The registrant, W.W. Grainger, Inc., was incorporated in the State of Illinois in 1928. It is the leading North American provider of maintenance, repair, and operating (MRO) supplies, services, and related information to businesses and institutions. W.W. Grainger, Inc. regards itself as being in the service business. As used herein, "Company" means W.W. Grainger, Inc., and/or its subsidiaries as the context may require.
In late 1997, the Company began an organizational restructuring with the formation of several business operations. Several of these operations were originally part of the Grainger branch-based business. In addition, Grainger Integrated Supply began refocusing on serving customers through materials management service contracts. These changes were made to create greater focus and accountability in serving the diverse needs of the Company's customers. 1998 was a transition year in establishing the refocused organization.
The Company offers a breadth of MRO solutions by combining products, services, and information. It tailors its capabilities toward the objective of providing the lowest total cost MRO solution to select customer groups. The Company serves the diverse needs of its customers through several focused businesses.
The Branch-based Distribution businesses serve traditional customers with immediate MRO needs. The other businesses of the Company serve customers with more complex needs and/or customers who prefer to purchase through less traditional channels, such as the Internet and direct marketing.
The Company also has a business support function which provides coordination and guidance in the areas of Accounting, Administrative Services, Aviation, Business Development, Communications, Compensation and Benefits, Employee Development, Finance, Government Regulations, Human Resources, Industrial Relations, Investor Relations, Insurance and Risk Management, Internal Audit, International Operations, Legal, Planning, Real Estate and Construction Services, Security and Safety, Taxes, and Treasury services. These services are provided in varying degrees to all of the business units.
A number of Company-wide strengths provide each business with an advantage in serving its market. These strengths include technology and information management, supplier partnerships, supply chain integration skills, and an understanding of the customers' MRO environments. The Company's efforts are guided by two major initiatives to drive growth and provide value:
The Company does not engage in basic or substantive product research and development activities. New items are added regularly to the Company's product lines on the basis of market information, recommendations of its employees, customers, and suppliers, and other factors. The Company's research and development, instead, are focused on new methods of serving customers.
For a discussion of the Year 2000 issue, see "Item 7: Management's Discussion and Analysis of Financial Condition and the Results of Operations" appearing later in this report.
Branch-based Distribution Businesses
The Company's Branch-based Distribution businesses provide customers with solutions to their immediate MRO needs throughout North America. Logistics networks are configured for rapid availability. A broad selection of MRO products
is offered at local branches through user-friendly catalogs and via the Internet. The Branch-based Distribution businesses include Grainger Industrial Supply, Acklands-Grainger Inc., Grainger Parts, Grainger, S.A. de C.V.,
Puerto Rico, Grainger Export, and Grainger Global Sourcing.
Grainger Industrial Supply
The focus of Grainger Industrial Supply is to provide a broad-line of MRO products quickly and easily to American businesses of all sizes. Its primary customers are small and medium-sized companies. It also addresses large-sized companies' immediate MRO needs.
Grainger Industrial Supply operates 349 branches in all 50 states. These branches are located within 20 minutes of the majority of U.S. businesses and carry inventory to support their local market needs. Products are available for immediate pick-up, same-day shipment, or delivery.
An average branch has 15 employees and handles about 280 transactions per day. During 1998, an average of approximately 98,100 sales transactions were completed daily. Each branch tailors its inventory to local product demand. In 1998, Grainger Industrial Supply invested more than $8,900,000 in new branches, relocations, and additions to branches. Three new branches were opened, seven were relocated, and a number of remodeling projects were completed during the year.
Grainger Industrial Supply has six Zone Distribution Centers (ZDCs) in operation. The ZDC logistics network provides a break-bulk function for faster branch stock replenishment. In addition, ZDCs handle shipped orders for all branches located in their zone.
Large computer controlled stocks, which are maintained at two Regional Distribution Centers (RDCs), located in Greenville County, South Carolina, and Kansas City, Missouri, and a National Distribution Center (NDC) located in the Chicago area, provide the branches and customers with some protection against variable demand and delayed factory deliveries. The NDC is a centralized storage and shipping facility servicing the entire network with slower moving inventory items.
