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

• Overview

• Acquisition

• Results of Operations

• Segment Results

• Financial Condition and Cash Flow

• Critical Accounting Estimates

• Outlook

Overview

Graco designs, manufactures and markets systems and equipment to pump, meter, mix and dispense a wide variety of fluids and coatings. The Company specializes in equipment for applications that involve difficult-to-handle materials with high viscosities, materials with abrasive or corrosive properties and multiple-component materials that require precise ratio control. Graco sells primarily through independent third-party distributors worldwide to industrial and contractor end-users. More than half of our sales are outside of the United States. Graco's business is classified by management into three reportable segments, each responsible for product development, manufacturing, marketing and sales of their products. The segments are headquartered in North America. They have responsibility for operations in the Americas and joint responsibility with Europe and Asia Pacific regional management for operations in those geographic areas.

Graco's key strategies include developing and marketing new products, leveraging products and technologies into additional, growing end-user markets, expanding distribution globally and completing strategic acquisitions that provide additional channel and technologies. Long-term financial growth targets accompany these strategies, including our expectation of 10 percent revenue growth and 12 percent consolidated net earnings growth.

Manufacturing is a key competency of the Company. Our management team in Minneapolis provides strategic manufacturing expertise, and is also responsible for factories not fully aligned with a single division. Our primary manufacturing facilities are in the United States and Switzerland, and our primary distribution facilities are located in the United States, Belgium, Switzerland, P.R.C., Japan, Korea and Australia.

Acquisition

On April 2, 2012, we completed the Finishing Brands acquisition, including Powder Finishing operations and Liquid Finishing operations. Results of the Powder Finishing business have been included in the Industrial segment since the date of acquisition. Pursuant to the hold separate order issued by the FTC, the Liquid Finishing business is being held separate from the rest of Graco's businesses until the FTC has issued its final order and the divestiture of the Liquid Finishing business is completed.

We have retained the services of an investment bank to help us market the Liquid Finishing businesses and identify potential buyers. While we seek a buyer, we must continue to hold the Liquid Finishing business assets separate from our other businesses and maintain them as viable and competitive. In accordance with the hold separate order, the Liquid Finishing businesses are managed independently by experienced Liquid Finishing business managers, under the supervision of a trustee appointed by the FTC, who reports directly to the FTC.

Under terms of the hold separate order, the Company does not have the power to direct the activities of the Liquid Finishing businesses that most significantly impact the economic performance of those businesses. Therefore, 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. Furthermore, the Company does not have a controlling interest in the Liquid Finishing businesses, nor is it able to exert significant influence over the Liquid Finishing businesses. Consequently, our investment in the shares of the Liquid Finishing businesses has been reflected as a cost-method investment on our Consolidated Balance Sheet as of December 28, 2012, and their 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 $12 million received in 2012 are included in other expense (income) on the Consolidated Statement of Earnings for the period ended December 28, 2012. We evaluate our cost-method investment for other-than-temporary impairment at each reporting period. As of December 28, 2012, we evaluated our investment in Liquid Finishing and determined that there was no impairment.

Results of Operations

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

                                           2012            2011            2010
Net Sales                               $    1,012      $      895      $      744
Operating Earnings                             225             220             153
Net Earnings                                   149             142             103
Diluted Net Earnings per Common Share   $     2.42      $     2.32      $     1.69

2012 Summary:

• Our net sales grew by 13 percent, including increases of 13 percent in the Americas, 22 percent in Europe and 5 percent in Asia Pacific. Sales in the Industrial segment grew by 20 percent sales in the Contractor segment grew by 3 percent and sales in the Lubrication segment increased by 7 percent.

• Foreign currency translation rates decreased sales by approximately $15 million and decreased earnings by approximately $5 million when compared to 2011 rates.

• Sales from acquired Powder Finishing operations totaled $93 million since April 2012, or 10 percentage points of our total growth in 2012 sales, and included $19 million in the Americas, $52 million in Europe and $22 million in Asia Pacific.

• Operating earnings were 22 percent of sales in 2012 as compared to 25 percent in 2011.

• Gross profit margin as a percentage of sales decreased 1 1/2 percentage points. Non-recurring purchase accounting effects related to acquired inventory totaled $7 million, reducing gross margin percentage for the year by approximately 1 percentage point. The effects of strong operational performance in legacy businesses offset the unfavorable effect of lower margin rates on acquired Powder Finishing operations.

• Investment in new product development was $49 million or 5 percent of sales in 2012.

• Total operating expenses were $45 million higher than 2011, including $25 million from Powder Finishing operations, an $8 million increase in acquisition and divestiture costs, $5 million from additional product development expenditures and an increase of $5 million in pension costs.

