Graco Inc (GGG) 2003 Q2 法說會逐字稿

Good morning and welcome to the second quarter 2003 earnings conference call for Graco Inc. If you wish to access the replay for this call, you may do so by dialing 1-800-428-6051 within the United States or Canada. The dialing number for international callers is 973-709-2089. The conference ID number is 300043. The replay will be available through July 23rd, 2003. At this time I'd like to inform that you this conference is being recorded and that all participants are in a listen-only mode. At the request of the company, we will open up the conference for questions and answers after the presentation. 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 exhibit 99 to the company’s 2002 annual report on form 10-Q and its most recent 10-Q. I would like to turn the conference over to Mr. Mark Sheehan, Vice President and Treasurer. Please go ahead, sir.

Thank you very much. Good morning. Welcome to Graco's second quarter earnings conference call. I've got Dave Roberts here with me today and I'd like to start out just by reviewing some of the highlights of the press release we issued yesterday after the market closed. First of all we're pleased to report another net sales increase in the quarter, 10% revenue growth this quarter represents our fifth consecutive quarter of sales growth. The increase in sales versus last year’s second quarter was due to a number of factors. Some of them included favorable exchange rates, the strong North American contractor equipment business, continued strong demand for our products in the Asia Pacific region and the incremental revenue associated with the Sharp Manufacturing acquisition which we completed earlier in the year. With regard to the exchange rates the weaker U.S. dollar versus the euro is the primary driver for the favorable translation impact that we are seeing both in the quarter and year-to-date numbers. In the first half of this year, the average euro to U.S. dollar exchange rate was $1.10 versus last year, during that same time period, the euro was worth 90 cents. Also, in the second quarter, our earnings per share were up 20%, and this reflected the combined impact of a 14% increase in net earnings, as well as the reduction in shares outstanding due to the large share repurchase which we completed in March of this year. Our year to date earnings per share is up 17% on a revenue increase of 11%.

Talking a little bit about what happened in the segments this quarter, for industrial automotive, their sales were $57.7 million, which were up 14% versus last year's second quarter. The base volume was virtually flat in the Americas, and slightly lower in Europe. But strong demand for products in Asia combined with the acquisition of Sharp Manufacturing and favorable currency led to the double digit reported revenue growth. The profitability for this segment remained good in the second quarter. Their operating margins were 26.5% and that compares to 26.1% last year. Operating profit dollars grew 16% versus last year's second quarter. And year-to–date industrial operating profits are up 17% on a revenue increase of 14%. Good performance.

If you look at our contractor business, when compared to last year's second quarter, worldwide contractor equipment sales were $76.9 million and they were up 12%. In the Americas, sales were higher in both the professional paint store side of the business as well as the home center channel. We're experiencing good demand for our new products and our existing products in the paint store channel, and that's offsetting some of the negatives which have occurred so far this year including wet weather conditions in a lot of regions in the United States and a weak commercial construction market. In the home center channel sales were also higher primarily in the quarter due to a new product we introduced, which was our 190 ES upright cart mounted sprayer. And then in Asia, with respect to the contractor business, we experienced volume gains in and Europe also experienced some very modest volume gains and benefited from the favorable currency translations. If you look at operating profits in the contractor segment they were strong in the second quarter. Their operating margins were at 25.9%. That's up from 25.1% last year. And again operating profit dollars grew 16% versus last year's second quarter. On a year-to-date basis, contractor operating profits are up 9% on a revenue increase of 10%.

In our lubrication business, in the second quarter their sales were $11.7 million. They were down 12% from last year's second quarter. This decline can be attributed to a sales promotion that we ran in the second quarter of last year, which was not run in the second quarter of this year. That same promotion was actually run in this year's first quarter. If you look at the second quarter operating earnings, they were down 22% versus last year. Lower sales were the reason for the decline in profits during the quarter. On a year-to-date basis lubrication equipment operating profits are up 1% and their revenues are virtually flat.

