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  • 10-K (Feb 27, 2015)
  • 10-K (Feb 27, 2014)
  • 10-K (Feb 28, 2013)
  • 10-K (Feb 28, 2011)
  • 10-K (Feb 25, 2010)

 
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GRAINGER W W INC 10-K 2007

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2006

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _______ to _______

 

Commission File Number 1-5684

W.W. Grainger, Inc.

(Exact name of registrant as specified in its charter)

Illinois

 

36-1150280

(State or other jurisdiction of 
incorporation or organization)

 

(I.R.S. Employer
Identification No.)

 

 

 

100 Grainger Parkway, Lake Forest, Illinois

 

60045-5201

(Address of principal executive offices)

 

(Zip Code)

(847) 535-1000

(Registrant’s telephone number including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

 

Name of each exchange on which registered

Common Stock $0.50 par value, and accompanying

New York Stock Exchange

Preferred Share Purchase Rights

Chicago Stock Exchange

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes

X

No

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yes

 

No

X

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes

X

No

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer x

Accelerated filer [ ]

Non-accelerated filer [ ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

Yes

 

No

X

 

The aggregate market value of the voting common equity held by nonaffiliates of the registrant was $5,726,592,535 as of the close of trading as reported on the New York Stock Exchange on June 30, 2006. The Company does not have nonvoting common equity.

 

The registrant had 84,248,635 shares of common stock outstanding as of January 31, 2007.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the proxy statement relating to the annual meeting of shareholders of the registrant to be held on April 25, 2007, are incorporated by reference into Part III hereof.

 

1

TABLE OF CONTENTS

 

 

 

 

PART I

 

 

Page(s)

Item 1:

BUSINESS

3-5

 

THE COMPANY

3

 

GRAINGER BRANCH-BASED

3-4

 

INDUSTRIAL SUPPLY

3-4

 

MEXICO

4

 

CHINA

4

 

ACKLANDS – GRAINGER BRANCH-BASED

4

 

LAB SAFETY

4

 

INDUSTRY SEGMENTS

5

 

COMPETITION

5

 

EMPLOYEES

5

 

WEB SITE ACCESS TO COMPANY REPORTS

5

Item 1A:

RISK FACTORS

5-6

Item 1B:

UNRESOLVED STAFF COMMENTS

6

Item 2:

PROPERTIES

6

Item 3:

LEGAL PROCEEDINGS

7

Item 4:

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

7

Executive Officers

7

PART II

Item 5:

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER

MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

8-9

Item 6:

SELECTED FINANCIAL DATA

9-10

Item 7:

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

10-20

Item 7A:

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

21

Item 8:

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

21

Item 9:

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON

ACCOUNTING AND FINANCIAL DISCLOSURE

21

Item 9A:

CONTROLS AND PROCEDURES

21

Item 9B:

OTHER INFORMATION

21

PART III

Item 10:

DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

22

Item 11:

EXECUTIVE COMPENSATION

22

Item 12:

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND

MANAGEMENT AND RELATED STOCKHOLDER MATTERS

22

Item 13:

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS,

AND DIRECTOR INDEPENDENCE

22

Item 14:

PRINCIPAL ACCOUNTING FEES AND SERVICES

22

PART IV

Item 15:

EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

22-23

Signatures

24

Certifications

65-68

 

 

 

 

 

2

PART I

Item 1: Business

 

The Company

W.W. Grainger, Inc., incorporated in the State of Illinois in 1928, is in the service business. It distributes products used by businesses and institutions primarily across North America to keep their facilities and equipment running. In this report, the words “Grainger” or “Company” mean W.W. Grainger, Inc. and its subsidiaries.

 

Grainger uses a multichannel business model to serve approximately 1.8 million customers of all sizes with multiple ways to find and purchase facilities maintenance and other products through a network of branches, sales representatives, call centers, catalogs and other direct marketing media and the Internet. Orders can be placed via telephone, fax, Internet or in person. Products are available for immediate pick-up or for shipment.

 

Effective January 1, 2006, Grainger revised its segment disclosure. Acklands – Grainger Inc., which had previously been included in Branch-based Distribution, is now being reported as a separate segment. Operations are managed and reported in three segments. The three reportable segments are Grainger Branch-based, Acklands –Grainger Branch-based (Acklands – Grainger) and Lab Safety Supply, Inc. (Lab Safety). Prior year segment amounts have been restated to maintain comparability. Grainger Branch-based is an aggregation of the following business units: Grainger Industrial Supply, Grainger, S.A. de C.V. (Mexico), Grainger Caribe Inc. (Puerto Rico) and Grainger China LLC (China). Acklands – Grainger is the Company’s Canadian branch-based distribution business. Lab Safety is a direct marketer of safety and other industrial products.

 

Grainger has internal business support functions which provide coordination and guidance in the areas of accounting, administrative services, business development, communications, compensation and benefits, employee development, enterprise systems, finance, human resources, insurance and risk management, internal audit, investor relations, legal, real estate and construction services, security and safety, taxes and treasury services. These services are provided in varying degrees to all business units.

 

Grainger does not engage in basic or substantive product research and development activities. Items are regularly added to and deleted from Grainger’s product lines on the basis of market research, customer demand, recommendations of suppliers, sales volumes and other factors.

 

Grainger Branch-based

The Grainger Branch-based businesses provide customers with product solutions for facility maintenance and other product needs through logistics networks which are configured for rapid product availability. Grainger offers a broad selection of facility maintenance and other products through local branches, catalogs and the Internet. The Grainger Branch-based businesses consist of the following business units: Grainger Industrial Supply (Industrial Supply), Grainger, S.A. de C.V. (Mexico), Grainger Caribe Inc. (Puerto Rico) and Grainger China LLC (China). The more significant of these businesses are described below.

 

Industrial Supply

Industrial Supply offers U.S. businesses and institutions a combination of product breadth, local availability, speed of delivery, detailed product information, simplicity of ordering and competitively priced products. Industrial Supply distributes material handling equipment, safety and security supplies, lighting and electrical products, tools and test instruments, pumps and plumbing supplies, cleaning and painting supplies and many other items. Its customers range from small and medium-sized businesses to large corporations, governmental entities at local, state and federal levels, and other institutions. During 2006, Industrial Supply completed an average of 89,000 sales transactions daily.

 

Industrial Supply operates 426 branches located in all 50 states. These branches are located within 20 minutes of the majority of U.S. businesses and serve the immediate needs of their local markets by allowing customers to pick up items directly from the branches.

 

Branches range in size from small, will-call branches to large master branches. The Grainger Express® will-call locations average 2,300 square feet, do not stock inventory and provide convenient pick-up locations. Branches primarily fulfill counter and will-call needs and provide customer service. Master branches handle counter and will-call customers, and ship to customers for other branches and themselves. On average, a branch is 21,000 square feet in size, has 12 employees and handles about 125 transactions per day. In 2006, Industrial Supply opened 11 full-size and two will-call branches, relocated ten branches and expanded or remodeled 24 branches. In 2006, three branches were closed.

 

Industrial Supply’s distribution network is comprised of nine distribution centers (DCs) that handle most of the customer shipping and also replenish branch inventories. The DCs, using automated equipment and processes, ship orders directly to customers for all branches located in their service areas.

 

3

Industrial Supply sells principally to customers in industrial and commercial maintenance departments, service shops, manufacturers, hotels, government, retail organizations, transportation businesses, contractors, and healthcare and educational facilities. Sales transactions during 2006 were made to approximately 1.3 million customers. Approximately 22% of 2006 sales consisted of private label items bearing the Company’s registered trademarks, including DAYTON® (principally electric motors, heating and ventilation equipment), TEEL® (liquid pumps), SPEEDAIRE® (air compressors), AIR HANDLER® (air filtration equipment), DEM-KOTE® (spray paints), WESTWARD® (principally hand and power tools), CONDOR™ (safety products) and LUMAPRO® (task and outdoor lighting). Grainger has taken steps to protect these trademarks against infringement and believes that they will remain available for future use in its business. Sales of remaining items generally consisted of products carrying the names of other well-recognized brands.

 

The Industrial Supply catalog, most recently issued in February 2007, offers almost 139,000 facility maintenance and other products. Approximately 2.0 million copies of the catalog were produced.

 

Customers can also purchase products through grainger.com. This Web site serves as a prominent service channel for the Industrial Supply division. Customers have access to more than 300,000 products through grainger.com. It is available 24/7, providing real-time product availability, customer-specific pricing, multiple product search capabilities, customer personalization, and links to customer support and the fulfillment system. For large customers interested in connecting to grainger.com through sophisticated purchasing platforms, grainger.com has a universal connection. This technology translates the different data formats used by electronic marketplaces, exchanges, and e-procurement systems and allows these systems to communicate directly with Industrial Supply’s operating platform.

 

Industrial Supply purchases products for sale from approximately 1,300 suppliers, most of which are manufacturers. No single supplier comprised more than 10% of Industrial Supply’s purchases and no significant difficulty has been encountered with respect to sources of supply.

 

Industrial Supply procures competitively priced, high-quality products produced primarily outside the United States from almost 200 suppliers through a global sourcing operation. Grainger businesses sell these items primarily under private labels. Products obtained through the global sourcing operation include WESTWARD® tools, LUMAPRO® lighting products and CONDOR™ safety products, as well as products bearing other trademarks.

 

Mexico

Grainger’s operations in Mexico provide local businesses with facility maintenance and other products from both Mexico and the United States. From its eight locations in Mexico, the business ships products to customers as well as fulfills counter and will-call needs. The largest facility, a 90,000 square foot DC, is located outside of Monterrey, Mexico. During 2006, approximately 900 transactions were completed daily. Customers have access to approximately 35,000 products through a Spanish-language general catalog or through grainger.com.mx.

 

China

During the third quarter of 2006, the Company opened two facilities in Shanghai, China, a 120,000 square foot DC with a showroom and a will-call express location. Customers can order products using a Chinese-language general catalog or purchase them through grainger.com.cn.

 

Acklands – Grainger Branch-based

Acklands – Grainger is Canada’s leading broad-line distributor of industrial, automotive fleet and safety supplies. It serves customers through 155 branches and five distribution centers across Canada. Acklands – Grainger distributes tools, lighting products, safety supplies, pneumatics, instruments, welding equipment and supplies, motors, shop equipment, fan belts and many other items. During 2006, approximately 15,000 sales transactions were completed daily. A comprehensive catalog, printed in both English and French, showcases the product line to facilitate customer selection. This catalog, with more than 40,000 products, supports the efforts of field sales representatives throughout Canada. In addition, customers can purchase products through acklandsgrainger.com.

 

Lab Safety

Lab Safety is a direct marketer of safety and other industrial products to U.S. and Canadian businesses. Headquartered in Janesville, Wisconsin, Lab Safety primarily reaches its customers through the distribution of multiple branded catalogs and other marketing materials distributed throughout the year to targeted markets. Brands include LSS, Ben Meadows (forestry), Gempler’s (agriculture), AW Direct (service vehicle accessories), Rand Materials (material handling), Professional Inspection Equipment (building and home inspection) and Construction Book Express (building and home inspection). Customers can purchase products by telephone, fax or through lss.com and other Web sites.

 

Lab Safety offers extensive product depth, technical support and high service levels. During 2006, Lab Safety issued 13 unique catalogs covering safety supplies, material handling and facility maintenance products, lab supplies, security and other products targeted to specific customer groups. Lab Safety provides access to approximately 117,000 products through its targeted catalogs and distributes products from two DCs.

 

4

Industry Segments

Effective January 1, 2006, Grainger revised its segment disclosure. Acklands – Grainger, which had previously been included in Branch-based Distribution, is now being reported as a separate segment. Operations are managed and reported in three segments. The three reportable segments are Grainger Branch-based, Acklands – Grainger and Lab Safety. Prior year segment amounts have been restated to maintain comparability. Grainger Branch-based is an aggregation of the following business units: Grainger Industrial Supply, Grainger, S.A. de C.V. (Mexico), Grainger Caribe Inc. (Puerto Rico) and Grainger China LLC (China). Acklands – Grainger is the Company’s Canadian branch-based distribution business. Lab Safety is a direct marketer of safety and other industrial products. For segment and geographical information and consolidated net sales and operating earnings see “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 17 to the Consolidated Financial Statements.

 

Competition

Grainger faces competition in all markets it serves, from manufacturers (including some of its own suppliers) that sell directly to certain segments of the market, wholesale distributors, catalog houses and retail enterprises.

 

Grainger provides local product availability, sales representatives, competitive pricing, catalogs (which include product descriptions and, in certain cases, extensive technical and application data), electronic and Internet commerce technology and other services to assist customers in lowering their total facility maintenance costs. Grainger believes that it can effectively compete with manufacturers on small orders, but manufacturers may have an advantage in filling large orders.

 

Grainger serves a number of diverse markets. Based on available data, Grainger estimates the North American market for facilities maintenance and related products to be more than $145 billion, of which Grainger’s share is approximately 4 percent. There are several large competitors, although most of the market is served by small local and regional competitors.

