Greetings, and welcome to the W. W. Grainger Second Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen only mode and a brief question and answer session will follow the formal presentation. And As a reminder, this conference is being recorded.
I'd now like to turn the conference over to Irene Holman, Vice President, Investor Relations.
Good morning. Welcome to Grainger's Q2 earnings call. With me are D. G. MacPherson, Chairman and CEO and Tom Okrae, 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 earnings, including those detailed in our SEC filings. Reconciliations of non GAAP financial measures with their GAAP measures are at the end of this slide presentation and in our Q2 press release. Both are available on our Investor Relations website. D. G.
Will cover our performance for the quarter and Tom will give an update on our 2018 expectations. After that, we will open the call for questions. DG, to you.
Thank you, Irene. Good morning, everybody, and thanks for joining us today. So the Q2 marked our 3rd consecutive quarter of strong results and the results certainly beat our expectations. Our volume growth significantly outpaced the market, driven by actions to consistently deliver value to our customers at relevant prices. The demand environment remains strong.
Our sales performance was driven largely by the strength of the U. S. Business and our single channel online businesses. In the U. S, we continue to see a solid response to our pricing actions with actions with total volume growth of 11%.
We saw growth across all of our major end markets, including manufacturing, commercial, healthcare and government. We know that customers value the relationships they have with Grainger, our customer service, technical support and fulfillment capabilities. When we couple that with our relevant pricing, our offer is very compelling. And as a result, we're growing faster and more attractive parts of the U. S.
Business. This is not only driving GP dollar growth, but also resulted in better than expected gross profit margin for the quarter. In Canada, the execution of our turnaround is progressing as planned, and our actions there led to GP and operating earnings improvement. Our single channel online and international businesses both had nice growth and expanded operating earnings in the quarter. Based on our performance and continued momentum, we're raising our full year guidance.
Tom will share the details of our updated guidance later in the presentation. Turning to reported results. Q2 2018 reported results include restructuring charges of $15,000,000.21 impact to EPS. Now 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 9%.
Volume was up 9%. Price was flat as price deflation in the U. S. Was offset by price increases in Canada. We had foreign exchange favorability of 1% in the quarter that was offset by negative 1% impact from the divestiture of Technetool in the U.
S. We have now lapped the Technetool divestiture as of mid July. Our normalized GP rate declined 30 basis points after adjusting for the revenue recognition accounting change and the timing of our annual sales meeting. We continue to realize operating expense leverage on higher volume. This all led to operating earnings growth of 23% in the quarter.
I'll cover our other businesses first. As a reminder, other businesses include our single channel online model and our international businesses. Sales for these businesses were up 18% in the quarter, 14% was price volume and 4% was from currency. Our online businesses drove 25% sales growth and continued to be a profitable growth driver. Our international businesses had solid organic growth in the quarter and contributed to operating margin expansion.
We are happy with where our international portfolio is today. In Canada, sales were down 6% and down 10% in local currency. We introduced price increases in the Q4 of last year and are renegotiating pricing on large customer contracts. As a result, price was up 10% and contributed to GP rate expansion of 4.55 basis points in the quarter after adjusting for the revenue recognition accounting change. Volume was down 20% due to the planned price increases, branch closures and sales coverage optimization activities.
As we've talked about before, this is going to be a smaller but more profitable business when we're through with the reset. Operating margin improved 2 90 basis points due to a higher GP rate and cost management. The turnaround is progressing as planned with several of the activities running ahead of schedule. Much of the heavy lifting is behind us and we're encouraged by the improvement in profitability.
We believe we'll be in
a good position to exit the year profitably and go on offense in 2019. In the U. S, both the volume response to our pricing actions and the demand environment were strong. Sales were up 9% in the quarter. Total volume was up 11%, including seasonal sales and holiday timing of positive 1%.
Volume growth was partially offset by price deflation of 1% and a negative 1% impact from the Technetool divestiture last July. Our normalized GP rate declined 65 basis points after adjusting for the revenue recognition accounting change and the timing of the sales meeting. Operating expenses in the U. S. Were up 2% after adjusting for the revenue recognition accounting change.
