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. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. 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.G. Macpherson, Chairman and CEO, and Tom Okray, 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 questions. D.G., to you.
Thank you, Irene. Good morning, and thanks to all of you for joining us this morning. We had another solid quarter. Demand remained very strong in the third quarter, and we're continuing to gain share. In the U.S., as we lapped our August 2017 pricing changes, we are encouraged with our volume growth of 8%, which significantly outpaced the market. We're continuing to see that our value proposition resonates with both large and mid-size customers now that we have removed pricing as a barrier. We continue to grow faster in more profitable parts of the business, notably with our mid-size customers. In addition, gross margin, when normalized for the revenue recognition accounting change, and operating margin were both favorable to prior year. In Canada, the execution of our turnaround continues to make progress and is on schedule.
We still expect to exit the year at a profitable run rate. Our single channel online businesses, mainly MonotaRO and Zoro, had strong growth and profitability. We recorded a non-cash 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 two other things. One, we had a very strong customer satisfaction reading in the U.S. this quarter. It's actually the strongest we've seen under the current methodology. Also with Hurricane Michael making landfall last week, I want to note that all of our people 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. Third quarter 2018 reported results contain restructuring charges of $142 million and a $2.37 impact to EPS. In the quarter, we took a non-cash impairment of $139 million 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. The uncertainty surrounding Brexit as it gets closer to being executed forces us to take our growth projections lower. Second, 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. 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 and hurricane comparisons of 1%.
This is the first quarter 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, D.G. 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 customer contracts. Moving to profit. In our comparison to the prior year, there were non-recurring adjustments 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 U.S., 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%, consistent with August growth for large and medium customers. After adjusting for the revenue recognition 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 to be strong in the U.S.
Having said that, you will notice some lumpiness in the quarter related to two factors: increased variable compensation versus the prior year, and the quarterly variable compensation true-up 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 mid-size 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 customers, 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 one 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% 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 D.G. for closing remarks.
Thanks, Tom. 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. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Our first question comes from the line of Ryan Merkel from William Blair. Please proceed with your question.
Thanks. Good morning. A couple questions from me. First, based on some of my inbound emails, people are picking on the lack of operating leverage in the U.S. for this quarter. Can you just discuss what exactly drove the variable comp true-up this quarter? Then can you confirm that this is a one-time event and that the U.S. operating leverage will be strong in 2019?
Yeah. 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 to 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 with sales growing approximately twice the rate of operating expenses.
Okay. That's helpful. Secondly, I know you're not talking about 2019, but on the last call, you stated you thought gross margins in 2019 could be stable with 2018. 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?
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. Mid-size 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. 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, 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, 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. 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.
Yeah. Thanks. Good morning. SG&A at the company level, adjusted SG&A was down a little sequentially despite the spike in the U.S. comp catch up. 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.
Yeah. I would also point to Canada as a big offset to that. We've taken about $85 million 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. Parsing the GM. Excluding the revenue rec, Company level gross margin was flat with the U.S. up 20% and Canada up more than that. 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 gross margin overall, and they're growing at a faster rate.
Yeah. 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 Company. 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 margin wouldn't have been a little bit better with that mix impact and the point of price. Were there any other items within that? 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 fourth quarter gross margin?
Let me take the first part of the question first. What I'd point you to is taking a look at the sequentials. Throughout the year, our gross margin typically declines, 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. We're very happy with what's happening with gross margin. One other thing that I would point out is, FX was a headwind this quarter. It's been a tailwind the previous two quarters. The dollar is getting stronger versus the CAD and the MXN.
Then the second part of your question was around inventory revaluation. We do not believe we will have any concerns there. As a reminder, we're on LIFO, and I think we shouldn't have a problem in any case.
Great. Thank you.
Our next question comes from the line of Steven Winokur 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 $1 impact if you didn't have alternate sourcing or pricing actions. Am I thinking about that the right way?
Yeah. First of all, we're certainly going line by line. We just simplified it for presentation's sake. As we noted in our prepared remarks, we think it's well understood and very manageable.
Okay. That math, though, makes sense as well?
Correct.
