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GGG > SEC Filings for GGG > Form 10-Q on 24-Oct-2012All Recent SEC Filings

Show all filings for GRACO INC

Form 10-Q for GRACO INC


24-Oct-2012

Quarterly Report


MANAGEMENT'S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

The Company designs, manufactures and markets systems and equipment to move, measure, control, dispense and spray fluid and coating 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") 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 September 28, 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 third quarter and $8 million received year-to-date are included in other expense (income) on the Consolidated Statements of Earnings for the periods ended September 28, 2012. The Company will evaluate its cost-method investment for other-than-temporary impairment at each reporting period. As of September 28, 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                     Thirty-nine Weeks Ended
                                Sep 28,        Sep 30,          %          Sep 28,        Sep 30,          %
                                  2012           2011         Change         2012           2011        Change

Net Sales                      $   256.5      $   227.3           13%     $   758.8      $   679.7          12%
Net Earnings                   $    37.1      $    36.6            2%     $   106.9      $   111.9         (5)%
Diluted Net Earnings per
Common Share                   $    0.60      $    0.60            0%     $    1.73      $    1.82         (5)%

The addition of Powder Finishing was the main factor in sales increases over last year. For the quarter, Powder Finishing contributed $30 million of sales, accounting for all of the increase. Year-to-date sales increased 12 percent from last year, with 9 percentage points of the growth from the addition of Powder Finishing.

Changes in currency translation rates decreased sales by approximately $6 million for the quarter and $14 million year-to-date, and decreased net earnings by approximately $2 million for both the quarter and $5 million 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                     2 %           (2) %               8 %            5 %            4 %         (10) %            1 %
Acquisitions                        25 %             - %               - %            6 %           34 %           14 %           14 %
Currency                           (3) %           (2) %             (1) %            - %         (10) %            - %          (2) %

Total                               24 %           (4) %               7 %           11 %           28 %            4 %           13 %


                                                                            Year-to-Date
                                                 Segment                                         Region
                                                                                                                 Asia
                              Industrial      Contractor       Lubrication       Americas        Europe        Pacific         Total
Volume and Price                     4 %             2 %              12 %            7 %            3 %          (1) %            4 %
Acquisitions                        17 %             - %               - %            4 %           21 %           10 %            9 %
Currency                           (2) %           (2) %             (1) %            - %          (7) %            - %          (1) %

Total                               19 %             - %              11 %           11 %           17 %            9 %           12 %

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

                   Thirteen Weeks Ended             Thirty-nine Weeks Ended
                 Sep 28,          Sep 30,          Sep 28,          Sep 30,
                   2012             2011             2012             2011

Americas1      $     135.8      $     122.8      $     402.4      $     364.1
Europe2               65.2             51.1            189.3            162.4
Asia Pacific          55.5             53.4            167.1            153.2

Consolidated   $     256.5      $     227.3      $     758.8      $     679.7

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

2 Europe, Africa and Middle East

Sales for the quarter included $30 million from Powder Finishing operations acquired at the beginning of April, including $7 million in the Americas, $16 million in Europe and $7 million in Asia Pacific. Year-to-date sales included $62 million from Powder Finishing, including $13 million in the Americas, $32 million in Europe and $17 million in Asia Pacific. For the quarter, sales at consistent translation rates and before acquisitions were up 5 percent in the Americas, up 4 percent in Europe and down 10 percent in Asia Pacific. On the same basis, year-to-date sales were up 7 percent in the Americas, up 3 percent in Europe and down 1 percent in Asia Pacific.

Gross profit margin, expressed as a percentage of sales, was 55 percent for the quarter and 54 percent year-to-date, down 1 percentage point from the third quarter last year and 2 percentage points lower than last year-to-date. For the quarter and year-to-date, the favorable effects of realized price increases were more than offset by the unfavorable effects of currency translation, higher material costs and lower margin rates on acquired Powder Finishing operations. Non-recurring purchase accounting effects totaling $7 million related to inventory reduced year-to-date gross margin percentage by approximately 1 percentage point.


Total operating expenses for the quarter increased $14 million, including $8 million from Powder Finishing operations. Increases in product development and general and administrative costs were partially offset by changes in currency translation rates. Year-to-date operating expenses increased $34 million, including $16 million from Powder Finishing and a $9 million increase in acquisition and divestiture expenses.