Turning next to the gross profit margin in the quarter, Graco's gross profit margin expressed as a percentage of sales was 51.9% versus 50.6% last year. The higher gross margin was due to a number of factors, including currency, very modest pricing increases, and other factors which were offsetting some cost pressures that we have that are pretty common in industrial America today, including higher payroll pension, medical, and other expenses. With respect to exchange on the gross profit margin line, it’s interesting to note that exchange rate changes have a large impact on our gross margin, since about 27% of our revenues are in non-U.S. dollars, while only 3% of our cost of goods sold are in non-U.S. dollars.

Looking at operating expenses, operating expenses were higher in the second quarter of 2003. Versus last year's second quarter, the overall expenses were up $4.2 million. When looking at it versus last year, the increases came in a number of areas. Some of the key items driving these increases were exchange rates, payroll related expenses, putting salaries, pensions, medical incentives, et cetera, and the addition of Sharp expenses into the P&L.

Our tax rate for the quarter was 32.3% and 32.5% on a year-to-date basis, which is in line with our expectations. Some other items to mention, year-to-date cash flow from operations was $41.2 million versus $38.8 million last year. Some of the significant uses of cash this year have been property, plant and equipment additions of about $7 million. Share repurchases of $55.5 million, dividends of approximately $8 million, and debt retirements of about $7 million. Our accounts receivable are higher than a year ago at $103.6 million versus $97.2 million. These reflect the increased sales activity that we are experiencing and the addition of Sharp. If you look at our DSO, it's running at 66 days, which is favorable to year end where we were at 74 days, and versus a year ago, where we were at 71 days. Inventories are also higher than at year end and last year. The majority of these increases can be distributed to the addition of Sharp as well as an increase of industrial automotive inventory to help support customer service objectives and new product introductions.

To summarize, Graco had a great first half with an 11% increase in sales and a 15% increase in net earnings and a 17% increase in earnings per share. We're especially pleased with the revenue growth without currency of 6% year-to-date. The favorable euro does have a favorable impact for Graco and that environment is still with us as we head into the last six months of the year. Hopefully that continues. Our average euro currency rate in the second half of 2002 was 99 cents. And when I looked this morning the euro's trading at $1.12. Finally as we head into the second half of the year we have a number of new products that are doing well and helping with the internal revenue growth that we're experiencing. We'd encourage anyone who’s interested in learning more about those products to look at our Website, which has a lot of material about our new products. Some of the ones we mentioned in prior calls include our Xtreme plural component airless spray packages for the industrial business, our Reactor plural component proportioning system for the industrial business, our Fusion plural component spray guns for the industrial business, and in the contractor side, our new ST and STX electric airless sprayers, our RAC X tips, our new texture spray products, and our new Contractor FTX gun. With that, I'll open up the line for your questions.

Thank you sir. The question and answer session will begin at this time. Please pick up the hand set before pressing any numbers. Should you have a question, please press star 1 on your push button telephone. If you wish to withdraw that question, please press star 2. Your questions will be taken in the order they are received. Please stand by for your first question, gentlemen. Our first question comes from Michael Schneider of Robert W Baird. Please state your question, sir.

Good morning, guys. Congratulations on a nice quarter, again.

Thank Michael.

I guess starting first just with some specific numbers, Mark, can you give us the contribution in dollars to the top line of currency and the Sharp acquisition just for our models?

We can tell you that the Sharp acquisition, Mike, was about a $11 million revenue business, and in the quarter it was about what you'd expect for a $11 million revenue business, in terms of the magnitude, maybe a little bit lower. And with regard to the currency piece of the equation, for the quarter, in total, the sales impact was in the range of about a $5-5.5 million increase, which again if you look at the press release, it gives you that information on a percentage basis, but the actual dollars were about $5.5 million.

Right, okay, thanks for the actual. Drilling down into each of the three segments, trying to get a sense of what organic growth was by segment. I presume industrial benefited the most from currency but if you could give us a sense of what organic growth was in x currency for each of the segments?

Again, for if quarter?

Yes.

The industrial business was on a non-currency basis, was up about 6%.

Okay.

And the contractor business was up about 9%. On a non-currency basis.

Yep. In lieu of probably minus 11 or so?

Yeah, a little bit, about 14.

