Graco Inc (GGG) 2009 Q2 法說會逐字稿

Welcome to the Second Quarter 2009 Conference Call for Graco Inc. If you wish to access the replay for this call you may do so by dialing 1-800-406-7325, within the United States or Canada. The dial-in number for international callers is 303-590-3030. The conference ID is 4114013. The replay will be available through July 27, 2009. Graco has additional information available and a Power Point slide presentation, which is available as a part of the webcast player.

At the request of the Company, we will open up the conference 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 risk factors including those identified in item 1A of and exhibit 99 to, the Company's 2008 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 the 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.

I will 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, President and CEO, and Jim Graner, our CFO. I will briefly review our second quarter results and Pat will follow up with additional comments. Following these opening comments we will open up the call for your questions.

Weak economic conditions worldwide continued to affect our operating results this quarter with a decrease in sales and orders in all segments and regions. Sales for the quarter declined by 38% or 36% at consistent exchange rates.

By region, sales decreased by 33% in the Americas, 52% in Europe or 46% at a consistent exchange rate and 29% in Asia Pacific.

Gross profit margin, as a percentage of sales, was 49% this quarter, down from 54% last year due to lower production volumes, which was approximately four percentage points, unfavorable currency translation rates, approximately 1.5% points, and increased pension costs approximately one percentage point. The impact of these items was somewhat offset by pricing and favorable material costs.

Total operating costs were lower than last year, down 12% in the second quarter as compared to last year. Effective currency translation decreased operating expenses by about approximately $2 million.

Lower incentive and bonus provisions and other spending reductions also decreased earnings. These reductions were somewhat offset by product development spending and increased pension expense.

Effective tax rate for the second quarter was 32%. The rate in the second quarter of 2008 was 35%. At this time in last year the R&D tax credit had not been renewed and no credit was included in the second quarter of last year.

On the liquidity side we continue to have strong cash flows with positive cash flows from operations of $69 million year-to-date. We continue to focus on managing our working capital and have seen a decline in accounts receivable of $15 million, and a decline in inventories of $23 million so far this year. We've also reduced our long-term debt by $36 million to date.

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

Good morning. Business conditions in the second quarter improved slightly compared to Q1 and while disappointing were generally in line with our expectations.

Expense reductions that we implemented in March contributed to our improved profitability versus Q1 and, although we did do some trimming around the edges during the second quarter, we had no major layoff. Our direct labor work force is the right size for our current production levels and we are maintaining our investments in new product development, new markets and international expansion.

Talk for a minute about our order rate. We saw about a 10% improvement in our weekly incoming order rate in the second quarter as compared to the first quarter. However, this improvement wasn't a consistent trend through the quarter. April and May were actually stronger from an incoming order rate perspective while June and July so far have been more in line with our Q1 incoming order rate.

As Caroline mentioned, cash flow for the quarter was good at $41 million. We do continue to focus on working capital management and we saw nice reductions in both inventory and receivables.

From a market standpoint, during the quarter we saw weakness in all markets and geographies. Our end customers, of course, continue to experience low production levels and low equipment utilization rates.

Western Europe, Eastern Europe and the Middle East all weakened from Q1. Eastern Europe is significantly weaker than Western Europe. I do believe we may be approaching a bottom for Europe in Q3 but I expect the conditions in Europe are going to remain challenged at least into early next year.

Our business in Asia was down across all regions with automotive related businesses particularly difficult, especially in Japan and Korea. Export manufacturing customers throughout the region are also being cautious with capital projects although we are seeing activity associated with infrastructure spending, especially in China.

Overall our contractor business in Asia declined the least while our lubrication business experienced the most significant decline. The large decline in lube is primarily related to a large mining order that we shipped in the second quarter of 2008 that did not repeat this year. We are seeing some signs of increased activity in Asia and we're actually more optimistic about the second half of the year.

We maintained our resource level internationally and we continue to set up specialized distribution and we work to strengthen our channel.

In the Americas contractor segment, the Home Center Channel is down slightly for the quarter. Our expanded store count versus last year allowed us to offset the channel load we had in last year's second quarter. You will recall that inventory load was related to the roll out of a new sprayer aligned to an existing channel partner.

Although the North American paint channel is down double digits versus Q2, 2008, year-over-year comparisons were slightly better than Q1 and I believe it's likely that we're approaching the bottom of the US housing market.

Operating earnings for the worldwide contractor segment, although still depressed, rebounded in the second quarter to 20% versus 3% in Q1.