• The April purchase of Powder Finishing and Liquid Finishing operations had significant impacts on interest expense, an increase of $10 million for the year, and other expense (income), which included dividend income of $12 million received from the Liquid Finishing businesses held as a cost-method investment.

• The effective tax rate was 31 percent as compared to 32 percent in 2011. The rate in 2012 was reduced by the effect of income received as a dividend (post-tax) from the Liquid Finishing investment.

• Cash flows from operations grew to $190 million compared to $162 million in the prior year, with modest changes in working capital.

• We paid $668 million to complete the Finishing Brands acquisition, using available cash and $350 million of borrowings on a new credit agreement.

• Dividends paid totaled $54 million in 2012.

2011 Summary:

• Net sales grew by 20 percent, with double-digit growth in all regions and segments. Fiscal 2010 included an additional week as compared to fiscal 2011. By region, sales increased by 17 percent in the Americas, 19 percent in Europe and 32 percent in Asia Pacific. Sales in the Industrial segment grew by 23 percent; sales in the Contractor segment grew by 13 percent and sales in the Lubrication segment increased by 32 percent.

• Foreign currency translation rates increased sales by $17 million and increased net income by $7 million in 2011 as compared to 2010, with strength in Asian currencies and the euro during much of the year.

• Operating earnings were $220 million as compared to $153 million in 2010, and as a percentage of sales were 25 percent as compared to 21 percent in the prior year.

• Gross profit margin as a percentage of sales improved by 2 percentage points from 2010, due to higher production volumes, pricing and favorable translation rates, partially offset by higher material costs.

• Investment in new product development was $42 million or 5 percent of sales in 2011.

• Total operating expenses were $30 million higher than 2010. Half of the increase was in selling, marketing and distribution expenses, including strategic spending to generate and support growth, especially in Asia Pacific. General and administrative expenses for the year increased by $11 million, including $8 million of acquisition related costs.

• The effective tax rate was 32 percent as compared to 31 percent in 2010. The rate in the prior year reflected the benefit from changes in unrecognized tax benefits.

• Cash flows from operations grew to $162 million compared to $101 million. Working capital investments to support the increased business included an increase in inventories of $13 million and an increase in accounts receivable of $27 million.

• Dividends paid totaled $51 million in 2011 and share repurchases totaled $43 million.

The following table presents net sales by geographic region (in millions):

                  2012            2011            2010
Americas1      $      536      $      476      $      408
Europe2               257             211             178
Asia Pacific          219             208             158

Total          $     1,012     $      895      $      744

1 North and South America, including the United States. Sales in the United States were $441 million in 2012, $394 million in 2011 and $341 million in 2010.

2 Europe, Middle East and Africa

In 2012, sales in the Americas increased by 13 percent, with increases of 19 percent in the Industrial segment, 5 percent in the Contractor segment and 13 percent in the Lubrication segment as compared to the prior year. Growth related to the acquired Powder Finishing business was 4 percentage points. The increase in the Americas reflected strength across a range of product lines with growth in a number of industrial end-markets as well as growth in the housing and construction industries.

In 2012, sales in Europe increased by 22 percent or 28 percent in consistent translation rates, primarily due to the sales from Powder Finishing of $52 million since the acquisition. Sales of legacy Graco products in the Industrial segment decreased by 2 percent during 2012 (increased by 3 percent at consistent exchange rates). Sales decreased by 5 percent in the Contractor segment (flat at consistent exchange rates) and increased by 2 percent in the Lubrication segment (7 percent at consistent exchange rates). We continued to see growth during 2012 in the emerging markets of Eastern Europe and the Middle East, though end-markets in many industries remained weak in Western Europe.

In 2012, sales in Asia Pacific grew by 5 percent overall. Sales of Powder Finishing equipment were $22 million since the acquisition. Sales decreased by 7 percent in 2012 for legacy Graco products in the Industrial segment. Sales in the Contractor segment grew by 4 percent and sales in the Lubrication segment decreased by 10 percent. Activity levels in many end-markets remain challenging throughout the region and across product categories.

In 2011, sales in the Americas increased by 17 percent, with increases of 17 percent in the Industrial segment, 13 percent in the Contractor segment and 25 percent in the Lubrication segment as compared to the prior year. Although residential and commercial construction activity remained low, industrial end-markets continued to strengthen in 2011.

In 2011, sales in Europe increased by 19 percent or 14 percent at consistent translation rates, with increases of 23 percent in the Industrial segment, 9 percent in the Contractor segment and 38 percent in the Lubrication segment. We continued to invest during 2011 in commercial resources in the developing economies of Eastern Europe, Middle East and Africa, and despite the Eurozone sovereign debt crisis, industrial and lubrication end-markets continued to grow.

