Overview
General. Grainger distributes facilities maintenance products and provides services and related information used by businesses and institutions primarily in the United States, Canada and Mexico to keep their facilities and equipment running. Grainger reports its operating results in three segments: Grainger Branch-based, Acklands - Grainger Branch-based (Acklands - Grainger) and Lab Safety Supply, Inc. (Lab Safety). Grainger distributes a wide range of products used by businesses and institutions to keep their facilities and equipment up and running. Grainger uses a multichannel business model to provide customers with a range of options for finding and purchasing products through a network of branches, sales representatives, direct marketing including catalogs, and a variety of electronic and Internet channels. Grainger serves customers through 617 branches, 18 distribution centers and multiple Web sites.

Business Environment. Several economic factors and industry trends shape Grainger's business environment. The current overall economy and leading economic indicators provide insight into anticipated economic factors for the near term and help in forming the development of projections for the upcoming year. In February 2009, Consensus Forecast-USA projected a 2009 GDP decline of 2.1% and an Industrial Production decline of 7.2% for the United States, as compared to 2008 GDP growth of 1.3% and a 1.7% decline in Industrial Production. In February 2009, Consensus Forecast-USA projected a GDP decline of 1.1% for Canada, as compared to the 2008 growth estimate of 0.6%.

Historically, Grainger's sales trends have tended to correlate positively with industrial production growth and non-farm payrolls. In more recent years, Grainger's sales growth in the United States has outperformed both economic indicators. For the first five months of 2008, Grainger benefited from the growth in industrial production and non-farm payrolls. Both economic indicators began to deteriorate in May 2008, however, Grainger continued to outperform both until late 2008, at which time Grainger's sales began to be negatively affected by the economic downturn.

The light and heavy manufacturing customer sectors, which comprised approximately 25% of Grainger's total 2008 sales, have historically correlated with manufacturing employment levels and manufacturing production. Manufacturing employment levels in the United States declined approximately 5.7% from December 2007 to December 2008, while manufacturing output decreased 9.9% from December 2007 to December 2008. This decline in manufacturing employment and output contributed to low single-digit sales growth in the light manufacturing customer sector and flat sales growth in the heavy manufacturing customer sector for Grainger in 2008.

Given the steep decline in the economic trends in Grainger's markets in the fourth quarter of 2008, it is difficult to project future results. During the fourth quarter, Grainger began implementing contingency plans to deal with the changing environment, which included a hiring freeze on all non-customer-facing positions, a reduction in hours of part-time employees and a significant reduction to travel, consulting and relocation expenses. In response to a continuing decline in sales, on February 11, 2009, Grainger announced plans to freeze salaries of all executives and salaried employees and indicated that the payment of management incentive bonuses for 2009 would occur only if Grainger meets aggressive sales targets. Additionally, Grainger announced 300 to 400 jobs would be eliminated as a result of lower sales volume and the combination of its Lab Safety Supply and Grainger Industrial Supply businesses, resulting in annualized cost savings of between $25 million and $35 million. See Note 22 to the Consolidated Financial Statements.

In 2004, Grainger launched a multiyear market expansion program in the United States to strengthen its presence in top metropolitan markets and better position itself to serve the local customer. The expansion program was completed in 2008, however, the benefits realized from this initiative are expected to continue.

In 2006, Grainger launched a multiyear product line expansion program in the United States. Over the past three years, Grainger has added over 150,000 new products to supplement Industrial Supply's plumbing, fastener, material handling and security product lines. The product line expansion program contributed to the sales growth in 2007 and 2008, and is expected to be a driver of growth in 2009 and beyond. In 2009, Grainger expects to add 50,000 new products to further supplement Industrial Supply's product lines.

Grainger's financial strength enables it to fund major initiatives, acquisitions and productivity improvements. Capital spending in 2008 for the U.S. market expansion program was approximately $40 million, with total capital expenditures of $196 million.

Capital expenditures are expected to range from $175 million to $200 million in 2009. Projected investments include improved infrastructure in distribution centers, both in the U.S. and Canada, information technology, including

upgraded electronic commerce platforms, and the normal recurring replacement of equipment. Grainger expects to fund 2009 capital investments from operating cash flows, with spending planned for the following major projects:

· $90 million to $105 million for supply chain infrastructure;

· $15 million to $35 million for information technology.

Matters Affecting Comparability. There were 256 sales days in 2008, compared to 255 sales days in 2007 and 254 sales days in 2006.

