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

Overview

General. Grainger is a broad line distributor of maintenance, repair and operating (MRO) supplies and other related products and services used by businesses and institutions. Grainger’s operations are primarily in the United States (U.S.) and Canada, with a presence in Europe, Asia and Latin America. Grainger uses a combination of multichannel and single channel business models to provide customers with a range of options for finding and purchasing products utilizing sales representatives, catalogs, direct marketing materials and eCommerce. Grainger serves approximately 3 million customers worldwide through a network of highly integrated branches, distribution centers and websites.

Grainger’s two reportable segments are the U.S. and Canada. The U.S. operating segment reflects the results of Grainger’s U.S. business. The Canada operating segment reflects the results for Acklands – Grainger Inc., Grainger’s Canadian business. Other Businesses include single channel online businesses such as MonotaRO in Japan and Zoro in the U.S., and business units in Europe, Asia and Latin America.

Business Environment. Given Grainger's large number of customers and the diverse industries it serves, several economic factors and industry trends tend to shape Grainger’s business environment. The overall economy and leading economic indicators provide general insight into projecting Grainger's growth. Grainger’s sales in the U.S. and Canada tend to positively correlate with Business Investment, Business Inventory, Exports and Industrial Production. In the U.S., sales tend to positively correlate with Gross Domestic Product (GDP). In Canada, sales tend to positively correlate with oil prices. The table below provides these estimated indicators for 2016 and 2017:

	U.S.						Canada
	Estimated 2016			Forecasted 2017			Estimated 2016			Forecasted 2017
Business Investment	(2.8	)%		3.4	%		(2.8	)%		0.7	%
Business Inventory	1.0	%		0.6	%		—			—
Exports	0.4	%		1.9	%		1.0	%		1.9	%
Industrial Production	(1.0	)%		1.4	%		(0.5	)%		1.9	%
GDP	1.6	%		2.3	%		1.3	%		2.1	%
Oil Prices	—			—			$43/barrel			$57/barrel
Source: Global Insight (February 2017)

In the U.S., Business Investment and Exports are two major indicators of MRO spending. Per the Global Insight February 2017 forecast, Business Investment is forecast to improve in 2017 through equipment related spendings as the influence from slow growth abroad and in the United States fades. Export growth is expected to improve in 2017 as the global economy stabilizes and attracts more capital to the United States.

Per the Global Insight February 2017 forecast, Canada economic growth in 2016 is forecast to continue to remain low but improve in 2017. For the year, the Canadian economy, as measured by GDP, is forecast to grow to 2.1% in 2017 compared to the 2016 estimate of 1.3%. The 2017 forecast assumes that oil prices will continue a slow but steady rise and that business nonresidental investment (a component of Business Investment) will begin to increase. The latest forecast for the Canadian dollar includes further downward adjustments and weakness over the next two years compared to the U.S. dollar.

Outlook. Grainger plans to continue to make investments in its supply chain, eCommerce capabilities, information systems, sales force productivity tools and inventory management services. These investments will support the Company’s revenue growth objectives of (i) continuing to grow its share of business with large, complex customers; (ii) creating a unique value proposition to further penetrate the medium customer segment and (iii) further leveraging its eCommerce capabilities to serve smaller customers. Through the execution of continuous improvement initiatives, the U.S. business will reduce its cost base while ensuring that it continues to deliver an effortless customer experience. In Canada, the Company took aggressive actions in 2016 that will position the business for long-term sustainable growth and profitability. These actions, which included business and personnel reorganization, branch closures, ERP and eCommerce investments, should position the Canadian business for growth in 2017 and restore the business to break even by the end of 2017.

On January 25, 2017, Grainger reiterated its 2017 sales and earnings per share guidance issued on November 11, 2016, and continues to expect 2 to 6 percent sales growth and earnings per share of $11.30 to $12.40 for 2017.

Matters Affecting Comparability. There were 255 sales days in the full year 2016 and 2015. Grainger completed one acquisition in 2015 and one in 2014, both of which were immaterial individually and in the aggregate. Grainger’s operating results have included the results of each business acquired since the respective acquisition dates.

Results of Operations

The following table is included as an aid to understanding changes in Grainger's Consolidated Statements of Earnings (in millions of dollars):

	For the Years Ended December 31,
													Percent Increase/(Decrease) from Prior Year						As a Percent of Net Sales
	2016 (A)				2015 (A)				2014 (A)				2016			2015			2016			2015			2014
Net sales	$	10,137			$	9,973			$	9,965			2	%		—	%		100.0	%		100.0	%		100.0	%
Cost of merchandise sold	6,023				5,742				5,651				5	%		2	%		59.4			57.6			56.7
Gross profit	4,115				4,231				4,314				(3	)%		(2	)%		40.6			42.4			43.3
Operating expenses	2,995				2,931				2,967				2	%		(1	)%		29.6			29.4			29.8
Operating earnings	1,119				1,300				1,347				(14	)%		(4	)%		11.0			13.0			13.5
Other expense	100				50				13				102	%		290	%		1.0			0.5			0.1
Income taxes	386				466				522				(17	)%		(11	)%		3.8			4.7			5.2
Noncontrolling interest	27				16				11				66	%		53	%		0.3			0.2			0.1
Net earnings attributable to W.W. Grainger, Inc.	$	606			$	769			$	801			(21	)%		(4	)%		6.0	%		7.7	%		8.1	%

(A) May not sum due to rounding

2016 Compared to 2015

Grainger's net sales of $10,137 million for 2016 were an increase of 2% when compared with net sales of $9,973 million for the comparable 2015 period. The 2% increase for the year consisted of the following:

	Percent Increase/ (Decrease)
Cromwell acquisition	3
Volume	1
Price	(2)
Total	2%

Sales growth to government, retail and light manufacturing customers were offset by a decline in sales to natural resource customers, resellers, contractors and heavy manufacturing customers. In 2016, eCommerce sales for Grainger were $4,757 million, an increase of 15% over the prior year and represented 47% of total sales. The increase was primarily driven by an increase in sales via EDI and electronic purchasing platforms in the U.S. and Japan businesses. If the Company included KeepStock®, the electronic inventory management offering, total eCommerce and KeepStock® sales would represent 56% of total sales. Refer to the Segment Analysis below for further details.

