Grainger's North American sales pick up. Why did gross margin slip?

Grainger raised its annual sales, earnings and operating-cash forecasts after stronger demand in its North American industrial-supplies business. Customers bought more, and the distributor also passed through higher costs in its prices.

The company now expects annual sales growth of 13% to 14.5% after adjusting for selling days, currency and its exit from the U.K. That compares with 11.5% to 13% in its August outlook. Its adjusted earnings-per-share range rose to $47 to $48 from $45.50 to $47.25.

Research by Ticker Byline shows that the improvement was uneven across the business. North American sales growth strengthened from the previous quarter's pace, while the online assortment business grew more slowly. The comparison uses each quarter's growth from a year earlier.

North American demand strengthens

Sales in High-Touch Solutions North America grew 13.8% on a daily, constant-currency basis, up from 11.7% in the second quarter. Grainger said double-digit volume growth and price increases drove the latest result. Its sales breakdown attributes most of the gain to volume and product mix, with a smaller contribution from pricing and customer mix. The division supplies businesses with products needed to maintain facilities and equipment.

Endless Assortment, which includes MonotaRO and Zoro, grew 19.3% after adjusting for selling days, currency and the U.K. exit. That remained faster than the North American division, but eased from 20.6% in the second quarter.

Group revenue reached $5.18 billion, up 11.3%. Adjusted operating profit rose to $836 million from $707 million. The adjusted operating-profit figures exclude acquisition expenses this year and the much larger U.K. exit loss a year earlier. That prior loss magnified the increase in reported earnings.

Stronger demand did not remove every cost pressure. The North American division's gross margin fell by 0.3 percentage points to 40.8%, reflecting freight expense and product mix. Yet its adjusted operating margin edged up to 17.3% from 17.2%, as sales grew faster than overhead costs.

For the U.S. business, management expects a larger-than-usual increase in gross margin from the third to the fourth quarter. It expects favorable supplier rebates to more than offset continued freight pressure. That is one reason a weaker third-quarter gross margin can coexist with higher annual earnings forecasts.

The cash improvement has two parts

Grainger raised its annual operating-cash forecast to $2.35 billion to $2.45 billion from $2.25 billion to $2.40 billion. That is a forecast for cash from operations, before capital spending and acquisitions.

Quarterly free cash flow, which subtracts capital spending from operating cash flow, rose to $546 million from $339 million. Operating cash flow improved by $64 million, while capital spending fell by $143 million. By our calculation, lower capital spending supplied about 69% of the increase in that quarter's free cash flow.

The annual capital-spending range changed much less, to $575 million to $625 million from $575 million to $650 million.

Grainger separately spent $215 million acquiring technology assets during the quarter. That acquisition sits outside free cash flow. The Grainger profile tracks the completed deal, debt and forecasts alongside the operating results.