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

General

W.W. Grainger, Inc. (Grainger) is a broad line, business-to-business distributor of maintenance, repair and operating (MRO) supplies and other related products and services with operations primarily in the U.S. and Canada, with a presence in Europe, Asia and Latin America. More than 3 million customers worldwide rely on Grainger for products such as safety, gloves, ladders, motors and janitorial supplies, along with services like inventory management and technical support. These customers represent a broad collection of industries including commercial, government, healthcare and manufacturing. They place orders online, on mobile devices, through sales representatives, over the phone and at local branches. Approximately 5,200 suppliers provide Grainger with approximately 1.7 million products stocked in Grainger's distribution centers (DCs) and branches worldwide.

Grainger’s two reportable segments are the U.S. and Canada. The U.S. operating segment reflects the results of Grainger’s U.S. businesses. The Canada operating segment reflects the results for Acklands – Grainger Inc. and its subsidiaries. Other businesses include the single channel online businesses (Zoro in the U.S. and MonotaRO in Japan) and operations 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 2017 and 2018:

	U.S.						Canada
	Estimated 2017			Forecasted 2018			Estimated 2017			Forecasted 2018
Business Investment	5.1	%		7.9	%		2.3	%		3.5	%
Business Inventory	0.8	%		2.1	%		—			—
Exports	3.4	%		5.3	%		1.1	%		1.8	%
Industrial Production	1.9	%		3.3	%		5.2	%		0.1	%
GDP	2.2	%		2.7	%		3.0	%		2.4	%
Oil Prices	—			—			$51/barrel			$54/barrel
Source: Global Insight (January 2018)

In the U.S., Business Investment and Exports are two major indicators of MRO spending. Per the Global Insight January 2018 forecast, Business Investment is likely to remain on a strong growth path during 2018, supported by expanding global markets, lower capital costs and an improving regulatory climate. Additionally on December 22, 2017, the Tax Cuts and Jobs Act was signed into law, which significantly lowered U.S. corporate income tax rates and introduced accelerated expensing of qualified capital investments, among other changes. These changes to U.S. tax laws may increase capital spending in the U.S. and attract incremental foreign capital to the U.S., which is expected to support export growth.

Per the Global Insight January 2018 forecast, Canada's GDP and industrial production are forecast slow in 2018, while exports and business nonresidental investment (a component of Business Investment) are expected to improve.

Outlook

Grainger’s portfolio consists of its U.S. business, its Canada business and other businesses. Grainger’s imperative to create unique value is focused on: (i) continuing to grow its share of business with large and mid-size customers in the U.S. by executing its high-value sales and service model, building an advantaged digital capability and completing its pricing strategy; (ii) executing a complete business model reset in Canada; (iii) driving profitable growth in its international portfolio and (iv) continuing the strong growth of its single channel businesses by expanding its assortment and innovation around customer acquisition. Grainger is also focused on improving the end-to-end customer experience by making investments in its eCommerce and digital capabilities and executing continuous improvement initiatives within its supply chain, such that customers have a positive experience with Grainger from order to delivery. Grainger intends to continue to reduce its cost base while ensuring that it delivers an effortless customer experience.

On January 24, 2018, Grainger updated its 2018 earnings per share guidance to reflect the 2017 actual results, lower corporate tax rate, lower tax benefit from clean energy, incremental investment in digital and higher share repurchases. The prior earnings per share guidance issued on November 10, 2017 for 2018 was $10.60 to $11.80. The Company still expects 3 to 7 percent sales growth and now expects earnings per share of $12.95 to $14.15 for 2018.