Gross profit of $4,115 million for 2016 decreased 3%. The gross profit margin for 2016 was 40.6%, down 1.8 percentage points versus 2015, primarily due to price deflation exceeding cost deflation and unfavorable customer mix.

Operating expenses of $2,995 million for 2016 increased 2% from $2,931 million for 2015. The increase was primarily due to the following:

•	$35 million of restructuring charges primarily in the U.S. and Canadian businesses.

•	$52 million of impairment charges for goodwill and intangible assets in Other Businesses.

•	$36 million adjustment for unclaimed property in the U.S. business, primarily for the five years 2008 through 2012.

•	$9 million increase in the U.S. business reserve related to certain tax, freight and miscellaneous billing issues in connection with the audit of government contracts with the General Services Administration first entered in 1999.

In 2015, operating expenses included $42 million related to restructuring and other charges primarily in the U.S. and Canadian business. Excluding the charges from both years, operating expenses were down 1%.

Operating earnings of $1,119 million for 2016 decreased 14% from $1,300 million for 2015. The decrease in operating earnings was driven by lower gross profit margin and higher restructuring costs and other charges. Operating earnings included the charges noted above. Excluding these charges from both years, operating earnings decreased 6%.

Net earnings attributable to Grainger for 2016 decreased by 21% to $606 million from $769 million in 2015. The decrease in net earnings primarily resulted from lower operating earnings, partially offset by lower income taxes. Excluding the charges from both years mentioned above and discrete tax items, net earnings decreased 10%.

Diluted earnings per share of $9.87 in 2016 were 15% lower than $11.58 for 2015, due to lower earnings, partially offset by lower average shares outstanding as a result of share repurchases. Excluding the charges mentioned above diluted earnings per share would have been $11.58 compared to $11.94 in 2015, a decrease of 3%.

The table below reconciles reported diluted earnings per share determined in accordance with generally accepted accounting principles (GAAP) in the U.S. to adjusted diluted earnings per share, a non-GAAP measure. Management believes adjusted diluted earnings per share is an important indicator of operations because it excludes items that may not be indicative of core operating results. Because non-GAAP financial measures are not standardized, it may not be possible to compare this financial measure with other companies' non-GAAP financial measures having the same or similar names.

	Twelve Months Ended December 31,
	2016				2015			%
Diluted earnings per share reported	$	9.87			$	11.58		(15	)%
Adjustments, pretax (1)	2.41				0.69
Tax effect (1)(2)	(0.55		)		(0.24		)
Discrete tax items	(0.15		)		(0.09		)
Subtotal	1.71				0.36
Diluted earnings per share adjusted	$	11.58			$	11.94		(3	)%

(1) Adjustments discussed in detail in Item 6.

(2) The tax impact of adjustments is calculated based on the income tax rate in each applicable jurisdiction.

Segment Analysis

Grainger’s two reportable segments are the U.S. and Canada. The U.S. operating segment reflects the results of Grainger’s U.S. business. The Canada operating segment reflects the results for Acklands – Grainger Inc., Grainger’s Canadian business. Other businesses include single channel online businesses such as MonotaRO in Japan and Zoro in the U.S., and business units in Europe, Asia and Latin America.

The following comments at the reportable segment and other business unit level include external and intersegment net sales and operating earnings. See Note 16 to the Consolidated Financial Statements.

United States

Net sales were $7,870 million for 2016, a decrease of $93 million, or 1% when compared with net sales of $7,963 million for 2015. The 1% decrease for the year consisted of the following contributors:

	Percent Increase/(Decrease)
Intercompany sales to Zoro	1
Volume	(1)
Price	(1)
Total	(1)%

Mid-single-digit sales growth to government and retail customers and low single-digit growth to light manufacturing was offset by mid-teen declines in sales to natural resource and reseller customers and mid-single-digit declines to heavy manufacturing customers and contractors.

In 2016, eCommerce sales for the U.S. business were $3,660 million, an increase of 12% over the prior year and represented 46% of total sales. The increase was primarily driven by an increase in sales via EDI and electronic purchasing platforms. If the Company included KeepStock®, the electronic inventory management offering, total eCommerce and KeepStock® sales would represent 57% of total sales.

The segment gross profit margin decreased 1.3 percentage points in 2016 compared to 2015, driven by price deflation exceeding cost deflation and stronger sales growth to lower margin customers.

Operating expenses were down 2% for 2016 versus 2015. The decrease in operating expenses was driven by lower employees benefit costs, partially offset by higher restructuring costs and other charges discussed above. Excluding the restructuring and other charges in both periods, operating expenses would have been down 4%.

For the segment, operating earnings of $1,275 million for 2016 decreased 7% versus $1,372 million in 2015. The decline in operating earnings for 2016 was primarily driven by lower sales and gross profit margin, partially offset by lower operating expenses. Excluding the restructuring costs and other charges in both periods, operating earnings decreased 5%.

Canada

Net sales were $734 million for 2016, a decrease of $157 million, or 18%, when compared with $891 million for 2015. In local currency, sales decreased 15% for 2015. The 18% decrease for the year consisted of the following contributors:

	Percent Decrease
Volume	(10)
Foreign exchange	(3)
Price	(2)
ERP implementation	(2)
Wildfire impact	(1)
Total	(18)%

Sales performance in Canada was primarily driven by declines within the oil and gas sector in Alberta, combined with declines in all other end markets across the country. The Alberta region, which represents about one-third of the sales in the Canadian business, decreased 23% versus prior year, as it was negatively impacted by oil prices. Sales growth

for the remaining regions in aggregate was down 10% in local currency. In addition, the Canadian business implemented the U.S. ERP system in February 2016, which negatively impacted sales as employees transitioned to operating with the new system.

