Graco Inc (GGG) 2003 Q3 法說會逐字稿

Good morning and welcome to the third quarter 2003 earnings conference call for Graco Inc. If you wish to access the replay for this call you may do so by dialing 800-428-6051 within the United States or Canada. The dial in number for international callers is 973-709-2089. The conference ID number is 309332. The replay will be available through October 21, 2003.

(OPERATOR INSTRUCTIONS)

During this call various remarks may be made by management about the 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-K and its most recent 10-Q.

I will now turn the conference over to Mark Sheahan, Vice President and Treasurer. Please go ahead, sir.

Thank you very much. Good morning. I will quickly go through the highlights of the results that we published yesterday afternoon, and then we will open up the call for your questions. Dave Roberts and I are here this morning.

We're pleased to report another net sales increase in the quarter. The 6 percent sales growth in the quarter was our sixth consecutive quarter of sales growth. And in this quarter all divisions and all regions reported sales increases from last year's third quarter.

The increase in the sales in the quarter was really driven by favorable exchange rates, growth in the contractor equipment business, growth in the Asia-Pacific region, and revenue associated with the Sharpe acquisition that we did earlier this year.

With regard to exchange, the weaker dollar versus the euro was the primary driver for the favorable currency impact that we've experienced this year and in the third quarter. Specifically, in the first nine months of the year the average euro to US dollar exchange rate has been approximately $1.11. And if you compare that to the first nine months of last year, that average euro to US dollar exchange rate was 93 cents. So that's a 20 percent weakening of the US dollar.

Currencies in the quarter added about 3 cents to the earnings per share -- diluted earnings per share -- and for the full year, added about 13 cents to the diluted earnings per share.

For the third quarter, the earnings per share, as reported, were up 17 percent. And that reflected the combined impact of the 11 percent increase in net earnings and the reduction of the shares outstanding due to the large share buyback that we did in March of this year.

On a year-to-date basis, diluted earnings per share are up 17 percent on a revenue increase of 9 percent.

Talking about the segments, in the third quarter the industrial/automotive equipment division reported sales of $57.3 million. That was up 9 percent versus the same period last year. Without the favorable impact of the currency, the sales would have been up 5 percent. Growth came from the Sharpe acquisition and continued growth in Asia. In the Americas the sales were up 7 percent in industrial/automotive due to the impact of the Sharpe acquisition. In Europe, the volume was flat but the recorded sales were up 11 percent due to the strength of the euro. In Asia-Pacific sales remain strong, volume increased 9 percent, and the reported sales were 10 percent higher.

Profitability for the industrial/automotive equipment division strengthened in the third quarter. Operating margins were reported at 29.6 percent versus 27.4 percent last year. Operating profit dollars grew 18 percent versus last year's third quarter. Year-to-date industrial/automotive operating profits are up 17 percent on a revenue increase of 12 percent.

In summary, for industrial/automotive we're seeing no underlying growth in North America and Europe. Capital spending remains soft, the Sharpe acquisition is contributing to the revenue growth, as are exchange rates, which are adding to revenue and operating profits. Underlying growth in Asia-Pacific is continuing. As we get into the fourth quarter these comparisons will be more difficult because we will start to anniversary some of the strong quarters that were posted beginning about a year ago.

Turning to the contractor equipment division, when compared to the third quarter of last year, the worldwide contractor equipment division sales increased by 4 percent. In the Americas the sales were up 2 percent and were characterized by growth in the professional paint store channel and a decline in the home center channel. As we mentioned in the press release, third quarter sales in the home center channel were adversely influenced by a change in inventory purchasing practices at one of our major customers. If you look at Asia in the contractor business, their revenue was up 18 percent, mostly volume related. And in Europe, the reported results were 14 percent higher, primarily due to the strong euro versus the dollar. But there was some underlying growth as well.

Operating profits in this segment strengthened in the third quarter. Margins were at 26.8 percent versus 24.5 percent last year. And operating profit dollars grew by 13.5 percent versus last year's third quarter. On a year-to-date basis the contractor operating profits are up 11 percent on a revenue increase of 8 percent.

