Graco Inc. (GGG) Q2 2010 Earnings Report, Transcript and Summary

Good morning and welcome to the second quarter 2010 Conference Call for Graco Inc. If you wish to access a replay for this call, you may do so by dialing 1800-406-7325 within the United States or Canada. The dialing number for international callers is 303-590-3030. The conference ID is 4323044. The replay will be available through July 25th, 2010. Graco has additional information available in PowerPoint Slide presentation which is available as part of the webcast player. At the request of the company, we’ll open the conference up for questions and answers after the opening remarks from management. During this call, various remarks may be made by management about their expectations, plans and prospects for the future. These remarks constitute forward-looking statements for the purposes of the safe harbor provisions of the Private Securities Litigation Reform Act. Actual results may differ materially from those indicated as a result of various risk factors. Due to those identified in item 1A of exhibit 99 to the company’s 2009 annual report on form 10-K. This report is available on the company’s website at www.graco.com and the SEC’s website at www.sec.gov. Forward-looking statements reflect management’s comment piece and speak only of the time they are made. The company undertakes no obligation to update these statements in light of new information or future events. (Operator Instructions). I will now turn the conference over to Caroline Chambers, Vice President and Controller; please go ahead.

Good morning and welcome to everyone. I’m here this morning with Pat McHale and Jim Graner. I’ll provide some comments on the financial highlights of our second quarter and Pat will follow with additional comments. PowerPoint slides are also available to accompany our call and can be found on our website. The slides include information about our consolidated financial results and each of the segments. After opening comments we will open up the call for your questions. Net sales were up 30% to 192 million for the quarter. There was increase in all divisions and regions with significant growth continuing in Asia Pacific and solid growth in both the Americas and Europe. Operating earnings as a percentage of sales were 20% up from 12% a year ago with net earnings totaling 25 million. Currency translations did not have a significant effect in the quarter as changes in the Asian currencies and Canadian Dollar offset changes in the Euro. The overall year to date growth rate of 25% included 2% points from translation primarily from currencies in Asia Pacific. Our growth proper margin as a percentage of sales was 53% as compared to 49% in the second quarter from last year. The improvement from last year was primarily due to higher production volumes. In Q2 our factories were running at about 85% of prior peak production as compared to approximately 55% a year ago. Approximately $1 million of additional production costs were incurred in the second quarter related to new products primarily in the contractor segment. Operating expenses for the quarter increases by 8 million as compared to last year. As a percentage of sales, operating services were 4% lower than last year. As expected, volume related items are receding from last year. Strong operating results drove higher incentives and bonus provisions in the second quarter with expense approximately 3 million higher than the first quarter of this year. For the full year, we expect that the incentive and bonus expense will be 15 to 20 million higher than last year. Marketing and selling expense related to new product launches increased by approximately 1 million as compared to the prior quarter primarily in the contractor segment. In the industrial segment we did not see the same [tailment] from currency translation in the second quarter that we saw on the first quarter. With continuing acceleration in sales growth we also saw increases in volume-related expenses primarily incentives and bonus provisions. Year today tax rate was 35% as compared to 32% last year. Several [R&D] tax credit has now been renewed so far in 2010 and no benefit is included in the current rates. We currently continue to have a full-year expectation of a tax rate of 34%. Year today cash flow from operations was 28 million as compared to 69 million last year. Our working capital investment increased in line with our increasing volumes. Year to date inventories have increased by 18 million with an improvement in turns and accounts receivables have increased by 37 million with consistent days of sales outstanding. Year to date primary cash uses have been capital expenditures of 6 million, dividends of 24 million and repayment of long-term debts of 6 million. The overall had share re-purchases in the second quarter that totaled 10 million including 6.5 million that actually settled in the third quarter. We will continue to re-purchase shares on an opportunistic basis going forward. On the financing side a long term debt total of 80 million at the second quarter with unused credit lines of 117 million. With that I’ll turn it over to Pat for additional comments.

