Graco Inc. (GGG) Q2 2013 Earnings Report, Transcript and Summary

Good morning, and welcome to the Second Quarter 2013 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 number is 4627991. The replay will be available through July 28, 2013. Graco has additional information available in a PowerPoint slide presentation, which is available as part of the webcast player. [Operator Instructions] 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 the company’s 2012 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. 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'll provide some top-level discussion on our overall financial results for the first quarter and then, we'll turn the call over to Pat. Slides are available to accompany our call and can be accessed on our website. The slides include information about our consolidated financial results for the second quarter in our usual format. Sales this quarter totaled $286 million, an increase of 7% from the prior year, with varying trends by division and region. Sales grew by 14% in the Americas, with increases in both Industrial and Contractor segments, while sales were flat in the Lubrication segment. The growth in the Americas was particularly strong in the Contractor segment, which grew by 28%, with strong sales in both the paint store and home center channels. Sales in EMEA increased by 2%, with growth in the Contractor and Lubrication segments. Sales declined by 6% in Asia Pacific, with ongoing weakness in mining and general industrial applications, affecting sales in the Industrial and Lubrication segment. Changes in currency translation rates from the prior year did not have a significant effect on sales or operating results for the quarter overall, with a $1 million of unfavorable currency translation from Asian currencies, partially offset by favorable currency translation from the euro. A table showing impact of volume, acquisitions and currency by segment and region is included on Page 5 of the slides. Net earnings totaled $58 million or $0.92 per diluted share for the quarter. Page 8 of the slide deck provides a quarter-over-quarter overview of changes in operating earnings. Gross profit margin, as a percent of sales, was 55.5% for the quarter, up from 52% for the quarter last year, which included $7 million of nonrecurring inventory…

Thanks, Caroline. Good morning, everyone. This morning, I'll provide some commentary on the trends we saw in our business in the second quarter, and our outlook for the second half of the year. During the second quarter, the sales line played out generally in-line with the outlook that we gave in April, with strong growth in the Americas and continued macro headwinds internationally. We're particularly pleased with the performance of our Contractor business in the Americas, which posted growth of 28% year-over-year. And the overall financial performance the company was a record level for both quarterly sales and earnings. Let's walk through each of the regions and segments, and I'll briefly give you a few data points. First, Asia Pacific. Overall, Asia Pacific was down 6% against the strong 2012 Q2 comparable, and performed slightly worse than anticipated in the quarter. At the same time, the business performed slightly better-than-anticipated in the first quarter, so our year-to-date performance of negative 3% is broadly in line with our original expectations for the first half. The macro environment is still weak, so quarter-to-quarter fluctuations aren't entirely surprising. In Asia Pacific, our Industrial segment declined 7%. Our Contractor segment posted low single-digit growth, while our Lube business was down double digits. The decline in Lube reflects ongoing weakness in certain key mining accounts, which had a strong first half of 2012. Our comparables for the second half in the Lubrication business will be easier, and we're not expecting this same level of year-over-year decline to be a theme. That being said, the Australian market for lubrication started softening in the first half, so we're keeping a close eye on that. Demand continues to be highly variable from country to country and across product lines for our Asia Pacific region. We saw moderate growth…

[Operator Instructions] Your first question from Jim Giannakouros from Oppenheimer & Co. James Giannakouros - Oppenheimer & Co. Inc., Research Division: The mixed headwinds that you alluded to overall, but more specifically, in Industrial, can you put some finer points as to the dynamics there affecting gross margin and outlook there for the second half racks?

Well, we have a lot of different product categories in Industrial, and selling to a lot of different regions. And we don't make break those out, those are niche product lines and we don't break out the sales trends by product line, for obvious competitive reasons. So those things can move around quarter-to-quarter. And I really view that as more noise than anything else.

Jim, Jim Graner. The sequential decline in the operating margins mainly comes from the decremental revenue of $4.2 million and headwinds from lower currency rates in Q2 versus Q1. Only about 1/3 of the difference represents the mix issue. James Giannakouros - Oppenheimer & Co. Inc., Research Division: Okay. That's helpful. And more specifically, on the Lube margin, that whips out quarter-to-quarter, nice lift there. How should we be thinking about -- exactly what lifted margin there? And is that sustainable in the second half?

