Graco Inc. (GGG) Q2 2008 Earnings Report, Transcript and Summary

Good morning and welcome to the Second Quarter 2008 Conference Call for Graco Inc. If you wish to access the replay for this call, you may do so by dialing 1-800-405-2236 within the United States and Canada. The dial-in number for international callers is 303-590-3000. The conference ID is 11116708. The replay will be available through July 28,2008. At the request of the company, we will open the conference for question-and-answers after the opening remarks from management. During this call, various remarks made by the management about their expectations and prospects for the future. These remarks constitute forward-looking statements and are for the purposes of the Safe Harbor Provision of the Private Securities Litigation Reform Act. Actual results may differ materially from these indicated as a result of various risk factors including those identified in the Item A1 of an Exhibit 99-2, the Company's 2007 Annual Report on Form 10-K. This report is available on the Company's website at www.graco.com and the CEC's website at www.cec.gov. Forward-looking statements reflect management current views and speak only as of the time that they are made. The company undertakes no obligation to update these statements in light of new information or future events. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions]. As a reminder, this call is being recorded today, Thursday, July 24, 2008. I'd now like to turn the conference over to Ms. Caroline Chambers, Vice President and Controller. Please go ahead ma'am.

Good morning and welcome to everyone. I'm here this morning with Pat McHale, President and CEO and Jim Graner, CFO. I will briefly review our second quarter results and then Pat will discuss business highlights by the operating segment. Following these comments, we will open up the call for questions. There was an increase in the second quarter by 3% as compared to the same quarter last year though when translated at consistent exchange rate, sales were flat compared to last year. We saw a strong sales growth in Europe and Asia this quarter, offsetting continued weakness in the contractor segment in the US. Sales in the second quarter included 3.5 million from GlasCraft. GlasCraft was acquired at the end of February of this year. In gross profit margins we saw the impact of higher material prices, though we continue to offset them with pricing and manufacturing productivity improvement. We also saw the benefit of consolidation of our Lubrication segment operations in our Anoka Minnesota facility. Favorable currency transition rate added 1.4 percentage points to the gross profit margin rate. Operating expenses for the quarter are 13% higher than last year including the effect of currency translation which was 3 percentage points of this increase. Operating expenses for GlasCraft were another 3 percentage points of this increase. And the impact of the new product launch in the home center channel was also another 2 percentage points. Net earnings are flat year-to-date and down 4% for the quarter as compared to last year. Earnings per share increased by 5% in the quarter. Interest expense was up $1.3 million as we continued with our planned share repurchases. The tax rate was consistent with the second quarter last year. We repurchased approximately 500,000 shares this quarter, approximately 4 million shares remain under our current Board authorization at the end of June. We will continue to repurchase shares and expect to complete purchases under this authorization by September 2009. Cash flow from operations were up about 3% in the first six months of this year as compared to the first six months of last year. A brief comment on inventories were $91 million at the end of June as compared to $82 million at the end of June of last year. This is partially due to $3 million of inventory related to the GlasCraft acquisition. And also with the sales growth internationally we're seeing higher levels in our international distribution centers. We're opening a distribution facility in Australia in the fourth quarter of this year to better serve this growing market, although overall inventory change related to this facility is expected to be modest. We have about approximately $1 million in inventory related to this initiative at the end of the quarter. Factory inventories are being managed based on business levels and service level standard. At this point I'll turn the call over to Pat for a discussion of the business unit results by segment as well as some discussion on our operating strategies.

