Graco Inc (GGG) 2008 Q1 法說會逐字稿

Good morning and welcome to the first quarter 2008 conference call for Graco Inc. If you wish to access for replay for this call, you may do so by dialing 1-800-405-2236 within the United States or Canada. The dialing number for the international callers is 303-590-3000. The conference ID number is 11112172. The replay will be available through April 28 of 2008. At the request of the Company, we will 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 risks factors including those identified in item 1A of, and Exhibit 99 to the Company's Annual Report on Form 10-K. This report is available at the Company's Web site at www.graco.com and the SEC's Web site at www.sec.gov. Forward-looking statements reflect the 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 new information or future events. (Operator Instructions). I will now turn the conference over to Caroline Chambers, Vice President and Controller. Please go ahead, ma'am.

Good morning and welcome to everyone. I am Caroline Chambers, the Vice President and Controller for Graco. I am here today with Pat McHale and Jim Graner and we will discuss the highlights of the first quarter 2008. After some brief opening comments, we will open up the call for your questions.

We experienced 3% sales growth in the first quarter with sales of $204 million. In Europe sales were up 21% or 9% with consistent translation rate. Asia was up 4% or 2% with consistent translation rate, incoming orders are 15% higher than last year, industrial sales were up 9% or 4% with consistent translation rate. Industrial increased by 6% in the Americas and 11% in Europe at consistent exchange rate with growth in Western Europe as well as the developing areas. We completed the acquisition of GlasCraft at the end of February 2008 and $1.5 million of sales were included in the industrial segment this quarter.

The business will not be accretive of earnings in 2008, but is expected to be in 2009. In the quarter, contractor equipment sales in the Americas declined by 16%. Despite flat sales in January, we saw weakening sales month by month for the rest of the quarter. We expect that condition will remain challenging for the rest of the year. The new product rollout in the home centers began in January; as anticipated operating earnings and contractor were affected by approximately $2.5 million for product returns, product development and marketing charges and other costs related to the Home Depot launch.

The total impact to the end of the launch is expected to be approximately $5 million. This is in line with our early estimates; there was an impact of $1 million at the end of 2007 and we expect that the remaining $1.5 million will impact the second quarter. Net earnings increased by 5% this quarter compared to last year while sales and earnings were favorably affected by currency translation rate. The operating earnings and the lubrication segment improved to 18% of sales this quarter compared to 14% last year.

Integration of the lubricant business and consolidation of lubrication operations in Anoka is complete now and we begin to see the benefits. We expect to return to a run rate in operating earnings for the lubrication segment in the low 20s by the end of the year. Profitability in the industrial segment continues to be strong with sales increases driving the earnings increase. In the first quarter, material cost increases from metals and other commodities have been largely offset by other purchasing activity.

However, we expect to see continued cost pressures going forward. The effective tax rate for the first quarter was 30% down from 35% for the first quarter last year. The decrease resulted from the completion of an examination of the Company's income tax return. The tax rate will vary by quarter and we expect to have the effective tax rate for the year will be approximately 34%. Concerning share repurchases, we had approximately $1.5 million shares or about $60 million worth of shares repurchased in the first quarter. In the current authorization, there remains $4.3 million shares and we expect to continue the sale repurchases throughout the year.

A brief comment on inventory, we believe that the increase inventory at the end of the first quarter is normal and expected. I would also like to add that the GlasCraft acquisition included about $3.5 million worth of inventory. In summary, we are encouraged by gains in our industrial and lubrication segments in North America and by continued strength in both Europe and Asia Pacific and we continue to be concerned by weakness in the US housing market and we will manage the business accordingly throughout the year.

This concludes our opening comments and we will now open up the call for your questions.

Thank you. Ladies and gentlemen, this time the question and answer session will begin. (Operator Instructions). The first question comes from the line of Terry Darling with Goldman Sachs. Please go ahead, sir.

Thanks, good morning. I am wondering if you could talk a little bit about the outlook for the lubrication margins now that you've got that process fairly complete, I know you just said low 20s by the end of the year but where do you see that in terms of upside potential beyond that on a longer term basis and do you see that ramp up in margins as we progress to 2Q, 3Q a sort of smoothing the way up to the low 20s or do you still expect some bumps along the way?