Okay. I guess then talk about your thoughts on the status of the U.S. and European industrial economies. You've had two solid quarters of upper single digit local currency growth in your industrial business. I'm surprised you're a little more optimistic at least in terms of core demand.

Michael, you know North America is still relatively flat from what we've seen. You know, I think we said this at our last conference call that mid-year 2000, it really declined, started to decline. It's been flat since that point. We've seen no indication that the North American industrial economy is picking up yet. Europe, I think, is actually weakening from what we had perhaps talked about a year ago, or even a half a year ago. That economy is, certainly in Germany is -- it's certainly in a recession and close to a depression, I guess you could say. And certainly France I think is following it.

Okay. So the -- what we're to assume then the growth is primarily coming from new products?

New products, we've gotten some nice growth out of our protective coatings product lines, Mark talked a little bit about here when he mentioned the website. We've seen some of that. And actually, if you look at the industrial product line, you know, X North America and X Europe, we're really having a very good year in Asia.

In fact, spend a minute on Asia because you gave us I guess the macro thoughts on Asia in the press release, but specifically is it just new distribution driving the growth over there or the automotive OEM starting to set up plants that you're capitalizing on?

A combination of a number of those things. We've added distribution, which has helped us, but really it is servicing the number of manufacturing operations that are moving into Asia and primarily southeast Asia and China. These aren't just North American manufacturers. We are also seeing even Taiwanese manufacturers moving in, into a variety of products. Not only automotive, but we talk about fine furniture and wood furniture in the past. We're seeing that, and it’s basically just general industrial type companies that are setting up in Asia.

And how are you getting the orders from these -- from these foreign companies setting up plants there? Is it your relationships outside of Asia or are there local partners that are enabling you to win these orders?

It is really a combination of that. Certainly we've got great relationships with the worldwide manufacturing organization in automotive. So the relationship we've established there has helped us. But frankly, our distributors are getting the orders for us in the other manufacturing operations.

Final question I'll get back in line. Mark, the R&D number is 3% of sales this quarter. I might be nitpicking but that's a historically low number for you guys.

I'll answer that. Really, there has been no change in R&D spending. We are still spending dollar-wise at the same rate. It is the fact that revenues are actually up. Yeah, when I looked at the number this quarter too, it looked low to me because traditionally we run 3.5-4%. But it's basically a result of revenues being up and not reduction spending.

Fair enough, thank you.

Thank you, our next question in queue can comes from Ned Armstrong from Friedman, Billings, Ramsey. State your question sir.

Yes, good morning, gentlemen.

Morning Ned.

Could you comment on any new channel initiatives that you’re pursuing and where you’re at, and how you think that that will benefit you going forward?

Sure, well we constantly, and I don't want to say churn our channel in North America and Europe, but we constantly upgrade the channel as we go. At the same time, we're adding distribution in eastern Europe, as well as Asia, and primarily focused on China and southeast Asia. So obviously as manufacturing locations increase in those regions of the world we'll have distribution that will be able to handle the expansion that's occurring.

Right. So that would be channel initiatives in the geographic sense.

Right.

How about different types of channels that you may be exploring?

Well, the channel, if we look at channels as we know them today, we're attempting to duplicate what we have in North America and Europe in the rest of the world. So we're expanding – well even in Europe, we're expanding into the home center channels or looking to expand in the home center channels in Europe, and then we're looking at traditional industrial expansion outside of Europe and some into the paint store channel as well for Contractor.

Okay.

So that's more developed in Europe than it is in Asia at this point.

Okay. You mentioned in your monologue there that you had seen some enhanced pricing. Where are you seeing that? Is that a geographic phenomenon or a product-type phenomenon?

It's where we really end up getting advantage in price, or can increase prices when we introduce new products. And it's generally worldwide as compared to one region of the world. As Mark said these prices are modest though in relative terms. But we have seen some real price increase primarily driven by new product.

So it's the new products where you're getting the increases?

Well, yeah. It is a situation where we are adding features to that product and we're able to command a price higher than the previous model.

Got it. And then finally, relative to the Sharp acquisition, how would you thus far assess its success and its strengths and weaknesses?