Operating margin was better than expected in the quarter as expense leverage on total volume growth of 11% more than offset the GP rate decline. Now as we look at growth in the U. S, continuing to see that our value proposition resonates with both large and midsized customers when we remove pricing as a barrier. We are gaining share and seeing volume growth with both customer groups. Our digital marketing activity is also having an impact and overall returns on both digital and offline marketing are improving.
U. S. Large customer volume increased 9% in the quarter, above expectations. We're seeing increased share gains with large customers as they buy more infrequently purchased items and consolidate their purchases with Grainger. U.
S. Midsized volume also exceeded expectations with growth of 29% over the prior year. We're seeing meaningful growth with both new and existing customers. Existing midsized customers, including lapsed customers, are buying more. We're seeing that in our volume, in the number of transactions per customer and in the number of customer contacts that are buying.
We're also acquiring net new midsize customers for the first time in a long time. When we look at the midsized business growth, a meaningful portion of it is coming from new customer acquisitions. Overall, we remain optimistic about the U. S. Business in 2018.
I'll now turn it over to Tom, who will discuss our expectations for the year.
Thanks, D. G. I want to start by adding some commentary on our results for the quarter. Let's take a closer look at gross profit. We normalized company gross profit rate in the quarter for 2 items: 1, a change in revenue recognition accounting standards and 2, the timing of our annual sales meeting.
As a reminder, due to a change in accounting standards related to revenue recognition, we were required to reclassify certain keep stock service costs from operating expense to cost of goods sold beginning in 2018. We have slides in the appendix that outline this change at the company and U. S. Level. Separately, suppliers provide funding for our annual sales meeting.
This funding benefits gross profit margin and is spread over 3 consecutive months, beginning in the month of the sales meeting. In 2017, the sales meeting occurred in March and in 2018, the sales meeting occurred in February. The company normalized gross profit rate of 39.2% was down 30 basis points, which was better than our expectation. This was driven by price cost spread and mix favorability in the U. S.
And the price increases in Canada. U. S. Normalized gross profit rate of 39.8 percent declined 65 basis points. As DG mentioned earlier, in the U.
S, we're growing in areas we want to be growing. With large customers, price deflation is improving as we aren't deeply discounting infrequently purchased items and customers are more comfortable with our pricing level. Some of the gross profit favorability in the quarter was also due to the delayed timing of our large customer contract negotiation. We're now through almost 90% of our contract revenue and expect to get through the majority of the remaining contracts by the end of this year. We did see some supplier inflation in the quarter, partially due to tariffs, and were able to pass through price while maintaining market competitiveness.
Company operating margin was 12.6%, up 150 basis points, driven largely by expense leverage on strong sales performance. Earnings per share of $4.37 in the quarter was up 59% versus the prior year, primarily driven by higher operating earnings and a lower corporate tax rate. Operating cash flow of $248,000,000 was up 30% versus the prior year and free cash flow of $211,000,000 was up 32% versus the prior year. The increase in both cash flow numbers was driven largely by higher earnings and a lower tax rate. Page 13 covers our updated guidance for the year.
What we shared in April is on the left side of the chart and our updated guidance is on the right. We outperformed our internal expectations by about $0.60 in Q2. That flows through to the updated guidance for the year. In addition, we are also adding $0.15 of favorability to the second half, largely as a result of the momentum we are seeing, including lower than expected price deflation. As a result, we are taking both the high and the low end of the EPS range up 0 $0.75 We now expect revenue growth to be in the range of up 5.5 percent to 8.5%.
We expect an operating margin of 11.5 percent to 11.9%, which is 50 basis points to 90 basis points higher than the prior year. We expect EPS to be between $15.05 $16.05 or 32% to 40% higher than the prior year. From a sales perspective, we continue to believe that our volume growth will outpace the market by 300 plus basis points this year. With respect to gross profit margin, after normalizing for the 50 basis points related to the revenue recognition accounting change, the rate is expected to decline between 50 20 basis points versus the prior year. Further, we expect our gross profit rate to follow the normal sequential trend in 2018.