In 2011, sales growth in Asia Pacific was 32 percent or 27 percent at consistent translation rates, with an increase of 31 percent in the Industrial segment, 25 percent in the Contractor segment and 57 percent in the Lubrication segment. Additional commercial resources were added in each segment in Asia Pacific in 2011 with continued focus on adding new distribution.

The following table presents components of net sales change:

                                                                                               2012
                                                          Segment                                             Region
                                        Industrial       Contractor      Lubrication        Americas          Europe        Asia Pacific      Consolidated
Volume and Price                               3 %              4 %              8 %              9 %              2 %             (5) %               4 %
Acquisitions                                  19 %              - %              - %              4 %             26 %              10 %              10 %
Currency                                     (2) %            (1) %            (1) %              - %            (6) %               - %             (1) %

Total                                         20 %              3 %              7 %             13 %             22 %               5 %              13 %

                                                                                             2011
                                                        Segment                                             Region
                                      Industrial       Contractor      Lubrication        Americas          Europe        Asia Pacific      Consolidated
Volume and Price                            20 %             11 %             30 %             16 %             14 %              27 %              18 %
Currency                                     3 %              2 %              2 %              1 %              5 %               5 %               2 %

Total                                       23 %             13 %             32 %             17 %             19 %              32 %              20 %

The following table presents an overview of components of operating earnings as a percentage of net sales:

                                         2012            2011            2010
Net Sales                                100.0 %         100.0 %         100.0 %
Cost of products sold                    45.6            44.1            45.8

Gross profit                             54.4            55.9            54.2
Product development                       4.8             4.7             5.1
Selling, marketing and distribution      16.2            16.9            18.2
General and administrative               11.2             9.8            10.3

Operating earnings                       22.2            24.5            20.6
Interest expense                          1.9             1.0             0.5
Other expense (income), net              (1.1)            0.1             0.1

Earnings before income taxes             21.4            23.4            20.0
Income taxes                              6.7             7.5             6.2

Net Earnings                              14.7 %          15.9 %          13.8 %

2012 Compared to 2011

Operating earnings as a percentage of sales were 22 percent in 2012 as compared to 25 percent in 2011. The impact of purchase accounting related to the Powder Finishing acquisition, higher acquisition/divestiture costs and an increase in pension costs were partially offset by other operating improvements.

Gross profit margin as a percentage of sales was 54 percent in 2012 as compared to 56 percent in 2011. Non-recurring purchase accounting effects totaling $7 million related to acquired inventory with the Powder Finishing operations reduced the gross margin percentage by approximately 1 percentage point. Strong operating performance and cost management improved margins on the legacy Graco operations, partially offsetting the lower margin rates on acquired Powder Finishing operations.

Operating expenses for the year increased $45 million, including $25 million from Powder Finishing operations, an increase of $8 million for acquisition and divestiture costs, an increase of $5 million in product development spending and an increase of $5 million in pension expense. Overall, product development spending was 5 percent of sales in 2012, consistent with 2011.

The purchase of Powder Finishing and Liquid Finishing operations had significant impacts on interest expense (an increase of $10 million for the year) and other expense (income), which included dividend income of $12 million received from the Liquid Finishing businesses held as a cost-method investment.

The effective income tax rate was 31 percent for the year as compared to 32 percent in 2011. The 2012 effective tax rate was reduced by the effect of the investment income from the Liquid Finishing businesses held separate and the effect of a tax rate change on deferred liabilities related to a tax holiday received in a foreign jurisdiction.

2011 Compared to 2010

Operating earnings as a percentage of sales were 25 percent in 2011, up from 21 percent in 2010, with improvements in gross margins and expense leverage as compared to the prior year.

Gross profit margin as a percentage of sales was 56 percent in 2011 as compared to 54 percent in 2010, reflecting higher production volumes and translation rates. Higher material costs were offset by manufacturing efficiencies and pricing.

Total operating expense increased $30 million as compared to 2010, a reduction of 2 percentage points as a percentage of sales from the prior year. The higher costs include $8 million of transaction costs related to the Finishing Brands acquisition, $4 million from currency translation and increased selling and marketing costs, primarily related to promotional activities and additional headcount, primarily in Asia Pacific. Product development was $42 million or 5 percent of sales in 2011. Selling, marketing and distribution costs were $151 million in 2011 as compared to $136 million in 2010. General and administrative costs were $88 million as compared to $77 million in the prior year.

Interest expense was $9 million in 2011 as compared to $4 million in 2010. The amount of debt more than doubled in 2011, as $300 million of proceeds from a private placement of notes were used to repay revolving line of credit borrowings and invested in cash and cash equivalents.