Good morning. In the second quarter we had 30% revenue growth compared to the second quarter of last year and 17% growth compared to Q1 of this year. The 17% sequential growth from Q1 to Q2 was generally in line with the historical patterns. Compared to the first quarter we saw a single digit growth in our industrial and loop segment and strong 40%+ growth in our contractor segment driven largely by seasonality, successful new products and good performance out of Europe and Asia. Our incoming order rate in the second quarter was solid with backlog increasing approximately 4 million from the end of the first quarter. Sales in Europe were up 27% versus the second quarter of 2009 and although the health of then markets varied considerably across Europe and construction was particularly weak in some areas, we are confident opportunities exist to generate growth in every segment and in the second quarter we achieved double digit growth across all major product categories. Revenue in Western Europe was up strong double digits from Q2 2009 and growth rats in Eastern Europe were even higher. Asia Pacific had another great quarter with consistent double digit increases across the most products lines in countries. Japan was the only weak area and declined versus Q2 of last year. In Asia Pacific this quarter was higher than our pre-recession Q2 peak as was also the case in Q1. We also saw a big growth in the Americas; in North America all segments wrapped double digits compared to last year. Our industrial segment performed well as unmarked conditions in our customer’s appetite for capital equipment spending has much improved versus last year. New products in industrial are being well received and we have a good pipeline that will launch in the second half as well. The lubrication segment achieved double-digit growth compared to last year. Growth in industrial lubrication was strong. The vehicles’ services lubrication market remains challenging although we did see much growth in that segment as well. In contractor North America the pro paint business was strong double digit driven almost completely by successful new product launches. This business in pro paint remains depressed due to market conditions in both residential and commercial construction. The home center business was down double digits compared to Q2 of last year. Q2 of 2009 included new store launches making the comparisons difficult. For the year the home center business is essentially flat. Canal inventory in both Pro and home center appears to be stable with no evidence of significant restocking as of yet. In Latin America off a small base we again posted gains in the high double-digit range and exceeded our pre-recession peak. Gross margins were solid at 53% from the quarter up from 49.5% last year but down slightly from Q1 due mainly to mix. In our contracted business we continued to see higher sales on lower priced, lower margin offerings. Operating margin in industrial and lubrication are significantly improved compared to last year’s second quarter and are in line with Q1 on similar volumes. Contractor operating margins improved substantially from Q1 on higher volumes but are below prior year primarily due to costs associated with major new product roll-outs. We anticipate further roll-out expenses associated with new products in Q3. Excluding the retirement and center payments, incremental operating margins are as expected on base business increases. The extent that revenue increases were driven by new products the incremental operating margins were lower. New products require substantial upfront investments and selling, marketing, manufacturing and engineering will be brought to market. Most of the growth from Q1 to Q2 came from contractor and specifically from new products. Profit contribution of the new product will normalize as the early launch carts roll off and manufacturing process improvements are implemented. We continue to invest in our pre-historic growth strategies during the quarter developing new products, recruiting and training international sales people and selectively increasing distribution coverage. These strategies have been delivering as evidenced by the quick return past peak in Asia Pacific and Latin America and strong growth in developing areas of Europe. The new products launched this year have also been well received in the market place and are contributing to revenue growth. Our new products sales as a percentage of the total increased to 28% in Q2 versus 26% for the full year of 2009. We continue to anticipate new product spending in the range of $40 million for the year. In certain categories we are putting more product development resources into new markets and less into product upgrades and line extensions. We believe this ship will drive better long term growth although we’ll have a short-term dampening effect on this particular metric. Products released in Q1 and Q2 have contributed nicely to our results and we have additional new products planned to launch in the second half of this year. Priorities for cash continue to be funding organic growth opportunities, making strategic acquisitions and returning cash to shareholders through dividends and share re-purchases. In terms of outlook we believe the global economy will continue to recover and while we don’t Asia Pacific will continue at the period over period growth rates we saw on the first half because of [several] comparisons for the rest of the year, we are positive about the near-term outlook for Asia Pacific and expect solid performance in 2010. We also anticipate continued good performance from Europe. The painfully slow recovery in the US housing markets and difficult conditions in the US commercial constriction markets will create challenges for our contractor division. In order to achieve reasonable growth rates our contractor North America business this year will need to continue to find success with new products and initiatives. This concludes my prepared remarks. I now ask the operator to open the session to Q&A.

