Greetings, and welcome to the W. W. Grainger Third Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen only mode. A question and answer session will follow the formal presentation.
As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Irene Holman, VP, Investor Relations.
Good morning. Welcome to Grainger's Q3 earnings call. With me are D. J. McPherson, Chairman and CEO and Tom Ocray, Senior Vice President and CFO.
As a reminder, some of our comments today may be forward looking statements 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 non GAAP financial measures with their corresponding GAAP measures are at the end of our slide presentation and in our Q3 press release. Both are available on our IR website. D.
G. Will cover performance for the quarter, and Tom will go deeper into our financials, including segment results. After that, we will open the call for
we had another solid quarter. Demand remained very strong in the Q3, and we're continuing to gain share. In the U. S, as we lapped our August of the business, notably with our midsized customers. In addition, gross margin would normalize for the revenue recognition accounting change and operating margin exit the year at a profitable run rate.
Our single channel online businesses, mainly Monotro and Zoro, had strong growth and profitability. We recorded a noncash impairment for Cromwell in the U. K, reflecting slower growth than planned at acquisition. The overall international businesses are profitable with the exception of the impairment. We believe that our current exposure to tariffs is well understood and effectively managed.
Tom will address tariffs later in the presentation. I would also mention 2 other things. 1, we had a very strong customer satisfaction reading in the U. S. This quarter.
It's actually the strongest seen under the current methodology. And also with Hurricane Michael making landfall last week, I want to note that all of our are safe, and our team members are doing a great job responding to the event as they always do. With that, let's take a look at our results. 3rd quarter 2018 reported results contain restructuring charges of $142,000,000 and a $2.37 impact to EPS. In the quarter, we took a noncash impairment of $139,000,000 related to our Cromwell business.
In 2015, we described to you the expected benefits of the acquisition based on the strength of the core Cromwell business, the ability to build the online model off of that core and the potential in the U. K. Market. Many of these benefits still exist. However, a few things have changed since the decision.
First, Brexit occurred within a year of acquisition, and the market slowed. And the uncertainty surrounding Brexit as it gets closer to being executed forces us to take our growth projections lower. 2nd, the cost of capital is higher now. These two structural issues explain the majority of the reduction in valuation. In addition, our strategy included building an online model with the Cromwell name.
In reality, this approach created customer conflict with the core business. We adjusted our approach and relaunched the online model under the Zoro name about a year ago. The opportunity with Zoro is large and compelling with very strong early signals in the market. But the late start of Zoro and the lower growth rate given market conditions impact the current valuation. While still early days, we do believe the U.
K. Is an attractive place for Grainger to play. This morning's call will focus on adjusted results, which exclude the items outlined in our press release. Total company sales in the quarter were up 7%. That included 7% in volume, 1% in price and a headwind due to foreign exchange comparisons of 1%.
This is the Q1 in 2018 with the foreign exchange headwind. Normalizing for foreign exchange and hurricanes, our sales increased over 8%. Our normalized GP rate was flat to the prior year after adjusting for the revenue recognition accounting change, which we discussed earlier. We continue to realize operating expense leverage on higher volume. This all led to operating earnings growth of 15% in the quarter and an operating margin that was 80 basis points higher than the prior year.
Now I'll turn it over to Tom for additional detail, including our segment results.
Thanks, DG. I'll cover our other business results first. As a reminder, other businesses include our single channel online model and our international businesses. Sales for these businesses were strong, up 13% in the quarter, 14% driven by price and volume, partially offset by a 1% reduction related to foreign exchange. Our online businesses grew 23%, continuing to be a profitable growth driver.
The international businesses were profitable, led by our Mexican operations. In Canada, the AGI turnaround is making progress. With many of our cost reduction initiatives behind us, we will now focus on growing profitably. Sales were down 20% or 17% in local currency. Price increases, branch closures and sales coverage optimization activities contributed to volume being down 27%.
This was partially offset by a 10% increase in price as we continue to renegotiate pricing on our large related to excessive and obsolete inventory and vendor rebates that impacted gross margin. After adjusting for these items and normalizing for revenue recognition, our gross margin was 430 basis points favorable to the prior year. Operating margin improved 200 basis points, driven by favorable pricing and cost reduction. Adjusting for the non recurring items, operating margin improved 570 basis points. Looking forward, we expect to exit the year with a positive operating margin run rate.