In 2016, eCommerce sales for the Canada business were $98 million, a decrease of 8% over the prior year and represented 13% of total sales. The decrease was primarily driven by lower sales volume. If the Company included KeepStock®, the electronic inventory management offering, total eCommerce and KeepStock® sales would represent 26% of total sales.

The segment gross profit margin decreased 7.8 percentage points in 2016 versus 2015, due to an inventory adjustment of $10 million in the second quarter of 2016, along with price deflation versus cost inflation and higher freight costs from an increase in shipping directly to customers. As a result of service issues due to the ERP system implementation, the Company did not increase prices to customers during 2016.

Operating expenses decreased 8% in 2016 versus 2015. The decrease was due to the benefit of a $7 million gain from the sale of the former Toronto DC in the first quarter of 2016 and lower ERP system project costs, partially offset by higher restructuring costs. Excluding the restructuring costs from both periods, operating expenses decreased 11%.

Operating losses of $65 million for 2016 versus operating earnings of $27 million in 2015, a decrease of $92 million. Excluding the restructuring costs mentioned above, the operating losses would have been $41 million due to lower sales and gross profit margin and operating expenses declining at a slower rate than sales when compared to the prior period.

Other Businesses

Net sales for other businesses, which include MonotaRO in Japan, Zoro in the U.S. and operations in Europe, Asia, Latin America and Cromwell in the United Kingdom (U.K.) (acquired September 1, 2015) were $1,885 million for 2016, an increase of $479 million, or 34%, when compared to $1,406 million for 2015. The net sales increase was primarily due to the Cromwell acquisition and incremental sales at Zoro and MonotaRO. The 34% increase for the year consisted of the following contributors:

	Percent Increase
Cromwell acquisition	18
Volume	15
Foreign exchange	1
Total	34%

Operating earnings for other businesses were $41 million for 2016 compared to $48 million for 2015. Excluding goodwill and intangible impairment charges of $52 million in the Fabory and Colombia businesses and other restructuring charges in the prior year, operating earnings for other business increased by $39 million driven by strong performance from MonotaRO, Zoro and the earnings contribution from Cromwell.

Other Income and Expense

Other expense was $100 million in 2016 compared to $50 million of expense in 2015. The following table summarizes the components of other income and expense (in thousands of dollars):

	For the Years Ended December 31,
	2016				2015
Interest income (expense) - net	$	(65,615	)		$	(32,405	)
Loss from equity method investment	(31,193		)		(11,740		)
Other non-operating income	1,300				1,102
Other non-operating expense	(4,931		)		(6,572		)
Total	$	(100,439	)		$	(49,615	)

The increase in expense was driven by higher interest expense from the $1 billion in long-term debt issued in June 2015 and $400 million in long-term debt issued in May 2016, as well as higher operating losses from the Company's clean energy investments.

Income Taxes

Income taxes of $386 million in 2016 decreased 17% compared with $466 million in 2015. Grainger's effective tax rates were 37.9% and 37.2% in 2016 and 2015, respectively. The year-over-year increase in the tax rate was primarily due to a larger proportion of earnings from higher tax rate jurisdictions, partially offset by a higher benefit from the Company’s clean energy investments. The twelve months ended December 31, 2016, included a benefit from the conclusion of the federal income tax audit for the years 2009 through 2012 and other discrete items. Excluding the discrete tax benefits and non-deductible intangible write-downs, the Company’s effective tax rate was 37.1%. The Company's clean energy investment generated $0.15 per share of earnings for the year ended December 31, 2016.

2015 Compared to 2014

Grainger's net sales of $9,973 million for 2015 were flat when compared with net sales of $9,965 million for 2014. Contributors to the sales performance for 2015 were as follows:

	Percent Increase/ (Decrease)
Volume	2
Business acquisition	2
Price	(1)
Foreign exchange	(3)
Total	—%

Sales growth to light manufacturing and government customers were offset by a decline in sales to natural resource customers, contractors, resellers and heavy manufacturing customers. In 2015, eCommerce sales for Grainger were $4,133 million, an increase of 16% over the prior year and represented 41% of total sales. The increase was primarily driven by an increase in sales via EDI and electronic purchasing platforms in the U.S. If the Company included KeepStock®, the electronic inventory management offering, total eCommerce and KeepStock® sales would represent 50% of total sales. Refer to the Segment Analysis below for further details.

Gross profit of $4,231 million for 2015 decreased 2%. The gross profit margin for 2015 was 42.4%, down 0.9 percentage point versus 2014, primarily driven by higher sales to lower margin customers and price deflation exceeding cost deflation.

Operating expenses of $2,931 million for 2015 decreased 1% from $2,967 million for 2014. The decrease was primarily driven by lower employee benefits, partially offset by higher severance and contract services costs. Operating expenses included new sales representatives, supply chain and inventory management solutions, as well as $42 million of charges primarily related to reorganizing the businesses in the U.S. and Canada. In 2014, operating expenses included $51 million related to the closing of the business in Brazil, restructuring costs, the transition of the retirement plan in Europe and an impairment charge for the business in Colombia. Excluding the reorganization and restructuring costs from both years, operating expenses were down 1%.

Operating earnings of $1,300 million for 2015 decreased 3% from $1,347 million for 2014. Operating earnings declined due to a lower gross profit margin, partially offset by operating expense leverage. Operating earnings included the charges noted above. Excluding these charges from both years, operating earnings decreased 5%.

