Graco Inc (GGG) 2011 Q3 法說會逐字稿

Good morning and welcome to the third quarter 2011 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 the international callers is 303-590-3030. The conference ID number is 4478419. The replay will be available through October 30, 2011.

Graco has additional information available in a PowerPoint slide presentation, which is available as part of the webcast player. At the request of the Company, we will open the conference up for questions and answers after the opening remarks from management.

During this call, various remarks may be made by management about their expectations, plans, and prospects for the future. These remarks constitute forward-looking statements for the purposes of the Safe Harbor Provisions of the Private Securities Litigation Reform Act. Actual results may differ materially from those indicated as a result of various risk factors, including those identified in the item 1A and Exhibit 99 to the Company's 2010 annual report on form 10-K and in item 1A of the Company's most recent quarterly report on form 10-Q. These reports are 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.

(Operator instructions)

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

Good morning everyone. I'm here this morning with Pat McHale, Jim Graner, and Christian Rothe. I will provide some comments on the financial highlights of our third quarter, and Pat will follow with additional comments. Slides are available to accompany this call and can be accessed on our website. The slides include information about our consolidated financial results and each of the segments. After our opening comments, we will open up the call for your questions.

Sales increased by 20% for the quarter, including four percentage points from currency translation with strong growth in all segments and regions. Changes in currency translation rates also increased net earnings by $3 million for the quarter. Additional information about effective currency translation on sales for the segments and regions, as well as sales by currency, are included on page five in the slides that accompany this webcast.

Gross profit margins were 56% for the quarter, up half a percentage point from the prior year. Overall, the favorable effects of higher volume, currency translation, and selling price increases were partially offset by higher material costs. However, within our lubrication segment, production costs and less favorable factory performance offset the higher volume.

Operating expenses for the quarter increased by $8 million, including $3 million of transaction costs related to the pending acquisition of ITW finishing businesses, and $2 million related to currency translation. Selling, marketing, and distribution expenses were $3 million higher in the quarter. Interest expense was $3 million for the quarter and the effective tax rate for the quarter was 32% compared to 28% for the quarter last year. The prior year included favorable effects of tax law ruling and expiring statutes of limitation.

Year-to-date cash flow from operations was $109 million compared to $62 million last year. Inventories and accounts receivable leveled off in the third quarter after increases in the first half related to increased business volume. Capital expenditures are $17 million year-to-date, and we have paid dividends of $38 million year-to-date. We also purchased $38 million of Company stock, representing 1,059,000 shares at an average price of $36.23. $35 million of the total share repurchases settled in the quarter and $3 million was in accounts payable at quarter end. The second $150 million of the previously announced $300 million of long-term debt was drawn in July, in accordance with our credit agreement. Cash is held in deposit accounts and money market funds.

A few other items to note. We expect to see material cost pressures moderate slightly in the fourth quarter as compared to the third quarter. Factory production levels are expected to be in line with sales growth and slightly lower than the fourth quarter last year, which included substantial wrap up in factory volumes.

Expenses associated with the pending acquisition are expected to be $3 million in the fourth quarter. We expect that expenses in total will be in the range of $20 million for the transaction.

Interest expense for the fourth quarter is anticipated to be $4 million, and based on the expected profitability of our international subsidiaries and the current exchange environment, we expect annualized tax rate to be approximately 33%.

With that, I will turn the call over to Pat McHale.

Good morning. Despite all the negative news, we had another strong quarter and with double-digit revenue growth in every region and segment. This is our seventh consecutive quarter of double-digit revenue and earnings growth, and this quarter we posted the highest revenue for any third quarter in the Company's history.

For the quarter, currency was the tail end of approximately $3 million on net earnings. However, ITW transaction costs, interest on borrowings that will be used to fund the transaction, and the normalization of our Q3 tax rate compared to last year were a $5 million headwind.

Heading these out, I am pleased with the solid incremental net earnings margin for the quarter. As you saw from our prepared slides, material costs remained a headwind in the quarter. We're expecting that to moderate slightly in Q4 based upon changes and commodity cost surcharges. I'll spend a few minutes talking through each of the divisions and regions.

Starting with the Contractor's segment, with worldwide segment growth of 11%, the division performed well during the quarter, especially given the weak -- ongoing weak conditions in the US and European construction markets. North America Paint Channel is down 2% for the quarter, primarily due to the store load for handheld that occurred in Q3 of last year. Without handheld, our Paint Channel business in North America was up 23%. Channel inventory of handheld products has normalized and we expect that Q4 handheld sales in North America Paint will meet or exceed 2010 Q4 levels.

