medium customer growth that you've made recently or you plan to make.
Thanks. Thanks, David. We still believe that we can grow mid-sized customers much faster than the market. We will need to grow them faster than 300 to 400 basis points faster than the market to be able to hit our overall targets. You know, we have some good signs with our mid-sized customers. I would say that covered customers have continued to grow very strongly, which is a signal that the customers we’ve acquired are actually repeating at very strong rates, which is great to see. We feel like we have some efforts and initiatives going on with merchandising and marketing that can help us accelerate growth.
You know, I would point out that it's pretty new to us to be through the pricing changes and focusing on mid-sized customers, so we're learning every day what's working and what's not. We're gonna know more as we go forward, but we still feel confident we can really grow significantly with that customer group, and it's important for the overall economics of the company.
Okay. Then as it relates to the reduction in the revenue outlook, I would assume that has more to do with your outlook for U.S. market growth just based on % than international or internal disruption. If you run the numbers based on the full-year guidance, to some extent, it might imply flat to lower growth in the market in the second half of this year. I am just wondering your thoughts on how severe this slowdown might be, and is there a recession in your forecasting right now?
Great question, one we've talked about a lot. You know, I would say we're certainly not gonna forecast a recession. And what we've seen in the market in the U.S. has been slow growth but pretty stable the last several months. We don't see anything that implies that we are heading off a cliff in the U.S. Obviously, internationally, there's, you know, pockets that are more problematic than others. In general, we're not forecasting negative necessarily. We think it's a possibility, but probably not a probability at this point.
Got it. Thanks, D.G.
Thank you.
Our next question comes from Robert Barry with Buckingham Research Group. Please state your question.
Yeah. Hey, guys. Good morning.
Morning.
I just wanted to circle back on the price. I mean, I think the price slowed from 1.5 in the Q1 to 0.5 in 2Q. I think the tariff headwinds are kind of moving in the other direction. I'm just curious how you're thinking about kind of tariffs and other inflation and how price might track over the next couple of quarters kind of vis-a-vis what's happening with tariffs and inflation.
I mean, I would say that Thanks, Robert. I would say that, you know, the tariff environment's still a significant uncertainty. We'll see what happens in the next couple of months in terms of either resolving it or not. You know, our philosophy is to make sure that we are priced to the market. We will continue to make sure we are priced competitively to be able to serve our customers well. You know, we will take actions to make sure we look at it every day basically to make sure we're priced within it at the appropriate range. That's really our philosophy, and that's what we'll focus on.
There's some uncertainty as to whether or not the tariffs are gonna come through in a bigger way, in which case price may go up or not. Our focus is really on making sure we're market competitive in terms of pricing.
Got it. I mean, just to clarify a couple things. I mean, since the List three did move up, I mean, is that going to be a bigger headwind for you in the back half? If you're pricing the market, does the fact that the pricing moderated at Grainger mean that what you're seeing in the market, I guess, is too, like, customers are not getting as much price?
Yeah. We've been planning for the List three change for quite some time. The way we've got it modeled is it's relatively small. As we said in the prepared remarks, we've been able to realize substantially less than the overall exposure. We don't believe that the change in List 3 is going to be that material for us.
Got it. Got it. Could I just clarify one more thing? When you're talking about getting the outgrowth from what was, I think, a point in 2Q to 3 points in the second half, is it all these items on slide eight that you think are driving it? Are they all just adding, like, 20 or 30 basis points, or is there one or two of them that's gonna, like, drive the lion's share of the acceleration?
Yeah, thanks for asking that. You know, we will provide more detail going forward on how much we expect each to provide. I will say that this is a pretty big shift for us and mindset shift in the sense that we've tracked market share in the past, but we've never targeted market share growth, and we've never had a set of initiatives that we are expecting to align to that growth, at least not explicitly. We do plan to become more explicit over time. You know, I gave the example of merchandising in the prepared remarks, which I think is a good one, where, you know, this is a little bit new to us.
We are having to break down some barriers to execute faster and move faster on some things, and we're seeing good results. We do expect that momentum to continue to build. We'll provide more of the specific details, but know that, yeah, that page 8 is pretty important for us right now, I would say.
All right. Thank you.
Our next question comes from Christopher Glynn with Oppenheimer. Please state your question.