Net earnings attributable to Grainger for 2015 decreased by 4% to $769 million from $802 million in 2014. The decrease in net earnings primarily resulted from lower operating earnings, partially offset by lower income taxes. Diluted earnings per share of $11.58 in 2015 were 1% higher than $11.45 for 2014, due to lower average shares outstanding.

The following table reconciles reported diluted earnings per share determined in accordance with generally accepted accounting principles (GAAP) in the U.S. to adjusted diluted earnings per share, a non-GAAP measure. Management believes adjusted diluted earnings per share is an important indicator of operations because it excludes items that may not be indicative of core operating results. Because non-GAAP financial measures are not standardized, it may not be possible to compare this financial measure with other companies' non-GAAP financial measures having the same or similar names.

	Twelve Months Ended December 31,
	2015				2014			%
Diluted earnings per share reported	$	11.58			$	11.45		1	%
Adjustments, pretax	0.69				0.94
Tax effect (1)	(0.24		)		(0.13		)
Discrete tax items	(0.09		)		—
Total, net of tax	0.36				0.81
Diluted earnings per share adjusted	$	11.94			$	12.26		(3	)%

(1) The tax impact of adjustments is calculated on the income tax rate in each applicable jurisdiction.

Segment Analysis

The following comments at the reportable segment and other business unit level include external and intersegment net sales and operating earnings. See Note 16 to the Consolidated Financial Statements.

United States

Net sales were $7,963 million for 2015, an increase of $37 million, or flat when compared with net sales of $7,926 million for 2014. Contributors to the sales performance for 2015 were as follows:

	Percent Increase/(Decrease)
Volume	—
Intercompany sales to Zoro	1
Price	(1)
Total	—%

Mid-single-digit sales growth to light manufacturing and government customers and low single-digit growth to commercial services were offset by a mid-teen decline in sales to natural resource customers and low-single-digit declines to heavy manufacturing customers and contractors. In 2015, eCommerce sales for the U.S. business were $3,275 million, an increase of 16% over the prior year, and represented 41% of total sales. The increase was primarily driven by an increase in sales via EDI and electronic purchasing platforms. If the Company included KeepStock®, the electronic inventory management offering, total eCommerce and KeepStock® sales would represent 51% of total sales.

The segment gross profit margin decreased 1.0 percentage point in 2015 compared to 2014, primarily driven by price decreases exceeding product cost decreases and higher sales to lower margin customers.

Operating expenses were up 1% for 2015 versus 2014. Operating expenses included an incremental $96 million in growth-related spending on eCommerce, new sales representatives, supply chain and inventory management solutions, as well as $32 million of charges related to reorganizing the business, including branch closures. Excluding the reorganization costs, operating expenses decreased 1% primarily due to lower employee benefit costs.

For the segment, operating earnings of $1,372 million for 2015 decreased 5% versus $1,444 million in 2014. Excluding the reorganization expenses mentioned above, operating earnings were down 3%. The decline in operating earnings for 2015 was due to a lower gross profit margin, partially offset by positive operating expense leverage.

Canada

Net sales were $891 million for 2015, a decrease of $185 million, or 17%, when compared with $1,076 million for 2014. In local currency, sales increased 5% for 2015. The 17% decrease for the year consisted of the following contributors:

	Percent Increase/ (Decrease)
Volume	(14)
Foreign exchange	(12)
Acquisition	5
Price	4
Total	(17)%

Sales performance in Canada was driven by mid-teen declines in the oil and gas, contractor, commercial services, heavy manufacturing, resellers and retail markets. Net sales in the agriculture and mining and utilities end markets were up in the mid-single digits. In 2015, eCommerce sales for Canada were $107 million, a decrease of 13% versus the prior year and represented 12% of total sales. If the Company included KeepStock®, the electronic inventory management offering, total eCommerce and KeepStock® sales would represent 23% of total sales.

The segment gross profit margin decreased 0.4 percentage point in 2015 versus 2014, primarily driven by product cost inflation exceeding price inflation driven by unfavorable foreign exchange, partially offset by higher supplier rebates.

Operating expenses decreased 4% in 2015. In local currency, operating expenses increased 11%, primarily due to higher severance costs related to reorganizing the business, higher depreciation driven primarily by a new DC and incremental costs from the WFS Enterprises Inc. (WFS) acquisition as 2014 included a partial year. Excluding the reorganization costs, operating expenses increased 9%.

Operating earnings of $27 million for 2015 decreased $61 million, or 69%, versus 2014. In local currency, operating earnings decreased 64%. The decrease in earnings was due to lower sales, lower gross profit margins and negative operating expense leverage.

Other Businesses

Net sales for Other Businesses, which include Zoro in the U.S. and operations in Europe, Asia and Latin America and Cromwell in the U.K. (acquired September 1, 2015), were $1,406 million for 2015, an increase of $224 million, or 19%, when compared with $1,182 million for 2014. The net sales increase was primarily due to incremental sales from Cromwell, Zoro and MonotaRO. The 19% increase for the year consisted of the following contributors:

	Percent Increase/ (Decrease)
Volume/Price	21
Acquisition	12
Foreign exchange	(14)
Total	19%

Operating earnings for other businesses were $48 million for 2015 compared to a loss of $38 million for 2014. The year 2015 included $6 million of charges for the continuing restructuring of the business in Europe and additional costs to shut down the business in Brazil. The year 2014 included a $29 million charge related to closing the business in Brazil, a $14 million charge related to the transition of the employee retirement plan in Europe, a $12 million impairment charge for the business in Colombia and $10 million in restructuring costs for the business in Europe. Excluding these charges in both years, operating earnings increased $27 million, primarily driven by improved operating performance by MonotaRO and Zoro, partially offset by incremental expenses associated with the single channel online business model in Europe.

