Overview

The Company designs, manufactures and markets systems and equipment to move, measure, control, dispense and spray fluid materials. Management classifies the Company's business into three reportable segments: Industrial, Contractor and Lubrication. Key strategies include developing and marketing new products, expanding distribution globally, opening new markets with technology and channel expansion and completing strategic acquisitions.

The following Management's Discussion and Analysis reviews significant factors affecting the Company's results of operations and financial condition. This discussion should be read in conjunction with the financial statements and the accompanying notes to the financial statements.

Acquisition

On April 2, 2012, the Company completed the purchase of the finishing businesses of Illinois Tool Works Inc. (the "Finishing Brands" acquisition), first announced in April 2011. The acquisition includes powder ("Powder Finishing") and liquid ("Liquid Finishing") equipment operations, technologies and brands. In Powder Finishing, Graco acquired the Gema® businesses. Gema is a global leader in powder coating technology, a market in which Graco had no previous product offerings. Results of the Powder Finishing business have been included in the Industrial segment since the date of acquisition. In Liquid Finishing, Graco acquired the Binks® spray finishing equipment businesses, DeVilbiss® spray guns and accessories businesses, Ransburg® electrostatic equipment and accessories businesses, and BGK curing technology.

In December 2011, the United States Federal Trade Commission ("FTC") filed a formal complaint to challenge the proposed acquisition on the grounds that the addition of the Liquid Finishing business to Graco would be anti-competitive, a position which Graco denied. In March 2012, the FTC issued an order (the "Hold Separate Order") that allowed the acquisition to proceed to closing on April 2, 2012, subject to certain conditions while it evaluated a settlement proposal from Graco. Pursuant to the Hold Separate Order, the Liquid Finishing business was to be held separate from the rest of Graco's businesses until the FTC determined which portions, if any, of the Liquid Finishing business Graco must divest.

In May 2012, the FTC issued a proposed decision and order (the "Decision and Order"), subject to a 30-day comment period, which requires Graco to sell the Liquid Finishing business assets, including business activities related to the development, manufacture, and sale of products under the Binks, DeVilbiss, Ransburg and BGK brand names, no later than 180 days from the date the order becomes final. The FTC has not yet issued its final Decision and Order.

The Company has retained the services of an investment bank to help it market the Liquid Finishing business and identify potential buyers. While it seeks a buyer, Graco must continue to hold the Liquid Finishing business assets separate from its other businesses and maintain them as viable and competitive. In accordance with the Hold Separate Order, the Liquid Finishing business is managed independently by experienced Liquid Finishing business

managers, under the supervision of a trustee appointed by the FTC, who reports directly to the FTC.

As a result of the Hold Separate Order, we have determined that the Liquid Finishing businesses are variable interest entities for which the Company is not the primary beneficiary, and that they should not be consolidated. Under terms of the Hold Separate Order, the Company does not have a controlling interest in the Liquid Finishing business, nor is it able to exert significant influence over the Liquid Finishing business. Consequently, the Company's investment in the shares of the Liquid Finishing business has been reflected as a cost-method investment on our Consolidated Balance Sheet as of June 29, 2012, and its results of operations have not been consolidated with those of the Company. As a cost-method investment, income is recognized based on dividends received from current earnings of Liquid Finishing. Dividends of $4 million received in the second quarter ended June 29, 2012 are included in other expense (income) on the Consolidated Statements of Earnings for the quarter ended June 29, 2012. The Company will evaluate its cost-method investment for other-than-temporary impairment at each reporting period. As of June 29, 2012, the Company evaluated its investment in Liquid Finishing and determined that there is no impairment.

Consolidated Results

Net sales, net earnings and earnings per share were as follows (in millions
except per share amounts and percentages):



                                           Thirteen Weeks Ended                               Twenty-six Weeks Ended
                                June 29,            July 1,            %           June 29,            July 1,            %
                                  2012               2011            Change          2012               2011            Change

Net Sales                      $    268.2        $      234.7             14%     $    502.3        $      452.3             11%
Net Earnings                   $     34.4        $       38.1           (10)%     $     69.7        $       75.4            (7)%
Diluted Net Earnings per
Common Share                   $     0.56        $       0.61            (8)%     $     1.13        $       1.22            (7)%

The completion of the Finishing Brands acquisition and changes in currency translation rates had significant impacts on the quarter and year-to-date financial results.

