Jul 23, 2009
Executives
Caroline M. Chambers - Vice President and Controller Patrick J.
McHale - President and Chief Executive Officer James A. Graner - Chief Financial Officer and Treasurer
Analysts
Kevin Maczka - BB&T Capital Markets Christopher Glynn – Oppenheimer and Company Tom Britman - BMO Capital Markets Mike Schneider – Robert W. Baird John Franzreb – Sidoti & Company
Operator
Good morning and welcome to the First Quarter 2009 conference call for Graco, Inc. If you wish to access the replay for this call, you may do so by dialing 1-800-405-2236 within the United States or Canada.
The dial-in number for international callers is 303-590-3030. The conference ID is 4114013.
The replay will be available through July 27, 2009. Graco has additional information available in a PowerPoint slide presentation, which is available as part of the webcast player.
At the request of the company, we will open up the conference for questions and answers after the opening remarks from management. During this call, various remarks may be made by management about their expectations, plans, and prospects for the future.
These remarks constitute forward-looking statements for the purposes of the Safe Harbor provision of the Private Securities Litigation Reform Act. Actual results may differ materially from those indicated as a result of various risk factors, including those identified in Item 1A of Exhibit 99-2 of the company's 2008 annual report on Form 10-K.
This report is available on the company's website at www.graco.com and the SEC's website at www.sec.gov. Forward-looking statements reflect management's current views and speak only of the time they are made.
The company undertakes no obligation to update these statements in light of new information or future events. I would now turn the conference over to Caroline Chambers, Vice President and Controller.
Please go ahead.
Caroline M. Chambers
Good morning and welcome to everyone. I am here this morning with Pat McHale, Graco's President and CEO, and Jim Graner, our CFO.
I will briefly review our second quarter results, and Pat will follow with additional comments. Following these opening comments, we'll open up the call for your questions.
Weak economic conditions worldwide continued to affect our operating results this quarter, with a decrease in sales and orders in all segments and regions. Sales for the quarter declined by 38% or 36% at consistent exchange rates.
By region, sales decreased by 33% in Americas, 52% in Europe or 46% at a consistent exchange rate, and 29% in Asia-Pacific. Gross profit margin as a percent of sales was 49% this quarter, down from 54% last year due to lower production volume which was approximately 4 percentage points, unfavorable currency translation rates, approximately 1.5 percentage points, and increased pension cost, approximately 1 percentage point.
The impact of these items was somewhat offset by pricing and favorable material costs. Total operating expenses were lower than last year, down 12% in the second quarter as compared to last year.
Effect of currency translation decreased operating expenses by approximately $2 million. Lower incentive and bonus provisions and other spending reductions also decreased.
These reductions were somewhat offset by bonus spending and increased pension expense. Effective tax rate for the second quarter was 32%.
The rate in the second quarter of 2008 was 35%. At this time of last year, the R&D tax credit had not renewed, and no credit was included in the second quarter of last year.
On the liquidity side, we continue to have strong cash flows, with positive cash flows from operations of $69 million year to date. We continue to focus on managing our working capital and has seen a decline in accounts receivable of $15 million and a decline in inventories of $23 million so far this year.
We’ve also received our long-term debt by $36 million to date. I'll now turn it over to Pat for additional comments on the quarter.
Patrick J. McHale
Business conditions in the second quarter improved slightly compared to Q1, and while disappointing, we’re generally in line with our expectations. Expense reductions that we implemented in March contributed to our improved profitability versus Q1, and although we did do some trimming around the edges during the second quarter, we had no major layoffs.
Our direct labor workforce is the right size for our current production levels, and we’re maintaining our investment in product development, new markets, and international expansion. I’ll talk for a minute about our order rate.
We saw about a 10% improvement in our weekly incoming order rate in the second quarter as compared to the first quarter. However, this improvement wasn’t a consistent through the quarter.
April and May were actually stronger from an incoming order rate perspective, while June and July so far have been more in line with our Q1 incoming order rate. As Caroline mentioned, cash flow for the quarter was good at $41 million.
We do continue to focus on working capital management, and we saw nice reductions in both inventory and receivables. From a market standpoint, during the quarter we saw weakness in all markets and geographies.