Thanks. Good morning. I'll start off this morning with our Industrial segment where we saw 16% growth worldwide during the quarter. We did have growth in all of our major product lines and in all of our regions. Results in the Americas were solid where we saw a 13% gain for the quarter. Outside the Americas we did see slowing in the developed countries in both Europe and Asia, but we saw strong double-digit growth in all the developing countries. Operating earnings in this segment increased... declined 2 percentage points from the prior quarter last year. As expected, operating earnings were negatively impacted by costs associated with the GlasCraft acquisition and integration in purchase accounting expenses. During the second half of this year we'll be integrating the GlasCraft operation into existing Graco facilities. We will incur some additional expense for these activities in 2008, but we should see a nice cash flow improvement and accretion in 2009. Consistent with strategy ramping up our product development, we have increased our product development expenses in the industrial segment, they're up 25% year-to-date and that does not include GlasCraft. This increased spending is going to result in more new product launches starting later in 2009 with the full impact really showing up in 2010 and beyond. We have had some nice new product launches late last year and through the beginning of this year in the Industrial segment that have helped drive growth. And we do have additional products that we're going to launch during the second half of this year. The company as a whole, we've got improvement in our new product percentage of sales that we've talked about previously. Last year we were at 22%, we're up to 27% in the first half of 2008. So I think you see us getting some traction with that initiative. During the last 12 months we've also added more than 100 new distributors in the Industrial segment in both Europe and Asia and we've expanded our sales force as we continue to pursue our global expansion. Move on to the Contractor segment which was down 13% for the quarter, in the Americas we saw very weak business conditions and we had a sales decline of about 24%. We saw actually a larger decline in propanes [ph] that we did in our home center business. We saw further inventory reductions at most of our accounts during Q2. And if you'll remember during discussions in Q1 we did not see inventory reduction early in the year. Contractor Europe continues to post gains, however we are seeing some slowing in several countries in the west that's been offset by strong double-digit growth in Eastern Europe, Russia and the Middle East. Asia Contractor was flat for the quarter but it's up 17% for the year. I don't have any major concerns about the second half for Contractor in Asia, other than we could have a little negative impact in Australia as we roll our new warehouse and we hope our existing distributor there work off some inventory. Operating earnings as a percentage of sales declined by 5 percentage points in Contractor this quarter versus the same quarter last year. However it was mostly driven by Home Depot and Lowe's. Without those one-time expenses for the rollouts, our operating earnings in Contractor would have been down by about 1 percentage point. In terms of dollars expenses related to both these rollouts were about $3 million for the quarter and that's in line with our expectations. Moving on to Lubrication segment, we had 5% growth this quarter. A strong double-digit growth in both Europe and Asia offset a slight decline in the Americas. And for lube our operating earnings as a percentage of sales were at 19%. We continue to make progress in our factory although we've got some more work to do there and we're still working towards our goal of reaching the low 20s by year-end and the mid-20s during 2009. Nothing really new to report on the acquisitions front, we continue to look for good opportunities but we remain disciplined in our valuation process. We're not really seeing any up tick in quality companies for sale in our space. I'd characterize the environment for us as being similar to what we've seen in the last two or three years. In summary, we continue to see growth and margin opportunities in both Industrial and Lube and we anticipate continued revenue growth in both Europe and Asia although we're seeing some slowing in the developed countries. The developing markets in Eastern Europe, Middle East and Asia continue to show strength and we're working to make sure that we maximize those opportunities. We do expect continued weakness in the Contractor segment, we'll manage that business accordingly. We're continuing to fully fund all of our growth initiatives and we're investing in new products and you can see that in the numbers. We're chasing new market opportunities, working hard to expand our global sales and distribution footprint and of course we'll continue to pursue strategic acquisitions. That includes my opening comments. If the operator to open up the line now for questions. Question and Answer

Thank you. Ladies and gentlemen, at this time we will conduct a question-and-answer session. [Operator Instructions]. And our first question comes from the line of Ned Armstrong from FBR Capital Markets. Please go ahead. Ned Armstrong - Friedman, Billings, Ramsey & Co.: Yes. Thank you, good morning.

Good morning. Ned Armstrong - Friedman, Billings, Ramsey & Co.: A couple of questions. One, regarding your Industrial segment, the performance was very, very impressive and I was just wondering on if you could comment on what you think you're doing right that makes your performance superior to a lot of other companies that we've seen thus far?