The Home Center business in North America was up strong double digit. In Europe, our contractor business was down 9% versus last year's third quarter at consistent exchange rates. Comparisons for 2010 include about $4 million of handheld load in Europe in Q3. There was also an additional $4 million in Q4. Excluding the handheld product, base business in Contractor Europe was up double digits in Q3. Our contractor business in Asia and Latin America continues to perform well with solid double-digit growth in those markets. Based upon feedback from the field, we are anticipating a soft Q4 in our Contractor segment. We expect good growth to continue in the developing markets, but in North America and Europe we anticipate that our channel partners will be cautious with inventory levels as we move into the winter season.

We continue to invest in new products and continue to expand our commercial resources and our channel in developing markets, and user conversion remains a priority around the world in areas where equipment penetration is low.

Moving onto the Industrial segment, we had another quarter of good growth in the industrial segment with strength across geographies and product lines. In fact, we hit peak third quarter revenues in industrial this quarter. This was achieved despite both North America and Europe revenues in this segment below peak. A great example of the return that we're getting on our strategic initiatives to drive growth in the developing markets. Gross and operating margins remain solid and we continue to invest for long-term growth. We've been monitoring incoming order rates closely and continue to see growth versus the prior year. Our outlook for this segment remains positive.

Moving to the Lubrication segment, the lube segment continues to perform well with double-digit growth across regions and product lines. In our historical vehicle services business in North America we see good investment activity in the service facilities. Our industrial lubrication initiative continues to grain traction. We also see strong growth in Europe and Asia. Similar to our industrial segment, the investments we are making in people and products continue to pay off. The segment is on track to deliver mid to high teen operating margins as expected in 2011 and outlook for operating margins for 2012 to exceed 20% based upon revenue growth and continued factory performance improvement. Our outlook for this segment also remains positive.

Moving onto Europe, during the quarter Europe continued to show revenue gains at double digit increases compared to last year driven by strong performance in our industrial and lubrication segments. Detailing the region a little further, the developing economies of Eastern Europe, the Middle East, and Africa grew 31% at constant exchange rates. Western Europe was essentially flat if you include the 2010 handheld sales. Excluding that comparison point, total sales in Western Europe were up double digits.

Moving onto Asia, Asia continues its trend of great performance with another strong quarter. We had double-digit increases in both developed and developing countries and across most product categories. In 2010, Asia-Pacific significantly exceeded our pre-recession peak so our 2011 growth is particularly good given that there's no rebound in these growth rates. We've invested heavily in people and channel during the past few years and these investments are paying off. There continue to be great Graco opportunities I this region and we'll be adding more people throughout 2011 and 2012.

During the second quarter, we opened a new Asia-Pacific headquarters in Shanghai. This facility includes product demonstration and training capabilities. Over the summer we've already trained more than 500 employees, material suppliers, and distributors at this facility. We anticipate heavy utilization of this capability in the coming years and expect it will contribute substantially to our efforts to capture share in this important market.

A few closing comments. Again, despite the negative new cycle in the last ten or 12 weeks, we continue to see solid incoming orders. We do have a short cycle business and will continue to monitor order trends closely, particularly in Western Europe where we have the most short-term concern. While we do expect a soft Q4 for the Contractor segment, we expect Lubrication and Industrial will continue to perform well.

I do remind you that Graco had a 53-week fiscal year in 2010 and only 52 weeks in 2011. Last year's Q4 had the benefit of the extra week and I suggest you take this into account while making your Q4 revenue estimates. That being said, we expect full year revenues for 2011 to be a Company record. Our growth strategies remain sound and are performing well. New products are well received and our product pipeline is robust. Our teams in Europe and Asia are growing, along with our channel and the capabilities of Graco and distributor personnel. This bodes well for 2012 and beyond.

This concludes my prepared remarks. I now ask the operator to open the session to Q&A. Mr. Operator, please open the session to Q&A.

(Operator Instructions) Thank you. The first question comes from Charlie Brady from BMO Capital Markets. Please go ahead with your question.

Thanks. Morning, guys.

Morning, Charlie.

Hey, just with regard to the comment on Contractor softness, obviously Q4 is seasonally softer but it sounds as though you're expecting something a little bit more than normal seasonality and even maybe more than the fact that you're short a week this year. Is that correct?

We're a little concerned as to what the headline news is going to do with regard to inventory stocking levels at our major channel partners. Our out to door sales information that we've received so far in October is good. So we're not seeing any decline in end user demand, but just thought we should put -- or share our concerns about headline impact on potential stocking levels.