Powder Finishing contributed $31 million of sales, accounting for most of the increase for the quarter. Year-to-date sales were up 11 percent from last year, with 7 percentage points of the growth from the addition of Powder Finishing. Costs and expenses related to the acquisition led to lower operating earnings compared to last year.

Changes in currency translation rates decreased sales by approximately $7 million for the quarter and $8 million year-to-date, and decreased net earnings by approximately $3 million for both the quarter and year-to-date.

The following table presents components of changes in sales:

                                                                                                           Quarter
                                                                            Segment                                             Region
                                                                                                                                                Asia
                                                        Industrial         Contractor        Lubrication        Americas        Europe         Pacific          Total
Volume and Price                                                1 %                4 %              15 %              7 %         (1) %           (2) %             3 %
Acquisitions                                                   24 %                - %               - %              5 %          30 %            18 %            14 %
Currency                                                      (3) %              (2) %             (2) %              - %        (10) %           (2) %           (3) %

Total                                                          22 %                2 %              13 %             12 %          19 %            14 %            14 %

                                                                                                         Year-to-Date
                                                                            Segment                                             Region
                                                                                                                                                Asia
                                                        Industrial         Contractor        Lubrication        Americas        Europe         Pacific          Total
Volume and Price                                                5 %                4 %              14 %              8 %           3 %             3 %             6 %
Acquisitions                                                   13 %                - %               - %              3 %          15 %             9 %             7 %
Currency                                                      (2) %              (2) %             (1) %            (1) %         (7) %             - %           (2) %

Total                                                          16 %                2 %              13 %             10 %          11 %            12 %            11 %

Sales by geographic area were as follows (in millions):

                    Thirteen Weeks Ended               Twenty-six Weeks Ended
                 June 29,           July 1,          June 29,           July 1,
                   2012               2011             2012               2011

Americas1      $     140.6        $     125.7      $     266.6        $     241.3
Europe2               69.4               58.0            124.1              111.3
Asia Pacific          58.2               51.0            111.6               99.7

Consolidated   $     268.2        $     234.7      $     502.3        $     452.3

1 North and South America, including the U.S.

2 Europe, Africa and Middle East

Sales included $31 million from the Powder Finishing operations acquired at the beginning of April, including $6 million in the Americas, $16 million in Europe and $9 million in Asia Pacific. Sales growth at consistent translation rates and before acquisitions was 7 percent for the quarter in the Americas and down slightly in Europe and Asia Pacific. On the same basis, sales growth was 8 percent year-to-date in the Americas and 3 percent in both Europe and Asia Pacific.

Gross profit margin, expressed as a percentage of sales, was 52 percent for the quarter and 54 percent year-to-date, down 4 percentage points from the second quarter last year and 3 percentage points lower than last year-to-date. Non-recurring purchase accounting effects totaling $7 million related to inventory reduced the margin rate by approximately 3 percentage points for the quarter and 1 1/2 points year-to-date. Unfavorable currency translation effects reduced the margin rate by approximately 1 percentage point for both the quarter and year-to-date.

Total operating expenses increased $13 million for the quarter and $20 million year-to-date. Powder Finishing operations accounted for $8 million of the quarter and year-to-date increases.

Acquisition expenses accounted for another $5 million of the increase for the quarter and $9 million of the year-to-date increase.

Interest expense increased $4 million for the quarter and $7 million year-to-date due to higher borrowing levels. Other expense (income) includes $4 million of dividends received from the Liquid Finishing business that is required to be held separate from the Company's other businesses and accounted for as a cost-method investment.

The effective income tax rates of 32 percent for the quarter and 33 percent for the year-to-date are consistent with the comparable periods last year. This year's rate is reduced by the effect of the investment income from the Liquid Finishing business held separate. Last year's rate was reduced by the effect of the federal R&D credit that is not available in 2012.