I think we've been really sticking to our stated strategies. There was no real magic that we performed during the quarter. We've had some good new product launches really later in 2007 and in the beginning of the year here. It's consistent with the strategy that we followed to make sure that we are fully investing there, growing our distribution channel especially in the developing market has been important and I think you've seen really over the last couple of years that growth in the emerging markets has been a nice driver for us. We continue to see that. Here in the Americas, as we've talked about before although there are some segments where business is difficult, there are some segments where there are still good business opportunities and our team has been chasing those and I think we've been executing pretty well. Ned Armstrong - Friedman, Billings, Ramsey & Co.: Do you think that you're taking share from some of your larger competitors or is it just you're more capitalizing on niche opportunities?

I think the answer to that question would vary by segment. There are some segments where I am confident that we are taking some share. There are some other segments where I am sure that the growth of the underlying business is helping all of us. Ned Armstrong - Friedman, Billings, Ramsey & Co.: Okay. And then, just on a more detailed basis. Do you have the organic growth in both the Contractor and Lubrication segments for your overseas businesses for the quarter?

We do, in Europe the Contractor growth was 6%. In Asia, the Contractor declined 2 percentage points for the quarter and was up 15 on a year-to-date basis. As Pat said, we're not seeing net indication of any trends in Asia. In Lubrication, Europe was up 15% for the quarter and Asia was up 80%. Ned Armstrong - Friedman, Billings, Ramsey & Co.: Great. Thank you.

Thank you. And our next question comes from the line of Terry Darling from Goldman Sachs. Please go ahead.

Thanks. Jim, I'm wondering if you could follow on with the... that same detail on the Industrial side?

Sure. Europe was positive 12 for the quarter and Asia-Pacific was a positive 9.

And on Industrial, it looks like the U.S. piece accelerated sequentially. I'm wondering what you would attribute that to and whether you see that continuing in the second half of the year?

Yes. It did. Our Industrial business tends to be a little bit lumpy. Yes, I think our Industrial... I think we still see opportunities both on the sales and the margin side but I wouldn't say that that would be a normal long-term growth rate for the industrial business in the Americas but it can happen from quarter-to-quarter.

And if we take first half versus second half, obviously a lot of end-market softness, is it reasonable to expect that first half or second half is slower than first half in the Americas Industrial piece or is that not what you see at this time?

I don't think. I wouldn't lead to that conclusion. Our backlog is pretty short and so we don't have real good visibility on what our business is going to look like several months out, but based upon what our field sales force sees and the opportunities that we are working on, I wouldn't make that lead.

Okay. And then on the U.S. Contactor piece, that rate actually decelerated or accelerated downside, however you want to characterize that, do you have some sense that maybe things can stabilize somewhat in the second half of the year or are we still in the grade area there?

You know, I don't feel like it's going stabilize in the second half of the year. Certainly we don't see any signs of that going into the third quarter. And really all the numbers that... all the macro numbers are still pointing to further erosion. So I think that you could expect, on a comparitive basis, I think that we might have a little bit of help, but I think from a market conditions standpoint it's still going to be pretty bad. Jim, I don't know if you like to comment...

Yes, just to follow up. Terry, I think you would see 20% kind of declines in North America in the third quarter. By the fourth quarter our comps get easier and you would see the percentage change there getting much smaller.

Okay. And then in terms of the comments that you made on the slowdown in some of the developing markets outside North America, I guess I'm trying to think about the strategy of continuing to ramp up your investment in distributors and so forth relative to that slowdown. Are you at a point where you want to slow that investment spending or is it you're in a mode of just continuing to watch how much weakness evolves there?

Yes, let me make sure that I'm clear. What we saw both in Europe and Asia were the countries that were more developed take Japan, Korea, Spain, Italy some of those developed countries in those geographies is where we saw the slowdown. We're still seeing great growth in Eastern Europe and the developing countries in Asia. So our strategy right now is pedalled to the metal, there is no reason for us to be looking to slow down in terms of adding sales and distribution in the emerging markets.