Other Income and Expense

Other income and expense was $50 million of expense in 2015 compared with $13 million of expense in 2014. The following table summarizes the components of other income and expense (in thousands of dollars):

	For the Years Ended December 31,
	2015				2014
Interest income (expense) - net	$	(32,405	)		$	(8,025	)
Loss from equity method investment	(11,740		)		—
Other non-operating income	1,102				483
Other non-operating expense	(6,572		)		(5,189		)
Total	$	(49,615	)		$	(12,731	)

The increase in expense was driven by higher interest expense from the $1 billion in long-term debt issued in June 2015, as well as operating losses from the Company's clean energy investments. As discussed below, the operating losses in this investment were more than offset by energy tax credits that lowered Grainger's tax rate, which provided Grainger with positive net earnings and cash flow. The clean energy investment generated $0.09 per share of earnings for 2015.

Income Taxes

Income taxes of $466 million in 2015 decreased 11% compared with $522 million in 2014. Grainger's effective tax rates were 37.2% and 39.1% in 2015 and 2014, respectively. Excluding the effect of restructuring and non-operating items reported in both 2015 and 2014, Grainger's adjusted tax rate was 37.6% and 38.2% in 2015 and 2014, respectively. The decrease in the tax rate in 2015 was primarily due to the Company's clean energy investments, partially offset by a higher proportion of earnings in the U.S. versus geographies with lower tax rates.

Financial Condition

Grainger expects its strong working capital position, cash flows from operations and borrowing capacity to continue, allowing it to fund its operations, including growth initiatives, capital expenditures, acquisitions and repurchase of shares, as well as to pay cash dividends.

Cash Flow

2016 Compared to 2015

Net cash provided by operating activities was $1,003 million and $990 million for the twelve months ended December 31, 2016 and 2015, respectively. The increase was primarily the result of lower employee related costs.

Net cash used in investing activities was $262 million and $843 million for the twelve months ended December 31, 2016 and 2015, respectively. The higher use of cash in 2015 was driven by the Cromwell acquisition in September 2015. In 2016, lower additions to property, buildings and equipment compared to the prior year and higher proceeds from the sale of branch real estate assets contributed to the reduction in cash used in investing activities.

Net cash used in financing activities was $755 million and $63 million in the twelve months ended December 31, 2016 and 2015, respectively. The change in financing activities was primarily driven by the issuance of $400 million in Senior Notes in 2016 compared to the issuance of $1 billion in Senior Notes in 2015 and significantly lower stock repurchases in 2016 compared to 2015.

2015 Compared to 2014

Net cash provided by operating activities in 2015 were $990 million versus $960 million in 2014. This positive cash flow was due to relatively flat receivable balances, partially offset by a decrease in employee benefit liabilities.

Net cash used in investing activities was $843 million and $384 million in 2015 and 2014, respectively. The higher use of cash was primarily driven by $464 million of net cash paid for a business acquisition in 2015 versus $31 million in 2014.

Net cash used in financing activities of $63 million in 2015 decreased $695 million from $758 million in 2014. The decrease was primarily due to proceeds from the issuance of $1 billion in Senior Notes, a £160 million term loan and issuance of commercial paper to support the acquisition of Cromwell, as well as ¥6 billion term loans to support the construction of a new distribution center in MonotaRO. These proceeds were partially offset by an increase in share repurchases and dividends paid.

Working Capital

Internally generated funds are the primary source of working capital and funds used in business expansion, supplemented by debt. In addition, funds are expended to support growth initiatives, as well as for business and systems development and other infrastructure improvements.

Working capital consists of current assets (less non-operating cash) and current liabilities (less short-term debt and current maturities of long-term debt). Working capital was $1,722 million at December 31, 2016, compared with $1,794 million at December 31, 2015. At these dates, the ratio of current assets to current liabilities was 2.4 and 2.5, respectively. The decrease in working capital was primarily related to increases in accounts payable.

Capital Expenditures

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

	For the Years Ended December 31,
	2016				2015				2014
Land, buildings, structures and improvements	$	70,942			$	86,082			$	159,793
Furniture, fixtures, machinery and equipment	139,474				202,137				140,358
Subtotal	210,416				288,219				300,151
Capitalized software	73,833				85,649				87,239
Total	$	284,249			$	373,868			$	387,390

In 2016, the Company continued to invest in the North America distribution network, as well as the distribution network in other segments, and sales productivity initiatives. Other significant investments in 2016 included the eCommerce platform, sustaining capital investments in branches and distribution centers and other technology infrastructure.

In 2015, Grainger invested in the North America distribution center network and the completion of the common ERP platform for North America and made investments in support of sales initiatives. Other significant investments in 2015 included the eCommerce platform, sustaining capital investments for Grainger's branches and distribution centers and other technology infrastructure.

In 2014, Grainger made significant capital investments to build new distribution centers in the United States and Canada. In the U.S., Grainger began the replacement of its existing New Jersey distribution center with construction of a new 1.3 million square-foot distribution center, completed in 2016. In Canada, Grainger continued construction of the new distribution center in the Toronto area, completed in 2015. Grainger also invested in technology infrastructure, vending machines for the KeepStock® program and normal recurring replacement of equipment.

In 2017, capital expenditures are expected to range from $250 million to $275 million. Projected spending includes continued investments in the supply chain, eCommerce and inventory management solutions. Grainger expects to fund 2017 capital spending primarily from operating cash.

Debt

Grainger maintains a debt ratio and liquidity position that provides flexibility in funding working capital needs and long-term cash requirements. In addition to internally generated funds, Grainger has various sources of financing available, including bank borrowings under lines of credit. Total debt, which is defined as total interest-bearing debt (current plus long-term) as a percent of total capitalization was 54.1% and 45.8%, as of December 31, 2016 and 2015, respectively.

