Graco Inc. (GGG) Q1 2014 Earnings Report, Transcript and Summary

Good morning, and welcome to the First Quarter 2014 Conference Call for Graco Inc. If you wish to access the replay of this call, you may do so by dialing 1 (800) 406-7324 within the United States or Canada. The dialing number for international callers is (303) 590-3030. The conference ID number is 4678040. The replay will be available through April 27, 2014. 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 purpose 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 2013 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 in 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 Ms. Caroline Chambers, Vice President, Controller and Information Systems. Please go ahead, ma'am.

Good morning, everyone. I'll provide a brief top-level summary of our quarter, and then we'll turn the call over to Pat for additional discussion. Our conference call slides are on our website and provide additional information on our quarter. Sales were $290 million, an increase of 8% from the prior year. Sales from the recently acquired EcoQuip and QED businesses were $7 million, or 3 percentage points, of our overall growth. Regionally, sales in the Americas grew by 15%, sales in EMEA increased by 7%, or 3% at consistent translation rate, and sales in the Asia Pacific were down 7%. Gross profit margin as a percent of sales is 55% for the quarter as compared to 56% in the prior year. Aquisition related inventory charges, lower margins from acquired operations and change in product mix contributed to the lower margin rates. Operating expenses included the effects of the acquired businesses and $1 million for incremental investment in regional and product growth initiatives. Operating expenses also included $1 million of acquisition and divestiture expenses in 2014. These expenses were not significant in the first quarter last year. Other income includes dividends from the Liquid Finishing businesses of $4 million for the quarter, the same as the first quarter 2013. The Liquid Finishing businesses are accounted for as a cost investment since we cannot control the operations of Liquid Finishing under the terms of the Hold Separate Order from the Federal Trade Commission. Additional discussion of the Liquid Finishing businesses is included in our 2013 Form 10-K and in our first quarter 2014 Form 10-Q. The effective tax rate for the quarter was 31%, 4% percentage points higher than the prior year. Last year's rate included the impact of the federal R&D tax credit that was renewed in the first quarter of 2013 and was retroactive to the beginning of 2012. The R&D tax credit has not been renewed for 2014. Net income totaled $51 million, or $0.81 per diluted share. Net cash provided by operating activities was $28 million for the quarter, with growth in working capital in line with business volumes and consistent with prior quarterly trends. Days of sales outstanding for accounts receivable remain consistent. Capital expenditures were $7 million. Other significant uses of cash this quarter included the acquisition of QED for $65 million, dividends of $17 million and share repurchases of $48 million. Couple of other discussion points: We expect the dividends from Liquid Finishing to be $11 million in the second quarter, the same as the second quarter in 2013. The tax rate for the second quarter is expected to be approximately 28% to 29%. The full year tax rate is expected to be approximately 29% to 30%, excluding any effects from intangible sale of the Liquid Finishing investment. This estimate also assumes that the federal R&D tax credit is not reinstated for 2014. I'll turn the call over to Pat now for further segment and regional discussions.

Thanks, Carol, and good morning, everyone. Our outlook remains generally in line with the 2014 view that we communicated in late January. The macro environment worldwide remained inconsistent but at slightly better growth rates than we saw in 2013. We continue to expect full-year organic growth in each of our regions and in each of our affordable segments. Our comments today are based on consistent exchange rates. I'll start with Contractor. As expected, our Contractor business posted double-digit growth in the Americas in Q1. Sales growth was relatively flat internationally for the quarter, but I do expect Contractor sales in both EMEA and Asia-Pacific to post growth for the full year. In the Americas, out-the-door sales were solid in Q1 with double-digit increases in both the paint store and the home center channels. We added another home center partner in the Americas in Q1, a household name in the Midwest with about 300 stores. The addition of this partner helped to offset a difficult sales comp from the first quarter of 2013 where we had a large sale of equipment to our rental channel partner that did not recur in 2014. At our last investor call, I discussed the significant renewal of our line of professional airless paint sprayers, which drove a spending increase in the fourth quarter of 2013. The products did successfully launch very late in the first quarter, and the initial reaction from our channel partners and from paying contractors has been positive. The incremental profitability on contractor revenue growth in the first quarter was an unimpressive 26%, as factory spending was up on capital equipment projects and the large new product launch. Mix was also a factor. Within our paint store channel, we saw faster growth in lower margin categories as our redesigned larger units were…

[Operator Instructions] And our first question comes from the line of Matt Summerville with KeyBanc.