Yes, I am not sure it is going to be completely smooth but I think that we are in pretty good shape to get there. We expected to be in the mid-teens here in Q1 and we were at 18 so we felt like we were on track to hit that 20s. What is happening up in the factory right now is for activities coming up to speed, efficiencies are coming up to speed. We are taking a look at the actual equipment that was used to produce a product up there and we are making cost reductions and bringing a new capital into that factory. So to some extent, those projects will deliver some lumpy results but I think that you should expect to see a reasonable trend of improvement through the end of the year. If you remember the strategy on the industrial lube business, that is a really big market and it is close to what Graco does in a lot of other businesses that we did not play and really the long term vision on industrial lube is to make that a significant segment of Graco's business and so we are really focusing on that on developing new products and working on distribution channels trying to make that a big business.

Acquisition in that area also a potential area to drive that growth?

Yes absolutely. They likely would be small. There is a fair number of fragmented smaller players in that marketplace that have some interesting product lines that we would be looking at so that could happen as well.

And then in the industrial side the top line performance was better than we had thought there. A bit of a pick up from recent trends. Can you talk about that and obviously the margin performance is very good there as well and was that related to the stronger volumes or is there something else going on there in terms of mix that may not be recurring.

No, this is Jim Graner.

Hi Jim.

The margins there are what we have been running historically. We continue to make some improvement in our product cost area and in our pricing as well, so I think the margins will continue. The volume, I think will even perform a little bit better. We ended the quarter with a 15% increase in orders in the Asia Pacific but only 4% were realized through billings. So most of that will be in the industrial segment as well so the volume should have some tailwinds here going into the second quarter.

Sounds like, I mean your organic growth has picked up a little bit. Sounds like you think that is sustainable through the year.

Yes certainly in Europe and Asia we expect to have strength in industrial throughout the year. We are still planning to have growth in industrial in North America. You see the same things that we see in the news that economic conditions look pretty precarious out there but right now we are still seeing some growth.

A little less visibility on North America side. And then on the margins just finally on the industrial side, the year over year improvements tend to be a little weaker in the first quarter and then accelerate as you move into 2Q and 3Q, is that a similar pattern that you expect to occur or is something else going on there?

I think it is again subject to some future events around the world; we put price increases in place during the first quarter. They were put in place towards the end of February in the Asia Pacific so that should give our margins some improvement going forward. As Caroline mentioned while we have not yet seen any impact from significant increases in metals we expect to have some headwind from that going forward so hopefully the equation will balance and give us our historical annual trend with a little bit of pick as the year goes on.

We will also have some impact on industrial numbers of course in the acquisition of GlasCraft that we recently completed and although we do not expect that to be accretive this year we do think we picked up some interesting product lines. Right now we are in the process of trying to sort out what we should do with those products strategically but I would think it would be a fair assumption to consider that we may have some integration costs as we go through the year in 2008.

Can you remind us the revenue contribution that that business will make.

When we acquired that business to add $18 million in revenue. It had historic growth; it did grow in 2007 as well so we would expect $18 plus.

You probably get an amortization step up there for a couple of quarters.

Yes some purchase accounting impact on the first month as well as second quarter but again as Caroline mentioned we do not expect it to be accretive for the year so a little negative for the first two quarters, slight positive on the second two quarters but fully accretive in 2008.

Can you help us at all with the order magnitude that amortization step up, is that a half million/million range or are we higher than that?

The purchase accounting is about $700,000. The amortization step up for all the intangibles on an annual basis will be an additional $2 million.

What is the difference between the two pieces? I am sorry. $2 million is --

The purchase accounting of course is your inventory and backlog. Valuations, amortization relates to how we assign the intangibles. And that is other than good will.

So the $700,000 for the full year?

Right most of that will be incurred in the first four months.

So mainly a 2Q impact, got it. Thank you very much.

Thank you, sir. The next question comes from the line of Matt Summerville with KeyBanc. Please go ahead.