On April 16, 2015, Grainger announced plans to issue $1.8 billion in long-term debt over the next three years, to partially fund the repurchase of $3 billion in shares. The remaining amount is expected to be funded from internally generated cash. In June 2015, Grainger issued $1 billion in long-term debt, which was the first of three expected debt issuances. The debt is payable in 30 years and carries a 4.60% interest rate, payable semiannually. In May 2016, Grainger issued $400 million in long-term debt, which was the second of three expected debt issuances. The new debt is payable in 30 years and carries a 3.75% interest rate, payable semiannually. With the new long-term debt, Grainger expects to maintain a debt to EBITDA ratio in the 1.0–1.5x range. EBITDA, which is defined as Earnings before Interest, Taxes, Depreciation and Amortization, is a non-GAAP measure and may not be defined and calculated by other companies in the same manner. Refer to Note 7 and Note 8 to the Consolidated Financial Statements included in Item 8. The Company ended 2016 with a Debt/EBITDA ratio of 1.7x, slightly beyond its targeted range of 1.0-1.5x. During 2017, the Company plans to reduce its share repurchase target to $600 million from the $800 million planned repurchases originally announced in 2015 to reduce short-term debt. This action, along with the performance indicated by the Company’s 2017 guidance announced on January 25, 2017, should help the Company improve its Debt/EBITDA ratio.

Commitments and Other Contractual Obligations

At December 31, 2016, Grainger's contractual obligations, including estimated payments due by period, are as follows (in thousands of dollars):

	Payments Due by Period
	Total Amounts Committed				Less than 1 Year				1 - 3 Years				4 - 5 Years				More than 5 Years
Debt obligations	$	2,266,176			$	406,106			$	158,009			$	295,065			$	1,406,996
Interest on debt	1,768,974				66,323				131,439				123,878				1,447,334
Operating lease obligations	178,325				59,045				78,120				25,691				15,469
Purchase obligations:
Uncompleted additions to property, buildings and equipment	71,350				69,171				1,871				308				—
Commitments to purchase inventory	469,215				469,215				—				—				—
Other purchase obligations	216,917				121,297				78,461				17,159				—
Other liabilities	200,504				65,757				29,365				31,478				73,904
Total	$	5,171,461			$	1,256,914			$	477,265			$	493,579			$	2,943,703

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

Other liabilities represent future payments for profit sharing and employee benefits plans as determined by actuarial projections and other employee benefit plans. Other employment-related benefits costs of $60 million have not been included in this table as the timing of benefit payments is not predictable. See Note 9 to the Consolidated Financial Statements.

See also Note 8 and Note 10 to the Consolidated Financial Statements for further detail related to interest on long-term debt and operating lease obligations, respectively.

Grainger has recorded a noncurrent liability of approximately $63 million for tax uncertainties and interest at December 31, 2016. This amount is excluded from the table above, as Grainger cannot make reliable estimates of these cash flows by period. See Note 14 to the Consolidated Financial Statements.

Off-Balance Sheet Arrangements

Grainger does not have any material exposures to off-balance sheet arrangements. All significant contractual obligations are recorded on the Company's Consolidated Balance Sheet or fully disclosed in the notes to Grainger's Consolidated Financial Statements.

Critical Accounting Estimates

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

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

Note 1 to the Consolidated Financial Statements describes the significant accounting policies used in the preparation of the Consolidated Financial Statements. The most significant areas involving management judgments and estimates follow. Actual results in these areas could differ materially from management's estimates under different assumptions or conditions.

Allowance for Doubtful Accounts. Grainger considers several factors to estimate the allowance for uncollectible accounts receivable including the age of the receivables, the percent past due and the historical ratio of actual write-offs to the age of the receivables. The analyses performed also take into consideration economic conditions that may have an impact on a specific industry, group of customers or a specific customer. Based on analysis of actual historical write-offs of uncollectible accounts receivable, Grainger's estimates and assumptions have been materially accurate in regards to the valuation of its allowance for doubtful accounts. However, write-offs could be materially different than the reserves established if business or economic conditions change or actual results deviate from historical trends, and Grainger's estimates and assumptions may be revised as appropriate to reflect these changes. For fiscal years 2016, 2015 and 2014, actual results did not vary materially from estimated amounts.

Inventory Reserves. Grainger establishes inventory reserves for excess and obsolete inventory. Grainger regularly reviews inventory to evaluate continued demand and identify any obsolete or excess quantities. Grainger records provisions for the difference between excess and obsolete inventory cost and its estimated realizable value. Estimated realizable value is based on anticipated future product demand, market conditions and liquidation values. As Grainger's inventory consists of approximately 1.6 million stocked products, it is not practical to quantify the actual disposition of excess and obsolete inventory against estimated amounts at a stock keeping unit (SKU) level and no individual SKU is material. There were no material differences noted between reserve levels compared to the level of write-offs historically. Grainger's methodology for estimating reserves is continually evaluated based on current experience and the methodology provides for a materially accurate level of reserves at any reporting date. Actual results could differ materially from projections and require changes to reserves that could have a material effect on Grainger's results of operations, based on significant changes in product demand, market conditions or liquidation value. If business or economic conditions change, Grainger's estimates and assumptions may be revised as appropriate. For fiscal years 2016, 2015 and 2014, actual results did not vary materially from estimated amounts.

Goodwill and Indefinite Lived Intangible Assets. Business acquisitions result in the recording of goodwill and identified intangible assets that affect the amount of amortization expense and possible impairment write-downs that may occur in future periods. Grainger reviews goodwill and intangible assets with indefinite lives for impairment at least annually or when events or changes in circumstances indicate the carrying value of these assets might exceed their current fair values.