Okay. Then just on the alternate sourcing point, just where you may have challenges on pricing or taking actions or are concerned about volume impact of those pricing actions, how are you thinking about your options there in terms of substituting supply?
Our team is looking very closely at pretty much a SKU by SKU level. 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. We just look at the total economics, total landed cost, and pick the one that's got the best cost for the business. Much of our shifts could, if it's China, if it's shifted, it could go either to India, to Mexico or to 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. We are able to work with suppliers to make sure that we're actually taking the right cost increase. That's a big focus for us.
How long do you think it'll take you to migrate once you make those decisions?
Well, it depends. If we have an alternative source, it's actually pretty quickly. At this point, we don't feel like we're going to be in a position where we're going to have any disruption, and we feel like we're on top of this. We are not concerned about being able to make any changes we need to make.
Okay, great. I'll pass it on. Thank you.
Our next question comes from the line of Luke Junk from Baird. Please proceed with your question.
Good morning, guys. First question, D.G. Canada revenues stepped down again this quarter, by design, of course. Can you help us understand when Acklands-Grainger revenue should start to normalize? I think Tom mentioned in the prepared remarks that many of the cost reduction initiatives are now behind you. What kind of volume assumption is built into your operating margin guidance exiting this year heading into 2019 broadly?
I would say, 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, we expect next year to be more of a stabilization period. I would note a couple of things. One is that the branch closures, which mostly are behind us, there's still some to come, have an impact on revenue, also has a positive impact on profitability. We have reorganized our sales team, coverage is now stable, we're now talking to customers and trying to drive growth, I think that will help us stabilize over the next year.
I would say, in general, it's hard to take a look at numbers that are down that much, it's hard for the team, this is what we expected, I think the team's doing a great job of managing through that. We're in a good position now to really create value for customers, improve service, improve the conversations we're having. We're optimistic about stabilizing and being able to grow.
Okay, 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 case 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. That's really our fundamental principle on driving the result here.
Perfect. Thank you.
Our next question comes from the line of Nigel Coe from Wolfe Research. Please proceed with your question.
Thanks. Good morning, guys. Going back to the tariffs, surprise. You mentioned half are 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 aren't 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 included in this. Roughly half of what we have coming from China is really in that bucket today.
Okay. 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 apples to apples basis? Are you including the depreciation of the Chinese currency in those calculations?
No, the calculation was done on a constant currency basis.
Okay. Just quickly on the hurricanes, the 160 basis points impact. You mentioned that there was some offsets last year with the two hurricanes that weren't there this year. I just want to understand what the difference is between last year and this year in terms of the benefits versus the impact.
Yeah. What we do when we look at hurricane impact is we look at two 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 two combined had a lot more hurricane sales offsetting the business slowdown. In fact, the Florida business slowdown was very fast. There wasn't much of it. 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 as highly populated area as Houston, the 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? I saw it was $142 million. Where do you stand in terms of the actions? How much are headcount? How much is footprint? Anything structural? Then expectations for the balance of the year.
I'll turn it over to Tom in a minute. Most of that $142 million was the Cromwell impairment, and that was $139 million of it. The rest were small in general. Most of the big changes in both Canada and the U.S. are mostly behind us. Maybe Tom can talk about that.
Yeah, exactly. Taking out the Cromwell, there's some small severance items, E&R Industrial integration, Fabory North America wind down in the U.S. Then there's some residual branch closure costs and severance costs in Canada, which is quite small and coming to an end.
Got it. Just want to get, I might have missed this, I apologize, 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&L?
The vast majority of it 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. In general, we'll be mostly done and we'll be talking about very small impacts going forward.
Got it. Thank you.
Yeah.
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 Q4 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 Q3 comps are probably even harder than your Q4 ones.
Well, I would talk about a couple things, Evelyn. Thanks for the question. One is, remember the third quarter, we made the change last year, August 1st. Part of the quarter was actually not under the new pricing. I would say we continue to be very encouraged and surprised by what we're seeing post-lapping the price change in terms of midsize customer growth. Our models do not have us growing 30% forever, as you might guess. When 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. 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 it.
I'd say all signs are very, very positive on midsize customers right now.
