Graco Inc (GGG) 2009 Q1 法說會逐字稿

Good morning, and welcome to the First Quarter 2009 Conference Call for Graco Inc. If you wish to access the replay for this call, you may do so by dialing 1-800-405-2236 within the United States or Canada. The dial-in number for International callers is 303-590-3000. The conference ID number is 11130290. The replay will be available through April 27, 2009.

Graco has additional information available on PowerPoint slide presentation, which is available as a part of Webcast Player. At the request of the Company, we will open the conference up for question 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 Provision of the Private Securities Litigation Reform Act.

Actual results may differ materially from those indicating as a result of various risk factors, including those identified in the item 1-A of [an exhibit 99-2], the Company's 2009 annual report on Form 10-K. This report is available on the Company's website at www.graco.com and the SEC's website at www.sec.gov. Forward-looking statements reflect management's current views and speak only as of the time they are made.

The Company undertakes no obligation to update these statements in light of new information or future events. At this time all participants are in a listen-only mode.

(Operator Instructions)

I would now turn the conference over to Caroline Chambers, Vice President and Controller. Please, go ahead.

Good morning, and welcome to everyone. I'm here this morning with Pat McHale, Graco's President and CEO and Jim Graner, our CFO. I will briefly review our first quarter results and Pat will follow with additional comments. Following these opening comments, we will open up the call for your questions.

Our operating results were severely affected by the depth of the recession with a decrease in sales in all segments and regions. Low volume drove a decrease in operating profit margin with impacts from low factory volume, workforce reduction costs and currency translations that also affected profitability.

Sales declined by 32% or 29% at consistent exchange rates in the first quarter, as compared to the same quarter last year. By region, sales decreased by 32% in the Americas, 40% in Europe or 32% at consistent exchange rates, and 24% in Asia Pacific. Our gross profit margin as a percent of sales was 46.7% this quarter, down from 54.8% last year. This is primarily due to lower production volumes, which was about four percentage points of the change, unfavorable currency translation rates, workforce reduction costs of $3 million, approximately 1.5 percentage points, and increased pension costs of about $2 million, approximately 1 percentage point.

Total operating expenses were slightly lower than last year. We saw product development spending that did increase by $2 million, as well as increased pension expense of $3 million and severance expense of $1 million in operating expenses. Offsetting these increases were the effects of the workforce reduction that was made in the fourth quarter of 2008, lower incentive and bonus provisions and other spending reductions. Effects of currency translation also decreased operating expenses by $2 million.

The effective tax rate for the first quarter was 34%; this is higher than last year's first quarter rate of 30% as there was a settlement of various exams in the first quarter of 2008.

On the Webcast Player you'll find there are some PowerPoint slides, and on page five are some additional segment comments. All of the segments were significantly affected by the effective volume and operating margins, unabsorbed manufacturing costs, severance costs related to the workforce reduction and the effective currency. All segments also saw additional investment in product development spending as compared to last year.

Profitability in the Contractor segment was also affected by the introduction of the entry-level unit in additional home center stores this quarter, and a change in the channel mix between the Paint Store channel and the Home Center channel. Profitability in the Lubrication segment was affected by change in product mix between vehicle services and industrial lubrication.

On page eight in the PowerPoint presentation, you'll find some comments concerning liquidity. We continued to have strong cash flow in the quarter with positive cash flows from operations of $28 million, down 13% as compared to last year. We are focused on managing working capital and saw a decline in accounts receivables of $21 million, and a decline in inventory to $6 million. We also reduced long-term debt by $13 million this quarter.

I'll now turn it over to Pat for additional comments on the quarter.

Morning. Business conditions in Q1 were obviously very difficult. We saw declines in production in our customer base, along with significant reductions in factory capital equipment spending, the weak construction markets and also inventory reduction by our channel partners and our end customers, and all those things pressured us in all product lines and all geographies.

The Q1 declines were steeper than we had anticipated in the fourth quarter, and so we took further expense actions in March, including a workforce reduction of about 180 people, both factory and office. Although we have reduced our headcount by more than 20% during the past year, we continue to protect our key long-term growth initiatives and our human capital.