For 2019, we expect the gross profit to be relatively stable versus 2018. I want to spend a moment on price cost spread in the U. S. We previously expected a price headwind of negative 1.5% for the year. Net value was a net number comprised of negative 3% from our August 2017 pricing reset, partially offset by a positive 1.5% from favorable mix and market based price increases.
Today, we are updating the total price headwind to be negative 1%. We now expect price deflation related to the reset to improve due in part to timing of contract negotiations. We expect to complete a majority of the contracts this year. Our expectation for COGS deflation remains unchanged at 50 bps, driven by our internal product cost optimization initiatives. We expect that we will see some supplier inflation related to tariffs in the second half, and we are confident in our ability to pass on price increases.
I think it's helpful to point out that the current market dynamic is similar to past periods of inflation. Granger has historically done well in managing costs and getting price realization through these periods. I'll now turn it back to DG for closing remarks.
Thanks, Tom. So overall, we're very pleased with our continued strong momentum. Our value proposition is resonating in the U. S, resulting in strong growth with gross margin rates above expectations, and we are developing stronger relationships with customers of all sizes. We are executing our turnaround as planned in Canada and expect to exit the year profitably.
Our online model continues to drive strong revenue growth and margin expansion, and our international businesses are contributing to earnings. We continue to get strong expense leverage across the business and are on track to achieve the productivity targets we laid out at Analyst Day in November. We are well positioned to gain share and improve our economics going
Our first question comes from the line of Ryan Merkel with William Blair. Please go ahead.
Thanks. Good morning and nice quarter.
Thanks, Ryan.
So first question, high level question on the cycle DG. There's been increasing talk and worry about peak cycle and what tariffs may do to demand. You just put up a very good quarter obviously, but what are you hearing from customers about the second half? And are there any signs of slowdown anywhere that you can see?
Well, through the quarter, we haven't seen any signs of the slowdown at this point. There are certainly conversations with customers. I would say most of those conversations tariff related tend to be longer term. So questions about whether or not product will actually be end product will be made in China and then shipped over given the way the tariffs are structured. I've talked to a couple of customers about that.
But in the short term, we feel like there hasn't been a lot of action yet and we don't see any slowdown at this point.
Perfect. That's helpful. And then secondly, OpEx growth has been very well controlled for a few quarters now, up low single digits. So two questions, how long can this last? And then could you comment on what is normal OpEx growth?
Well, I think if you looked over our history, normal probably would you have to have it in quotes. I'm not sure you have anything that's exactly normal. I would say, we feel like for this year and next at least and in 2020, we have the opportunity to get pretty significant leverage. Our expectation is that our OpEx will cover merit for folks every year. There's a built in productivity every single year.
And so if the market if we grow 6% volume, we would expect our OpEx to be 3% or something like that or less in general.
Okay, helpful. Thank you. I'll pass it on.
Our next questions are from the line of Christopher Glynn with Oppenheimer.
Thanks. Good morning. Good morning. Exciting result there. So as you talk about the U.
S. Large customers finishing their round of contract negotiations, just curious what happens next as you would envision it assuming contracts renew on a rolling basis over time, you finish now, maybe it starts up again. The subsequent rounds tend to include some additional price concession versus volume trade offs?
Well, I think anytime you are in a negotiation for a contract, it's a competitive situation. That has not changed at all. That will continue to be the case moving forward. What we do feel like is off of the price reset, we are competitive. I think what you're seeing with large customer GP is gross profit is that it's not down very much because we've always been competitive with those customers.
And we feel like we're well positioned to go through whatever cycles come up in the future. And our focus to those negotiations typically is how do we save customers' time, how do we save them money. And if we focus on that, we have the ability to continue to have really strong economics at the other end if we do the right things.