Our end customers of course continue to experience low production levels and low equipment utilization rates. Western Europe, Eastern Europe, and the Middle East all weakened from Q1.
Eastern Europe was significantly than Western Europe. I do believe we may be approaching a bottom for Europe in Q3, but I expect the conditions in Europe are going to remain challenged at least into early next year.
Our business in Asia was down across all regions, with automotive-related businesses particularly difficult especially in Japan and Korea. Export manufacturing customers throughout the region also being cautious of capital projects, although we are seeing activity with infrastructure spending, especially in China.
Overall, our contractor business in Asia declined the least, while our lubrication business experienced the most significant decline. The large decline in lube was primarily related to a large mining order that we shipped in the second quarter of 2008 that did not repeat this year.
We are seeing some signs of increased activity in Asia, and we’re actually more optimistic about the second half of the year. We maintained our resource level internationally, and we continue to set up specialized distribution, and we worked to strengthen our channel.
In the Americas contractor segment, the home center channel was down slightly for the quarter. Our expanded store count versus last year allowed us to offset the channel load we had in last year’s second quarter.
You will recall that inventory load was related to the rollout of a new sprayer aligned to an existing channel partner. Although the North American pain channel is down double digits versus Q2 2008, year over year comparisons were slightly better than Q1, and I believe it’s likely that we’re approaching the bottom of the US housing market.
Operating earnings for the worldwide contractor segment, although still depressed, rebounded in the second quarter to 20% versus 3% in Q1. In the Americas lubrication segment, we expect the revenue situation will remain difficult for sometime, impacted significantly by conditions in the car dealership market.
Our focus in lube continues to be on implementing the planned product cost reductions on acquired products, so that when volume improves the division returns to operating margins in the 20s. As we’ve discussed, these cost reductions are behind our original schedule; however, we are making progress, and we’re confident that we’ll achieve the targets.
Our spending in product development was in line with Q1, and we anticipate similar levels of spending on a go-forward basis. As communicated previously, we’ll begin to see the first new product launched as a result of the incremental investment during the second half of this year, and we’ll achieve the full rate in 2010.
Our purchasing team is doing well on cost reductions, approximately $1.3 for the quarter, and we do anticipate favorable comparisons on materials for the year. Near-term, we expect the business to remain challenged, but we remain confident in the strength of our business model.
We’ve already made significant expense reductions, cutting approximately 20% of our headcount from 2008 peak levels. We’ve been very selective in our cuts, and have maintained our investments in growth initiatives.
Apart from volume, our gross margins are strong. Our incremental operating margins are high, and we expect earnings will improve quickly with improved volumes.
With that, I will go ahead and turn it back to the operator, and we’ll open it up for questions.
Operator
The question and answer session will begin at this time. (Operator Instructions).
Our first question comes from the line of Kevin Maczka with BB&T Capital Markets. Please go ahead.
Kevin Maczka - BB&T Capital Markets
Regarding seasonality, I think in a normal year, Q1 is usually the lowest revenue and earnings quarter, Q2 is the best, and Q3 and Q4 are somewhere in between. Based on what you’ve said about your order patterns, are you seeing anything that would suggest that we’re back to a more normal seasonality, or do you still think this is going to be something that we will sequentially try to climb out of from the depressed level?
Patrick J. McHale
The optimistic side of me says the latter. I am not sure.
Our seasonality has been a little bit mixed up since the contractor business started declining at the end of 2006, so the quarter comparisons are not holding exactly as they were back in that early 2000 spectrum, but I’m cautiously optimistic that part of what we’re going to see is a climb out.
Kevin Maczka - BB&T Capital Markets
Is there anything kind of drilling down there by segment; usually I think contractors is something that might recover earlier when the cycle turns, but would you think that would still be the case this time or does industrial look to be a little bit more early cycle in terms of a recovery this time?
James A. Graner
When we’re looking at it by geography, I think your scenario looks like its going to be more true in North America. In other words, the contractor business looks like has a chance to lead us out of this on a quicker basis.
I think in the rest of the world probably the opposite is true. If you drilled down into the numbers you’ll see contractor has decline less dramatically vis-à-vis the industrial, especially in Europe, but I think we might have a little bit of offset to that normal cycle that we’ve seen before.