In summary, we're seeing continued growth in the paint store channel. Home center sales were disappointing this quarter, but we believe that the decline was really due to the change in inventory practices. And Europe is benefiting from underlying growth and a strong euro currency. Asia is growing as we're continuing to build our market position in airless spray equipment to serve the growing economies in that region of the world.

In the lubrication equipment division, in the third quarter their sales were $11.2 million, which is up 10 percent from last year's third quarter. And this increase was due to stronger sales in the Americas versus the third quarter of last year, which was a particularly weak quarter for lubrication.

For the third quarter our operating margins in lubrication were 13.8 percent versus 18.3 percent last year. The operating earnings in the third quarter of 2003 include approximately $1 million of warranty and rework expenses as a result of design issues associated with the Matrix fluid management system that we launched late last year. The Company is working to address these issues, and the product will be re-launched when the design issues are resolved. The year-to-date lubrication operating profits are down 3 percent and the year-to-date sales are up 3 percent.

Looking at the gross profit margin in the quarter, the gross profit margin was 53.4 percent company-wide versus 52 percent last year. And this gross margin was due to a combination of factors, including the favorable currency environment that we're operating in, some enhanced pricing, material cost reductions and factory efficiencies.

As a reminder, in terms of the gross profit margin, exchange has a favorable impact on our gross margins when the dollar weakens since changes in exchange rates have less of an impact on cost than on sales, given that about 27 percent of our sales are in non-US dollars, while only 3 percent of our cost of goods sold are in non-US dollars. This obviously works the other way if the currencies move in different directions.

Looking at the Company's operating expenses, selling, marketing and distribution and G&A expenses were higher in the third quarter of 2003 versus the third quarter of last year. Overall these expenses were up $3.6 million. There were a number of areas where the increases occurred, consistent with what we've seen so far this year. These would include things like exchange rates. We do have some of our costs in non-US dollars. So as the euro weakens, for example, the costs, when they get translated into US dollars, are higher on a comparable basis than a year ago. We do have some payroll related expenses that are higher this year, including salaries, pension, medical, incentives, those type of things. We have added the Sharpe expenses to the income statement. In the third quarter this year we did make additional contribution to the Graco Foundation; we did not make one last year in the third quarter. And we do have the warranty issues that were previously mentioned associated with the Matrix product and other areas.

Looking at the tax rate for the quarter, the effective rate was 32.2 percent versus 32.4 year-to-date.

And some other items -- the year-to-date cash flow from operations very strong at $84.8 million, up from 73.7 million for the first nine months of last year. The significant uses of cash this year have been for property, plant and equipment additions of about $11 million; share repurchases of about $55.5 million; dividends of about $11.5 million; and the retirement of debt of about $9 million.

In addition to these items, it was noted in the press release that Graco has made a $20 million, or $13 million after-tax, contribution to its defined benefit pension plan. The contribution was made to increase the pension assets at a time when the values have declined due to the weak short-term asset performance. This contribution will substantially enhance the funded status of the plan and reduce the near term need for additional cash contribution. It is expected that the plan will be over-funded at the end of the year, provided that the asset values remain where they're at for the remainder of the year.

Accounts receivable are higher than a year ago. They're at 95.5 million versus 93.6 million. This reflects the increased sales activity that we've experienced this year and the addition of Sharpe.

Inventories are also higher than at year-end and at last year, with the majority of the increases due to the Sharpe inventory being added, as well as some increases in industrial/automotive to support some new product introductions that were launched earlier in the year.

In summary, Graco had a good third quarter -- 6 percent increase in sales; 11 percent increase in net earnings; and a 17 percent increase in earnings per share.

This concludes the opening comments. I'd ask the operator to open up for your questions.

(OPERATOR INSTRUCTIONS) Ned Armstrong, Friedman Billings Ramsey & Company.

Good morning, gentlemen. Could you elaborate on some of the growth initiatives, both product-wise and channel-wise, that you're pursuing?

We certainly are still investing in product development. We've seen some strong growth from new products that we've introduced in the industrial segment, primarily what we call the reactor infusion . We have seen nice growth this year from that product. And also in our contractor business we saw nice growth.

Unfortunately the investment that we made in Matrix, were having a short-term impact on earnings as we fix some of the problems we have there. But we still think that's a good product and have heard a lot of, frankly, very good comments from the field from the customer base.