We did win 300 new home center outlets in Q1 for our entry-level spray equipment business; we had one-time costs associated with that of $1.5 million. Due to the nice growth of outlets over the past few quarters, our North America Home Center business actually grew in Q1, while our North America Paint Channel business declined in line with the segment.

As Caroline mentioned, we are seeing pressure on margins, due to this mix shift. We're also seeing customers buying down to lower priced and less profitable equipment in both the Home Center and the Paint Channel segments. I expect this dynamic to continue until we begin to see the North American housing market turn.

Our pricing powers remain intact, we are on-track to realize the 3% that we had planned and previously communicated. Our cash flow for the quarter remains strong at $28 million, that's 20% of revenue, and we're certainly going to continue to focus on cash generation in the coming quarters.

As you know we had a goal during 2008 to increase our investment in new product development. By Q4 we had completed our ramp-up of hiring and we were running to our expanded project plan. Our $10 million spend in Q1 was roughly flat to Q4, but it was up 26% versus a year ago.

As communicated previously, we will begin to see the first results of this incremental investment in the second half of 2009, and we should achieve the full impact in 2010. We continue to be positive on the long-term growth opportunities internationally, particularly in the developing markets. However, currently Eastern Europe is extremely weak and I don't expect much improvement there this year.

I am more optimistic about our 2009 opportunities in both India and China, and long-term I'm convinced developing markets will offer above average growth opportunities as people strive for a higher standard of living and industrial production grows to meet those demands.

You'll recall last year we increased our sales and marketing people in Asia by 33% and in Europe by 15%. To-date we have maintained this investment level, although we're not currently adding additional headcount, but we do continue to set up specialized distribution and to strengthen our channel.

On the acquisition front, we continue to explore opportunities to acquire businesses where we can add value, although we will become conservative in our decision process and we favor a near-term debt reduction to anything but really the most ideal acquisition opportunities. The August 2008 acquisition of Lubrication Scientific was integrated into our Anoka Lube facility in the first quarter. This acquisition broadens our product offering in the Industrial Lube segment, which we've targeted for growth.

As discussed in the Q4 call, our factory performance in Anoka is behind plan, and we have a number of significant projects yet to be implemented to get product margins in the Industrial Lubrication segment to our desired levels.

Operational excellence remains a top priority. We continue to drive cost reduction programs in all factories. We anticipate lower capital needs this year, approximately $20 million as the current volume levels are not driving the need for capacity expansion, and we've also increased the hurdle rate on other investments to reflect the uncertain conditions.

Our purchasing team is doing well harnessing cost reductions, approximately $1 million for the first quarter. We anticipate favorable comparisons on materials for the year. Near-term, we expected the business to remain challenged, few end markets or geographies show any real signs of strength. I will say that our order rate over the past several weeks has improved slightly from a run rate perspective, although we expect Q2 comparisons to be difficult.

Forecasting is nearly impossible, so we're developing some contingency plans to address various potential scenarios that might unfold. I want to make sure that everybody understands our business model is still sound, the competitive environment is stable, our product offering, our channel and our sales organization are all as strong or stronger than ever. While the reductions we've made have been painful, we have attempted to avoid cutting too much muscle, and we expect our results will improve quickly with modest volume improvements.

Apart from volume and mix, our gross margins are strong. Our incremental operating margins are high, more so are our decremental margins, and with the expense actions already taken, we expect our earnings will improve quickly when business normalizes.

With that, I'll go ahead and open up the call to questions.

Thank you. The question and answer session will begin at this time.

(Operator Instructions)

Our first question comes from the line of Kevin Maczka with BB&T Capital Markets. Please, go ahead.

Good morning.

Morning.

Good morning.

I guess, Pat, you just mentioned it at the end of your remarks there that you have seen some modest uptick in your order rates in the last few weeks. I'm just wondering if you can give us a little more color on specifically what you've seen, either by segment or by region of the world?

I can tell you that the uptick we're seeing for the last few weeks is in that single-digit kind of an uptick, it's not dramatic, but if you're looking for glimmers of hope there's one there. I'd say the area that's not really showing that yet in my book is Europe. I think that there's still a little bit of weakening happening there. In fact, I talked to one of our European team guys here yesterday in the office, and I think that's probably the softest region at the moment.