That's helpful, D.G. I guess apologies for an unoriginal question on tariffs, but just curious, I think what you laid out in 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? Is that going to be something closer to, I think, the 30% of total company COGS that you've discussed in other forums?
First of all, we don't know how that will be implemented or if it will be implemented. Like all these things, we are watching it very closely, but 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. Then I guess last question from me. I think you noted that your spot buy has been increasing with some of your contract customers. Just curious to know, what is the mix of your planned 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. It's a great question, but we haven't typically laid that out.
Great. Thanks, guys.
Thanks, Evelyn.
Thank you.
Our next question comes from the line of Ryan Tezlick from North Coast Research. Please proceed with your question.
Hey, good morning.
Morning.
Morning.
First, I wanted to go back to the guidance, just make sure we're clear on what you guys are saying. If I heard you right, you said that when excluding the $0.14 benefit from stock comp on the tax rate, you're running at the high end of your EPS guidance range. One, is that correct? Two, does that assume 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?
Yeah. It's a good question. I just want to make it clear that we've raised guidance twice this year, we are tracking toward the high end of that range. We're very encouraged by our performance, 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.
Tom, would you say you 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. We're always slugging it out with the other parameters as well.
I would say we're tracking towards the high end of all the dimensions that we laid out. 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 fourth quarter?
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. For my other question, looking at the U.S. volume growth it continues to be strong. But when you look at it on a two-year stack trend, which we all do to try to get a sense of the adjusted or prior year comps, it looks like it's flat-lined a little bit, and implies maybe into the fourth 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 fourth quarter as it relates to some of the marketing 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?
We haven't really seen anything that suggests that we cannot continue to gain share and continue to grow. Like I said before, we're really encouraged by post-pricing change that we see in our large customer volume grew, consistent with what had been growing before post price change and our mid-size customer continues to grow. We would expect to be certainly north of five, if that's your question, and we expect to have strong revenue results going forward in the U.S.
My last question, I'll hop back into queue. When you look at the tariff-related commentary that you guys gave and 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 something in that two-thirds of your private label 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.
I think the confusion there would be two-thirds would be on a revenue basis. Given the GP on a COGS basis, it's roughly the math as you see it. That's the difference there.
Got you. Thanks, guys.
Thank you.
Our next question comes from the line of Justin Bergner from Gabelli & 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 points differential on 5% growth versus 9%, I'm in the $20 million range. Should I think of then the effect on the third quarter, the unusual effect of the third quarter being, I guess, three-quarters of that $20 million sort of being compressed in one quarter versus four quarters?
Yeah. 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? How much of that 20% is related to private label versus branded?
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. 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. 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 that's only produced in China today, there are some products like that, obviously we don't have alternative source. We can go find them, and that's going to be more work.
Okay. Got it. The 25% tariff assumption, I assume that a good chunk of the imports from China are being tariffed at 10% today. 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.
Yeah, we assumed worst case for the calculation, so we didn't take any credit for staying at 10%.
Some of the 10% has 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. Then lastly, on the sales side, was there anything that was sort of disappointing in terms of U.S. sales, whether it be deceleration in natural resources or government customers, things that you would point to as sort of falling short of your expectations in the quarter?
No, I would say that pretty much all things U.S. revenue margin, all of it was positive in the quarter relative to our expectations. Of course, there was more uncertainty going in because of the price lap. Pretty much at every turn, it'd 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 one 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. I'm assuming, of course, that the price actions were negative, but that you had price increases and mixes in there as well. Could you give us any color on the buckets?
Yeah, sure. 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. 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. We've been very consistent in 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. 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.
D.G., would you say that that's the 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 second quarter that that started to read through. Don't hold me to that, but I believe that's true.
Lastly, again, on the pricing. 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 where there sort of upper bands and this kind of thing that slows things down, or how do you work through that with those customers?
Yeah. 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. Our commercial team does a great job of navigating with our customers to get the best outcome for both of us.
Okay, thanks.
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 cleanups here. A lot's been covered already. Just on the tariffs, it sounds like you fully expect to mitigate through alternate sourcing or pricing. Do you think you can offset the tariff cost right away, or you think there might be some lag?