In the United States, the demand environment was strong and we were able to grow profitably. Our value proposition combined with continued favorable response to our pricing actions resulted in increased share. Sales were up 9% in the quarter. Volume was up 8% and price was up 1% due to general inflation as well as lapping the price reset. In the month of September, hurricanes negatively impacted sales growth by 160 basis points.
In 2017, Harvey and Irma had a larger benefit than Florence contributed in 2018. Normalizing for this impact, sales in September grew at 8 percent, consistent with August growth for large and medium customers. After adjusting for the revenue accounting change, our normalized gross profit rate increased 20 basis points. The increase was driven by customer mix and favorable price cost spread. Operating leverage continued be strong in the U.
S. Having said that, you will notice some lumpiness in the quarter related to 2 factors: increased variable compensation versus the prior year and the quarterly variable compensation true of methodology. On a calendar year basis, these factors will wash out with sales growing significantly faster than operating expense. All in, operating margin at 15.1% improved 20 basis points versus prior year. Let's take a look at our large and medium customers.
Despite lapping our pricing actions in mid August, we continue to see strong volume growth from both large and midsized customers. Our value proposition continues to resonate and we are seeing the results. Our U. S. Large customer business is performing consistently.
We are seeing strong performance with our non contract customer. And spot buy purchases are increasing with contract customers. U. S. Medium volume growth of 22% is strong, especially considering a tough comp.
New customers continue to be a meaningful contributor to volume growth. We're excited by what we're seeing. While we expect continued double digit growth with medium customers, the rate of growth in Q4 will moderate. I want to take a few minutes to go into more detail on tariffs and other issues. With respect to tariffs, we have deployed a cross functional task force to gain a clearer understanding of the tariff impact as well as to execute mitigating actions.
The team meets daily reporting to senior leadership at least weekly. Some of their actions include validating tariff increases, working with suppliers to minimize the cost impact, including identifying alternative supply and evaluating pricing actions while ensuring that our pricing stays market based. With respect to quantifying the impact, product directly sourced from China represents about 20% of the U. S. Segment's cost of goods sold.
This product is split between our national brands and our private label. National Brands, which comprise the majority, are sourced from suppliers with manufacturing in multiple locations, providing flexibility in addressing the tariffs. Approximately half of this product sourced from China is impacted by 301 tariffs. Applying tariff rates of 25%, we estimate our costs will increase by about 2% for the U. S.
Segment. Based on the task force work combined with our experience to date, we are confident that we can find alternative supply and or price to cover the expected tariff cost increases. Moving to taxes, we want to ensure that the main drivers between reported and adjusted tax rate versus the prior year is understood. The Q3 reported rate of 32.7% is up 1 percentage point versus prior year. We had tax benefits from U.
S. Tax reform and stock based compensation. This was more than offset by the impact of the Cromwell impairment, which is nondeductible and increased the rate by 16.3 percentage points. With respect to the adjusted rates, the Q3 rate of 20.0 percent is down 11.7 percentage points versus prior year. As with the reported rate, the adjusted rate reflects benefits from U.
S. Tax reform and stock based compensation. However, the Cromwell impairment is removed from our adjusted results and does not impact the adjusted tax rate. Finally, in July, we gave EPS guidance of $15.05 to $16.05 Further, we mentioned that it did not include the tax benefit from stock based compensation for the second half. We have stayed away from predicting the exercise of stock based awards, which is inherently difficult.
Excluding that benefit, which was $0.14 in Q3, we are trending to the high end of our guidance. As a reminder, we will provide 2019 guidance on our Q4 earnings call in January. I'll now turn it back to DG for closing remarks. Thanks, Tom. So overall, we're very pleased with our continued strong momentum.
We know that
we have a compelling value proposition, and our team members are energized and focused on creating value for our customers. After lapping the price increases, the U. S. Continued to gain share at attractive margins. The turnaround in Canada is on track.
We are now focused on profitable growth off of the business model reset. Our online model continues to show very strong profitable growth, and our narrowed international portfolio continues to improve profitability. With that, I will open it up for any questions.
At this time, we will be conducting a question and answer session. Our first question comes from the line of Ryan Merkel from William Blair. Please proceed with your question.
Thanks. Good morning. A couple of questions from me. So first, based on some of my inbound emails, people are picking on the lack of operating leverage in the U. S.
For this quarter. So can you just discuss what exactly drove the variable comp true up this quarter? And then can you confirm that this is a one time event and that the U. S. Operating leverage will be strong in 2019?