During 1998, Grainger Industrial Supply began its conversion from its legacy systems to a new business enterprise system. This conversion will continue into 1999.
Grainger Industrial Supply sells principally to contractors, service shops, industrial and commercial maintenance departments, manufacturers, hotels, government, and health care and educational facilities. Sales transactions during 1998 were made to more than 1,300,000 customers. Grainger Industrial Supply estimates that approximately 24% of 1998 sales consisted of items bearing the Company's registered trademarks, including DAYTON¨ (principally electric motors, heating and ventilation equipment), TEEL¨ (liquid pumps), SPEEDAIRE¨ (air compressors), AirHandler¨ (air filtration equipment), DEM-KOTE¨ (spray paints), WESTWARD¨ (hand and power tools), and LUMAPROª (task and outdoor lighting), as well as other trademarks. The Company 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 other well recognized brands.
Grainger Industrial Supply's marketing programs had important changes in 1998. Now, all marketing resources are integrated to achieve maximum results during each promotion. Sales calls, phone sales, branch merchandising, direct marketing, and advertising are all focused around the overall marketing program.
The Grainger Industrial Supply Catalog offers more than 81,000 MRO products from more than 1,000 suppliers, most of whom are manufacturers. Approximately 2 million copies of the catalog are printed and distributed. The most current edition was issued in January 1999. The largest supplier in 1998, a diversified manufacturer through 20 of its divisions, accounted for 10.8% of purchases. No significant difficulty has been encountered with respect to sources of supply.
The Grainger Industrial Supply Electronic Catalog brings, directly to the customer's place of business, a fast, easy way to select products. Through the Electronic Catalog, the customer can use a variety of ways to describe a needed product, and then review Grainger Industrial Supply's offerings, complete with specifications, prices, and pictures. Another Electronic Catalog feature includes a cross-reference function that allows customers to retrieve product information using their own stock numbers. More than 350,000 copies of the current version of the Electronic Catalog have been distributed. The Electronic Catalog is also used at the branches as a training tool and a resource for identifying appropriate products for customers' applications.
The Internet is an important growth initiative for Grainger Industrial Supply. Access to Grainger Industrial Supply 24 hours a day, 7 days a week, is a major convenience for many customers.
Acklands-Grainger Inc. (AGI)
AGI, acquired in December 1996, is the leading branch-based Canadian broad line MRO distributor. It serves customers through 180 branches and 6 distribution centers across Canada. AGI distributes tools, lighting, HVAC, safety supplies, pneumatics, instruments, welding equipment and supplies, motors, and shop equipment, as well as many other items. A comprehensive catalog is used to showcase the product line and to help customers select products. This catalog, with over 70,000 products listed, supports the efforts of 268 sales representatives throughout Canada. A French language catalog was introduced during 1998. During 1998, an average of 17,800 sales transactions were completed daily.
Grainger Parts
Grainger Parts provides access to over 250,000 parts and accessories through its centralized warehouse located
in Northbrook, Illinois. Over 180,000 pages of parts diagrams are maintained on-line. Grainger Parts handled about 1,800,000 customer calls in 1998 through its call centers in Northbrook, Illinois and Waterloo, Iowa.
Grainger Parts maintained its ISO 9002 certification in 1998. Grainger Parts' 100% compliance with ISO 9002 standards ranked them among the top 10% of all ISO-certified companies.
Grainger, S.A. de C.V.
Grainger, S.A. de C.V. serves the traditional MRO product needs of customers in Mexico. The business employed
66 sales representatives at December 31, 1998. From its 80,000 square foot facility outside Monterrey, the business provides rapid delivery of over 60,000 products throughout Mexico.
Grainger Global Sourcing
Grainger Global Sourcing procures competitively priced, high quality products sourced outside the United States. These items are sold primarily under private label by Grainger Industrial Supply and the Company's other businesses. Products obtained through Grainger Global Sourcing in 1998 include WESTWARD¨ tools and LUMAPROª lighting products.