You know, I'm very encouraged by the last month. The first two months of the acquisition, we bought it on March 31st, I think it was. And the first two months, we really saw the effects of a small, family-owned business, and the owners who were actually operating the business focused on due diligence. And so the first few months was the revenues were less than what we had hoped for. It has started to pick up and we've got some efforts going there with marketing help out of the -- out of Graco itself. We've also introduced, I think it's 28 new products, Sharp products that we've introduced into the Graco channel that we think will help us from a revenue standpoint. And those were just introduced. So those are now, you know, Graco branded products that came out of the Sharp acquisition.

Okay, great. I'll get back in line.

Thank you, our next question comes from John Franzreb from Sidoti & Company. Please state your question, sir.

Good morning gentlemen. I was wondering, normally about 40% of your revenue is derived from parts and accessories. Did that change meaningfully in the June quarter?

No, you know John, I don’t have the number in front of me, but no, we have seen nothing that would indicate that the parts business has changed at all.

Okay. And do you have a sense of how much of your revenues were actually derived by new products in the period?

Not for the quarter.

We don't have that data yet John.

Okay. 0 for 2 here. Last kind of question I had is the ASM acquisition, part of the philosophy behind the acquisition was to develop new products into maybe a new alternative home center channel and you kind of referenced Europe as a possibility. Wonder if you could give us an update on that initiative and what's going on.

John, we don't at this point have any intent to carry the ASM brand into Europe. If we're going to create the home center channel in Europe we’d create it under the Graco brand name. We think that's got more brand equity than certainly ASM does. And we’re still pursuing our strategy here in the U.S., that we will go after or look to other home center customers, using either a Graco brand or an ASM brand is about all I can tell you.

There is nothing new on the ASM side that we would add incrementally in the future? Anything good?

There is nothing that we can talk about on the conference call, John, that would indicate that, you know, there's something that that's going to occur are within the next few months or so from an ASM standpoint.

Great, thanks a lot guys.

Thank you. As a reminder, ladies and gentlemen, should you have a question, please press star 1 or 1 followed by 4 on your push button telephones. Our next question comes from Michael Schneider of Robert W. Baird. Please state your question, sir.

Guys, could you spend a minute just on the leverage of this business, when the economy does begin to grant you a favor? I'm wondering if you could give us some numbers on where you think capacity utilization stands and what you use or estimate incremental margins are, by business, if you have it.

Mike, I guess capacity standpoint, I can talk to that. What we've done, or what we're in the process of doing, and you're fortunate, you've been on our campus and have seen this. Our old facility, we're in the process of building a new office location, we’ll be tearing down what we call the main plant. We've been able to move product into the Riverside building here in Minneapolis primarily because we expanded that building back in the early part of 2001. And we think probably capacity utilization standpoint, we're still in the area of maybe 75% capacity utilization. We've got some square footage that's available down at Sioux Falls. We expanded that plant at the at the same time we expanded Riverside and we just picked up a facility in Santa Fe Springs, California, so we do have some capacity available to us.

I would say the leverage is going to come on the industrial automotive side, Mike, because the contractor business has been pretty strong throughout this cycle.

Right.

With respect to that business I think the spending levels that we're experiencing are sized to the levels of orders that we're receiving, and I think that we tend to do a fairly decent job managing the cost side of the equation, if and when the revenues pick up. And historically we've seen both bottom line earnings growth as well as margin growth in periods when our sales have improved. But in terms of percentages and dollars, we -- we're not going to get into that with you guys here, because the overall comment is, it should be better but there's a lot of unknown factors there that can come into play in terms of coming up with specifics.

Okay. And then separately, hedging the currency, obviously you guys are benefiting immensely right now and probably makes up for 1998. But the question is, do you intend to employ any hedging strategies?

We don't intend to. We have really taken the position that over time, these things even out. And it's one of the things that you purchase when you buy the Graco stock. I think there's a lot of people listening that are pretty happy that we didn't go out and hedge a couple of years ago when there was some pressure to do that. And you know, I think that that's the approach that we've taken and that's the one that we're going to continue to take.

Okay. And then final question on the balance sheet. Incredibly strong with the dividend taxation change. Any new thoughts on either increasing the yield, doing a special dividend, or what the acquisition landscape holds?

