Graco Inc (GGG) 2010 Q2 法說會逐字稿

Good morning and welcome to the second quarter 2010 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 4323043. The replay will be available through July 25, 2010. Graco has additional information available in PowerPoint slide presentation, which is available as part of the webcast player at the request of the Company, we will be opening the conference up for questions and answers after the opening remarks from Management.

During this call various remarks may be made by Management about the expectations, plans and prospects for the future. These remarks constitute forward-looking statements for the purposes of the Safe Harbor provisions of the Private Securities Litigation Reform Act. Actual results may differ materially from those indicated a as result of various risk factors, including those identified in item 1a of exhibit 99 to the Company's 2009 annual report on Form 10-K. This report is available on the Company's web site at www.graco.com and the SEC's web site 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 the statements in light of new information or future events. (Operator Instructions). I will now turn the call 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 and Jim Graner. I will provide some comments on the financial highlights of our second quarter and Pat will follow with additional comments. PowerPoint slides are also available to accompany our call and can be found on our web site. The slides include information about our consolidated financial results and each of the segments. After opening comments we will open up the call for your questions.

Net sales were up 30% to $192 million for the quarter. Sales increased in all divisions and regions, with significant growth continuing in Asia Pacific and solid growth in the both the Americas and Europe. Operating earnings as a percentage of sales were 20%, up from 12% a year ago, With net earnings totaling $25 million. Currency translation did not have a significant effect in the quarter. As changes in the Asian currencies and Canadian dollar offset changes in the Euro. The overall year-to-date growth rate of 25% included two percentage points from translation, primarily from currencies in Asia Pacific.

Our gross profit margin as a percentage of sales was 53%, compared to 49% in the second quarter last year. The improvement from last year was primarily due to higher production volumes. In Q2 our factories were running at about 85% of prior peak production as compared to approximately 55% a year ago. Approximately $1 million of additional production costs were incurred in the second quarter related to new products, primarily in the contractor segment. Operating expenses for the quarter increased by $8 million as compared to last year. As a percentage of sales, operating expenses were 4% lower than last year. As expected, volume-related items are resetting from last year. Strong operating results drove higher incentive in bonus provisions in the second quarter with expense approximately $3 million higher then the first quarter of this year. For the full year, we expect that the incentive and bonus expense will be $15 million to $20 million higher than last year.

Marketing and selling expense related to new product launches increased by approximately $1 million as compared to the prior quarter, primarily in the contractor segment. In the industrial segment, we did not see the same tailwind from currency translation in the second quarter than we saw in the first quarter. With continuing acceleration in sales growth, we saw also increases in volume-related, primarily incentive and bonus provisions. Year-to-date tax rate was 35% compared to 32% last year. Federal R&D tax credit has not been renewed so far in 2010 and no benefit is included in the current rate. We currently continue to have a full-year expectation of a tax rate of 34%.

Year-to-date cash flow from operations was $28 million as compared to $69 million last year. Our working capital investment increased in line with our increasing volumes. Year-to-date inventories increased by $18 million with an improvement in turn, and accounts receivable have increased by $37 million, with consistent days of sales outstanding. Year-to-date primary cash uses have been in capital expenditures of $6 million, dividends of $24 million and repayment of long-term debt of $6 million. We also had share repurchases in the second quarter that totaled $10 million, including $6.5 million that actually settled in the third quarter. We will continue to repurchase shares on an opportunistic basis going forward.

On the financing side, our long-term debt totaled $80 million at the end of the second quarter with unused credit lines of $178 million. With that, I'll turn it over to Pat for additional comments.

Good morning. In the second quarter we had 30% revenue growth compared to the second quarter of last year, and 17% growth compared to Q1 of this year. The 17% sequential growth from Q1 to Q2 was generally in line with the historical patterns. Compared to the first quarter, we saw single-digit growth in our industrial and lube segments, and strong 40-percent-plus growth in our contractor segment, driven largely by seasonality, successful new products and good performance out of Europe and Asia. Our incoming order rate in the second quarter was solid, with backlog increasing approximately $4 million from the end of the first quarter.