We had some really nice performance in the Lubrication segment in the factory in the second quarter versus the first quarter. And primarily, all of the improvement in operating margin came from the factory. And taking a cautious look at that, we would say that you should look at the 6 months results as being typical of what you should expect for the second half of the year.

Your next question comes from the line of John Franzreb from Sidoti & Company. John Franzreb - Sidoti & Company, LLC: I want to talk a little bit about the $10 million in divestiture cost that you expect to come. Can you talk a little bit how that's going to play out? You had $1 million of costs in the quarter. Should we be thinking about $1 million in incremental cost each quarter going forward and the bulk of it when the final sale order comes in? Just a little bit of color about that $10 million number?

Yes, John, that's pretty appropriate. And majority of that cost will come with fees that relate to the sale, investment banker and other fees, legal fees. But the $1 million rate is probably appropriate until such time as we announce that transaction. John Franzreb - Sidoti & Company, LLC: Okay, perfect. And what's the rationale or the thought process behind the dividend number you're taking each quarter? You jumped it up and now next quarter, looking at $8 million, a little bit about what goes into that discussion?

Yes. So part of this process, we're thinking we'd do a steady $4 million per quarter, trying to just offset our interest cost, not giving a lot of volatility to future comparables. We found ourselves with a larger balance in cash in that business than we wanted. So we attempted to take it all out in an additional $10 million or $11 million in the second quarter. We failed to get approval from 1 government jurisdiction, it looks like that approval came in July. So the delta between the $11 million and $15 million will be paid out in the third quarter, giving us $8 million for the quarter. So we're still sticking with the thought process of $4 million a quarter as the standard rate. John Franzreb - Sidoti & Company, LLC: Got it. That's perfect, Jim. That makes sense. And one last question, did you say that the new product rolled out in Contractor, the restocking was 100 basis point headwind to Contractor margins, did I hear that properly?

Yes, yes. John Franzreb - Sidoti & Company, LLC: Okay. And do we have any information on what the sell-through of the new product is, how it is being received?

Yes, so I would say that both in the paint channel and the home center channel, our sell-through is a little bit less than their purchases were from us in the quarter. Just typical, I would say, of the stocking cycle on a seasonal basis. We're not concerned with the inventory level in either channel at this point. John Franzreb - Sidoti & Company, LLC: And is this the second generation of the handheld?

That's part of it, yes. And also, just some, I'll say, the medium-sized electric units. John Franzreb - Sidoti & Company, LLC: Okay. And I guess, one last question, have we seen any change in mix with some of the larger paint spreads versus the smaller size?

Well, when we look at the segment in total, we don't just because of the large increase in the home center units. We just target the paint center channel. We are seeing a sequential increase in the larger units, about 6 percentage points in this quarter coming between what we call our gas, large electrics and our niche products.

Your next question comes from the line of Charles Brady from BMO Capital Markets.

Andrew Dunham on for Charlie Brady. I just had a question, just kind of -- want to confirm it, you guys haven't -- you guys don't expect any continued stocking in the next coming quarters at all for the paint channel or the home center channel?

That's basically behind us. There might be $500,000 to $1 million this quarter. But the initial stocking order is there. We do expect, of course, flow-through and sell-through if they're being replaced. So there's an expansion of the market share for us.

Okay. And -- your comps notwithstanding, do you see the Asia Pacific market environment getting better or worse?

This is Pat. We're trying to figure that out. My view is that it's kind of been a sideways place right now. And I don't see any signs of great improvement likely in China here in the next couple of quarters, they've got some challenges that they're working through. And I think mining is going to continue to remain soft. On the other hand, automotive production is still okay, and we play in a lot of niche markets. We've got the Contractor business, where we can still convert end users. So from a Graco standpoint, we think we can eke out full year organic growth. But the market over there, in general, I think is weak, and it's likely to remain that way for a while, in my view.

Okay. And in terms of change in product mix in Contractor to higher-priced, higher-margin equipment, I guess, how -- have you guys been seeing that? And how much of Contractor today is the higher-priced, high-margin equipment? And if you have any timeline on when it might return to more normalized levels?

