Irene Holman - Vice President of Investor Relations D. G. Macpherson - Chairman and Chief Executive Officer Tom Okray - Senior Vice President and Chief Financial Officer.

Ryan Merkel - William Blair Christopher Glynn - Oppenheimer Adam Uhlman - Cleveland Research Steven Winoker - UBS Luke Junk - Baird Nigel Coe - Wolfe Research Deane Dray - RBC Capital Markets Evelyn Chow - Goldman Sachs Ryan Cieslak - Northcoast Research Justin Bergner - Gabelli and Company Scott Graham - BMO Capital Markets Patrick Baumann - JPMorgan Hamzah Mazari - Macquarie Capital Steve Barger - KeyBanc Capital Markets John Inch - Gordon Haskett.

Greetings, and welcome to the W.W. Grainger Third Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions]. As a reminder, this conference is being recorded.

I’d now like to turn the conference over to your host, Irene Holman, VP, Investor Relations..

Good morning. Welcome to Grainger’s Q3 earnings call. With me are D. G. Macpherson, Chairman and CEO; and Tom Okray, Senior Vice President and CFO. As a reminder, some of our comments today may be forward-looking statements based on our current view of future events.

Actual results may differ materially as a result of various risks and uncertainties, including those detailed in our SEC filings. Reconciliations of non-GAAP financial measures with their corresponding GAAP measures are at the end of the slide presentation and in our Q3 press release. Both are available on our IR website. D.G.

will cover performance for the quarter, and Tom will go deeper into our financials including segment results. After that, we will open the call for questions. D. G., to you..

Thank you, Irene. Good morning, and thanks to all of you for joining us this morning. So we had another solid quarter. Demand remained very strong in the third quarter and we are continuing to gain share. In the US, as we lapped our August 2017 pricing changes, we are encouraged with our volume growth of 8%, which significantly outpaced the market.

We are continuing to see that our value proposition resonates with both large and midsize customers now that we have removed pricing as a barrier. We continue to grow faster in more profitable parts of the business, notably with our midsize customers.

In addition, gross margin when normalized for the revenue recognition accounting change, and operating margin, were both favorable to prior year. In Canada, the execution of our turnaround continues to make progress and is on schedule. We still expect to exit the year at a profitable run rate.

Our single channel online businesses, namely, MonotaRO and Zoro, had strong growth and profitability. We recorded a non-cash impairment for Cromwell in the UK, reflecting slower growth than planned at acquisition. The overall international businesses are profitable with the exception of the impairment.

We believe that our current exposure to tariffs is well understood and effectively managed. Tom will address tariffs later in the presentation. I would also mention two other things. One, we had a very strong customer satisfaction rating in the US this quarter, actually the strongest we’ve seen under the current methodology.

And also with Hurricane Michael making landfall last week, I want to note that all of our people are safe and our team members are doing a great job responding to the event as they always do. With that, let’s take a look at our results. Third quarter 2018 reported results contained restructuring charges of $142 million and a $2.37 impact to EPS.

In the quarter, we took a non-cash impairment of $139 million related to our Cromwell business. In 2015, we described to you the expected benefits of the acquisition, based on the strength of the core Cromwell business, the ability to build the online model off of that core and the potential in the UK market. Many of these benefits still exist.

However, a few things have changed since the decision. First, Brexit occurred within a year of acquisition and the market slumped. And the uncertainty surrounding Brexit as it gets closer to being executed forces us to take our growth projections lower. Second, the cost of capital is higher now.

These two structural issues explain the majority of reduction in valuation. In addition, our strategy included building an online model with the Cromwell name. In reality, this approach created customer conflict with the core business. We adjusted our approach and re-launched the online model under the Zoro name about a year ago.

The opportunity with Zoro is large and compelling with very strong early signals in the market. But the late start of Zoro and the lower growth rate given market conditions impacted current valuation. While it’s still early days, we do believe the UK is an attractive place for Grainger to play.

This morning's call will focus on adjusted results which exclude the items outlined in our press release. Total company sales in the quarter were up 7%, that included 7% in volume, 1% in price and a headwind due to foreign exchange and hurricane comparisons of 1%. This is the first quarter in 2018 with a foreign exchange headwind.

Normalizing for foreign exchange and hurricanes, our sales increased over 8%. Our normalized GP rate was flat to the prior year after adjusting for the revenue recognition accounting change which we discussed earlier. We continue to realize operating expense leverage on higher volume.

This all lead to operating earnings growth of 15% in the quarter and an operating margin that was 80 basis points higher than the prior year. Now, I’ll turn it over to Tom for additional detail, including our segment results..