As far as expansion of distribution, we continue to add distributors, primarily in Asia. As we go through our US distribution and what we call specializing those distributors, focusing on our four product areas in industrial. And we're starting to see growth certainly in Asia and see a little additional growth here in North America because of that.

Is the Asian growth across the continent or is it largely coming from specific markets or a specific market?

Actually, our growth is coming out of three areas -- actually four areas. It's coming up China, Korea, Southeast Asia and Australia. Japan is the only region that is actually down.

One more and I will let someone else jump in. With regard to the Matrix, what specifically was the issue there?

What we had, it's a radio frequency device and we had interference in some of the dealerships with the phone system they were using and also some of the other equipment they had in the dealership. We were focused on specifically one RF band. We've now come up with basically what's called a looping band that jumps from band to band and it's being tested in lab today. We also had some memory loss with the meter, which frankly is in field test today and looks as though that problem is resolved.

Thank you.

John Franzreb, Sidoti & Company.

I was wondering if you could provide a little color as to what the change was in inventory purchasing practices by a major customer and how it is impacting you.

What that was, it was a large home center customer. And what they did was reduce their on-hand inventory of from eight weeks to six weeks and it had an impact on sales in the third quarter for us. We think that that is now complete. We weren't the only vendor that they did that with. Basically we saw out the door sales of their stores actually improve in our segment, but what we were selling in the quarter actually declined, primarily because of an inventory adjustment.

That's all flushed through now?

Yes.

I guess in a similar vein, regarding the Matrix product line are there any more costs that you expect to incur in the fourth quarter regarding that rework?

We don't think there's anything significant there. That could change, obviously, as we get into field testing. But we think that we've identified all the cost issues. And at this point we don't anticipate any other costs impact because of Matrix.

And one last question. When I looked at the operating margin on the industrial/automotive side, there was a significant tickup compared to the previous quarter -- not year-over-year, but really sequentially. I wonder if there's something going on in the product mix, because it shouldn't really be a currency issue from the second to the third. Can you give me a little color what's going on there?

I think it's the spending levels have come down in the operating expense side of the equation. The margins have been strong because that business is really a benefactor of the euro. A large portion of the European sales are in industrial/automotive. But I think they did a better job managing their spending and getting distribution and product development in the quarter.

Thanks a lot.

Mike Schneider, Robert W. Baird.

Two questions. First, just the inventory hit to the quarter at the retail customer. I've got it at about 2 to $3 million as what the cost of that two weeks was. Is that a good ballpark figure?

We haven't really done any work on it, Mike. And you never really know. So we are not comfortable giving out a number.

Just switching gears to a more macro question, your capacity now that you have done some bricks and mortar work up in Minneapolis and you have started sourcing more from Asia, can you just give us kind of an 18 or 24 month view on where you stand in capacity, what you think the revenue capacity of the current fixed costs or the fixed structures are, and then also where you standing your sourcing initiatives and what's to come in '04?

The brick and mortar that we added really is office facility as compared to manufacturing capacity. We think our capacity is probably in the 75 percent range today. We made an announcement -- I think it was the end of September -- that we're closing the Santa Fe Springs facility that we bought, bringing that back into Sioux Falls, South Dakota -- the production that we were doing in Santa Fe Springs back into Sioux Falls. We still think we're about 75 percent capacity, so I guess you could take that and multiply it by what you think the revenue will increase to get where we would be for capacity.

I would say if you look out over the next 18 months, we're not planning for any additional manufacturing capacity with the internal growth of the Company. The only caveat to that would be in acquisitions, where if we were to do one and bring it in then we'd need to expand our capacity.

And your sourcing initiatives, what's on the board or in the plan for the next 18 months going (multiple speakers) --?

We're still aggressively sourcing product out of Asia. We announced, I think it was a year ago, that we added a purchasing group in Shanghai itself. We're really starting to see those efforts pay off now. It's taken a while to qualify vendors so on and so forth. Today -- and this is purely a guess on my part -- but I think it's about 5 percent of our purchases are coming out of Asia today and we will see those increase as we go forward.

And then just final question -- if you look at your professional sales, they were up nicely this quarter and presumably the strong housing starts are benefiting them. When you talk to Dale and others in that channel, what is the attitude of builders these days? Are they cautious and prone to draw down inventories? Are they still optimistic, given the building permits hit the new record high? Some qualitative comments?