Okay, thanks. And then on Canada, just wondering your comment go on offense in 2019. You're clearly seeing a volume impact from the price resets. But could you elaborate on what you mean by go on offense?
Turn the situation from shrinking to growing. We are through teams that did a really nice job there getting through the vast majority, if not all, of the restructuring and the changes we have to make. We're stabilizing the business with certain customers and then to grow. We're going to grow in a way that allows us to be profitable as we grow. And so when we talk about going on offense, actually what we mean grow profitably.
Okay. Thank you.
Thanks.
Our next question comes from the line of David Manthey with Robert W. Baird.
Thanks. Good morning. Good morning. D. G, about a year ago, you declined to refine your 2021 margin goals and I assume that's still the case.
But first off, the 12% to 13% overall operating margin target for 2019, should we assume that's still in effect?
Until we change it, yes, you should assume that's still in effect.
Okay, fair enough. 2nd, as we look at that prior 2021 range, especially for Canada, you were looking at 7% to 9% and I believe your 2019 goal is 4% to 8%. When we think about Canada, should we assume that structural operating margins are limited to high single digits or changes you've made to the footprint and the model here just recently, can you ultimately start to approach double digits and maybe even get closer to U. S. Levels?
Well, I think I'd answer that with 2 comments. The first one is, we don't believe there's anything structurally that should keep us from having double digit margins in Canada if we do all the right things. So we do believe that. Given where we're sitting, we're really focused on getting to the improvement goals we've set in the next year. That's really, really important.
And so we view that as a step on the path to improving growth and profitability of the business. But I don't think there's any reason why we couldn't be low double digit earnings in Canada at some point.
Our
next question comes from the line of Chris Dankert with Longbow. Please go ahead.
Hey, good morning. Thanks for taking my question.
I guess first off, D. G, would
you mind kind of like highlighting what we've seen as far as your restructuring savings in the first half versus the back half? It seems like it should be a little bit back half weighted here and just kind of your confidence in hitting those targets?
Well, really confident in hitting the targets mostly because most of the actions that we have to take have already been taken or were just completed in the last quarter. So we feel like the Canada targets are going to be where I hit those and the U. S. Targets, most of the actions we've already taken. So we are highly confident in what we're seeing.
Got it. Got it. And then just kind of looking at 2Q here, it seems like the loss on your investment in clean energy was quite a bit lower 2Q versus last year and last quarter. I mean, anything you'd stake out as far as expectations there going forward? Should we expect that the losses there just will be structurally
smaller now?
We've got no change in terms of our guidance on our coal investment. We're keeping with $0.05 to $0.10 EPS range.
That's even despite what we saw in the Q2 here?
Yes.
Okay. Okay. Thanks so much guys.
Thank you.
Our next questions are from the line of Patrick Baumann with JPMorgan.
Hi, good morning guys. Good morning. Quick question on the margins. You guys did 12.5% total company margins in the first half. Full year guidance, I guess, 11.5% to 11.9% now.
So it kind of implies the second half kind of implies margins. That's a little bit worse than normal sequential deterioration versus the first half. Historically, it's about 100 basis points. This year, it seems like you're embedding 150 basis points of degradation versus the 12.5% you did in the first half. And I'm just curious if there's anything that stands out that's driving that.
I know you mentioned large contract renegotiations, maybe that's a factor. I'm just want to help with the math there, if you can.
Yes. So it's a great question. I think that the reality is that we still are in many ways in new waters in certain places. So to the extent we saw midsize customers continue to grow like we've seen them grow, we saw large local customers grow like we've been seeing, Certainly, there's a chance for us to be better than what we've talked about. But it's so early on many things that we're seeing.
We're still getting a real handle on that. We felt like we wanted to stick with a wide range at this point, and we're optimistic about the path along.
Okay. Makes sense. And can you talk about your direct exposure to China sourcing? And I assume some of the private label products you sell come from there. I'm just not sure if you can quantify or also how you're approaching kind of the tariff situation just from a risk mitigation perspective for some of that stuff?