Mike, I guess I can address that. We look at our dividend policy every year at the end of the year. We review it with the board and we'll do that again this year. We are obviously aware of what have changed in the tax laws when we look at the dividend policy but we don't have anything at this point that we are going to announce from a dividend change. From an acquisition standpoint, we continue to pursue acquisitions as we go forward, you know, basically the same thing we said in the past that we won't do anything that would long-term jeopardize the financial performance of this business. So we're looking for acquisitions that really fit well with Graco like Sharp was.

Okay. Thanks and congratulations again.

Thanks.

Gentlemen, our next question comes from Taren Connor (ph) of Wellington.

Good morning. Most of my questions have been answered. Just a quick question on free cash flow, Mark, could you give us the components of that in the quarter please?

I'm flipping my pages here. Hold on. The quarter free cash flow is about $19.7 million.

Okay.

That's cash from operations, $23.7 million minus the CAPEX.

Okay. Great, thank you.

Yep.

As a reminder, ladies and gentlemen, should you have a question, please press star 1 or one followed by 4 on your push button telephones at this time. Gentlemen, please stand by for any further questions. Our next question comes from Ned Armstrong of Friedman, Billings, Ramsey. Please state your question.

Yes, as far as the growth that you're seeing in the Asian market, what are the drivers behind that growth and how might they vary from region to region?

Well, Ned, I think if you look at the growth in Asia, it's primarily driven by China and southeast Asia, and China being the largest of the two obviously. We're still seeing relatively flat to declining sales in Japan. Actually, in the second quarter, Korea had a great quarter. They were, you know, they were growing at very good rates. And actually, Australia also had a very good quarter from growth. But primarily, the growth is driven by China. And the southeast Asia, again, our industrial customer base is really what's growing there. We continue to work and try to create a market for our contractor business. We'll work that and put resource on that over the next few years. But really, the industrial market there is more developed than the contractor market at this point.

Okay. And can you elaborate on any new markets that you might be exploring, and by new markets I'm talking about product or end-user markets rather than geographic markets.

Well, the only thing I can say is that our brand new product that we just recently introduced was in the protective coatings area was our fast-set foams. We continue to look for new markets like that. This is the Reactor Fusion product that we introduced at the start of the year. It's been a great product for us and our Xtreme mix that was introduced has been a great product for us, both of them in the protective coatings area. We'll continue to look for new markets like that as we go. Obviously we are not going to sit here and tell you what we're working on from a product development standpoint in new markets going forward. But we can tell you the new markets we've entered in the last six months have been very successful for us.

Great, thank you.

You're welcome.

Our next question comes from John Franzreb of Sidoti & Company. Please state your question.

Just a quick clarification, could you remind me how much of your industrial automotive business sales are to Europe?

To Europe?

Uh-huh.

Hold on a second, John. Well, for the year to date, John, Europe industrial automotive is about a little more than a -- it's about a third of our sales.

Third of IA sales?

Yep.

Now, it looks like it's almost a one to one ratio, the euro-dollar exchange in the second half of '02. And at the current exchange rate that would suggest, you know, in constant dollars a 12% bump. Dave, you seem to indicate that Europe is kind of weakening on you. What are the expectations on European sales in the IA market for the second half of the year?

Obviously we don't get into forecasting, but I can tell you that, you know, everything I read says that Europe is basically flattening out, and there is some hope that perhaps at least it is flat, as compared to continuing to decline. You know, we're continuing to be aggressive, going after large projects, and medium size projects in Europe. I -- you know, it is certainly not a situation where we're losing market share. In fact I think our guys have done a nice job in gaining some share in Europe over the last six months or so. So we'll continue to be aggressive but it would be difficult to forecast what Europe's going to do. John, all I can say is that, you know, we think at this point it's relatively flattened out. And we should, you know, continue down the same road that we are.

Okay. So you don't expect any further weakness, at best you’re bouncing along the bottom?

Yeah, that's sitting here today, obviously anything can happen. But yeah, I would say that's probably true.