Grainger completed the annual impairment testing during the fourth quarter of 2016. For all of the Company’s reporting units, the estimated fair values substantially exceeded the carrying values, except for the Fabory reporting unit. As of the 2015 test, the fair value of the Fabory reporting unit exceeded its $106 million carrying value by 15%. During the current year testing, Grainger considered Fabory’s performance and the revised outlook. Prior branch rationalization initiatives and structural changes in the business contributed to cost improvements. However, declines in sales, primarily in the Netherlands and France, and price pressure contributed to lower earnings for the year. The current year business performance and revised financial projections also reflect market conditions, which continued to be negatively impacted by the downturn in oil and gas and maritime industries in the Netherlands, Fabory’s largest market. The revised outlook and uncertainty beyond 2016 were factored into lower earnings, cash flow projections and long-term expectations for Fabory’s future performance, resulting in the calculated fair value of the reporting unit below its carrying value in step one of the two-step quantitative test, and step two impairment calculations were required. As a result, a $47 million

goodwill impairment charge was recorded with no tax benefit due to the non-deductibility of goodwill in the relevant taxing jurisdictions.

The risk of potential failure of step one of the quantitative tests in future reporting periods is highly dependent upon key assumptions included in the determination of the reporting unit's fair value. The fair value of reporting units is calculated primarily using the discounted cash flow (DCF) method and incorporating value indicators from a market approach to evaluate the reasonableness of the resulting fair values. The DCF method incorporates various assumptions regarding the amount and timing of future expected cash flows, including revenues, gross margins, operating expenses, capital expenditures and working capital based on operational budgets, long-range strategic plans and other estimates. The terminal value growth rate is used to calculate the value of cash flows beyond the last projected period and reflects management’s best estimates for perpetual growth for the reporting units. Estimates of market-participant risk-adjusted weighted average cost of capital are used as a basis for determining the discount rates to apply to the reporting units’ future expected cash flows and terminal value.

Changes in assumptions regarding future performance and unfavorable economic environment may have a significant impact on reporting units' cash flows in the future. Grainger performed a sensitivity analysis to determine the reasonableness of the step one results for the reporting units subject to the two-step quantitative tests and evaluated the impact of a 100 basis point increase in the discount rate or a 100 basis point decrease in the terminal growth rate. No indications of impairment resulted from this sensitivity analysis. Given the sensitivity of the calculated fair value to changes in these key assumptions, Grainger may be required to recognize an impairment for goodwill in the future due to changes in market conditions or other factors related to these key assumptions.

Stock Incentive Plans. Grainger maintains stock incentive plans under which a variety of incentive grants may be awarded to employees and directors. Grainger uses a binomial lattice option pricing model to estimate the fair value of stock option grants. The model requires projections of the risk-free interest rate, expected life, volatility, dividend yield and forfeiture rate of the stock option grants. The fair value of options granted used the following assumptions:

		For the Years Ended December 31,
		2016		2015		2014
Risk-free interest rate		1.4%		1.5%		2.0%
Expected life		6 years		6 years		6 years
Expected volatility		24.5%		24.9%		25.0%
Expected dividend yield		2.0%		1.9%		1.7%

The risk-free interest rate is selected based on yields from U.S. Treasury zero-coupon issues with a remaining term approximately equal to the expected term of the options being valued. The expected life selected for options granted during each year presented represents the period of time that the options are expected to be outstanding based on historical data of option holders' exercise and termination behavior. Expected volatility is based upon implied and historical volatility of the closing price of Grainger's stock over a period equal to the expected life of each option grant. Historical information is also the primary basis for selection of the expected dividend yield assumptions. Because stock option compensation expense is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures, using historical forfeiture experience. The amount of stock option compensation expense is significantly affected by the valuation model and these assumptions. If different assumptions were used, the stock option compensation expense could be significantly different from what is recorded in the current period.

Compensation expense for other stock-based awards is based upon the closing market price on the last trading date preceding the date of the grant. Because the expense for other stock-based awards should reflect the awards ultimately expected to vest, it has been reduced for estimated forfeitures, using historical forfeiture experience.

For additional information concerning stock incentive plans, see Note 11 to the Consolidated Financial Statements.

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

The discount rate assumptions used by management reflect the rates available on high-quality fixed income debt instruments as of December 31, the measurement date, of each year. A higher discount rate reduces the present value of benefit obligations and net periodic benefit costs. As of December 31, 2016, Grainger decreased the discount rate used in the calculation of the postretirement plan obligation from 4.20% to 4.00% to reflect the decrease in market interest rates. Grainger estimates that this decrease could decrease 2017 pretax earnings by approximately $0.8 million. However, other changes in assumptions may increase, decrease or eliminate this effect.

A 1 percentage point change in assumed healthcare cost trend rates would have had the following effects on December 31, 2016 results (in thousands of dollars):

	1 Percentage Point
	Increase				(Decrease)
Effect on total of service and interest cost	$	1,411			$	(1,162	)
Effect on postretirement benefit obligation	27,542				(22,748		)

Grainger used Mortality Table RPH-2014 and changed the mortality improvement scale used to project mortality rates into the future from Mortality Improvement Scale MP-2015 to Mortality Improvement Scale MP-2016 at December 31, 2016. Mortality Table RPH-2014 is a headcount-weighted table that is more appropriate for the measurement of other postretirement employee benefit plans. Scale MP-2016, published by the Society of Actuaries, reflects the most recent data for mortality improvement. Grainger estimates this change could increase 2017 pretax earnings by approximately $0.6 million.

Grainger updated the 2016 census for involuntary terminations that occurred in 2016. Grainger estimates this change could increase 2017 pretax earnings by approximately $0.5 million.

As of December 31, 2016, Grainger adopted a new healthcare trend rate to include a pre and post age 65 trend rate. The alternative trend rates allow for a better estimate of expected trends for this plan. Grainger estimates this change could decrease 2017 pretax earnings by approximately $1.8 million.

Grainger uses the long-term historical return on the plan assets and the historical performance of the S&P 500 and the Total International Composite Index to develop its expected return on plan assets. In 2016, the Company increased the after-tax expected long-term rate of return on plan assets from 6.65% to 7.13% based on the historical average of long-term rates of return due to a change in the estimated tax rate. This change was due to the nature of the taxable income earned on the investments in the Group Benefit Trust and the applicable tax rates. Grainger estimates this change could increase 2017 pretax earnings by approximately $0.8 million.