Yes. I mean, as we said in our prepared remarks, the big impact that we had in terms of operating leverage was the true up. We do this on a quarterly basis and as our results for the year are very strong, we had put a disproportionate amount in Q3 and Q4. Obviously, throughout the year, this is going to wash out. If you normalize for that, we are going to see tremendous operating leverage
19, but on the last call you stated you thought gross margins in 2019 could be stable with 2018. And I guess now that we have more information on the contract price reset and I guess an educated guess on tariffs, do you still think that you could have stable gross margins into next year?
So Ryan, we're working through all that. We will provide details in January as we announce earnings. I would say there's a couple of things that are pretty exciting. One is customer mix is a positive right now. So midsize customers, non contract customers growing faster than large contract.
That'll be a benefit. We have to work through the specifics of the tariff, but we feel like we're on top of that. Our goal is to be as close to flat as we can be, and we think we've got the right process in place to get the best outcome.
All right. And then maybe just lastly on tariffs before I turn it over. I know this is a tricky question as you're starting to have conversations with customers about pricing. But is your goal to protect gross profit dollars and maybe protect gross margin rate? Is that something you can comment on today?
Our goal is always the same. We want to be competitively priced and we want to get the best cost we can. Our expectation is that we will be able to pass through the price or find alternative sources to mitigate the impact of the tariff. And again, in January, we'll talk about where we think we land on that. We will know by then.
Very good. Thanks.
Our next question comes from the line of Christopher Glynn from Oppenheimer. Please proceed with your question.
Yes, thanks. Good morning. So SG and A SGA at the company level, adjusted SGA was down a little sequentially despite the spike in the U. S. Comp catch up.
I'm just wondering what was kind of the offset there?
Well, the offset is just the continued cost
out productivity that we've been doing
for the past several quarters.
Taken about $85,000,000 out of the cost structure in Canada and most of those actions are behind us and we got another benefit in the quarter there.
Okay. And then, passing the GM. So excluding the revenue rec, company level gross margin was flat with the U. S. Up 20% and Canada up more than that.
So just wondering were there some pressures in the other businesses gross margin?
The other businesses gross margin is down slightly. You also have just the algebraic dynamic of their lower margin gross margin overall and they're growing at a faster rate.
I mean that's the online model continues to grow very quickly and it starts at a lower GP and that has a big impact. Okay. Thank you.
Our next question comes from the line of Adam Uhlman from Cleveland Research. Please proceed with your question.
Hi, good morning. I was wondering if we could start with the U. S. Segment gross margin this quarter. Congrats on expanding it, positive price cost and mix.
I guess I'm wondering why the gross wouldn't have been a little bit better with that mix impact and the point of price were there. Any other items within that? And then I'll just glue my second question on and that's related to the tariffs. Is there any potential for inventory revaluation associated with that? Is that something we have to think about for the Q4 gross margin?
Let me take the first part of the question first. What I point you to is taking a look at the sequential. Throughout the year, our gross margin typically declines. And if you look at how we're performing this year, it's at much less of a decline than we have had in previous years. So we're very happy with what's happening FX was a headwind this quarter.
It's been a tailwind the previous two quarters. The dollar is getting stronger versus the Canadian dollar and the Mexican peso.
And then the second part
of your question was around inventory revaluation. We do not believe we will have any concerns there. And as a reminder, we're on LIFO, and should be we shouldn't have a problem in any case.
Great. Thank you.
Our next question comes from the line of Steven Winoker from UBS. Please proceed with your question.
Hi. Thanks and good morning all. Just to drill down maybe a little bit on the tariff points that you raised on Page 11. The first question is just the simple math on that 25% on 50% on 20%, I think is maybe closer to 2% than 2.5%. I assume those are just rounding points in all of it.
Have you gone line by line there, math there on 2% looks like it's under a dollar impact if you didn't have alternate simplified
it for simplified it for presentation sake. And as we noted in our prepared remarks, we think it's well understood and very manageable.
Okay. And that math though makes sense as
well? Correct.
Okay. And then just on
the alternate sourcing point, just where you may have challenges on pricing or taking actions or concerned about volume impact of those pricing actions, how are you thinking about your options there in terms of substituting supply? So we our team is looking very closely at pretty much a SKU by SKU level. And like all sourcing decisions, we look at the quality of the product, we look at the cost of the product, depending on how the tariff plays out. We have alternative sources already in many places, and we may have to find some additional ones. But we just look at the total economics, total landing cost and pick the one that's got the best cost for the business.