Yeah, thanks. Just had a couple questions about the endless assortment strategy there. You know, with the incremental investment you're putting in this year, is that investment in the cost base, or does it tail off next year? What are you thinking about timeframe for that business to be standalone capable?
Let me get to the last one second. Most of the investment that we're making in terms of getting platform and platform independence we should be through that by the end of this year. We expect some of the costs we've added in terms of analytics and people to stay, but a lot of the cost will fall off next year as well. In terms of standalone, it'll come in pieces.
One of the biggest things we're doing is developing the capability for that business to add their own items and to add items from third-party shippers, which will make that business less reliant on Grainger. Obviously, for the core Grainger items, Grainger will still fulfill.
That business will become less directly reliant on the Grainger supply chain over time. We're going to implement that system in the Q3 . By the end of the year, we should have that capability. Similarly, the data analytics platform should be complete by the end of the year. A lot of this should really be through this year in terms of giving that business more independence, and that's really what we're targeting.
Okay. Just to follow up on the medium, if you go a little deeper into what you're seeing in terms of customer retention versus the pay positions and, you know, overall, how is the base holding on from the initial burst of growth there?
The base is holding on quite well. As I mentioned, we've taken a portion of that base. About half of the midsize customers are now in some sort of coverage model, and that has continued to grow, you know, at a pretty good clip. The base has held on pretty well, and we are acquiring customers as well. Certainly we're happy with what we see with the base.
Thank you.
Thank you.
Our next question comes from Deane Dray with RBC Capital Markets. Please state your question.
Thank you. Good morning, everyone.
Morning.
Hey, it was really interesting about what you did not say in your prepared remarks or in your slides. There was no comment about weather, and we've seen all kinds of pressures on your peers, and you had to have felt some of the same pressures because this was it's always an important HVAC opportunity for, you know, filters and refreshing refrigerants and so forth. It didn't seem to impact you, and maybe you can clarify what sort of pressures you did see or did not see.
Yeah, I mean, you know, certainly the weather was not helpful. It was a very small impact to us. It's less than half a % impact. We didn't call it out as a separate item.
Good. Appreciate that. Just to clarify and just make sure I'm clear on this, when you cut the sales high end of the guidance, you've cut that more than what the market growth cut on the high end. 3.5 points on the on your sales high end. Why are you cutting that more? Is that all Canada and Cromwell? Just, you know, just to clarify that, please.
Yeah. It's a lot of it is Cromwell and Canada, yeah, being the shrinking. That's a big part of it, absolutely.
Got it. Just one last quick one. It's helpful on the appendix where you give the monthly progression. Can you comment on how June ended as being their strongest month, and what sort of setup have you seen in July so far?
Yeah, I mean, you know, we don't wanna overindex on any monthly trends, given some of the noise that can happen in the month. I would say that, you know, we do feel like we gained a little bit more share in June, and we do feel like the market, like I mentioned before, is not falling off a cliff. We expect to be in a slow growth market, moving forward and, you know, it's been pretty stable from our perspective over the last several months.
Thank you.
Our next question comes from Joshua Pokrzywinski with Morgan Stanley. Please state your question.
Hi. Good morning, guys.
Good morning.
I appreciate the color you guys gave on the tariff environment and, you know, the ability to navigate that a little bit better, as we move into the 25% on List three. Maybe I missed it, but, you know, how would you know, kinda check that against the pricing environment out there? Maybe you have to ask for a little bit less price, but, you know, what's the appetite in the market? You know, some of the folks in the space have mentioned that's gotten a bit more challenging. You know, what would be your take on those?
Yeah. We're finding that we're able to pass on in most of the tariff related, you know, price increases. You know, the one thing that we called out in terms of price neutral is the only thing impacting that we excluded was the price reset. We've had a great relationship since the tariff started working with our supplier partners. They want to sell their products with us, and it's been going extremely well as the results show.
Got it. That's helpful. Just coming back to endless assortment, you know, obviously there's, you know, some kinda strategic synergy or, you know, operational playbook synergy from MonotaRO with Zoro. Once Zoro is, you know, further down the path and, you know, maybe it's kinda learned all it can, is there a place for MonotaRO in the portfolio, you know, just given that it's, you know, it's a little bit more distant and, you know, probably doesn't get full credit, you know, from an external perspective given, you know, the strength of the business?