Thank you. The question-and-answer session will begin at this time. (Operator Instructions) And to our first question comes from Kevin Maczka from BBT Capital Markets, please go ahead. Kevin Maczka – BB&T Capital Markets: Good morning.

Morning Kevin. Kevin Maczka – BB&T Capital Markets: Pat, I guess first…can I just clarify a comment in the press release about the contractor business? You say there that you’re looking for modest improvements in the Americas and Europe in the back half; is that true of the segment as a whole and are you talking about sequential improvement from here or on a year-over-year basis?

Well second quarter is typically our highest quarter in contractor just due to the painting season, so when we talked about margin improvement I talked really about much improvement in market conditions compared to last year at the same time. Kevin Maczka – BB&T Capital Markets: Got it, and last year Q2 and Q3 were both similar margins in that business about 20%. With the ongoing new products roll-out costs, how should we think about margins there as we go forward? Is the Q2 run rate maybe a high water mark because revenues will be lower but will still have these new products roll-out costs coming through?

Kevin this is Jim, we are expecting a slightly better margin in the third quarter on the new products as our production…our one time production cost becomes smaller and the sales pick up slightly on the new products side. So if you put that together with the seasonality maybe we’re flat to a modest improvement. Kevin Maczka – BB&T Capital Markets: Okay, and just maybe one more if I could; I’ll get back in line but just…just a kind of a high level question, just interested in where…where you’re seeing the growth in places like contractors and lube; is this all new products? Because again contractor is heavily exposed to [rays and non-rays] which doesn’t work that great at the moment and lube, a lot of exposure there to vehicle service stations which it doesn’t feel like a 27% growth world we’re living there either, is this all new products or…I guess where is the growth coming from here in this if it's not the new products?

In contractor it's mainly coming from the new products and we’ve been talking for the last 18 to 24 months about the ramp up we did in product development across the organization and we expect to see the results fro that in 2010 and I think we are and will and really new products drove the contractor business. On the lube side even though the base is small we’ve had some really nice growth in Europe and Asia and that’s helped the overall worldwide lubrication numbers showing the kind…the numbers you’re talking about. In North America we’ve got more modest numbers really not driven by new products, really driven by I think slight increases in help at the end market conditions but primarily by lube at the international story. Kevin Maczka – BB&T Capital Markets: And you said Pat you’re not seeing any signs of the headlines we see about China perhaps taping the breaks things like that, you’re not seeing that but of course the comps get more difficult and are you also not seeing any signs that concern you in Europe as well?

If you want to look for things to be concerned about you can spend your…a lot of time finding things I guess…in general I’m not overly concerned about Europe I think it's going to be sporty and we need to make sure we are going where the opportunities are good. But I think overall the second half of Europe is going to be fine. China is trying to tap the brakes a bit, they’ve done that…tried to do that many times in the past with minimal success and although they may slow it down a little bit our team feels pretty good about the next few quarters and that there is not going to be a big meaningful change there from the government. Kevin Maczka – BB&T Capital Markets: Okay, great. Thank you.

Thank you, our next question comes from Charles Brady from BMO Capital Markets, please go ahead. Charles Brady – BMO Capital Markets: Thanks, to start in regard to the product cost mix/price break out on the three segments, if I look at industrial equipment third quarter last year had a pretty +6% favorable, this you’ve got another 2% favorable. How much looking into the third half of this year you think you’ll get more on that line item and is it being driven by a majority of those three items in that line item?

I think it's really driven by the product cost and pricing for the most part in that segment. Charles Brady – BMO Capital Markets: And is it correct to say that number of new products you’re getting at that pricing…you got even better pricing on the new products and that’s what’s driving some of that new pricing. And how…if I pass that out, how does pricing on legacy products compare?

I would say that your assumption is not correct. We’re getting good pricing and we did increase prices issues on our existing products so the price I’m talking about comes both from existing product and new products. Charles Brady – BMO Capital Markets: Okay, and if we just draw down to the lubrication equipment on that human liner below the 9% favorable in this quarter, pretty strong number…I’m just trying to…what really drove that 9% in lubrication?