Yes. So we the vast majority of our source items come from China, up to 2 thirds or even more than that at this point. There's also so there's 2 things. 1 is our private brand products that come from China. The other is branded products that come from China, both have the potential to be impacted here.
If I focus on our private branded products, so we have been looking very closely at alternative sources and understanding what we can do and how we can shift. And so if you think about private brand, we have 23% private brand. Most of that's China. For every item that is that you could, we have an alternative source effectively and we can shift if we need to. We haven't seen yet the economics make that work, but we are looking at it consistently, and we feel like we're in good shape to really understand what to do.
Got it. Makes sense. And then last one for me. The buyback in the quarter slowed down a bit. Any reason for that?
And is there any update to kind of cash flow expectations or buyback for the year?
No. We're just looking at our model and opportunistically buying back. For the year to date. We bought back over 760,000 shares. Just really looking at the price of the stock in the market, no intentional slowdown.
Thanks. Thank you.
And our next question comes from the line of Deane Dray with RBC.
Thank you. Good morning, everyone.
Good morning.
Could you comment on your business with the U. S. Government and specifically exposure on Section 846 of the NDA contract?
Yes. So 846 is still I think you know this, it's still under study. So there's absolutely no implementation of that at this point. Our business with the government, the U. S.
Government has been very strong this year, continues to be strong. We have great relationships across a number of different organizations, military organizations and beyond. And we've seen really strong results with what we do. In many cases, we are really helping military bases and other federal governments manage their inventory. And that's a big part of what we do for them.
And so we haven't seen any impact yet from that bill. And I think there's uncertainty around what that bill will actually look like at the end.
Got it. And then just in terms of where we are in the cycle, are you seeing or feeling pressures, let's say freight? Are you able to pass that typical that types of incremental charges to your customers and any issues with labor shortages in your organization?
Well, certainly, I would say that the labor market is tight and the freight market is tight. So there's no question about that. We haven't seen labor shortage just taking the second of those 2. With freight, our team has done a really nice job of looking at alternatives. Our initiatives have more than offset the pressure for price increases at this point.
Certainly, there is pressure, particularly with truckload and LTL, where drivers are at a shortage and there's all kinds of issues that are challenging in that market. But so far, we've managed through that really well, Dave.
Got it. Thank you.
Thank you.
And our next question comes from the line of Nigel Coe with Wolfe Research.
Yes, thanks. Good morning. Just wanted to go back to the OpEx control and appreciate the detail, DG. But given can you just maybe just give an update on where you are with the sales force expansion, sales force effectiveness and also your marketing strategies? And maybe just go into a bit more detail, obviously, you're investing in certain categories.
Where are
the offsets to SG and
A to enable you to get that leverage into 2019?
Nigel, I didn't understand.
You said I didn't fully understand the question. You said sales force expansion and you had another thing in it that I didn't understand.
Yes, marketing. So online marketing and yes, traditional.
Yes, yes. So when we think about OpEx control, we look at the entirety of our spend. We get very strong productivity typically in pockets that have very big populations. That includes our distribution centers, our contact centers. We continue to see that go well.
We're continuing to get productivity in our sales force and putting in the CRM has helped our sales force have the right conversations, go to the right customers and it's improving. We expect to we're learning and we expect that to continue going forward. We have added some sellers. We are adding sellers, I would say, at a modest level consistently, and the sellers that we do have are going to be more productive, and that's the way we think about that.
Okay, great. And then just picking up on the 301s. I think you said 20 2 percent of your sales are white label or private label products. Bulk of that comes from China. Is that right?
That's correct.
Yes. So based on the current tariff that we have, the initial 50 and then the next 200, have you done any work in terms of how much of that 20% is currently wrapped into those lists?
Yes. So far, it's a small portion of it and our team is working very hard to make any changes we need to make with that portion. We'll have obviously, if this expands and the next tranche comes in, we'll have more to tell you about that as we learn more.
Great. Thank you.