And lastly the commentory on lube margins in the mid-20s in '09. I think you had been alluding to that earlier as potential and now it seems you are making little bit more of a... something more formal out of that. And what has given you the confidence to do that at this point?

I don't think from my standpoint, maybe how we communicated it changed. But from my standpoint, my confidence that lube would be able to get back into the mid-20s in 2009 has been, that's not new. We've got some work to do there. Our biggest challenges in the factory right now, are in the efficiency side and those continue to get better I think throughout the second half of the year and other than that we're doing pretty well and I think we're on track.

Okay. Thank you very much.

Thank you. And our next question comes from the line of Mike Schneider from Robert W. Baird. Please go ahead. Michael Schneider - Robert W. Baird & Co., Inc.: Thank you and good morning.

Morning Mike. Michael Schneider - Robert W. Baird & Co., Inc.: Maybe first, just going back to Industrial. The path of growth rate still seem incredible given the state of the global economy. I guess maybe you could... especially for North America and Europe just give us some deeper dive into the four segments that comprise Industrial to give us some sense of where the growth is flowing from and the fact that it even accelerated domestically?

I can give you a kind of a thumbnail sketch on that. If you take a look at our finishing business... and as I stated earlier we did see growth really across the regions and across our product lines. So we didn't get the torch carried by one particular product line throughout a big number and made up for a lot of other declines. We saw a pretty good strength. Our finishing business on a worldwide basis, was up high single-digits, our process business was up nice double-digits, our lube business outside North America was up double-digits and so really across most of our product categories, we saw some strength. We did see some weakness here in North America on our fast-set foam business, we've talked about that I think at length on the conference calls and we had a lower single-digit growth here in North America and our fast-set foam business as the housing contraction, I think is putting some impact on that business. But our 2-K and our slow-set business for infrastructue coding, that's really been the strong double-digit worldwide. So, it wasn't any one particular thing, we saw pretty good strength in our product segments across the different geographies. Michael Schneider - Robert W. Baird & Co., Inc.: Okay and is there some element of pricing that kicked in this quarter across the Industrial segments?

There is not. Michael Schneider - Robert W. Baird & Co., Inc.: Okay. And then just going back to the mix in Europe now specifically in some of those developed markets Spain, Italy and presumably UK, are you actually seeing declines or actually negative performance and offset by what is presumably very strong double-digit Eastern European?

Yes, Mike. What we're seeing is accelerating growth in East Europe and the Middle East in particular as well as the developing regions in Asia. So the growth there was bigger in the second quarter than it was in the first quarter. The declines we're talking about are a couple of percentage point changes in the level of growth first quarter to second quarter. So if we were growing 10% in one country, we saw an 8% kind of growth in the second quarter and only area that we're seeing any negative numbers, we were flat in the first quarter in what we call South Europe, Spain and Italy and we were down a couple of percentage points in the second quarter. So rest of it, we are still growing in Western Europe countries. Michael Schneider - Robert W. Baird & Co., Inc.: Okay. And then switching to Contractor. This is probably a first-time and long-time professional was down much harder than retail, is one I just guess just a ballpark, was it down north of 20% this quarter and then how does that rate compare to the actual sellthrough that you are able to determine through the professional channel?