Since June 2008, Grainger's operating results have included the operating results of Excel F.I.G. Inc. (Excel) in the Acklands - Grainger segment, and since July 2008 Grainger's operating results have included the operating results of Highsmith Inc. (Highsmith) in the Lab Safety segment.

Since May 2007, Grainger's operating results have included the operating results of McFeely's Square Drive Screws (McFeely's) in the Lab Safety segment.

See Note 3 to the Consolidated Financial Statements for additional information regarding business acquisitions.

Results of Operations
The following table is included as an aid to understanding changes in Grainger's Consolidated Statements of Earnings:

                                                      For the Years Ended December 31,
                                                                               Percent Increase/(Decrease)
                                      As a Percent of Net Sales                      from Prior Year
                                  2008           2007          2006             2008                  2007

Net sales                           100.0 %        100.0 %       100.0 %              6.7 %                9.1 %
Cost of merchandise sold             59.0           59.4          60.0                6.0                  8.1
Gross profit                         41.0           40.6          40.0                7.9                 10.6
Operating expenses                   29.6           30.1          30.2                4.8                  8.8
Operating earnings                   11.4           10.5           9.8               16.7                 16.0
Other income (expense)               (0.1 )          0.2           0.4             (184.3 )              (55.1 )
Income taxes                          4.4            4.1           3.7               13.8                 19.2
Net earnings                          6.9 %          6.6 %         6.5 %             13.1 %                9.6 %

2008 Compared to 2007
Grainger's net sales of $6,850.0 million for 2008 increased 6.7% when compared with net sales of $6,418.0 million for 2007. There was one more selling day in 2008 versus 2007. Daily sales were up 6.3%. The increase in net sales was led by high single-digit sales growth in the government sector, and mid single-digit sales growth in the commercial and reseller sectors. Approximately 1 percentage point of the sales growth came from Grainger's product line expansion initiative and approximately 5 percentage points came from price and volume. Refer to the Segment Analysis below for further detail of Grainger's ongoing strategic initiatives.

The gross profit margin for 2008 improved 0.4 percentage point to 41.0% from 40.6% in 2007. The improvement in the gross profit margin was primarily driven by positive inflation recovery, partially offset by unfavorable selling price category mix.

Operating earnings of $782.7 million for 2008 increased 16.7% over the $670.7 million for 2007. This earnings improvement exceeded the sales growth rate due to an improved gross profit margin and positive operating expense leverage.

Net earnings for 2008 increased by 13.1% to $475.4 million from $420.1 million in 2007. The growth in net earnings for 2008 primarily resulted from the improvement in operating earnings, partially offset by lower interest income, higher interest expense and the write-off of Grainger's $6.0 million investment in Asia Pacific Brands India Ltd. (Asia Pacific Brands). Diluted earnings per share of $6.04 in 2008 were 22.3% higher than the $4.94 for 2007. This improvement was higher than the percentage increase for net earnings due to the effect of Grainger's share repurchase program.

Segment Analysis
The following comments at the segment level include external and intersegment net sales and operating earnings. Comments at the business unit level include external and inter- and intrasegment net sales and operating earnings. See Note 18 to the Consolidated Financial Statements.

Grainger Branch-based
Net sales were $5,678.8 million for 2008, an increase of $326.3 million, or 6.1%, when compared with net sales of $5,352.5 million for 2007. Daily sales were up 5.7%. Daily sales in the United States were up 5.5%. Sales were led by high single-digit sales growth in the government sector, and mid single-digit sales growth in the commercial and

reseller sectors. Approximately 2 percentage points of the sales growth came from Grainger's product line expansion initiative and approximately 4 percentage points came from price and volume. Sales volume was negatively affected by approximately 1 percentage point due to a decline in sales of seasonal products.

In 2004, Grainger launched a multiyear market expansion program to strengthen its presence in top metropolitan markets and better position itself to serve local customers. The market expansion program was completed in 2008, however, the benefits realized from this initiative are expected to continue.