Thank you.
Our next question is from the line of Evelyn Chow with Goldman Sachs. Please go ahead.
Good morning, guys. Congrats on a great quarter. Thank you. My first question, just thinking about the medium customer volume growth still very strong and you noted that you're finally seeing new customers acquired after a long time. What are those new customers responding to most out of your offerings and initiatives?
Well, so I would say that the interesting thing about our performance the last few years with midsized customers has been when we've talked to them, they have been very positive about their perceptions of Grainger. But pricing has their comments have been well, the price is not for me. You aren't for me. And so I think what we're seeing now is our technical product support, our assortment, our delivery performance, the basics that we provide customers are really, really valuable to midsize industrial customers. We can help them find the right product.
We have we're very easy to deal with. If they need to get somebody on the phone to understand things, they can. And so what we're seeing is price is not a barrier. And so the things we've always done and we continue to do better are really resonating with those customers.
Makes sense, C. G. And then I just want to make sure I understand the components of the back half guidance raise. So I know of the roughly $0.75 raise that you put up today for the full year, you said $0.60 was from 2Q and then $0.15 in the back half. Am I correct in understanding that if A, OpEx performance is better than you expect, there's perhaps upside to that?
And then secondarily, I think in your prior guide, there was about $0.10 of timing related negative impact on the back half. Could you just update that for us as well?
Yes, Evelyn, you're correct. We basically took the 0.60 dollars which was our forecast to versus our EPS and took that through to the guide and then put another $0.15 in the back half related to price volume in the U. S. And as DG said earlier, we're intentionally keeping the range wide. It's early days dealing with customers we haven't dealt with in a while.
So intentionally keeping the range wide. But as DG said, we're very optimistic in terms of how we're performing.
All right. Thanks, Tom.
Thank you.
Our next question comes from the line of Hamzah Mazari with Macquarie. Please go ahead.
Good morning. Thank you. The first question is just around the medium customer business. DG, is there anything preventing your market share in medium customer being similar to large customer? Is there any underlying dynamics in that medium customer market that either make it more competitive or different from the larger customer market?
Any color there? Thank you.
Well, I think the competitiveness is different. I think if you're serving large complex customers, the set of customers that can't even do the things that you want to do or a set of competitors that can't do the things you want to do are probably narrower. That said, I don't know that there's any gate to us achieving similar share with midsized customers as we have with large, primarily because of how much they value our assortment, our tech support, our search, our ability to help them get what they need. But that's an interesting question for the future, Hamzah. We're looking at that really closely and we'll see the trajectory we get on and we will figure that out.
Great. And just a follow-up, you talked about stable gross margin in 2019, maybe for Tom, do you assume that the COGS deflation that you guys are seeing, even though there's inflation in the market today, that that's structural and that's sustainable in 2019 when you talk about stable gross margin? Yes.
I think we've got many levers we can pull in 2019 going forward. Our PPO organization really I think is very good process and it's going to enable us have deflation going forward. So there's other opportunities as well as in the supply chain for gross margin and we're comfortable that the gross margin going forward is going to be stable.
Great. Thank you.
Our next question comes from the line of Ryan Cieslak with Northcoast. Please go ahead.
Hey, good morning. Congrats on another nice quarter. Just to stick on that last question there, If price cost is improving for you guys and certainly it feels like mix is also moving in the right direction, I'm just trying to understand why you wouldn't be able to expand gross margins in 2019 or maybe you're just trying to be conservative just giving timing right now. As you said, it's still early days, but maybe talk a little bit about ultimately what would offset your ability to expand gross margins in 2019?
Yes. I think that on a like for like basis, we would expect to have slight GP expansion in 2019. I think that what you're probably not accounting for is there are a number of contracts, large contracts that are going to be implemented in the back half of this year that will have some impact on GP. And we've talked about that before, but it's 10% of the contracts or something that we still have to do roughly and some of those are fairly large. So that's going to be the drag in 2019 that we'll need to overcome.