You know, right now we're learning a lot from MonotaRO. There's a lot to learn from their success. There's probably more leadership synergy than might be easy to recognize in the sense that the leaders of all of the businesses get together frequently and talk about what they're doing. We haven't talked much about Zoro UK. Zoro UK is on a terrific path and will be profitable in early 2020.
That's partly because of the linkages they have with MonotaRO and Zoro US. You know, it's a fair question. For now, we certainly feel like we're getting a lot of synergies out of the portfolio, and it's an important part of our portfolio going forward.
Got it. Thanks for the color. I'll leave it there.
Thank you. Our next question comes from Ryan Merkel with William Blair. Please state your question.
Hey, thanks. First off, really nice job on the U.S. margins. My question is, what is surprising you positively to hit the high end of the operating margin guidance just given the slower sales trajectory?
Well, I think it's been our ability to generate incremental margin. You know, we know we're in a choppy, slowing market, and our sales growth isn't going to be as great as we had planned. We're doing a lot of good work on COGS, as we described. I think managing the tariff environment very well. We're being very fiscally responsible on SG&A, while also really continuing to invest in our priorities, advertising, digital. So it's really comes down to our ability to generate incremental margin. I mean, we had very good results as we called out.
Okay, that's helpful. Moving to Canada, you know, I hear what you're saying. Average daily sales is stable from the Q1 , but the recovery still seems to be tracking a little bit slower. What are the main issues? Then any change to getting to breakeven by the Q4 ?
Yeah, the main issues have been when we went through some of the changes which were significant, there were many changes that we made. You know, we had some customer disruption that we, you know, weren't fully expecting. I would say the most important sign for me is that the service has improved in the business. We're hearing better things from our customers.
We're starting to win back some customers, which is really important. I think the business is very well positioned from a cost and business model perspective now. We need to get the top line going, that's taken a little bit longer than we thought. That's really the only thing that concerns us at this point is can we get the top line going.
Breakeven by the Q4 of 2019, is there any update there that you can provide?
Well, as we said in our guidance, which is 1%-5% for Canada, we believe it to be tracking to the low end. The answer would be yes. You know, breakeven, better than breakeven for the year.
Okay, great. Thanks.
Welcome. Thank you.
Our next question comes from John Inch with Gordon Haskett. Please state your question.
thanks. Good morning, everybody.
Good morning.
Can we talk about the trajectory in the quarter? Was there a step down from the first to Q2 as we hit April? How did sort of medium versus large play out sequentially? If there's any color you could provide there because I know, D.G., you've said that it's stable, but, you know, it seemed Like the numbers seem sort of low, but it looks like they picked up. Is there any color you could provide?
Certainly, I would say May was lower across all segments, if that's what you're referring to, and June was better. You know, I would say some of that are factors that are frankly not worth talking about from the last year or two in terms of, you know, setting the baseline that you're comparing to. Certainly, we don't see, like I said before, we don't see anything falling off a cliff, and we do see midsize customers growing faster than the rest of the business, and we would expect to see that going forward.
It sounds like you're sort of downplaying the significance of at least the monthly June tick back up to 3%. Is that a function then of compares, or is it just you don't wanna get ahead of your skis by overpromising just based on one month?
Well, I mean, I guess I would downplay May being down as well as it was as well.
Right.
you know, we would say that the quarter was, you know If you average out the quarter, that makes sense in terms of what we see from market growth.
Was there a disconnect between kind of the large versus the medium, going back to my prior question?
No.
As you exited, there wasn't really.
No, not really.
It seems like medium, then, is gonna be pretty challenged to get back to double digit. Is that fair, or do you see?
In the short term, yeah, that would be fair. You know, like I said, we're learning every day, and we're doing things to continue to improve the trajectory, and we like what we're seeing. Certainly in the short term, that's true.
Your margin guidance for the year, right, implies a significant step down from really commendable performance on the gross and op profit margin side, especially in the U.S., to sort of the total guide, which remains unchanged for the back half. Is that seasonality, or are there other things going on there? Are you just being conservative, or why didn't you You know, why the step down, I guess, particularly at the midpoint?
You're referring to the U.S.?
Well, kind of the whole thing, right? I mean, just you look at the guide, but then you look at the, you know, with just the complexion of what's driving that, right?