In the Americas' lubrication segment, we expect the revenue situation will remain difficult for some time impacted significantly by conditions in the car dealership market. Our focus on lube continues to be on implementing the planned product cost reductions on acquired products so that when volume improves the division returns to operating margins in the twenties. As we've discussed, these cost reductions are behind our original schedule. However, we are making progress and we're confident that we'll achieve the target.

Our spending on product development was in line with Q1 and we anticipate similar levels of spending on a go forward basis. As communicated previously, we'll begin to see the first new products launched as a result of the incremental investment during the second half of this year and will achieve the full run rate in 2010.

Our purchasing team is doing well on cost reductions, approximately $1.3 million for the quarter and we do anticipate favorable comparisons on material for the year.

Near term we expect the business to remain challenged, but we remain confident in the strength of our business model. While we've made significant expense reductions cutting approximately 20% of our head count from 2008 peak levels, we've been very selective in our cuts and have maintained our investments in growth initiatives.

Apart from volume, our gross margins are strong, our incremental operating margins are high and we expect earnings will improve quickly with improved volumes.

With that, I'll go ahead and turn it back to the operator and we'll open in up for questions.

(Operator Instructions). Kevin Maczka with BB&T Capital Markets.

Pat, I guess first seasonality, I think in a normal year Q1 is usually the lowest revenue and earnings quarter. Q2 is the best and Q3 and Q4 are somewhere in between. I guess, based on what you've said about your order patterns, are you seeing anything that would suggest we're back to a more normal seasonality or do you still think this is going to be something that kind of sequentially we try to climb out from the depressed levels?

Well, the optimistic side of me says the latter. I am not sure. Our seasonality has been a little bit mixed up since the contractor business started declining at the end of 2006 so the quarter comparisons are not holding exactly as they were back in the early 2000s but I am cautiously optimistic that part of what we're going to see is a climb out.

All right and is there anything kind of drilling down there by segment, usually I think contractors something that might recover earlier when the cycle turns but would you think that would still be the case this time or does industrial look to be a little bit more early cycle in terms of a recovery this time?

Kevin, this is Jim. When we're looking at it by geography I think your scenario looks like it's going to be more true in North America. In other words, that contractor looks like it has a chance to lead us out of this on a quicker basis. I think in the rest of the world probably the opposite is true. I think if you drill down in the numbers you'll see contractors declined less dramatically vis-a-vis the industrial, especially in Europe, so I think we might have a little bit of offset to that normal cycle that we've seen before.

Okay and just one more if I could, Jim, on the gross margin items you called out that were incremental negatives or positives compared to last quarter, volume four points and then I guess, you know, that will depend of course on where volumes go but if you look at Q3 currency, pension, raw materials, these could all be better than they were in Q2. I that correct or will pension continue to be a lag going forward?

Well pension the magnitude will be the same. I think currency will be less negative, especially if it -- you know, the Euro holds at 1.42. I think our average in the third quarter last year was EUR1.50 versus EUR1.56 in the second quarter so I think that decrement will be less. And then, of course, part of the equation here what happens with unabsorbed burden when our inventory decline is over. So we should see some production increases but most likely that won't happen until the fourth quarter.

Okay yes because what I was getting at is I guess even if volumes don't change much based on currency and pension and raw materials, maybe you might see a couple more points of gross margin, even with flat volumes.

Yes for sure. You know, we've been -- we've reduced our inventory $21 million year-to-date and, as that's a fairly rapid rate of decline and as that smoothes out and becomes less we'll have to produce more, so our unabsorbed costs should become less.

Christopher Glynn with Oppenheimer & Co.

So first one for Pat, your comments on more optimistic in the second half, was that isolated, that comment isolated to the Asia markets?

Yes it was.

Okay and within industrial I was just wondering if you're seeing any differential in the trends and spares versus new equipment, anything that gives you a meaningful read on what's going on out there?

No nothing that really I think sheds any light on the situation more than what we've talked about in Q1. You know, spares are down as well. We're seeing spares down less than new units but they're still down and I think that's consistent with what we're seeing in terms of industrial production and plants being shut down and just lower volume levels. Our spares business, a lot of that runs off of how many gallons they pump and apply and, as that picks up, our spares business will pick up as well.

Okay and then an interesting comment in the Press Release, hopeful that the world economic crisis getting behind us as it pertains to you. Could you just kind of square that and elaborate with the comments that June, July kind of back to first quarter run rates?