Okay. And D. G, just sticking with the 2019 thought process, is 6% to 8% volume growth still the range that we should be thinking about? Or is there any change in how to think about that either from, 1, the fact that volumes are running ahead of your expectations, but also that also makes the comp a little bit more difficult now going into 2019?
Yes, I mean, we haven't changed that. I think what I would say is that as we look at all the different sources of our growth right now, we're getting a better understanding of what we think next year will be and we'll talk about that as we get more refined in understanding who we're growing with and how fast we're growing with Okay, great. And then my
last question and I'll get back in line. The digital marketing initiatives you guys deployed, if I remember right, that was something that really was deployed more so in this past quarter. Just can you help me thinking about the timing of that? Maybe did you only have half of a benefit do you think from those initiatives? Or meaning did you get a bigger benefit as you go here into the Q3 as it relates to potential new customer growth in the back half of the year?
Thanks.
So we've been fairly consistent in the investments we've made in digital marketing throughout the year. We've stepped it up a bit. I think we'll get more benefits because I think we're going to get better at it and we're learning as we go. And so I think it won't necessarily be because we spend a whole lot more, but as we understand what customers respond to, we're going to keep getting better and the effectiveness of that will increase.
Thanks.
Thank you.
Our next question comes from the line of Scott Graham with BMO. Please go ahead.
Hey, good morning. Nice quarter all.
Good morning.
I'm hoping and this is maybe a question for Tom to maybe square my math here. Last quarter, the U. S. Business price mix was again away from the resets was plus 1.5 and this quarter it looks like it's plus 1.5 again. Now I'm assuming that price was more of a component
of the
1.5% in this past period, which would suggest that the mix actually deteriorated if my math is square, whereas the areas where you're getting the better volumes off of the price reset are mix positive. Could you kind of maybe walk us through that?
Yes. I'm not sure I fully understand the question. Can you take me back again and repeat, please?
Sure. So you're showing on your slide in your slide deck here, page 14, that price mix this past quarter thereabouts was up 1.5% and last quarter 1.5%. Assuming that price increases have accelerated modestly as the year has progressed, which suggests that the mix component of that 1.5 has actually deteriorated. Yet the areas where you're lowering prices, including with large customers on the spot buy business and medium sized customers, which are much higher gross margin sales, those are accelerating. So where is the mix negative coming from because it doesn't appear to be coming from those areas.
In fact, those areas are going the other way.
Yes. I think your first assumption in terms of the comparable mix, I mean, the comparable price increase is not fully accurate for Q1 and Q2, because we are seeing favorable mix related to gross profit in terms of certainly our medium sized customers, which have higher gross profit. Now it's a much smaller amount of the total. We do see minor deterioration related to product mix and that's probably a function of our customer mix. But we're not seeing large deteriorations associated with customer mix.
We're seeing favorable with customer mix.
Yes, as I would have thought.
I guess, maybe I'm just still having trouble squaring the math, but I'll take that with Irene offline. My follow-up question is simply on the tariffs and how you source and what have you and I guess it's good news you're not seeing a
lot of the products that
you source on the list. But I guess what I'm wondering is, are you But that alternate sourcing would obviously come at a higher But that alternate sourcing would obviously come at a higher cost. So are you implying that you're not concerned about it because you'll get the price to compensate for that?
Yes, that's exactly right. If the market price of items goes up because of the tariffs, we will be able to pass that through and our history suggests that is true.
Very good. Thank you, D. J. J.
Rice:] Thank you.
Our next question comes from the line of Justin Bergner with Gabelli.
Good morning, DG. Good morning, Tom. Very great quarter.
Thank you.
First off, I just want to make sure I understand that the $0.60 I guess better performance versus expectations doesn't include any sort of pull forward from the second half in terms of the $0.15 that you're guiding better for the second half?
It does not.
Okay. Great. And then on the cost inflation side, you're keeping that at negative 50 basis points. Is that because the cost inflation won't really come through until 2019? Or is it because it's coming through in the second half, but you're taking better actions to offset some of that?