Other Business Units
While some larger companies have immediate MRO needs that can be handled by the Company's Branch-based Distribution businesses, many also require integrated supply or commodity management services to handle their
more complex purchasing and operating environments. In addition, as technology advances and the MRO marketplace evolves, some customers are choosing to buy products through less traditional channels such as the Internet and direct marketing. For these customers, the Company offers a number of solutions. These businesses include Grainger Custom Solutions, Grainger Integrated Supply, Grainger Consulting Services, Internet Commerce, and Lab Safety Supply, Inc.
Grainger Custom Solutions
Grainger Custom Solutions was formed in 1998 and serves large customers that are looking to businesses to manage entire MRO product categories. Many companies are looking for some of the benefits of integrated supply, but are not ready for a total outsourcing solution or on-site management services.
Grainger Custom Solutions offers customers management of six major product categories, along with access to the other broad product lines from Grainger Industrial Supply. Customers are guaranteed specific cost reductions, with incentives for both them and Grainger Custom Solutions if targets are exceeded.
In 1998, the business began operating two call centers and four distribution centers. Grainger Custom Solution's customers' additional broad product needs are fulfilled through the Grainger Industrial Supply branch system.
Grainger Integrated Supply
Grainger Integrated Supply is focused on customers who have chosen to outsource their entire indirect materials management process. By retaining Grainger Integrated Supply for this purpose, these organizations are better able
to focus on their core business objectives and improve their global competitiveness.
Grainger Integrated Supply offers a full complement of on-site outsourcing solutions, including business process reengineering, inventory management, supply chain management, tool crib management, and information management. Grainger Integrated Supply provides its clients with access to millions of products through its relationships with world class manufacturers, service providers, and distributors, including Grainger Industrial Supply. Products not covered through these partnerships are found through Grainger Integrated Supply's product sourcing process.
Grainger Consulting Services
Many customers realize that they are not effectively managing their MRO procurement process, but are not sure
what approach to take to improve the process. Grainger Consulting Services is a leading professional services firm specializing in MRO materials management consulting.
Grainger Consulting Services provides the expertise and professional resources that help clients address indirect materials management issues and improve operating efficiencies, productivity, and asset utilization. The business offers consulting services which include process reengineering, inventory database development, and "turn-key" stockroom set up.
Internet Commerce
The Company's product information content, relationships with leading manufacturers and distributors, and
access to over two million business customers position the Company uniquely to benefit from Internet commerce.
The Grainger.com site was one of the first MRO Web sites. In 1998, Internet Commerce continued to invest to increase
its Internet presence. New functionality for Grainger.com included the introduction of CasterMatchSM, another in the Company's MatchMakerSM series and a new, more powerful search capability was added. Grainger.com also began accepting credit card purchases in 1998. The Company was pleased to have Grainger.com once again be named among the top ten business-to-business Internet sites in the world by Advertising Age's Business Marketing Magazine.
In February 1999, the Company announced OrderZone.com by Grainger, an Internet marketplace where customers can buy products from a number of different suppliers using a single site. The Company has brought six industry leaders together to create a one-stop, on-line, business-to-business service for the procurement of a wide variety of products and services. OrderZone.com is a powerful, easy, and convenient solution for businesses looking to streamline their procurement process. Internet Commerce applied its expertise to create this Internet-based multi-distributor site. Customers can search across products from a number of leading complementary distributors. A single order can be placed across multiple distributors, and customers will receive a single invoice. Currently in test market, OrderZone.com is expected to open for business later in 1999.
Lab Safety Supply, Inc.
Lab Safety Supply is a leading direct marketer of safety products and other industrial supplies to U.S. businesses. Located in Janesville, Wisconsin, Lab Safety Supply reaches its customers through its General Catalog, targeted catalogs, and other marketing materials which are distributed throughout the year.
Customers select Lab Safety Supply for its extensive product depth (over 50,000 products in the 1999 General Catalog), its superior technical knowledge, and its excellent service. It is a primary safety supplier for many small and medium-sized companies and a critical safety back-up supplier for many larger companies.