The Company's effective tax rate was 32 percent in 2011, higher than the effective tax rate of 31percent in 2010. The rate is lower than the U.S. federal statutory rate of 35 percent due primarily to U.S. business credits and the domestic production deduction. Overall, the effect of the business credits and domestic production deductions in 2011 was lower in 2011 as a percentage of pre-tax earnings as compared to the prior year.

Segment Results

The following table presents net sales and operating earnings by business
segment (in millions):




                            2012             2011             2010
Sales
Industrial              $       603      $       502      $       409
Contractor                      299              291              257
Lubrication                     110              102               78

Total                   $     1,012      $       895      $       744


Operating Earnings
Industrial              $       186      $       174      $       126
Contractor                       54               51               37
Lubrication                      23               19                9
Unallocated corporate          (38)             (24)             (19)

Total                   $       225      $       220      $       153

Management looks at economic and financial indicators relevant to each segment and geography to gauge the business environment, as noted in the discussion below for each segment.

Industrial

The following table presents net sales, components of net sales change and
operating earnings as a percentage of sales for the Industrial segment (dollars
in millions):




                                                 2012            2011            2010
Sales
Americas                                      $      261      $      220      $      187
Europe                                               184             135             109
Asia Pacific                                         158             147             113

Total                                         $      603      $      502      $      409


Components of Net Sales Change
Volume and Price                                     3 %            20 %            30 %
Acquisitions                                        19 %             - %             - %
Currency                                           (2) %             3 %             1 %

Total                                               20 %            23 %            31 %


Operating Earnings as a Percentage of Sales         31 %            35 %            31 %

In 2012, sales in the Industrial segment totaled $603 million, an increase of 20 percent from the prior year, including $93 million from Powder Finishing operations acquired in April 2012. Without Powder Finishing, sales increased by 10 percent in the Americas, decreased 2 percent in Europe (3 percent increase at consistent translation rates) and decreased 7 percent in Asia Pacific.

Operating earnings as a percentage of sales was 31 percent in 2012 as compared to 35 percent in 2011. Powder Finishing operations contributed to segment earnings, but at a lower rate on sales, which drove the decrease in the operating margin for the Industrial segment.

In 2011, sales in the Industrial segment increased 23 percent, with increases in all regions. By geography, sales increased by 17 percent in the Americas, 23 percent in Europe (19 percent at consistent translation rates) and 31 percent in Asia Pacific (27 percent at consistent translation rates).

In 2011, operating earnings were $174 million or 35 percent of sales as compared to $126 million or 31 percent of sales in 2010, with the improvement mainly due to improved expense leverage.

In this segment, sales in each geographic region are significant and management looks at economic and financial indicators in each region, including gross domestic product, industrial production, capital investment rates, automobile production, building construction and the level of the U.S. dollar versus the euro, the Canadian dollar, the Australian dollar and various Asian currencies.

Contractor

The following table presents net sales, components of net sales change and
operating earnings as a percentage of sales for the Contractor segment (dollars
in millions):




                                                 2012            2011            2010
Sales
Americas                                      $      194      $      184      $      163
Europe                                                64              68              63
Asia Pacific                                          41              39              31

Total                                         $      299      $      291      $      257


Components of Net Sales Change
Volume and Price                                     4 %            11 %            23 %
Currency                                           (1) %             2 %             - %

Total                                                3 %            13 %            23 %


Operating Earnings as a Percentage of Sales         18 %            17 %            14 %

In 2012, sales in the Contractor segment increased 3 percent. By geography, sales increased by 5 percent in the Americas, decreased 5 percent in Europe (flat at consistent exchange rates) and increased 4 percent in Asia Pacific.

Higher sales and the leveraging of expenses led to improvement in operating earnings as a percentage of sales.

In 2011, sales in the Contractor segment increased 13 percent, with increases in all regions. By geography, sales increased by 13 percent in the Americas, 9 percent in Europe (4 percent at consistent translation rates) and 25 percent in Asia Pacific (18 percent at consistent translation rates).

In 2011, operating earnings were $51 million as compared to $37 million in 2010, an improvement of 3 points as a percentage of sales from the prior year, primarily resulting from improved volume and expense leverage.

In this segment, sales in all regions are significant and management reviews economic and financial indicators in each region, including levels of residential, commercial and institutional construction, remodeling rates and interest rates. Management also reviews gross domestic product for the regions and the level of the U.S. dollar versus the euro and other currencies.

Lubrication

The following table presents net sales, components of net sales change and
operating earnings as a percentage of sales for the Lubrication segment (dollars
in millions):




                                                 2012            2011            2010
Sales
Americas                                      $       81      $       72      $       58
Europe                                                 9               8               6
Asia Pacific                                          20              22              14

Total                                         $      110      $      102      $       78


Components of Net Sales Change
. . .