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W.W. Grainger, Inc. (GWW - Analyst Report) reported third-quarter 2013 earnings per share of $2.95, up 5% from adjusted earnings of $2.81 per share in the year-ago quarter. However, the earnings fell short of the Zacks Consensus Estimate of $3.08.

During the prior-year quarter, Grainger had recorded pre-tax reserves of $76 million (66 cents per share). This included a $70 million reserve for a settlement in principle to resolve pricing disclosure issues relating to government contracts with the General Services Administration and United States Postal Service and a $6 million reserve for resolving related tax, freight and miscellaneous billing issues. 

Including this, earnings per share in the third quarter of 2012 stood at $2.15. Using this as a base comparison, earnings of $2.95 in the reported quarter increased 37%.

Operational Update

Revenues in the quarter were $2,398 million, up 5% from $2,281 million in the year-ago quarter. However, revenues missed the Zacks Consensus Estimate of $2,432 million. Sales improved on the back of volume growth (4 percentage points) and acquisitions (1 percentage point), offset by a negative currency impact of 1 percentage point. On a daily basis, sales increased 4%.

Gross profit increased 6% year over year to $1,051 million. Gross margin expanded 20 basis points to 43.8%, primarily driven by Canada and the Other Businesses. Operating income in the quarter increased 5% to $347 million from an adjusted $330 million in the prior-year quarter, primarily driven by higher sales volume and improved gross margins. The year-ago figure excluded the abovementioned reserves. Operating margin remained flat at 14.5% on an adjusted basis in the quarter.

Segment Performance

Revenues from the United States segment increased 7% year over year to $1,904 million, driven by favorable volume and acquisitions. Solid growth was witnessed in the light and heavy manufacturing, natural resources, and commercial end markets. Operating income rose 6% to $342 million (excluding the reserves), driven by higher sales growth.

Revenues from the Acklands-Grainger business in Canada dipped 0.8% to $270.7 million. However, in local currency, sales went up 4% and 2% on a daily basis driven by higher volume. Among the end-markets, growth was witnessed in oil and gas, forestry, light manufacturing and utilities. Operating income in Canada declined 7% (down 3% in local currency) to $31.8 million, hurt by incremental spending for the new IT system that is slated for implementation in late 2014.

Revenues from Other businesses (which include Asia, Europe and Latin America) remained flat at $258 million. Growth from volume and price (7 percentage points) was compensated by a 7 percentage point dip due to unfavorable foreign exchange. The segment reported an operating profit of $6 million, down 30% from $8.8 million in the year-ago quarter, dragged down by weak results in Mexico, Colombia and Brazil.

Financial Position

Grainger had cash and cash equivalents of $540 million as of Sep 30, 2013, compared with $452 as of Dec 31, 2012. The company generated cash flow from operating activities of $740 million during the first nine months of fiscal 2013, up from $576 million in the prior-year comparable period.

This increase came on the back of higher earnings and lower inventory purchases versus the prior-year period. Long-term debt stood at $448 million as of Sep 30, 2013, compared with $467 million as of Dec 31, 2012.

During the third quarter, Grainger paid dividends worth $65 million and spent $77 million to buy back 0.3 million shares. The company has approximately 4.2 million shares remaining in its share repurchase authorization.

Outlook

Citing continuing headwinds of a softer global economy and stronger U.S. dollar, Grainger narrowed its EPS guidance to the range of $11.45-$11.65 per share for fiscal 2013, from the prior guidance of $11.40-$12.00 per share. Grainger tweaked its sales growth guidance to a new range of 5% to 6% as against the prior guidance of 5% to 8%.

Our Take

Grainger is expected to benefit in the long term from its incessant focus on expanding its sales force, product offerings and strengthening its businesses across all operating regions, mainly in Asia and Latin America, as well as continued investment in e-commerce -- its most profitable channel.

Furthermore, Grainger’s sound balance sheet, low debt level and cash flow allow the company to further invest in growth opportunities, raise dividends and reinvest capital through share repurchases. The company has been rewarding shareholders with consistent dividend hikes over the last 42 years, a record that only 3% of the S&P 500 companies can boast.

However, the recent slowdown in sales is a concern. Grainger has an incremental $135 million of growth spending in the pipeline for 2013. Even though these initiatives will lead to additional share gains in the future, it will weigh on margins in the short term.

Lake Forest, IL-based Grainger is a leading North American distributor of material handling equipment, safety and security supplies, lighting and electrical products, power and hand tools, pumps and plumbing supplies, cleaning and maintenance supplies, forestry and agriculture equipment, building and home inspection supplies, vehicle and fleet components, and various aftermarket components.

Grainger currently retains a Zacks Rank #3 (Hold). MSC Industrial Direct Co. Inc. (MSM - Snapshot Report) is another stock in the industry that warrants a look as it carries a Zacks Rank #2 (Buy).

Grainger’s peers such as ScanSource, Inc. (SCSC - Snapshot Report) and Hudson Technologies Inc. (HDSN - Snapshot Report) are yet to announce their quarterly results.

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