Industry Segments
The Company has concluded that it has one reportable industry segment: Branch-based Distribution. For segment information and the Company's consolidated revenue and operating earnings see "Item 7: Management's Discussion
and Analysis of Financial Condition and the Results of Operations," and "Item 8: Financial Statements and Supplementary Data." The total assets of the Company for the last five years were: 1998, $2,103,902,000;
1997, $1,997,821,000; 1996, $2,119,021,000; 1995, $1,669,243,000; and 1994, $1,534,751,000.
Competition
The Company faces competition in all the markets it serves, from manufacturers (including some of the Company's own suppliers) that sell directly to certain segments of the market, from wholesale distributors, catalog houses, and certain retail enterprises.
The principal means by which the Company competes with manufacturers and other distributors is by providing local stocks, efficient service, account managers, competitive prices, its several catalogs, which include product descriptions and in certain cases, extensive technical and application data, procurement process consulting services, utilizing electronic and Internet commerce technology, and other efforts to assist customers in lowering their total MRO costs. The Company believes that it can effectively compete on a price basis with its manufacturing competitors on small orders, but that such manufacturers may enjoy a cost advantage in filling large orders.
The Company serves a number of diverse markets, and is able in some markets to reasonably estimate the Company's competitive position within that market. However, taken as a whole, the Company is unable to determine its market shares relative to others engaged in whole or in part in similar activities.
Employees
As of December 31, 1998, the Company had 15,270 employees, of whom 12,967 were full-time and 2,303 were
part-time or temporary. The Company has never had a major work stoppage and considers its employee relations generally to be good.
Item 2: Properties
As of December 31, 1998, the Company's facilities totaled 16,799,000 square feet, an increase of 2.1% over 1997.
The Company's Grainger Industrial Supply and Acklands-Grainger Inc. (AGI) businesses account for the majority
of the Company's total square footage. Grainger Industrial Supply facilities are located throughout the United States.
AGI facilities are located throughout Canada.
The Company's Grainger Industrial Supply branches range in size from 2,000 to 109,000 square feet and average 22,000 square feet. Most are located in or near major metropolitan areas, many in industrial parks. A typical owned branch is on one floor, is of masonry construction, consists primarily of warehouse space, contains an air-conditioned office and sales area, and has off-the-street parking for customers and employees. The Company considers that its properties are generally in good condition and well maintained, and are suitable and adequate to carry on the Company's business.
The significant facilities of the Company are briefly described below:
The Company is constructing an office facility to house a large portion of the Chicago-area office workforce on owned property. Construction of this Lake Forest, Illinois facility is scheduled to be completed during 1999. Certain Chicago-area owned and leased office facilities will be vacated when this new facility becomes operational.
(1)These facilities are either owned or leased with leases expiring between 1999 and 2003. The owned facilities are not subject to any mortgages.
(2) Grainger Industrial Supply branches consist of 278 owned and 71 leased properties. The owned facilities are not subject to any mortgages.
(3) Other facilities represent owned and leased general branch offices, distribution centers, and branches. 2 branches are located in Puerto Rico, and 1 branch/distribution center is located in Monterrey, Mexico. The owned facilities are not subject to any mortgages.
(4) The majority of these facilities were acquired through the acquisition of the industrial distribution business of Acklands Limited on December 2, 1996. The properties consist of general offices, distribution centers, and branches that are either owned or leased. The owned facilities are not subject to any mortgages.
Item 3: Legal Proceedings
There are pending various legal and administrative proceedings involving the Company that are incidental to
the business. It is not expected that the outcome of any such proceeding will have a material adverse effect upon
the Company's consolidated financial position or its 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 1998.
Executive Officers of the Company
Following is information about the Executive Officers of the Company as of March 1, 1999. Executive Officers of the Company generally serve until the next annual election of officers, or until earlier resignation or removal.
PART II
Item 5: Markets for Registrant's Common Equity and Related Shareholder Matters
The Company's common stock is traded 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 1998 and 1997, as adjusted to reflect the Company's 2-for-1 stock
split effective May 11, 1998, are shown below.