Kevin Maczka - BB&T Capital Markets
Just one more if I could Jim, on the gross margin items you called out that were incremental negatives or positives compared to last quarter, volume 4 points, and that’ll depend of course on where volumes go, but if you look at Q3, currency, pension, raw materials, these could all be better than they were in Q2. Is that correct or will pension continue to be a lag going forward?
James A. Graner
For pension, the magnitude will be the same. I think currency will be less negative especially if the euro holds at 1.42.
I think our average in the 3rd quarter last year was 1.50 versus 1.56 in the second quarter. So I think that decrement will be less, and then of course part of the equation here is what happens with unabsorbed burden when our inventory decline is over.
We should see some production increases, but most likely that won’t happen until the fourth quarter.
Kevin Maczka - BB&T Capital Markets
What I was getting at is even if volumes don’t change much based on currency, pension, and raw materials, maybe you might see a couple of more points of gross margin even with flat volumes.
James A. Graner
Yes, for sure. We’ve reduced our inventory $21 million year to date.
That’s a fairly rapid rate of decline and as that moves out and becomes less, we’ll have to produce more, so our unabsorbed cost should become less.
Operator
Your next question comes from the line of Christopher Glynn of Oppenheimer & Co.
Christopher Glynn – Oppenheimer & Co.
Pat, your comments on more optimistic in the second half, was that comment isolated to the Asian markets?
Patrick J. McHale
Yes, it was
Christopher Glynn – Oppenheimer & Co.
Within industrial, I was wondering if you’re seeing any differential in the trends in spares versus new equipment, anything that gives you a meaningful read on what’s going on out there?
Patrick J. McHale
Nothing that really sheds any light on the situation more than what we talked about in Q1. Spares are down as well.
We’re seeing spares down less than new units, but they’re still down, and I think that’s consistent with what we’re seeing in terms of industrial production and plants being shut down and just lower volume levels. Our spares business, a lot of that runs off how many gallons they pump and apply, and as that picks up our spares business will pick up as well.
Christopher Glynn – Oppenheimer & Co.
An interesting comment in the press release: Hopeful that the world economic crisis is getting behind us as it pertains to you, could you just kind of square that and elaborate what the comments that June/July backed to the first quarter run rates?
Patrick J. McHale
I’m not sure I can exactly but of course I’m watching what’s happened with a lot of the indicators out there and a lot of the companies that are releasing, and I think that there are some signs out there that the odds of things getting sequentially worse are probably a lot less than they were, in my mind here 4-5 months ago. I’m just feeling by some of the numbers we’re seeing and some of the numbers that are being put out that we’re probably clunking along the bottom.
Christopher Glynn – Oppenheimer & Co.
In the segment slides where you call up unabsorbed manufacturing costs as a separate line and some volume effect on operating leverage, is that a strictly accounting for the inventory reductions?
James A. Graner
No, that’s really accounting for the fact that our total hours are less than they were last year, so the hour decline is really represented in two pieces, one is the inventory decline and second is the decline in the absolute volume in those segments.
Christopher Glynn – Oppenheimer & Co.
Could you estimate or ballpark the split?
James A. Graner
Operator
Your next question comes from the line of Tom Britman from BMO Capital Markets.
Tom Britman - BMO Capital Markets
I was just wondering if you could talk about some details of your contingency plans in case things do deteriorate a little bit versus the second quarter.
Patrick J. McHale
If they deteriorate a little bit, I think we’re pretty much where we want to be. We’ve made all the adjustments I’d like to see us make pending a significant downturn.
We have a contingency plan in place if we see a significant step-down, and we’ve been able to react pretty quickly. We made a decision in November, and we implemented in December, and we did the same thing in the first quarter.
So if need arises we can execute in a matter of weeks. We don’t have factories scattered all around the world and distribution centers scattered all around the world that are going to take us weeks and months to shut down.
Basically we’ve got a pretty lean organization, and the cuts that we have to make are cuts that we can make pretty quickly. I’m anticipating and hopeful that we’re going to be able to avoid that.