That's right.
Yeah.
Right. Okay. Yeah. There is some seasonality as you look at, you know, the way that we've performed historically. The gross margin does go down over the year. Recognizing the uncertain economic environment we're in, we just thought it would be prudent to be cautious in this, be measured in our guidance range.
Tom, there's no price-cost dynamic. I mean, I know you talked about tariffs, and you feel like you're on top of it, but there's no other price-cost dynamic that's kind of playing out here that would be, you know, driving some of that disruption.
No.
All right. It almost implies the guide could have a little cushion in it. Is that fair?
It's seasonality and just the economic environment that we're in. I think it pays to be prudent.
Yeah, agreed. All right. Thank you very much.
Welcome.
Thank you. Our next question comes from Justin Bergner with G.research, LLC. Please state your question.
Good morning, D.G. Good morning, Tom.
Morning.
Just on the guide, you know, maintained margin guide, at least at the company level on, you know, 2%+ lower sales.
Just mathematically would suggest that EPS would be 2% lower, but it seems like you're maintaining that. Should we also read that you're expecting operating margins to be a little bit above the midpoint of the guide at the company level to offset the lower sales?
Well, I'm really not gonna get into, you know, where we think we're gonna land in the range other than, you know, what we said in the prepared remarks. You know, we've been running the play in the first half of, you know, not getting the sales we've wanted, generating very strong incremental margins. You know, we're gonna continue to do that in the back half. You know, we think it'll work out well for us. I really don't wanna get into going forward where we think we're gonna land in the range.
Understood. Then on repurchases, I guess you did a healthy amount of repurchases this quarter. You've done $400 million year to date. You know, that would put you tracking, you know, at or above the high end of your range if you sort of annualize that. Are you potentially gonna do more repurchases in your earlier guide, or were they just more weighted into the Q2 ?
Well, I would go back to our capital structure tenets. One of the tenets that we have is we don't want to hold any excess cash, and we were in a good position where we had generated quite a bit of cash, and we just used that to return back to the shareholders. You know, really nothing to read into that. As it goes to our initial guide, we're sticking with that, and if it changes, we'll talk about it next quarter.
Great. Thanks for taking my questions.
Thank you.
Just a reminder, if you would like to ask a question, press the star key followed by the number one key on your telephone keypad. You can press star two to remove yourself from the queue. Our next question comes from Patrick Baumann with JPMorgan. Please state your question.
Hi. Good morning, D.G. Good morning, Tom. Just had a few follow-ups here. Really good job on SG&A control in the first half of the year really. It looks like it was down year-over-year on a cumulative basis. Can you take it down again year-over-year in the second half? I'm just trying to understand what the levers are, you know, for that, if you can. I ask because you said the cost actions are now, I guess, complete. So I'm just kind of curious of the levers on SG&A.
Yeah. Our philosophy is that you can always optimize SG&A, and we will continue to look at that every day. The way we're looking at, though, is really trying to get to our 20%-25% incremental margin. I mean, that's the objective that the organization is focused on. There's always ways to take out costs. I think in the prepared remarks, the cost and cost takeouts ending were primarily related to Canada.
Yeah. I would also just add that, you know, I think if you look at our cost structure, a big part of our cost structure is process costs of distribution centers, contact centers. We've made some pretty big changes, for example, in our contact centers. They are performing quite well now. They're gonna continue to get better and better.
Maybe the restructuring's done, but we expect every single year to get continuous improvement out of our big operations, and we continue to see that and would expect to see that going forward. It's not like we're not gonna improve our cost structure. It's just that we may not have as much restructuring type things going on.
Yeah. Just finally, I would add one important thing is even in this down market, because of what D.G talked about, our focus on market share and our focus on growth, we are not backing off of any of our strategic initiative spending to hit an SG&A number. We're continuing to go forward full speed on that.
Do you think SG&A can decline in the second half year-over-year? You know, what drives the I think last year you had some big profit-sharing headwinds in the second half that were an impact to the numbers there. I'm just, so maybe that's an easy comp. I don't know. I'm just trying to kinda tie those, all this stuff together here.
We do have an easier comp as far as variable compensation. What I would say for the second half is we expect the SG&A rate to be lower than the previous year, for sure.