Much of our shifts could from if it's China, if it's shifted, it could go either to India to Mexico or the U. S. Depending on the nature of the product. The other thing I would say is, as we're going through this, we have a fairly refined should cost approach, looking at what the product cost should be. We understand what portion of the cost should be related to the tariff.
And so we are able to work with suppliers to make sure that we're actually taking the right cost increase and that's a big focus for us.
And how long do you think it will take you to migrate once you make those decisions?
Well, it depends. If we have an alternative source, it's actually pretty quickly. We don't at this point, we don't feel like we're to be in a position where we're going to have any disruption and we feel like we're on top of this. So we don't we're not concerned about being able to make any changes we need to make.
Our next question comes from the line of Luke Junk from Baird. Please proceed with your question.
Good morning, guys. First question, DG, Canada revenues stepped down again this quarter by design, of course. Can you help us understand when run rate revenue should start to normalize? I think Tom mentioned in the prepared remarks that many of the cost reduction initiatives are now behind you. Basically, what kind of volume assumptions built in to your operating margin guidance exiting this year heading into 2019 broadly?
So I would say and we'll talk in January about the specifics for what our volume expectations are for next year. We do expect volume to stabilize over the next several quarters into next year, and we expect next year to be more of a stabilization period. I would note a couple of things. One is the branch closures, which mostly are behind us, there's still some to come, have an impact on revenue, have also has a positive impact on profitability. We have reorganized our sales team and coverage is now stable and we're now talking to customers and trying to drive growth and I think that will help us stabilize over the next year.
So we feel I would say in general, it's hard to take a look at numbers that are down that much and it's hard for the team, but this is what we expected. And I think the team is doing a great job of managing through that and we're in a good position now to really create value for customers and grow. Okay. And then second
grow. Okay. And then second question on tariffs. What I'm wondering is, do you approach recovering the tariffs differently by line of business, whether it's a different customer value proposition, obviously areas that are impacted by recent price actions or something like Kiss of Canada where some of the product is being imported from the U. S?
Any thoughts you can share in respect to that?
What I would say is that the cross functional team we have has people from our sourcing, from our product management teams, from our pricing teams and including our commercial teams, all working together to make sure that we make the right decisions. I won't go into specifics about that. But in general, like I said before, we're really focused on making sure we get the right cost from our suppliers and have a competitive price. And so that's really our fundamental principle on driving the results here. Perfect.
Thank you.
Our next question comes from the line of
tariff spreads, half of the you mentioned half included and half excluded. Can you give any color in terms of what's currently not covered in terms of product categories? Any color there would be
helpful. I
don't know that we want to go through the details of which ones are covered and are covered. But what we've seen is that the way 301 is written, there are a number of product categories that aren't exactly that aren't included in this. And so roughly half of what we have coming from China is really in that bucket today.
Okay. And then on the impact you laid out, the 2% or whatever it is on the U. S. Cost, does that include any benefit from the weaker RMB? Or is that on an applesauce basis?
So are you including the depreciation of the Chinese currency in those calculations?
No, the calculation was done on a constant currency basis.
Okay. And then just quickly on the hurricanes, the 160 basis points impact, And you mentioned that there was some offsets last year with the 2 hurricanes that weren't there this year. I just want to understand how that what the difference is between last year and this year in terms of the benefits versus the impact?
Yes. So what we do when we look at hurricane impact is we look at 2 things. We look at run rate business in the market that the hurricane hits and we look at hurricane product sales into the markets that it hits. Last year, Harvey obviously had a huge impact on the Houston market, which lasted for a long time and then Irma hit Florida. Those 2 combined had a lot more hurricane sales, hurricane sales offsetting the business slowdown.
In fact, the Florida business slowdown was very, very fast. There wasn't much of it. And this year, Florence did not have as much impact. It still had a significant impact on that market. But given it didn't hit in this highly populated area impact was a little bit less this year.
Okay. Thank you very much.
Our next question comes from the line of Deane Dray from RBC Capital Markets. Please proceed with your question.
Thank you. Good morning, everyone.
Good morning.
Could we talk through the restructuring actions in the quarter? So it was $142,000,000 Where do you stand in terms of the actions? How much are headcount? How much is footprint? Anything structural and then expectations for the balance of the year?
I'll turn it over to Tom in a minute. Most of that $142,000,000 was the Cromwell impairment and that was $139,000,000 of it. The rest were small in general, and most of the big changes in both Canada and the U. S. Are mostly behind us.
So maybe Tom could can talk about.