I want to go over the raw material thing again. I think it was mentioned that you offset the inflation you saw on the first quarter with purchasing related activity first. Can you go into a little more detail about that and then the price increase you put into place in industrial, is that enough to cover the inflation that we've seen out there in metals post the close of the first quarter.

On the purchasing side, our strategy in purchasing is really consistent year to year and we go into every year with a host of cost production projects and every buyers got them and sometimes they are resourcing and sometimes they are working with engineering or manufacturing. So we work that cost production list hard and we were able to, at least in the first quarter, offset some of the price pressure we saw with cost reductions. The numbers that we are looking at out there in terms of the metal price increases are substantial and I know our purchasing group is working hard to hold those increases off to minimize them where they can and to offset where they can. I would expect that that is going to be a challenge over the course of the next 9 months. From a pricing standpoint, in terms of the overall impact on Graco, I think our price increase is more than enough to offset the dollars that we will get on material cost but we will have to see how that plays out.

Okay. And then you mentioned in the contractor business how revenue performance or order tempo progressed throughout the quarter and I guess as we are sitting here in April, have you seen that sequential degradation like you saw in Q1, does it appear that that has bottomed that obviously at a lower level, and then can you do a similar walk in the industrial business with what you saw as the quarter progressed?

On the contractor side, we started out January looking fairly flat and January is typically a slow month for us. Obviously most of the country is not into the painting season but certainly as we went into February and March, which March is really the beginning of the painting season in earnest really around the country, we saw that business continue to weaken and I think our view and how we intend to manage the business going forward is just the kind of weakness that we saw in the first quarter you could expect to see that here in the next couple of quarters, if not, for the full year. So we are not managing the business as if we expect a significant rebounding contractor this year.

Our percentage declined for the quarter pretty much models what out the door sales that have been reported to us by distributors or channel.

Are you speaking industrial or contractor?

Contractor.

And then can you talk about how order sales tempo in the industrial segment looked like as we moved throughout the first quarter similar to how you just spoke about contractor?

The industrial side was a different story. The tempo really remained pretty consistent month to month. We did have the pickup in orders from Asia.

The 15% increase you spoke of early in the preferred remarks, was that 15% relegated to Asia Pacific? I want to double check on that.

Correct, just Asia Pacific.

Okay. Great. Thanks a lot.

Thank you sir. The next question comes from the line of Charles Brady with BMO Capital Markets. Please go ahead sir.

Thanks, good morning. With respect to the home center channel and the paint retail channel, can you give us a sense of just what the clients were?

The clients in both segments were double-digits with home center being a little bit steeper.

And as you rolled that new product out into the deepest stores, can you compare that product's sort of acceptance, I know it is hard because the market obviously is different than it was, but sort of what kind of product market acceptance you are seeing with that or not seeing?

I am going to take a stab at it and try not to confuse you but when we did the test last year, the results of the test were that the new unit sold significantly better than the old units and our early results here from the stores -- we started resetting in mid to late January, is the new units are selling at about 11% pace better than the old units. However, our business is still down so it is not enough to offset the negatives that we are seeing in the overall market but if you just do a comparison before/after out the door sales units versus old units, our units are kind of holding in that range that we expected based upon the results of the test.

Okay. Thanks a lot.

Thank you. The next question comes from the line of Ned Armstrong with FBR Capital Markets. Please go ahead.

Hi this is actually Chris Van Horn filling in for Ned. I just had a question on the breakout of the industrial sales. If you could just go into a little more color on the product lines, finishing, adhesives, coatings, and things of that nature?

In terms of directional, really all the segments perform well in Europe so that we start strength across to all of our industrial segments. Here in North America we saw a good strength on the finishing side. We saw some decent strength on high-performance coating and foam side which include our insulating foam business and our 2K business as well as some growth in our sealant business.

We have some real specific product families where we saw some big differences, but in general we were seeing positive territory across most of the products segments.

Okay. Great. Just a quick follow up what are you guys seeing in the commercial construction arena. Are you continuing to see a slow down or have you seen anything different?