A majority of that is the cost reduction, again if you recall at this time last year we were having some issues in our factory specifically with our [gauge] to acquired products so the cost changes and the improvement factor was able to deliver in the third and fourth quarter of last year as well as this year today that are really rolling up into that 9% number. So it's really straight…quite a strong performance out of that group on the cost side. Charles Brady – BMO Capital Markets: And that ought to be sustainable into the back half of the year, correct? What’s the level that promise that it's not going to back track from there?

It is not, no that’s solid improvements, solid profit exchanges, solid use of automation in that factory. Charles Brady – BMO Capital Markets: Thank you I’m backing out of the cue.

Thank you, our next question comes from Michael Halloran from Robert W. Baird, please go ahead. Michael Halloran – Robert W. Baird & Co. Inc.: Morning, on the…you sort of crossed that rope back in this quarter I think you said it was about 3 million, is that allocated back to the various divisions and if so how is that allocated back?

Yes it is allocated back and it's…again it's calculation by individual soothe sales people on those respective units increases in sent us charge to those specific cost. The 3 million number that you’re calling out is the delta between the first quarter and the second quarter. The absolute numbers are 3 million in the first quarter and 6 million in the second quarter and then Caroline gave you a forecast of where we expect…we might be for the year. Michael Halloran – Robert W. Baird & Co. Inc.: Right, and I was trying to drive down into the delta between the first, second quarter and the industrial margin; I’m assuming that’s fully the explanation for why it is on a two basis sequential decline despite a little bit better sales. Sequentially it's going to be driven by this incentive cost and so I was just curious how much of that three million gets allocated to the industrial side versus the contractor side and the lube side?

I’ll answer it that two million of the six million in the second quarter went to the industrial segment. Michael Halloran – Robert W. Baird & Co. Inc.: Okay, so from your perspective that explains the move of the lower sequential margins?

It does, yes. Michael Halloran – Robert W. Baird & Co. Inc: And that stating on the industrial side just from the sequential stand point, what sort of typical sequential growth would you expect second to third quarter and…a little uncertain from your outlook session in the press release but I just want to make sure I understood what your expectations were from the sequential stand point and whether…in the industrial side and whether the end market improvements you’re referring to were solely on the contractor side or also refer to the industrial side?

I think the end market comments are really fro the total company. The…if you go back to when we were in the normal cycle rather than the new normal, industrial was 48-52, 48% first half 52% second. Second half I don’t know where we’re headed in the cycle, my expectations are that we should continue to see some good growth out of the industrial global economy. Michael Halloran – Robert W. Baird & Co. Inc: Thanks for the time.

Thank you our next question comes from Ned Borland from Hudson Securities, please go ahead. Ned Borland – Hudson Securities: Hi, good morning. Just to clarify again on the incentives, you said that delta is at six million for the year, it's going to be 15 to 20 million so you’ve got an additional 9 to 14 million in the back half of the year, is that…?

Let me try again. So the…for the past six months Ned we’re at nine million and for the year, at out current run rate we will be accruing 18 million versus three million last year. Most of the three million in expense last year was recorded in the second half due to the cycle of how the improvements came. The six million is the second quarter versus three million in the first quarter as our sales trends continue to accelerate. Ned Borland – Hudson Securities: Okay, so…alright I think I got it. Then on the new product pay point you have one just coming in the back half of the year, anything of the magnitude that you’ve seen so far in the first half of the year?

Well I think in the industrial side I think our product launches are spread fairly evenly through out the year so I would expect it to be as good in the second half, probably the same for lube or maybe even a little better because some of their good products were launched late in the first half. With the contractor business while we had some little made success it's really going to depend on what the sell through is and early indications are that the sell through looks really good. So we are hoping that this year for the next few months of the key painting season we’re going to continue to see a nice success on the products that we had launched here in Q2. Ned Borland – Hudson Securities: Okay thanks.

Thank you our next question comes from Matt Summerville from Keybanc, please go ahead. Matt Summerville – Keybanc Capital Markets : Morning, a couple of questions; first within the contractor business over the last couple of quarters you’ve been kind of gradually migrating into product lines at least with some of your home center customers and that sub $300 price point more of a consumer DIY product line, if I go back in history with Graco historically that’s been a place that the company strategically decided to deliberately avoid. It seems like there has been a change in that view on that piece of the business and I guess Pat if you can kind of walk through what the thinking is there and then how, if at all does that shift or does that decision change the incremental margin profile of contractor going forward?