All right, and then on the cost side, Pat, and the downsizing that you've done -- I have to look back I think to Q1 of '04 to see the last time that revenues were at this level and at that time, operating margins were 25%. Now, I know you're a much bigger, much more global company today than you were then, but with the cost actions that you've done -- what do you view as normal in this environment?

Well, it's hard to view anything as normal in this environment to be perfectly honest with you. Taking a look at that from a cost structure perspective there's a lot of things that were different in 2004. You need to take a look at what's going on with pension and there's probably a $15 million delta there. We've got $10 million of intangibles we didn't have back then, we've got $9 million of stock compensations since that -- accounting for that change. So, there are some things that are different.

In terms of the fundamentals of the business, we've got about 300 more people now than we did in that timeframe. After all the cuts we've made, we've taken out well over 500 -- we've got about 300 more than we had back then. Those heads are primarily in Europe and Asia -- that's about half of them, and the other half is mostly in product development here in North America. And again, as I've communicated I think pretty consistently for the last year and a half, we're doing everything we can to hang on to those investments because we see that those investments are what's going to drive our future.

Okay, and then finally if I could, Pat, on the product development cost and the operating expenses, you're still aggressive with your product rollout, is $10 million or so kind of the run rate that you envision for the rest of the year, or will that taper off somewhat? And then on the other OpEx, is that more fixed than maybe we might have previously thought, because it didn't decline nearly at the rate that revenues did?

Kevin, Jim Graner. The product development spend should remain in that $10 million a quarter number. There will be some volatility as to when we launch products, some of the expenses tend to bunch up, but I think your annual rate there is right on. Again, our fixed costs on the operating expense side are human in nature, and as Pat mentioned, we are doing nothing to cut the muscle from our business model.

Okay, thanks, guys.

Thank you. Our next question comes from the line of Mike Schneider with Robert W. Baird. Please, go ahead.

Good morning. Wondering first if we can start with contractor -- Pat, you mentioned that the Paint channel was down consistent with the segment, but if Home Center was up, I believe slightly you said, what was Paint channel actually down? It must have been down significantly more than the segment average.

Well, you got Europe and Asia you got to mix in there. That wasn't down significantly more than the average.

I see. And, in speaking to Asia, just both in contractor and across all three segments, can you describe what specifically is hitting Graco that may not be hitting other companies, because I struggle to find anybody else shrinking 25 percent-ish in Asia right now? Is it something to do with the distribution channel or some other element?

I think it has more to do with our automotive exposure over there than it does anything else. That's typically how we get into markets early is we get in with automotive and then we expand into the other businesses. And, our balance of our business between contractor and plain vanilla industrial and automotive tends to be more heavily weighted towards automotive over in Asia.

India and China are still doing okay. Japan, Korea, other chunks of Southeast Asia are not doing well at all right now. If I was trying to make some view of what Asia's going to do, I still pretty optimistic on India and China having a decent year this year. I'm not too optimistic really on Japan showing any kind of strength later in the year.

Okay, and then sticking with the contractor in North America now, do you sense that things -- or did they deteriorate through the quarter within contractor?

Well, we should be seeing a seasonal increase in North America contractor, and we are seeing that, it's just very muted. So it's kind of hard to say whether things are getting better than worse, but my sense in the propane side here is that the bottom has not been reached and things are continuing to get a little bit weaker. I'm assuming we've got to be getting close to the bottom, but it's been three years, so I'm not sure.

Well, if professional was down something on the order of 28 with the segment, can you -- do you know what sell-through looks like both in the professional channel and the retail channel right now?

Yes, we do. There's definitely still a little bit of inventory reduction, but that's not the major problem. The major problem is sell-through is bad.

Okay, and pricing within both retail and professional? I realize it's held up to-date, but as volumes continue to erode like this, do you expect pricing to come under pressure? Any new contract terms to be renegotiated as the year unfolds?