It is okay for us right now. We think that it is going to hold up okay from a Graco perspective through the year but I think we see what everybody else is sort of seeing out there is that we expect there to be a softening in the construction market and probably gave some impact on us going on into 2009.

Okay. Thank you.

The next question is comes from the line of Mike Schneider with Robert W Baird. Please go ahead.

Thank you and good morning guys. Maybe first you mentioned that orders in Asia were up 15%, was that for the total Company or just industrial?

That was for the total company.

Okay. What were orders up in the Americas and in Europe?

I think -- hang on a second, I will go to the right page for the detail. In the Americas including the contractor business, they were down 3.5 and in Europe they were up about 8%.

And Europe, Jim, that would be about half currency.

These are both the 15% and numbers here I am giving you for Europe are at constant rates. Neither of them have any currency.

And again, just some more color in the industrial space. The industrial group by my calculations if you back out GlasCraft was up about 3% but that includes the Asia growth. Could you give us a sense though if you back, if you kind of back into the US and look at the easy comp and also exclude price. It looks like United States industrial was probably flat to down in units and that somewhat complex Pat with your comments about good growth and sounds like all 4 segments of industrial in the United States and wondered if you could just give us some more color.

I think the GlasCraft business is more global than you are estimating. In the first month, it was pretty much evenly split the sales between the 3 regions, so we are talking a fine line here of percentages.

Our growth in the segment that I talked about finishing HPCF and SAE also includes price.

In units Pat, it looks like maybe aside from process, these businesses at least in United States industrial were roughly flat.

: They maybe slightly positive.

And with the back drop of the United States economy, are you surprised that for example sealants and protective coatings are actually flat to up and is there some new products rolling through there or new customer programs?

Actually I am more optimistic about our industrial business than people are about the general industrial economy. We got a lot of stuff going on in the new product front. We are doing some things on the distribution front so we think some of those positive opportunities that we have are the things that are really within our control versus just sitting here and waiting for orders to come in. So we got the GlasCraft business, it is going to be very interesting for us. We are really excited about that. There is some new market opportunities there. We are launching products in finishing. We are launching products in process, heavily weighted towards the second half by the way in finishing and in process. We got a nice slate of new products coming out in our high-performance coatings and foams and SAE business this year. So there are some things that we think that are within our control and that are going to help us offset some of the softness we see.

And process specifically, I presume, is the strongest of the four subdivisions.

No, I do not think that is a safe presumption.

No, it is not.

But businesses no longer grow double digits.

For the first quarter, I mean, again, our business is lumpy. We had strong double-digit growth in that business in Asia in the first quarter. We had some delivery issues with a particular product family here in North America so our North America actual billings number is significantly less than our bookings in that number in that business -- that should square itself away here in the second quarter. We have a substantial backlog in that business right now.

Okay. James just specific to GlasCraft, 1.5 million in sales. And you mentioned in the release there is a million from GlasCraft operation expenses, by that phrase, do you mean that that is a specific inventory write up or additional amortization in such that it is a one time in nature or is that actually really the cost of goods sold in SG&A for GlasCraft in the quarter.

Mike it is really just all the operating expenses for the month -- while some of them are not recurring I would not say they are extraordinary. I mean what was booked as expenses for the month nothing has to do anything with purchase accounting, does includes amortization that we have talked about before the $2 million on the annual basis, 1 month's worth.

I am sorry, does include an inventory step up at least 1 month's worth?

The inventory step up is in cost to goods sold so therefore it is not in the expense line that we were referring to on the $1 million.

Oh, I see. So the operating expense, you are talking about just SG&A, not cost of goods sold as well?

Right.

Got it, okay. I believe that is it. Thanks.

Thank you sir. Next question comes from the line of Ned Borland with Next Generation Equity Research. Please go ahead.

Hi guys. I just want to get your comments on the sell through in the professional paint channel for contractor in North America.

Our measure is again are reported to us show that the sell through from the distributors was down about 15%, it varied by account but overall about 15%.

Okay. And then I guess could you comment a little bit about your international expansion for distributors.