Thanks, D. G. I’ll cover our other business results first. As a reminder, other businesses include our single channel online model and our international businesses. Sales for these businesses were strong, up 13% in the quarter; 14% driven by price and volume, partially offset by a 1% reduction related to foreign exchange.

Our online businesses grew 23%, continuing to be a profitable growth driver. The international businesses were profitable led by our Mexican operations. In Canada, the AGI turnaround is making progress. With many of our cost reduction initiatives behind us, we will now focus on growing profitably. Sales were down 20% or 17% in local currency.

Price increases, branch closures and sales coverage optimization activities contributed to volume being down 27%. This was partially offset by a 10% increase in price as we continue to renegotiate pricing on our large customer contracts. Moving to profit.

In our comparison to the prior year, there were non-recurring adjustments related to excessive and obsolete inventory and vendor rebates that impacted gross margin. After adjusting for these items and normalizing for revenue recognition, our gross margin was 430 basis points favorable to the prior year.

Operating margin improved 200 basis points, driven by favorable pricing and cost reduction. Adjusting for the non-recurring items, operating margin improved 570 basis points. Looking forward, we expect to exit the year with a positive operating margin run rate. In the United States, the demand environment was strong and we were able to grow profitably.

Our value proposition combined with a continued favorable response to our pricing actions resulted in increased share. Sales were up 9% in the quarter. Volume was up 8% and price was up 1% due to general inflation as well as lapping the price reset. In the month of September, hurricanes negatively impacted sales growth by a 160 basis point.

In 2017, Harvey and Irma had a larger benefit than Florence contributed in 2018. Normalizing for this impact, sales in September grew at 8%, consistent with August growth for large and medium customers. After adjusting for the revenue recognition accounting change, our normalized gross profit rate increased 20 basis points.

The increase was driven by customer mix and favorable price cost spread. Operating leverage continued to be strong in the US. Having said that, you will notice some lumpiness in the quarter related to two factors; increased variable compensation versus the prior year; and the quarterly variable compensation true-up methodology.

On a calendar year basis, these factors will wash out with sales growing significantly faster than operating expense. All-in, operating margin at 15.1% improved 20 basis points versus prior year. Let's take a look at our large and medium customers.

Despite lapping our pricing actions in mid-August, we continued to see strong volume growth from both large and midsize customers. Our value proposition continues to resonate and we are seeing the results. Our US large customer business is performing consistently.

We're seeing strong performance with our non-contract customer and spot buy purchases are increasing with contract customers. US medium volume growth of 22% is strong, especially considering a tough comp. New customers continue to be a meaningful contributor to volume growth. We are excited by what we are seeing.

While we expect continued double-digit growth with medium customers, the rate of growth in Q4 will moderate. I want to take a few minutes to go in some more detail on tariffs and other issues.

With respect to tariffs, we have deployed a cross-functional taskforce to gain a clearer understanding of the tariff impact as well as to execute mitigating actions. The team meets daily, reporting to senior leadership at least weekly.

Some other actions include validating tariff increases, working with suppliers to minimize the cost impact, including identifying alternative supply and evaluating pricing actions while ensuring that our pricing stays market-based.

With respect to quantifying the impact, product directly sourced from China represents about 20% of the US segment’s cost of goods sold. This product is split between our national brands and our private label.

National brands, which comprise the majority, are sourced from suppliers with manufacturing in multiple locations, providing flexibility in addressing the tariffs. Approximately half of this product sourced from China is impacted by 301 tariffs. Applying tariff rates of 25%, we estimate our costs would increase by about 2% for the US segment.

Based on the taskforce work combined with our experience to-date, we are confident that we can find alternative supply and/or price to cover the expected tariff cost increases. Moving to taxes, we want to ensure that the main drivers between reported and adjusted tax rate versus the prior year is understood.

The Q3 reported rate of 32.7% is up 1 percentage point versus prior year. We had tax benefits from US tax reform and stock-based compensation. This was more than offset by the impact of the Cromwell impairment, which is non-deductible and increased the rate by 16.3 percentage points.

With respect to the adjusted rates, the Q3 rate of 20.0% is down 11.7 percentage points versus prior year. As with the reported rate, the adjusted rate reflects benefits from US tax reform and stock-based compensation. However, the Cromwell impairment is removed from our adjusted results and does not impact the adjusted tax rate.

Finally, in July, we gave EPS guidance of $15.05 to $16.05. Further, we mentioned that it did not include the tax benefit from stock-based compensation for the second half. We’ve stayed away from predicting the exercise of stock-based awards, which is inherently difficult.