Matters Affecting Comparability

There were 254 sales days in the full year 2017 and 255 sales days in the full years 2016 and 2015. Grainger completed one divestiture in 2017 and one acquisition in 2015, 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
	2017 (A)				2016 (A)				2017			2017			2016
Net sales	$	10,425			$	10,137			3	%		100.0	%		100.0	%
Cost of merchandise sold	6,327				6,023				5	%		60.7			59.4
Gross profit	4,098				4,115				—	%		39.3			40.6
Warehousing, marketing and administrative expenses	3,049				2,995				2	%		29.3			29.6
Operating earnings	1,049				1,119				(6	)%		10.1			11.0
Other expense, net	113				100				13	%		1.1			1.0
Income taxes	313				386				(19	)%		3.0			3.8
Net earnings	622				633				(2	)%		6.0			6.2
Noncontrolling interest	37				27				36	%		0.4			0.3
Net earnings attributable to W.W. Grainger, Inc.	$	586			$	606			(3	)%		5.6	%		6.0	%

(A) May not sum due to rounding

2017 Compared to 2016

Grainger's net sales were $10,425 million for 2017, an increase of 3%, when compared with net sales of $10,137 million for the comparable 2016 period. On a daily basis, the 3% increase for the year consisted of the following:

	Percent Increase/ (Decrease)
Volume	8
Divestiture	(1)
Price	(4)
Total	3%

The increase in net sales was primarily driven by the single channel online businesses in the U.S. and Japan, as well as volume increases in the U.S. business as a result of the pricing actions. The U.S. business pricing actions were primarily implemented in the first and third quarters of 2017 and included adjusting list price and introducing new lower web prices on the entire business assortment, which drove faster growth in 2017 through share gains with existing customers and acquisition of new customers. Refer to the Segment Analysis below for further details.

In 2017, eCommerce sales for Grainger were $5,283 million, an increase of 11% over the prior year. Total eCommerce sales represented 51% and 47% of total sales for 2017 and 2016, respectively. The increase was primarily driven by Grainger.com and other electronic purchasing platforms in the U.S. and across all single channel online businesses.

If the Company included KeepStock®, total eCommerce and KeepStock® sales would represent 56% and 53% of total sales for 2017 and 2016, respectively. Refer to the Segment Analysis below for further details.

Gross profit of $4,098 million for 2017 was down $17 million compared with $4,115 million for 2016. The gross profit margin for 2017 was 39.3%, down 1.3 percentage points versus 2016, driven primarily by the pricing actions in the U.S. business.

Operating expenses of $3,049 million for 2017 increased 2% from $2,995 million for 2016. Excluding restructuring costs, gains on the sale of assets and other charges in both periods as noted below, operating expenses increased 3%, driven primarily by higher employee related costs.

Operating earnings of $1,049 million for 2017 decreased 6% from $1,119 million for 2016. Excluding restructuring costs, gains on the sale of assets and other charges in both periods as noted below, operating earnings decreased 8% or $107 million, driven primarily by lower gross profit and higher operating expenses.

Other expense, net was $113 million in 2017 compared to $100 million of expense in 2016. The increase in expense was primarily due to incremental interest expense on $400 million in long-term debt issued in May 2016 and $400 million in long-term debt issued in May 2017, as well as higher operating losses from the Company's clean energy investments.

Income taxes of $313 million in 2017 decreased 19% compared with $386 million in 2016. Grainger's effective tax rates were 33.5% and 37.9% in 2017 and 2016, respectively. The lower rate versus the prior year is due to discrete tax items and U.S. tax legislation.

On December 22, 2017, the Tax Cuts and Jobs Act (the Tax Act) was signed into law, which significantly revised the U.S. corporate income tax system by lowering corporate income tax rates from 35% to 21% effective January 1, 2018, allowing accelerated expensing of qualified capital investments for a specific period, limiting net interest expense deductions and transitioning U.S. international taxation from a worldwide to a territorial tax system, among other changes. Grainger recognized a net provisional tax benefit of $3.2 million for the year ended December 31, 2017, related to the estimated impact of the Tax Act. See Note 14 to the Consolidated Financial Statements for additional information.

Grainger projects a tax rate of 23% to 26% for 2018, which includes the impact of the Tax Act.