Sales in Europe were up 27% versus the second quarter of 2009, and although the health of end markets varies considerably across Europe and construction is particularly weak in some areas, we are confident opportunities exist to generate growth in every segment, and in the second quarter, we achieved double-digit growth across all major product categories. Revenue in Western Europe was up strong double digits from Q2 2009 and growth rates in Eastern Europe were even higher. Asia Pacific had another good quarter with consistent double-digit increases across most product lines and countries. Japan was the only weak area and declined versus second quarter of last year. In Asia Pacific, this quarter was higher than our pre-recession Q2 peak, as was also the case in Q1. We also saw good growth in the Americas. In North America all segments were up double digits compared to last year.

Our industrial segment performed well as end market conditions and our customers appetite for capital equipment spending is much improved versus last year. New products in industrial are being well-received and we have a good pipeline that we'll launching the second half, as well. The lubrication segment achieved double-digit growth compared to last year. Growth in industrial lubrication was strong. The vehicle services lubrication market remains challenging, although we did see modest growth in that segment as well. In contractor North America, the Pro Paint business was up strong double digits driven almost completely by successful new product launches. Base business in Pro Paint remains depressed due to market conditions in both residential and commercial construction.

The home center business was down double digits compared to Q2 of last year. Q2 of 2009 included new store launches, making comparisons difficult. For the year, the home center business is essentially flat. Channel inventory in both Pro and home center appears to be stable with no evidence of significant restocking as of yet.

In Latin America, off a small base, we again posted gains in the high double-digit range and exceeded our pre-recession peak. Gross margins were solid at 53% for the quarter, up from 49.5% last year, but down slightly from Q1 due mainly to mix. in our contractor business we continue to see higher sales on lower-priced, lower-margin offerings. Operating margins in industrial and lubrication are significantly improved compared to last year's second quarter, and are in line with Q1 on similar volumes. Contractor operating margins improved substantially from Q1 on higher volumes, but are below prior year primarily due to cost associated with major new product roll outs. We anticipate further roll out expenses associated with new product in Q3.

Excluding the return of incentive payments, incremental operating margins are as expected on base business increases. The extent that revenue increases were driven by new products, the incremental operating margins were lower. New products require substantial up-front investments in selling, marketing, manufacturing and engineering to be brought to market. Most of the growth fromQ1 to Q2 came from contractor and specifically from new products. Profit contribution of new products will normalize as the early launch costs roll off and manufacturing process improvements are implemented.

We continue to invest in our key growth strategies during the quarter, developing new products, recruiting and training international sales people and selectively increasing distribution coverage. These strategies have been delivering, as evidenced by the quick return past peak in Asia Pacific and Latin America and strong growth in developing areas of Europe. The new products launched this year have also been well-received in the marketplace and are contributing to revenue growth. Our new product sales as a percentage of the total increase to 28% in Q2. versus 26% for the full year of 2009. We continue to anticipate new product spending in the range of $40 million for the year.

In certain categories we are putting more product development resources into new markets and less in to product upgrades and line extensions. We believe this shift will drive better long-term growth although it will have a short-term dampening effect on this particular metric. Products released in Q1 and Q2 have contributed nicely to our results and we have additional new products planned to launch in the second half of this year. Priorities for cash continue to be funding organic growth opportunities, making strategic acquisitions and returning cash to shareholders through dividends and share repurchases.

In terms of outlook, we believe the global economy will continue to recover. And while we don't expect Asia Pacific will continue with a period-over-period growth rates we saw in the fist half because of tougher comparisons for the rest of the year, we are positive about the near-term outlook for Asia Pacific and expect solid performance in 2010. We also anticipate continued good performance from Europe. A painfully slow recovery in the US housing market and difficult conditions in the US commercial construction market will create challenges for our contractor division. In order to achieve reasonable growth rates, our contractor North America business this year will need to continue to find success with new products and initiatives. This concludes my prepared remarks, I now ask the Operator to open the session to Q&A.