Interest expense increased $2 million for the quarter and $9 million year-to-date due to higher borrowing levels. Other expense (income) includes dividends of $4 million for the quarter and $8 million year-to-date, received from the Liquid Finishing businesses that are 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 businesses 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              Thirty-nine Weeks Ended
                                          Sep 28,           Sep 30,           Sep 28,           Sep 30,
                                            2012              2011              2012              2011

Net sales (in millions)
Americas                                $      67.0       $      53.8       $     192.0       $     162.6
Europe                                         47.0              33.1             133.7             103.6
Asia Pacific                                   40.7              37.6             121.3             110.4

Total                                   $     154.7       $     124.5       $     447.0       $     376.6

Operating earnings as a percentage
of net sales                                    30 %              34 %              31 %              35 %

Industrial segment sales increased 24 percent for the quarter and 19 percent year-to-date, mostly from the addition of Powder Finishing operations. Without the increase from Powder Finishing operations, sales for the quarter increased 12 percent in the Americas, decreased 7 percent in Europe (1 percent increase at consistent translation rates) and decreased 12 percent in Asia Pacific. On the same basis, year-to-date sales increased 10 percent in the Americas, decreased 2 percent in Europe (4 percent increase at consistent translation rates) and decreased 5 percent in Asia Pacific. Powder Finishing operations contributed to segment operating earnings in the third quarter, but at a lower rate on sales, which drove the decrease in the operating margin rate for this segment.

--------------------------------------------------------------------------------
Contractor
                                          Thirteen Weeks Ended             Thirty-nine Weeks Ended
                                        Sep 28,          Sep 30,          Sep 28,           Sep 30,
                                         2012             2011              2012              2011
Net sales (in millions)
Americas                              $     48.7       $     51.2       $     149.5       $     148.6
Europe                                      16.1             16.0              49.2              52.3
Asia Pacific                                10.1             10.6              30.2              27.8

Total                                 $     74.9       $     77.8       $     228.9       $     228.7


Operating earnings as a percentage
of net sales                                 17 %             21 %              19 %              19 %

Contractor segment sales decreased 4 percent for the quarter and were flat year-to-date. Sales for the quarter decreased 5 percent in both the Americas and in Asia Pacific and increased 1 percent in Europe (9 percent at consistent translation rates). Year-to-date sales increased 1 percent in the Americas, decreased 6 percent in Europe (increased 1 percent at consistent translation rates) and increased 8 percent in Asia Pacific. Lower sales volume, product mix and higher marketing and general spending led to lower third quarter operating earnings in the Contractor segment. Year-to-date operating earnings as a percentage of sales are consistent with last year.

Lubrication
                                           Thirteen Weeks Ended             Thirty-nine Weeks Ended
                                         Sep 28,          Sep 30,          Sep 28,           Sep 30,
                                          2012             2011              2012             2011
Net sales (in millions)
Americas                               $     20.0       $     17.8       $      60.8       $     52.8
Europe                                        2.2              2.1               6.4              6.6
Asia Pacific                                  4.7              5.2              15.6             15.0

Total                                  $     26.9       $     25.1       $      82.8       $     74.4


Operating earnings as a percentage
of net sales                                  20 %             17 %              21 %             18 %

Lubrication segment sales increased 7 percent for the quarter and 11 percent year-to-date. Sales for the quarter increased 13 percent in the Americas, 8 percent in Europe (15 percent at consistent translation rates) and decreased 11 percent in Asia Pacific. Year-to-date sales increased 15 percent in the Americas, decreased 2 percent in Europe (3 percent increase at consistent translation rates) and increased 4 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 $132 million in 2012 and $109 million in 2011. Changes in receivable and inventory levels moderated in the first nine months of 2012 after increasing in 2011.

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 and third quarters, the Company received a total of $8 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 September 28, 2012, the Company had various lines of credit totaling $469 million, of which $174 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

We are expecting macroeconomic crosscurrents to continue into the fourth quarter, with favorable conditions in the Americas and challenges in China, India and Western Europe. The investments we have made during the past few years to broaden our geographic coverage and diversify our product portfolio give us opportunities to outperform our end markets, while the nascent housing recovery in the U.S. should be a positive for our Contractor equipment business. We will forge ahead with new product development, expansion of our distribution channel, conversion of end users from manual painting to using equipment, and continue our efforts to expand into adjacent new markets.

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 finishing businesses from ITW and proposed divestiture of the Liquid Finishing equipment operations 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.


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