Yes, exactly. Taking out the Cromwell, there's some small severance items, E and R integration, favoring North America wind down in the U. S. And then there's some residual branch closure costs and severance costs in Canada, which is quite small and coming to an end.
Got it. And then just want to get I might have missed this, I apologize. But last quarter, you talked about some pricing delays in large U. S. Customers because of contract negotiations.
But where did that stand and how much of that has been run through the P and L?
So the vast majority of what will be done by the end of the year, we'll get 95% done by the end of the year. The contracts that aren't done are customer choices and or implementation slowdowns depending on what we're talking about and particularly some government customers. But in general, we'll be mostly done and we'll be talking about very small impacts going forward.
Our next question comes from the line of Evelyn Chow from Goldman Sachs. Please proceed with your question.
Hi, good morning everyone. Maybe just starting on a comment you made on the medium customer. I think you noted that you expect 4Q to grow double digits, but for the rate to moderate. Just curious if that's just a function of harder comps, especially noting that I guess your 3Q comps are probably even harder than your 4Q ones?
Well, so I would talk about a couple of things, Evelyn. Thanks for the question. So one is, remember, the Q3 we made the change last year, forever, as forever, as you might guess. So we talk about moderating, we think it's going to be moderating to a very strong growth rate. And we've only had 10 weeks after lapping the prices to really understand it.
But I would say we are encouraged by what we're seeing, and we'll be more definitive at the end of the year as we talk through. But I'd say we're all signs are very, very positive on midsize customers right now.
That's helpful, DG. And then I guess apologies for an question on tariffs. But just curious, I mean, I think what you laid out on Slide 11 is very helpful. I know the President has intimated that he is contemplating additional tariffs. In that event, have you thought about how to ring fence the math you laid out already?
I mean, is that going to be something closer to, I think, the 30% of total company COGS that you've discussed in other forums?
Yes. So we first of all, we don't know how that will be implemented or if it will be implemented. So like all these things, we are watching it very closely, but we haven't we don't have an opinion yet as to how that will play through. I would say, in general, obviously, the tariffs are simply inflationary. And I think you see what the inflation is roughly based on the math we've seen so far.
We think in the short term, we would be able to navigate this no matter what happens. We think relative to competitors, we might be in a better position. The long term impacts, we could all sort of argue about over time. But certainly in the short term, we feel like we're on it and we know what we need to do depending on what happens.
Understood. And then I guess last question for me. I think you noted that your spot buy has been increasing with some of your contract customers. So just curious to know what is the mix of your plan versus unplanned purchase now versus kind of normal or maybe versus target?
We don't typically talk about that specifically. We'll take the question and think about whether at the end of the year we talk about it or not. But thanks, but it's a great question, but we haven't typically laid that out.
Great. Thanks guys.
Thanks, Ellen. Thank you.
Our next question comes from the line of Ryan Cheslick from Northcoast Research. Please proceed with your question.
Hey, good morning.
Good morning. Good morning.
Just first, I wanted to go back to the guidance and just make sure we're clear on what you guys are saying. So if I heard you right, you said that when excluding the $0.14 benefit from stock comp and the tax rate, you're running at the high end of your EPS guidance range. 1, is that correct? And then 2, does that assume then the other inputs to your guidance as it relates to both sales growth and gross margins are also running at the high end of your prior guidance?
Yes, it's a good question. I just want to make it clear that we've raised guidance twice this year and we are tracking toward the high end of that range. We're very encouraged by our performance and I'd be disappointed if we don't beat guidance this year. With respect to your question on the other elements other than EPS, the same holds true. We're tracking toward the high end of the range.
And Tom, what you see also would be surprised if you didn't beat the high end of both sales and gross margin guidance or is that more of an EPS comment you made there?
I would say it's more EPS, but we're always slugging it out with the other parameters as well.
And I would say we're tracking towards the high end of all the dimensions that we laid out. So obviously, we hope to beat them, but we're really tracking to the high end.
Okay. Just to quickly close that question, I'd just be curious, is there any reason why maybe you're not giving more specific formal guidance on the full year? Is this a change in practice or just based on where we are in the year and some variability in the Q4?
It's really a transition in practice. We want to get out of the business of giving quarterly guidance and giving a range and working toward a midpoint. Going forward for next year, we'd like to give guidance once a year and then quite frankly not talk about it the rest of the year, talk more about the results we're putting on the Board.