Thank you. The question-and-answer session will begin at this time. (Operator Instructions). Your question will be taken in the order that it is received. Please stand by for your first question. Thank you. Our first question comes from Kevin Maczka from BB&T Capital Markets. Please go ahead.

Good morning.

Good morning, Kevin.

Pat, I guess first, can I just clarify a comment in the press release about the contractor business. You say there that you are looking for modest improvement in the Americas and Europe in the back half. Is that true of the segment as a whole, and are you talking about sequential improvement from here or on a year-over-year basis?

Well second quarter is typically our highest quarter in contractor just due to the painting season. So when we talk about modest improvement, I talk really about modest improvement in end market conditions compared to last year at the same time.

Got it. And last year, Q2 and Q3 were both similar margins in that business, about 20%. With the ongoing new product roll out costs, how should we think about margin there is as we go forward? Is the Q2 run rate maybe a high water mark because revenues will be lower but we still have these new product roll out costs coming through?

Kevin, this is JIm. We are expecting a slightly better margin in the third quarter on the new products as our production -- our one-time production costs become smaller and the sales pick up slightly on the new product side. So if you put that together with the seasonality, maybe we're flat to a modest improvement.

Okay. Just maybe one more if I could, I will get back in line. But just a high level question, just interested in where you are seeing the growth in places like contractor and lube. Is this all new product, because again contractor is heavily exposed to res and non-res, which doesn't look that great at the moment, and lube, a lot of exposure there to vehicle service stations, which it doesn't feel like a 27% growth world we are living in there either. Is this all new products or where is the growth coming from here in these if it's not the new products?

Sure. In contractor it's mainly coming from the new product. We have been talking for the last 18-24 months about the ramp-up we did in product development across the organization and we expect to see the results of that in 2010, and I think we are and will. And really, new products drove the contractor business. On the lube side, even though the base is small we've had some really nice growth in Europe and Asia. And that's helped the overall worldwide lubrication numbers showing the numbers you are talking about. In North America, we got more modest numbers. Really not driven by new product, really driven by I think slight increases in the health of the end market condition. But primarily in lube it's an international story.

But you said, Pat, you are not seeing any signs of the headlines we see about China, perhaps tapping the brakes, things like that, you are not seeing that but of course the comps get more difficult. Are you also not seeing any signs that concern you in Europe as well?

If you want to look for things to be concerned about you can spend a lot of time finding things. I guess in general, I'm not overly concerned about Europe, I think its going be spotty and we need to make sure we are going where the opportunities are good. But I think overall, the second half in Europe is going to be fine.

China is trying to tap the brakes as bit. They have tried to do that many times in the past with minimal success. And although they may slow it down a little bit, our team feels pretty good about the next few quarters and that there is not going to be a big meaningful change there from the government.

Okay. Great. Thank you.

Thank you. Our next question come from the Charles Brady from BMO Capital Markets. Please go ahead.

Hey, thanks. In regards to the product cost mix/ price breakout on the three segments, if I look at industrial equipment, third quarter last year had a pretty -- 6% favorable, this year you've got another 2% favorable, how much looking to the back half of this year you think you get more on that line item? Is it being driven by a majority of one of those three items in that line item?

I think it's really driven, Charles, by the product cost and pricing for the most part in that segment.

Is it fair to say that the number of new products you are getting at that price -- you're obviously getting better pricing on the new products, and that's what is driving some of that new pricing and if I back that out, how does pricing on legacy products compare?

I would say that your assumption is not correct. We are getting good pricing and we did increase prices this year on our existing products, so the price I'm talking about comes both from existing products and new products.

Okay. And if we could scroll down to the lubrication equipment on that one line item, that was a 9% favorable in this quarter, pretty strong number. What really drove that 9% in lubrication?