I think we're seeing that trend in the paint channel. As I mentioned sequentially, the share of the gas units and electronic units and what we call our niche product categories, grew by 6 points of the total, so the share grew, and that's getting part of our underlying profit growth, getting us, I'll say, to an adjusted 26%. For the quarter, so we see it coming back in small pieces and the trend continuing, at least, for another 4 to 6 quarters.

Your next question comes from the line of Matt Summerville from KeyBanc.

A couple of questions, first, I just want to make sure I understand the stocking in Contractor. Does this happen as an extension of your existing shelf space at the expense of someone else's? Is this a new product category? How many stores were impacted here, sort of the price point? Can you just give a little more granularity as to what exactly transpired?

So sure. It did happen at the expense of some competitors. So we have an expanded product offering, pretty much similar in 1,925 of this account stores. They have started to sell the handheld units, as well as the, I'll call them the medium-size electrics from I'll say, up to the $799 to $899 price point. So it's a nice change for us. That doesn't quite get us back to where we were in 2007, but it's a nice step in that direction.

So what sort of prompted that decision on the part of the customer to, I guess, kind of come back to Graco? Or is this more Graco pushing to get back into the customer at those price points?

I think we continue to win, Matt, due to better service and better products.

Okay. Just on China, how much was your business down in China in Q2 and year-to-date? Do you have that figure?

I do, hang on a second and I'll find it.

And I guess, maybe while you're looking for that, Jim, Pat, you mentioned mining, you mentioned auto. Can you maybe just give a little more of a high-level overview on some of your, the end market trends you're observing across the world?

Well, it's -- the North America market is probably or I should say, the Americas is probably the strongest product categories right now, although, I wouldn't say it's smoking hot other than the Contractor business. In terms of other kind of end markets that are pretty good worldwide, the process business is pretty good worldwide. There are some exceptions but generally, our process pumping is performed pretty well in most regions. We've seen some recent strength in our foam and polyurethane business over in Asia Pacific, which has been good. Our Sanitary business has been strong. And then our, what we call our AFD business, which is really our, I call it sealant and adhesive sort of business, which includes the new hot melt product that we launched here earlier this year, that's performed pretty well on a global basis. So it's not all doom and gloom, there are definitely some niches that are still performing pretty well globally. But there's a lot of other fairly significant product categories where things are looking pretty weak.

Has customer uptake of that new hot melt product met your expectations so far?

Yes, I think so far, we're very pleased. Generally, what a customer would want to do is they want a test product before they make a commitment to change over their production capabilities. And we've got really good reception to our efforts to get testing in place, particularly here in the Americas. Certainly, more work to do in the regions. But as of right now, I'm still feeling very positive about our ability to hit our projections on that.

Matt, back to your question on China, year-to-date, China sales are down 3% and they were down 8% in the second quarter.

Your next question comes from the line of Mike Halloran from Robert W. Baird. Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division: So tacking on to the Industrial side, did you see any change in demand trends as you worked through the quarter in any of the regions? Or was it continued choppiness or continued stability depending on which region you were in?

I will share with you that our orders in June, on a daily average basis, were 5% higher than the average of April and May. And I can't tell you the breakout by segment, I haven't got the calculation with me. Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division: And was that comps driven or was the fact that you were seeing a little bit of underlying improvement in some of the regions?

This is sequential. So April -- average April and May on a daily basis, and compare it to the average order rate for June. So sequentially, the orders in June were 5 points higher than the average for April and May. Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division: Okay. And then, do you happen to have a trailing 12-month EBITDA and revenue numbers for the ITW business that's held aside?

Yes -- this is Christian. The trailing 12 revenue number and -- keep in mind that we report a certain number for the hold separate business, but the Liquid Finishing business that we would be selling is just slightly different. So on an adjusted basis, it's going to be in the ballpark of about $260 million on sales. And the EBITDA is in kind of that mid-50s number. The other caveat I would give you is that if we get to a sales process at some point, when the decision on the order is issued, that -- a potential buyer may look at that adjusted EBITDA number, and it may look up or down, depending on how they look at it. Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division: Makes sense. And then, on the acquisition side, how aggressively are you guys looking today? And does this Liquid Finishing business preclude you from being a little bit more aggressive in the marketplace if you found the right transaction?