Consistent with the overall downturn in the economy, beginning in October most of these markets saw negative sales growth, which significantly affected sales growth for 2008. Results for the market expansion program were as follows:

                                                                      Daily Sales
                                                                       Increase
                                                                     2008 vs. 2007
Phase 1 (Atlanta, Denver, Seattle)                                           7%
Phase 2 (Four markets in Southern California)                                5%
Phase 3 (Houston, St. Louis, Tampa)                                         10%
Phase 4 (Baltimore, Cincinnati, Kansas City, Miami,
Philadelphia, Washington, D.C.)                                              2%
Phase 5 (Dallas, Detroit, New York, Phoenix)                                 3%
Phase 6 (Chicago, Minneapolis, Pittsburgh, San Francisco)                    6%

Over the past three years, Grainger has added over 150,000 new products to supplement Industrial Supply's plumbing, fastener, material handling and security product lines as part of its ongoing product line expansion initiative. The most recent catalog, issued in 2009, offers a total of 237,000 products, an increase of 50,000 products over the 2008 catalog.

Sales in Mexico increased 11.9% in 2008 versus 2007. Daily sales were up 11.5%. In local currency, daily sales were up 12.7%, driven primarily by increased market share coming from the ongoing branch expansion program.

The segment gross profit margin increased 0.5 percentage point in 2008 over 2007, driven primarily by positive inflation recovery, partially offset by unfavorable selling price category mix.

Operating expenses in this segment were up 3.4% in 2008. Expenses grew at a slower rate than sales primarily due to lower advertising expenses, bonus accruals, severance and lower bad debt expense, the result of improved collection efficiency.

For the segment, operating earnings of $782.7 million for 2008 increased 16.9% over the $669.4 million for 2007. This earnings improvement exceeded the sales growth rate due to an improved gross profit margin and positive operating expense leverage.

Acklands - Grainger Branch-based
Net sales at Acklands - Grainger were $728.0 million for 2008, an increase of $91.5 million, or 14.4%, when compared with $636.5 million for 2007. Daily sales were up 13.9%. In local currency, daily sales increased 13.1%. The increase was led by sales growth in the contractor, agriculture and mining and government sectors.

The gross profit margin increased 0.3 percentage points in 2008 over 2007. The improvement in the gross profit margin was primarily due to positive inflation recovery.

Operating expenses were up 13.7% in 2008. The increase in operating expenses was primarily due to payroll and benefits as a result of increased headcount, merit increases and commissions, and higher advertising and occupancy expenses, and expenses related to the bankruptcy of a provider of freight payment services.

Operating earnings of $54.3 million for 2008 were up $10.0 million, or 22.7%. This earnings improvement exceeded the sales growth rate due to an improved gross profit margin and operating expenses that grew at a slower rate than sales.

Lab Safety
Net sales at Lab Safety were $450.7 million for 2008, an increase of $16.0 million, or 3.7%, when compared with $434.7 million for 2007. Daily sales were up 3.3%. Excluding sales from the Highsmith acquisition, sales declined 3.3%.

The gross profit margin decreased 0.6 percentage point in 2008 over 2007, driven primarily by unfavorable selling price category mix and product mix.

Operating expenses were up 10.0% in 2008. Expenses grew at a faster rate than sales primarily due to costs associated with the Highsmith acquisition.

Operating earnings of $45.4 million for 2008 were down 16.4% over 2007. Operating earnings were down as a result of lower gross profit margins and higher operating expenses.

Other Income and Expense
Other income and expense was $9.5 million of expense in 2008, a decrease of
$20.7 million as compared with $11.2 million of income in 2007. The following
table summarizes the components of other income and expense (in thousands of
dollars):

                                                      For the Years Ended December 31,
                                                         2008                  2007
Other income and (expense):
Interest income (expense) - net                     $        (9,416 )     $         9,151
Equity in net income of unconsolidated entities               3,642                 2,016
Write-off of investment in unconsolidated entity             (6,031 )                   -
Unclassified - net                                            2,351                    41
                                                    $        (9,454 )     $        11,208

The change from net interest income to net interest expense was primarily attributable to the four-year bank term loan obtained in May 2008. The write-off of the investment relates to Asia Pacific Brands as described in Note 6 to the Consolidated Financial Statements. Unclassified - net increased primarily due to higher foreign exchange transaction gains.

Income Taxes
Income taxes of $297.9 million in 2008 increased 13.8% as compared with $261.7 million in 2007.

Grainger's effective tax rates were 38.5% and 38.4% in 2008 and 2007, respectively. Excluding the effect of after tax items related to the write-off and the earnings of unconsolidated entities, the effective income tax rates were 38.4% and 38.5% for 2008 and 2007, respectively.

For 2009, Grainger is projecting its estimated effective tax rate to be approximately 38.9%, excluding equity in net income of unconsolidated entities.