Yes. In terms of distributor count on a rolling 12-month basis, we put about another 165 distributors in between Europe and Asia and that continues to be a key growth strategy for us. We have also really been continuing to ramp up the headcount in both sales and marketing in those geographies and as those sales people come on board we will be continuing to build out the channel. Primarily, those channel adds are in developing countries, eastern part of Europe, Middle East, and then India, China, and some parts of Southeast Asia.

I guess the percentage of revenue you got from new products, I guess, products launched in the last 3 years.

Last year, our number was 21%. I have not seen the quarterly number at this point.

It is about 28% at this point in time for the first quarter.

Okay, great. Thanks. That is all I had.

Thank you sir. (Operator Instructions) Next question comes from the line of Kevin Maczka with BB&T Capital Markets. Please go ahead.

Good morning.

Good morning, Kevin.

Just a question on the SG&A step up, that was up much more than I expected in the quarter and even when I back out some of the unusual items that you cited in the release, it looked like it was still a much higher run rate than it's been, can you just give some more color on when that was from?

In addition to what we called out in the press release in the [MDNA] there are increased expenses in the Asia and Europe. I think we have mentioned before that we feel that scenario that we can really grow, so we funded lots of sales of people in both regions and really what you seeing that part that we did not cover the step up in spending to support those people, to add to the distributors that Pat just mentioned.

Okay. So that should be more of an ongoing expense because those people are obviously are going to ramp up and be productive in sales going forward.

Yes, and we of course feel that their sales they are generating more than pay for those incremental expenses.

Sure, okay, and in Asia, it looks like in terms of revenue growth, ex-currency that was up just slightly and had been running much higher than that in previous quarters. Is that just a more lumpy business than maybe I thought it was or is there something that else going on there short term?

I think that if you look back to 2007, the percentage increase over 2006 was close to 30%. So one of the comparisons had some big percentage increases before, but there does tend to be lumpiness with respect to the orders at the margin. There are some significant industrial plants being built both in India and China and if you get an order for 500,000 or 1 million and you lump two or three of those together swinging from one quarter to another,that will cause the kind of fluctuations that you are seeing.

Okay and just one more if I could. In terms of channel inventory, you talked a little bit about your own inventory situation, but in terms of channel inventory it looks like orders were up in Europe and Asia but down in the Americas. Is that sort of the moving parts in terms of the channel inventory kind of work themselves out now?

Yes. I think out big issues with channel inventory were on a contractor side through really out 2006 and 2007. When you take a look at sell-through versus sell-end to the contractor channel here in North America over the course here it looks like that is starting to balance out. We still have some accounts that are reducing inventory, we had a couple of accounts that put in a little bit more inventory. So overall I think that we are starting to see a much better alignment with our sell-through and our sell out than we have seen in 2007 and prior.

The industrial side, our distributors do not carry a lot of inventory in excess of what they need to serve the repairs to the local market, we ship quick and that is typically not an issue for us in the industrial channel.

I got it. Thanks for the time.

Thank you sir. The next question to follow up question is a follow up question from the line of Charles Brady, please go ahead sir.

Thank you. With regard to contractor segment and given I guess what sounds like maybe an acceleration, some slow down towards March, any additional promotional activity, ramping that up that could impact some of the margins maybe more than normal?

I think you should not expect that going into the end of the year. We really started the year out with a desire to try to do what we could do in the contractor channel and we really did all of our normal programs in Q1. We allowed our sales people to travel as normal; we used our normal sales buster promotions and our channel promotions, and our end-user pull promotions and we wanted to let that play out in the first quarter and see if we really did everything we could, do how that would turn out and you can see how it turned out and it didn't turn out too good. And so going into second and third, and fourth quarter, I think we will be taking a look at how to manage the expenses of that business more appropriately for the market conditions that we have and you should not expect that we are going to go out there and get into some promotional price war with the competition at this point.

We do have some things that hopefully over the course of the year are going to help us when the Home Depot roll out launches complete. That should help the contractor division. We have also been working hard on trying to get a test at Lowe's and although we do not have a deal at this point, we are close enough to having a deal with Lowe's that I think that you could plan that at the second quarter Graco's going to launch a test program with Lowe's. That would probably be earnings neutral over the test period but we think that that has some potential upside for us if we're successful on that endeavor.