The pro was down north of 20% this quarter and in terms of the sellthrough, we actually did see inventory reduction, I alluded to that and that's not a precise number because we only get reports from a certain number of our accounts but it gives us pretty good directional information and so I would say that based upon a limited data set, the out-the-door sales might have been five or six points less negative than our sales to them. But it was still pretty tough. Michael Schneider - Robert W. Baird & Co., Inc.: Okay. And do you sense that there is an element of maybe trading down occurring in the professional channel as more residential contractors participate in the commercial space and they generally buy a lower price point units which may not be your brand. The other phenomenon and that's --

I didn't really see... I'm not really seeing a lot of that but if you recall from I think the first quarter conference call and even during last year when this housing thing hit in the middle of '06, we have seen an impact all along on our large units, especially our gas products, that was a little bit more dramatic that we had expected because typically you see those products going into some of the bigger commercial applications and that has continued but I would say no, we haven't seen any particular worrisome trend here in the second quarter that leads us to believe that we are losing share to the competition. Michael Schneider - Robert W. Baird & Co., Inc.: And retail then must have been down single-digits. Was that actually boosted by the channel fill of the new product line or?

That's a little messy, as you could imagine. We had the lowest launch mixed in there here through... in the month of June and then we had the puts and takes with the Home Depot product line, resetting stores that may have had six units in and we shipped the 11 units to it to get it reset. So I wouldn't put a whole lot of stock in the home centre number this quarter with all the puts and takes. I think we'll get a better view of what's going to happen there in Q3. Michael Schneider - Robert W. Baird & Co., Inc.: The net of those moving parts was probably a benefit in the retail channel during the quarter.

I think probably.

It might be on the sales line, it wasn't on the gross margin line. Michael Schneider - Robert W. Baird & Co., Inc.: Right. Okay. That's all, thanks guys.

Do you have any further questions at this time? Michael Schneider - Robert W. Baird & Co., Inc.: No. I'm good. Thank you.

Thank you very much. And our next question comes from the line of Matt Summerville from Keybanc. Please go ahead.

A couple of questions. First, in terms of pricing versus raw material costs in the quarter. Where do you think you were Pat and I guess moving into the backhalf of the year we're seeing additional inflation, is there an opportunity for you to put through additional price increases in your two larger businesses in the backhalf of the year or do you have to wait till next year?

Our cost... net cost increases on materials were about four-tenths of a percentage point of sales. So that's the net of what we're able to reduce prices and what the price pressures we're incurring, our pricing should be greater than that for the rest of the year. Our outlook for material cost, while it is worsening, we are not significantly concerned about it. We don't see a major erosion in profitability for the rest of the year. We are looking at pricing increase... price increases especially in our export business so that's denominated in dollars. We may do something in September but the rest of our price changes will happen on our normal regular cycle in the first quarter of 2009.

Okay and then with respect to the Contractor business, can you talk about and if you said in your prepared remarks, Pat, I apologize but do you anticipate any level of ongoing development-related expenses I'll call it with respect to Home Depot and Lowe's in the backhalf of the year? And then is there I guess some additional rampup with Lowe's to be had yet in Q3 given that that just started in June, it sounded like.

From a... if nothing changes I think we've worked through most of the cost associated with both of the rollouts. However, if you recall Lowe's has indicated to us that they are going to run their test through the end of September, should they make any changes to that if they make a decision to go Graco and they do it sooner or later than that date of course that's going to get us into a whole another round of phase-in, phase-out and rolling cost and what not. But assuming that they run their test and the Home Depot continues on its way I think we're pretty much through the uglies in terms of the expense side.

Okay. Moving back to the Industrial business can you talk about and maybe discussion by region would be helpful, as we move through the quarter how order tempo kind of looked entering Q2, exiting Q2 and then I guess whether or not you've seen any change, given that we're pretty much through July at this point?

Well, I'd say I didn't notice anything specific in terms of tempo through the quarter and again we've got a number of different product categories and they can be moved in any one of... any different way at any different time, but I think in general the tempo to the second quarter was pretty consistent and you saw that it was spread pretty well geographically and across our products offerings. So I think that gives us some reason to be optimistic about where we are headed here in the second half.

With respect to share repurchase going forward, can you talk about what you've... you're looking at somewhere in the neighborhood of 45% net debt-to-cap now. Typically, you guys throw off a pretty good amount of free cash flow. I guess, how should we think about the tempo share repurchase activity going forward, and then Jim what's the full year effective tax rate that we should be using?