Okay. And then for my other question, looking at the U. S. Volume growth, it continues to be strong. But when you look at it on a 2 year stack trend, which we all do to try to get a sense of the adjusted of prior year comps, It looks like it's flat lined a little bit and implies maybe into the 4th quarter, you're starting to run more in the mid single digits versus the high single digits for U.
S. Volume all in. Is there something going into the Q4 as it relates to some of the market initiatives that maybe would re inflect that higher where
you can maybe achieve something in
the high single digits? Or is mid single digit volume growth sort of the right way to think about at least near term where the volumes might be growing?
Yes. So we haven't really seen anything that suggests that we cannot continue to gain share and continue to grow. And like I said before, we're really encouraged by post pricing changes. What we see in our large customer volume grew consistent with what had been growing before post price change and our midsize customer continues to grow. So we would expect to be north of certainly north of 5, that's your question and we expect to have strong revenue results going forward in the U.
S.
Okay. And then my last question and I'll hop back in into queue. When you look at the tariff related commentary that you guys gave in your exposure there, 20% of your COGS. I think the prior guidance or color that you gave was specific to private label. And I think what it was, was something in that 2 thirds of your private label, it was directly sourced from China.
Is that still the case? Or is that now maybe a little bit lower? Just when you do the math, it suggests maybe that's a little bit lower than what you guys were previously talking about? Thanks.
Yes. I think the confusion there would be 2 thirds would be on a revenue basis. And given the GP on a COGS basis, it's roughly the math as you see it. So that's the difference there. Got you.
Okay. Thanks, guys. Thank you.
Our next question comes from the line of Justin Bergner from Gabelli and Company. Please proceed with your
question.
Good morning, DG. Good morning, Tom.
Hi.
First question just on the incentive comp and how it affected the OpEx growth. If I take that 400 basis point differential on 5% growth versus 9%, I'm in the $20,000,000 range. Should I think of then the effect on the Q3 of the unusual effect of the Q3 being sort of, I guess, 3 quarters of that $20,000,000 sort of being compressed in 1 quarter versus 4 quarters?
Yes. I mean, we're not going to get into the specific math, but you're thinking about it the right way.
Okay, great. Secondly, on the tariffs, I'm not sure I understood correctly on the private label merchandise. Is that private label merchandise stuff that you can redirect to other countries as it relates to where you supply from? And how much of that 20% is related to private label versus branded?
So private brand, we have a whole bunch of products that we buy in China that are private branded. In many cases, we already have alternative sources that are identified. And so what we're referring to is if we have an alternative source, depending on how the math works with the tariffs, we may be looking to switch that. We may not be if the cost is still better in China post the increase. And so the way we think about this, some of it's risk mitigation.
If we are buying something uniquely in China, we have to have an alternative source and we will have it. If we're buying something and it's only produced in China today, there are some products like that, then obviously, we don't have alternative source. We can go find them and that's going to be more work.
Okay. Got it. And then the 25% tariff assumption, I assume that a good chunk of the imports from China are being tariffed at 10% today. So how much of that impact today is at the 10% versus the 25% rate? I guess I'm assuming that you expect it to step up to 25% at year end.
Yes, we assumed worst case for the calculation. So we didn't take any credit for staying at 10%. And some of
the 10% is actually already started to flow as you correctly state.
Okay. Do you want to break out how much is the 10% versus 25% or would you rather not?
We'd rather not right now.
Okay, great. And then lastly on the sales side, was there anything that was sort of disappointing in terms of U. S. Sales, whether it be
I would say that pretty much all things U. S. Revenue margin, all of it was positive in the quarter relative to our expectations. And of course, there was more uncertainty going in because of the price lap. And pretty much at every turn, it actually be what we expected to happen.
Thank you for taking all my questions.
Our next question comes from the line of Scott Graham from BMO Capital Markets. Please proceed with your question.
Yes. Hi, good morning.
I
just have a question about U. S. Price, which flipped positive to 1 in the quarter. I was just hoping you can give us
a little bit of color on the
sort of the disaggregation of that because the price actions are still lapping. So I'm assuming, of course, that the price actions were negative, but that you had price increases and mix is in there as well. Could you give us any color on the buckets?
Yes, sure. I mean the way we look at it, the pricing is how much is commodity vendor related and market levers and then how much is related to the price reset. I mean, what we've seen is the decreases associated with the price reset has slowed considerably as you would expect, as we work through the contracts. And we've been very consistent and actually improving in terms of the price we've been able to pass on related to tariffs and other market based.