Yes, you know, I am not sure I can exactly but I am of course watching what's happening with a lot of the indicators out there and lot of the companies that are releasing and I think that there are some signs out there that the odds of things getting sequentially worse are probably a lot less than they were in my mind here four or five month's ago. I am just feeling by some of the numbers we're seeing, some of the numbers that are being put out, that we're probably clunking along the bottom.

Okay, last one just housekeeping for Jim, in the segment slides where you call it the unabsorbed manufacturing costs as a separate line item from volume effect on operating leverage, is that a strictly accounting for the inventory reductions?

No that's really accounting for the fact that our total hours are less than they were last year so that power decline is really represented in two pieces. One is the inventory decline and the second is the decline in the absolute volume in those segments.

That is correct.

Okay could you estimate or ball park the split?

I think it's about 1/3 with respect to inventory decline and 2/3 volume decline.

Okay that's very helpful, thank you very much.

Charles Brady with BMO Capital Markets.

Good morning. This is actually Tom Brinkman standing in for Charley Brady. Just wondering if you could talk about some details on your contingency plans in case things do deteriorate a little bit versus the second quarter?

Yes if they deteriorate a little bit I think we're pretty much where we want to be. We've made, I think that all the adjustments that I'd like to see us to make pending a significant downturn. We have a contingency plan in place if we see a significant step down and we've been able to react pretty quickly. You know, we made a decision in November and we implemented in December and we did the same thing in the first quarter.

So, if the need arises, we can execute in a matter of weeks. We don't have factories scattered all around the world and distribution centers scattered all around the world that are going to take us weeks and months to shut down. Basically we've got a pretty lean organization and the cuts that we have to make are cuts that we made pretty quickly. I am anticipating and hopeful that we are going to be able to avoid that.

Okay. Now you said that the June and July order rates were in line with the first quarter order rates and you had mentioned back in March that the order rates were down about 40% year-over-year but I'm just wondering with the monthly sort of break outs it's kind of hard to follow but does that mean that June and July were down by 40% year-over-year also? Or is the year-over-year comparison not quite as adverse as that?

Prefer to stay away from the year-over-year comparisons if we can and really just think about run rate. It's just with -- you know, last year at this time we could barely keep up. Our industrial business was screaming and we were doing great internationally and so the year-over-year comparisons by quarter get a little bit squirrelly I'd say here throughout 2009 compared to 2008. So, if you just look at run rate, run rate in June and July were more like incoming order run rate in the first quarter.

Okay and also, I apologize. You mentioned quickly and it was kind of hard to follow, North America Paint Center Channel I believe you said is down double digits whereas the Home Center Channel is down slightly, If that's correct. Could you just talk about what that was compared with your expectations? Was it in line with expectations?

Yes that is correct and that's about what we expected.

Okay, I'll get back in queue. Thank you.

Matt Summerville with KeyBanc.

Couple of questions, Pat, just talking about again sequential order trends, was the little bit of tail off in June and July, was that consistent across the three segments and regions or was that relegated to maybe one area of the world or one or two of your segments?

No, I think it's a pretty good general comment as I look at the numbers.

And then with regards to Europe specifically can you talk about, I guess, what gives you, or I guess, what do you see in the business that makes you sort of feel and if I am taking your comment our of context, please correct me. They were sort of bumping along the bottom there.

Really that's feedback from distribution channel, key end users and some of our field sales people, so it's not any reported number that I can put my hands on, but it's really based upon the knowledge that we've got of our customer-based distribution channel and really their view of the near term future here looks like.

You guys obviously talked about and it's very evident how much inventory you've taken out of your own business. Do you have a full-year target? If you gave it, I apologize if I missed it, and then can you also comment on how you feel inventory levels are looking among the general industrial distributors you deal with globally and then in your domestic contractor business for the home centers and professional paint customers you deal with?

Sure I'll handle the first part of that. Our target is $30 million of which we've achieved over $20 million so our expectations for the last half of the year are $10 million. There is a chance that we may exceed that and we may increase the target as we progress.

In terms of the second part of your question, I didn't do an analysis in the second quarter. I did one in the first quarter and my view after doing the analysis in the first quarter was is that we did have inventory reduction happening with our channel partners and with our end users, but that the majority of that would probably be done by the end of the second quarter.

And, I think based upon again and/or [levenance] that that's probably the case that we'll have less impact of inventory reduction in the third quarter than we did here in the second quarter and that unless there is another step down in the world economy that we're probably getting closer to where everybody needs to be.