Majority of that is cost reduction. Again if you recall at this time last year, we were having some issues in our factory. Specifically with regards to acquired products. So the cost changes in the improvements the factory was able to deliver in the third and fourth quarter of last year as well as this year to date are really rolling up into that 9% number. So it's really a quite strong performance out of that group on the cost side.

That ought to be sustainable in the back half of the year correct. Once it's at this level, it's permanent, it's not going to back track from there?

It is not. No. That's solid improvement, solid process changes. Solid use of automation in that factory.

Thanks, I will hop back in the queue.

Thank you. Your next question comes from Mike Halloran from Robert W. Baird. Please go ahead.

Morning. On the incentive cost that rolled back in this quarter, I think you said it was about $3 million, is that allocated back to the various divisions, and if so, how is that allocated back?

Yes, it is allocated back and it's, again, calculation by individual, so the salespeople and those respective units increases in incentives are charged to those specific segment costs. The $3 million number that you are calling out is the delta between the first quarter and the second quarter. The absolute numbers are $3 million in the first quarter and $6 million in the second quarter. And then Caroline gave you the forecast of where we expect we might be for the year.

Right. I was trying to drive down in to the delta between the first, second quarter and the industrial margin. I'm assuming that that's almost fully the explanation for why there is a 200-basis-point sequential decline despite a little bit better sales, sequentially is going to be driven by this incentive comp. And so I was just curious how much of that $3 million gets allocated to the industrial side versus the contractor side and the lube side?

Well I'll answer that $2 million of the $6 million in the second quarter went to the industrial segment.

Okay. So from your perspective that explains the move, the lower sequential margins?

It does. Yes

Then staying on the industrial side, just from a sequential standpoint, what sort of typical sequential growth would you expect second to third quarter and, I'm a little uncertain from your outlook section in the press release, but I just wanted to make sure I understood what your expectations were from a sequential standpoint in the industrial side, and whether the end market improvements you were referring to were solely on the contractor side or also referred to the industrial side?

I think the end market comments are really for the total Company. If you go back to when we were in a normal cycle, rather than the new normal. Industrial was 48%, 52%. 48% first half, 52% second half. I don't know where we are at this the cycle. My expectations are that we should continue to see some good growth out of the industrial global economy.

Thanks for the time.

Thank you. Your next question comes from Ned Borland from Hudson Securities. Please go ahead.

Hi, good morning. Just to clarify again on the incentives, you said year-to-date that delta is at $6 million for the year, it's going to be $15 million to $20 million, so you got an additional $9 million to $14 million in the back half of the year.

Let me try again. For the first six months Ned we are at 9 million.

Okay.

And for the year, at our current run rate, we would be accruing $18 million versus $3 million last year. Most of the $3 million in expense last year was recorded in the second half due to the cycle of how the improvements came. The $6 million in the second quarter versus $3 million in the first quarter as our sales trends continue to accelerate.

Okay. I think I got it. On the new product pipeline, you have launches coming in the back half of the year. Anything of the magnitude that you've seen so far in the first half of the year?

Well I think, on the industrial side, I think our new product launches are spread fairly evenly throughout the year, so I would expect to it be as good in the second half, probably the same for lube, maybe even a little better, because some of their nice products were launched here late in the fist half.

With the contractor business, where we had some real nice success, it's really going depend on what the sell through is, and early indications are that the sell through looks pretty good. So we're hoping for the next few months of the key painting season we're going to continue to see nice success on the products that we have launched here in Q2.

Okay. Thanks.

Thank you. Our next question comes from Matt Summerville from KeyBanc. Please go ahead.

Morning, a couple of questions. First, within the contractor business, over the last couple of quarters, you've been gradually migrating into product lines, at least with some of your home center customers, in that sub-$300 price point, more of a consumer DIY product line. If I go back in history with Graco, historically that's been a place that the company strategically decided to deliberately avoid, it seems like there has been a change in that view on that piece of the business. I guess, Pat, if you can walk through what the thinking is there and then how, if at all does that shift or does that decision change the incremental margin profile of contractor going forward?