No, I think we're putting more effort into it than we ever have. At Graco, we've got some pretty good resources in place across the organization. We've worked hard to identify market spaces, where we think that we can bring our core competencies and add value. We're building relationships. We're knocking on a lot of doors. We're looking at a lot of things. And I feel pretty good about the effort that we're putting in. Of course, valuations are a little bit higher right now, as I'm sure you guys know. So we need to make sure that we're using Graco-like discipline as we take a look at opportunities, and I'm sure that we will. I do not feel, at this point, constrained by the fact that we haven't divested Liquid Finishing yet.

Your next question comes from the line of Joe Ritchie from Goldman Sachs.

So as it relates to the Contractor margins this quarter, can you give us any kind of color on how much of the improvement was related to just the volume leverage versus mix? And then, further, as we think about the trajectory into the back half of the year, it typically tends to be, seasonally, a little bit weaker. And so how should we think about the trajectory in the second half?

Yes. So we tried to do some reconciliation for the operating margins on our slides. So on Slide 15, you can see the year-to-date and the volume leverage, and you can see that majority of this improvement is coming from the expense volume leverage. So in other words, flattish expense with more volume. Margins, slightly -- gross margins slightly higher just due to the mix of things we talked about before. And for sure, Joe, you're correct that sequentially or on a seasonal basis, the second quarter tends to be our peak of operating profitability. So the volumes, we're expecting to drop off in the third and fourth quarter, as they have every year.

Okay. Again, if you do get the 100 basis point benefit, there's a drag this quarter from the -- I think you mentioned it was 100 basis point drag earlier and -- but you do expect, seasonally, for those margins to get worse. I guess, as we think through from an -- on the Industrial side, there were some mix issues in the quarter, the margins were still very good. But last quarter, I think you've guided to 34% to 35% over the next couple of quarters. So again, there, with the mix issues behind you, how should we think about Industrial margins as we look at 3Q?

Yes. So again, the guidance, 2 caveats: one, that the volume was the same; and two, that the exchange rates stayed the same. So detrimental volume of $4 million plus and the headwind from various Asian currencies, in particular, the yen and Aussie dollar, caused 2/3 of that decline from the 34 to the 32 in round numbers. So we still feel very good about that. The next will fluctuate a little bit from quarter-to-quarter. I'll let you make the call on the volume and the exchange rates.

Okay, great. And I guess, one last question. On the share repurchases, it looks like you did resume some modest repurchases this quarter. Again, how should we think about that on a go-forward basis?

Yes, so as we stated before, it is our intention to keep the share count flat. So we're currently buying at a level that would do that over the next 12 months. And again, we'll be opportunistic, given other alternatives for acquisitions and other deployment of capital.

Your next question comes from Jim Krapfel from Morningstar.

You talked about -- you spoke about your Industrial margins for the next quarter. Longer-term, do you see more upside there? Historically speaking, they were at very high levels.

Jim, this is Pat. We get asked this question, I don't know, all the time, at least for the 6 years I've had this job, and probably, for Jim's 30 years that he's been doing his work. Our model is, try to drive value into our product so that we can command price increases on an annual basis by giving the customer more. And then, to drive our factories to 0 cost change. And if we can do those 2 things, we give ourselves some opportunity to increase our gross margin. And then, we've got a pretty good structure the way we're set up, driving our products through global distribution that we can take any increases that we get in volume and leverage those through the commercial channel pretty effectively. So we don't sit around necessarily thinking about how are we going to increase our operating margin in Industrial. We spend a lot of time thinking about how can we add value to our product, how can we improve the productivity of our factories, how can we improve the efficiency of our channel. And if we do well on those things, that seems to provide an ongoing opportunity for us to perform.

Okay. Got you, okay. And second question, you've spoken about Industrial capital spending, outlooks still not being great, I guess. I guess, what are you seeing there now maybe versus, say, 90 days ago?