Pat, can you give a little bit more granularity in terms of just the magnitude of volatility you're seeing in China on either a week-to-week or month-to-month basis? What end markets there seem to be working? Which ones don't?

Our overall in counting the order rate in China has been fairly flat, and so I don't think there's really any particular story to be seen as you kind of look within our product categories. From quarter-to-quarter and product line-to-product line, we see things moving up and down, and we just don't see that sort of kind of continued upward push that we had seen 1.5 years or 2 years ago across all the product categories. So I think they're just kind of struggling in general, but I can't point at anything in particular.

And then with respect to the new home center customer, can you maybe quantify what the initial sell-in added to your Contractor results in the quarter? And are you fully stocked there at this point?

Matt, this is Jim. So it's about -- between $1 million and $2 million in the first quarter. We expect a little bit more in the second quarter but then, it should be fully stocked.

[Operator Instructions] Our next question comes from the line of Walter Liptak with Global Hunter Securities.

Walter Liptak. One may ask about your -- I think your comments on China are a little bit better than they were at the conference call last quarter. And I guess, as you look at some of your end markets -- and I know you'd commented a little bit about this in the last question, but you think we'll get back to some of the growth rates that you had seen in the past? Or is this a market now that's matured and when it recovers, we're going to see more kind of matured growth like we see in the rest of the world?

Obviously, their economy has gotten a lot bigger. And as it gets larger, of course, putting up the same sort of percentage increases becomes more difficult. My long-term view is that there's a long way to go, and that what we're going to see is, we're going to see a return of nice growth rates in China again. But I think, for a while there, everybody got caught up in "It's going to be great double-digit shoot-to-the-moon forever." And my view is, it's not going to work that way, that it's going to be a bit more of a choppy ride. But I -- so I think that we're going to have periods where things are a little difficult, but I really still expect it to be a good long-term story. We were over there just a month ago and there is a lot going on, and there's still a lot of people that are moving themselves up towards the middle class, and I think the story there is going to be positive if you've got that -- the patience to wait for it.

Okay. Did you exit the quarter stronger than the way you entered it?

For our orders for the first quarter of '14, we're just slightly under our first quarter of 2013. So positive on orders versus our decline but not significant for the second quarter.

And that's specific to China, correct?

Correct.

Okay. And then on -- in the U.S. with some of the housing numbers looking a little bit weaker here this year, and I think you alluded to some of this in your comments in the press release. I wonder if you'd talk about what you're hearing from the contractors, and we have, and as well as new construction now that's impacting your outlook for the year?

We look at all the same data everybody else looks at. My personal opinion is that housing market's going to be fine this year, and that we're going to finish somewhere between that $1 million and $1.1 million start level. I think there's -- interest rates are still pretty low. Pricing has firmed up in most of the markets. In fact, some markets, we're seeing some pretty significant increases in pricing. Inventories seem to be low. And the current field rate, I think, is just not enough for, I'll say, a normal stable U.S. economic environment. So I think we're still on the way back, and I don't get too concerned over the little bit of noise we've seen here in some of the recent numbers.

Okay. And then I guess the last one, with respect to the kind of the -- some of the higher spending levels this quarter, are those going to -- you saw some recurring costs for incremental spending in the second quarter, and then the back half they're lower? Or is it, in the back half you start getting some benefits of the spending?

Walter, this is Jim. Our spend should be consistent with those initiatives for all 4 quarters of this year. It's part of our base now, and we like those efforts. We like the opportunities that those markets provide.

[Operator Instructions] We have a follow-up question from the line of Matt Summerville with KeyBanc.