Tom Britman – BMO Capital Markets
You said that the June and July order rates were in line with the first quarter order rates, and you had mentioned back in March that the order rates were down about 40% year over year, but I’m just wondering with the monthly break outs, it’s hard to follow, but does that mean June and July were down by 40% year over year also, or is the year over year comparison not quite as adverse as that?
Patrick J. McHale
I’d prefer to stay away from the year over year comparisons if we can and really just think about just run rates. Last year at this time, we could barely keep up.
Our industrial business was screaming, and we were doing great internationally, and so the year over year comparisons by quarter get a little bit difficult to compare, I’d say here, throughout 2009 compared to 2008, so if you’d just look at run rate, our run rate in June and July were more or like incoming order run rate in the first quarter.
Tom Britman – BMO Capital Markets
You mentioned it quickly and it was hard to follow—North American paint center channel, I believe, you said was down double digits whereas the home center channel was down slightly. If that’s correct, could you just talk about what that was compared with your expectations?
Was it in line with expectations?
Patrick J. McHale
Yes, that is correct, and that’s about what we expected.
Operator
Your next question comes from the line of Matt Summerville – KeyBanc.
Matt Summerville - KeyBanc
Pat, just talking about again sequential order trends, the little bit tail-off in June and July, was the consistent across the three segments and regions, or was that relegated to maybe one area of the world or one or two of your segments?
Patrick J. McHale
I think it’s a pretty good general comment as I look at the numbers.
Matt Summerville - KeyBanc
With regard to Europe specifically, can you talk about what are you seeing in the business that makes you feel, and if I’m taking your comment out of context, please correct me, that we’re sort of bumping along a bottom there?
Patrick J. McHale
That’s feedback from distribution channel, key end-users, and some of our field salespeople, so it’s not any reported number that I can put my hands on, but it’s really based upon the knowledge that we’ve got from our customer base and distribution channel and their view of what the near term future here looks like.
Matt Summerville - KeyBanc
You guys obviously talked about and it’s very evident how much inventory you’ve taken out of your own business. Do you have a full year target?
If you gave it, I apologize if I missed it, and then can you also comment on how you feel inventory levels are looking among the general industrial distributors you deal with globally and your domestic contractor business for the home centers and professional paint customers you deal with.
James A. Graner
I’ll handle the first part of that. Our target is $30 million, of which we’ve achieved over $20, so our expectations for the last half of the year are $10.
There is a chance that we may exceed that and we may increase the target as we progress.
Patrick J. McHale
In terms of the second part of your question, I didn’t do an analysis in the second quarter. I did one in the first quarter, and my view after doing the analysis in the first quarter was that we did have inventory reduction happening with our channel partners and end-users, but the majority of that would probably be done by the end of the second quarter, and I think based upon, again anecdotal evidence, that’s the probably the case that will have less impact of inventory reduction in the third quarter than we did here in the second quarter and that unless there is another step down in the world economy that we are probably getting closer to where everybody needs to be.
Matt Summerville – Keybanc Capital Markets
In the past, you quantify the cost experienced with regards what you are doing in building out your presence with home centers and professional paint. Can you talk about what that number looked like?
You mentioned it was a little bit of a drag on margins, and if it’s on the slides, I apologize. I haven’t seen it yet, but can you just give that number?
James A. Graner
It was less in the second quarter and year to date 2009 than it was in 2008, so you’ll see on the contractor slide that it’s actually an add-back to the operating earnings of 2 percentage points for the quarter, 1% for the year to date. Year to date this year, it’s about $1.8 million.
Caroline M. Chambers
Last year, it was closer to 3.
Matt Summerville – Keybanc Capital Markets
Then what do you expect in the back half of the year, Jim, on those expenses?
Jim Graner
Expectations are for zero going forward. We haven’t built into any of our assumptions that we will have more stores.
Of course, we are hoping that our negotiation or expecting our negotiations could go better, and we would have an announcement at that time. At this point, there is nothing scheduled.
Matt Summerville – Keybanc Capital Markets
Can you talk about in the quarter all things considered between how the home center channel overall performed relative to professional paint and where you are from a manufacturing learning curve standpoint on the more entry level units that you’re selling now, can you talk about how mix is trending in that business and just looking forward net of seasonality you’re thinking about, although Pat you made some comments around that, how should we think about profitability in contractor unfolding for the rest of the year relative to what was a pretty good performance obviously in the second quarter?
