Graco Inc. — Q2 2012 Form 10-Q
Business context and period. Unaudited results cover the 13 and 26 weeks ended June 29, 2012, compared with periods ended July 1, 2011. Graco designs, manufactures and markets fluid-handling equipment and reports Industrial, Contractor and Lubrication segments. The period includes the April 2 acquisition of ITW’s finishing businesses; Powder Finishing is consolidated, while Liquid Finishing is held separate and not consolidated.
Financial performance
| Metric | Q2 2012 | Q2 2011 | First half 2012 | First half 2011 |
|---|---|---|---|---|
| Net sales | $268.2 million | $234.7 million | $502.3 million | $452.3 million |
| Operating earnings | $52.5 million | $58.3 million | $110.4 million | $115.3 million |
| Net earnings | $34.4 million | $38.1 million | $69.7 million | $75.4 million |
| Diluted EPS | $0.56 | $0.61 | $1.13 | $1.22 |
| Gross margin | 52% | 56% | 54% | 57% |
| Operating cash flow | — | $64.7 million | $43.9 million |
- Sales rose 14% in Q2 and 11% year to date. Powder Finishing contributed $31 million in sales after acquisition, accounting for most of the quarterly increase; reported sales were also reduced by currency translation effects of approximately $7 million in Q2 and $8 million year to date.
- Despite higher sales, net earnings fell 10% in Q2 and 7% year to date. Acquisition-related costs, higher interest expense, purchase-accounting inventory charges, currency effects and increased operating expenses weighed on earnings.
- Gross margin declined 4 percentage points in Q2 and 3 points year to date. The $7 million purchase-accounting inventory effect reduced margin by approximately 3 points in Q2 and 1.5 points year to date; unfavorable currency reduced it by about 1 point in both periods.
- Q2 segment sales and operating earnings: Industrial $158.2 million and $43.2 million; Contractor $82.1 million and $18.0 million; Lubrication $27.9 million and $5.5 million. Industrial earnings declined from $45.3 million, while Contractor and Lubrication earnings increased.
- Interest expense was $5.4 million in Q2 and $9.0 million year to date, up from $1.7 million and $2.3 million, respectively, reflecting higher borrowing. The effective tax rate was 32% in Q2 and 33% year to date.
Cash, debt and liquidity
- Cash and equivalents were $23.1 million at June 29, down from $303.2 million at year-end. Operating activities provided $64.7 million; investing activities used $666.1 million, primarily for the acquisition and the $426.8 million investment in the held-separate businesses; financing activities provided $321.1 million.
- Long-term debt was $627.2 million and short-term bank notes were $6.3 million, versus $300.0 million and $8.7 million, respectively, at year-end. The company reported compliance with its debt covenants.
- A new unsecured revolving credit agreement, expiring March 2017, provides up to $450 million. At quarter-end, the company reported total credit lines of $469 million, of which $137 million was unused. Management expected internally generated funds and unused financing sources to meet 2012 liquidity needs.
- The board-declared cash dividend was $0.23 per share in Q2, compared with $0.21 a year earlier. First-half dividends declared were $0.45 per share.
Acquisition, material changes and risks
- Graco completed its purchase of ITW’s finishing businesses for $660 million at closing and paid an additional $8 million in July. Preliminary accounting allocated $241.6 million to net Powder Finishing assets and $426.8 million to the Liquid Finishing investment; total purchase consideration was $668.4 million. Purchase-price allocations remain preliminary.
- The FTC’s May proposed order requires Graco to sell the Liquid Finishing assets, including Binks, DeVilbiss, Ransburg and BGK-related operations, within 180 days after the order becomes final. The final order had not been issued as of the filing. Graco was marketing the business and must keep it separate and viable under FTC supervision.
- Liquid Finishing is accounted for as a cost-method investment and is not consolidated. Its Q2 sales were $66.6 million and operating earnings were $12.8 million; Graco recorded $4 million of dividend income. Graco reported no impairment at quarter-end. Maximum exposure includes the $426.8 million investment and potentially unquantifiable reimbursement of operating losses required under the hold-separate order.
- Acquisition-related expenses were $7 million in Q2 and $11 million year to date. Currency translation reduced net earnings by approximately $3 million in both the quarter and first half. Other comprehensive income included a $9.5 million cumulative translation loss in the first half.
Outlook and management commentary
Management expected all segments to achieve organic growth in the second half of 2012 on a constant-currency basis. It expected favorable demand in the Americas, while citing headwinds in Western Europe, China and India. Developing Asia-Pacific economies and demand for Contractor and Lubrication products were expected to offset continued softness in Chinese industrial project activity. The filing gives no specific numerical revenue or earnings guidance.
Risks highlighted include global economic conditions, currency fluctuations, political and regulatory changes, product demand, acquisition integration and realization of expected benefits, FTC divestiture requirements, finding an acceptable buyer and completing a sale on the FTC’s timetable. Management stated that interim results are not necessarily indicative of full-year results.
Important facts for investors to verify
- Whether and when the FTC issues its final order, the scope and timing of any required divestiture, and the proceeds and terms of a sale.
- The final purchase-price allocation and the carrying value and recoverability of the $426.8 million held-separate investment, including any additional funding obligations.
- Whether operating margins recover as acquisition-related costs, inventory purchase-accounting effects and integration expenses change.
- Liquidity and debt levels following the acquisition, including covenant headroom and the availability of unused credit facilities.
- How currency, regional demand and the differing performance of the three operating segments affect second-half results.