It's the latter. Yes, it's the latter. We're taking better actions to offset some of that.
Okay. And can
you clarify sort of what you're able to do more on the cost side to improve the price cost dynamic?
Well, I mean, a lot
of that has to do with the process, as Tom mentioned, which is really understanding working with suppliers to understand what the cost should be and making sure we get the right assortment, which can be at the right cost. So I would say that the processes we use consistently drive COGS improvement and we continue to see that today. Yes.
I mean, one of the things coming into Grainger, I was very pleasantly surprised looking at the clean sheet approach that they do related to working with the suppliers. I would think it would be up close to being industry benchmark in terms of clean sheet and looking at replicating the supplier's income statement, etcetera. So it's really a top notch process in place.
Okay. Thank you. And then just lastly, if I may, I assume that some of the higher earnings is going to translate into better free cash flow. Any sort of comments on how you intend to deploy that better free cash flow versus sort of the view set out at the end of last year?
Yes. We'll have more to say about that at a later date. But I mean, just to touch on it briefly, I mean, obviously, we like our investment grade credit rating and that's important to us. Following that, we're going to invest in the operations. We've got opportunities to have a lot of high ROIC projects, which we're sorting through right now.
And then 3rd, we'll give the money back to shareholders, dividends and buybacks. I wouldn't expect any dramatic change in the current capital allocation process.
Great. Thank you.
And our next question comes from the line of Steve Winoker with UBS.
Thanks and good morning.
Good morning.
So I just wanted to follow-up a couple of the questions. One is on the whole sourcing discussion and tariffs. Just to be clear, the comments that you made were about the first $50,000,000,000 tranche in terms of what's affected to you, not the $200,000,000,000 correct?
That is correct. That is absolutely correct, yes.
Okay. And then, I mean, do you see in that, should this continue to escalate? And obviously, there's a lot of uncertainty around that. Is there actually a share gain opportunity for you here as you look at customers? Or is this sort of hard to kind of see through some positives in this?
Well, I'd have to ask you what you mean by share gain opportunity and how that would come about. But generally, as you know, it's just an inflationary action. And so we would expect that to be the outcome here.
Okay. All right. Well, let me take it offline. On the medium customer comments that you made on the daily volume growth and now that those are comping against difficult more difficult numbers, but still accelerating significantly or significantly higher. How much when you think about the reengagement versus the customer acquisition growth that you've been commenting on, where do you see this settling out over the next 3 or 4 quarters when you're past the tougher comps given the rate of growth that you're seeing on the customer acquisition side?
Yes, I think we'll give a lot more detail on that as we move through the next couple of quarters. What we said at this point is we are having a meaningful portion of this that is actually new customer acquisition. So, we're trying to understand exactly where we think that sells. We don't have enough months quarters behind us to be completely sure yet. But as we do and get more certainty, we will be sharing that.
Right. But just again, back to some of the comments you've made versus your 2% versus your 4% share historically, even if it is a more competitive dynamic, I mean that I mean, there's no reason to believe that 4% is really the ceiling there, I would assume.
Right, right, exactly.
Yes. Okay,
thanks. Thank you.
Thank you. We've reached the end of our question and answer session. I'd like to turn the floor back to D. G. Macpherson for closing comments.
All right. Thanks everybody for joining us today. As you probably gathered, we're very pleased with the momentum of the business and where we're headed. In the U. S, our value proposition is really resonating with customers of all sizes and types, and we're getting strong traction with those customers.
The turnaround in Canada is going as we expected it to go. Lots of reason to be optimistic there. Our online model continues to drive strong revenue growth and margin expansion and our international portfolio is much stronger. It's contributing to earnings and we've seen decent growth there as well. And we continue to get strong expense leverage across the business and we're on track to achieve the targets we set for ourselves last November.
So all in all, we feel very positive. We are well positioned to gain share and improve the economics of the business going forward and we appreciate the time today. Thank you.
This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.