Graco Inc. (GGG) Q3 2012 Earnings Report, Transcript and Summary

Good morning, and welcome to the Third Quarter 2012 Conference Call for Graco Inc. If you wish to access the replay for this call, you may do so by dialing 1 (800) 406-7325 within the United States or Canada. The dial-in number for international callers is (303) 590-3030. The conference ID number is 4568468. The replay will be available through October 28, 2012. Graco has additional information available in a PowerPoint slide presentation, which is available as part of the webcast player. At the request of the company, we will open up the conference for question and answer after opening remarks from management. And 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, including those identified in Item 1A of, and Exhibit 99 to, the company’s 2011 Annual Reports on Form 10-Q, and in Item 1A of the company’s most recent quarterly report on Form 10-Q. These reports are available on the company’s website at www.graco.com/ir and the SEC's website at www.sec.gov. Forward-looking statements reflect management’s current views and speak only as of the time they are made. The company undertakes no obligations to update these statements in light of the new information or future events. I would now turn the conference over to Caroline Chambers, Vice President and Controller. Please go ahead.

Good morning, everyone. I'm here this morning with Pat McHale, Jim Graner and Christian Rothe. I'll start by providing some top level discussion on our overall financial results for the third quarter, and then we'll turn the call over to Pat. Slides are available to accompany our call and can be accessed on our website. The slides include information about our consolidated financial results for the third quarter in our usual format. We have also included several additional slides about the effect of Powder Finishing operations for the quarter and year-to-date that may be helpful. Sales totaled $256 million for the quarter, including $30 million from Powder Finishing operations. A table showing impact of volume, acquisitions and currency by segment and region is included on Page 5 of the slides. Changes in currency translation rates decreased sales by approximately $6 million. Without the increase in sales in the Industrial segment related to the addition of Powder Finishing sales, sales in the segment were flat compared to the prior year. Lubrication segment sales increased by 7%, and Contractor segment sales declined by 4%. Without the channel dynamics, base business sales in the Contractor segment were slightly higher in the Americas and worldwide. Also, without the increase in sales related to the addition of Powder Finishing and a consistent exchange rate, sales in the Americas grew by 5%, sales in Europe grew by 4% and sales in Asia Pacific declined by 10%. By region, Powder Finishing sales were $7 million in the Americas, $16 million in Europe and $7 million in Asia Pacific. Net earnings totaled $37 million or $0.60 per diluted share for the quarter. Changes in currency translation rates decreased earnings by approximately $2 million for the quarter. We have also included a walk to provide an overview of change…

Thank you, Caroline. Good morning, everyone. This morning, I'll give you some color on the general trends we saw in our business in the third quarter and our views for the remainder of 2012. Q3 business conditions in the legacy Graco business, excluding the powder business acquired in April, continued to be challenging, particularly in Asia Pacific where base business comparisons to the second quarter's run rate and to last year's Q3 were both negative. And frankly, were significantly worse than we had -- than what we had anticipated on our second quarter call in July. Third quarter performance in the legacy business in Europe was in line with our expectations, and the Americas performed well with the exception of our Contractor business, which was disappointing. I don't have any particular concerns regarding our Contractor Americas business and remain positive about that segment going forward. More on that in a moment. Factory performance was solid again in Q3 as our operating people continue to do a great job despite the volume challenges. Factory performance, along with price realization, grow nice underlying gross margin results for the quarter. The powder business also had a decent quarter and is contributing to our profitability as expected. I'll walk through each of the regions and segments and briefly give you a few data points and our go-forward outlook. My comments are based on year-over-year performance on a constant currency basis. Starting with Asia. All segments were down compared to last year's Q3. China, India, Korea and Japan were all down double digits. We do continue to see growth in Australia and the developing economies of Southeast Asia. It's challenging to get hard data on short-term trends and specific end markets in our Industrial business due to our selling through third-party distribution. We did do…

[Operator Instructions] Our first question comes from Charlie Brady with BMO Capital Markets.