As a percentage of sales, you're just saying the absolute number.
As a percentage of sales. We also expect the second half of the year to perform better than the first half of the year as it relates to favorability to the prior year.
From a absolute dollar perspective?
From a rate perspective.
Oh, from a rate. Oh, got it. Got it. Understood. Was that profit-sharing expense line, was that a help in the Q2 year-over-year? Was it a tailwind?
Sure. Yeah.
Then just Go ahead. I'm sorry. I didn't mean to interrupt.
No, that's okay. That's okay. Yeah.
Then D&A looks like it's down year-to-date. What's driving that?
That's a compare to last year. We had some issues in terms of KeepStock write-off from machines, older machines that we replaced. We also had some capital expenditures at 2 of our bigger DCs. We had a favorable compare there to last quarter.
Thank you.
Welcome.
Our next question comes from Bhupinder Singh with Wolfe Research. Please state your question.
Hey, good morning, guys.
Good morning.
This is here sitting in for Singh. So, you know, just, Tom, I think you mentioned, you gave some guidance on the other businesses margin here. Can you just give some more color on those margin targets and, you know, what your confidence is actually in the back half to achieve those targets for the year?
Yeah. We're, you know, we took down the other business unit operating margin target primarily due to the performance in our Cromwell business unit. Obviously, with the uncertainty of Brexit, also that just combined with the transformation that we got going on in that entity, where we're really changing the business model there in terms of being decentralized with the branch network and trying to have more centralization.
Some of the things that we've noted on Canada, we're seeing there where we've disrupted the customer base, those types of things. That's why we're taking down primarily for the other business units.
Okay. Is investment spending a big part of that? Or is it a pretty small amount? You guys have done a great job trying.
Certainly the investment spending in Zoro, in the U.S. is a big part. That was planned at the beginning of the year, and we are spending that money and seeing what we wanna see out of that. We had always planned for the Zoro margins to come down in the year. That's what we're seeing. When we talk about investment spending, that's really what we're referring to.
Okay, got it. If I can, another one here, on pricing. You know, as we saw in the Q1 , pricing was 1.5%, second 0.5%. How should we think about the back half? Because, you know, when you look at last year's second half, I think we had pretty, you know, kind of, close to 100 basis points actually pricing every quarter. Are we gonna see much more realization what we have seen in the quarter? Or, as the, you know, kind of tariffs kick in, like in the second half historically. If you can give some color on that. Thanks.
Yeah. I think, I mean, like we said before, our focus really is to make sure that we are market priced in everything that we do. Depending on how the tariffs play out, that could mean more price or less price, I think. That there's some uncertainty around that, but we are tracking and watching this very, very closely and our objective always to make sure that we'll price competitively, and we will make sure we do that.
Thank you.
Thank you. Welcome.
Our next question comes from Steve Barger with KeyBanc Capital Markets. Please state your question.
Hey, good morning.
Morning.
Just looking at heavy manufacturing down low single digit, natural resources down mid single. In general, what are the customers or your sales force saying there? Is there an expectation for improvement in the back half for those segments?
It's hard to tell. I mean, heavy manufacturing was basically flat for the second quarter. Actually, in June, the overall market I'm referring to is actually negative. You know, so it's hard to tell where that segment's going to go. Obviously, we've got a number of initiatives in play, which DG referenced in the prepared remarks in the Q&A, that we think despite that down or slowing market, we're going to be able to gain share.
Right. Just more broadly, given softer markets, are customers leaning towards lowering reorder points or the amount of inventory they're willing to hold? Does that change how you think about inventory at the DCs?
Generally not much. I mean, the reality is that customers don't hold a whole bunch of our inventory anyway. The way we structured most of our large customer relationships, we're helping them manage their inventory. We set MOQs that allow them to operate at a pretty lean level. We don't see a lot of channel loading or anything like that with our customers, given the business model and our business model is based almost entirely on helping them manage their inventory effectively.
Got it. Thanks.
Thank you. Thank you.
Thank you. Our next question comes from John Inch with Gordon Haskett. Please state your question.
Yeah. Just as a follow-up, I wanted to ask you about Europe. You know, one of the things we've gleaned this quarter thus far from other companies is the European economies are actually starting to show up in a much more pronounced basis negatively. It implied that the other business results were more U.K., Brexit oriented, maybe a little bit of your own affliction.