Item 6: Selected Financial Data
Item 7: Management's Discussion and Analysis of Financial Condition and the Results of Operations
The Company has adopted Statement of Financial Accounting Standards (SFAS) No.131, "Disclosures About Segments of an Enterprise and Related Information." SFAS No. 131 requires disclosure of certain business segment information based on how management evaluates the business. In late 1997, the Company began an organizational restructuring with the formation of several business operations to meet the diverse needs of its customers. The Company has reported 1998 data reflecting this new organization. 1997 and 1996 segment data were not reported because it is impractical to restate these years to reflect the new organization. (See Note 15 to the Consolidated Financial Statements included in the Company's 1998 Form 10-K).
All per share data have been adjusted to reflect the 2-for-1 stock split effective May 11,1998.
The following table, which is included as an aid to understanding changes in the Company's Consolidated Statements of Earnings, presents various items in the earnings statements expressed as a percent of net sales for the years ended December 31, 1998, 1997, and 1996, and the percent of increase (decrease) in such items in 1998 and 1997 from the prior year.
As used in "Item 7: Management's Discussion and Analysis of Financial Condition and the Results of Operations," "Grainger branch-based business" reflects the operations of the Company excluding Acklands-Grainger Inc., Lab Safety Supply, Inc., and Grainger Parts.
Net SalesThe 1998 Company net sales increase of 4.9%, as compared with 1997, was principally volume related. This increase primarily represented the effects of the Company's market initiatives which included new product additions, and the National Accounts, Integrated Supply, and direct marketing programs. Partially offsetting the growth from these initiatives was a decline in sales at Acklands-Grainger Inc. (AGI), the Company's Canadian subsidiary. This decline resulted from an unfavorable change in the Canadian exchange rate. In Canadian dollars, AGI's sales rate was relatively flat when comparing 1998 with 1997. Weak demand in the mining, forestry, oil, exploration, and agriculture sectors was the primary cause for AGI's flat sales performance. The Company's sales growth rate was 6.1% after excluding AGI from both 1998 and 1997.
The Company's Grainger branch-based business experienced selling price increases of about 0.7% when comparing 1998 with 1997. Sales to National Account customers within the Grainger branch-based business increased to approximately $1,120,000,000. Sales to National Account customers increased about 8%, on a comparable basis, over 1997.
The 1997 Company net sales increase of 16.9%, as compared with 1996, was principally volume related. This increase was affected by 1997 having one less sales day than 1996 (on a daily basis, net sales increased 17.4%). Excluding the incremental net sales of AGI, the Canadian industrial distribution business acquired on December 2, 1996, net sales increased 7.7% (8.1% on a daily basis). This increase primarily represented the effects of the Company's marketing initiatives which included new product additions, the expansion of branch facilities, and the National Accounts, Integrated Supply, and direct marketing programs. Partially offsetting the growth from these initiatives were two factors. Sales in the 1997 third quarter were negatively affected by the United Parcel Service's (UPS) work stoppage which began on August 4, 1997, and lasted more than two weeks. The Company estimates that 1997 sales were approximately $14,000,000 lower as a result of the UPS work stoppage. The second factor was that daily sales of seasonal products for the Company, excluding AGI, declined an estimated 4% in the year 1997, as compared with the same 1996 period. Many regions of the United States experienced milder weather during most of 1997 versus 1996.
The Company's Grainger branch-based business experienced selling price increases of about 1.1% when comparing the year 1997 with 1996. The Grainger branch-based business National Accounts program showed strong growth for the year, with sales increasing to approximately $1,015,000,000. Daily sales to National Account customers increased approximately 17%, on a comparable basis, over 1996.
Net EarningsNet earnings for 1998 increased 2.9% over 1997. The increase for 1998 was lower than the increase in net sales due to losses incurred in developing business ventures, operating expenses increasing at a rate faster than the growth rate in net sales, lower interest income, higher interest expense, and higher unclassified-net expenses, partially offset by higher gross profit margins. A number of factors contributed to 1998 net earnings increasing at a slower rate than 1998 net sales.
1. The Company continues to invest in developing its business operations. The following operations experienced pre-tax operating losses for the year 1998:
Grainger Integrated Supply's average daily sales grew about 56% for the year 1998 as compared with 1997. Grainger Integrated Supply serves customers through materials management services contracts. These contracts are characterized by a complete outsourcing of the indirect materials process. Customers not meeting the above definition were transferred to the Company's Grainger Custom Solutions and Grainger Industrial Supply businesses during 1998.