Just on the Contractor segment, Pat, can you go into a little more detail about what the channel realignment was on the parts and why that's not going to repeat again? And then can you talk a little bit about, I guess in the release, you talked about higher marketing costs? Is that a temporary issue? Or is that level at a higher level now going forward?

Regarding the inventory alignment that happened during the quarter, it's not a completely unusual event, but I'll call it a one-off. And one of our major channel partners just went through an inventory analysis and decided to make some changes in terms of what quantities, of what they stock and where. And so we had an adjustment based upon that. In terms of the marketing spend, those are really supporting some selling initiatives that we have. And they may or may not recur in the fourth quarter.

Okay. And I don't know if I missed it or not, did you comment on the activity level at the home center channel in contractor in the quarter?

We did not. Overall, the home center business in the fourth quarter was soft compared to -- excuse me, the third quarter was soft compared to last year. Although you'll remember that we had the impact of the big rollout in Lowe's last year. And we also had a pretty good sized order going into the home centers regarding another initiative that they had in rental. Overall, I think it's okay. Although for us, our sales weren't so great.

So year-to-date, sales in the home center, including the load that Pat talked about, are down $1 million. So we expect by the end of the year that our home center sales will be equal to last year.

Your next question comes from Matt Summerville with KeyBanc.

A couple of questions. First, Pat, can you talk -- as you progress through the quarter month-to-month and kind of what you're seeing in October thus far, did income and order rates change meaningfully? Were they volatile? It sounded like July was maybe okay. And then I guess, when did things incrementally soften up for you?

So Matt, this is Jim. August was our really disaster month with respect to orders. We had significant declines there. September was better, orders were over last year and sequentially much better than they were in August. And the first few weeks, we have visibility into October, are also over last year and better than both August and July.

Do you get the sense that your Asia Pacific business has bottomed yet? Or is that not what you would glean from the conversations you're having with your sales folks or your incoming order rates?

I'm not ready to make that call yet. I think it's too early to say. On a comparative basis, they had a bang up fourth quarter last year but just on a run rate basis. We don't see a cliff, but we just kind of see flat and not really any big positives here in the short term that I think can turn that around.

Okay. And then just one last one, with respect to the Contractor business, maybe speak about both the professional paint and home center channels. Is there any sort of trend that you can share as what you're seeing in terms of -- you mentioned out-the-door volumes, but what you're seeing there with respect to average selling prices?

So I think the underlying trends in both paint and home center are out-the-door sales are nice improvements and again there's some noise here in the third quarter. And I would say that average sales prices, we're really not seeing any difference. There's no headwind with respect to average sales prices.

I'm sorry, maybe I asked the question the wrong way. I guess I'm trying to get a sense for -- in your Pro Paint channel, for example, if you're seeing a greater mix of higher dollar systems going out-the-door versus lower dollar?

So when we take a look at the mix, we've been sharing with you the significant improvement from the lower priced units to the higher priced units. That trend in our shipments to the stores changed in the third quarter where they were more equal, equal gross rates or equal sales rates. So the trend that we had been seeing for the first half of the year adds some temporary abatement here in the third quarter.

Your next question comes from Kevin Maczka with BB&T Capital Markets. Kevin R. Maczka - BB&T Capital Markets, Research Division: Pat, I apologize my phone cut out, but if I missed this. In respect to your comments on Asia, it's clearly challenging. The comp in Q4 is more difficult. Is it your sense, though, that that's bottoming in any way? Or is it just a function of a more difficult comp in Q4 that makes you sound like the numbers may still be very challenging?

Yes, we've got a tough comp in Q4, but I'm really expecting that the most likely result in Q4 is sort of a continuation of the current run rate. I don't really see a big catalyst move that to the positive nor do I see it falling off a cliff. It just seems to me that we're sort of flat right now. Kevin R. Maczka - BB&T Capital Markets, Research Division: And is that a fair statement regarding Europe as well, with the east maybe continuing to be better and the west continuing to be a drag?