Given what we know now, there would not be a big lag. Given what we expect in terms of the 10 going to 25, we think we'll be roughly coincident, close enough.
Okay. Just a couple of little cleanups here. I couldn't find anything on branch count. I'm not sure if it was in the release. If it was, then I missed it. Just wondering what that looks like today versus the second quarter end. I know you guys are still closing branches in Canada, or I think you are.
We are. 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 seven in the quarter in Canada, really the rest is virtually nothing. The branch count's stable pretty much everywhere else.
As you've been closing these branches in Canada, have there been any gains on those? 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 branch sales? I haven't seen them called out.
Yeah. Keep in mind, yes. Typically, they're smaller branches and not necessarily as valuable as the U.S. branches in terms of sales.
Yeah. The gains would obviously show up in our restructuring charges, and they're relatively small.
Got it. Those restructurings are net of gains.
Yes, correct. Yes.
Got it. Understood. 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. That's almost all customer choice.
Sorry. Yeah, I missed that. Last one for me, just Zoro U.S., how did that grow in the quarter?
Continued to grow strong. Strong growth in Zoro U.S.
Is it up like, because you said 23% for total single channel. Is it up at that kind of rate? Or is it
It's not quite that, but it was up
It was up 18%.
18 in the quarter. We were 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. 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?
No. What we talk about is price cost spread and are we able to mitigate COGS increases and get the right price for our customers. This year, we had talked about being down half a percent. 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. Otherwise, we would actually be in an inflation mode this year of 1%-2%, probably.
To be clear, though, for the quarter, we did have product cost deflation.
Yeah, we did.
Got it. Very helpful. Last question, I'll turn it over. Just on the Canadian turnaround, D.G., Grainger's 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?
Yeah. 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. All of that basically means we've taken about $85 million 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 of the U.S. We're really focused on expanding, diversifying the customer base throughout the business. All those things, I think, will mean it feels very different and allows us to be much more consistent in the growth we see and the performance we see out of that business going forward.
Okay, wonderful. Thank you.
Our next question comes from the line of Steve Barker from KeyBanc Capital Markets. Please proceed with your question.
Thank you. 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. Should we expect that you remain positive on a quarterly basis going forward?
You should expect that we remain positive going forward. A lot of what you're going to see in the fourth quarter, it'll be the first time that you see really clean look at the cost structure as well. It's not just price and volume stabilization, it's also the cost structure getting to the new level.
Understood. 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.
All right, thanks.
Thank you.
Our last question comes from the line of John Inch from Gordon Haskett. Please proceed with your question.
Thanks. Good morning, everyone. 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? Presumably those are going to slow, but do you still expect that ratio to kind of hold that two for one or whatever?
Yeah, we'll come back and talk to you about that in January specifically, our expectation is that midsize customers will be growing faster than the rest of the business, and that'll help us. That'll be a positive.
Okay. That makes sense. It's a little bit of a follow-up on that variable contribution question, if we back into kind of the OpEx leverage, if you x out restructuring, we're coming up with about 20%. The genesis of my question is, I think, D.G., earlier in the discussion, you or Tom 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? Do you see as much opportunity to go after various projects in Canada or the U.S., or how should we think about that?
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. 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&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. We continue to get comfortable with the contact center footprint we have and getting more effective, more efficient there. 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 from me. Canada, I guess we had talked about a 4%-8% margin rate in 2019. What's changed in 2018 that perspectively kind of makes that not a viable target or the low end or something like that? What ultimately changed in Canada this year? Maybe the 4%-8% is still an aspirational target if we're going positive at the end of the quarter. How do you sort of triangulate it?
We actually don't think anything's changed. That's still-
Okay
the range we're talking about.
4-8 is still on the table?
Yes. We'll talk about 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. I would like to turn the call back to D.G. Macpherson for closing remarks.
Good. 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. 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. 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. We're very positive there.
The international business, which is much narrowed, is in a good position to continue to drive margin. We feel really good about where we're at as a company and where we're heading. I really appreciate the time. Thanks for being on the call.
This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.