The table below reconciles reported net earnings determined in accordance with U.S. generally accepted accounting principles (GAAP) to adjusted net earnings, a non-GAAP measure. Management believes adjusted net earnings 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. (In thousands of dollars):

	Twelve Months Ended
	December 31,
	2017				2016			%
Net earnings reported	$	585,730			$	605,928		(3	)%
Restructuring (U.S.)	30,352				21,234
Branch gains (U.S.)	(20,620		)		(11,421		)
Other (gains) charges (U.S.)	(2,830		)		28,531
Restructuring (Canada)	30,390				11,085
Inventory reserve adjustment (Canada)	—				7,278
Restructuring (Other businesses)	55,324				—
Other charges (Other businesses)	—				52,318
Restructuring (Unallocated expense)	6,647				5,603
U.S. tax legislation	(3,250		)		—
Discrete tax items	(12,123		)		(9,378		)
Subtotal	83,890				105,250
Net earnings adjusted	$	669,620			$	711,178		(6	)%

Net earnings attributable to W.W. Grainger, Inc. for 2017 decreased by 3% to $586 million from $606 million in 2016. The decrease in net earnings primarily resulted from lower operating earnings, partially offset by lower income taxes. Excluding the net charges from both years mentioned above and discrete tax items, net earnings decreased 6%.

Diluted earnings per share of $10.02 in 2017 were 2% higher than $9.87 for 2016, due to lower average shares outstanding partially offset by lower earnings. Excluding the charges mentioned above, diluted earnings per share would have been $11.46 compared to $11.58 in 2016, a decrease of 1%.

2016 Compared to 2015

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)				2016				2016			2015
Net sales	$	10,137			$	9,973			2	%			100.0	%		100.0	%
Cost of merchandise sold	6,023				5,742				5	%			59.4			57.6
Gross profit	4,115				4,231				(3	)%			40.6			42.4
Warehousing, marketing and administrative expenses	2,995				2,931				2	%			29.6			29.4
Operating earnings	1,119				1,300				(14	)%			11.0			13.0
Other expense, net	100				50				102	%			1.0			0.5
Income taxes	386				466				(17	)%			3.8			4.7
Net earnings	633				785				(19	)%			6.2			7.9
Noncontrolling interest	27				16				66	%			0.3			0.2
Net earnings attributable to W.W. Grainger, Inc.	$	606			$	769			(21	)%			6.0	%		7.7	%

(A) May not sum due to rounding

Grainger's net sales were $10,137 million for 2016, 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%

In the U.S. business, 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. The increase in sales in 2016 was also due to the acquisition of Cromwell on September 1, 2015.

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®, total eCommerce and KeepStock® sales would represent 53% 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. Excluding the charges from both years mentioned above, operating expenses decreased 1% primarily due to lower employee benefit costs.

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%.

Other expense, net 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 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 nondeductible 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.

The table below reconciles reported net earnings determined in accordance with U.S. generally accepted accounting principles (GAAP) to adjusted net earnings, a non-GAAP measure. Management believes adjusted net earnings 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. (In thousands of dollars):

	Twelve Months Ended
	December 31,
	2016				2015			%
Net earnings reported	$	605,928			$	768,996		(21	)%
Restructuring (U.S.)	21,234				22,231
Branch gains (U.S.)	(11,421		)		—
Other charges (U.S.)	28,531				—
Restructuring (Canada)	11,085				3,090
Inventory reserve adjustment (Canada)	7,278				—
Restructuring (Other businesses)	—				4,814
Other charges (Other businesses)	52,318				—
Restructuring (Unallocated expense)	5,603				(24		)
Discrete tax items	(9,378		)		(5,984		)
Subtotal	105,250				24,127
Net earnings adjusted	$	711,178			$	793,123		(10	)%

Net earnings attributable to W.W. Grainger, Inc. 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%.

Segment Analysis - 2017 Compared to 2016

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 $7,960 million for 2017, an increase of $90 million, or 1% when compared with net sales of $7,870 million for 2016. On a daily basis, the 2% increase consisted of the following:

	Percent Increase/(Decrease)
Volume	7
Intercompany sales to Zoro	1
Divestiture	(1)
Price	(5)
Total	2%

Sales to customers in natural resources, resellers and retail end markets increased mid-single digits, while heavy manufacturing and government increased low single digits. The sales growth was partially offset by declines in contractors and commercial services. Volume increased year over year, primarily driven by the pricing actions.