Yes, I would say that that's the way that we see it. Although we are seeing a little -- without currency affect, we are still seeing a pinch [ph] of growth in the west. And there's some reason to believe with our own initiatives that, that might sustain. Kevin R. Maczka - BB&T Capital Markets, Research Division: Okay. And then as it relates to the housing lift, I think that's something that most people have been waiting to see and, of course, the industry data looking better. Your Americas Contractor was down 5%. But is that more a function of this inventory realignment versus not seeing that lift yet? And that still being a coming attraction, maybe even in Q4 we'll see better numbers there?

A couple of us can weigh in on that. I'll give you my thoughts. That was only a part of it. And I can tell you that it was just -- third quarter was just soft. It was softer than I thought it was going to be, and that inventory realignment was a piece of it. But that's not the whole story, and my gut tells me it's noise, but I'll let Jim weigh in.

No, I would echo Pat's comments that even with the inventory, after you exclude the impact of the inventory realignment, our sales were disappointing. We did have modest -- would've had modest growth. The belief is that the out-the-door sales in the professional paint channel is still about 9%. The few people that report information to us. So the division is still positive and expects to have a good close to the year and part of that, again, is reflected in Pat's outlook that we'll have improved sales in Contractor.

The data that we get doesn't indicate there's anything happening with market share or anything else. So again, I don't have any reason to be overly concerned at this point.

And remember that painting is the last thing that's done on a house before its complete. So starts are one thing. We tend to have a lag. Whether that happens in the fourth quarter or next year, we're unsure.

Your next question on the line comes from Jim Giannakouros with Oppenheimer & Co. James Giannakouros - Oppenheimer & Co. Inc., Research Division: Not to harp on Asia, but just one quick question on the Japanese auto seeking capacity out of China recently, those announcements there. How disruptive do you think that's going to be to you near term? And could it even serve as a source of opportunity for new equipment?

Well, as things move around, that's typically positive for us but it can be a timing issue as well. When one industry picks up and moves somewhere else for whatever reason, typically, they can't pull the equipment out and move it and start that facility up again. So typically, it's a new install, and it's over the longer term that relocation of production volumes tends to favor us. James Giannakouros - Oppenheimer & Co. Inc., Research Division: Okay. Great. And on Industrials Americas, I think your core growth, either you said -- or my math indicates low double-digit growth if you strip out the Gema acquisition. That's an acceleration from 2Q, if my math is correct. And I guess the question is, where are you seeing the strength there and how sustainable is that in the coming quarters?

It's been fairly broad -- the Industrial business hasn't been all one segment that's been carrying the load. Our Americas business in Industrial has been pretty decent. I don't have a crystal ball, and I hate to say what the future might hold. We got the election coming up and lots of other noise. But for right now, it seems reasonably solid to us.

Your next question comes from Liam Burke with Janney Capital Markets.

Pat, on the powder coatings business, have you been able to pick up any additional distribution now that the powder is under the Graco umbrella?

I'd have to go back and find that out. It hasn't been substantial I can tell you that. Whether we've added -- converted anybody, I don't know. Our main focus for that management team here over the last number of months has been really getting the business ready to split away from the liquid business. And so those things that have to happen in shared sales locations around the world and then of course, making sure that they're fully engaged in driving the top line, which has been the #1 priority that we've given them. But I'm not aware of anything specific at this point.

Liam, we're being very deliberate with respect to the channel. We want to make sure that powder distributors don't envision their business disappearing. We don't intend for that to happen. So we want to make sure we're careful on where we add or convert Graco distributors. We're not just taking away from the existing channel.

Sure. And Jim, on the CapEx front, it's a little lower than last year. Is there any significant difference, or is it just the way it's falling out for 2012?