Excluding that benefit, which was $0.14 in Q3, we are trending to the high-end of our guidance. As a reminder, we will provide 2019 guidance on our Q4 earnings call in January. I'll now turn it back to D. G. for closing remarks..

Thanks, Tom. So, overall, we’re very pleased with our continued strong momentum. We know that we’ve a compelling value proposition, and the team members are energized and focused on creating value for our customers. After lapping the price increases, the US continued to gain share at attractive margins. The turnaround in Canada is on track.

We’re now focused on profitable growth off of the business model reset. Our online model continues to show very strong profitable growth and our narrowed international portfolio continues to improve profitability. With that, I will open it up for any questions..

[Operator Instructions]. Our first question comes from the line of Ryan Merkel from William Blair. Please proceed with your question..

A couple of questions from me. So first, based on some of my inbound emails, people are picking on the lack of operating leverage in the US for this quarter.

Can you just discuss what exactly drove the variable comp throughout this quarter? And then can you confirm that this is a one-time event and that the US operating leverage will be strong in 2019?.

Yes, I mean as we said in our prepared remarks, the big impact that we had in terms of operating leverage was the true-up. We do this on a quarterly basis. And as our results for the year are very strong, we had to put a disproportionate amount in Q3 and Q4.

Obviously throughout the year, point to wash out, if you normalized for that, we're going to see tremendous operating leverage with sales growing approximately twice the rate of operating expenses..

And then secondly, I know you are not talking about 2019 but on the last call you stated you thought gross margin in 2019 could be stable with 2018.

And I guess now that we have more information on the contract price reset and I guess an educated guess on tariffs, do you still think that you could have stable gross margins in the next year?.

So, Ryan, we are working through all that. We will provide details in January as we announce earnings. Obviously there’s a couple of things that are pretty exciting. One is customer mix is a positive right now, so midsize customer -- non-contract customer is growing faster than large contract that will be a benefit.

We have to work through the specifics of the tariffs, but we feel like we're on top of that. Our goal is to be as close to flat as we can be and we think we have got the right process in place to get the best outcome..

And then maybe just lastly on tariffs before I turn it over. I know this is a tricky question as you are starting to have conversations with customers about pricing.

But is your goal to protect gross profit dollars and maybe protect gross margin rate, is that something you can comment on today?.

Our goal is always the same. We want to be competitively priced and we want to get the best cost we can. Our expectation is that we will be able to pass through the price or find alternative sources to mitigate the impact of the tariff. And again in January we will talk about where we think we land on that, we’ll look then..

Our next question comes from the line of Christopher Glynn from Oppenheimer. Please proceed with your question..

So SG&A -- SG&A at the company level -- I guess SG&A was down a little sequentially despite the spike in the US comp catch up.

I’m just wondering what was kind of the offset there?.

Well, so the offset is, just we continued cost out productivity that we've been doing for the past several quarters..

Yes, I would also point to Canada, as a big offset to that we've taken about $85 million out of the cost structure in Canada. And those two those actions are behind us as we had another benefit in the quarter there..

And then passing the GM, so excluding the revenue wreck, company level gross margin was flat with the US up 20, and Canada up more than that, so it’s -- wondering whether it’s some pressures in the other businesses’ gross margin?.

The other businesses’ gross margin is down slightly. You also have just the algebraic dynamic of their lower margin -- gross margin overall, and they’re growing at a faster rate..

I mean that -- the online model continues to grow very quickly and it starts with a lower GP, and that has a big impact..

Our next question comes from the line of Adam Uhlman from Cleveland Research. Please proceed with your question..

I was wondering if we can start with the US segment gross margin this quarter. Congrats on expanding it, positive price costs and mix.

I guess I am wondering why the gross margin -- would it have been a little bit better with that mix impact in the point of price, were there any other items within that? And then I’ll just loop my second question on and that's related to the tariffs.

Is there any potential for inventory reevaluation associated with that, because that’s something we have to think about for fourth quarter gross margin?.

Let me take the first part of the question first. What I pointed to is taking a look at the sequential. Throughout the year, our gross margin typically declined. And if you look at how we’re performing this year, it’s a much less of a decline than we have had in previous years. So we’re very happy with what’s happening with gross margin.

One other thing that I would point out is FX was a headwind this quarter. It’s been a tailwind the previous two quarters. The dollar is getting stronger versus the Canadian dollar and the Mexican peso..

And then the second part of your question was around inventory revaluation, we do not believe we’ll have any concerns there. And as a reminder we’re on LIFO, I think we shouldn’t really -- we shouldn’t have a problem in any case..

Our next question comes from the line of Steven Winoker from UBS. Please proceed with your question..