Patrick J. McHale
I’ll let Jim make a comment on the numbers piece of it, but from a manufacturing perspective and from a market perspective, we are still seeing the trend towards people buying the smaller units so that they are going in instead of buying a $2000 sprayer, if they can buy a $1000 sprayer, they are doing that, so we are seeing the bottom of our line get more activity in both channels than we had in past. From a manufacturing standpoint, we continue to put cost reductions and process improvements in place on that entry level line.
So we would expect it over the course of the next year or so, we’d see some improvement in margin on the entry level side. I’ll let Jim give you his thoughts on overall profitability for the division based upon mix in the second half.
Jim Graner
For sure, the profitability on the home center part of the channel has improved especially sequentially from a year ago when we were incurring lots of costs. Our expectation is going forward that that will get better.
Again, we’re still driving some cost out of that product line and have expectations for more cost to come out in the future, but that doesn’t mean our professional segment is doing worse. I think you’ve seen a dramatic improvement from 3% to sales to 20%, so profitability is looking better in that segment as well, and will get better of course as volumes pick up.
Matt Summerville – Keybanc Capital Markets
Do you think though from a revenue standpoint again based on, and I know normal seasonality is little bit may be out the window here, should we think based on what you are seeing in the contractor business the second quarter being the high water mark in terms of sales for the year?
Jim Graner
I think that’s true for sure in North America.
Operator
The next question comes from the line of Mike Schneider with Robert W. Baird.
Mike Schneider – Robert W. Baird
I’m wondering if I could just drill on a couple of items and then as they relate to the second half. First corporate expense running at over $5 million, could we just get some more color on why that amount has almost doubled year over year, if that’s all pension or if there are other things in there, and what is the run rate you would expect for the second half.
Jim Graner
The delta is all pension expense, and it will double further rest of the year, so we’re roughly $5 million year to date, and it will be $10 million for the full year. We previously disclosed that our pension expense increase was $16 to $18 million for the full component, so the other $8 million on an annual basis is charged to the business segments, but we said the underfunding piece we were going to keep as a corporate expense.
Mike Schneider – Robert W. Baird
Just the savings rate, from the headcount reductions, the other cost initiatives, would you say that you’ve realized all those savings during Q2 on a run rate basis or are there more incremental savings that will spill into the third quarter?
Jim Graner
There will be some in the third quarter, but it is not significant.
Mike Schneider – Robert W. Baird
To the previous question, just about seasonality, it is very typical for total corporate revenue to decline from 2Q to 3Q, but based again on your comments about June-July order rates, do you think that comment holds for the third quarter this year.
Patrick J. McHale
It’s looking that way right now. We are only a few weeks into it, so I can’t say for sure, but that’s the indication.
Mike Schneider – Robert W. Baird
That Q3 will be seasonally lower in revenue?
Patrick J. McHale
It looks like it.
Mike Schneider – Robert W. Baird
Just taking you a step back, looking at the total enterprise now, the Q2 with most of the savings, the pension costs unchanged during the second half, and then typical seasonality, is there anything else that we should consider in our models when trying to model the second half that would explain why profitability would improve in the second half from this 2Q run rate despite lower revenue? The one thing I can think of is absorption, but is that meaningful enough to change the outlook for the second half in earnings?
Jim Graner
For sure, the absorption again my expectation is that will be more of a fourth quarter event than a third quarter event, and it could help again by the magnitude of 1 to 2 percentage points of sales. The other thing of course is the Euro, 1.42 today versus the average for the second quarter of 1.36.
Other than that, the second quarter should trend, again, if volumes stay where they are at.
Mike Schneider – Robert W. Baird
On your comments about Euro bottoming, Pat, I guess I’m curious about that comment because if we look at the industrial segment in particular in Europe this quarter, it clearly hit a stair step lower. Is there any reason you expect though that you’ve seen the bottom in that business, and I understand your feedback from the channel says that you are bumping along the bottom, but it strikes me that we’ve only seen one quarter of significant deterioration, why wouldn’t it continue?
Patrick J. McHale
My comment was that I expect that we may see the bottom of Europe in Q3, not that we would see the bottom of Europe in Q2, and that’s the feedback that we are getting from the field, and from our people and our channel partners. They believe that Europe in general is going to see the bottom in probably between now and Q3.