Okay, and then the commentary on the Home Center channel I guess being up double digit, does that kind of tie into -- do you think there's any sort of front loading of that in Q3 that impacts the Q4 or is there something else driving kind of the strength in the Home Center channel?

No. Again, we believe that out the door sales or the data we see from our channel partners show that out the door sales are strong as well.

Okay. Can you give any kind of commentary around what kind of incremental margins you're looking for in Q4 and into 2012?

Is that for the total Company, Charlie, or just with respect to Contractor?

Well, actually both.

So in contractor, we're seeing a continuation of the shift in the mix to the higher performing units, those that carry higher prices and higher margins. So that trend that we experienced in I'll call it the last three quarters continues. So we're expecting a pick up in the operating profits in the contractor segment both for the fourth quarter and for next year. With respect to the Company, we've got some price increases that will be effective in January and February. So we expect that that will more than offset the material costs pressures that we've experienced to date and those that we're expecting, and we're expecting a relatively positive top line growth.

So we should see small incremental margins towards the total Company as well.

Okay, I just want to clarify a point. So on Contractor, you're talking about improving margins in Q4. Are you talking about incrementally or absolute basis despite the sales being softer?

Well, sales being soft we'd say rather than softer. So yes, we're seeing both of those, incremental and absolute margin improvement in that segment.

Thank you. The next question comes from Terry Darling from Goldman Sachs. Please go ahead with your question.

Thanks. Good morning. Hey, Pat, I wonder if you might talk a little about how you're thinking about growth rates in Asia looking forward. There's obviously a lot of signs of slow down going on there yet you're working off of a small base. You've got a lot of new product going in there. You're building out your channel investments. 2012 versus 2011, do you see any degradation there at all or do you think the growth investments can continue to sustain these very nice growth rates you're seeing?

Well, my view is that with the opportunity that we're going to have due to the economies in those regions and whether they're a little, a couple points less or a couple points more, plus all the investment that Graco is making and will continue to make that we ought to see double-digit revenue growth for an extended period of time in Asia. And whether it's going to match the 2011 numbers or not, I don't know, but I am planning for double-digit revenue growth in Asia over the course of the next few years.

And I think you're on pace for something like 40%. There's 35% or 40% this year. Double digit gives you a lot of cushion in that comment. Can you provide a little bit more color maybe just on the level of investment or the level of growth in your sales force. Maybe help us this year on this 40%, 35%, 40%. How much is kind of same store sales growth versus the incremental investments that you've made?

I wouldn't be baking 40% ongoing growth rate into our Asia-Pacific numbers. But no, I'm not going to help you get fine with 2012 growth rates in Asia-Pacific. I will tell you that since about 2007 that business has doubled during that time period from at least a commercial resource standpoint. We've probably been close to doubling our commercial resources in that area as well. We may add in the range of 50 from a Graco headcount perspective next year, which would be probably consistent with what we're actually achieving the last couple of years. And we typically will add several hundred new outlets on an annual basis and I don't see that trajectory really declining either.

Okay, and then, Pat, on growth for the industrial segment, despite the shift in the comps the growth remained very strong there on a year-over-year basis and your comments suggest you're expecting similar growth rates. I think I heard you say for the fourth quarter. Maybe you could talk about what your thought process is for 2012 there and maybe parse for us again the underlying market versus the outgrowth of the Graco self-determined drivers there relative to the investments that you've been making.

Are we talking about industrial -- ?

Industrial broadly now. Obviously, we're inclusive of Asia. So shift it from geography across the Company just industrial.

We're still below peak in North America and in Europe. So there's still, I'll say, a little bit of rebound left to be had there. Of course, the last three months it seems like the world has been trying to scare itself into some sort of a recession, but thankfully we're not seeing that in our industrial numbers. We ought to grow more than GDP or industrial production due to several factors. We're going to get a little bit of price on an annual basis. Certainly, we invest more in new products than any of our competition by a factor of two to three times as much and our new products have been well received. We still have the opportunity to grow channel in specialized, particularly in the developing markets.

So our stated growth objective for the Company is 10 plus on the top and 12 plus on the bottom, and certainly in this environment where construction remains soft, the industrial business we expect to be a very important driver of that.

Okay, and then I guess just coming back to the Contractor 4Q comment, I guess first off one less week, is that -- are we talking roughly $15 million across the Company, Jim? Is that about right?

That's reasonable.

Okay. And given the tough comp and the commentary about distribution pulling in inventories, does contractor grow organically in 4Q or is that, you're thinking pretty close to flattish year-over-year?

At this point, we're not sure. I think it could be flattish. We could see some growth, but compared to our confidence in our industrial and our lube business, we're just a little bit more cautious regarding what's going to happen with our channel partners.