Just to drill down maybe a little bit on the tariff points that you’ve raised on Page 11. The first question is, just the simple math on that 25, on 50, on 20 I think is maybe closer to 2% and 2.5%. I do know there’s just rounding point, then all of it.

Have you gone line-by-line there, math there on 2% it looks like it’s under a $1 impact if you didn’t have alternate sourcing or pricing action.

Am I thinking about that the right way?.

Yes, I mean we’re -- well first of all we’re certainly going line-by-line. We just simplified it for presentation sake. And as we noted in our prepared remarks, we think it’s well understood and very manageable..

And that math though makes sense as well?.

Correct..

And then just on the alternate sourcing point just where you may have challenges on pricing or taking actions or concerned about volume impact of those pricing actions.

How are you thinking about your options there in terms of substituting supply?.

So we -- our team is looking very closely at pretty much SKU-by-SKU level and like all sourcing decisions we look at the quality of the product, we look at the cost of the product depending on how the tariff plays out. We have alternative sources already in many places, and we may have to find some additional ones.

But we just look at the total economics, total landing cost and pick the one that’s got the best cost for the business. Much of our ships could -- if it’s China, if it’s shifted it could go either to India, to Mexico or the US depending on the nature of the product.

The other thing I would say is, as we're going through this, we have a fairly refined should cost approach looking at what the product cost should be.

We understand what portion of the cost should be related to tariff and so we are able to work with suppliers to make sure that we are actually taking the right cost increase and that’s a big focus for us..

And how long you think it will take you to migrate once you make those decisions?.

Well, it depends. If we have an alternative source, it’s actually pretty quickly. We don’t -- at this point we don't feel like we're in a position where we are going to have any disruption and we feel like we are on top of this. So, we don’t -- are not concerned about being able to make any changes we need to make..

Our next question comes from the line of Luke Junk from Baird. Please proceed with your question..

First question, D. G., Canada revenues slipped down again this quarter, by design, of course. Can you help us understand when run rate revenues should start to normalize? I think Tom mentioned in the prepared remarks that many of the cost reduction initiatives are now behind you.

Basically, what kind of volume assumption is built into your operating margin guidance including this year heading into '19, broadly?.

And we'll talk in January about the specifics for what our volume expectations are for next year. We do expect volume to stabilize over the next several quarters into next year. And we expect next year to be more of a stabilization period. I would note a couple of things.

One is that the branch closures, which are mostly behind us, there's still some to come, have an impact on revenue. It also has a positive impact on profitability. We have reorganized our sales team and coverage is now stable. And we're now talking to customers and trying to drive growth. And I think that will help us stabilize over the next year.

So we feel -- I would say in general, it's hard to look at numbers that are down that much. And it's hard for the team. But this is what we expected. And I think the team has doing a great job of managing through that. And we're in a good position now to really create value for customers, improve service, and improve the conversations we're having.

So, we're optimistic about stabilizing and being able to grow..

And then second question on tariffs. What I'm wondering is do you approach recovering the tariffs differently by line of business, whether it's a different customer value proposition.

Obviously, either they’re impacted by your recent price actions or something like in Canada where some of the product is being imported from the US? Any thoughts you can share in respect to that?.

So, what I would say is that the cross-functional team we have has people from our sourcing, from our product management teams, people from our pricing teams and including our commercial teams, all working together to make sure that we make the right decisions. I won't go into specifics about that.

But in general, like I said before, we're really focused on making sure we get the right cost from our suppliers and have a competitive price. And so, that's really our fundamental principle in driving the results here..

Our next question comes from the line of Nigel Coe from Wolfe Research. Please proceed with your question..

Going back to the tariffs, best price, half of the -- you mentioned half -- included half activity. Can you give any color in terms of what's currently not covered in terms of product categories? Any color there would be helpful..

I don't know that we want to go through the details of which ones aren't covered and are covered. But what we've seen is that the way 301 is written, there are a number of product categories that aren’t exactly -- that aren't included in this. And so, roughly half of what we have coming from China is really in that bucket today..

Okay.

And then on the impact you’ve laid out, the 2% or whatever it is on the US cost, does that include any benefit from the weaker RMB or was that on an episodic basis? So, are you including the depreciation of the Chinese currency in those calculations?.

No. The calculation was done on a constant currency basis..

Okay. And then just quickly on the hurricanes, the 160 basis points impact and you mentioned that there was some offset last year with the two hurricanes that weren't there this year.

I just want to understand how that’s -- what the difference is between last year and this year in terms of the benefits versus the impact?.

Yes. So, what we do when we look at hurricane impact is we look at two things. We look at run rate business in the market that the hurricane hits and we look at hurricane product sales in the markets that it hits. Last year, Harvey obviously had a huge impact on the Houston market which lasted for a long time. And then Irma hit Florida.