 

Employees

As of December 31, 2006, Grainger had 17,074 employees, of whom 14,708 were full-time and 2,366 were part-time or temporary. Grainger has never had a major work stoppage and considers employee relations to be good.

 

Web Site Access to Company Reports

Grainger makes available, free of charge, through its Web site, its Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements and amendments to those reports, as soon as reasonably practicable after this material is electronically filed with or furnished to the Securities and Exchange Commission. This material may be accessed by visiting grainger.com/investor.

 

Item 1A: Risk Factors

 

The following is a discussion of significant risk factors relevant to Grainger’s business that could adversely affect its financial condition or results of operations.

 

A slowdown in economic activity could negatively impact Grainger’s sales growth. Economic and industry trends affect Grainger’s business environments. Grainger’s sales growth has tended to correlate with commercial activity, manufacturing output and non-farm employment levels. Thus, a slowdown in economic activity could negatively impact Grainger’s sales growth.

 

The facilities maintenance industry is a highly fragmented industry, and competition could result in a decreased demand for Grainger’s products and services. There are several large competitors in the industry, although most of the market is served by small local and regional competitors. Grainger faces competition in all markets it serves, from manufacturers (including some of its own suppliers) that sell directly to certain segments of the market, wholesale distributors, catalog houses and retail enterprises. Competitive pressures could adversely affect Grainger’s sales and profitability.

 

Unexpected product shortages could negatively impact customer relationships, resulting in an adverse impact on results of operations. Grainger’s competitive strengths include product selection and availability. Products are purchased from approximately 1,600 key suppliers, no one of which accounts for more than 10% of purchases. Historically, no significant difficulty has been encountered with respect to sources of supply. If Grainger were to experience difficulty in obtaining products, there could be a short-term adverse effect on results of operations and a longer-term adverse effect on customer relationships and reputation. In addition, Grainger has strategic relationships with key vendors. In the event Grainger was unable to maintain those relations, there might be a loss of competitive pricing advantages which could in turn adversely affect results of operations.

 

A delay in the implementation of Grainger’s multiyear market expansion program could negatively affect anticipated future sales growth. In 2004, Grainger launched a six phase market expansion program to strengthen its presence in top metropolitan markets and better position itself to serve the local customer. The program is being

 

5

implemented in these markets in a phased approach. The success of the market expansion program is expected to be a driver of growth in 2007 and beyond. The first phase of the market expansion program was completed in 2005. Phases two through six were in various stages of completion at December 31, 2006. A delay in the implementation of the program or lower than projected results from the program could negatively impact anticipated future sales growth.

 

The addition of new product lines could impact future sales growth. Grainger, from time to time, expands the breadth of its offerings by increasing the number of products it distributes. In 2006, Grainger launched a multiyear product line expansion program. The success of the expansion program is expected to be a driver of growth in 2007 and beyond. The success of these expansions will depend on Grainger’s ability to accurately forecast market demand and to obtain product from suppliers.

 

Interruptions in the proper functioning of information systems could disrupt operations and cause unanticipated increases in costs or decreases in revenues, or both. The proper functioning of Grainger’s information systems is critical to the successful operation of its business. Although Grainger’s information systems are protected through physical and software safeguards and remote processing capabilities exist, information systems are still vulnerable to natural disasters, power losses, unauthorized access, telecommunication failures and other problems. If critical information systems fail or are otherwise unavailable, Grainger’s ability to process orders, identify business opportunities, maintain proper levels of inventories, collect accounts receivable and pay expenses could be adversely affected.

 

In order to compete, Grainger must attract, retain and motivate key employees, and the failure to do so could have an adverse effect on our results of operations. In order to compete and have continued growth, Grainger must attract, retain and motivate executives and other key employees, including those in managerial, technical, sales, marketing and support positions. There is no assurance that Grainger will continue to be able to hire or retain key employees. Grainger competes to hire employees, and then must train them and develop their skills and competencies. Granger’s operating results could be adversely affected by increased costs due to increased competition for employees, higher employee turnover or increased employee benefit costs.

 

Item 1B: Unresolved Staff Comments

 

None.

 

Item 2: Properties

 

As of December 31, 2006, Grainger’s owned and leased facilities totaled 19,133,000 square feet, an increase of approximately 4% from December 31, 2005. This increase primarily related to the market expansion program. Industrial Supply and Acklands – Grainger accounted for the majority of the total square footage. Industrial Supply facilities are located throughout the United States and Acklands – Grainger facilities are located throughout Canada.

 

Industrial Supply branches range in size from 1,200 to 109,000 square feet and average approximately 21,000 square feet. Most are located in or near major metropolitan areas with many located in industrial parks. Typically, a branch is on one floor, is of masonry construction, consists primarily of warehouse space, sales areas and offices and has off-the-street parking for customers and employees. Grainger believes that its properties are generally in good condition and well maintained.

 

A brief description of significant facilities follows:

Location

 

Facility and Use (6)

 

Size in

Square Feet

United States (1) (2)

 

426 Industrial Supply branch locations

 

8,790,000

United States (1)

 

Nine Distribution Centers

 

5,100,000

U.S. and International (3)

 

Other facilities

 

938,000

United States (4)

 

Three Lab Safety facilities

 

823,000

Canada (5)

 

166 Acklands – Grainger facilities

 

2,155,000

Chicago Area (1)

 

Headquarters and General Offices

 

1,327,000

 

 

Total Square Feet

 

19,133,000

 

(1)

These facilities are either owned or leased with most leases expiring between 2007 and 2018.

(2)

Industrial Supply branches consist of 280 owned and 146 leased properties.

(3)

Other facilities primarily include leased locations for Puerto Rico, Mexico, China and properties under construction.

(4)

Lab Safety facilities consist of general offices and a distribution center which is owned, one leased office facility and one leased distribution center.

(5)

Acklands – Grainger facilities consist of general offices, distribution centers and branches, of which 55 are owned and 111 leased.

(6)

Owned facilities are not subject to any mortgages.

 

6

Item 3: Legal Proceedings

 

Grainger has been named, along with numerous other nonaffiliated companies, as a defendant in litigation in various states involving asbestos and/or silica. These lawsuits typically assert claims of personal injury arising from alleged exposure to asbestos and/or silica as a consequence of products purportedly distributed by Grainger. As of January 17, 2007, Grainger is named in cases filed on behalf of approximately 3,100 plaintiffs in which there is an allegation of exposure to asbestos and/or silica. In addition, five cases alleging exposure to cotton dust were amended during 2004 to add allegations relating to asbestos, but during 2006 the pleadings in those cases were amended and no longer contain allegations of asbestos exposure.

 

Grainger has denied, or intends to deny, the allegations in all of the above-described lawsuits. In 2006, lawsuits relating to asbestos and/or silica and involving approximately 300 plaintiffs were dismissed with respect to Grainger, typically based on the lack of product identification. If a specific product distributed by Grainger is identified in any of these lawsuits, Grainger would attempt to exercise indemnification remedies against the product manufacturer. In addition, Grainger believes that a substantial number of these claims are covered by insurance. Grainger is engaged in active discussions with its insurance carriers regarding the scope and amount of coverage. While Grainger is unable to predict the outcome of these lawsuits, it believes that the ultimate resolution will not have, either individually or in the aggregate, a material adverse effect on Grainger’s consolidated financial position or results of operations.

 

In addition to the foregoing, from time to time Grainger is involved in various other legal and administrative proceedings that are incidental to its business, including claims relating to product liability, general negligence, environmental issues, employment, intellectual property and other matters. As a government contractor, from time to time Grainger is also subject to governmental or regulatory inquiries or audits, including current inquiries relating to pricing compliance and Trade Agreement Act compliance. It is not expected that the ultimate resolution of any of these matters will have, either individually or in the aggregate, a material adverse effect on Grainger’s consolidated financial position or results of operations.

 

Item 4: Submission of Matters to a Vote of Security Holders

 

No matters were submitted to a vote of security holders during the fourth quarter of 2006.

 

Executive Officers

 

Following is information about the Executive Officers of Grainger including age as of February 23, 2007. Executive Officers of Grainger generally serve until the next annual election of officers, or until earlier resignation or removal.

 

Name and Age

 

Positions and Offices Held and Principal

Occupations and Employment During the Past Five Years

Y.C. Chen (59)

 

President, Grainger Industrial Supply, a position assumed in February 2007. Mr. Chen had previously been the Company’s Group President, a position assumed in 2006 after serving as Senior Vice President, Supply Chain Management. Before assuming that position in 2003, Mr. Chen served as Vice President, Supply Chain Services, Vice President, International Internet Commerce, and Vice President, Asia Pacific.

 

Nancy A. Hobor (60)

 

Senior Vice President (formerly Vice President), Communications and Investor Relations, a position assumed in 1999.

 

John L. Howard (49)

 

Senior Vice President and General Counsel, a position assumed in 2000.

 

Ronald L. Jadin (46)

 

Vice President and Controller, a position assumed in November 2006 after serving as Vice President, Finance-Industrial Supply, a position assumed in 2000.

 

Richard L. Keyser (64)

 

Chairman of the Board, a position assumed in 1997, and Chief Executive Officer, a position assumed in 1995.

 

Larry J. Loizzo (52)

 

Senior Vice President (formerly Vice President) of the Company and President of Lab Safety Supply, Inc., a position assumed in 1996.

 

P. Ogden Loux (64)

 

Senior Vice President, Finance and Chief Financial Officer, a position assumed in 1997.

 

James T. Ryan (48)

 

President and Chief Operating Officer, a position assumed in February 2007. Mr. Ryan had previously been the Company’s President, a position assumed in April 2006 after serving as Group President. Before assuming that position in 2004, Mr. Ryan served as Executive Vice President, Marketing, Sales and Service since 2001.

 

 

7

PART II

 

Item 5: Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities

 

Market Information and Dividends

 

Grainger’s common stock is listed on the New York Stock Exchange and the Chicago Stock Exchange, with the ticker symbol GWW. The high and low sales prices for the common stock and the dividends declared and paid for each calendar quarter during 2006 and 2005 are shown below.

 

 

 

 

Prices

 

 

Quarters

 

High

 

Low

 

Dividends

2006

First

 

$    76.59

 

$    69.30

 

$    0.24

 

Second

 

79.95

 

68.22

 

0.29

 

Third

 

76.21

 

60.60

 

0.29

 

Fourth

 

75.90

 

65.86

 

0.29

 

Year

 

$    79.95

 

$    60.60

 

$    1.11

2005

First

 

$    67.25

 

$    59.85

 

$    0.20

 

Second

 

63.38

 

51.65

 

0.24

 

Third

 

66.19

 

53.10

 

0.24

 

Fourth

 

72.45

 

60.50

 

0.24

 

Year

 

$    72.45

 

$    51.65

 

$    0.92

 

The Company expects that its practice of paying quarterly dividends on its Common Stock will continue, although the payment of future dividends is at the discretion of the Company’s Board of Directors and will depend upon the Company’s earnings, capital requirements, financial condition and other factors.

 

Holders

The approximate number of shareholders of record of Grainger’s common stock as of January 31, 2007, was 1,200 with approximately 22,500 additional shareholders holding stock through nominees.

 

Issuer Purchases of Equity Securities – Fourth Quarter

 

Period

Total Number

of Shares Purchased (A)

Average Price

Paid per

Share (B)

Total Number of Shares

Purchased as Part of

Publicly Announced Plans

or Programs (C)

Maximum Number of

Shares that May Yet Be

Purchased Under the

Plans or Programs (D)

Oct. 1 – Oct. 31

304,300

$  72.48

304,300

9,695,700

shares

 

 

 

 

 

 

Nov. 1 – Nov. 30

1,106,852

$  71.54

1,052,400

8,643,300

shares

 

 

 

 

 

 

Dec. 1 – Dec. 31

917,900

$  71.39

917,900

7,725,400

shares

Total

2,329,052

$  71.61

2,274,600

 

 

 

(A)

The total number of shares purchased includes Grainger’s retention of 54,452 shares to satisfy tax withholding obligations in connection with the vesting of employee restricted stock awards.

 

(B)

Average price paid per share includes any commissions paid and includes only those amounts related to purchases as part of publicly announced plans or programs. Activity is reported on a trade date basis.

 

(C)

Purchases were made pursuant to a share repurchase program approved by Grainger’s Board of Directors.

 

(D)

On October 16, 2006, Grainger announced that its Board of Directors granted authority to repurchase up to 10 million shares. This program has no specified expiration date.

 

Company Performance

The following stock price performance graph compares the cumulative total return on an investment in Grainger common stock with the cumulative total return of an investment in each of the S&P 500 Stock Index, a peer group index (the “Former Peer Group Index”) made up of all of the companies, other than Grainger, which constitute the Dow Jones Industrial Suppliers Index, and the Dow Jones Wilshire 5000 Industrial Supplier Index.