I don't think we'll see that for a couple reasons; number one, I'm not sure that in this market promotional activity really works that well. If people need a sprayer they're going to buy it. But -- so, I think that we're being more conservative trying to cut expenses on a promotional side. The pricing was implemented in January that stuck; I don't expect any renegotiations on it.

I think the bigger issue, really is that when either contractors or tradesmen that are walking in the door to look to buy a unit, they're buying smaller units than they bought in the past. Instead of spending $2000, they're going to spend $1500, or instead of buying a $700 unit in the Home Center channel, they're buying a $400 unit. That's not a good dynamic for us and I expect that that's likely -- that dynamic is likely to continue to pressure our margin in that segment until we see the bottom in the housing market.

Okay, and the home center rollout, you said that home centers were up for you in Q1, when does that tail off, and when do you -- when does home center then migrate towards whatever the channel itself is doing ex the rollout?

Well, the channel, the home center channel is struggling just like everywhere else. The big reason that we're doing better there is our own sales initiatives. And if you think back to our store ads throughout 2008, you'll see that as we go through each quarter, we have more difficult comparisons because we had more stores. We added some stores in June; we added more in August, we added more in the fourth quarter.

So -- by towards the end of the year our store count will be more consistent with where we're at today. But we do have the advantage of the program we rolled out -- the program that we announced on the entry-level program in December that we rolled out this year. That will carry for most of the year, and some of the home center store ads will have six months at least benefit on those. So, it's not going to be a wipeout quick.

So by Q4, let's say we're at comparable store levels, or store counts, what do you believe the channel is down right now?

Boy, again I don't have any numbers to give you exact numbers, but I'm sure the channel on a same-store basis is down double digit.

Is it down as much as the professional channel at 25, 30?

I don't think I can give you a good answer on that right now. I don't -- Jim, do you have?

No, I don't have any better info on that.

We've got a lot of puts and takes in our [double] business right now.

Okay. And then, Jim, just on pension expense; it was $3 million in the quarter incremental. I believe last quarter you told us it would be $18 million for the year, have you taken that assumption down for the year then?

No. You're right, Mike. The total is $18 million for the year and its $4.5 million for the quarter, $1.5 million in COGS and $3 million in operating expenses.

Got it, got it. And then final question, just on this ray of hope, Pat. Just so as we don't get carried away, if orders were running down near 40% on your update as of March 18th, does that mean they're only down 35 now? How do I interpret your single-digit comment?

I don't think you should try to interpret it as a comparison to second quarter of last year. I think you ought to just take it as a run rate comment. So if you take a look at the incoming order run rate, the run rate the last few weeks has been a little bit better.

Okay. All right. Thank you.

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

Next Generation Equity Research. Just on some of these cost issues, are there any more charges expected or expenses expected with regard to the headcount reduction in 2Q?

Not with the ones that we just announced, but if things continue to weaken, we'll continue to make decisions on cost, so I can't tell you that we're done for the year, but I can tell you that the stuff that we did in the second quarter is in the second -- or in the first quarter is in the first quarter.

Okay. And then on -- any more additional expense with regard to the rollout, or that's all done?

Well, the stores we've won are done. We're not giving up on trying to expand our channels so there's always possibility that we get more stores somewhere, but we don't have any overhang.

Okay. And then with regard to Lubrication, what should we think about in terms of the trajectory to get back to profitability in that business over the course of the year?

What volume assumption do you want to make?

Right, okay. Well, you had some discontinued products there that weighed on the quarter, I mean, maybe if you could just break that out for us?

Yes, Caroline, do you want to --?

That relates to a product line that we discontinued. The volume on that product line has been relatively low over the past 18 months -- two years.

And we expect those costs to be behind us.

Okay. Well, with regard to the Anoka plant, you said it was behind schedule, I mean I'm just wondering when we're going to get back to being on schedule?

To be perfectly honest with you, I'm not optimistic that that's going to happen real quick. I think it's more likely to be at a year from now before we're really where we want to be, but we've got products that we're working on currently and every quarter we ought to be seeing cost reduction improvements being implemented in the factory that are going to help us on our gross margin front.

So, obviously we need to get some volume through that facility up there, but beyond that we've got work to do on cost reduction. When I talk about being behind, that's really where we're behind on, is implementing some cost reduction projects. So those are ongoing, and I would expect to see some healing as we go forward here.