In 2017, eCommerce sales for the U.S. business were $3,909 million, an increase of 7% over the prior year. Total eCommerce sales represented 49% and 46% of total sales for 2017 and 2016, respectively. The increase was primarily driven by Grainger.com and other electronic purchasing platforms. If the U.S. business included KeepStock®, total eCommerce and KeepStock® sales would represent 55% and 53% of total sales for 2017 and 2016, respectively.

Gross profit margin decreased 1.7 percentage points in 2017 compared to 2016, primarily driven by price deflation exceeding higher volume in response to pricing actions.

Operating expenses of $1,994 were down 2% for 2017 versus 2016. Excluding restructuring costs, net gains on the sale of assets and other charges in both periods mentioned above, operating expenses increased 1% or $19 million, driven by higher employee related costs. See Note 6 to the Consolidated Financial Statements.

Operating earnings of $1,213 million for 2017 decreased 5% versus $1,275 million in 2016. Excluding restructuring costs, gains on the sale of assets and other charges in both periods mentioned above, operating earnings decreased 9% or $116 million, driven primarily by price deflation. See Note 6 to the Consolidated Financial Statements.

Canada

Net sales were $753 million for 2017, an increase of $19 million, or 3%, when compared with $734 million for 2016. On a daily basis, the 3% increase consisted of volume across all end segments.

In 2017, eCommerce sales for the Canada business were $135 million, an increase of 38% over the prior year. Total eCommerce sales represented 18% and 13% of total sales for 2017 and 2016, respectively. If the Canada business included KeepStock®, total eCommerce and KeepStock® sales would represent 32% and 26% of total sales for 2017 and 2016, respectively.

Gross profit margin increased 1.0 percentage point in 2017 versus 2016, primarily due to a favorable comparison to an inventory adjustment in the second quarter of 2016 that did not repeat in 2017, partially offset by price deflation, cost inflation and higher freight costs from an increase in shipping directly to customers in 2017.

Operating expenses decreased 9% in 2017 versus 2016. Excluding restructuring costs in both periods, operating expenses would have increased 3%, primarily related to higher professional service fees related to the business transformation.

Operating losses of $77 million for 2017 increased versus operating losses of $65 million in 2016. Excluding the restructuring costs and the inventory adjustment, operating losses would have been $37 million compared to $41 million in the prior year.

Other businesses

Net sales for other businesses were $2,120 million for 2017, an increase of $235 million, or 12%, when compared to $1,885 million for 2016. The net sales increase was primarily due to incremental sales at Zoro and MonotaRO. On a daily basis, the 13% increase consisted of the following:

	Percent Increase/(Decrease)
Volume	15
Foreign exchange	(2)
Total	13%

Operating earnings for other businesses were $56 million for 2017 compared to $41 million for 2016. Excluding restructuring charges in 2017 and the goodwill and intangible impairment charges of $52 million in the Fabory and Colombia businesses in the prior year, operating earnings increased $18 million or 19%, due to strong performance from the single channel online businesses.

Segment Analysis - 2016 Compared to 2015

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 consisted of the following:

	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 were 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 U.S. business included KeepStock®, the electronic inventory management offering, total eCommerce and KeepStock® sales would represent 53% of total sales.

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%.

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 consisted of the following:

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

Sales performance in the Canada business 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 Canada 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 Canada 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 Canada business included KeepStock®, total eCommerce and KeepStock® sales would represent 26% of total sales.

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 business 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 were $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 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 September 1, 2015 Cromwell acquisition and incremental sales at Zoro and MonotaRO. The 34% increase consisted of the following:

	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.

Financial Condition

Grainger expects its strong working capital position, cash flows from operations and borrowing capacity to continue, allowing it to fund its operations, growth initiatives and capital expenditures as well as pay cash dividends, repurchase shares and repay its long-term debt obligations while maintaining an adequate credit rating.