In the past you've quantified the cost experience with regards to what you're doing in building out your presence with home centers and professional paint. Can you talk about what that number looked like? You mentioned it was a little bit of a drag on margins and if it's on the slides I apologize. I haven't seen it yet but can you just give that number?

Well it was less in the second quarter and the year-to-date of 2009 than it was in 2008 so you'll see on the contractor slide that it's actually an add back to the operating earnings of two percentage points for the quarter, 1% for the year-to-date. Year-to-date this year it's about $1.8 million. Last year --

Last year was closer to $3 million.

And then what do you expect in the back half of the year, Jim, on those expenses?

Expectations are for zero going forward. We haven't built into any of our assumptions that we'll have more stores. Of course, we're hoping that our negotiation or expecting our negotiations could go better and we would have an announcement at that time. At this point there is nothing scheduled.

Okay, just one final question on contractor, can you talk about in the quarter all things considered between how the Home Center Channel over all performed relative to professional paint and where you are from the manufacturing learning curve standpoint on the more entry level units that you're selling now? Can you talk about how mix is trending in that business and just looking forward net of any seasonality you're thinking about although, Pat, you made some comments around that. I guess how should we think about profitability and contractor unfolding for the rest of the year relative to what was a pretty good performance obviously in the second quarter?

I'll let Jim make a comment on the numbers piece of it but from a manufacturing perspective and from a market perspective we are still seeing the trend towards people buying the smaller units so that they are going in instead of buying a $2,000 sprayer if they can buy a $1,000 dollar sprayer they are doing that. So we are seeing the bottom of our line get more activity in both channels than we had in the past.

From a manufacturing standpoint we continue to put cost reductions in process, improvements in place on that entry level line so we would expect that over the course of the next year or so we'd see some improvement in margins on the entry level side. I'll let Jim give you his thoughts on overall profitability for the division based upon mix in the second half.

Yes, Matt, for sure the profitability in the home center part of the channel has improved, especially sequentially, and from a year ago when we were incurring lots of costs. Our expectation is going forward that that will get better. Again, we're still driving some costs out of that product line and have expectations for more costs to come out in the future. But that doesn't mean our professional segment is doing worse. I mean I think you've seen the dramatic improvement from 3% of sales to 20%. So profitability is looking better in that segment as well and we'll get better of course as volumes pick up.

Do you think though from a revenue standpoint, again based on -- and I know that normal seasonality is a little bit maybe out the window here. I guess should we think based on what you're seeing in the contractor business the second quarter being the high water mark in terms of sales for the year?

I think that's true for sure in North America.

Okay, thank you.

Mike Schneider, Robert W. Baird.

Good morning. I'm wondering if I could just drill on a couple of items and then as they relate to the second half. First, corporate expense running at over $5 million, could we just get some more color on why that amount is almost doubled year-over-year, if that's all pension or if there is other things in there? And then what is the run rate you would expect for the second half?

That is all -- the delta is all pension expense and it will double for the rest of the year or so. We're at roughly $5 million year-to-date and it will be $10 million for the full year. we've previously disclosed that our pension increase was $16 million to $18 million for the full component, so the other $8 million on an annual basis is charged to the business segments but we said the under funding piece we were going to keep as a corporate expense.

Okay and then just the savings rate from the headcount reductions, the other cost initiatives, would you say that you've realized all those savings during Q2 on a run rate basis or are there more costs that will -- or incremental savings that will spill into the third quarter?

There will be some in the third quarter but it's not significant.

Okay and then to the previous question just about seasonality, it is very typical for total corporate revenue to decline from 2Q to 3Q but based again on your comments about June, July order rates, do you think that comment holds for the third quarter this year?

It's looking that way right now. I mean we're only a few weeks into it so I can't say for sure but that's the indication.

That Q3 will be seasonally lower in revenue?

It looks like it.

Okay and then just taking a step back and looking at the total enterprise now, so the Q2 with most of the savings, the pension costs unchanged during the second half and then typical seasonality, is there anything else that we should consider in our models when trying to model the second half that would explain why profitability would improve in the second half from this 2Q run rate despite lower revenue? The one thing I can think of is absorption but is that meaningful enough to change the outlook for the second half in earnings?

For sure the absorption, again, my expectations that will be more of a fourth quarter event than the third quarter event and it could help by again by the magnitude of one to two percentage points of sales. The other thing, of course, is the Euro at 1.42 today versus the average for the second quarter at EUR1.36. So, other than that, the second quarter should trend again if volumes stay where they're at.