Segment Results

Certain measurements of segment operations compared to last year are summarized below:

Industrial



                                                       Thirteen Weeks Ended               Twenty-six Weeks Ended
                                                    June 29,           July 1,          June 29,           July 1,
                                                      2012               2011             2012               2011

Net sales (in millions)
Americas                                          $      65.6        $      55.9      $     125.0        $     108.8
Europe                                                   49.9               36.1             86.7               70.5
Asia Pacific                                             42.7               37.3             80.6               72.8

Total                                             $     158.2        $     129.3      $     292.3        $     252.1


Operating earnings as a percentage of net sales           27 %               35 %             31 %               36 %

Industrial segment sales increased 22 percent for the quarter and 16 percent year-to-date, mostly from the addition of Powder Finishing operations. Without Powder Finishing, sales for the quarter increased 6 percent in the Americas, decreased 6 percent in Europe (1 percent increase at consistent translation rates) and decreased 9 percent in Asia Pacific. On the same basis, year-to-date sales increased 9 percent in the Americas, were flat in Europe (6 percent increase at consistent translation rates) and decreased 1 percent in Asia Pacific. Purchase accounting effects related to inventory reduced the operating margin for the quarter by approximately 4 percentage points. Intangibles amortization charges and changes in currency translation also adversely affected operating earnings in the Industrial segment.

Contractor



                                                       Thirteen Weeks Ended               Twenty-six Weeks Ended
                                                    June 29,           July 1,          June 29,           July 1,
                                                      2012               2011             2012               2011

Net sales (in millions)
Americas                                          $      54.6        $      52.5      $     100.8        $      97.4
Europe                                                   17.2               19.6             33.2               36.3
Asia Pacific                                             10.3                8.6             20.1               17.2

Total                                             $      82.1        $      80.7      $     154.1        $     150.9


Operating earnings as a percentage of net sales           22 %               20 %             20 %               18 %

Contractor segment sales increased 2 percent for both the quarter and year-to-date, with gains for the quarter of 4 percent in the Americas and 21 percent in Asia Pacific. Contractor sales for the quarter were down 12 percent in Europe (5 percent at consistent translation rates) compared to the second quarter last year. Year-to-date sales increased 3 percent in the Americas, decreased 9 percent in Europe (3 percent at consistent translation rates) and increased 17 percent in Asia Pacific. Product display and store set costs incurred in 2011 were not repeated in 2012, leading to reduced selling, marketing and distribution expenses and improved operating earnings in this segment.

Lubrication



                                                       Thirteen Weeks Ended               Twenty-six Weeks Ended
                                                    June 29,           July 1,          June 29,           July 1,
                                                      2012               2011             2012               2011

Net sales (in millions)
Americas                                          $      20.5        $      17.2      $      40.8        $      35.0
Europe                                                    2.3                2.3              4.2                4.5
Asia Pacific                                              5.1                5.2             10.9                9.8

Total                                             $      27.9        $      24.7      $      55.9        $      49.3


Operating earnings as a percentage of net sales           20 %               16 %             21 %               19 %

Lubrication segment sales increased 13 percent for both the quarter and year-to-date, with 19 percent growth for the quarter in the Americas. Sales for the quarter were flat in Europe (6 percent increase at consistent translation rates) and in Asia Pacific. Year-to-date, sales increased 16 percent in the Americas, decreased 7 percent in Europe (3 percent at consistent translation rates) and increased 12 percent in Asia Pacific. Higher volume and leveraging of expenses led to improved operating earnings in the Lubrication segment.

Liquidity and Capital Resources

Net cash provided by operating activities was $65 million in 2012 and $44 million in 2011. Inventory levels stabilized in the first half of 2012 after increasing in 2011. Increases in receivables moderated compared to the first half of last year.

On March 27, 2012, the Company's $250 million credit agreement was terminated in connection with the execution of a new unsecured revolving credit agreement. The new credit agreement is with a syndicate of lenders and expires in March 2017. It provides up to $450 million of committed credit, available for general corporate purposes, working capital needs, share repurchases and acquisitions. The Company may borrow up to $50 million under the swingline portion of the facility for daily working capital needs.

Loans denominated in U.S. Dollars bear interest, at the Company's option, at either a base rate or a LIBOR-based rate. Loans denominated in currencies other than U.S. Dollars bear interest at a LIBOR-based rate. The base rate is an annual rate equal to a margin ranging from 0% to 1%, depending on the Company's cash flow leverage ratio (debt to earnings before interest, taxes, depreciation, amortization and extraordinary, non-operating or non-cash charges and expenses), plus the highest of (i) the bank's prime rate, (ii) the federal funds rate plus 0.5% or (iii) one-month LIBOR plus 1.5%. In general, LIBOR-based loans bear interest at LIBOR plus 1% to 2%, depending on the Company's cash flow leverage ratio. The Company is also required to pay a fee on the undrawn amount of the loan commitment at an annual rate ranging from 0.15 percent to 0.40 percent, depending on the Company's cash flow leverage ratio.