Yeah, we’ve had some pretty interesting I’d say com technology breakthroughs and really if you take a step back, prior to 1999 we weren’t in the home center business at all and we didn’t want to go and play in that channel with the [me to] products and we were able to find a way to bring piston pump technology into the…let’s call it $400 to $1000 price point and so we entered that space and to the extent that we’re able to find technologies that allow us to play at other price points with a differentiated product then we think that’s still consistent with our overall business philosophy and business strategy. It's definitely the case that…to the extent that we end up with more sales at the $300 kind of a level we’re going to see margins that are slightly less. Matt Summerville – Keybanc Capital Markets : Now, I would assume that this something that you weigh and kind of go in into this process but one of the things we found is we go through the channels that are great less tremendous brand equity, we’ve known that for years; can it gain in into this lower price point level of the market? Doesn’t that essentially give you customers better access to keep that brand maybe more prominently in the lower price I guess as we come out of this down turn maybe a better way for me to ask the question is how do you give people that are buying $300 things right now to start buying $500, $600,$700 sprayers again if they’re now conditioned to know that they can get Graco at that lower price point? Does that make sense?

Yeah, I understand your question obviously that’s part of our product line up and planning process and if you take a look at each incremental price step that a consumer would take or a contractor would take, there are performance and pitches at that next individual level that pay for that price differential so I’m not really concerned about that. Somebody who is buying a $300 sprayer when they’re going to go to buy a $500 sprayer they’re going to get more performance, they’re going to get a larger chip size, they’re going to get more flow, they’re going to be able to do jobs faster and so there is reason that people climb the ladder. And you don’t get a $300 Graco Sprayer that performs like a $1000 Graco sprayer should; it's still best in category and it's still great performance but there are definitely differences and I don’t see that as being a trend. And also like the comment to the extent that the contractor new products influenced the second quarter results that hand-held product that we’re talking about has got a $450 street price so we’re not talking about consumer toys for what was launched here in the second quarter. Matt Summerville – Keybanc Capital Markets : Correct, okay. Thanks Pat.

Thank you, our next question comes from John Francis from Sidoti & Company, please go ahead. John Francis - Sidoti & Co.: Good morning guys, just quickly it looks like you elected to do some open market re-purchases versus repaying a debt; could you just talk a little bit about that decision and maybe give us what the average cost was of buying back the stock in the quarter?

Sure debt and purchases under our 10B51 program in the quarter we thought I’ll call it the year all panic happening and we thought that might give us an opportunity to buy our Graco shares and our price was less than $30, we picked up equity 3000+ shares during that period a little bit before the prior period happened so again our strategy here is to be somewhat opportunistic not trying to go back to the 2008 level of share re-purchases but to buy enough shares to keep our share comp flat for the near-term. John Francis - Sidoti & Co.: Okay that’s it, that’s all I got, thanks James.

Thank you. (Operator Instructions). Next we have a question from Terry Darling from Goldman Sachs, please go ahead. Eddie [Theo] – Goldman Sachs: Thank you; it's actually Eddie [Theo] on behalf of Terry here. One question for you guys regarding the outlook for House and related revenues, we saw some comments coming from Share and Williams that they’re going to see a weaker back half from 2010, I don’t know if you guys have any insight about that?

Well there are major player in the industry and I think you can take their commentary for what it's worth and again what we’re trying to do is we’re trying to manage our own future the best that we can and that was the reason that we did a big push on product development a couple of years ago and hopefully that’s going to help us navigate through what looks what looks to be a few more quarters of choppy waters on the housing front. Eddie [Theo] – Goldman Sachs: And kind of in early 11 are kind mauling are turn of thinking about a turn in the housing markets?

Yeah, well to be honest with you if you have asked me in the spring of 09 I would have told you by the summer of 2010 that things were going to be a lot better and unfortunately they are not, so yeah I would anticipate that next year is going to be better but what we’re trying to do is not just be victims the next year and we’re going to continue that invests and drive initiatives and see what we can do in contractor. Eddie [Theo] – Goldman Sachs: I guess just as a follow up on kind of the comment you guys made about Europe, kind on the flip side, your European competitors have they been using the weaker currency as a way to kind of be more competitive or gain more picture?