We've had some pretty interesting I would say, call them technology breakthroughs, and really if you take a step back prior to 1999, we weren't in the home center business at all. And we didn't want go in and play in that channel with a me-too product. We were able to find a way to bring piston-pump technology into, let's call it $400 to $1,000 price point and so we entered that space. And to the extent we are able to find technologies that allow us to play at other price points with a differentiated product, then we think that's still consistent with our overall business philosophy and strategy. It's definitely the case that to the extent that we end up with more sales at $300 kind of a level, we are going to see margins that are slightly less.

I would assume this is something that you weigh in going in to this process. But one of the things we found is we go through the channels, that Graco has tremendous brand equity, we've known that for years. Getting in to this lower price point level of the market, doesn't that essentially give your customers better access to keep that brand maybe more permanently at a lower price, I guess, as we come out of this downturn, maybe a better way to ask the question is how do you get people that are buying $300 things to start buying $500, $600, $700 sprayers again if they are now conditioned to know they can get Graco at that lower price point. Does that makes sense?

I understand your question. Obviously that's part of our product line-up and planning process. If you take a look at each incremental price step that a consumer would take or a contractor would take, there are performance and features at the next individual level that pay for that price differential. So I'm not really concerned about that. Somebody who's buying a $300 spayer when they are going to buy a $500 sprayer, they are going to get more performance, they're going to get a larger tip size, they're going to get more flow, they're going to be able to do jobs faster, and so there are reasons that people climb the ladder, and you don't get a $300 Graco sprayer that performs like a $1000 Graco sprayer. It's still best in category and it's still great performance, but there are definitely differences and I don't see that as being a trend. I also like to comment that to the extent that contractor new product influenced the second quarter results, that handheld product that we are talking about has got a $450 street price. So we're not talking about consumer toys for what was launched here in the second quarter.

Correct. Okay. Thanks, Pat.

Thank you our next question comes from John Franzreb from Sidoti and Company. Please go ahead.

Good morning, guys. Just quickly, it looks like you elected to do some open market repurchases versus repaying of debt. Could you talk a little bit about that decision and maybe give us what the average cost was of buying back the stock in the quarter?

Sure. We did some purchases under a 10b5-1 program in the quarter. We saw the, we'll call it the Euro panic, happening. We thought that might give us an opportunity to buy Graco shares and our price was less than $30, we picked up 300-plus-thousand shares during that period. A little bit before the quiet period happened. So again our strategy here is to be somewhat opportunistic, not trying to go back to the 2008 level of share repurchases but to buy enough shares to our keep share count flat for the near-term.

Okay. That's it, that's all I got. Thank you.

Thank you. (Operator Instructions). Thank you. We have a question from Terry Darling from Goldman Sachs. Please go ahead.

Good morning, it's actually Eddie on behalf of Terry here. One question for you guys regarding the outlook for housing-related revenues. We saw comments coming out of Sherwin Williams they are going to see a weaker back half to 2010, I don't know if you have any insight around that?

Well, they're a major player in the industry, so I think you can take their commentary for what it's worth. And again what we are training to do is we are trying to manage our own future to the best that we can, and that was the reason we did big push on product development a couple of years ago and hopefully that's going to help us navigate through what looks to be a few more quarters of choppy waters on the housing front.

Kind of in early 2011, you guys are modeling a turn or thinking about a turn in the housing market?

Yes, well to be honest with you, if you would have asked me in the spring of 2009, I would have told you by the summer of 2010 things would be a lot better, and unfortunately they are not. I would anticipate next year is going to be better. But what we are trying to do is not to be victims to next year and continue to invest and drive initiatives and see what we can do in contractor.

Got you. Just as a follow up on the comment you guys made about Europe. On the flip side, your European competitors, have they been using the weaker currency as a way to be more competitive or gain market share?