Average daily sales in Mexico grew about 21% for the year 1998 as compared with 1997. Grainger Integrated Supply and the Mexico business continue to grow sales, improve processes, develop systems, and expand marketing programs.
2. The Company's business-to-business Web site, Grainger.com, allows customers to do business using the Internet. The Company developed an Internet marketplace where customers will be able to buy products from a number of different suppliers using a single site. This marketplace concept is currently being tested with customers. In developing these Internet initiatives, the Company incurred operating expenses of approximately $14,000,000 in 1998 and $6,000,000 in 1997.
3. Operating expenses related to data processing were higher by an estimated $15,000,000 as compared with 1997, as adjusted for 1998 volume increases. This was primarily due to incurring expenses related to Year 2000 compliance and the ongoing installation of the new business enterprise system.
4. Operating expenses were also higher in 1998 versus 1997 as a result of the following investments:
a. Development of the Grainger Custom Solutions business; and
b. Expanded marketing programs at Lab Safety Supply.
The decrease in interest income resulted from lower average daily invested balances and from lower average interest rates earned. The increase in interest expense resulted from higher average interest rates paid on all outstanding debt, partially offset by lower average borrowings and by higher capitalized interest. The higher unclassified-net expense primarily resulted from foreign currency translation losses relating to the Company's operations in Mexico and to a write-off of abandoned capital projects.
The Company's gross profit margin increased by 0.67 percentage point when comparing the years 1998 and 1997.
Of note are the following factors affecting the Company's gross profit margin:
Net earnings for 1997 increased 11.2% over 1996. This increase for 1997 was lower than the increase in net sales due to operating expenses increasing at a rate faster than the rate of growth in net sales, lower interest income, higher interest expense, and a higher effective income tax rate, partially offset by higher gross profit margins. Factors contributing to the increase in operating expenses were the following:
1. Payroll and other operating expenses were higher as a result of the following initiatives:
a. Continued expansion of the Company's integrated supply business;
b. Continued development of the Company's full service marketing capabilities on the Internet;
c. Continued refocus and realignment of the Direct Sales force;
d. Increased advertising expenses supporting the Company's marketing initiatives; and
e. Expansion of the Company's telesales capability.
2. Payroll and other operating expenses were higher by an estimated $13,000,000 for Year 2000 compliance, of which approximately $10,000,000 related to outside services.
3. The operating expenses of AGI, which contributed to the increase, were included for the entire year of 1997 as compared with only the month of December in 1996.
The decrease in interest income resulted from lower average daily invested balances. This decrease was partially offset by higher average interest rates earned. The increase in interest expense resulted from higher average borrowings, partially offset by lower average interest rates paid on all outstanding debt. The increase in interest expense was primarily related to debt added to finance the AGI acquisition and to the short-term debt added to partially fund the repurchase of shares of the Company's common stock.
The Company's effective income tax rate was 40.5% for the year 1997 versus 40.2% for the year 1996. The increase in the effective income tax rate is attributable to proportionately higher income generated in Canada (AGI), which is taxed at a higher rate than domestic income.
The Company's gross profit margin increased by 0.30 percentage point when comparing the years 1997 and 1996. Excluding AGI, the Company's gross profit margin increased 0.56 percentage point when comparing the years of 1997 and 1996. Of note were the following factors affecting the gross profit margin for the Company, excluding AGI:
1. The change in product mix was favorable as sales of seasonal products (generally lower than average gross profit margins) declined, and Lab Safety Supply sales (generally higher than average gross profit margins) increased as a percent of total sales.
2. Selling price increases exceeded the level of cost increases. Partially offsetting the above factors was an unfavorable change in selling price category mix, which primarily resulted from the growth in sales to the Company's larger volume customers. Net earnings were negatively affected by the UPS work stoppage which occurred in August 1997. The gross profit margin lost on the estimated $14,000,000 in lost sales, along with the incremental operating expenses incurred to serve customers during this period, resulted in an estimated negative effect on net earnings of about $0.03 per share.