 

8

When Grainger first began using the Former Peer Group Index in its stock performance graph, one of the principal constituent companies of the index was Hughes Supply, Inc. Hughes Supply, Inc. was acquired during 2006 and as a result is no longer publicly traded and no longer part of the index. Grainger believes that the Dow Jones Wilshire 5000 Industrial Supplier Index – which includes all of the current constituent companies in the Former Peer Group Index as well as a number of other businesses – now provides a more representative comparator group. The graph covers the period commencing December 31, 2001 and ending December 31, 2006. The graph assumes that the value for the investment in Grainger common stock and in each index was $100 on December 31, 2001 and that all dividends were reinvested.

 

 

December31,

 

2001

 

2002

 

2003

 

2004

 

2005

 

2006

W.W. Grainger, Inc.

$100

 

$109

 

$102

 

$145

 

$157

 

$157

S&P 500 Stock Index

100

 

78

 

100

 

111

 

117

 

135

Dow Jones Industrial Suppliers Index 

(excluding W.W. Grainger, Inc.)

100

 

100

 

129

 

158

 

196

 

186

Dow Jones Wilshire 5000 Industrial 

Supplier Index

100

 

102

 

115

 

155

 

175

 

181

 

Other

On May 23, 2006, Grainger timely submitted to the New York Stock Exchange (NYSE) an Annual CEO Certification, in which Grainger’s Chief Executive Officer certified that he was not aware of any violation by Grainger of the NYSE’s corporate governance listing standards as of the date of the certification.

 

Item 6: Selected Financial Data

 

2006

 

2005

 

2004

 

2003

 

2002

 

(In thousands of dollars, except for per share amounts)

Net sales

$  5,883,654

 

$  5,526,636

 

$  5,049,785

 

$  4,667,014

 

$  4,643,898

Net earnings

383,399

 

346,324

 

286,923

 

226,971

 

211,567

Net earnings per basic share

4.36

 

3.87

 

3.18

 

2.50

 

2.30

Net earnings per diluted share

4.24

 

3.78

 

3.13

 

2.46

 

2.24

Total assets

3,046,088

 

3,107,921

 

2,809,573

 

2,624,678

 

2,437,448

Long-term debt 

(less current maturities)

4,895

 

4,895

 

 

4,895

 

119,693

Cash dividends paid per share

$         1.110

 

$         0.920

 

$         0.785

 

$         0.735

 

$         0.715

 

Effective January 1, 2006, Grainger adopted Statement of Financial Accounting Standards (SFAS) No. 123R, “Share-Based Payment,” for the accounting of employee stock-based compensation using the modified prospective method. The effect of the adoption was approximately a $0.14 earnings per share reduction for 2006. See Note 2 to the Consolidated Financial Statements for further discussion of information related to SFAS No. 123R.

 

9

The results for 2006 included an effective tax rate, excluding the effect of equity in unconsolidated entities, of 36.7%. The 2006 rate included tax benefits from the resolution of uncertainties related to the audit of the 2004 tax year and a tax benefit from a reduction of deferred tax liabilities related to property, buildings and equipment. These benefits increased diluted earnings per share by $0.15.

 

The results for 2005 included an effective tax rate, excluding the effect of equity in unconsolidated entities, of 35.2%. The 2005 rate included tax benefits related to a favorable revision to the estimate of income taxes for various state taxing jurisdictions and the resolution of certain federal and state tax contingencies. These benefits increased diluted earnings per share by $0.10.

 

The results for 2004 included an effective tax rate, excluding the effect of equity in unconsolidated entities, of 35.6%, which was down from 40.0% in the prior year. The lower tax rate resulted in an increase of $0.21 per diluted share. The tax rate reduction was primarily due to a lower tax rate in Canada, the realization of tax benefits related to operations in Mexico and to capital losses, the recognition of tax benefits from the “Medicare Prescription Drug, Improvement and Modernization Act of 2003” (the Medicare Act) and the resolution of certain federal and state tax contingencies.

 

The results for 2002 included an after-tax gain on the sale of securities of $4.5 million, or $0.04 per diluted share, and an after-tax gain on the reduction of restructuring reserves established for the shutdown of the Material Logic business of $1.2 million, or $0.01 per diluted share. These were offset by the cumulative effect of a change in accounting for the write-down of goodwill of $23.9 million after-tax, or $0.26 per diluted share, related to Acklands – Grainger.

 

For further information see Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Overview

General. Grainger is the leading broad-line supplier of facilities maintenance and other related products in North America. For each of the three years presented in this Annual Report on Form 10-K for the year ended December 31, 2006, Grainger reports its operating results in three segments: Grainger Branch-based, Acklands – Grainger Branch-based (Acklands – Grainger) and Lab Safety Supply, Inc. (Lab Safety). Grainger distributes a wide range of products used by businesses and institutions to keep their facilities and equipment up and running. Grainger uses a multichannel business model to provide customers with a range of options for finding and purchasing products through a network of branches, sales representatives, direct marketing including catalogs, and a variety of electronic and Internet channels. Grainger serves customers through a network of 593 branches, 18 distribution centers and multiple Web sites.

 

Business Environment. Several economic factors and industry trends shape Grainger’s business environment. The current overall economy and leading economic indicators forecast by economists provide insight into anticipated economic factors for the near term and help in forming the development of projections for the upcoming year. At the start of 2007, Consensus Forecast-USA predicted 2007 GDP growth of 2.4% and Industrial Production growth of 2.5% for the United States, a slight decrease from preliminary fourth quarter 2006 GDP estimates. For Canada, Consensus Forecast-USA predicted 2007 GDP growth of 2.3%, below the 2006 estimate of 2.7%.

 

In 2006, Grainger benefited from the economic growth in the United States. Grainger’s sales correlate positively with industrial production growth. With the improvement in Industrial Production and general growth in the economy, Grainger realized an increase in sales across all customer sectors. Grainger’s sales also tend to increase when non-farm payrolls grow, especially during economic recoveries. Non-farm payrolls increased approximately 1%, on average, in 2006 over 2005. For 2006, Grainger benefited from the combination of increased Industrial Production and non-farm payroll growth.

 

The light and heavy manufacturing customer sectors, which comprised more than 25% of Grainger’s total 2006 sales, have historically correlated with manufacturing employment levels and manufacturing production. Manufacturing employment levels in the United States were flat during 2006, however, manufacturing output increased almost 5%. This contributed to almost double-digit sales growth in the heavy manufacturing and mid single-digit sales growth in the light manufacturing customer sectors for Grainger in 2006. Economic forecasts suggest that the manufacturing sector will continue to expand in 2007.

 

In 2004, Grainger launched a multiyear initiative to strengthen its presence in top metropolitan markets and better position itself to serve the local customer. The market expansion program contributed to the sales growth in 2006 and is expected to be a driver of growth in 2007 and beyond. The first phase of the market expansion program was completed in 2005. Phases two through six were in various stages of completion at December 31, 2006.

 

In 2006, Grainger launched a multiyear product line expansion program. The product line expansion program contributed to the sales growth in 2006 and is expected to be a driver of growth in 2007 and beyond. In 2007, the company plans to add approximately 25,000 additional products to supplement the plumbing, fastener, material handling and security product lines.

 

10

Customer buying behavior is also important in Grainger’s business environment. Grainger believes that customers will continue to focus on reducing their cost to procure facilities maintenance products. Consequently, during 2006, Grainger increased information available to employees for improved service to customers by installing an upgraded SAP branch operating system as part of an overall conversion to an integrated SAP system in the U.S. branch-based business.

 

Grainger’s financial strength positions it to fund major initiatives and acquisitions and to improve effectiveness. Capital spending in 2006 for the market expansion program was approximately $63 million, with total capital expenditures of $139 million.

 

For 2007, Grainger anticipates total capital expenditures of $150 million to $175 million. Grainger intends to continue its investment in the market expansion program and information technology enhancements with spending planned for the following major projects:

 

$50 million to $80 million for continued market expansion;

 

$10 million to $15 million for information technology;

 

$10 million to $12 million for international expansion;

 

$3 million to $5 million for product line expansion.

Lease or purchase decisions, based on availability of facilities, may affect the timing and amount of capital expenditures associated with the market expansion program.

 

Matters Affecting Comparability. Effective January 1, 2006, Grainger adopted SFAS No. 123R, “Share-Based Payment,” for the accounting of employee stock-based compensation using the modified prospective method. The effect of the adoption was approximately a $0.14 earnings per share reduction for 2006. See Note 2 to the Consolidated Financial Statements for further discussion of information related to SFAS No. 123R.

 

During the fourth quarter of 2006, Grainger adopted SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and 132R.” As a result of the adoption, Grainger recorded an additional liability of $36.8 million to Accrued employment-related benefit costs offset by $14.3 million of deferred income taxes and a reduction of Accumulated other comprehensive earnings of $22.5 million. See Note 2 to the Consolidated Financial Statements for further discussion of information related to SFAS No. 158.

 

Grainger’s operating results for 2006 include the operating results of Rand Materials Handling Equipment Co. (Rand) from the acquisition date of January 31, 2006. Grainger’s operating results for 2006 also include the operating results of Professional Inspection Equipment, Inc. (Professional Equipment) and Construction Book Express, Inc. (Construction Book) from the acquisition date of November 17, 2006. The results of these acquisitions are included in the Lab Safety segment.

 

There were 254 sales days in 2006 compared to 255 sales days in 2005.

 

Grainger’s operating results for 2005 included the operating results for AW Direct from the acquisition date of January 14, 2005. AW Direct’s results are included in the Lab Safety segment.

 

Results of Operations

The following table is included as an aid to understanding changes in Grainger’s Consolidated Statements of Earnings:

 

 

For the Years Ended December 31,

 

Items in Consolidated Statements of Earnings

 

As a Percent of Net Sales

 

Percent Increase/(Decrease)

from Prior Year

 

2006

 

2005

 

2004

 

2006

 

2005

Net sales

100.0%

 

100.0%

 

100.0%

 

6.5%

 

9.4%

Cost of merchandise sold

60.0   

 

60.9   

 

62.2   

 

4.9   

 

7.1   

Gross profit

40.0   

 

39.1   

 

37.8   

 

8.9   

 

13.4   

Operating expenses

30.2   

 

29.7   

 

29.1   

 

8.1   

 

12.1   

Operating earnings

9.8   

 

9.4   

 

8.7   

 

11.4   

 

17.6   

Other income (expense)

0.4   

 

0.3   

 

0.1   

 

82.3   

 

252.3   

Income taxes

3.7   

 

3.4   

 

3.1   

 

17.9   

 

17.8   

Net earnings

6.5%

 

6.3%

 

5.7%

 

10.7%

 

20.7%

 

2006 Compared to 2005

Grainger’s net sales for 2006 of $5,883.7 million were up 6.5% versus 2005. There was one less selling day in 2006 versus 2005. Daily sales were up 6.9%. The increase in net sales was led by strong sales to the commercial, government and manufacturing sectors. Also contributing to the improvement was growth from the U.S. market expansion program. Partially offsetting these sales improvements was the negative effect of the continued wind-down of low margin contracts with integrated supply and automotive customers.

 

11

The gross profit margin of 40.0% in 2006 improved 0.9 percentage point over the gross profit margin of 39.1% in 2005, principally due to selling price category mix and the positive effect of product mix, including the global sourcing of products. The major driver of the improvement in the selling price category mix was reduced sales to integrated supply and automotive customers, which carry lower than average gross profit margins.

 

Grainger’s operating earnings of $578.1 million in 2006 increased $59.1 million, or 11.4%, over the prior year. The operating margin of 9.8% in 2006 improved 0.4 percentage point over 2005, as the combined effect of increased sales and improvement in gross profit margin exceeded the increase in operating expenses. Operating expenses were up 8.1% in 2006 principally due to higher payroll and benefits driven by increased stock-based compensation expense due to the adoption of SFAS No. 123R, and increased healthcare and profit sharing costs, partially offset by lower systems implementation costs.

 

In 2006, net earnings of $383.4 million increased $37.1 million, or 10.7%, over the prior year. The growth in net earnings was due to the improvement in operating earnings and higher net interest income, partially offset by an increase in income tax expense. Diluted earnings per share for 2006 of $4.24 were 12.2% higher than the $3.78 for 2005, the result of higher net income and fewer shares outstanding.

 

Segment Analysis

The following comments at the segment level include external and intersegment net sales and operating earnings. Comments at the business unit level include external and inter- and intrasegment net sales and operating earnings. See Note 17 to the Consolidated Financial Statements.

 

Grainger Branch-based

Net sales of $4,910.8 million increased by 5.6% in 2006 compared to net sales of $4,649.2 million in 2005. Daily sales were up 6.0%. Daily sales in the United States were up 6.0%, with growth in all customer end markets, led by the government and heavy manufacturing sectors. The wind-down of the Company’s low margin integrated supply and automotive contracts reduced sales growth by approximately 2 percentage points.

 

In 2004, the Company launched a multiyear market expansion program to strengthen its presence in top metropolitan markets and better position itself to serve local customers. Phases 1 through 4 include sixteen markets. Work on Phases 5 and 6 began during 2006.