Right and just your comments about Europe bottoming, Pat, I guess I am curious about that comment because if we look at the industrial segment in particular in Europe this quarter it clearly hit a stair step lower. Is there any reason to expect though that you've seen the bottom in that business and I understand your feedback from the channel says you're bumping along the bottom but it strikes me that we've only seen one quarter of significant deterioration? Why wouldn't it continue?

My comment was is that I expect that we may see the bottom of Europe in Q3, not that we'd see the bottom of Europe in Q2 but that's the feedback that we're getting from the field and from our people and from our channel partners is that they believe that Europe in general is going to see the bottom in probably between now and Q3.

Okay. All right thank you.

John Franzreb, Sidoti & Company.

Could you tell us a little bit about market penetration and your ability to add distributors in this environment?

Yes in general our distributor adds are on target for this year. We have had in a few areas a little bit of a challenge where typically when we set up a distributor we expect an opening stocking order, not just a sign up and hang the Graco shingle in their window and hope they get an order so we look for a commitment on the inventory front just to make sure that they're serious and they're going to go up through the training programs and there have been a couple of product categories in general where we're out setting up distribution where that's been a bit of a challenge for us because distributors just don't want to make the investment. But I would say in general we're pretty much on schedule and I don't think that we're going to miss our targets by much this year.

Great and, Pat, as you kind of illustrated over the year R&D spending remains elevated. You were supposed to roll out a bunch of products, particularly in the second half of the year. Can you bring us up to speed on new product introductions and what kind of margin contributions we should expect from those products?

Well, you know, we don't talk about the new products until we launch them for obvious competitive reasons but we did about a 20% increase in product development spending. That was the ramp and we've achieved that ramp so what you should expect to see is you'll see a couple incremental products in 2009 and then going into 2010 you should expect you'll see 20% more impact from new products from Graco than you would have historically.

And it depends a lot on what we're launching. We launch a new entry level product line into the Home Center Channel. That's quite a different dynamic than launching say a product into the Asian lube market, so there's a lot of variation there but in general our new products have strong incremental gross margins and they go through our existing channel, our existing sales force and they've got a nice impact on our incremental operating margins.

Kevin Maczka, BB&T Capital Markets.

I had just a follow-up on the some of the SG&A and operating expense lines in the second half, so G&A was kind of flat year-over-year. That's more fixed. The selling and marketing is more variable. That was down based on some of the cost actions you've done. I guess is this $28 million level with this volume assumption in the second half, is this kind of a good run rate at this point?

I think so yes.

Okay and the G&A will continue to be fixed or are there other specific cost actions that are happening there that might knock that number down somewhat?

No that's a good number to model going forward.

Okay and just separately, Pat, I guess can you talk about the lube segment longer term? Just, given all the turmoil in the auto portion of that business and what's happened there around the world, has your long-term view of that business changed at all?

It hasn't but certainly our short-term view is impacted pretty significantly here. You know, that's really been a North America focused business for us and, of course, the North American automotive is in pretty rough shape and so our vehicle services segment is going to have some pain working through that but you'll recall that in late 2006 we made a decision to jump into the industrial lube segment and with the acquisition that we did in the second half of 2006 and then another one that we did late last year so we see a lot of growth opportunity there. We need to get our product cost on those two acquired companies where we expect them to be. We're still a little bit off. We're making progress and then it's a matter of setting up channel and launching new product.

So -- and we're also working to expand our international footprint. Effective in January we implemented a specialized sales force for Lubrication in Europe. We never had that before and we reorganized our European -- or our Asian operations and we have a dedicated team in Asia selling lube. So we believe that the growth opportunities internationally and in industrial lube still hold. We think we're going to be penalized for a while by what's happening on the car dealership side.

Got it. Thank you.

(Operator Instructions). If there are no further questions I will now turn the conference over to Pat McHale.

All right thank you. To summarize, we are expecting weak conditions to persist in the short-term but we believe we've positioned the business for a strong profit rebound as the volume improves. Our incremental margins are going to be very high. Our balance sheet is in good shape, giving us flexibility to pursue new opportunities, and we've resisted the temptation to cut the muscle and we've remained committed to the investments in our key growth initiatives during the downturn. And we think this strategy maximized long-term shareholder value and we're going to stick to it.

Thanks a lot for your time this morning.

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