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

Grainger has used its best judgment in making assumptions and estimates and believes such assumptions and estimates used are appropriate. Changes to the assumptions may be required in future years as a result of actual experience or new trends or plan changes and, therefore, may affect Grainger's retirement plan obligations and future expense. For additional information concerning postretirement healthcare benefits, see Note 9 to the Consolidated Financial Statements.

Income Taxes. The tax balances and income tax expense recognized by Grainger are based on management's interpretations of the tax laws of multiple jurisdictions. Income tax expense reflects Grainger's best estimates and assumptions regarding, among other items, the level of future taxable income, interpretation of tax laws and tax planning opportunities, plans for reinvestment of cash overseas and uncertain tax positions. Future rulings by tax authorities and future changes in tax laws and their interpretation, changes in projected levels of taxable income, changes in planned need for cash overseas and future tax planning strategies could impact the actual effective tax rate and tax balances recorded by Grainger.

Contingent Liabilities. At any time, Grainger may be subject to investigations, legal proceedings or claims related to the ongoing operation of its business, including claims both by and against Grainger. Such proceedings typically involve claims related to product liability, general negligence, contract disputes, environmental issues, unclaimed property, wage and hour laws, intellectual property, employment practices, regulatory compliance or other matters and actions brought by employees, consumers, competitors, suppliers or governmental entities. Grainger retains a significant portion of the risk of certain losses related to workers' compensation, auto liability, general liability and property losses through the utilization of high deductibles and self-insured retentions. Grainger routinely assesses the likelihood of any adverse outcomes related to these matters on a case by case basis, as well as the potential ranges of losses and fees. Grainger establishes accruals for its potential exposures, as appropriate, for claims against Grainger when losses become probable and the financial impact of an adverse outcome is reasonably estimable. Legal fees are recognized as incurred and are not included in accruals for contingencies. Where Grainger is able to reasonably estimate a range of potential losses, Grainger records the amount within that range that constitutes Grainger's best estimate. Grainger also discloses the nature of and range of loss for claims against Grainger when losses are reasonably possible and the exposure is considered material to Grainger's Consolidated Financial Statements. These accruals and disclosures are determined based on the facts and circumstances related to the individual cases and require estimates and judgments regarding the interpretation of facts and laws, as well as the effectiveness of strategies or other factors beyond Grainger's control. If the assessment of any of these factors changes, the estimates may change. Predicting the outcome of claims and litigation, and estimating related costs and exposure, involves substantial uncertainties that could cause actual costs to vary materially from estimates and accruals.

Other. Other significant accounting policies, not involving the same level of measurement uncertainties as those discussed above, are nevertheless important to an understanding of the financial statements. Policies such as revenue recognition, depreciation, intangibles, long-lived assets, fair value measurements and valuations and warranties require judgments on complex matters that are often subject to multiple external sources of authoritative guidance such as the Financial Accounting Standards Board and the Securities and Exchange Commission. Possible changes in estimates or assumptions associated with these policies are not expected to have a material effect on the financial condition or results of operations of Grainger. More information on these additional accounting policies can be found in Note 1 to the Consolidated Financial Statements.

Effects of Inflation and Changing Prices

Grainger is affected by inflation through increased product and operating costs, and the ability to pass on cost increases to customers over time is dependent upon market conditions. The ability to achieve sales growth through increased prices is also subject to inflation and normal competitive conditions. The predominant use of the last-in, first-out (LIFO) method of accounting for inventories and accelerated depreciation methods for financial reporting and income tax purposes result in a substantial recognition of the effects of inflation in the financial statements.

Some of Grainger's products contain significant amounts of commodity-priced materials, such as steel, copper, petroleum derivatives or rare earth minerals, and are subject to price changes based upon fluctuations in the commodities market.

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

Forward-Looking Statements

From time to time, in this Annual Report on Form 10-K, as well as in other written reports and verbal statements, Grainger makes forward-looking statements that are not historical in nature but concern forecasts of future results, business plans, analyses, prospects, strategies, objectives and other matters that may be deemed to be “forward-looking statements” under the federal securities laws. Such forward-looking statements are identified by words such as “anticipate,” “estimate,” “believe,” “expect,” “could,” “forecast,” “may,” “intend,” “plan,” “predict,” “project” and similar terms and expressions.

Grainger cannot guarantee that any forward-looking statement will be realized, although Grainger does believe that its assumptions underlying its forward-looking statements are reasonable. Achievement of future results is subject to risks and uncertainties, many of which are beyond the Company's control, which could cause Grainger's results to differ materially from those that are presented.

Important factors that could cause actual results to differ materially from those presented or implied in a forward-looking statement include, without limitation: higher product costs or other expenses; a major loss of customers; loss or disruption of source of supply; increased competitive pricing pressures; failure to develop or implement new technologies or business strategies; the outcome of pending and future litigation or governmental or regulatory proceedings, including with respect to wage and hour, anti-bribery and corruption, environmental, advertising, privacy and cybersecurity matters; investigations, inquiries, audits and changes in laws and regulations; disruption of information technology or data security systems; general industry or market conditions; general global economic conditions; currency exchange rate fluctuations; market volatility; commodity price volatility; labor shortages; facilities disruptions or shutdowns; higher fuel costs or disruptions in transportation services; natural and other catastrophes; unanticipated weather conditions; loss of key members of management; the Company's ability to operate, integrate and leverage acquired businesses; changes in credit ratings; changes in effective tax rates and other factors identified under Item 1A: Risk Factors and elsewhere in this Form 10-K.

Caution should be taken not to place undue reliance on Grainger's forward-looking statements and Grainger undertakes no obligation to publicly update any of its forward-looking statements, whether as a result of new information, future events or otherwise.