GRACO INC quarterly report, Q1 FY2012

Business context and reporting period

Graco Inc. designs, manufactures and markets equipment and systems for moving, measuring, controlling, dispensing and spraying fluid materials. This unaudited Form 10-Q covers the 13 weeks ended March 30, 2012; comparisons are with the 13 weeks ended April 1, 2011 unless stated otherwise. The company reports Industrial, Contractor and Lubrication segments.

Financial results and position

Gross margin was 56%, slightly below the prior-year quarter, as higher material costs partly offset price increases and efficiency improvements. Cash and cash equivalents were $326.8 million at March 30, 2012. Total assets were $925.7 million and shareholders’ equity was $371.0 million. Debt included $300.0 million of long-term notes and $10.5 million of short-term bank notes. The company reported $470 million of credit lines, of which $462 million was unused at quarter-end, and compliance with its debt covenants.

Changes versus the prior period

Sales increased 8%, while net earnings and diluted EPS each declined 5%. Management attributed the earnings decline to higher expenses—particularly product development, acquisition-related costs and interest—which outweighed higher sales and strong gross margins. Interest expense rose to $3.7 million from $0.6 million. Operating expenses increased about $7 million; unallocated corporate expense included $4 million of acquisition-related expense, and product development expense increased $2 million.

All three segments grew sales: Industrial $134.1 million (up 9%), Contractor $72.0 million (up 3%) and Lubrication $28.0 million (up 14%). Geographic sales grew 9% in the Americas, 3% in Europe (6% at consistent exchange rates) and 10% in Asia Pacific (8% at consistent exchange rates). Contractor and Lubrication operating margins improved; Industrial’s operating earnings as a percentage of sales was 36%, versus 37% a year earlier.

Operating cash flow increased to $23.5 million from $14.2 million. Receivables rose $21 million and inventory rose $5 million from year-end, reflecting higher sales and demand; management said increases in both were more moderate than in the prior-year quarter.

Outlook, risks and unusual items

Management remained optimistic about growth in all geographies and segments for full-year 2012, without providing a numerical forecast. It described demand in the Americas as favorable, cited challenging Western European economies and selected construction markets, and noted some weakening in Asia Pacific industrial project activity. Management expected second-half product launches to help counter softness and said it would monitor worldwide orders closely.

On April 2, 2012, after quarter-end, Graco completed its $650 million cash acquisition of ITW’s finishing businesses. The acquired businesses had 2011 sales of $375 million. Funding included available cash and $350 million borrowed under a new $450 million revolving credit agreement expiring in March 2017. The FTC ordered the industrial liquid finishing businesses—about two-thirds of the acquired business—to be held separate from Graco and Gema while it reviews the transaction. Those operations are to be run independently under trustee supervision; Graco will not control or consolidate them during the hold-separate period. The FTC’s final decision will determine required divestitures, which Graco must complete within 180 days after that decision. Risks include the scope and timing of divestitures, finding acceptable buyers, integration and realizing anticipated benefits.

Other notable factors include the expiration of the federal R&D tax credit, which contributed to a higher effective tax rate, and higher pension benefit costs. The filing says market-risk disclosures had no material change and reports effective disclosure controls with no material change in internal control over financial reporting during the quarter.

Important facts for investors to verify

• Progress and final FTC requirements for the held-separate liquid finishing businesses, including the extent, timing and terms of any divestiture.
• Post-acquisition debt, interest expense, liquidity and covenant headroom following the $350 million borrowing and $650 million purchase.
• Whether management’s expected full-year growth is supported by order trends, given regional demand risks and the absence of quantified guidance.
• Drivers of the earnings decline despite sales growth, including acquisition costs, product development spending, material costs, interest and the expired R&D credit.
• Working-capital trends and operating cash generation as receivables and inventories rise.