Okay, and then just lastly when modeling it, the commentary on the deal cost 3Q versus 4Q, does that suggest the corporate expense within the segment buildup is down $2 million sequentially?

I'll try to refine your question, Terry. The corporate expense where we put the transaction cost is not charged against the segment. So if you look at our segment operating margins for industrial, it's not penalized by the transaction cost. Our total Company operating margin is. So it's roughly the same dollar amount in the second quarter, third quarter, and fourth quarter in our projection.

So that $6.9 million corporate expense line similar in the fourth quarter?

Correct.

Thanks very much.

Thank you. The next question comes from Matt Summerville from Keybanc. Please go ahead with your question.

Morning. Just a couple questions. I think if you look at your slides on, I think it's page 17, it was mentioned on the lubrication business that you had some unabsorbed manufacturing costs or product cost inefficiencies maybe is the better way to phrase it, excuse me. Can you talk about what was driving that factory performance in lube? And I guess a year or so ago, or two years maybe you had some factory challenges. Does it relate back to that? Because I guess I thought those problems were kind of solved.

I don't really see it relating back to that. They've made tremendous improvement over the course of the last couple of years and again, that division is going to deliver on its commitment to me to have that mid to high teens in operating margins. They have been growing fast. So it's been a really big snap back for our lube business, so that's created some challenges for them on manufacturing (inaudible). In some cases, they're running product on what we call alternative operations where it's not the primary machine to run it on, but since they're busy they run it on a less efficient machine in order to take care of our customers.

So we've really been focused on driving throughput and driving some of our customer service improvement metrics and that's cost us a little bit, particularly in the third quarter. We do have some capital equipment that's been justified by the lube division over the course of this year that's not here yet. It's just showing up here in the fourth and the first quarter, and as we put that into service that should give us a little bit more breathing room on the output side and I would expect that then that will help us get some of the efficiencies back that we're giving up in order to take care of our customers here.

And then, Pat, maybe could you just spend a minute kind of talking through the three regions on the industrial side of the business, what you're seeing plusses and minuses from an end market standpoint over the course of the quarter or in your current incoming order rates?

I can't give you any hard numbers obviously because we sell through distribution. But in terms of the end markets that are doing well in North America. Ag is doing well. We're still seeing quite a bit of business in aerospace. Automotive has had a really nice rebound off of the lows. The businesses that are tied into kind of the big ticket consumer discretionary business, the boat business, the RV business, those are still tough. Businesses associated with the construction markets that affect our industrial business like window and door, those remain challenging. So I don't think we're really seeing anything significantly different than probably what you're hearing from everybody else.

On the European front, despite maybe a little bit that you hear, the automotive investments in Europe still seem to be being made. They haven't seemed to pull back their horns yet from an automotive standpoint. So our business there is continuing to hold up, and of course the developing markets, whether you're talking about Europe or Asia are still cooking along at pretty high levels across I'd say most of the industry and segment. Certainly anything associated with mining or anything associated with energy production has been pretty good.

I can't say that I can pick out a lot of weak areas in Asia. Even Japan for us is continuing to show nice double-digit growth rates for both quarter and for the year.

Appreciate the color. Thanks, Pat.

Thank you, and the next question comes from Mike Halloran from Robert Baird. Please go ahead with your question.

Morning, guys. So first, just to be clear on the tax rate. That 33% you referenced, that's 4Q and for 2012 or is that just 4Q?

That's the annual rate we're projecting for --

'11.

'11, and if you're modeling 2012 I'd use between 33% and 34%.

Okay, so it's going to track up a touch. Okay, and then I know you talked about some softening sequentially on the contractor side, but the commentary certainly seems pretty positive on the industrial and lubrication side. Any reason why you wouldn't see some sort of normal sequential pattern? Anything in the quarter that you think in the industrial, lubrication side would skew that normal sequential trend?

If you take out the impact of the extra week, which I suggest that you do, I don't see anything other than the concerns about what may happen in Europe. And of course, today is a happy day. So apparently Europe is now going to be fine, but I'm still concerned about Western Europe and although we haven't really seen a significant impact in order rates, I think you'd be wise, a person would be wise to be watching that cautiously. Other than those two things, I feel pretty good about where our industrial lube business is going and I think we're going to continue to perform well.

Okay, good. That's all I had, guys. Appreciate it.

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

All right, well thanks for your participation in our conference this morning. Again, we're pleased with the quarter and generally pretty positive in terms of our outlook over the course of the next year or two. We think what we're doing is working and we're going to continue to make those investments. Thanks.

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