 

Market expansion contributed approximately 2 percentage points to the sales growth for the segment. Results for the market expansion program were as follows:

 

 

Daily Sales

Increase

2006 vs. 2005

 

Estimated

Percent

Complete*

 

Phase 1 (Atlanta, Denver, Seattle)

 

10%

 

100%  

 

Phase 2 (Four markets in Southern California)

 

12%

 

95%

 

Phase 3 (Houston, St. Louis, Tampa)

 

13%

 

90%

 

Phase 4 (Baltimore, Cincinnati, Kansas City,

Miami, Philadelphia, Washington, D.C.)

 

8%

 

90%

 

 

 

 

 

 

 

*

Phases are reported once they reach 50% completion. Completion occurs when a new branch opens or a branch expansion or remodeling is finished.

 

 

Products added in 2006 for the product line expansion program contributed approximately 2 percentage points to the growth in the segment.

 

Daily sales in Mexico increased 20.1% in 2006 versus 2005. In local currency, daily sales were up 21.0%, driven by an improving economy, an expanded telesales operation, new branches in Santa Catarina and Chihuahua and an expanded presence in Tijuana.

 

Segment gross profit margin increased 1.1 percentage points in 2006 over the comparable 2005 period, primarily driven by positive inflation recovery and a positive change in selling price category mix. A major driver in the improvement in selling price category mix was the reduction of sales related to low margin integrated supply and automotive contracts.

 

Operating expenses were up 6.4% for 2006. The operating expense growth was primarily driven by higher payroll and benefits costs primarily due to higher stock-based compensation related to the adoption of SFAS No. 123R and higher profit sharing costs, partially offset by lower systems implementation costs.

 

Operating earnings of $593.5 million for 2006 increased 13.6% over the $522.6 million for 2005. The earnings improvement resulted from higher sales and improved gross profit margins, partially offset by operating expenses, which grew at a faster rate than sales.

 

12

Acklands Grainger Branch-based

Net sales at Acklands – Grainger of $565.1 million increased by 12.6% in 2006 compared to 2005 net sales of $502.0 million, including the effect of a favorable exchange rate. Daily sales were up 13.0%. In local currency, daily sales increased 5.8% due to a stronger economy, improved branch presence, and higher sales to the oil and gas sectors, partially offset by weak sales in the forestry industry.

 

The gross profit margin increased 0.5 percentage point in 2006 over 2005 primarily driven by positive inflation recovery.

 

Operating expenses for Acklands – Grainger were up 14.9% in 2006, primarily driven by payroll and benefits due to increased headcount and higher severance, information technology, advertising and occupancy costs.

 

Operating earnings of $15.2 million in 2006 increased 8.8% from the $14.0 million in 2005 as a result of sales growth and an improved gross profit margin, partially offset by operating expenses which grew at a faster rate than sales.

 

Lab Safety

Net sales at Lab Safety were $411.5 million for 2006, an increase of $31.4 million, or 8.3%, when compared with $380.1 million for 2005. Daily sales were up 8.7%. The sales growth included the benefit of incremental sales from Rand, acquired on January 31, 2006, and Professional Equipment and Construction Book, acquired on November 17, 2006, as well as sales growth in the manufacturing sector. Rand contributed 4.0 percentage points to the daily sales increase. Professional Equipment and Construction Book contributed 0.6 percentage point to the daily sales increase. Excluding Rand, Professional Equipment and Construction Book, daily sales increased 4.1%.

 

The gross profit margin decreased 0.3 percentage point in 2006 from 2005 primarily as a result of increased freight costs and lower margin Rand product sales, partially offset by positive inflation recovery.

 

Operating expenses of $121.8 million were $12.8 million, or 11.7%, higher in 2006, primarily due to incremental costs associated with the acquisitions, higher advertising and increased expenses from the upgrade of the business’ ERP system.

 

Operating earnings of $52.3 million for 2006 were down 0.8% compared to 2005, resulting from a lower gross profit margin and higher operating expenses, partially offset by increased sales.

 

Other Income and Expense

Other income and expense was $25.0 million of income in 2006, an improvement of $11.3 million as compared with $13.7 million of income in 2005. The following table summarizes the components of other income and expense:

 

 

For the Years Ended December 31,

 

2006

 

2005

 

(In thousands of dollars)

Other income and (expense):

 

 

 

Interest income (expense) – net

$          19,570 

 

$         11,019 

Equity in income of unconsolidated entities – net

2,960 

 

2,809 

Gain on sale of unconsolidated entity

2,291 

 

– 

Unclassified – net

131 

 

(143)

 

$          24,952 

 

$         13,685 

 

The improvement in other income and expense in 2006 over 2005 was primarily attributable to higher interest income and the gain on the sale of Acklands – Grainger’s interest in the USI-AGI Prairies joint venture. The increase in interest income in 2006 was the result of higher interest rates and higher average cash balances.

 

Income Taxes

Income taxes of $219.6 million in 2006 increased 17.9% as compared with $186.4 million in 2005.

 

Grainger’s effective tax rates were 36.4% and 35.0% in 2006 and 2005, respectively. Excluding the effect of equity in unconsolidated entities, which is recorded net of tax, the effective income tax rates were 36.7% for 2006 and 35.2% for 2005.

 

The 2006 tax rate benefited from resolution of uncertainties related to the audit of the 2004 tax year and from a reduction of deferred tax liabilities related to property, buildings and equipment.

 

The 2005 tax rate included tax benefits related to a favorable revision to the estimate of income taxes for various state and local taxing jurisdictions and the resolution of certain federal and state tax contingencies.

 

For 2007, Grainger is projecting its estimated effective tax rate to be 38.5%, excluding the effects of equity in unconsolidated entities.

 

13

2005 Compared to 2004

Grainger’s net sales for 2005 of $5,526.6 million were up 9.4% versus 2004. The increase in net sales was led by strong sales to the commercial, government, manufacturing and natural resource sectors. Also contributing to the improvement was growth from the U.S. market expansion program. Partially offsetting these sales improvements was the negative effect of the wind-down of integrated supply and related automotive contracts.

 

The gross profit margin of 39.1% in 2005 improved 1.3 percentage points over the gross profit margin of 37.8% in 2004, principally due to selling price category mix and the positive effect of product mix, including the global sourcing of products. A major driver of the improvement in the selling price category mix was reduced sales to integrated supply and automotive customers, which carry lower than average gross profit margins.

 

Grainger’s operating earnings of $519.0 million in 2005 increased $77.7 million, or 17.6%, over the prior year. The operating margin of 9.4% in 2005 improved 0.7 percentage point over 2004, as the combined effect of increased sales and improvement in gross profit margin exceeded the increase in operating expenses. Operating expenses were up 12.1% in 2005 principally due to higher variable compensation and benefits associated with the improved performance for the year, as well as to incremental costs related to the market expansion and information technology programs.

 

In 2005, net earnings of $346.3 million increased $59.4 million, or 20.7%, over the prior year. The growth in net earnings was due to the improvement in operating earnings, higher net interest income and a lower tax rate. Diluted earnings per share for 2005 of $3.78 were 20.8% higher than the $3.13 for 2004.

 

Segment Analysis

The following comments at the segment level include external and intersegment net sales and operating earnings. Comments at the business unit level include external and inter- and intrasegment net sales and operating earnings. See Note 17 to the Consolidated Financial Statements.

 

Grainger Branch-based

Net sales of $4,649.2 million in 2005 increased 8.5% over 2004 net sales of $4,283.3 million. Sales in the United States were up 8.4% over the prior year. All customer segments increased, with the strongest sales growth in the commercial, government and manufacturing sectors. National account sales, which include all customer segments, were up 11.9%. The wind-down of integrated supply and automotive contracts reduced sales growth by approximately 2 percentage points.

 

In 2004, the Company launched a multiyear market expansion program to strengthen its presence in top metropolitan markets and better position itself to serve local customers. Phases 1 through 3 included ten markets.

 

As of the fourth quarter of 2005, the Company began Phase 4 of the program. Additional phases began in 2006.

 

 

 

Sales Increase

2005 vs. 2004

 

Estimated

Percent

Complete*

 

Phase 1 (Atlanta, Denver, Seattle)

 

10%

 

100%  

 

Phase 2 (Four markets in Southern California)

 

14%

 

90%

 

Phase 3 (Houston, St. Louis, Tampa)

 

19%

 

70%

 

 

 

 

 

 

 

*

Phases are reported once they reach 50% completion. Completion occurs when a new branch opens or a branch expansion or remodeling is finished.

 

 

Overall, market expansion contributed approximately 1 percentage point to the segment sales growth. The sales growth in Phase 1 was negatively affected in the Denver market due to lower sales to one large customer. Excluding the effect of this customer, sales in Phase 1 were up 13%.

 

Sales in Mexico were up 18.6% in 2005 as compared to 2004, driven by a strong local economy, expanded telesales operations and improved sales to national accounts.

 

Cost of merchandise sold of $2,817.5 million increased $155.2 million, or 5.8%, over 2004 due to increased volume. Gross profit margins improved 1.6 percentage points to 39.4% in 2005 from 37.8% in 2004. Contributing to the improvement in gross profit margin were selling price category mix and the positive effect of product mix, which included the global sourcing of additional products. The major driver of the improvement in selling price category mix was reduced sales to integrated supply and automotive customers, which carry lower than average gross margins.

 

Operating expenses for the Grainger Branch-based businesses increased 11.3% in 2005. Operating expenses were up primarily as a result of payroll and benefits costs. Payroll increases were due to higher headcount to support strategic initiatives including the market expansion program and information technology upgrades. In addition, sales commissions and profit sharing accruals increased due to the improved 2005 performance. Partially offsetting these increases was lower bad debt expense, the result of improved collections and reduced write-offs.

 

14

In 2005, operating earnings of $522.6 million increased by $78.1 million, or 17.6%, over 2004. The improvement was the result of sales growth, combined with the improvement in gross profit margin, and was partially offset by operating expenses, which grew faster than sales.

 

Acklands Grainger Branch-based

Net sales at Acklands – Grainger of $502.0 million increased by 15.6% in 2005 compared to 2004 net sales of $434.3 million, including the effect of a favorable Canadian exchange rate. In local currency, sales increased 7.7%, primarily due to strength in the Canadian economy driven by the natural resources sector.

 

The gross profit margin increased 0.3 percentage point in 2005 over 2004 primarily due to positive inflation recovery.

 

Operating expenses were up 24.8% in 2005, primarily driven by payroll and benefits due to increased headcount and bonus accruals, and higher information technology, advertising and occupancy costs.

 

Operating earnings decreased 33.2% in 2005, primarily driven by increased operating expenses which grew at a faster rate than sales, partially offset by a slightly improved gross margin.

 

Lab Safety

Net sales at Lab Safety were $380.1 million in 2005, an increase of $43.4 million, or 12.9%, when compared with $336.7 million of sales in 2004. Higher sales were principally driven by incremental sales from AW Direct, which was acquired on January 14, 2005. Excluding AW Direct, sales increased 4.0 percentage points over 2004.

 

The gross profit margin of 42.5% increased 0.7 percentage point when compared to the gross profit margin of 41.8% for 2004. Contributing to the improvement was a favorable selling price category mix, partially offset by the negative effect of AW Direct sales, which carry lower gross profit margins.

 

Operating expenses were $109.0 million in 2005, up $13.7 million, or 14.3%, over 2004. The increase over the prior year was principally driven by higher variable compensation expense related to the strong performance for the year and higher catalog media costs, partially offset by lower data processing expense related to fully amortized enterprise software. Also contributing to the increase were costs associated with the AW Direct acquisition.

 

Operating earnings of $52.7 million were up 15.9% in 2005 over 2004, resulting primarily from the increase in sales and the improved gross profit margin, partially offset by increased operating expenses.

 

Other Income and Expense

Other income and expense was $13.7 million of income in 2005, an improvement of $9.8 million as compared with $3.9 million of income in 2004. The following table summarizes the components of other income and expense:

 

 

For the Years Ended December 31,

 

2005

 

2004

 

(In thousands of dollars)

Other income and (expense):

 

 

 

Interest income (expense) – net

$          11,019 

 

$              1,988

Equity in income of unconsolidated entities – net

2,809 

 

996

Gain on sale of unconsolidated entity

– 

 

750

Unclassified – net

(143)

 

151

 

$          13,685 

 

$              3,885

 

The improvement in other income and expense in 2005 over 2004 was primarily attributable to higher interest income and lower interest expense and improvement in the results of unconsolidated entities. The increase in interest income in 2005 was primarily the result of higher interest rates. Interest expense decreased due to the payment of the cross-currency swap in September 2004.

 

Income Taxes

Income taxes of $186.4 million in 2005 increased 17.8% as compared with $158.2 million in 2004.

 

Grainger’s effective tax rates were 35.0% and 35.5% in 2005 and 2004, respectively. Excluding the effect of equity in unconsolidated entities, which is recorded net of tax, the effective income tax rates were 35.2% for 2005 and 35.6% for 2004.

 

The 2005 tax rate included tax benefits related to a favorable revision to the estimate of income taxes for various state and local taxing jurisdictions and the resolution of certain federal and state tax contingencies.

 

The tax rate in 2004 included the realization of tax benefits related to operations in Mexico and to capital losses, the recognition of tax benefits from the Medicare Act and the resolution of certain federal and state tax contingencies.