The agreement requires the Company to maintain certain financial ratios as to cash flow leverage and interest coverage. The Company is in compliance with all financial covenants of its debt agreements.

On April 2, 2012, the Company paid $660 million to complete the Finishing Brands acquisition, using available cash and $350 million of borrowings on the new credit agreement. In July 2012, the Company made an additional payment of $8 million, representing the difference between cash balances acquired and the amount estimated at the time of closing. Assets acquired in the acquisition included $18 million of cash, of which $6 million was available to Powder Finishing operations.

Under terms of the FTC's Hold Separate Order, the Company is required to provide sufficient resources to maintain the viability, competitiveness and marketability of the Liquid Finishing business, including general funds, capital, working capital and reimbursement of losses. To the extent that the Liquid Finishing business generates funds in excess of financial resources needed, the Company has access to such funds consistent with practices in place prior to the acquisition. In the second quarter, the Company received $4 million of dividends from current earnings of the Liquid Finishing business.

While the FTC has not yet issued a final Decision and Order requiring the Company to divest the Liquid Finishing business, the Company has retained the services of an investment bank to help it market the business and identify potential buyers. The Company believes its investment in the Liquid Finishing business, carried at a cost of $427 million, is not impaired.

At June 29, 2012, the Company had various lines of credit totaling $469 million, of which $137 million was unused. Internally generated funds and unused financing sources are expected to provide the Company with the flexibility to meet its liquidity needs in 2012, including the needs of the Powder Finishing and Liquid Finishing businesses acquired in April 2012.

Outlook

Management is optimistic that all business segments will show organic growth in the second half of 2012 on a constant currency basis, despite headwinds from Western Europe, China and India. The demand environment in the Americas is expected to remain favorable in all business segments in the second half. In Europe, continued unfavorable currency translation rates may drive year-over-year growth rates into negative territory. Growth in the developing economies of Asia Pacific, along with continued demand for Contractor and Lubrication products in the region, is expected to more than offset continued softness in industrial project activity in China. Management remains focused on executing core strategies to deliver long-term shareholder returns.

SAFE HARBOR CAUTIONARY STATEMENT

A forward-looking statement is any statement made in this report and other reports that the Company files periodically with the Securities and Exchange Commission, as well as in press or earnings releases, analyst briefings, conference calls and the Company's Overview report to shareholders, which reflects the Company's current thinking on market trends and the Company's future financial performance at the time they are made. All forecasts and projections are forward-looking statements. The Company undertakes no obligation to update these statements in light of new information or future events.

The Company desires to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 by making cautionary statements concerning any forward-looking statements made by or on behalf of the Company. The Company cannot give any assurance that the results forecasted in any forward-looking statement will actually be achieved. Future results could differ materially from those expressed, due to the impact of changes in various factors. These risk factors include, but are not limited to: economic conditions in the United States and other major world economies, currency fluctuations, political instability, changes in laws and regulations, and changes in product demand. In addition, risk factors related to the Company's acquisition of the ITW finishing businesses include: to what extent or when the required regulatory approvals will be obtained, whether and when the Company will be able to realize the expected financial results and accretive effect of the transaction, how customers, competitors, suppliers and employees will react to the transaction, economic changes in global markets, the extent of the acquired businesses required to be divested, whether the Company will be able to find a suitable purchaser(s) and structure the divestiture on acceptable terms, and whether the Company will be able to complete a divestiture in a time frame that is satisfactory to the Federal Trade Commission. Please refer to Item 1A of, and Exhibit 99 to, the Company's Annual Report on Form 10-K for fiscal year 2011 and Item 1A of this Quarterly Report on Form 10-Q for a more comprehensive discussion of these and other risk factors.

Investors should realize that factors other than those identified above and in Item 1A and Exhibit 99 might prove important to the Company's future results. It is not possible for management to identify each and every factor that may have an impact on the Company's operations in the future as new factors can develop from time to time.