2007 Compared to 2006
Grainger's net sales of $6,418.0 million for 2007 increased 9.1% when compared with net sales of $5,883.7 million for 2006. There was one more selling day in 2007 versus 2006. Daily sales were up 8.7%. The increase in net sales was led by sales growth in the upper teens in the government sector, high single-digit sales growth in the commercial sector and mid single-digit sales growth in the manufacturing sector. Approximately 3 percentage points of the sales growth came from Grainger's ongoing strategic initiatives, market expansion and product line expansion, with another 1 percentage point from foreign exchange. Partially offsetting these sales improvements was a negative 1 percentage point effect from the continued wind-down of low margin integrated supply contracts. Refer to the Segment Analysis below for further detail of Grainger's ongoing strategic initiatives.

The gross profit margin for 2007 improved 0.6 percentage point to 40.6% from 40.0% in 2006. The improvement in the gross profit margin was primarily driven by positive inflation recovery, partially offset by unfavorable selling price category mix.

Operating earnings for 2007 totaled $670.7 million, an increase of 16.0% over 2006. This earnings improvement exceeded the sales growth rate due to an improved gross profit margin and operating expenses which grew at a slightly slower rate than sales.

Net earnings for 2007 increased by 9.6% to $420.1 million from $383.4 million in 2006. The growth in net earnings for 2007 primarily resulted from the improvement in operating earnings, partially offset by lower interest income, no counterpart to a gain on the sale of Acklands - Grainger's interest in the USI-AGI Prairies joint venture in 2006, and a higher effective tax rate in 2007. The results for 2006 included tax benefits from the resolution of uncertainties related to the audit of the 2004 tax year and a tax benefit from a reduction of deferred tax liabilities related to property, buildings and equipment. These benefits increased diluted earnings per share by $0.15 in 2006. Diluted earnings per share of $4.94 in 2007 were 16.5% higher than the $4.24 for 2006. This improvement was higher than the percentage increase for net earnings due to the effect of Grainger's share repurchase program.

Segment Analysis
The following comments at the segment level include external and intersegment net sales and operating earnings. Comments at the business unit level include external and inter- and intrasegment net sales and operating earnings. See Note 18 to the Consolidated Financial Statements.

Grainger Branch-based
Net sales were $5,352.5 million for 2007, an increase of $441.7 million, or 9.0%, when compared with net sales of $4,910.8 million for 2006. Daily sales were up 8.6%. Daily sales in the United States were up 8.5%, with growth in all customer end markets, led by sales growth in the upper teens in the government sector and high single-digit sales growth in the commercial sector. Approximately 4 percentage points of the sales growth came from Grainger's ongoing strategic initiatives, market expansion and product line expansion. The wind-down of Grainger's low margin integrated supply contracts reduced sales growth by approximately 1 percentage point.

In 2004, Grainger launched a multiyear market expansion program to strengthen its presence in top metropolitan markets and better position itself to serve local customers. Market expansion contributed approximately 2 percentage points to the sales growth for the segment. Results for the market expansion program were as follows:

                                                 Daily Sales    Estimated
                                                  Increase       Percent
                                                2007 vs. 2006   Complete
         Phase 1 (Atlanta, Denver, Seattle)          15%          100%
         Phase 2 (Four markets in Southern
         California)                                  6%          100%
         Phase 3 (Houston, St. Louis, Tampa)         13%          100%
         Phase 4 (Baltimore, Cincinnati,
         Kansas City, Miami, Philadelphia,
         Washington, D.C.)                           10%          100%
         Phase 5 (Dallas, Detroit, New York,
         Phoenix)                                     9%           75%
         Phase 6 (Chicago, Minneapolis,
         Pittsburgh, San Francisco)                   9%           65%

Product line expansion contributed approximately 2 percentage points to the growth in the segment. Over the past two years, Grainger has added approximately 90,000 new products in the plumbing, fastener, material handling and security product lines as part of its ongoing product line expansion initiative.

Daily sales in Mexico increased 22.7% in 2007 versus 2006. In local currency, daily sales were up 22.8%, driven primarily by the ongoing branch expansion program and an improved economy.

The segment gross profit margin increased 0.4 percentage point in 2007 over 2006, driven primarily by positive inflation recovery, partially offset by unfavorable selling price category mix.

Operating expenses in this segment were up 9.0% in 2007. Expenses grew at the same rate as sales with payroll and benefits growing at a slower rate than sales offset by other operating expenses growing faster than sales, primarily due to increased bad debt expense and provisions and higher facility costs related to market expansion.