Those two combined had a lot more hurricane sales offsetting the business slowdown. In fact, the Florida business slowdown was very fast. There wasn't' much of it. And this year, Florence did not have as much impact. It still had a significant impact on that market.

But given it didn't hit in as highly populated area as Houston, the impact was a little bit less this year..

Our next question comes from the line of Deane Dray from RBC Capital Markets. Please proceed with your question..

Could we talk through the restructuring actions in the quarter, so that was $142 million? Where do you stand in terms of the actions, how much are headcount, how much is footprint, anything structural? And then expectations for the balance of the year..

I'll turn it over to Tom in a minute. Most of that $142 million was the Cromwell impairment. And that was $139 million of it. The rest were small in general. And most of the big changes in both Canada and the US are mostly behind us. So, maybe Tom can talk about..

Yes, exactly. Taking out the Cromwell, there's some small severance items in our integration favoring North America wind down in the US. And then there's some residual branch closure costs and severance costs in Canada which is quite small and coming to an end..

Got it. And then just want to get -- I might have missed this I apologize. But last quarter, you talked about some pricing delays in large US customers because of contract negotiations.

But where did that stand and how much of that has been run through the P&L?.

So, the vast majority of what we've done by the end of the year, we'll get 95% done by the end of the year. The contracts that aren't done are customer choices and/or implementation slowdowns depending on what we're talking about, and particularly, some government customers. But in general, we'll be mostly done.

And we'll be talking about very small impacts going forward..

Our next question comes from the line of Evelyn Chow from Goldman Sachs. Please proceed with your question..

Maybe just starting on a comment you made on the medium customer, I think you noted that you expect 4Q to grow double-digits but for the rate to moderate.

Just curious if that's just a function of harder comps, especially noting that I guess your 3Q comps are probably even harder than your 4Q ones?.

Well, so I would talk about a couple things, Evelyn. Thanks for the question. So, one is remember, the third quarter, we made the change last year, August 1st. So, part of the quarter was actually not under the new pricing.

I would say we continue to be very encouraged and surprised by what we're seeing post-lapping the price changes in terms of midsize customer growth. Our models do not have us growing 30% forever, as you might guess. So we’ve talked about moderating, we think it's going to be moderating to a very strong growth rate.

And we only had 10 weeks after lapping the prices to really understand it. But I would say we are encouraged by what we're seeing. And we'll be more definitive at the end of the year, as we talk through it. But I'd say all signs are very, very positive on midsize customers right now..

That's helpful, D. G. And then apologies for an unoriginal question on tariffs but just curious, I mean I think what you laid out in Slide 11 is very helpful. I know the President has intimated that he is contemplating additional tariffs.

In that event, have you thought about how to re-sense the math you laid out already? I mean is that going to be something closer to hitting the 30% of total company COGS that you've discussed in other forums?.

Yes. So, first of all, we don't know how that will be implemented or if it will be implemented. So, like all these things, we are watching it very closely. But we don't have an opinion yet as to how that will play through. I would say, in general, obviously the tariffs are simply inflationary.

And I think you see what the inflation is roughly based on the math we've seen so far. We think in the short-term, we would be able to navigate this no matter what happens. We think relative to competitors, we might be in a better position. The long-term impacts, we could all sort of argue about over time.

But certainly, in the short-term, we feel like we're on it and we know what we need to do depending on what happens..

Understood. And then I guess last question from me. I think you noted that your spot buy has been increasing with some of your contract customers.

So, just curious to know what is the mix of your planned versus unplanned purchase now versus normal or maybe versus target?.

We don't typically talk about that specifically. And we'll take the question and think about whether at the end of the year we talk about it or not. But thanks. It's a great question, but we haven't typically laid that out..

Our next question comes from the line of Ryan Cieslak from Northcoast Research. Please proceed with your question..

Just first, I wanted to go back to the guidance and just make sure we're clear on what you guys are saying. So, if I heard you right, you said that when excluding the $0.14 benefit from stock comp and the tax rate, you're running at the high end of your EPS guidance range.

One, is that correct? And then two, does that assume then the other inputs to your guidance as it relates to both sales growth and gross margins are also running at the high end of your prior guidance?.

Yes. It's a good question. I just want to make it clear that we've raised guidance twice this year. And we're tracking toward the high end of that range. We're very encouraged by our performance. And I'd be disappointed if we don't beat guidance this year. With respect to your question on the other elements other than EPS, the same holds true.

We're tracking toward the high end of the range..