Cash and Cash Equivalents

At December 31, 2017, 2016 and 2015, Grainger had cash and cash equivalents of $327 million, $274 million and $290 million, respectively. Approximately 64%, 72% and 76% were outside the U.S. business as of December 31, 2017, 2016 and 2015, respectively. Grainger has no material limits or restrictions on its ability to use or access these foreign liquid assets.

Cash Flow

2017 Compared to 2016

Net cash provided by operating activities was $1,057 million and $1,024 million for the twelve months ended December 31, 2017 and 2016, respectively. The increase in cash provided by operating activities is primarily the result of lower payments related to employee benefits, partially offset by lower earnings and higher working capital.

Net cash used in investing activities was $146 million and $262 million for the twelve months ended December 31, 2017 and 2016, respectively. The decrease in net cash used in investing activities was driven by lower additions to property, buildings and equipment compared to the prior year and higher proceeds primarily from the sales of branch real estate assets in the U.S. and a U.S. business divestiture when compared to the prior year.

Net cash used in financing activities was $867 million and $776 million in the twelve months ended December 31, 2017 and 2016, respectively. The increase in net cash used in financing activities was primarily driven by lower proceeds of long-term debt and higher net payments of commercial paper, offset by lower stock repurchases in 2017 compared to 2016 and lower payments of long-term debt.

2016 Compared to 2015

Net cash provided by operating activities was $1,024 million and $1,036 million for the twelve months ended December 31, 2016 and 2015, respectively. Net cash provided had been reported as $1,003 million and $990 million in 2016 and 2015, respectively. The $1,024 million and $1,036 million reflects the adoption of ASU 2016-09, Stock Based Compensation: Improvement to Employee Shared-Based Payment Accounting, which required retrospective

reclassification of $21 million and $46 million from operating activities to financing activities for 2016 and 2015, respectively. The reclassification relates to employee taxes paid as part of the exercise of stock options.

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 $776 million and $109 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.

Working Capital

Internally generated funds are the primary source of working capital and funds used for growth initiatives and capital expenditures. Grainger's working capital is not impacted by significant seasonality trends throughout the year.

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 $1,669 million at December 31, 2017, compared with $1,722 million at December 31, 2016, primarily due to an increase in accounts receivable offset by increases in current liabilities. At these dates, the ratio of current assets to current liabilities was 2.2 and 2.4, respectively.

Capital Expenditures

In each of the past three years, a portion of the Company's net cash flows has been used for additions to property, buildings, equipment and capitalized software (presented in Intangibles - net on the Consolidated Balance Sheet) as summarized in the following table (in thousands of dollars):

	For the Years Ended December 31,
	2017				2016				2015
Land, buildings, structures and improvements	$	108,753			$	70,942			$	86,082
Furniture, fixtures, machinery and equipment	65,996				139,474				202,137
Subtotal	174,749				210,416				288,219
Capitalized software	62,534				73,833				85,649
Total	$	237,283			$	284,249			$	373,868

In 2017, the Company continued to invest in its worldwide distribution network (e.g. new or expanding existing facilities and technology), digital platforms (e.g. eCommerce websites and inventory management solutions), capital maintenance of its existing branch networks across the enterprise and other supporting information technology assets.

In 2016, the Company continued to invest in the North America distribution network, as well as the distribution network in other businesses 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, the Company 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 included the eCommerce platform, sustaining capital investments for Grainger's branches and distribution centers and other technology infrastructure.

In 2018, capital expenditures are expected to range from $290 million to $330 million. Projected spending includes continued investments in the supply chain, eCommerce/digital and inventory management solutions. Grainger expects to fund 2018 capital spending primarily from operating cash flows.

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 (short-term current and long-term) as a percent of total capitalization was 56.2% and 54.1%, as of December 31, 2017 and 2016, respectively.