I would also say that the other elements, customer mix was positive in the quarter, which helps price. And we talked about spot buys. Spot buys increasing helps as well with large contract customers as we're not selling as much deeply discounted items. So
DG, would you say that that's first or the second quarter that spot buy and medium sized customer mix has actually begun to read through?
Boy, I think it's the 2nd quarter that that started to read through, but I don't hold me to that, but I believe that's true.
Okay. And lastly, again, on the pricing. So you have the price actions with the large customers. When you go back to those customers for price increases, could you kind of walk us through what they're sort of upper bands and this kind of thing that slows things down? Or how do you work through that with those customers?
Yes. We won't talk about specifics. I would say we have a very tried and true process that we use to work through any changes with customers. And our commercial team does a great job of navigating with our customers to get the best outcome for both of us.
Okay, thanks.
Thank you.
Our next question comes from the line of Patrick Baumann from JPMorgan. Please proceed with your question.
Hey, guys. Thanks for taking my call. Just had a couple of cleanups here. Lots been covered already. Just on the tariffs, it sounds like you still expect to mitigate through alternate sourcing or pricing.
Do you think you can offset the tariff costs right away? Or you think there might be some lag?
So given what we know now, there would not be a big lag. We think it would be given what we expect in terms of the 10% going to 25%, we think we'll be roughly coincident close enough.
Okay.
And then just a couple of cleanups here. I couldn't find anything on branch count. I'm not sure if it was in the release. If it wasn't, I missed it. Just wondering what that looks like today versus the Q2.
And I know you guys are still closing branches in Canada, and I think you are.
Yes, we are. So we will, by the end of this year, have 30, 31 branches, 35 branches open in Canada. Most of them have already been closed. We closed 7 in the quarter in Canada and really the rest is virtually nothing. The branch count is stable pretty much everywhere else.
And as you've been closing these branches in Canada, have you been have there been any gains on those? Or I haven't seen any of those kind of running or I don't think you've called any of those out.
Could you repeat the question?
Have there been gains on those branches? I haven't seen them
called out. Yes. Keep in mind, yes. So typically, they're smaller branches and not necessarily as valuable as the U. S.
Branches in terms of Zoom.
Yes. The gains would obviously show up in our restructuring charges, and they're relatively small.
Got it. So those restructurings are net of gains?
Yes, correct. Yes. Got it.
Got it. Understood. And then last couple, just in terms of the price write down, I'm not sure if you mentioned that, but are you done now with U. S. Large customer contracts?
We talked about that before. By the end of the year, we'll be 95% done. So mostly, the rest will be small. And that's almost all the customer choice.
Sorry, I missed that. And then last one for me, just Zuora U. S, how did that grow in the quarter?
Continue to grow strong growth in Zuora U. S.
Is it up like, can you say 23% for total single channels? Is it up at that kind of rate or
is it It's
not quite that, but it was up
It's up 18% in the quarter.
We're just looking at the number 18.
Okay, great. Thanks a lot guys.
Thanks. Our next question comes from the line of Hamzah Mazari from Macquarie Capital. Please proceed with your question.
Good morning. Thank you. My first question is just around price cost. We talked a lot about pricing, but I think a few quarters ago, DG, you had talked about COGS deflation. And as you know, there's a lot more inflation in the system now whether you look at labor, freight, other items.
Do you still expect COGS deflation going forward?
So, no. What we talk about is price cost spread and are we able to get are we able to mitigate COGS increases and get the right price for our customers? This year, we had talked about being down 0.5%. We still expect to be roughly there. That's mostly because of the initiatives we've done to manage our cost, to understand supplier costs and improve our cost structure.
But otherwise, we would actually be in an inflation mode this year of 1% to 2% probably.
To be clear, though, for the quarter, we did have product cost deflation. Yes, we did.
Got it. Very helpful. And then last question, I'll turn it over. Just on the Canadian turnaround, DG, Granger has tried that for several years, as you know. This time, maybe just frame for us what's different this time in terms of strategy?
I know you highlighted sort of operating margin run rate positive Q4, but just high level, what's different in this turnaround versus past several years?
Yes. Well, this one is a lot more, I would say, intense in the sense that we've completely reset the business. We've combined the back office with the U. S. And created North American Centers of Excellence.
We've gone from 170 to 35 branches. We've completely restructured the sales organization. And all of that basically means we've taken about $85,000,000 in cost out of the business. And we're now going to start growing that business. We're adding some of the U.
