Graco Inc. — Q3 2012 Form 10-Q
Business context and period. Unaudited results cover the 13 weeks ended September 28, 2012, and the 39 weeks ended that date; comparisons are with the corresponding 2011 periods. Graco designs, manufactures and markets fluid and coating-material handling equipment. It reports Industrial, Contractor and Lubrication segments. The April 2 acquisition of ITW’s finishing businesses materially affects comparisons: Powder Finishing is consolidated in Industrial, while Liquid Finishing is held separate and accounted for as an investment.
Key financial metrics
| Metric | Q3 2012 | Q3 2011 | 39 weeks 2012 | 39 weeks 2011 |
|---|---|---|---|---|
| Net sales | $256.5m | $227.3m | $758.8m | $679.7m |
| Gross profit | $139.9m | $126.3m | $411.6m | $383.2m |
| Operating earnings | $56.3m | $56.8m | $166.8m | $172.1m |
| Net earnings | $37.1m | $36.6m | $106.9m | $111.9m |
| Diluted EPS | $0.60 | $0.60 | $1.73 | $1.82 |
| Gross margin | 54.6% | 55.6% | 54.3% | 56.4% |
| Operating margin | 22.0% | 25.0% | 22.0% | 25.3% |
| Net margin | 14.5% | 16.1% | 14.1% | 16.5% |
Q3 sales rose 13%, while net earnings increased 2%; year-to-date sales rose 12%, but net earnings fell 5%. Q3 sales growth included $30m from Powder Finishing; management attributed all of the reported increase to that addition. Excluding acquisitions and currency, Q3 volume and price increased 1%; year-to-date it increased 4%. Currency translation reduced sales by about $6m in Q3 and $14m year-to-date, and reduced net earnings by about $2m and $5m, respectively.
Q3 gross margin was down about 1 percentage point and year-to-date margin down about 2 points. Price increases were more than offset by currency, higher material costs and lower margins on acquired Powder Finishing operations. A $7m inventory purchase-accounting charge reduced year-to-date gross margin by about 1 point. Operating expenses increased, including acquisition-related expenses of $4m in Q3 and $15m year-to-date. Higher borrowing levels increased interest expense by $2m in Q3 and $9m year-to-date. Effective tax rates were 32% for Q3 and 33% year-to-date.
Segments and cash flow
- Industrial: sales increased 24% in Q3 and 19% year-to-date, mainly from Powder Finishing. Operating margin was 30% in Q3 versus 34% a year earlier; acquired operations had lower margins.
- Contractor: sales declined 4% in Q3 and were essentially flat year-to-date. Q3 operating margin fell to 17% from 21%, reflecting lower volume, product mix and higher marketing and general spending.
- Lubrication: sales grew 7% in Q3 and 11% year-to-date. Q3 operating margin improved to 20% from 17%, with higher volume and expense leverage.
- Cash flow, 39 weeks: operating cash flow was $132.0m, versus $108.8m. Investing used $682.8m, principally reflecting acquisition and the $426.8m investment in Liquid Finishing. Financing provided $275.6m. Cash declined to $27.3m from $303.2m at year-end 2011.
Debt, liquidity and acquisition
At September 28, cash was $27.3m, current assets $776.0m and current liabilities $143.8m. Long-term debt was $589.6m, compared with $300.0m at year-end; short-term bank notes were $7.6m. The company reported $469m in credit lines, of which $174m was unused. Its new unsecured revolving facility provides up to $450m of committed credit and expires in March 2017. Graco said it was in compliance with debt covenants and expected internal funds and unused financing to meet 2012 liquidity needs.
The ITW finishing acquisition had total purchase consideration of $668.4m, including $241.6m allocated to Powder Finishing and a $426.8m cost-method investment in Liquid Finishing. Powder Finishing contributed $62m of sales and $4.1m of operating earnings year-to-date. Liquid Finishing is not consolidated; Graco recorded $4m of dividends in Q3 and $8m year-to-date. The company reported no impairment of the investment at quarter-end.
Outlook, risks and unusual items
Management expected macroeconomic crosscurrents to continue into Q4: favorable conditions in the Americas, with challenges in China, India and Western Europe. It cited U.S. housing recovery as a potential benefit to Contractor equipment and planned continued product development, distribution expansion and entry into adjacent markets. No quantified earnings or sales guidance was provided.
The FTC had issued a proposed order requiring Graco to divest Liquid Finishing within 180 days after the order becomes final; the final order had not been issued by the filing date. Graco was marketing the business and was required to maintain it as viable and separate, including funding necessary resources and reimbursing losses. The company’s stated maximum exposure included its $426.8m investment and unquantified operating-loss reimbursements. Risks also include economic conditions, currency, demand, regulatory timing, divestiture terms and the ability to realize acquisition benefits or meet financing covenants. The filing states that market-risk disclosures had no material change from the 2011 Form 10-K.
Most important facts for investors to verify
- FTC final order, required divestiture scope and timing, sale proceeds, and any additional funding or impairment of the Liquid Finishing investment.
- Post-acquisition debt, interest costs, liquidity and covenant headroom; cash was substantially lower and debt higher than at year-end.
- Underlying sales and margin trends apart from Powder Finishing, particularly Contractor demand and conditions in Asia Pacific.
- Extent to which material costs, acquired-business margins and acquisition-related expenses continue to pressure profitability.
- Whether management’s Q4 regional outlook and expected liquidity flexibility are borne out; interim results are not necessarily indicative of full-year results.