Okay, thanks.

Thank you. Our next question comes from the line of Terry Darling with Goldman Sachs. Please, go ahead.

Pat, I'm wondering if you can square up -- the orders are getting a little bit better, but on the other hand you're building some new contingency plans. I'm just uncertain as to where you're really going with your actions around cost cutting. I know you've got the $18 million in hand, and it sounds like you're moving towards doing more, but it's just not clear to me. Can you help there?

Yes, I can try. I think it's always wise to have contingency plans available that you haven't executed to yet, and we executed one in December, and we executed another one in March. So as we execute to a contingency plan, we need to think about what the possible future could hold, and that's anything from a stable run rate to a slightly down, to a let's say this turns out to be the Great Depression and it's going to last for five years.

And our actions in those different scenarios are going to need to be different, and we don't want to have to start scratching our head trying to figure out what we're going to do. When we see things happen, we want to have some plans in place and some triggers in place that allow us to act fairly quickly. And we think we did that in December and again here in March, and we just want to be ready if we need too.

By nature, I tend to be more optimistic than pessimistic. I travel a lot. There's huge populations in huge chunks of this world that people are really striving for a better life. I was just recently over in Asia, in several different countries over there. They're not ready to go back to the Stone Age. So personally, I don't think we're going into the Great Depression and we're going into a five-year funk, but that doesn't mean that I don't have a plan in my desk drawer in case that might turn out to be the case.

But, Pat, if we assume that trends are stable here, so down 35 or 40, do you make another step on your cost profile, or does March account for that kind of a scenario?

March should account for that scenario unless I believe that we're not going to start to climb out. Again, a lot of this has to do with time framing. If you tell me we're going to have two more quarters like this quarter and then things were going to heal up, would make no sense to go and cut 300 more people and slash product development back to 2003 levels and get rid of our international sales force.

There wouldn't even be a payback in that kind of a timeframe to make that kind of an action. But, if we determine through I guess the facts as they're presented to us that the thing is going to last three years, well, then we have to be willing to look at some more difficult decisions.

So, it's not really only a matter of what we see in terms of incoming order rate, but it's also what we view the length of this thing is going to be. And right now I'm still -- I would say I'm more in a wait-and-see attitude, where we're going to try to be flexible and we're going to try to be agile, but we're not going to predict doomsday and we're not going to predict a quick rebound either.

Okay. And then, Jim, can you square us up? The foreign currency impact at the EPS level -- I know you called out the two points at gross margin, but at the EPS level year-over-year was what? And based on your latest assessment, where do you expect that to be for a full year?

Sure. It's $2 million on net earnings, so it's 60 million shares -- you're a little bit more than $0.03. And the full year would be -- again, we'll have some negative comparisons in the second quarter and third quarter. The fourth quarter should be closer to a push, so my forecast if the euro stays at 130 is about $8 million to $9 million pressure for the year.

Okay. And just lastly, where are you on CapEx for the year at this point?

$20 million is the current run rate, and current approval level.

Okay, thanks very much.

Thank you. Our next question comes from the line of Anthony Kure with KeyBanc. Please, go ahead.

Good morning, gentlemen. Just a couple quick questions -- on gross margins you mentioned the trading down impact is more of an impact than price, but do you think it's possible given the raw material price declines that you should recognize in the second, third quarter, is it possible to see maybe a sequential improvement on the gross margin line from first quarter to second?

That would be our expectation. Again, as Pat mentioned, we do see a little bit of this trading down happening in particular in the Contractor segment, and we do see a shift in mix within the Lubrication segment to our currently lower profitable rate in the Industrial Lubrication. So, those things tend to offset, but if you were looking at unit by unit, I would say yes we do see tailwind and should see some improving margins.

Okay. And then I noticed in the 10-Q there was a comment on that the Company could take cost-effective alternative liquidity options. Just hoping you can provide a little more color on that and maybe some insight.

Yes, I guess it goes along the lines of what Pat was talking about with respect to contingency plans, so we're looking at alternatives to our revolver and we're weighing the cost-effective alternatives.