Year 2000
The Company uses various software and technology that is affected by the Year 2000 issue. The Year 2000 issue is
the result of computer programs being written using two digits rather than four to define the applicable year. Computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or in miscalculations causing disruptions to operations, including, among other things, a temporary inability to process transactions, to send invoices to customers, or to engage in similar normal business activities. The Year 2000 issue affects virtually all companies and organizations.
The Company has put in place project teams dedicated to implementing a Year 2000 solution and to improving the Company's overall systems capabilities. The teams are actively working to achieve the objectives of Year 2000 compliance and improved internal systems. The work includes the modification of certain existing systems, a major new system initiative, replacing hardware and software for other systems, the creation of contingency plans, and surveying suppliers of goods and services with whom the Company does business.
In addition to solving some Year 2000 issues, the major new system initiative reduces the complexity which has evolved over time from the development of in-house systems. This complexity, which makes it difficult to change and modify systems quickly, has resulted in a proliferation of programs and databases. These issues will be addressed by the installation of a new business enterprise system to replace a majority of the Company's primary operating systems. This major system initiative has been undertaken to improve the Company's ability to quickly respond to changing market conditions, to reduce the cost of maintaining and supporting existing systems, and to leverage the use of information.
The Company is using a standard methodology with three phases for the Year 2000 compliance project. Phase I includes conducting a complete inventory of potentially affected areas of the business (including information technology and non-information technology), assessing and prioritizing the information collected during the inventory, and completing detailed project plans to address all key areas of the project. Phase II includes the remediation and testing of all mission critical areas of the project, surveying suppliers of goods and services with whom the Company does business, and the creation of contingency plans to address potential Year 2000 related problems. Phase III of the project includes the remediation and testing of non-mission critical areas of the project, and the implementation of contingency plans as may be necessary. The Company completed Phase I. Phase II and Phase III are in process.
The Company is using both internal and external resources to reprogram, replace, and test the software and hardware for Year 2000 compliance. Year 2000 work for mission critical and most non-mission critical systems and testing of all system revisions is planned to be completed in the third quarter of 1999. The expenses associated with this project include both a reallocation of existing internal resources plus the use of outside services. Project expenses for 1998 and 1997 amounted to an estimated $39 million. The total remaining expenses associated with the Year 2000 project are estimated to be between $34 and $39 million. Due to the Year 2000 project and the major new system initiative, 1998 data processing expenses were approximately $15 million higher than 1997 expenses as adjusted for 1998 volume related charges. The data processing expenses for 1999 are estimated to be a net $10 to $12 million higher than the 1998 expenses as adjusted for 1999 volume related changes. It is expected that these projects will be funded through the Company's operating cash flows.
In addition to addressing internal systems, the Company's Year 2000 project team has surveyed suppliers of goods and services with whom the Company does business. This is being done to determine the extent to which the Company is vulnerable to failures by third parties to remediate their own Year 2000 issues. However, there can be no guarantee that the systems of other companies, including those on which the Company's systems interact, will be timely converted. A failure to convert by another company on a timely basis or a conversion by another company that is incompatible with the Company's systems, may have a material adverse effect on the Company.
As part of Phase II of the Year 2000 project, the Company is creating contingency plans to address potential Year 2000 related problems with key business processes. These plans, which are scheduled to be completed and tested in the second quarter of 1999, are expected to address risks to the Company's systems as well as risks from third party suppliers, customers, and others with whom the Company does business. It is recognized that while the Company cannot eliminate all potential risks, the effect of the risks on the business can be partially mitigated by creating and testing contingency plans where appropriate.
The estimated expenses for these projects and the dates by which the Company will complete the Year 2000 work are based on management's current assessment and were derived utilizing numerous assumptions of future events, including the continued availability of certain resources, third-party modification plans, and other factors. However, there can be no guarantee that these estimates will be achieved or that all components of Year 2000 compliance will be addressed as planned. Uncertainties include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, and the sources and timeliness of various systems replacements.
Management believes that failure to address the Year 2000 issue on a timely basis could have a material adverse effect on the Company and continues to be committed to devoting the appropriate resources to address the Year 2000 issue.