Over the last three years, Grainger issued $1.8 billion in long-term debt to partially fund the repurchase of $2.8 billion in shares of the total $3 billion previously announced. The remaining amount was funded from internally generated cash. Debt was issued as follows:

•	In June 2015, $1.0 billion payable in 30 years and carries a 4.60% interest rate, payable semiannually.

•	In May 2016, $400 million payable in 30 years and carries a 3.75% interest rate, payable semiannually.

•	In May 2017, $400 million payable in 30 years and carries a 4.20% interest rate, payable semiannually.

Refer to Note 7 and Note 8 to the Consolidated Financial Statements included in Item 8.

The Company ended 2017 with a Debt/EBITDA ratio of 1.8x 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.

Commitments and Other Contractual Obligations

At December 31, 2017, 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	$	2,365,795			$	94,312			$	334,930			$	136,553			$	1,800,000
Interest on debt	2,197,909				83,002				161,853				156,604				1,796,450
Operating lease obligations	196,544				63,625				82,594				34,446				15,879
Purchase obligations:
Uncompleted additions to property, buildings and equipment	68,806				68,287				346				173				—
Commitments to purchase inventory	541,834				541,834				—				—				—
Other goods and services	141,883				98,843				36,481				6,474				85
Other liabilities	130,256				91,879				9,703				6,569				22,105
Total	$	5,643,027			$	1,041,782			$	625,907			$	340,819			$	3,634,519

See Notes 7, 8 and 10 to the Consolidated Financial Statements for further detail related to debt, interest on debt and operating lease obligations.

Purchase obligations 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 other employee benefit plans.

The Company’s obligation for the postretirement healthcare benefits plan, as determined by actuarial projections, is $208 million at December 31, 2017. The Company has established a Group Benefit Trust (Trust) to fund the plan obligations. The Trust assets available for benefits payments are $189 million at December 31, 2017. The Company has no minimum funding requirements and the timing and amounts of the Company’s additional contributions into the Trust have not been determined. Other employment-related benefits obligations of $65 million have also not been included in this table as the timing of benefit payments is not predictable. See Note 9 to the Consolidated Financial Statements for further detail.

Grainger has recorded a noncurrent liability of approximately $45 million for tax uncertainties and interest at December 31, 2017. This amount is excluded from the table above, as Grainger cannot predict the timing of these cash payments 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 disclosed in the notes to Grainger's Consolidated Financial Statements.

Critical Accounting Estimates

Note 1 to the Consolidated Financial Statements describes the significant accounting policies used in the preparation of the Consolidated Financial Statements. As discussed in Note 1, 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 about future events that affect the amounts reported in the financial statements and accompanying notes.

Accounting policies and estimates are considered critical when they require management to make subjective and complex judgments, estimates and assumptions about matters that have a material impact on Grainger's financial statements and accompanying notes.

The Company believes that the following discussion addresses Grainger’s most critical accounting policies and estimates.

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 2017, 2016 and 2015, 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 1.7 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 2017, 2016 and 2015, 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 tests reporting units’ goodwill and intangible assets for impairment annually during the fourth quarter and more frequently if impairment indicators exist. Grainger periodically performs qualitative assessments of significant events and circumstances such as reporting units' historical and current results, assumptions regarding future performance, strategic initiatives and overall economic factors to determine the existence of impairment indicators and assess if it is more likely than not that the fair value of the reporting unit or indefinite-lived intangible assets is less than its carrying value and if a quantitative impairment test is necessary. In the quantitative test, Grainger compares the carrying value of the reporting unit or an indefinite-lived intangible asset with its fair value. Any excess of the carrying value over fair value is recorded as an impairment charge.

The fair value of reporting units is calculated primarily using the discounted cash flow (DCF) method and utilizing value indicators from a market approach to evaluate the reasonableness of the resulting fair values. The DCF method incorporates various assumptions including 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.

Grainger’s indefinite-lived intangibles are primarily trade names. The fair value of trade names is calculated primarily using the relief from royalty method, which estimates the expected royalty savings attributable to the ownership of the trade name asset. The key assumptions when valuing a trade name are the revenue base, the royalty rate and the discount rate.