What's going on actually with respect to Fabory and just what you're seeing in continental Europe, and does that weigh on the results and have any sort of bearing on the second half in terms of your own expectations?
I mean, I think what we've seen over there is we've seen obviously the U.K. market has been struggling a bit. We've seen some manufacturers ship some of their production from U.K. to the mainland of Europe. The Fabory business has had sort of consistent modest growth this year. We think the market in the Netherlands and Belgium, where they are, has been up combined, but not up significantly. Certainly there are signs of some pressures in the European market, what we've seen at Fabory hasn't really weighed on results. What we've seen in the U.K. has.
The expectations, D.G., do you think it's just more of the same coming, or are there reasons based on just exit quarter trends or anything else that things get better or a little bit worse?
Yeah, I mean, I would just remind, they may get a little bit worse. I would just remind you that we are very small in Fabory, so it doesn't have a meaningful impact on us right now. I also don't know that we have the best lens. I mean, we have the lens of the Netherlands primarily and some Belgian business. We don't have anything really in France to speak of, or very little, very little in Spain. We don't really have much exposure to the big markets to have a position.
Got it. Thanks very much. Appreciate it.
Our next question comes from Justin Bergner with G.research. Please state your question.
Guy, thanks for the follow-up. With respect to neutral price cost, are you seeing any different dynamic between sort of the industrial part of your portfolio and the non-industrial part of your portfolio? Just given, you know, some of the comments from other MRO distributors earlier in the quarter.
You know, I'd have to go think about that. I'm not sure I have a great answer for you, to be honest. My inkling is probably not seeing much different. I don't know that I could necessarily say that with certainty. I, you know, I've looked at the total and I'd have to go ask some questions about that. It's an interesting question.
Okay, great. Then lastly, with respect to the endless assortment model, you used the term continuous growth versus accelerating growth. Does that just reflect, you know, more challenging end markets, or is there anything sort of structural to be read into that change in language?
Nothing is being structural. I think there's a sort of law of the universe, which is, Endura's been growing over 20 for the first five or six years. If we want it to continue to grow in the 20s, we need to do something else, given as it gets bigger, that becomes harder and harder to do. We didn't want you to think that we're going to accelerate from the 20s to the 30s or 40s. We're going to try to continue to have a strong growth rate.
Great. Thanks again.
Thank you. Our final question comes from Patrick Baumann with JPMorgan. Please state your question.
Oh, hi. Thanks for giving me a follow-up. I just wanted to follow up. You've mentioned KeepStock, and you said it's now profitable and was 10% of the business in 2018 and will grow faster, I guess, than the rest of the business going forward.
There hasn't been a ton of visibility here the last couple of years, so just curious if you could, you know, give a quick update on kinda what you've been doing there. Was it losing money last year? Kinda what changes have you made to improve profitability and make you feel like you can grow it better and more profitably in the future?
Yeah. You know, we have about three years ago, two to three years ago, we made some changes. That's improved the profitability. We're now squarely in the place where we're building new capabilities. We've done some work on software. We've done some work on visibility and analytics and reporting to help customers understand the value that we're bringing. We're gonna continue to push on those things.
The comment truly around for a couple of years, we haven't been focused as much on capability building as we've improved the profitability. Now we're really focused on that. That's gonna be our focus going forward.
I think it's important to note that in June, we had our fastest growth rate that we've had in two years related to KeepStock.
Got it. Okay. Makes sense. Thanks. Thanks again. Good luck.
Thank you. Appreciate it. Thanks.
Thanks. I will now turn the conference back over to Mr. D.G. Macpherson for closing remarks.
All right. Well, good. Well, thanks for joining us. You know, I would just reiterate a couple of points. One is in the U.S., given the profitability, we are really focused on growth and gaining share going forward. It's a bit of a new orientation for us to say we're gonna gain share on a consistent basis. We are wiring ourselves up to be able to do that, and that's our primary focus.
The other is the online model continues to be very profitable and a fast grower, and so we're investing to make sure we can do that. If those two things go well and we're pretty excited about the future, I look forward to talking to you one-on-one. Thanks for your time today. I appreciate you on the phone.
Thank you. This concludes today's conference. All parties may disconnect. Have a great day.