It's pretty weak over there, John, as you know, and the forecast has been cut below 1% for 2003 as far as the GDP growth. And the construction industry in Germany is weak, they're expecting a 2-3% decline in 2003. The whole environment over there is really -- we characterize as soft to weak.

Well, yeah. I'm just trying to get a sense Mark.

I think we're doing a fairly good job of maintaining in that type of an environment and hopefully I think our comment would be that we're hoping to continue that here for the second half of the year because we don't see a big change in the economic outlook.

Okay. Thank you guys.

Yep.

Thank you, our next question comes from David Gerot of T. Rowe Price. Please state your question, sir. Mr. Gerot, your line is now live.

[Extended silence.]

That's a tough one.

As a reminder ladies and gentlemen should you have a question please press star 1 or 14 on your push button telephones at this time. Our next question comes from Zuben Bomenshaw (ph) of Telecapital Advisors. Please state your question.

Hi guys. Just a quick update. I joined the call a little late. Any progress in adding any more home center chains to the existing ones?

Zuben, we talked about that. You know, we're continuing to pursue our initiative and our strategy. You know, to look at home centers, not only here in the U.S. but also in Europe. But there's really nothing new to report.

Okay, so there's not been any really big signings that have happened?

That's correct.

Okay, thank you.

You're welcome.

Our next question comes from David Gerot of T. Rowe Price. Please state your question, sir.

Hello? Can you hear me?

Yes! We can hear you now.

Thank you. That's strange. Couple of things or couple of questions. First, you talked about a product in the home center channel that sort of helped boost contractor sales a little bit. Was there sort of a fill in benefit in Q2 from that new product or was that just sort of normal new incremental sales and that should continue going forward?

I don't think it was as much of a fill as it was potentially going to be incremental going forward. It was a variation of an existing product that we had in home center, what we called the 190 ES. It was on a stand previously, it's now on a cart. We think that it serves the professional painter perhaps better than the 190 on the stand did. And I wouldn't -- there was some fill, but it wasn't dramatic.

Okay. I guess a clarification question. When you went through the organic growth and that was just without FX. If we actually strip out Sharp, the industrial automotive equipment division was more like 2 to 3%.

Correct.

Okay, just wanted to make sure I understood that correctly. The other question is when we're talking about sort of leverage and the company, I guess the one thing that is a little bit disappointing was, we had 6% or maybe 5% sort of organic growth in the quarter. And yet only on a precurrency basis and only 1% earnings growth on a precurrency basis which would imply that margins actually deteriorated on a precurrency basis even with some very healthy internal revenue growth. Can you talk a little bit about why that was? It was sort of these ongoing costs or these ongoing costs couldn't be absorbed by the normal incremental margins?

We did have some ongoing costs that Mark talked about, the health insurance pensions and so on and so forth. But also what we’ve done is taken advantage of the currency, and we’re investing in product development rollout programs and so on that would allow us to actually get leverage next year and the years after from new products being developed and introduced. As you look at our I guess our headcount, our headcount is actually down excluding Sharp, so we haven't added any resource that would cause us to be concerned that we, I think I heard it described yesterday as we couldn't take our foot off the accelerator on the spending side if we had to, and didn't have the tail winds of currency.

Okay. Okay. That is fine. The other -- is a lot of that investment being made actually in the industrial and automotive segment? Because it looks like basically sequentially, you had about $5-6 million or higher revenues. And yet the operating margins on that same revenue base were down and were only up slightly, and normally they're up more than just slightly. Is that mix, is that Asian lower margin, is that incremental investment?

Well, the investment really is -- the vast majority of the investment is coming in contractor.

Okay.

We've got, you know, as always we go through our evolution of product development. And we're, you know, we're in the midst of designing additional new products that will introduced early next year, and that's really where the investment is coming.

Okay, all right, thank you very much.

You're welcome.

If there are no further questions at this time, I will now turn the conference back to Mark Sheehan.

Okay. Hearing none, I will conclude by thanking everyone for joining us today for the conference call. We appreciate your interest in the company, and look forward to speaking with you some time here in the near future.

Thank you, sir. This concludes our conference for the day. Thank you for participating and have a great day. All parties may disconnect.