I would say we haven’t seen any dramatic evidence of that, no real big change in what the market dynamics are. Eddie [Theo] – Goldman Sachs: That’s right, and just last week thinking about second half incrementals, I mean just as we are looking out towards next two quarter, any comments you guys can make there on how we should be thinking about incrementals in business?

No I think the profitability on the incremental business will…after you account for these extra provisions on the incentives just because the rate of change continues to accelerate here in our sales will be consistent with your expectations at you have before. Eddie [Theo] – Goldman Sachs: Correct. Alright thanks guys.

Thank you. We have a follow up question from Matt Summerville from Keybanc, please go ahead.

With regards to the incentive comp, corrective me if I am wrong, I guess that I prompt the expectation originally was at that line out of eight that increased roughly, $10 million in 2010 verses 2009, what I guess has occurred from an expectation stand point that’s driving that number to potentially almost double this year of these new product launches being more successful is underlined and demand for a call year core products for lack for a better term, than better what you would have thought you know three months to go. Can you help close the loop on that?

Yeah you know all those things are true and if you take a look at what just happened between Q1 and Q2, Q1 were up 19% and Q2 were up 30% and so obviously the pay out is going to be significantly different at those two levels and that really drove the big delta between the 6 million and Q2 and the 3million and Q1. But you know looking out I’ll anticipate their continued to perform well in the second half and the numbers that Caroline gave you there in the fifteen to twenty for the year are reflective of that.

With regards to some of the success you’ve had in the professional pain side with some of the new product launches like you’ve mentioned, have you seen the full benefit from that initial stocking did you experience that in the second quarter or will you see some continued positive effective that in the Q3?

We’d expect to see that positive effect to continue to Q3.

And then how would you characterize just to make sure am clear on what’s driving the contractor business, how would you characterize sell through or out the door volumes for your core products in both the home center and propane channel, can you go through that again Pat?

Yeah I didn’t cover out the door sales in those channels, but I did mention that inventory seems to be fairly stable in both of those channels and so based business in contractor or call or it the ‘flattish’ maybe flat growth in the year to date basis sort of similar kind of coming out the home center. The base business is sort of what it is.

So as we take all these items, the things that are maybe going to give a little bit maybe on the cost going for you a little bit on the top line, is there any reason to think that the second quarter wont be the high water mark for Graco’s quarterly earnings? Is that still, the right way as you see the rest of the year unfolding to think about it?

I tend to be a little more optimistic on the state of the economy but I don’t think anybody knows.

Okay and then I guess lastly Pat if maybe you can just provide you know if within your industrial business, the growth you are seeing there kind of more and market commentary across the geographies would industries are driving the growth and success you are seeing there.

Well you know global automotive has been pretty good this year and although we are not seeing a lot in terms of the new facility construction in places like the U.S we are seeing that they are doing a fair amount of retooling and we are getting a fair amount of repair and replacement as they do that. Asia automotive has been really hot since I would say last August or last September and that’s continues through the first half. Not only you know transplants in the Asia taking advantage of labor aids but some of the domestic part companies that are in place like china that are doing a lot of investing in unit volumes look pretty good. So in overall automotive and automotive feel here on the global basis are much improved verses where they were at last year. Some segments of airspace are descent some segments are tough, the small private jet business is not so great, but other segments of airspace are still pretty good. Oil and gas has been okay pretty much in a global basis prices have been hanging in there. We’ve been seeing investments that are protecting all these businesses have been doing well. Mining has been strong and in places like Australia and down South America, we’ve continued to benefit both in our industrial and our lubrication business on the strength of investments in the mining sector. So there are a fair number of things going right. Construction worldwide is tough, it’s still pretty good in Asia but in Europe in general construction is week and of course we all know what it is here in the U.S.

Appreciate the color thanks Pat.

Thank you once again if you’d like to ask a question please switch the cell phone by the one your telephone. If there are no further questions I will now turn the call over to Patrick J. McHale, President and Chief Executive Officer.

Alright well thank you all for your time this morning and have a good week.

This concludes our conference call for today thank you…