The Company performed its annual tests of goodwill and indefinite-lived intangible assets for impairment, including qualitative assessments of all of its reporting units’ goodwill and intangible assets with indefinite lives. Quantitative tests of the Company’s reporting unit in Canada and the Cromwell reporting unit in other businesses were also performed due to lower-than-expected operating performance and lowered short-term forecasts. Based on the results of the quantitative tests performed, the fair values of these reporting units exceeded their carrying values by approximately 31 percent for the Canada reporting unit and 15 percent for the Cromwell reporting unit.

The Company performed sensitivity analyses on the reporting units’ fair values utilizing alternate assumptions that reflect reasonably possible changes to future assumptions. Holding all other assumptions constant, the impact of a 100 basis point increase in discount rates or a 100 basis point decrease in terminal growth rates would have not resulted in the reporting units failing the quantitative tests.

While the Company’s impairment test and respective sensitivity analyses supported no impairment of goodwill and intangibles, the risk of potential failure of quantitative tests in future reporting periods is highly dependent upon key assumptions included in the determination of reporting unit or intangible fair values. Changes in assumptions regarding future performance and the ability to execute on growth initiatives and productivity improvements may have a significant impact on future cash flows. Likewise, changes in terminal value and discount rate assumptions, unfavorable economic environment or market conditions and other factors may result in future impairments of goodwill and intangible assets. The Company will continue to monitor results and projected cash flows to assess whether goodwill or intangible impairments may be necessary.

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.

During the third quarter of 2017, the Company implemented plan design changes effective January 1, 2018, for the post-65 age group. This plan change will move all post-65 Medicare eligible retirees to healthcare exchanges and provide them a subsidy to purchase insurance. The amount of the subsidy will be based on years of service. The plan obligation was remeasured as a result of this plan design change. The Company has elected to amortize the amount of net unrecognized gains over a period equal to the average remaining service period for active plan participants expected to retire and receive benefits. Grainger estimates that this plan change could increase 2018 pretax earnings by approximately $5.3 million. However, other changes in assumptions may increase, decrease or eliminate this effect.

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, 2017, Grainger decreased the discount rate used in the calculation of the postretirement plan obligation from 4.00% to 3.44% to reflect the decrease in market interest rates. Grainger estimates that this decrease could decrease 2018 pretax earnings by approximately $2.0 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, 2017 results (in thousands of dollars):

	1 Percentage Point
	Increase				(Decrease)
Effect on total of service and interest cost	$	1,269			$	(1,053	)
Effect on postretirement benefit obligation	5,516				(5,095		)

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-2016 to Mortality Improvement Scale MP-2017 at December 31, 2017. Mortality Table RPH-2014 is a headcount-weighted table that is more appropriate for the measurement of other postretirement employee benefit plans. Scale MP-2017, published by the Society of Actuaries, reflects the most recent data for mortality improvement. Grainger estimates this change could increase 2018 pretax earnings by approximately $0.2 million.

Grainger updated the 2017 census for involuntary terminations that occurred in 2017. Grainger estimates this change could increase 2018 pretax earnings by approximately $0.9 million.

When assumptions are selected, expected results can vary from actual results. Grainger's expected results varied from actual results for both expected return on plan assets and benefit payments. Grainger estimates this impact could increase 2018 pretax earnings by approximately $2.9 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. On December 22, 2017, the Tax Cuts and Jobs Act was signed into law, which significantly revised the U.S. corporate income tax system including lowering the corporate income tax rates from 35% to 21% effective January 1, 2018. See Note 14 to the Consolidated Financial Statements for additional information.

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, customers, competitors, suppliers or governmental entities. As a government contractor selling to federal, state and local governmental entities, the Company is also subject to governmental or regulatory inquiries or audits or other proceedings, including those related to contract administration or to pricing compliance. 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, communications 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 implementation, timing and results of the Company's strategic pricing initiatives and other responses to market pressures; 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.