I think that if you look at it, talking to the customer base, they are still optimistic. The NAHB released their '04 forecast here a couple of days ago. They're actually forecasting new housing starts to be up about 3 percent next year compared to this year, which obviously was a very healthy year. We don't see anything at this point that would suggest that that market would soften at all.

Thanks again.

(OPERATOR INSTRUCTIONS) Ned Armstrong, Friedman Billings Ramsey & Co.

Regarding the pension contribution, is any portion of that going to flow through the expense line?

Eventually the funded status of the plan has an impact on how much expense you record. So I guess the answer would be yes.

In terms of the amount, at this point, given that we do the analysis at the end of the year, I would not have a number for you. But again, it should substantially enhance the funded status of the plan. And when the actuaries run the numbers over a long time horizon, that should help with the overall expense impact.

Thank you.

Mike Schneider, Robert W. Baird.

Along those lines, the pension expense for this year, what will it be? And then again assuming a constant market, what do you expect pension income to be next year, because I presume this is a positive arbitrage for you, given the interest rates on cash and the assumed pension return?

I don't think we've disclosed in the pension expense. But in 2003 it is an expense item for Graco. And again, at this point, given that I'm not sure where the asset values are going to be at the end of the year, I'm not prepared to give you a number for 2004. But it should be beneficial to Graco on a year-over-year comparison basis, given the fact that the market has come back, and the fact that we've made this contribution.

The pension cost this year -- last year, in '02, it was just about $0.75 million, I believe, of a credit. And in '03 it will be an expense item. Can you just give us a ballpark figure?

A couple million bucks.

So presumably, if you're even balanced or that is zero funded or over-funded in '04, that $2 million pension expense goes away?

Again, I'm not an actuary, and they run the numbers. It depends on what happens to the asset values between now and the end of the year.

Almost out of obligation I have to ask about the cash balance. What is the status of the acquisition pipeline? Presumably the Board meets here after year-end or near year-end and the dividend policy, etc.?

We stated previously that acquisitions certainly would be hopefully the major consumer of the cash. If not, then we would do something with either share buybacks or dividends.

We can just tell you that we are hot on the acquisition trail. We're are continuing to look at companies. And I can basically say that we think activity is starting to pick up in that area. We're seeing more opportunities today than we did a year ago. But certainly that's all I can say on the acquisition mode.

The Board does meet the 1st of December -- in the first week of December. And at that point we will be discussing the dividend policy going forward.

Thanks again.

Tulen Conna , Wellington Management.

Just a quick question on foreign currency. I know there have been a few here. Clearly it's been a big beneficiary -- it has really helped Graco over the last 12, 18 months. I'm just wondering I guess on a longer-term basis, what measures are you taking in the event that the US dollar actually swings the other way? We have been there as recently as '99, 2000, when it was at 87 cents to the euro. And it came fast and just swung the other way. So what kind of longer-term measures are you putting in place to prevent any major impact on your earnings and margins?

Certainly, as we're focused on next year, and preparing for next year, that's an element of our earnings this year that we're very aware of. And we will continue to deliver earnings that we think are Graco-like going forward. And we constantly look at our expense levels in all the various areas and we will continue to do that. But the management team is aware that we've gotten some tail wind due to currency this year. And we're very concerned if it does return the other way. But I think you have to look back as shortly as 2001, and we did have head winds from currency, and we still delivered, frankly, very good results during those years. So we took advantage of the tail wind this year and made some investments in the business that we think are going to help us going forward.

One other fall on, and I may have missed this. But the two issues that impacted you this quarter -- the Home Depot inventory issue and the charge that you took in the lubrication business -- combining those two, what was the impact on an EPS basis?

We didn't break that out, primarily because we don't have a good confidence level in the number related to the home center.

But I think you said it was two weeks of sales, right?

Two weeks of inventory.

Thank you.

(OPERATOR INSTRUCTIONS) If there are no further questions, I will now turn the conference back to Mark Sheahan.

I'd like to thank you for your participation today. And at this time I'd like to conclude the call.

This concludes our conference for today. Thank you all for participating and have a nice day. All parties may now disconnect.