 

15

Financial Condition

Grainger expects its strong working capital position and cash flows from operations to continue, allowing it to fund its operations including growth initiatives and capital expenditures, and to repurchase shares, as well as pay cash dividends at or above historical levels.

 

Cash Flow

Net cash flows from operations of $436.8 million in 2006, $432.5 million in 2005 and $406.5 million in 2004 continued to improve Grainger’s financial position and serve as the primary source of funding. Net cash provided by operations increased $4.3 million in 2006 over 2005, driven primarily by increased net earnings. The Change in operating assets and liabilities – net of business acquisitions and joint venture contributions used cash of $97.2 million in 2006. The use of cash was primarily driven by increases in inventory and trade accounts receivable, which were up due to increased sales throughout 2006 and an increase in days sales outstanding. These changes were partially offset by an increase in trade accounts payable due to the higher inventory purchases. The increase in net cash flows from operations from 2004 to 2005 was primarily attributable to increased net earnings. The Change in operating assets and liabilities – net of business acquisitions and joint venture contributions used cash of $57.1 million in 2005. The use of cash was primarily driven by increases in inventory and trade accounts receivable, which were up due to higher inventory purchases and sales in December. These changes were partially offset by an increase in trade accounts payable due to the higher inventory purchases and increases in profit sharing and compensation-related accruals, driven by an improved 2005 performance.

 

Net cash flows used in investing activities were $139.7 million, $163.0 million and $142.4 million for 2006, 2005 and 2004, respectively. Capital expenditures for property, buildings, equipment and capitalized software were $136.8 million, $157.2 million and $160.8 million in 2006, 2005 and 2004, respectively. Additional information regarding capital spending is detailed in the Capital Expenditures section below. In 2006, Grainger also invested $13.9 million to purchase Rand and $20.5 million to purchase Professional Equipment and Construction Book, which are part of the Lab Safety segment. The results of operations for Rand have been included in the consolidated financial statements since the acquisition date of January 31, 2006, and the results of operations for Professional Equipment and Construction Book have been included in the consolidated financial statements since the acquisition date of November 17, 2006.

 

Net cash flows used in financing activities for 2006, 2005 and 2004 were $492.9 million, $154.1 million and $240.6 million, respectively. Treasury stock purchases increased $335.3 million in 2006, as Grainger repurchased 6,950,900 shares, compared with 2,404,400 shares in 2005. Treasury stock purchases were 2,001,000 shares in 2004. As of December 31, 2006, approximately 7.7 million shares of common stock remained available under Grainger’s repurchase authorization. Dividends paid to shareholders were $97.9 million in 2006, $82.7 million in 2005 and $71.2 million in 2004. Partially offsetting these cash outlays were proceeds from stock options exercised of $64.4 million, $66.0 million and $72.3 million for 2006, 2005 and 2004, respectively. During 2004, Grainger liquidated its cross-currency swap and related commercial paper debt with payments totaling $140.8 million.

 

Working Capital

Internally generated funds have been the primary source of working capital and for funds used in business expansion, supplemented by debt as circumstances dictated. In addition, funds were expended for facilities optimization and enhancements to support growth initiatives, as well as for business and systems development and other infrastructure improvements.

 

Working capital was $1,155.8 million at December 31, 2006, compared with $1,290.2 million at December 31, 2005, and $1,108.4 million at December 31, 2004. At these dates, the ratio of current assets to current liabilities was 2.6, 2.9 and 2.7, respectively.

 

Capital Expenditures

In each of the past three years, a portion of operating cash flow has been used for additions to property, buildings, equipment and capitalized software as summarized in the following table:

 

 

For the Years Ended December 31,

 

2006

 

2005

 

2004

 

(In thousands of dollars)

 

 

 

 

 

 

Land, buildings, structures and improvements

$   67,554

 

$   52,955

 

$   41,929

Furniture, fixtures, machinery and equipment

62,233

 

59,342

 

86,347

Subtotal

129,787

 

112,297

 

128,276

Capitalized software

8,950

 

44,950

 

32,482

Total

$ 138,737

 

$ 157,247

 

$ 160,758

 

 

16

In 2006, Grainger’s investments included the market expansion program, which is designed to realign branches in several metropolitan markets, international expansion and the normal, recurring replacement of equipment.

 

In 2005 and 2004, Grainger’s investments included the market expansion program, ongoing SAP initiatives, expenditures related to Canadian branch and systems projects, as well as the normal, recurring replacement of equipment.

 

Capital expenditures are expected to range from $150 million to $175 million in 2007 and include investments for the ongoing market expansion program, information technology, international expansion, as well as other general projects including the normal, recurring replacement of equipment. Grainger expects to fund 2007 capital investments from operating cash flows, which Grainger believes will remain strong.

 

Debt

Grainger maintains a debt ratio and liquidity position that provides flexibility in funding working capital needs and long-term cash requirements. In addition to internally generated funds, Grainger has various sources of financing available, including commercial paper sales and bank borrowings under lines of credit. At December 31, 2006, Grainger’s long-term debt rating by Standard & Poor’s was AA+. Grainger’s available lines of credit, as further discussed in Note 8 to the Consolidated Financial Statements, were $250.0 million at December 31, 2006, 2005 and 2004. Total debt as a percent of total capitalization was 0.4%, 0.4% and 0.5% as of the same dates.

 

Grainger entered into a two-year cross-currency swap on September 25, 2002. On September 27, 2004, the cross-currency swap and related commercial paper debt matured and were liquidated with payments totaling $140.8 million. See Note 10 to the Consolidated Financial Statements.

 

Grainger believes any circumstances that would trigger early payment or acceleration with respect to any outstanding debt securities would not have a material impact on its results of operations or financial condition. Certain holders of industrial revenue bonds have various rights to require Grainger to redeem these bonds, thus a portion is classified as Current maturities of long-term debt.

 

Commitments and Other Contractual Obligations

At December 31, 2006, Grainger’s contractual obligations, including estimated payments due by period, are as follows:

 

 

Payments Due by Period

 

Total

Amounts

Committed

 

Less than

1 Year

 

1 – 3

Years

 

4 – 5

Years

 

More than

5 Years

 

(In thousands of dollars)

Long-term debt obligations

$         9,485

 

$          4,590

 

$               –

 

$       4,895

 

$              –

Operating lease obligations

168,900

 

34,221

 

69,253

 

30,138

 

35,288

Purchase obligations:

 

 

 

 

 

 

 

 

 

Uncompleted additions to

property, buildings and

equipment

48,027

 

48,027

 

 

 

Commitments to 

purchase inventory

213,904

 

213,904

 

 

 

Other purchase obligations

79,730

 

48,300

 

30,563

 

867

 

Other liabilities 

118,715

 

 

12,840

 

13,559

 

92,316

Total

$     638,761

 

$      349,042

 

$    112,656

 

$     49,459

 

$   127,604

 

Purchase obligations consist primarily of inventory purchases made in the normal course of business to meet operating needs. While purchase orders for both inventory purchases and noninventory purchases are generally cancelable without penalty, certain vendor agreements provide for cancellation fees or penalties depending on the terms of the contract.

 

Payments for Other liabilities represent future benefit payments for postretirement benefit plans and postemployment disability medical benefits as determined by actuarial projections. Other employment-related benefits costs of $32.3 million have not been included in this table as the timing of benefit payments is not as statistically predictable. See Note 9 to the Consolidated Financial Statements.

 

See also Notes 10 and 11 to the Consolidated Financial Statements.

 

17

Off-Balance Sheet Arrangements

Grainger does not have any material exposures to off-balance sheet arrangements. Grainger does not have any variable interest entities or activities that include nonexchange-traded contracts accounted for at fair value.

 

Critical Accounting Estimates

The preparation of financial statements, in conformity with accounting principles generally accepted in the United States of America, requires management to make judgments, estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses in the financial statements. Management bases its estimates on historical experience and other assumptions, which it believes are reasonable. If actual amounts are ultimately different from these estimates, the revisions are included in Grainger’s results of operations for the period in which the actual amounts become known.

 

Accounting policies are considered critical when they require management to make assumptions about matters that are highly uncertain at the time the estimate is made and when different estimates than those management reasonably could have made have a material impact on the presentation of Grainger’s financial condition, changes in financial condition or results of operations.

 

Note 2 to the Consolidated Financial Statements describes the significant accounting policies used in the preparation of the Consolidated Financial Statements. The most significant areas involving management judgments and estimates follow. Actual results in these areas could differ materially from management’s estimates under different assumptions or conditions.

 

Postretirement Healthcare Benefits. Postretirement obligations and net periodic costs are dependent on assumptions and estimates used in calculating such amounts. The assumptions used include, among others, discount rates, assumed rates of return on plan assets and healthcare cost trend rates. Changes in assumptions (caused by conditions in equity markets or plan experience, for example) could have a material effect on Grainger’s postretirement benefit obligations and expense, and could affect its results of operations and financial condition. These changes in assumptions may also affect voluntary decisions to make additional contributions to the trust established for funding the postretirement benefit obligation.

 

The discount rate assumptions used by management reflect the rates available on high-quality fixed income debt instruments as of December 31, the measurement date, of each year in accordance with Statement of Financial Accounting Standards (SFAS) No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” A lower discount rate increases the present value of benefit obligations and net periodic postretirement benefit costs. As of December 31, 2006, Grainger increased the discount rate used in the calculation of its postretirement plan obligation from 5.5% to 5.9% to reflect the increase in market interest rates. Grainger estimates that the increase in the expected discount rate will increase 2007 pretax earnings by approximately $1.4 million, although other changes in assumptions may increase, decrease or eliminate this effect.

 

Grainger considers the long-term historical actual return on plan assets and the historical performance of the Standard & Poor’s 500 Index in developing its expected long-term return on plan assets. In 2006, Grainger maintained the expected long-term rate of return on plan assets of 6.0% (net of tax at 40%) based on the historical average of long-term rates of return.

 

Grainger may terminate or modify the postretirement plan at any time, subject to the provisions of the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code, as amended. In the event the postretirement plan is terminated, all assets of the Group Benefit Trust inure to the benefit of the participants. The foregoing assumptions are based on the presumption that the postretirement plan will continue. Were the postretirement plan to terminate, different actuarial assumptions and other factors might be applicable.

 

Grainger has used its best judgment in making assumptions and estimates and believes such assumptions and estimates used are appropriate. Changes to the assumptions may be required in future years as a result of actual experience or new trends and, therefore, may affect Grainger’s retirement plan obligations and future expense.

 

For additional information concerning postretirement healthcare benefits, see Note 9 to the Consolidated Financial Statements.

 

Insurance Reserves. Grainger retains a significant portion of the risk of certain losses related to workers’ compensation, general liability and property losses through the utilization of deductibles and self-insured retentions. There are also certain other risk areas for which Grainger does not maintain insurance.

 

Grainger is responsible for establishing policies on insurance reserves. Although it relies on outside parties to project future claims costs, it retains control over actuarial assumptions, including loss development factors and claim payment patterns. Grainger performs ongoing reviews of its insured and uninsured risks, which it uses to establish the appropriate reserve levels.

 

18

The use of assumptions in the analysis leads to fluctuations in required reserves over time. Any change in the required reserve balance is reflected in the current period’s results of operations.

 

Allowance for Doubtful Accounts. Grainger uses several factors to estimate the allowance for uncollectible accounts receivable including the age of the receivables and the historical ratio of actual write-offs to the age of the receivables. The analyses performed also take into consideration economic conditions that may have an impact on a specific industry, group of customers or a specific customer.

 

Write-offs could be materially different than the reserves provided if economic conditions change or actual results deviate from historical trends.

 

Inventory Reserves. Grainger establishes inventory reserves for shrinkage and excess and obsolete inventory. Provisions for inventory shrinkage are based on historical experience to account for unmeasured usage or loss. Actual inventory shrinkage could be materially different from these estimates affecting Grainger’s inventory values and cost of merchandise sold.

 

Grainger regularly reviews inventory to evaluate continued demand and identify any obsolete or excess quantities of inventory. Grainger records provisions for the difference between excess and obsolete inventory and its estimated realizable value. Estimated realizable value is based on anticipated future product demand, market conditions and liquidation values. Actual results differing from these projections could have a material effect on Grainger’s results of operations.

 

Income Taxes. Grainger accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes.” Under SFAS No. 109, deferred tax assets and liabilities are determined based on the differences between the financial statement and tax bases of assets and liabilities, using enacted tax rates in effect for the year in which the differences are expected to reverse. The tax balances and income tax expense recognized by Grainger are based on management’s interpretations of the tax laws of multiple jurisdictions. Income tax expense reflects Grainger’s best estimates and assumptions regarding, among other items, the level of future taxable income, interpretation of tax laws and tax planning opportunities. Future rulings by tax authorities and future changes in tax laws and their interpretation, changes in projected levels of taxable income and future tax planning strategies could impact the actual effective tax rate and tax balances recorded by Grainger.