I would say we haven't seen any dramatic evidence of that, no real big change in what the market dynamics are.

Got you. And just lastly, thinking about second-half incremental, just as we are looking out towards next two quarters, any comments you guys could make on how we should be thinking about incrementals for the business?

No, I think the profitability on the incremental business will -- after you account for this extra provisions on incentives just because the rate of change continues to accelerate here in our sales will be consistent with your expectations that we've had before.

Perfect. Thanks, guys.

Thank you. We have a follow-up question from Matt Summerville from KeyBanc. Please go ahead.

With regards to the incentive comp, correct me if I'm wrong, I guess I thought the expectation originally was that that line item would increase roughly $10 million in 2010 versus 2009. What I guess has occurred from an expectation standpoint that's driving that number to potentially almost double this year. Are these new product launches being more successful? Is underlying demand for, I'll call it your core product for lack of a better term, been better than what you would have thought three months ago? Can you help close the loop on that?

Yes, all those things are true. And if you take a look at just what happened between Q1 and Q2. Q1 we were up 19% and Q2 we were up 30%. Obviously the payout is going to be significantly different at those two levels and that really drove the big delta between the $6 million in Q2 and $3 million in Q1. Looking out, we anticipate continuing to perform well in the second half and the numbers that Caroline gave you in the $15 million to $20 million for the year are reflective of that.

With regards to some of the success you had in the professional paint side with some of the new product launches, like you mentioned, have you seen the full benefit from that initial stock-end, did you experience that in the second quarter or will you see some continued positive effect of that in to Q3.

We expect to see that positive effect of that to continue into Q3.

Then how would you characterize, just to make sure I'm clear on what is driving the contractor business, how would you characterize sell through or out-the-door volumes for your core products in both the home center and ProPaint channel ,can you go through that again, Pat?

Yes, I didn't cover out-the-door sales in those channels. But I did mention that inventory seems to be fairly stable in both of those channels. And so base business in contractor, I will call it flattish, maybe slight growth, and on a year-to-date basis, sort of similar kind of stuff coming out of the home center. The base business is sort of what it is.

As we take all these items, the things that are maybe going against you a little bit on the cost side, going for you a little bit on the top line, is there any reason to think that the second quarter won't be the high water mark for Graco's quarterly earnings, is that still the right way, as you see the rest of the year unfolding, to think about it?

I tend to be a little bit more optimistic on the state of the economy. But I don't think anybody knows.

Okay. Then, I guess lastly, Pat, if maybe you can just provide, within your industrial business, the growth you are seeing there? Kind of more end market commentary across the geographies what industries are driving the growth and the success you are seeing there?

Global automotive has been pretty good this year. Although we are not seeing a lot in terms of new facility construction in places like the US, we are seeing they are doing a fair amount of retooling and we're getting a fair amount of repair and replacement as they do that. Asia automotive has been really hot since, I would say, last August or last September, that's continued through the first half, not only transplants into Asia taking advantage of labor rates but also some of the domestic car companies that are in places like China that are doing a lot of investing and unit volumes look pretty good. So overall, automotive and automotive feeder on a global basis are much improved versus where they were at last year.

Some segments of aerospace are decent, some segments are tough. The small private jet business is not so great, but other segments of aerospace are still pretty good. Oil and gas has been okay pretty much on a global basis, prices have been hanging in there and we have been seeing investments, so our protective coatings business has been doing well. Mining has been strong and in places like Australia and down in South America, we continued to benefit both in our industrial and our lubrication business on the strength of investments in the mining sector. So there is a fair number of things going right. Construction worldwide is tough. It's still pretty good in Asia, but in Europe in general construction is weak, and of course, we all know what it is here in the US.

Appreciate the color, thanks, Pat.

Thank you. (Operator Instructions). If there are no further questions, I will now turn the conference over to Pat McHale, President and Chief Executive Officer.

All right, well thank you all for your time this morning and have a good week.

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