And Tom, would you say you also would be surprised if you didn't beat the high end of both sales and gross margin guidance or is that more of an EPS comment you made there?.

I would say it's more EPS, but we're always slugging it out with the other parameters as well..

And I would say we're tracking toward the high end of all the dimensions that we laid out. So, obviously, we hope to beat them. But we're really tracking to the high end..

Okay. Just quickly to close that question, I'd just be curious.

Is there any reason why you're not giving more specific formal guidance on the full year? Is this a change in practice or just based on where we are in the year and some variability in the fourth quarter?.

It's really a transition in practice. We want to get out of the business of giving quarterly guidance and giving a range and working toward a midpoint. Going forward, for next year, we'd like to give guidance once a year and then quite frankly not talk about it the rest of the year, talk more about the results we're putting on the board..

Okay. And then for my other question, looking at the US volume growth, it continues to be strong.

But when you look at it on a two-year stack trend which we all do to try to get a sense of adjusting for prior year comps, it looks like it flatlined a little bit and implies maybe into the fourth quarter, you're starting to run more in the mid single-digits versus the high single-digits for US volume all-in.

Is there something going into the fourth quarter as it relates to some of the marketing initiatives that maybe would re-inflect that higher where you can maybe achieve something in the high single-digits or is mid single-digit volume growth sort of the right way to think about at least near-term where the volumes might be growing?.

Yes. So, we haven't really seen anything that suggests that we cannot continue to gain share and continue to grow. And like I said before, we're really encouraged by post-pricing changes, what we see in our large customer volume grew consistent with what had been growing before post-price change, and our midsize customer continues to grow.

So, we would expect to be north of -- certainly north of 5, if that's your question. And we expect to have strong revenue results going forward in the US..

Okay. And then my last question, and I'll hop back into queue. When you look at the tariff related commentary that you guys gave in your exposure there, 20% of your COGS, I think the prior guidance or color that you gave was specific to private label.

And I think what it was, was something in that two-thirds of your private label, it was directly sourced from China. Is that still the case or is that now maybe a little bit lower? Just when you do the math, it suggests maybe that's a little bit lower than what you guys were previously talking about. Thanks..

Yes. I think the confusion there would be two-thirds would be on a revenue basis. And given the GP on a COGS basis, it's roughly the math as you see it. So, that's the difference there..

Our next question comes from the line of Justin Bergner from Gabelli and Company. Please proceed with your question..

First question just on the incentive comp and how it affected the OpEx growth. If I take that 400 basis point differential on 5% growth versus 9%, I'm in the $20 million range.

Should I think of then effect on the third quarter -- the usual effect on the third quarter being sort of three quarters of that $20 million being compressed in one quarter versus four quarters?.

Yes. We're not going to get into the specific math, but you're thinking about it the right way..

Secondly, on the tariffs, I'm not sure I understood correctly on the private label, the merchandise.

Is that private label merchandise stuff that you can redirect to other countries as it relates to where you supply from? And how much of that 20% is related to private label versus branded?.

So, private brands, we have a whole bunch of products that we buy in China that are private branded. In many cases, we already have alternative sources that are identified. And so, what we're referring to is if we have an alternative source, depending on how the math works with the tariffs, we may be looking to switch that.

We may not be if the cost is still better in China post the increase. And so, the way we think about this -- some of it's risk mitigation. If we are buying something uniquely in China, we have to have an alternative source and we will have it.

If we're buying something that's only produced in China, and there are some products like that, then obviously we don't have alternative source. We can go find them and that's going to be more work..

And then the 25% tariff assumption, I assume that a good chunk of the imports from China are being tariffed at 10% today. So, how much of that impact today is at the 10% versus at the 25% rate? I guess, I'm assuming that you expect it to step up to 25% at year-end..

Yes. We assumed worst case for the calculation. So, we didn't take any credit for staying at 10%..

And some of the 10%, it actually already started to flow as you correctly state..

Okay.

Do you want to break out how much of the 10% versus the 25% or would you rather not?.

We'd rather not right now..

And then lastly, on the sales side, was there anything that was disappointing in terms of US sales, whether it be deceleration in natural resources or government customers, things that you would point to as falling short of your expectations in the quarter?.

I would say that pretty much all things US, revenue margin, all of it was positive in the quarter relative to our expectations. And of course, there was more uncertainty going in because of the price lap. And pretty much at every turn, it would actually be what we expected to happen..

Our next question comes from the line of Scott Graham from BMO Capital Markets. Please proceed with your question..

I just have a question about US price which was a positive to 1 in the quarter. I was just hoping you could give us just a little bit of color on sort of the disaggregation of that because the price actions were still lapping. So, I'm assuming, of course, that the price actions were negative but that you had price increases and mixes in there as well.