The share repurchases we are executing under a 10b5-1 program and we... then continuing with the same matrix in the first and second quarter, more shares at lower prices, fewer shares at higher prices. Really given our concerns over the economy, we may change that in the future. We are targeting one and a half times EBITDA as our leverage on the balance sheet. We are not concerned about our debt to capitalization ratios, you have followed the business for a long time you know our strong cash flows, our people that are providing us financing aren't concerned about those either, all of our metrics there relate to leverage off of EBITDA.

Yes. I was more trying to get at whether or not you would make a sizeable increase to your leverage to take out a lot of stock all at once, maybe, but it sounds like you're going to continue to be systematic and might actually back off of the pace that you're buying back because of your macro concerns. Is that the right view, Jim?

I would say that's correct on the first part that we're happy with our approach buying back shares on a daily basis. We are not backing off from our expectations that we will complete the remaining 4 million by September of '09. So that would cause us to accelerate from the share repurchase level we had in the second quarter.

Okay. And then just one more on Industrial and I'll hop off here. With respect to GlasCraft and I apologize if you already stated, but what were the integration costs in the second quarter and what's your outlook there as far as expense in Q3 and Q4?

Well, the only thing we said Matt is that there was an operating loss in the quarter and year-to-date, we expect more integration costs in the third and fourth quarter less than $1 million the operating loss you should get less because the purchase accounting goes away and our outlook for '09 is that GlasCraft will be accretive, it is accretive already on a cash flow basis and I don't think I answered your first...one of your first questions with respect to tax rates.

Oh, yes.

Our rate in the quarter at 34.7%, that's higher than last year because Congress hasn't reinstated the R&D credit. If they do that, our tax rate would fall back to the 34% on a going forward basis. So you should model the 34.5% going forward.

Okay. Thanks a lot guys.

Thank you. And our next question comes from the line of Charlie Brady from BMO Capital Markets. Please go ahead.

Good morning. Yes, this is actually Tom Brinkman. Just wondered if you could give us an organic sales growth number, I guess, excluding currency translation in the GlasCraft acquisition for the quarter?

I think it's around a 3% decline.

Okay. And then also what about orders in all three segments, sort of the order trends?

We really haven't ever discussed order trends, our backlog at the end of the quarter was consistent with the backlog at the end of the second quarter of 2007.

Okay. And then, can you quantify at all, I guess you sort of talked about some declines in the home center channel versus paint center channel. Can you break those out a little bit separately, I think you touched on this but I'm not sure if you really quantified it?

We don't share exact numbers on that but we were down 24% here in North American Contractor and the pro paint was worse than the home center channel. Again, the home center channel, there was a lot of noise in it because we had things happening with the rollout of Home Depot and the rollout of the Lowe's program.

Okay. And then as I guess aside from share buybacks in the absence of acquisitions as you said that you don't see an uptick in availability of quality companies what else do you plan to do with the cash? How do you deploy that, is it just more distribution capabilities worldwide or other things as well?

Yes. Our number one priority is to make sure that we're funding all of our organic growth initiatives and we've been doing that even in the face of some challenging economic especially frontier on the housing side. We've been continuing to fully fund product development, that's a priority. Any opportunities we have to chase in markets we're fully funding those. We're fully funding our international expansion, we haven't cut any international sales people but to the contrary we continue to add. So that's our number one priority for cash. Secondly if we found good acquisition certainly we want to do those. But we're going to be disciplined, we're not just going to try to go out and buy our way out of this trouble that we're in. And then from a remainder standpoint we'll be paying dividends and we'll be doing the share repurchase program and we intend to have some debt on the balance sheet, and I think Jim's talked a little bit about where we're headed there.

Okay, and on a positive note, can you quantify at all the cost savings from the consolidation of lubrication operations that you completed in 2007, the year-over-year cost savings in the second quarter?