 

Other. Other significant accounting policies, not involving the same level of measurement uncertainties as those discussed above, are nevertheless important to an understanding of the financial statements. Policies relating to revenue recognition, depreciation, intangibles, long-lived assets and warranties require judgments on complex matters that are often subject to multiple external sources of authoritative guidance such as the Financial Accounting Standards Board and the Securities and Exchange Commission. Possible changes in estimates or assumptions associated with these policies are not expected to have a material effect on the financial condition or results of operations of Grainger. More information on these additional accounting policies can be found in Note 2 to the Consolidated Financial Statements.

 

New Accounting Standards

The following new accounting standards exclude those pronouncements that are unlikely to have an effect on Grainger upon adoption.

 

In July 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109.” FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measure of a tax position taken or expected to be taken in a tax return. It also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company does not expect adoption of FIN 48 to have a material effect on its results of operations or financial position.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. The provisions of SFAS No. 157 are effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact adoption may have on its results of operations or financial position.

 

19

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and 132R.” SFAS No. 158 requires an employer to recognize in its statement of financial position an asset for a plan’s overfunded status or a liability for a plan’s underfunded status, measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year (with limited exceptions), and recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. SFAS No. 158 requires funded status changes of a defined benefit postretirement plan within accumulated other comprehensive income, net of tax, to the extent such changes are not recognized in earnings as components of net periodic benefit costs. SFAS No. 158 is effective for fiscal years ending after December 15, 2006. The Company adopted SFAS No. 158 during the fourth quarter of 2006. As a result of the adoption, Grainger recorded an additional liability of $36.8 million to Accrued employment-related benefit costs, offset by $14.3 million of deferred income taxes and a reduction of Accumulated other comprehensive earnings of $22.5 million. See Note 2 to the Consolidated Financial Statements for further discussion of information related to SFAS No. 158.

 

In September 2006, the SEC issued Staff Accounting Bulletin (SAB) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in the Current Year Financial Statements.” SAB No. 108 addresses how the effects of prior year uncorrected misstatements should be considered when quantifying misstatements in current year financial statements. SAB No. 108 requires an entity to quantify misstatements using a balance sheet and income statement approach and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors. The adoption of SAB No. 108 is effective for fiscal years ending on or after November 15, 2006. The Company adopted SAB No. 108 during the fourth quarter of 2006. The adoption of SAB No. 108 did not have a material effect on the Company’s results of operations or financial position.

 

See Note 2 to the Consolidated Financial Statements for further discussion of new accounting standards.

 

Inflation and Changing Prices

Inflation during the last three years has not had a significant effect on operations. The predominant use of the last-in, first-out (LIFO) method of accounting for inventories and accelerated depreciation methods for financial reporting and income tax purposes result in a substantial recognition of the effects of inflation in the financial statements.

 

The major impact of inflation is on buildings and improvements, where the gap between historic cost and replacement cost continues for these long-lived assets. The related depreciation expense associated with these assets increases if adjustments were to be made for the cumulative effect of inflation.

 

Grainger believes the most positive means to combat inflation and advance the interests of investors lies in the continued application of basic business principles, which include improving productivity, increasing working capital turnover and offering products and services which can command appropriate prices in the marketplace.

 

Forward-Looking Statements

This document contains forward-looking statements under the federal securities laws. The forward-looking statements relate to Grainger’s expected future financial results and business plans, strategies and objectives and are not historical facts. They are often identified by qualifiers such as “will,” “could,” “should,” “might,” “may,” “would,” “tend,” “planned,” “presumption,” “expects,” “intends,” “is likely,” “anticipates,” “scheduled,” “believes,” “positions it,” “continue,” “estimates,” “forecast,” “predicting,” “projection,” “potential,” “ assumption” or similar expressions. There are risks and uncertainties the outcome of which could cause Grainger’s results to differ materially from what is projected.

 

Factors that may affect forward-looking statements include the following: higher product costs or other expenses; a major loss of customers; increased competitive pricing pressure on Grainger’s businesses; failure to develop or implement new technologies or other business strategies; the outcome of pending and future litigation or governmental or regulatory proceedings relating to claims, inquiries or audits; changes in laws and regulations; facilities disruptions or shutdowns; disruptions in transportation services; natural and other catastrophes; unanticipated weather conditions; and other difficulties in achieving or improving margins or financial performance.

 

Trends and projections could also be affected by general industry and market conditions, gross domestic product growth rates, general economic conditions including interest rate and currency rate fluctuations, global and other conflicts, employment levels and other factors.

 

20

Item 7A: Quantitative and Qualitative Disclosures About Market Risk

 

Grainger is exposed to foreign currency exchange risk related to its transactions, assets and liabilities denominated in foreign currencies. During a portion of 2004, Grainger partially hedged its net Canadian dollar investment in Acklands – Grainger with a cross-currency swap agreement. This agreement was terminated in 2004. See Note 10 to the Consolidated Financial Statements. For 2006, a uniform 10% strengthening of the U.S. dollar relative to foreign currencies that affect Grainger and its joint ventures would have resulted in a $1.0 million decrease in net income. Comparatively, in 2005 a uniform 10% strengthening of the U.S. dollar relative to foreign currencies that affect Grainger and its joint ventures would have resulted in a $1.6 million decrease in net income. A uniform 10% weakening of the U.S. dollar would have resulted in a $1.2 million increase in net income for 2006, as compared with an increase in net income of $1.9 million for 2005. This sensitivity analysis of the effects of changes in foreign currency exchange rates does not factor in potential changes in sales levels or local currency prices. Grainger does not hold derivatives for trading purposes.

 

Grainger is also exposed to interest rate risk in its debt portfolio. During 2006 and 2005, all of its long-term debt was variable rate debt. For both 2006 and 2005, a 1 percentage point increase in interest rates paid by Grainger would have resulted in a decrease to income of approximately $0.1 million and a 1 percentage point decrease in interest rates would have resulted in an increase to income of approximately $0.1 million. This sensitivity analysis of the effects of changes in interest rates on long-term debt does not factor in potential changes in exchange rates or long-term debt levels. Grainger’s level of interest rate risk has been reduced due to the liquidation of the cross-currency swap and related commercial paper debt during 2004. See Note 10 to the Consolidated Financial Statements.

 

Grainger is not exposed to commodity price risk since it purchases its goods for resale and does not purchase commodities directly.

 

Item 8: Financial Statements and Supplementary Data

 

The financial statements and supplementary data are included on pages 26 to 64. See the Index to Financial Statements and Supplementary Data on page 25.

 

Item 9: Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

 

None.

 

Item 9A: Controls and Procedures

 

Disclosure Controls and Procedures

 

Grainger carried out an evaluation, under the supervision and with the participation of its management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of Grainger’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that Grainger’s disclosure controls and procedures were effective as of the end of the period covered by this report.

 

Internal Control over Financial Reporting

 

(A)

Management’s Annual Report on Internal Control Over Financial Reporting

 

Management’s report on the Company’s internal control over financial reporting is included on page 26 of this Report under the heading Management’s Annual Report on Internal Control Over Financial Reporting.

 

(B)

Attestation Report of the Registered Public Accounting Firm

 

The report from Ernst & Young LLP on its audit of management’s assessment of the effectiveness of Grainger’s internal control over financial reporting as of December 31, 2006, is included on page 27 of this Report under the heading Report of Independent Registered Public Accounting Firm.

 

(C)

Changes in Internal Control Over Financial Reporting

 

There have been no changes in Grainger’s internal control over financial reporting during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, Grainger’s internal control over financial reporting.

 

Item 9B: Other Information

 

None.

 

21

PART III

 

Item 10: Directors, Executive Officers and Corporate Governance

 

The information required by this item is incorporated by reference to Grainger’s proxy statement relating to the annual meeting of shareholders to be held April 25, 2007, under the captions “Election of Directors,” “Board of Directors and Board Committees” and “Section 16(a) Beneficial Ownership Reporting Compliance.” Information required by this item regarding executive officers of Grainger is set forth in Part I of this report under the caption “Executive Officers.”

 

Grainger has adopted a code of ethics that applies to the principal executive officer, principal financial officer and principal accounting officer. This code of ethics is incorporated into Grainger’s business conduct guidelines for directors, officers and employees. Grainger intends to satisfy the disclosure requirement under Item 5.05 of Form 8-K relating to its code of ethics by posting such information on its Web site. A copy of the business conduct guidelines is available at grainger.com/investor and is also available in print without charge to any person upon request to Grainger’s Corporate Secretary. Grainger has also adopted Operating Principles for the Board of Directors, which are available on its Web site and are available in print to any person who requests them.

 

Item 11: Executive Compensation

 

The information required by this item is incorporated by reference to Grainger’s proxy statement relating to the annual meeting of shareholders to be held April 25, 2007, under the captions “Board of Directors and Board Committees,” “Director Compensation,” “Report of the Compensation Committee of the Board” and “Compensation Discussion and Analysis.”

 

Item 12: Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

The information required by this item is incorporated by reference to Grainger’s proxy statement relating to the annual meeting of shareholders to be held April 25, 2007, under the captions “Ownership of Grainger Stock” and “Equity Compensation Plans.”

 

Item 13: Certain Relationships and Related Transactions, and Director Independence

 

The information required by this item is incorporated by reference to Grainger’s proxy statement relating to the annual meeting of shareholders to be held April 25, 2007, under the captions “Election of Directors” and “Transactions with Related Persons.”

 

Item 14: Principal Accounting Fees and Services

 

The information required by this item is incorporated by reference to Grainger’s proxy statement relating to the annual meeting of shareholders to be held April 25, 2007, under the caption “Audit Fees and Audit Committee Pre-Approval Policies and Procedures.”

PART IV

 

Item 15: Exhibits and Financial Statement Schedules

 

(a)

1.

Financial Statements. See Index to Financial Statements and Supplementary Data.

 

2.

Financial Statement Schedules. The schedules listed in Reg. 210.5-04 have been omitted because they are either not applicable or the required information is shown in the consolidated financial statements or notes thereto.

 

3.

Exhibits

 

 

 

 

(3)

(a)

Restated Articles of Incorporation, incorporated by reference to Exhibit 3(i) to Grainger’s Quarterly Report on Form 10-Q for the quarter ended June 30, 1998.

 

 

 

(b)

Bylaws, as amended.

 

 

(4)

Instruments Defining the Rights of Security Holders, Including Indentures

 

 

 

(a)

Agreement dated as of April 28, 1999, between Grainger and Fleet National Bank (formerly Bank Boston, NA), as rights agent, incorporated by reference to Exhibit 4 to Grainger’s Current Report on Form 8-K dated April 28, 1999, and related letter concerning the appointment of EquiServe Trust Company, N.A. (now Computershare Trust Company, N.A.), as successor rights agent, effective August 1, 2002, incorporated by reference to Exhibit 4 to Grainger’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2002.

 

 

 

(b)

No instruments which define the rights of holders of Grainger’s Industrial Development Revenue Bonds are filed herewith, pursuant to the exemption contained in Regulation S-K, Item 601(b)(4)(iii). Grainger hereby agrees to furnish to the Securities and Exchange Commission, upon request, a copy of any such instrument.

 

 

22

 

 

 

(10)

Material Contracts

 

 

 

 

 

Compensatory Plans or Arrangements

 

 

 

 

(i)

Director Stock Plan, as amended, incorporated by reference to Exhibit 10(c) to Grainger’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2006. 

 

 

 

(ii)

Office of the Chairman Incentive Plan, incorporated by reference to Appendix B of Grainger’s Proxy Statement dated March 26, 1997.

 

 

 

(iii)

1990 Long-Term Stock Incentive Plan, as amended, incorporated by reference to Exhibit 10(a) to Grainger’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2006.

 

 

 

(iv)

2001 Long-Term Stock Incentive Plan, as amended, incorporated by reference to Exhibit 10(b) to Grainger’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2006.

 

 

 

(v)

Executive Death Benefit Plan, as amended, incorporated by reference to Exhibit 10(b)(v) to Grainger’s Annual Report on Form 10-K for the year ended December 31, 2001.

 

 

 

(vi)

Executive Deferred Compensation Plan, incorporated by reference to Exhibit 10(e) to Grainger’s Annual Report on Form 10-K for the year ended December 31, 1989.

 

 

 

(vii)

1985 Executive Deferred Compensation Plan, as amended, incorporated by reference to Exhibit 10(d)(vii) to Grainger’s Annual Report on Form 10-K for the year ended December 31, 1998.

 

 

 

(viii)

Supplemental Profit Sharing Plan, as amended, incorporated by reference to Exhibit 10(viii) to Grainger’s Annual Report on Form 10-K for the year ended December 31, 2003.

 

 

 

(ix)

Supplemental Profit Sharing Plan II, incorporated by reference to Exhibit 10(ix) to Grainger’s Annual Report on Form 10-K for the year ended December 31, 2005.

 

 

 

(x)

Form of Change in Control Employment Agreement between Grainger and certain of its executive officers, incorporated by reference to Exhibit 10 to Grainger’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2006.

 

 

 

(xi)

Voluntary Salary and Incentive Deferral Plan, incorporated by reference to Exhibit 10(x) to Grainger’s Annual Report on Form 10-K for the year ended December 31, 2003.