Could you give us any color on the buckets?.

Yes. Sure. I mean the way we look at the pricing is how much is commodity, vendor-related, end market levers, and then how much is related to the price reset. I mean what we've seen is the decreases associated with the price reset has slowed considerably, as you would expect, as we work through the contracts.

And we've been very consistent and actually improving in terms of the price we've been able to pass on related to tariffs and other market base..

I would also say that the other element is customer mix was positive in the quarter which helps price. And we talked about spot buys; spot buys increasing helps as well with large contract customers as we're not selling as much deeply discounted items. So, yes..

D.

G., would you say that's the first or the second quarter that spot buy and medium size customer mix has actually begun to read through?.

Boy, I think it's the second quarter that that's started to read through. But I don't -- don’t hold me to that, but I believe that's true..

Okay. And lastly, again on the pricing. So, you have the price actions with the large customers.

When you go back to those customers for price increases, could you kind of walk us through were there sort of upper bands and this kind of thing that slows things down or how do you work through that with those customers?.

Yes. We won't talk about specifics. I would say we have a very tried and true process that we use to work through any changes with customers. And our commercial team does a great job of navigating with our customers to get the best outcome for both of us..

Our next question comes from the line of Patrick Baumann from JPMorgan. Please proceed with your question..

Hey, guys. Thanks for taking my call. Just had a couple clean-ups here, a lot has been covered already. Just on the tariffs, it sounds like you still expect to mitigate through alternate sourcing or pricing.

Do you think you can offset the tariff cost right away or you think there might be some lag?.

So, given what we know now, there would not be a big lag. We think it would be -- given what we expect in terms of the 10 going to 25, we think we'll be roughly coincident, close enough..

Okay. And then just a couple little clean-ups here. Can you tell me anything on branch count? I'm not sure if it was in the release or if it was I missed it. Just wondering what that looks like today versus the second quarter end.

I know you guys are still closing branches in Canada or I think you are?.

Yes. We are. So, we will, by the end of this year, have 30 -- 31 branches -- 35 branches opened in Canada. Most of them have already been closed. We closed seven in the quarter in Canada. And really, the rest is virtually nothing. The branch count is stable pretty much everywhere else..

And as you've been closing these branches in Canada, have there been any gains from them because I haven't seen any of those kind of running -- or I don't think you've called any of those out?.

Could you repeat the question?.

Have there been gains on those branches? I haven't seen them called out..

Yes. Keep in mind, yes, so, typically, they're smaller branches and not necessarily as valuable as the US branches in terms of sales..

Yes. The gains would obviously show up in our restructuring charges. And they're relatively small..

Got it.

So, those restructurings are net of gains?.

Yes. Correct..

Yes..

Got it. I understand.

And then last a couple of, just in terms of the price write down, I'm not sure if you mentioned that, but are you done now with US large customer contracts?.

We talked about that before. By the end of the year, we'll be 95% done, so mostly. The rest will be small. And that's almost all customer choice..

Sorry. Yes, I missed that. And then last one from me.

Just Zoro US, how did that grow in the quarter?.

It continued to grow strong -- strong growth in Zoro US..

Is it up like -- I think you said 23% for total single-channel.

Is it up at that kind of range or is it going …?.

It's not quite that. But it was up ….

It was up 18%..

…18% in the quarter. We're just looking at the number 18..

Okay, great. Thanks a lot, guys..

Our next question comes from the line of Hamzah Mazari from Macquarie Capital. Please proceed with your question..

My first question is just around price/cost. We talked a lot about pricing. But I think a few quarters ago, D. G., you had talked about COGS deflation. And as you know, there's a lot more inflation in the system now, whether you look at labor, freight, other items.

Do you still expect COGS deflation going forward?.

So, no. What we talked about is price cost spread and are we able to get -- are we able to mitigate COGS increases and get the right price for our customers. This year, we had talked about being down half a percent. We still expect to be roughly there.

That's mostly because of the initiatives we've done to manage our costs, to understand supplier cost and improve our cost structure. But otherwise, we would actually be in an inflation mode this year of 1% to 2%, probably..

To be clear though, for the quarter, we did have product cost deflation..

Yes. We did..

Good. Got it. Very helpful. And then last question. I'll turn it over. Just on the Canadian turnaround, D. G., Grainger has tried that for several years, as you know. This time, maybe just frame for us what's different this time in terms of strategy. I know you highlighted operating margin run rate positive Q4.

But just high level, what's different in this turnaround versus past several years?.