I don't think we have identified it in the second quarter, we had one-time costs in 2007 for the full-year or about 6.5 million in the Lubrication segment for the consolidation activities. We of course expect to not have similar kinds of costs in 2008 as well as our outlook for '08 and '09 and in the future years is that we're becoming more efficient in our manufacturing processes, new tools and new processes are put in place in the operations there so in the 19% you're seeing the removal of the one-time costs in vast expectations for rates in the 20s. You are seeing the expected improved profitability or results from our manufacturing operations.

Got you. Okay. And can you, I guess, quantify at all the rollout costs Home Depot versus Lowe's. You touched on that also.

Lowe's started in the '09 June, the rollout costs were less than $1 million, and the $3 million in total is for both panes together.

Okay, thank you very much.

Thank you and our next question comes from the line of Ned Borland from Next Generation Equity Research. Please go ahead.

Actually all my questions have been answered. Thank you.

Very much. Our next question comes from the line of John Franzreb from Sidoti & Company. Please go ahead.

I was just wondering about the increase in R&D spending. Could you talk a little bit about what kind of topic [ph] we should think about as far as R&D cost for the full-year? And maybe give us a little color as to what end-markets of product line opportunities you're addressing?

Yes, really, we're looking at product development headcount and project increases in all of our divisions. So we got some programs going on up in Contractor that I think are going to be interesting in the next two or three years. In Lube we're tending to focus our product development efforts on the industrial lube side. And so we've added some headcounts, some engineering teams there to focus on trying to build out the product line that we purchased with the Lubriquip acquisition. On the industrial side, we've got two or three separate engineering groups there that are all investing in new products, obviously I don't want to talk about really which markets we're headed into or what products that we're doing. But you can figure that they're fluid handling and they're fairly close to the core. And part of it is going to be making sure that we keep our current product line refreshed and leading in technology. And so we've always continued to invest in that, but a lot of this new effort that we're putting is really on products that are incremental of what we are doing today. And we think that that's going to drive some incremental growth. We started doing the increased funding back in the August timeframe of last year and we approved a lot of additional staff versus taking time to get those people on board. In terms of what you should expect for the expenses into the second half and I think it would be wise to expect an increase but to give you a good number on that is difficult because it depends on the stage of each project but we are into doing prototypes and we are doing live testing on dozens of products, then we're going to have a big spike in cost. So it's not necessarily a nice level expense as we go through the projects.

Our rate will be growing closer to 4% as we get to the end of the year and you should expect the rate in '09 getting closer to 4.25% or 4.5%.

Okay. Great. That's very helpful. And I don't know if you can answer the second question. But firstly, are you still adding distributors and in Eastern Europe and if so do you have an idea how many?

Yes we are and yes, we do.

Okay. How many?

Well, not sure that level of the granularity if that will be all right.

Okay. Well, how about this then? Would it be fair to assume or maybe you can tell me that if we look at the distributors that you've added, can we kind of look at it maybe on a same distributor basis year-over-year? Are they still buying this much products as aggressively or is more of the growth coming from the new distributor account. I'm trying to get maybe a same distributor kind of a sales concept versus the incremental that you're getting from adding the distributors to the pipeline?

We do track the incremental sales that we get on new distribution but you also have to keep in mind that we do have puts and takes on the distribution channel too. So, we'll have distributors that we closed during the course of the year. I think the important thing for you to think about in terms of our distribution expansion into the developing geographies that when Sherwin-Williams opens up a net 30 or 40 new stores here in North America, that's distribution expansion for Graco. But it's much different when we go and we open up 5 or 10 new distributors in Southeast Asia. Those distributors there really carry a much broader product line, they're going to be much bigger than a paint outlet or distributor expansion in one of the developed countries. So our initiative to get our footprint in those developing geographies and the number of distributors, I don't think is really reflective of what we think those seeds are going to bear over time.