I haven't seen much difference, to be honest with you. Things just feel kind of sluggish out there. There's a fair amount of concern and there's no reason -- there's no region that's really on fire. We don't have China cooking now and making up for the fact that Western Europe's a little bit soft. We've got some concerns in China. We've got some concerns in Western Europe. I really feel like the performance that we're going to drive over the course of the next few quarters is going to be a lot up to us and the effectiveness of our new product launches and things that we can do to convert end users and drive growth. I'm just not seeing any sort of a global catalyst, and I haven't seen much change from 90 days ago. And Jim wants to weigh in with his thoughts. We've been traveling, different places. He's willing to do that as well.

I share those same thoughts.

Your next question comes from Walt Liptak from Global Hunter.

Yes. This is the first quarter where we've really seen the Contractor business pick up inside mix. I want to make sure that I'm understanding this, so we've got...

We have grown double-digits for a number of years in Contractor. I just -- it would pain me not to point that out.

Okay. All right. Well, you've had a definite uptick, and I wonder if it could be -- you called out that $4 million of inventory build with restocking. Is there a way of looking at the product that went through the stores versus inventory build or have you already done that?

So let me just take a shot at this and then Jim can jump in if I didn't understand the real part of your question. On the home center side, that $4 million of inventory stocking is because we took shelf space from competitors, and we expanded our product offering, so that's not a reaction by them to add more units of an existing product category in anticipation of the improvement in the general business. But that was really a specific sales win by the Contractor Equipment team at Graco. And what that should do for us, on a go-forward basis, with a broader product offering and more shelf space, is give us more out-the-door sales. In terms of what that overall out-the-door sales activity was versus sell in, it's of course, a little bit muddled this quarter because of the inventory stocking and the line expansion that we did. So I prefer not to try to put too much granularity around those numbers. Did I get your question?

Yes, right. So if we back out the $4 million, you had roughly 15% growth in Contractor. And then, I think the guidance that you're talking about is kind of double-digits or something like 10% to 15% in the back half.

We saw growth in both the professional and home center in terms of both their purchases and their sales.

I'll try another way to answer the question. In North America, without the $4 million sales in the home center, both the sales in the paint channel and the home center channel grew in the low 20% kind of range. Your 15% of the global number impacted by Asia and Pacific -- excuse me, Asia Pacific and EMEA lower growth rates. So we're seeing some pretty good volumes in both our channels here in North America.

Okay, got it. And along the same lines of another question on the -- on the Industrial. In the Contractor business, is there an aspiration or a target market -- margin that you think you can get to in Contractor?

Really, that model that we use across our division is fairly similar. Contractor invest a lot in new products to try to target new niches, and to drive -- try to drive increasing value for our Contractor end users, and we work hard in our factories. It's really the same model, and we don't have kind of an end game that we're after. We like continuous improvement, that's our culture, that's how we run our incentive programs, that's how we run our internal metrics. And so we just keep digging every year, trying to get a little bit better.

Okay. Is there anything structurally different about Contractor versus Industrial that says that you couldn't get to the low 30s margins?

Yes, I think there is, for sure. I mean, if you take a look at the kind of product categories and the price points that were in there, they're different. And so I wouldn't necessarily try to equate the 2. I think you're better off taking a look at historical Contractor performance and then, trying to figure out what the mix is going to be long-term between our home center and Pro Paint business also has implications there. I think our -- Jim, you can chime in, our long-term peak operating margins in the Contractor business were in the high 20s.

27, 28. So that's our short-term goal, short-term being the next couple of years of being back to our peak, and that's -- a lot of the questions earlier about the mix of the bigger units, when that mix happens, there's nothing that should prevent us from getting back to those levels.

[Operator Instructions] Your next question comes from Nicholas Prendergast from BB&T Capital Markets. Nicholas V. Prendergast - BB&T Capital Markets Inc.: Most of my questions have been answered and I'm sure you guys answered this one. So I hate to back track, but my phone was breaking up. Earlier, you gave some numbers regarding the ITW Liquid Finish. I believe you gave trailing 12 revenue in EBITDA, is that correct?

We did, yes. Nicholas V. Prendergast - BB&T Capital Markets Inc.: Okay. What did you -- I think I caught EBITDA was somewhere in the mid-50s, what did you say for revenue?

About $260 million. Nicholas V. Prendergast - BB&T Capital Markets Inc.: 260?

Yes.

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

All right. Thank you, everybody, for your time this morning. And we'll talk to you again next quarter, if not, before it.

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