Okay, so you weren't talking about like issuing more equity or dividend cuts or things like that?

We are not.

Okay. Thanks, that's all I have.

(Operator Instructions)

Our next question comes from the line of Dave Rochester with Capital Markets. Please, go ahead.

Mr. Rochester, your line is now open.

We'll move on to the next question. Our next question comes from the line of Charlie Brady with BMO Capital Markets. Please, go ahead.

Hey thanks, good morning. With respect to the Lubrication System segment, what effect are you guys being negatively impacted by, by closures of automotive dealerships? Is that having any kind of meaningful impact on the business?

Oh, yes, significant. That business has been under pressure since automotive started to tank late last summer, but -- we got two segments of that business; we got our Vehicle Services, which is our historical Lubrication business, and of course that's got that nice gross margins that we've enjoyed all along.

And that business -- that Vehicle Services piece of the business has been under pressure on the car dealership front since last summer. Industrial Lubrication business is the new targeted market where we're working on our cost reductions and what's actually holding up a little bit better than the Vehicle Services business right now, giving us a little mix issue.

Okay. And then just on the mix issue, in regards to the Contractor business -- I know in the slide you break out channel mix, but back to your discussion about consumer pricing down -- buying the lower priced products. Can you quantify what impact that might be having on the margins, that product slide down?

I don't think we can. The -- that just saying the fact that we got some lower input costs and some pricing changes that are not separately identifiable, but we do see a shift in the mix to the lower -- I'll call it lower valued units -- lower priced units.

Okay. Can you give us what the order run rate is by segment and geography?

We can't. We don't have that broken down on a weekly basis. Weekly -- we have it by region, and we'd prefer not to go there other than the comments that Pat passed on with respect to the continuing weakness in Europe.

Okay, thanks.

Thank you. Our next question comes from the line of Mike Schneider with Robert W. Baird. Please, go ahead.

Guys, could you just guide one level deeper into Industrial? With the segment off, obviously strong double-digits this quarter, can you go into sealants, adhesive, finishing process, et cetera, just to give us a sense of where the discrepancies lie?

I think all I can really tell you there, Mike, is everybody -- all the segments are down, and they're all down everywhere and they're all down double-digit.

Even processed?

Yes.

Processed decline is the smallest of the product groupings in the Industrial segment, but it's still in double digits.

And sealants and adhesives, I presume is down most?

I don't think that's actually the case.

No, I don't think that's true.

Excluding the high performance stuff, because isn't that the biggest automotive exposed?

Yes, it is, but I think -- I don't have the number right here in front of me, but I do not believe that's correct. I do not believe sealants is down the most.

Okay. And the High Performance division, how has that held up during this market?

That's actually been tough like everywhere else; double-digit kind of down in all geographies. Although, again, from a glimmer of hope perspective, the last few weeks have been better.

Okay, and in fact on that, just -- you mentioned that you're seeing some seasonal uptick. Are you able to differentiate the seasonality effect here, which is very natural from what you've identified, I guess as just some slight glimmer of hope? Or indeed is that what's occurring, that the seasonality is what's improving the order flow?

No, I think -- and again, this is my unscientific analysis, but if I take out what's happening with the contractor seasonality, I think the comment still holds, again with the exception of Europe.

Okay.

If you take a look at our Industrial business, our Industrial business in North America, or our Lubrication business, I think that the comment is a valid comment in terms of that slight increase in our run rate.

Okay. And then -- so that sounds like it's sequential. So, year-over-year, you've been talking again as of March 18 that things were running down to 40%, what are they running down now?

Again, I'm trying to confine my comments to order run rate, and not get into comparisons. It really starts to get difficult to give you good information. We talk about comparisons by segment, when they go up and down every month and every week. So, let's stick to run rate.

Are they of the same magnitude, though? Or have you -- do you sense a significant improvement in that 40% decline?

I don't see any significant improvement, and we see a slight improvement.

Okay. All right, thank you.

Thank you.

(Operator Instructions)

If there are no further questions, I will now turn the conference over to Pat McHale. Please, go ahead.

All right. No closing comments here today. Thanks for your participation.

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