For the segment, operating earnings of $669.4 million for 2007 increased 12.8% over the $593.5 million for 2006. This earnings improvement exceeded the sales growth rate due to an improved gross profit margin.

Acklands - Grainger Branch-based
Net sales at Acklands - Grainger were $636.5 million for 2007, an increase of $71.4 million, or 12.6%, when compared with $565.1 million for 2006. Daily sales were up 12.2%. In local currency, daily sales increased 5.8% due to a stronger economy. This increase was led by the mining sector with sales growth in the low twenties, high single-digit sales growth in the oil sector and mid single-digit sales growth in the government sector. These increases were partially offset by a mid-teens sales decline in the forestry sector.

The gross profit margin increased 2.6 percentage points in 2007 over 2006. The improvement in the gross profit margin was primarily due to positive inflation recovery.

Operating expenses were up 6.7% in 2007. Expenses grew at a slower rate than sales due to operating expense leverage, the result of improved cost management and lower severance costs.

Operating earnings of $44.2 million for 2007 were up $29.0 million, or 190%. This earnings improvement exceeded the sales growth rate due to an improved gross profit margin and operating expenses that grew at a slower rate than sales.

Lab Safety
Net sales at Lab Safety were $434.7 million for 2007, an increase of $23.2 million, or 5.6%, when compared with $411.5 million for 2006. Daily sales were up 5.2%. Sales from the acquisitions made during 2007 and late 2006 contributed 6.1 percentage points to the growth.

The gross profit margin decreased 0.5 percentage point in 2007 over 2006. Gross profit margin was down as a result of increased freight costs and unfavorable selling price category mix and product mix, partially offset by positive inflation recovery.

Operating expenses were 4.6% higher in 2007 and grew at a slower rate than sales due to cost management efforts.

Operating earnings of $54.3 million for 2007 were up 3.8% over 2006. This earnings improvement was less than the sales growth rate primarily due to a lower gross profit margin.

Other Income and Expense
Other income and expense was $11.2 million of income in 2007, a decrease of
$13.8 million as compared with $25.0 million of income in 2006. The following
table summarizes the components of other income and expense (in thousands of
dollars):

                                                      For the Years Ended December 31,
                                                         2007                  2006
Other income and (expense):
Interest income (expense) - net                     $         9,151       $        19,570
Equity in net income of unconsolidated entities               2,016                 2,960
Gain on sale of unconsolidated entity                             -                 2,291
Unclassified - net                                               41                   131
                                                    $        11,208       $        24,952

The decrease in interest income was primarily attributable to lower average cash balances due to working capital needs and share repurchases. There was a decrease in equity in net income of unconsolidated entities in 2007 versus 2006 primarily driven by the absence of earnings related to the joint venture that was sold.

Income Taxes
Income taxes of $261.7 million in 2007 increased 19.2% as compared with $219.6 million in 2006.

Grainger's effective tax rates were 38.4% and 36.4% in 2007 and 2006, respectively. Excluding the equity in net income of unconsolidated entities, the effective income tax rates were 38.5% for 2007 and 36.7% for 2006.

The 2006 tax rate benefited from resolution of uncertainties related to the audit of the 2004 tax year and from a reduction of deferred tax liabilities related to property, buildings and equipment.

Excluding the equity in net income of unconsolidated entities and the tax benefits noted above, the effective income tax rate for 2006 was 38.9%.

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 pay cash dividends.

Cash Flow
Net cash flows from operations of $530.1 million in 2008, $468.9 million in 2007 and $436.8 million in 2006 continued to improve Grainger's financial position and serve as the primary source of funding. Net cash provided by operations increased $61.2 million in 2008 over 2007, driven primarily by increased net earnings. The Change in operating assets and liabilities - net of business acquisitions used cash of $143.1 million in 2008. This use of cash was driven primarily by an increase in inventory due to the product line expansion initiative.

The increase in net cash flows from operations from 2006 to 2007 of $32.1 million was primarily attributable to increased net earnings. The Change in operating assets and liabilities - net of business acquisitions used cash of $106.4 million in 2007. This use of cash was primarily driven by increases in inventory and trade accounts receivable as well as a decrease in trade accounts payable due to the timing of payments at year-end. The increases in inventory and trade accounts receivable were due to product line expansion and increased sales. These changes were partially offset by an increase in other current . . .