To expand a little bit on the Industrial segment, we had some fall off in the new distributors we established but I think our rate is, success rate is closer to 50% and you will see an exponential growth with those distributors so generally they start on a small basis and the second year is double or triple the first year and third and fourth year, continue that kind of a trend until they sort of plateau with the level of resources they are able to put to it.

Okay. That was too much [inaudible]. Thank you. That was very helpful. That's all I've got.

Thank you. [Operator Instructions]. Our next question comes from the line of Kevin Maczka from BBT Capital Markets. Please go ahead.

Hi Pat, Jim, good morning.

Good morning.

Good morning.

Jim, just a question on pricing. I thought I heard you say that it wasn't a big benefit in the quarter. So did you not take a price increase in the quarter or did you try to take one that didn't stick?

I think what I was trying to say, Kevin was that there was no incremental pricing that we did in the second quarter versus the first quarter. So we are seeing a realization of the prices we put in place in the first quarter of the year about two percentage points.

Okay, got it. And I also don't think I understood your comment on material cost inflation that you're seeing, I think you said something about 0.4% just help us understand the... in general the material cost inflation that you're seeing and obviously, you guys usually do a very good job of overcoming that.

But we are seeing materials going up mainly in the metals, significant increases in aluminum and carbon steel, and in the castings that we purchased. But you should also recognize that a large component of our metals we buy is stainless steel products and stainless steel is down 7% to 8% over the last 12 months. So we're getting some reductions in some of our pressures there. We're also offsetting some of those material cost changes by our sourcing changing vendor is consolidating volume of certain vendors and some offshoring of some of that sourcing. So overall, the net of all those activities is a 0.4 percentage point hit to our gross margin, second quarter versus the second quarter of last year.

Got it. And then just last question, if I could, on Europe in general there is so much doom and gloom that we're hearing about Europe. But it sounds like your Eastern European operations are still growing nicely. Can you maybe comment about your view on Europe in general and what is your mix between East and West Europe?

I think, and when we tried there to communicate that here today. We do, we are watching Western Europe closely, we really have been for probably about nine months as people have been concerned about whether or not this is going to spill over. We are still seeing some growth in Western Europe. So I'm not doom and gloom about Western Europe. There are some real tough spots, Spain being one of them. Our team over there has some concerns about what's going to happen in the Scandinavian area. But France is still holding up, Germany is still holding up, okay. Their growth is... we're still seeing growth all though it's slower than the growth that we saw before. In terms of our mix between East and the West, I'll let Jim share those numbers with you.

Today we're about two-thirds, Western Europe and one-third Eastern Europe and the Middle East, growing rapidly in the latter.

Okay guys that's all I had. Thank you.

Thank you and our next question comes from the line of Seaver Wang from Utendahl Capital Partners. Please go ahead.

No, actually, my questions have been answered. Thank you.

Thank you. And our next question comes from the line of Satish Halai [ph] from ASA Capital Partners. Please go ahead.

Good morning.

Good morning.

Good morning.

Pat or Jim, question on the general corporate expense line. It was a little light both sequentially as well as year-over-year. What should we expect in third and fourth quarter?

We have some pressures in the G&A line from exchange, and some pressures from accounting through stock options as well as amortization with respect to the intangibles with the GlasCraft acquisitions, rest of the growth is really modest and it will fluctuate from quarter-to-quarter, no significant changes should be expected.

Or should we look for the same kind of run rate as in the second quarter?

Yes.

Thank you.

Thank you. And I'm showing that we have no further questions. Management, please continue with any closing remarks.

All right. Well, thank you all and overall the message that we're trying to leave here is that we're expecting Contractor North America to be tough, but we're going to manage to it. And that although we're seeing a little bit of slowing in some of the developed countries, we still are pretty optimistic about our opportunities in Europe and Asia and our Industrial business worldwide continues to execute. So we're going to work hard and we'll talk to you again in the third quarter.

Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation. You may now disconnect.