 

 

 

(xii)

Summary Description of Directors Compensation Program effective January 1, 2005, incorporated by reference to Exhibit 10(xv) to Grainger’s Annual Report on Form 10-K for the year ended December 31, 2004.

 

 

 

(xiii)

2005 Incentive Plan, as amended, incorporated by reference to Exhibit 10(d) to Grainger’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2006.

 

 

 

(xiv)

Form of Stock Option Award Agreement between Grainger and certain of its executive officers, incorporated by reference to Exhibit 10(xiv) to Grainger’s Annual Report on Form 10-K for the year ended December 31, 2005.

 

 

 

(xv)

Form of Stock Option and Restricted Stock Unit Agreement between Grainger and certain of its executive officers, incorporated by reference to Exhibit 10(xv) to Grainger’s Annual Report on Form 10-K for the year ended December 31, 2005.

 

 

 

(xvi)

Form of Performance Share Award Agreement between Grainger and certain of its executive officers, incorporated by reference to Exhibit 10(xvi) to Grainger’s Annual Report on Form 10-K for the year ended December 31, 2005.

 

 

 

(xvii)

Summary Description of 2007 Management Incentive Program.

 

 

(11)

Computations of Earnings Per Share.

 

 

 

(21)

Subsidiaries of Grainger.

 

 

 

(23)

Consents of Independent Registered Public Accounting Firms.

 

 

(31)

Rule 13a – 14(a)/15d – 14(a) Certifications

 

 

 

 

(a)

Chief Executive Officer certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

 

(b)

Chief Financial Officer certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

(32)

Section 1350 Certifications

 

 

 

 

(a)

Chief Executive Officer certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

 

(b)

Chief Financial Officer certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

23

SIGNATURES

 

Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, Grainger has duly issued this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

DATE: February 23, 2007

W.W. GRAINGER, INC.

By:

/s/  Richard L. Keyser

 

Richard L. Keyser

Chairman of the Board 

and Chief Executive Officer

 

Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of Grainger on February 23, 2007, in the capacities indicated.

 

 

 

 

/s/ Richard L. Keyser

 

/s/ Stuart L. Levenick

Richard L. Keyser

 

Stuart L. Levenick

Chairman of the Board

 

Director

and Chief Executive Officer

 

 

(Principal Executive Officer and Director)

 

 

 

 

 

/s/ P. Ogden Loux

 

/s/ John W. McCarter, Jr.

P. Ogden Loux

 

John W. McCarter, Jr.

Senior Vice President, Finance

 

Director

and Chief Financial Officer

 

 

(Principal Financial Officer)

 

 

 

 

 

/s/ Ronald L. Jadin

 

/s/ Neil S. Novich

Ronald L. Jadin

 

Neil S. Novich

Vice President and Controller

 

Director

(Principal Accounting Officer)

 

 

 

 

 

/s/ Brian P. Anderson

 

/s/ Michael J. Roberts

Brian P. Anderson

 

Michael J. Roberts

Director

 

Director

 

 

 

/s/ Wilbur H. Gantz

 

/s/ Gary L. Rogers

Wilbur H. Gantz

 

Gary L. Rogers

Director

 

Director

 

 

 

/s/ V. Ann Hailey

 

/s/ James D. Slavik

V. Ann Hailey

 

James D. Slavik

Director

 

Director

 

 

 

/s/ William K. Hall

 

/s/ Harold B. Smith

William K. Hall

 

Harold B. Smith

Director

 

Director

 

 

 

 

 

24

INDEX TO FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

December 31, 2006, 2005 and 2004

 

 

 

Page(s)

 

MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORITNG

26

 

REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMS

27-29

 

FINANCIAL STATEMENTS

 

 

CONSOLIDATED STATEMENTS OF EARNINGS

30

 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE EARNINGS

31

 

CONSOLIDATED BALANCE SHEETS

32-33

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

34-35

 

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

36-37

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

38-62

 

EXHIBIT 11 – COMPUTATIONS OF EARNINGS PER SHARE

63

 

EXHIBIT 23 – CONSENTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMS

64

 

 

 

 

25

MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

 

The management of W.W. Grainger, Inc. (Grainger) is responsible for establishing and maintaining adequate internal control over financial reporting. Grainger’s internal control system was designed to provide reasonable assurance to Grainger’s management and Board of Directors regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements under all potential conditions. Therefore, effective internal control over financial reporting provides only reasonable, and not absolute, assurance with respect to the preparation and presentation of financial statements.

 

Grainger’s management assessed the effectiveness of Grainger’s internal control over financial reporting as of December 31, 2006, based on the framework set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control – Integrated Framework. Based on its assessment under that framework and the criteria established therein, Grainger’s management concluded that Grainger’s internal control over financial reporting was effective as of December 31, 2006.

 

Ernst & Young LLP, an independent registered public accounting firm, has audited management’s assessment of the effectiveness of Grainger’s internal control over financial reporting as of December 31, 2006, as stated in their report which is included herein.

 

26

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors and Shareholders

W.W. Grainger, Inc.

 

We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting, that W.W. Grainger, Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). W.W Grainger, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that W.W. Grainger, Inc. maintained effective internal control over financial reporting as of December 31, 2006 is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, W.W Grainger, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006 based on the COSO criteria.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of W.W. Grainger, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of earnings, comprehensive earnings, shareholders’ equity, and cash flows for the years then ended of W.W. Grainger, Inc. and our report dated February 26, 2007, expressed an unqualified opinion thereon.

 

/s/ Ernst & Young LLP

 

Chicago, Illinois

February 26, 2007

 

27

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors and Shareholders

W.W. Grainger, Inc.

 

We have audited the accompanying consolidated balance sheets of W.W Grainger, Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of earnings, comprehensive earnings, shareholders’ equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of W.W. Grainger, Inc. and subsidiaries at December 31, 2006 and 2005, and the consolidated results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.

 

As described in Note 2 to the consolidated financial statements, effective January 1, 2006, the Company changed its method of accounting for share-based payments to conform with FASB Statement No. 123(R).

 

As described in Note 2 to the consolidated financial statements, effective December 31, 2006, the Company changed its method of accounting for other postretirement plans to conform with FASB Statement No. 158.

 

The financial statements of W.W. Grainger, Inc. as of December 31, 2004, and for the year then ended were audited by other auditors. As described in Note 17 – Segment Information, the Company changed the composition of its reportable segments in 2006, and the amounts in the 2004 financial statements relating to reportable segments have been restated to conform to the 2005 and 2006 composition of reportable segments. We audited the adjustments that were applied to restate the disclosures for reportable segments reflected in the 2004 financial statements. Our procedures included (a) agreeing the adjusted amounts of segment sales, operating earnings, assets, depreciation and amortization, and additions to long-lived assets to the Company’s underlying records obtained from management, and (b) testing the mathematical accuracy of the reconciliations of segment amounts to the consolidated financial statements. In our opinion, such adjustments are appropriate and have been properly applied. However, we were not engaged to audit, review, or apply any procedures on the 2004 financial statements of the Company other than with respect to such adjustments and, accordingly, we do not express an opinion or any other form of assurance on the 2004 financial statements taken as a whole.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of W.W. Grainger, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 26, 2007 expressed an unqualified opinion thereon.

 

/s/ Ernst & Young LLP

 

Chicago, Illinois

February 26, 2007

 

 

28

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

Shareholders and Board of Directors

W.W. Grainger, Inc.

 

We have audited, before the effects of the adjustments to retrospectively reflect the change in the composition of reportable segments described in Note 17, the accompanying consolidated balance sheet of W.W. Grainger, Inc., and Subsidiaries as of December 31, 2004, and the related consolidated statement of earnings, comprehensive earnings, shareholders’ equity, and cash flows for the year then ended. These 2004 financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above, which are before the effects of the adjustments to retrospectively reflect the change in the composition of reportable segments described in Note 17, present fairly, in all material respects, the financial position of W.W. Grainger, Inc., and Subsidiaries as of December 31, 2004, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

 

We were not engaged to audit, review or apply any procedures to the adjustments to retrospectively reflect the change in the composition of reportable segments described in Note 17 and, accordingly, we do not express an opinion or any other form of assurance about whether such adjustments are appropriate and have been properly applied. Those adjustments were audited by other auditors.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of W.W. Grainger, Inc. and Subsidiaries’ internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO") and our report dated February 11, 2005 (not presented herein) expressed an unqualified opinion on the effectiveness of W.W. Grainger, Inc. and Subsidiaries’ internal control over financial reporting.

 

/s/GRANT THORNTON LLP

 

Chicago, Illinois

February 11, 2005

 

 

29

W.W. Grainger, Inc. and Subsidiaries

 

CONSOLIDATED STATEMENTS OF EARNINGS

(In thousands of dollars, except for per share amounts)

 

 

 

For the Years Ended December 31,

 

 

2006

 

2005

 

2004

 

 

 

 

 

 

 

Net sales

 

$       5,883,654 

 

$     5,526,636 

 

$      5,049,785 

Cost of merchandise sold

 

3,529,504 

 

3,365,095 

 

3,143,133 

Gross profit

 

2,354,150 

 

2,161,541 

 

1,906,652 

Warehousing, marketing and administrative expenses

 

1,776,079 

 

1,642,552 

 

1,465,624 

Restructuring charge

 

– 

 

– 

 

(226)

Total operating expenses

 

1,776,079 

 

1,642,552 

 

1,465,398 

Operating earnings

 

578,071 

 

518,989 

 

441,254 

Other income and (expense):

 

 

 

 

 

 

Interest income

 

21,496 

 

12,882 

 

6,376 

Interest expense

 

(1,926)

 

(1,863)

 

(4,388)

Equity in income of unconsolidated entities – net

 

2,960 

 

2,809 

 

996 

Gains on sales of unconsolidated entities

 

2,291 

 

– 

 

750 

Unclassified – net

 

131 

 

(143)

 

151 

Total other income and (expense)

 

24,952 

 

13,685 

 

3,885 

Earnings before income taxes

 

603,023 

 

532,674 

 

445,139 

Income taxes

 

219,624 

 

186,350 

 

158,216 

Net earnings

 

$          383,399 

 

$        346,324 

 

$         286,923 

Earnings per share:

 

 

 

 

 

 

Basic

 

$                4.36 

 

$              3.87 

 

$               3.18 

Diluted

 

$                4.24 

 

$              3.78 

 

$               3.13 

Weighted average number of shares outstanding:

 

 

 

 

 

 

Basic

 

87,838,723 

 

89,568,746 

 

90,206,773 

Diluted

 

90,523,774 

 

91,588,295 

 

91,673,375 

 

 

The accompanying notes are an integral part of these financial statements.

 

30

W.W. Grainger, Inc. and Subsidiaries

 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE EARNINGS

(In thousands of dollars)

 

 

 

For the Years Ended December 31,

 

 

2006

 

2005

 

2004

 

 

 

Net earnings

 

$        383,399 

 

$       346,324 

 

$      286,923 

 

 

 

 

 

 

 

Other comprehensive earnings (losses):

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustments,

net of tax benefit (expense) of $147,

$(1,642) and $(8,734), respectively

 

(1,181)

 

9,383 

 

15,458 

 

 

 

 

 

 

 

Unrecognized holding gain (loss) on other

employment-related benefit plans, net of tax

(expense) benefit of $(21) and $226, respectively

 

33 

 

(353)

– 

 

 

(1,148)

 

9,030 

 

15,458 

Comprehensive earnings

 

$        382,251 

 

$       355,354 

 

$      302,381 

 

 

 

 

 

 

 

 

The accompanying notes are an integral part of these financial statements.