Just a couple of more quick ones on the Contractor business. This next-generation airless line that you launched late in the first quarter, was that material to revenue? Number one. And then number two, if you look at this current generation of sprayers relative to the prior generation, what would you say is the ASP differential?

Let's see. I'll answer the first part, because it wasn't significant in the first quarter. We launched it pretty late, and we may have gotten a little bit of revenue from it at the very end of the first quarter, but we probably also had people that weren't buying in anticipation of it. So I really think it's going to show its stripes here in the second quarter. I'm not sure on the ASP. It might be a little bit higher. I don't think it's dramatically different.

I think our expectations all in, as these product launches, our gross margins should improve slightly versus the same products a year ago. Pat mentioned earlier that our profitability was disappointing -- incremental profitability was disappointing at 26% in the first quarter. Part of that has to do with the fact that we think a number of people were waiting for these larger units to come out. So once again, we find ourselves with bigger percentage increase in smaller lower-priced units versus the higher-performing, higher-priced units.

So with this -- the Q2 sort of having the full impact of this new line being available with -- I don't know if you thought there was maybe some purchases that got deferred due to weather, if that was an impact. Is the second quarter going to be more seasonal than you would normally expect because of those factors?

We're not sure. Again, we do think that there's some pent up demand for these larger units that will impact the second quarter.

Our next question comes from line of Liam Burke with Janney Capital markets.

Pat, you gave some color on the Industrial side in the markets. Can you give us a little more detail on what products did particularly well during the quarter?

So when you looked at Industrial's strength, a lot of it was coming out of the Americas, and we actually saw demand across most of our product platforms being pretty decent. It wasn't like we had one particular product category that spiked. We'll note that our split Foam business had a good first quarter. And so that continues to be a nice business for Graco. But generally, demand was pretty broad-based. And again, when you look at -- by product category and you look at it in Europe and Asia, there's not any particular story. I think to give -- different product lines had different rates of growth or decline in different countries. And I think it's more reflective of the overall growth in the marketplace, or a lack thereof, than anything happening in any particular industry.

Okay. And would you anticipate -- it looks like nonresidential construction is beginning to show some signs of life. Do you think that's going to be any kind of significant help to the Contractor business in 2014?

There's been some optimism about that kicking in here, and when it does really kick in, that's going to be a plus for us. And so we're looking forward to that. Certainly, they tend to buy the larger pieces of equipment, and we haven't really seen a robust non-res market since it kind of started falling apart back in that kind of '07, early '08 timeframe. So we welcome that, and I agree with you, the data that's coming out, hence they indicate that maybe that's going to start to kick in but we've kind of been there for a few quarters, really. We've talked about non-res coming back and although the data's up a little bit, we haven't seen it really kick in yet. So I'm going to take a wait-and-see attitude but certainly, it will help our Contractor business when it becomes real.

Our next question comes from the line of Jim Krapfel with Morningstar.

So one of your key strategic growth initiatives is the conversion of end users from manual painting techniques to spray equipment. So just curious to hear your recent efforts there? And how much traction that's getting?

In terms of level of activity, we're very active on that front. And we're actually expanding that initiative down into South and Central America. We're putting more feet on the ground. I would say, from a traction standpoint, the last few quarters had been disappointing. We have lots of opportunity in places like China. We took a little bit of a road trip from our corporate headquarters out to one of our factories there, and I couldn't count the number of buildings that were going up and the number of cranes that were going up, and yet the penetration rate on spray equipment is very low. So there -- the opportunity continues to be large. I'm a little bit disappointed on our ability to capture that in some of those markets over the last few months, but we believe it's still the right long-term play and that it's going to provide good benefits for us.

What is the overall penetration rate in China?

My estimation in China is it's probably in that 10% sort of a range.

[Operator Instructions] If there are no additional questions, I will now turn the conference over to Mr. Pat McHale. Please go ahead, sir.

All right. Well, thanks for your participation in the call today. And we're going to work hard, and we look forward to have a good year. Thanks.

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