Thank you very much.

Thank you. The next question to follow up from the line of Matt Summerville with KeyBanc, please go ahead.

With respect to your last comment Pat, how long would one of these test periods last with a customer of Lowe's size?

We expect that it would run through the painting season, so again, I do not have a schedule at this point but I would anticipate that that would be a test that would be on a 6 month plus type of basis.

So pretty much carry you through the end of the year, is that fair?

Yes. I think that for sure it would carry us to the third quarter.

So if you were going to see any type of ramp in selling to Lowe's on a more broad basis, it would be more of an '09 event?

I think that is a good estimate.

Okay, and then a couple other questions. I guess how are you guys thinking about the tempo share repurchase going forward, should we anticipate similar things to what we saw here in Q1 and then if you could just give me the quarter-end fully diluted share count as opposed to the average like reported in the press release.

Yes. We have the open authorization remaining from the board at about $4.3 million shares so we will continue to buy shares and I would expect to be close to the run rate of the last two quarters.

Caroline is checking the share count.

Okay. I will just ask my next question then, with respect to Europe, can you provide a little bit of color on the tempo business I guess between I think you spoke about seeing strength in both Western Europe and developing markets within that geography, Pat, could you just give a little more granularity there?

Sure. You know we have seen in the Western Europe from the beginning of the year is growth rate that is kind of in that two times GDP type range which would be I think a normal kind of a Graco expected growth rate over the one term for that geography, and then we have seen very strong double digit growth in Eastern part of Europe and in the Middle East and in Africa. We think that that is likely to be a sustainable trend. Jim and I were just in a meeting here with all of our top European sales people, and we got to spend us some significant time talking about some of those markets over there. And it really looks like and really it is my own observations while traveling in those geographies, is that the business activity in places like Russia and the Middle East and even parts of Africa now look to be favorable for Graco and sustainable. So I think that mix of a mid-digit growth in Western Europe and then high double digit growth in the other part of geography is something that we would expect to continue to drive.

And then just one final question, you provided order activity for the quarter by geography I believe for all of Graco. Do you have that for just the industrial business?

We do not go drill down into orders by segment, incoming orders. No we do not.

I just wanted to get back to you on the share count is about 61 million.

At the end of the quarter. Thank you.

Thank you. If there are no further questions I would like to turn the conference back over to Patrick McHale. Please go ahead.

Alright. Thanks, just in terms of a couple of comments about how we plan to manage the business gone forward, really Graco's profit per sales dollar is high and I am really committed to making sure that were making the incremental investments that we need both in new product development and in our geographic expansion initiatives to drive revenue into the organization and we are really focused on making sure that even in light of some tough conditions year in North America right now that were not going to starve our growth opportunities for 2009 and beyond. From a cost standpoint we have put a lot of emphasis on our factory operations, we are having detailed cost reductions, meetings with every manufacturing sale about every 6 weeks and going through the details of their cost reduction programs; we are really focusing on productivity.

And fortunately from a Graco standpoint, with our factories located the way they are, we are able to flex both people and jobs from factory-to-factory and we have think we done a pretty good job of managing the work load despite some lumpiness and how the orders are coming in. We were really laser focused on cost reduction in the purchasing organization; as we talked about earlier today the commodities pricing, the situation out there looks extremely tough and we need to make sure that were doing everything that we can to have offsets. We have been successful for the first few months. We want to continue to work hard and focus on that. We are also focusing on product development resources on cost reduction projects in conjunction with manufacturing and purchasing initiatives or in conjunction with actual new product launches.

We are going to work to manage discretionary expenditures in our North American contractor division. We do expect tough conditions to remain there throughout the year. We are currently not in a situation where were looking at and doing a wholesale headcount reduction in that particular division but we are looking at how we can reallocate some of our resources to make sure that were generating growth opportunities where they exist. I appreciate your time today and thank you very much.

Thank you. Ladies and gentlemen, this concludes our conference for today. Thank you for participating and have a nice day. All parties may now disconnect.