Operator
The next question comes from the line of John Franzreb with Sidoti & Company.
John Franzreb – Sidoti & Company
Could you tell us a little bit about our market penetration and your ability to add distributors in this environment?
Patrick J. McHale
In general, our distributor adds are on target for this year. We have had in a few areas little bit of a challenge where typically when we setup a distributor, we expect an opening stocking order, not just a sign up and hang the Graco shingle in their window and hope to get an order.
We look for a commitment on inventory front just to make sure they are serious, and they are going through the training programs, and there had been a couple of product categories in general where we’re out setting up distribution where that’s been a bit of a challenge for us because distributors just don’t want to make the investment, but I would say in general we’re pretty much on schedule, and I don’t think that we’re going to miss our targets by much this year.
John Franzreb – Sidoti & Company
As you illustrated over the year, R&D spending remains elevated. You’re supposed to rollout a bunch of products particularly in the second half of year.
Can you bring us up to speed on new product introductions and what kind of margin contributions we should expect from those products?
Patrick J. McHale
We don’t talk about the new products until we launch them for obvious competitive reasons, but we did have about a 20% increase in product development spending. That was that ramp, and we’ve achieved that ramp, so what you should expect to see is you’ll see a couple of incremental products in 2009, and then going into 2010, you should expect to see 20% more impact from new products from Graco than you would have historically, and it depends a lot on what we are launching.
If we launch new entry level product line into the home center channel, that’s a quite a different dynamic than launching a product into the Asian lube market, so there is a lot of variation there, but in general, our new products have strong incremental gross margins, and they go through our existing channel, our existing salesforce, and they’ve got a nice impact on our incremental operating margins.
Operator
The next question comes from the line of Kevin Maczka with BB&T Capital Markets.
Kevin Maczka – BB&T Capital Markets
I had just a followup on some of the SG&A and operating expense lines in the second half. G&A was kind of flat year over year, that’s more fixed; the selling and marketing is more variable, that was down based on some of the cost actions you’ve done.
This $28 million level with this volume assumption in the second half, is this kind of a good run rate at this point.
Jim Graner
I think so. Yes.
Kevin Maczka – BB&T Capital Markets
The G&A will continue to be fixed or are there other specific cost actions that are happening there that might knock that number down somewhat?
Jim Graner
No. That’s a good number to model going forward.
Kevin Maczka – BB&T Capital Markets
Can you talk about the lube segment longer term, given all the turmoil in the auto portion of that business and what’s happened there around the world? Has your long-term view of that business changed at all?
Patrick J. McHale
It hasn’t, but certainly our short-term view is impacted pretty significantly here. That’s really been a North America focused business for us, and of course North American automotive is in pretty rough shape, and so our vehicle services segment is going to have some pain working through that, but you’ll recall that in late 2006, we made decision to jump into the industrial lube segment, and with the acquisition that we did in the second half of 2006 and then another one that we did late last year.
We see a lot of growth opportunity there. We need to get our product cost on those two acquired companies where we expect them to be.
We’re still a little bit off. We’re making progress, and then it’s a matter of setting up the channel and launching new products.
We are also working to expand our international footprint. Effective in January, we implemented a specialized salesforce for lubrication in Europe.
We never had that before, and we reorganized our Asian operations, and we have a dedicated team in Asia selling lube, so we believe that growth opportunities internationally and in industrial lube still hold. We think we are going to be penalized for a while by what’s happening on the car dealership side.
Operator
There are no further questions. I’ll now turn the conference over to Pat McHale.
Pat McHale
To summarize, we are expecting weak conditions to persist in the short term, but we believe we’ve positioned the business for a strong profit rebound as the volume improves. Our incremental margins are going to very high.
Our balance sheet is in good shape giving us flexibility to pursue new opportunities, and we’ve resisted the temptation to cut the muscle, and we have remained committed to the investments in our key growth initiatives during the downturn, and we think the strategy maximizes long-term shareholder value, and we are going to stick to it. Thanks a lot for your time this morning.
Operator
This concludes our conference for today. Thank you all for your participating, and have a nice day.