S. Assortment to that business, the ability to buy out the U. S. We're really focused on expanding, diversifying the customer base throughout the business. And all those things, I think, will mean it feels very, very different and allows us to be much more consistent in the growth we see and the
Our next question comes from the line of Steve Barger from KeyBanc Capital Markets. Please proceed with your question.
Yes. Thank you. So going back to what you just said about Canada, the 4Q positive operating margin exit is more on price and volume stabilization at this point, less on cost control like the branch closures that you just executed? And should we expect that you remain positive on a quarterly basis going forward?
Yes, you should expect that we remain positive forward. A lot of what you're going to
see in the Q4, it will be
the first time that you see really clean look at the cost structure as well. So it's not just price and volume stabilization, it's also the cost structure getting to the new level.
Understood. And incrementals have been solid year to date, averaging about 24%. As you think about tougher comps, you think about mix, volume, tariffs, if we see a mid single digit growth environment going into 2019, do you think you can maintain a 20% incremental or better? Or should we be thinking high teens given the puts and takes?
I think we should be able to maintain a 20% or higher.
Higher. Our last question comes from the line of John Inch from Gordon Haskett. Please proceed with your question.
Thanks. Good morning, everyone. So, if we're going to hold or aspire to a framework of gross margins stable, does that imply a similar boost to mix from growth rates at the medium versus large today? I mean presumably those are going to slow, but do you still expect that ratio to kind of hold that 2 for 1 or whatever?
Yes, we'll come back and
talk to you about that in January specifically, but our expectation is that midsized customers will be growing faster than the rest of the business and that will help us. That will be a positive.
Okay. So that makes sense. If we back into a little bit of a follow-up on that variable contribution question. But if we back into kind of the OpEx leverage, if you ex out restructuring, we're coming up with about 20%. And the genesis of my question is, I think, D.
G, earlier in the discussion, you alluded to the fact that you were talking to alluded to the fact that perhaps restructuring was maybe sort of tapering off. I'm curious because it seems like a lot of the OpEx benefit has come from restructuring Canada and so forth. What's your trajectory for restructuring? I mean, do you see as much opportunity to go after various projects in Canada or the United States? Or what's how should we think about that?
Yes. So for we've been running to a cost program that we talked about last year. We have been meeting or exceeding those expectations. We are in a good position now to make sure we improve our cost structure in 2019. And it comes across the entirety of the business.
A lot of it actually comes from changes we have made recently, whether it's centralizing contact centers or going to the centers of excellence at AGI, all that flows through the P and L next year. I would also say that there's still great opportunity to improve the core big cost buckets in the U. S, whether that's getting more revenue per seller in the U. S, whether that's getting more lines per hour in the distribution centers. We're going to have the Louisville distribution center up and running next year.
More of our volume will then be going through automation, which will help the cost structure. And we continue to get comfortable with the contact center footprint we have and getting more effective, more efficient there. So the big cost buckets, we see a path to continue to improve the cost structure. We think that's going to continue in the future.
Makes sense. Just last one for me. Canada, I guess we had talked about a 4% to 8% margin rate in 2019. What's changed in 2018 that prospectively kind of makes that not a viable target or it looked at the low end or something like that? Like what ultimately changed in Canada this year?
And maybe the 4% to 8% is still an aspirational target if we're going positive at the end of the quarter? I mean, how do you sort of
try to get it? We actually don't think anything's changed. That still that's what Ranger is talking about.
So $48,000,000 is still on the table then?
Yes. And we'll talk about specifics what we think specifically in January.
Got it. Thanks guys.
Thank you.
Ladies and gentlemen, we have reached the end of the question and answer session. And I would like to turn the call back to D. G. McPherson for closing remarks.
G. McPherson:] So good.
So thanks for joining us today. I would just make a few points coming out of the call. Thanks for your questions. The first one is in the U. S, there was a lot of uncertainty going into the quarter about what would happen when we lapped the prices.
That actually has been very positive. Almost every metric we have in the U. S. Is looking positive in terms of our growth, our GP, our expenses, our customer acquisition. So we're really excited about what we saw in the quarter from the United States.
Canada turnaround continues to go well. It's very challenging, but we are in a good position now based on the new cost structure to drive growth and to be profitable going forward in Canada. The online model continues to grow and to grow at attractive rates, so we're very positive there. And then the international business, which is much narrowed, is in a good position to continue to drive margins. So we feel really good about where we're at as a company and where we're heading.
And I really appreciate the time. So thanks for being on the call.
This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.