Yes, it's, I'll, say a little bit less growth rate. So the factories still have lots of ideas, and they'll be executing those when the growth rate returns. So we have a -- and I'll call it more aggressive CapEx for next year than we'll spend this year closer again to the $30 million kind of number.

[Operator Instructions] Your next question comes from Kevin Maczka with BB&T Capital Markets. Kevin R. Maczka - BB&T Capital Markets, Research Division: Your buyback announcement from last month, does the FTC timing influence at all? Do you plan to be -- can you say anything about your plans in terms of being more or less aggressive than you've been historically now that you have such a big buyback in place?

Well, we will be aggressive again when it gets us the right ROI. But for sure, we're being cautious now until we sell the liquid business. So once that's done, we'll have lots of cash, net cash debt of close to 0. So we have the opportunity to be more aggressive going forward than we've been in the past 9 months. Kevin R. Maczka - BB&T Capital Markets, Research Division: Okay. And then as it relates to the powder business, maybe it's too early yet, but I know you had intended to do a number of things to kind of boost the margins more towards Graco-like margins in that area, in-sourcing some products, some other things like that. Can you maybe give a little bit of an update there on how those plans are progressing? And have you seen any tangible improvements yet?

Yes. So again, Kevin, remember that's a 5-year journey. So a couple of things that we've done is we funded some CapEx for the business that they wouldn't have had funded in their prior ownership. So they have some plans there that are directed to take cost out of the existing product. We've had their manufacturing team here in our factories. We're studying the various ways we put together the liquid spray guns versus the powder spray guns, so that study continues. And we continue to share ideas with vendors in sourcing. So small incremental things that over time we expect to have the margin get higher.

Your next question comes from Matt Summerville with KeyBanc.

I just had 2 quick follow-ups. One, a clarification on Contractor. You indicated a heightened degree of confidence, you see growth in that business. I assume that's on a year-over-year basis. You're not talking sequentially, correct? You would still anticipate year end seasonality there?

That is correct.

Okay. And then second, as indicated in your press release and on Slide 12, the FTC has yet to issue the final decision and order thing. I would assume that there's not a whole lot involved in doing with that -- in doing that. So I guess I'm lost as to why that hasn't been done yet so you can formally kind of get under the way or get -- in the process of selling these businesses and moving on?

Matt, again, there's some, I'll call them, issues that the FTC is deliberating around intellectual property. And the split from Gema and the liquid businesses, they're not significant, in Graco's opinion, relative to revenues. But there are a couple of things that need to be cleaned up and there's, I'll say, analysis going on in the FTC with respect to those issues. Again, today, we own all of it. It's just a separation between the liquid and powder assets.

Your next question on the line comes from Charlie Brady with BMO Capital Markets.

Just a follow up. So the margin impact from powder in the quarter was 400 basis points. And I guess just back to a couple of questions ago on what you're doing to get the profitability up over time, it sounds like though near term, we can still expect that kind of year-on-year drag on the margin?

Yes, that's correct. Again, remember they were earning about 1,500 basis points less than us. And on top of that, we have some amortization, intangible assets that will be with us for a few years.

Your next question on the line comes from Jim Krapfel with Morningstar.

How do you see the America reception for the Liquid Finishing assets? Do you think you'll be able to recoup your investment there?

Yes. We're quite confident that we should get in excess of the $427 million that's on our balance sheet.

Okay. And then on the Industrial margins, excluding the Powder Finishing, how long do you think you can sustain these historically high margin levels?

Well, it's been part of Graco's business model for 15 or 20 years. Again, we sell highly engineered specific applications in few quantities to markets where they get a significant return on our investment. So they like what value we add to their ability to return profits to their P&L. So again, as long as we continue the innovation we've done and continue to introduce new products that continue to improve the end users' productivity, I think we'll be there and maybe even get a few tenths of a point higher margin, again, as we bring innovation to the end user.

If there are no further questions, I will now turn the conference over to you Pat McHale, President and Chief Executive Officer.

All right. Thank you very much. Have a good day.