Working capital was $541,872,000 at December 31, 1998, compared with $649,107,000 at December 31, 1997, and $704,175,000 at December 31, 1996. The ratio of current assets to current liabilities was 1.8, 2.2, and 2.1 at such dates.
Net cash flows from operations of $334,591,000 in 1998, $426,563,000 in 1997, and $272,410,000 in 1996, have continued to improve the Company's financial position and serve as the primary source of funding for capital requirements. For information as to the Company's cash flows, see "Item 8: Financial Statements and Supplementary Data."
In each of the past three years, a portion of working capital has been used for additions to property, buildings, and equipment, and capitalized software as summarized in the following table.
On April 29, 1998, the Company's Board of Directors voted to restore an existing share repurchase authorization to its original level of 10,000,000 shares. The Company repurchased 4,483,100 shares of its common stock during 1998, 8,435,972 shares of its common stock during 1997, and 819,200 shares of its common stock during 1996. As of December 31, 1998, approximately 5,600,000 shares of common stock remain available under this repurchase authorization.
Dividends paid to shareholders were $56,683,000 in 1998, $53,934,000 in 1997, and $50,035,000 in 1996.
On December 2, 1996, the Company acquired AGI for approximately $289,334,000, including transaction expenses. The purchase consisted of cash payments and transaction expenses of $136,801,000 (funded principally by short-term debt of $132,874,000), and the issuance of 4,079,772 shares of W.W. Grainger, Inc. common stock valued at $152,533,000. The Company repurchased the 4,079,772 shares during 1997, which is included in the 8,435,972 shares repurchased during 1997.
Internally generated funds have been the primary source of working capital and funds needed for expanding the business, supplemented by debt as circumstances dictated. In addition to continuing facilities optimization efforts, business development, and systems and other infrastructure enhancements, funds are being expended for the consolidation of Chicago-area offices into the Lake Forest, Illinois office facility currently being constructed.
The Company continues to maintain a low debt ratio and strong liquidity position, which provides flexibility in funding working capital needs and long-term cash requirements. In addition to internally generated funds, the Company has various sources of financing available, including commercial paper sales and bank borrowings under lines of credit and otherwise. Total debt as a percent of shareholders' equity was 18%, 12%, and 11%, at December 31, 1998, 1997, and 1996, respectively.
The major impact of inflation is on buildings and improvements, where the gap between historic cost and replacement cost continues to be significant for these long lived assets. The related depreciation expense associated with these assets increases significantly when adjusting for the cumulative effect of inflation.
The Company believes the most positive means to combat inflation and advance the interests of investors lies in continued application of basic business principles, which include improving productivity, increasing working capital turnover, and offering products and services which can command proper price levels in the marketplace.
Item 8: Financial Statements and Supplementary Data The financial statements and supplementary data are included on pages 18 to 38. See the Index to Financial Statements and Supplementary Data on page 17.
Item 9: Disagreements on Accounting and Financial Disclosure
None.
Item 10: Directors and Executive Officers of the Registrant Information regarding directors of the Company will be set forth in the Company's proxy statement relating to the annual meeting of shareholders to be held April 28, 1999, and, to the extent required, is incorporated herein by reference. Information regarding executive officers of the Company is set forth under the caption "Executive Officers."
Item 11: Executive Compensation Information regarding executive compensation will be set forth in the Company's proxy statement relating to the annual meeting of shareholders to be held April 28, 1999, and, to the extent required, is incorporated herein by reference.
Item 12: Security Ownership of Certain Beneficial Owners and Management Information regarding security ownership of certain beneficial owners and management will be set forth in the Company's proxy statement relating to the annual meeting of shareholders to be held April 28, 1999, and, to the extent required, is incorporated herein by reference.
Item 13: Certain Relationships and Related Transactions Information regarding certain relationships and related transactions will be set forth in the Company's proxy statement relating to the annual meeting of shareholders to be held April 28,1999, and, to the extent required, is incorporated herein by reference.
Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Company has duly issued this report to be signed on its behalf by the undersigned, thereunto duly authorized.
DATE: March 24, 1999
W.W. GRAINGER, INC.