 

31

W.W. Grainger, Inc. and Subsidiaries

 

CONSOLIDATED BALANCE SHEETS

(In thousands of dollars, except for per share amounts)

 

 

 

As of December 31,

 

 

2006

 

2005

 

2004

ASSETS

 

 

 

 

 

 

 

 

 

 

 

 

 

CURRENT ASSETS

 

 

 

 

 

 

Cash and cash equivalents

 

$      348,471 

 

$     544,894 

 

$     429,246 

Marketable securities at cost,

which approximates market value

 

12,827 

 

– 

 

– 

Accounts receivable (less allowances for

doubtful accounts of $18,801, $18,401

and $23,375, respectively)

 

566,607 

 

518,625 

 

480,893 

Inventories

 

827,254 

 

791,212 

 

700,559 

Prepaid expenses and other assets

 

58,804 

 

54,334 

 

47,086 

Deferred income taxes

 

48,123 

 

76,474 

 

86,632 

Total current assets

 

1,862,086 

 

1,985,539 

 

1,744,416 

 

 

 

 

 

 

 

PROPERTY, BUILDINGS AND EQUIPMENT

 

 

 

 

 

 

Land

 

167,218 

 

162,123 

 

154,673 

Buildings, structures and improvements

 

890,380 

 

841,031 

 

804,317 

Furniture, fixtures, machinery and equipment

 

769,506 

 

716,497 

 

679,141 

 

 

1,827,104 

 

1,719,651 

 

1,638,131 

Less accumulated depreciation and amortization

 

1,034,169 

 

949,026 

 

876,558 

Property, buildings and equipment – net

 

792,935 

 

770,625 

 

761,573 

 

 

 

 

 

 

 

DEFERRED INCOME TAXES

 

48,793 

 

16,702 

 

29,168 

 

 

 

 

 

 

 

INVESTMENTS IN UNCONSOLIDATED ENTITIES

 

8,492 

 

25,155 

 

26,126 

 

 

 

 

 

 

 

GOODWILL

 

210,671 

 

182,726 

 

165,011 

 

 

 

 

 

 

 

OTHER ASSETS AND INTANGIBLES – NET

 

123,111 

 

127,174 

 

83,279 

 

 

 

 

 

 

 

TOTAL ASSETS

 

$   3,046,088 

 

$  3,107,921 

 

$  2,809,573 

 

 

32

W.W. Grainger, Inc. and Subsidiaries

 

CONSOLIDATED BALANCE SHEETS – CONTINUED

(In thousands of dollars, except for per share amounts)

 

 

 

As of December 31,

 

 

2006

 

2005

 

2004

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

 

 

 

 

CURRENT LIABILITIES

 

 

 

 

 

 

Current maturities of long-term debt

 

$           4,590 

 

$         4,590 

 

$         9,485 

Trade accounts payable

 

334,820 

 

319,254 

 

289,388 

Accrued compensation and benefits

 

140,141 

 

152,543 

 

127,994 

Accrued contributions to employees’ 

profit sharing plans

 

113,014 

 

90,478 

 

76,052 

Accrued expenses

 

106,681 

 

103,932 

 

97,860 

Income taxes

 

7,077 

 

24,554 

 

35,253 

Total current liabilities

 

706,323 

 

695,351 

 

636,032 

 

 

 

 

 

 

 

LONG-TERM DEBT (less current maturities)

 

4,895 

 

4,895 

 

– 

 

 

 

 

 

 

 

DEFERRED INCOME TAXES

 

6,235 

 

7,019 

 

4,482 

 

 

 

 

 

 

 

ACCRUED EMPLOYMENT-RELATED BENEFITS COSTS

 

151,020 

 

111,680 

 

101,089 

 

 

 

 

 

 

 

SHAREHOLDERS’ EQUITY

 

 

 

 

 

 

Cumulative Preferred Stock – 

$5 par value – 12,000,000 shares authorized;

none issued nor outstanding

 

– 

 

– 

 

– 

Common Stock – $0.50 par value – 

300,000,000 shares authorized;

issued, 109,657,938, 109,667,938 and

109,672,938 shares, respectively

 

54,829 

 

54,834 

 

54,836 

Additional contributed capital

 

513,667 

 

451,578 

 

432,171 

Retained earnings

 

3,007,606 

 

2,722,103 

 

2,458,442 

Unearned restricted stock compensation

 

(35,213)

 

(17,280)

 

(14,463)

Accumulated other comprehensive earnings

 

3,431 

 

27,082 

 

18,052 

Treasury stock, at cost – 

25,590,311, 19,952,297 and 

19,075,511 shares, respectively

 

(1,366,705)

 

(949,341)

 

(881,068)

Total shareholders’ equity

 

2,177,615 

 

2,288,976 

 

2,067,970 

TOTAL LIABILITIES AND SHAREHOLDERS’EQUITY

 

$     3,046,088 

 

$  3,107,921 

 

$  2,809,573 

 

The accompanying notes are an integral part of these financial statements.

 

33

W.W. Grainger, Inc. and Subsidiaries

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands of dollars)

 

 

 

For the Years Ended December 31,

 

 

2006

 

2005

 

2004

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

 

Net earnings

 

$          383,399 

 

$         346,324 

 

$      286,923 

Provision for losses on accounts receivable

 

6,057 

 

1,326 

 

5,159 

Deferred income taxes

 

9,858 

 

23,663 

 

(4,450)

Depreciation and amortization:

 

 

 

 

 

 

Property, buildings and equipment

 

100,975 

 

98,087 

 

85,566 

Capitalized software and other intangibles

 

17,593 

 

10,695 

 

12,690 

Stock-based compensation

 

33,754 

 

9,015 

 

8,226 

Tax benefit of stock incentive plans

 

1,563 

 

11,962 

 

12,068 

Net gains on sales of property, 

buildings and equipment

 

(11,035)

 

(7,337)

 

(1,725)

(Income) from unconsolidated entities

 

(2,960)

 

(2,809)

 

(996)

(Gains) on sales of unconsolidated entities

 

(2,291)

 

– 

 

(750)

Change in operating assets and liabilities – 

net of business acquisitions and 

joint venture contributions:

 

 

 

 

 

 

(Increase) decrease in accounts receivable

 

(53,056)

 

(36,378)

 

(49,935)

(Increase) decrease in inventories

 

(33,839)

 

(84,031)

 

(30,728)

(Increase) decrease in prepaid expenses

 

(3,918)

 

(6,251)

 

(9,087)

Increase (decrease) in trade accounts payable

 

10,888 

 

27,121 

 

29,302 

Increase (decrease) in other current liabilities

 

(2,558)

43,056 

 

64,372 

Increase (decrease) in current income 

taxes payable

 

(17,395)

 

(10,632)

 

(4,268)

Increase (decrease) in accrued 

employment-related benefits costs

 

2,634 

 

10,012 

 

8,613 

Other – net

 

(2,916)

 

(1,280)

 

(4,493)

Net cash provided by operating activities

 

436,753 

 

432,543 

 

406,487 

 

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

 

Additions to property, buildings and equipment

 

(127,814)

 

(112,297)

 

(128,276)

Proceeds from sales of property, 

buildings and equipment – net

 

17,314 

 

15,037 

 

17,616 

Additions to capitalized software

 

(8,950)

 

(44,950)

 

(32,482)

Purchase of marketable securities

 

(13,187)

 

– 

 

– 

Proceeds from sale of unconsolidated entity 

 

27,843 

 

– 

 

– 

Net cash paid for business acquisitions

 

(34,390)

 

(24,817)

 

– 

(Investments in) and loan repayment 

from unconsolidated entities 

 

(3,988)

 

4,088 

 

– 

Other – net

 

3,426 

 

(46)

 

750 

Net cash used in investing activities

 

(139,746)

 

(162,985)

 

(142,392)

 

 

34

W.W. Grainger, Inc. and Subsidiaries

 

CONSOLIDATED STATEMENTS OF CASH FLOWS – CONTINUED

(In thousands of dollars)

 

 

 

For the Years Ended December 31,

 

 

2006

 

2005

 

2004

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

 

Long-term debt payments

 

$                     – 

 

$                    – 

 

$      (140,800)

Stock options exercised

 

64,437 

 

65,997 

 

72,275 

Excess tax benefits from stock-based compensation

 

13,373 

 

– 

 

– 

Purchase of treasury stock

 

(472,787)

 

(137,473)

 

(100,872)

Cash dividends paid

 

(97,896)

 

(82,663)

 

(71,243)

Net cash used in financing activities

 

(492,873)

 

(154,139)

 

(240,640)

 

 

 

 

 

 

 

Exchange rate effect on cash and cash equivalents

 

(557)

 

229 

 

2,967 

 

 

 

 

 

 

 

NET (DECREASE) INCREASE 

IN CASH AND CASH EQUIVALENTS

 

(196,423)

 

115,648 

 

26,422 

 

 

 

 

 

 

 

Cash and cash equivalents at beginning of year

 

544,894 

 

429,246 

 

402,824 

 

 

 

 

 

 

 

Cash and cash equivalents at end of year

 

$          348,471 

 

$         544,894 

 

$       429,246 

 

 

 

 

 

 

 

Supplemental cash flow information:

 

 

 

 

 

 

Cash payments for interest 

(net of amounts capitalized)

 

$              1,413 

 

$             1,791 

 

$           3,408 

Cash payments for income taxes

 

212,350 

 

162,030 

 

154,589 

 

 

 

 

 

 

 

Noncash investing activities:

 

 

 

 

 

 

Fair value of noncash assets 

acquired in business acquisitions

 

$            38,430 

 

$           26,811 

 

$                  – 

Liabilities assumed in business acquisitions

 

(4,040)

 

(1,994)

 

– 

 

 

 

 

 

 

 

 

The accompanying notes are an integral part of these financial statements.

 

35

W.W. Grainger, Inc. and Subsidiaries

 

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(In thousands of dollars, except for per share amounts)

 

 

Common

Stock

Additional

Contributed

Capital

Retained

Earnings

Unearned

Restricted

Stock

Compensation

Accumulated

Other

Comprehensive

Earnings (Losses)

Treasury

Stock

Balance at January 1, 2004

$          54,689 

$        394,409 

$     2,242,762 

$            (11,471)

$                  2,594 

$       (837,848)

Exercise of stock options

253 

11,910 

– 

– 

– 

60,112 

Tax benefits on stock options

exercised

– 

10,138 

– 

– 

– 

– 

Issuance of other stock-based 

compensation awards

12,647 

– 

(12,652)

– 

– 

Tax benefits on other vested

stock-based compensation 

awards

– 

1,930 

– 

– 

– 

– 

Conversion of restricted stock 

to restricted stock units

(108)

108 

– 

– 

– 

– 

Remeasurement of stock

options and other stock-based

compensation awards

– 

2,620 

– 

(809)

– 

– 

Cancellation of other stock-

based compensation awards

(3)

(1,479)

– 

1,482 

– 

– 

Amortization of unearned

compensation on other stock-

based compensation awards

– 

– 

– 

8,987 

– 

– 

Settlement of other stock-based 

compensation awards

– 

(161)

– 

– 

– 

(2,411)

Purchase of 2,001,000 shares of

treasury stock; 5,510

shares issued

– 

49 

– 

– 

– 

(100,921)

Other comprehensive earnings 

– 

– 

– 

– 

15,458 

– 

Net earnings

– 

– 

286,923 

– 

– 

– 

Cash dividends paid 

($0.785 per share)

– 

– 

(71,243)

– 

– 

– 

Balance at December 31, 2004

$          54,836 

$        432,171 

$     2,458,442 

$            (14,463)

$                 18,052 

$       (881,068)

Exercise of stock options 

– 

(3,882)

– 

– 

– 

69,879 

Tax benefits on stock options

exercised

– 

11,546 

– 

– 

– 

– 

Issuance of other stock-based

compensation awards

– 

12,932 

– 

(12,932)

– 

– 

Tax benefits on other vested

stock-based compensation

awards

– 

416 

– 

– 

– 

– 

Remeasurement of stock options

and other stock-based

compensation awards

– 

303 

– 

(208)

– 

– 

Cancellation of other stock-

based compensation awards

(2)

(1,401)

– 

1,403 

– 

– 

Amortization of unearned 

compensation on other stock-

based compensation awards

– 

– 

– 

8,920 

– 

– 

Vesting of restricted stock 

– 

– 

– 

– 

– 

(994)

Settlement of other stock-based

compensation awards

– 

(507)

– 

– 

– 

315 

Purchase of 2,372,300 shares

of treasury stock 

– 

– 

– 

– 

– 

(137,473)

Other comprehensive earnings

– 

– 

– 

– 

9,030 

– 

Net earnings

– 

– 

346,324 

– 

– 

– 

Cash dividends paid 

($0.920 per share)

– 

– 

(82,663)

– 

– 

– 

Balance at December 31, 2005

$          54,834 

$        451,578 

$     2,722,103 

$            (17,280)

$                 27,082 

$       (949,341)

 

 

36

W.W. Grainger, Inc. and Subsidiaries

 

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY – CONTINUED

(In thousands of dollars, except for per share amounts)

 

 

Common

Stock

Additional

Contributed

Capital

Retained

Earnings

Unearned

Restricted

Stock

Compensation

Accumulated

Other

Comprehensive

Earnings (Losses)

Treasury

Stock

Balance at December 31, 2005

$          54,834 

$        451,578 

$     2,722,103 

$            (17,280)

$                 27,082 

$       (949,341)

Exercise of stock options 

– 

(3,984)

– 

– 

– 

68,421 

Tax benefits on stock options

exercised

– 

13,989 

– 

– 

– 

– 

Stock option expense

– 

19,904 

– 

– 

– 

– 

Issuance of other stock-based

compensation awards

– 

33,726 

– 

(33,726)

– 

– 

Tax benefits on other vested

stock-based compensation 

awards

– 

947 

– 

– 

– 

– 

Remeasurement of stock options 

and other stock-based

compensation awards

– 

488 

– 

(488)

– 

– 

Cancellation of other stock-

based compensation awards

(5)

(2,431)

– 

2,436 

– 

– 

Amortization of unearned 

compensation on other stock-

based compensation awards

– 

– 

– 

13,845 

– 

– 

Vesting of restricted stock 

– 

– 

– 

– 

– 

(4,263)

Settlement of other stock-based

compensation awards

– 

(1,003)

– 

– 

– 

592 

Purchase of 6,983,000 shares

of treasury stock

–