Yes. Well, this one is a lot more, I would say, intense in the sense that we've completely reset the business. We've combined the back office with the US and created North American centers of excellence. We've gone from 170 to 35 branches. We've completely restructured the sales organization.

And all of that basically means we've taken about $85 million in cost out of the business. And we're now going to start growing that business. We're adding some of the US assortment to that business, the ability to buy out of the US. We're really focused on expanding -- diversifying the customer base throughout the business.

And all those things I think will mean it feels very, very different and allows us to be much more consistent in the growth we see and the performance we see out of that business going forward..

Our next question comes from the line of Steve Barger from KeyBanc Capital Markets. Please proceed with your question..

Yes. Thank you. So, going back to what you just said about Canada, the 4Q positive operating margin exit is more on price and volume stabilization at this point, less on cost control like the branch closures that you just executed.

And should we expect that you remain positive on a quarterly basis going forward?.

Yes. You should expect that we remain positive going forward. A lot of what you're going to see in the fourth quarter, it will be the first time that you see really clean look at the cost structure as well. So, it's not just price and volume stabilization. It's also the cost structure getting to the new level..

Understood. And incrementals have been solid year-to-date, averaging about 24%. As you think about tougher comps, you think about mix, volume, tariffs.

If we see a mid single-digit growth environment going into '19, do you think you could maintain a 20% incremental or better? Or should we be thinking high-teens given the puts and takes?.

Oh! I think we should be able to maintain a 20% or higher..

Our last question comes from the line of John Inch from Gordon Haskett. Please proceed with your question..

So, if we're going to aspire to a framework of gross margins stable, does that imply a similar boost to mix from growth rates at the medium versus large today, I mean presumably those are going to slow, but do you still expect that ratio to kind of hold at 2 for 1 or whatever?.

Yes. We'll come back and talk to you about that in January, specifically. But our expectation is that midsize customers will be growing faster than the rest of the business. And that will help us. That'll be a positive..

Okay. So, that makes sense. If we back into -- it's a little bit of a follow-up on that variable contribution question. But if we back into kind of the OpEx leverage, if you ex-out restructuring, we're coming up with about 20%. And the genesis of my question is I think, D.

G., earlier in the discussion, you alluded to the fact that -- you or Tom alluded to the fact that perhaps restructuring was maybe sort of tapering off. I'm curious because it seems like a lot of the OpEx benefit has come from restructure in Canada and so forth.

What's your trajectory for restructuring? I mean do you see as much opportunity to go after various projects in Canada or the United States or how should we think about that?.

Yes. So, we've been running to a cost program that we talked about last year. We had been meeting or exceeding those expectations. We are in a good position now to make sure we improve our cost structure in 2019. And it comes across the entirety of the business.

A lot of it actually comes from changes we have made recently, whether it's centralizing contact centers or going to the centers of excellence at AGI. All that flows through the P&L next year.

I would also say that there's still great opportunity to improve the core big cost buckets in the US, whether that's getting more revenue per seller in the US, whether that's getting more lines per hour in the distribution centers. We're going to have the Louisville distribution center up and running next year.

More of our volume will then be going through automation which will help the cost structure. And we continue to get comfortable with the contact center footprint we have and getting more effective, more efficient there. So, the big cost buckets, we see a path to continue to improve the cost structure. We think that's going to continue in the future..

Makes sense. Just last one from me. Canada, I guess we had talked about a 4% to 8% margin rate in '19.

What's changed in 2018 that prospectively makes that not a viable target or the low end or something like that? What ultimately changed in Canada this year? And maybe the 4% to 8% is still an aspirational target if we're going positive at the end of the quarter.

I mean how do you sort of translate?.

We actually don't think anything has changed. So that's still the range we're talking about so..

Okay.

So, 4% to 8% is still on the table then?.

Yes. And we'll talk specifics -- on about what we think specifically in January..

Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would like to turn the call back to D. G. Macpherson for closing remarks..

So, thanks for joining us today. I would just make a few points coming out of the call. Thanks for your questions. The first one is in the US, there was a lot of uncertainty going into the quarter about what happened when we lapped the prices. That actually has been very positive.

Almost every metric we have in the US is looking positive in terms of our growth, our GP, our expenses, our customer acquisition. So, we're really excited about what we saw in the quarter from the United States. Canada turnaround continues to go well.

It's very challenging, but we are in a good position now based on the new cost structure to drive growth and to be profitable going forward in Canada. The online model continues to grow and to grow at attractive rates. So, we're very positive there.

And then the international business which is much narrowed is in a good position to continue to drive margins. So, we feel really good about where we're at as a company and where we're heading. And I really appreciate the time. So, thanks for being on the call..

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation..