Apr 23, 2010
Executives
Caroline Chambers - Vice President & Controller Pat McHale - President & Chief Executive Officer Jim Graner - Chief Financial Officer
Analysts
Kevin Maczka – BB&T Capital Markets Mike Halloran – Robert W. Baird Tom Brinkman – BMO Capital Market John Franzreb – Sidito & Company Ned Borland – Hudson Security.
Christopher Glynn – Oppenheimer & Co. Matt Summerville – Key Bank
Operator
Good morning and welcome to the first quarter 2010 conference call for GRACO Inc. If you wish to access the replays of this call you may do so by dialing 1-800-406-7325 within the United States or Canada.
The dial in number for international callers is 303-590-3030. The conference ID number is 4282472.
The replay will be available through April 27th, 2010. GRACO has additional information available in a PowerPoint slide presentation which is available as part of the webcast play.
As the request of the company we will open the conference up for questions and answers after the opening remarks from management and instructions will be given in that time. During this call, various remarks may be made by management about their expectation, plans and prospects for the future.
These remarks constitute forward-looking statements for the purposes of the safe harbor provisions of the Private Securities Litigation Reform Act. Actual results may differ materially from those indicated as the result of various respecters including those identified in item 1A of and exhibit 992, the company's 2009 annual report on form 10-K.
This report is available on the company's website at www.graco.com and the SCC's website at www.scc.gov. Forward-looking statements reflect management's current views and speak only as of the time they are made.
The company undertakes no obligations to update these statements in light of new information or future events, if you need assistance at anytime during the conference, please press star, zero and then the operator will assist you. I will now turnover the conference to Caroline Chambers, Vice President and Controller.
Caroline Chambers
Good morning and welcome to everyone, it is a pleasure for Pat McHale, Jim Graner and me to be with you this morning. Today, I will provide some comments on the financial highlights of our first quarter and Pat will follow with the additional comment.
As noted earlier, PowerPoint slides are also available to accompany the call and can be access that on our website. As our opening comment, we will open up the call for your question.
For our first quarter, net sales were up to 19% to a 165 million. Sales increase in all divisions and regions with significant growth in Asia Pacific and moderate growth in Europe.
We are pleased to report that operating earnings as a percentage of sales increased to 20% up from 4% a year ago with net earnings total in 21 million. Currency translation had a favorable effect on sales of 5 million on our net – and our net earnings of 2 million.
Our gross profit margin as a percentage of sales was 54% as compared to 47% for the first quarter last year. This improvement was primarily due to currency translation, work force reduction cost in last year and higher production volume.
Lower material and pension cost, price increases and product mix also contributed to the higher margin rate. Operating expenses were down 3% as compared to last year.
As we saw the benefits from cost reduction activities in prior years and lower pension expense. These improvement were partially offset the by defects of currency translations and increases in bad debt expense.
As we expected, volume related items such as incentive accruals are readjusting. The tax rate was 34.5% this quarter.
The Federal R&D tax credit has not been renewed for 2010 and no benefit is included in the current rate. Our first quarter cash flow from operations was 16 million, our primary use of the cash for capital expenditures of 3 million, dividends of 12 million and long term debt repayment of 6 million.
Our working capital investment increase in line with our increasing volume, we hire demand inventories increase by 8 million with an improvement in turn and account receivable increase by 18 million with the higher sales level. Our days of sales outstanding remain consistent with prior period.
On the financing side, our credit line totaled 270 million with a 178 million unused at the end of the quarter. With that, I'll turn it over to Pat for additional comments.
Pat McHale
Good morning. In the first quarter we had double digit revenue growth compared to both Q1 2009 and more importantly compared to Q4.
We saw growth in most geographies and business segments indicating a broad based recovery is likely underway. Historically Q1 is been our lost revenue quarter so that increase is particularly encouraging.
The following comments compared Q1 of 2010 to Q1 2009. We had double digit growth in Europe before currency benefit with Eastern Europe and the Middle East growing at strong double digit rates and Western Europe growing at mid single digits.
Growth was fairly well balanced across all our product segments. Asia Pacific had a very strong quarter China, Korea, South East Asia had the highest growth rates but we also saw double digit rates in India, Australia, New Zealand and Japan as well.
We benefited from strong car, bus, truck, motorcycle and tier one production in the region as well as rail, energy production, mining, aerial, space and construction. For Asia this quarter was approximately 10% higher than our peak Q1 prerecession.
We also saw growth in the America's. In North America we saw nice double digit growth in our industrial business while contractor and lube were essentially flat to last year.
The contractor in North America, the Pro Paint business was down mid single digits, offset by the Home Center Business which was up low double digits. The Pro Paint revenue caps were impacted by Q1 2009 channel sale of approximately of $1.5 million for an entry level product roll out.
The improvement in the Home Center Businesses was primarily due to increase store count and the roll out of a new sprayer model to 1700 stores of a major retailer in Q1 of this year. Contractor started the year off slowly that a strong march and prospect should improve as we enter the painting season.
Compared to Q4, both Pro Paint and Home Center improves significantly. Channel inventory appears to be stable with no evidence of restocking yet.
In Latin America off a small base, we had a strong quarter with sales up double digit in every reporting segment. Switching gears a bit, overall we are pleased with our operating performance gross margins were solid at 54% and up from Q4.
Operating margins continue to improve with volume, there's margin reconciliation for you in the slides at the company to call. Industrial had a nice quarter with 31% operating margins on revenues that remain well below prerecession levels.
[Irrigation] margins are trailing in the right direction. Improvements implement in the acquired businesses along with volume increases and the reduction in one time cost are all contributing.
To continue to invest in growth initiatives and lubrications and a return to historical operating margin will require significant volume increases. Contractor operating margins remains stable from Q4 at 10% and remain well below historical levels due to volume declines that begun in 2007 as the housing market crashed.
Mix issues also continue to impact the profitability to a segment as we continue to see lower demand on larger higher margin equipment. We continue to invest in our keys, grow strategies during the quarter, developing new products, recruiting and training international sales people and selectively increasing distribution coverage.
About product spending, product development spending was down compared to the first quarter of 2009. Our spending was up from Q4 due to project timing.
We continue to anticipate spending for the full year – full year of 2010, we'll be in the $40 million range. A new product sales of a percentages of total increase to 27% in Q1 versus 26% for the full year of 2009.
Our goal as we stated is 30%, well products release in Q1 contributed to our sales resolves we expect the impact to be greater as the year progresses. We have many products launching in Q2 and Q3.
Our balance sheet is strong and we continue to look for good acquisition opportunities. The MNAM Market has been challenging for the past 18 months, we expect the environment to approve as the economy recovers.
[Briary's] for cash, continue to be funding organic growth opportunities making strategic acquisitions and returning cash to shareholders, to dividends and share repurchases. In terms of outlook, we believe that the global economy has entered recovery mode while we don’t expect the Asia will continue with the period over period growth rates we saw on Q1 because of tougher comparisons for the rest of the year.
We are positive on the near term outlook for the region and expect solid performance from Asia in 2010. We also anticipate continued solid performance from Europe as the year progresses.
We continued slow recovery in the US housing market and the difficult conditions in the commercial construction market will create newer term challenges for our contractor division. And we will need good success with the new products to make significant headway in our key North American market this year.
This concludes my prepared remarks, I now ask the operator to open the session to Q&A.
Operator
Thank you. The question and answer session will begin at this time.
If you had a question, please press star followed by the one on your touch tone phone. If you’d like to withdraw your question, please press star followed by the two and if you're using speaker equipment, you will need to lift the handset before making your selection.
Your question will be taken in the order it is received. And our first question is from Kevin Maczka, please state your question.
Kevin Maczka – BB&T Capital Markets
Hi, good morning.
Pat McHale
Good morning.
Kevin Maczka – BB&T Capital Markets
Pat, congratulations on the quarter, and I guess my first question, you've mentioned in terms of seasonality, Q1 historically being the lowest revenue quarter. You think we're back to the point in the recovery where we can talk about normal seasonality with Q2, maybe being the best quarter and Q3 and 4 somewhere in between Q1 and Q4?
Pat McHale
You know, it's hard to say because we're so early into what I see is being the recovery here, but – you know I think there are some signs that the recovery is broad based, and you know we're going to see the residential housing market in the US, I think improve as the year progresses, I don't think the same can be said for commercial. So, I'm not a 100% confident in it.
But, I think that it's more probably more likely than that.
Kevin Maczka – BB&T Capital Markets
All right, and then I want to ask a question on the operating expense, down 3%, you know, given the big revenue increase. You're adding sales people in International market, you're doing a lot product development work, and you're rolling out new products all over the world.
How, can you give a little more color on how exactly you're finding the cost savings to offset all of those additional costs?
Jim Graner
Kevin, this is Jim. You know, last year, we did have about $1 million in operating expenses from severance cost which did not repeat this year, and more, most of the expected head count that your reference is going to happen in the second, third, and fourth quarters.
We have roughly 30 people in our International regions that are going to be added, so that you should project the trends for operating expenses to get higher as the year progresses.
Kevin Maczka – BB&T Capital Markets
OK. And I think you said before that you're expectation all in was relatively flat operating expense, but maybe there'll be some additional incentives and things like that, that would come back.
Is that still kind of directionally correct?
Jim Graner
Yes, you know, we indicated that, if we met our plan, our plan and send off the targets, so you should see an incremental expense at around $10 million for the year.
Kevin Maczka – BB&T Capital Markets
And does that go up significantly with presumably is better revenues than you would have expected?
Jim Graner
That's correct, you know, so we've provided in the first quarter incentives relative to the level of sales we've recorded, and the 10 million numbers we'll require in additional increase in revenues for the rest of the year.
Kevin Maczka – BB&T Capital Markets
OK. And then just finally, just a broad question on this contract to recovery, I'd just like to get some more thoughts on how you see that playing out.
There's a lot of product already in the field that was sold back at the prior peak for the housing market. Do you see demand for your new products, or your existing products coming back strong as those markets recover, or will there be still a long wag there because of all the product that's already in the field?
Jim Graner
You know our product in the field is starting to get a little bit old, you know, we're really talking about that peak being 05', 06' and so we're four, five years out from that, and that business of course has been under kind of a double digit declined here in North America for the last several years. So I believed it's likely there are lot of used equipment has been burned up out there as contractors submitted equipment over the course last three or four years, and just have taken one out of the backroom, or purchased one somewhere.
It's hard to say what exactly has left, but certainly does passage of all this time from the last peak I think is in our favor. The other thing that I think that will help us once the recovery here in North America from a construction market is starts to be sustainable is that the channel inventory will probably increase, you know our channel partners did a nice job during the down turn of management inventory's down and the inventories are probably appropriate for if you are at market conditions, but we'll need to go up as demand improve.
So, again, you know, we think housing will get a little better, we think commercial still will going to be tough for the rest of the year. But at some point, when that changes, we should get some benefit from the inventory, and I think that our sales will follow.
There'll maybe some negative impact from the equipment out in the field, but that's got to be lessening.
Kevin Maczka – BB&T Capital Markets
OK, thank you.
Operator
Thank you. And our next question comes from the line of Mike Halloran with Robert W.
Baird. Please state your question.
Mike Halloran - Robert W. Baird
Good morning.
Jim Graner
Hey Mike.
Mike Halloran - Robert W. Baird
Is there any reason the first quarter margin here isn't sustainable on a go forward basis taking a new account seasonality and seasonality obviously, and how much of the threat do you think inflationary environment and the raw material side will be?
Pat McHale
We, we're comfortable with our gross margin, you know, at the level of sales. So you know, we're benefiting from more production through our factories.
Last year, you know, we had roughly 25 million in manufacture burden cost that didn't flow through inventory, they were period cost. We reduce the run rate of that approximately 50% in the first quarter.
So, again our prices have held. Surprisingly, in the first quarter as well our material costs are favorable to a margin, you know, we're monitoring daily, weekly the – the metal inflation – inflation of the metal cost.
So, right now Mike, we don't see any of that being headwind that the pricing won't and our efficiency won't more than off offset.
Mike Halloran - Robert W. Baird
And so then, you know, the first quarter number seems like an operating margin, and we can build off, and I think you said there was really no push back on the pricing side. So, I'm thinking the past you'd said about a 150 to 200 basis points of pricing in 2010 if that's still hold?
Pat McHale
Yes, that's still correct.
Mike Halloran - Robert W. Baird
OK, well, appreciate the time.
Operator
Thank you. And our next question comes from the line of Charles Brady with BMO Capital Market.
Please go ahead.
Tom Brinkman – BMO Capital Market
Good morning, this is actually Tom Brinkman standing in for Charlie Brady. Just follow up on something on earlier comments.
Curious about the, with all the new products you have rolling out, maybe if you can talk about by 2011, what kind of percentage you see of new products, you know, sales versus overall sales?
Pat McHale
Well, you know, our new goal is to get to the 30% number, but keep in mind that that's not incremental. We had, we spend up their month project development to make sure that our base product offering is cutting edge technology, and so that we can continue to maintain our leadership position out in the field.
So, you know, you can't take increases or decreases in that number and necessary role or ride in the BMO. We have definitely over the course for the last 18 months, focused more on the divisions on the developing products that are purely incremental, through some of the new marketing initiatives that we've got going on.
And so I do believed that if you look forward in the, step back at the 2010 and the 2011 that we're likely to have more incremental growth on new product, but you know, most of the time our new products are, they're not a $100 million kind of deals, they're not game changers. There's a lot of them, and they move the needle in aggregate but not individually.
Tom Brinkman – BMO Capital Market
Great, and can you just talk about on how the, I guess how the gross margins would differ from the new products and the existing legacy products?
Pat McHale
You know, it depends on, whether which part of the product line we're looking at. You know, historically, I guess what the exception really of our, I'll call it our entry level or home center kind of products, the new products are equivalent to or, maybe slightly better than existing products in terms of margins, to the extent that the new product is slanted towards entry level or home center, those margin are less.
Tom Brinkman – BMO Capital Market
OK. And I guess you talked about not having any evidence yet of re-stocking, I believed that you said both the home center and pro paid channels.
I guess, what is your visibility is now into the, I guess in the North American stores, what are the trends there in terms of the demand, how do you see that progressing over the course of the year?
Pat McHale
You're talking specifically in terms of a contractor?
Tom Brinkman – BMO Capital Market
Yes.
Pat McHale
Well, you know, I believed that the second quarter is going to be better, because we're entering the paying season and historically is and I think the order trends that we saw in the March indicates that that's going to be the case. I'm not seeing high desire by the channel partners to bet on the com and load up their stores with inventory yet.
I think that we're going to need to see it before we would see any significant kind of inventory restocking and if you ask what you all be surprise that does happen this year, I'd be more optimistic for some significant inventory restocking in 2011.
Tom Brinkman – BMO Capital Market
OK. And you mentioned orders, can you comment on it all in the orders, basically by segment overall not just by geography but also across the whole company?
Pat McHale
Talking about our incoming order rates?
Tom Brinkman – BMO Capital Market
Yes.
Pat McHale
Just in aggregate, our incoming order rate for that beginning year of April looks to be very consistent with what's been happening through the first quarter. So we don't see any cracks happening at this point, but of course it's early.
So, we’ve been strong really across the geographies and across the product segments.
Tom Brinkman – BMO Capital Market
OK. And then speaking of geographies, Asia was typically strong this quarter.
Just wondering how much of that is, you know, new market penetration, I just want to build out your capabilities there, how much you taking share, how much of that is just a reflection of the overall market growth.
Pat McHale
Well, I think the big piece of it is what's happening with the economy over there. The economy is strong in most of those regions, but you will recall that during the down turn here in 08' and 09' we continue to invest so more people, more distributors.
So it’s a combination, I'm sure. Certainly, I take a great economy over anything else but when you've got a strong economy and you've made the investments hopefully you can capitalize and up those.
We don’t have any way to measure in any kind of a pure way what's happening with market share. We can tell you where we're putting people, where we're putting distribution in it, and that the growth is good and the economy is strong and all in all it seems to be working.
Tom Brinkman – BMO Capital Market
OK, it's all I had. Thank you.
Operator
Thank you. And our next question comes from the line of John Franzreb with the Sidoti & Company.
Please go ahead.
John Franzreb - Sidoti & Company
Good morning guys.
Pat McHale
Good morning John.
John Franzreb - Sidoti & Company
Pat, just to talk a little bit about your job or customer base, in the past, you mentioned that they were kind of reluctant to restock. Do you think their inventory levels are now at equilibrium or which a sense of that current spending patterns or are they still conservative?
Pat McHale
When you talk about job or you're talking about, what segment are you referring to?
John Franzreb - Sidoti & Company
Industrial.
Pat McHale
Right, an industrial site, you know, there maybe a few little areas where there's some restocking going on just to support the fact that a demand is better but in general we don’t have any evidence that change dramatically. And to be honest with you in most of our industrial businesses, the distributors other than spare parts, [old] stock, a ton of completed units because our industrial product is a very high mix logo in kind of stuff and configurable and so distributors order when they're working on a project.
So, you know, I believe that most of the performance that were seen out of our industrial division is directly related to and demand with the exception of maybe some spare parts and a certain geographies where we're getting a little bit of benefit.
John Franzreb - Sidoti & Company
OK. And could you give us a little color about the lubrication side?
You have nice upticks sequentially as far of the revenue side. To the talk of your thoughts of whether how you expect the progression of recovery to unfold them a little bit over the next year.
Pat McHale
Well, you know that the clients were similar to our industrial business and it wouldn't surprise me to see it comeback sort of in a similar fashion. One big exception there is the fact that we're pretty heavily weighted towards the vehicle services North America.
Not seen any signs that the dealers are going crazy yet in terms of making investments. Although I think with the up taking car sales is just in general improvement in the economy here we will see some strength in that as the recovery picks up.
But, you know with that exception the industrial [lubrication] initiative and what we're doing internationally. I would think, could move along in line sort of with our industrial recovery.
John Franzreb - Sidoti & Company
OK, great. Thanks a lot.
Operator
Thank you and our next question comes from the line of Ned Borland with Hudson Security. Please go ahead.
Ned Borland – Hudson Security
Hi guys, great quarter. I just have one question going back to seasonality.
When you touch someone in contractor, It seems like there was a – you know a normal years not so much last year but you know, before that there was a sort of a seasonal uptick in industrial and I was just wondering, you know given some restocking activity which you expect a similar seasonal, you know move upward sequentially in the second quarter or would it be, you know maybe a little bit more muted.
Pat McHale
For our – for our consolidated global performance, I would expect that if the recovery doesn't weaken on this year that we would see hopefully a more normal pattern going into the second quarter with some uptick.
Jim Graner
OK. And then again, I bet the cost headwinds in that segment.
I mean other than raw materials and perhaps some product development spending whether other cost that we should be thinking about in that segment.
Pat McHale
You know how to make your own call on what currency is going to do.
Ned Borland – Hudson Security
OK. All right, thanks.
Operator
Thank you and our next question is from the line of Christopher Glynn with Oppenheimer & Company. Please go ahead.
Christopher Glynn – Oppenheimer & Co.
Thanks. Good morning, question on contractor.
If we're – you know operating from baseline of normal seasonality as you get heard you have some retail channel fill in the first quarter, would that you know against the normal seasonal pattern?
Pat McHale
A little bit.
Christopher Glynn – Oppenheimer & Co.
OK. Just a little and from the fourth quarter to the first, you had a – it's look like a little bit of an abnormal uptick from normal seasonality as well but we didn’t see the margin moves sequentially with that next related to the channel fill or …
Pat McHale
Yes, partially mixed in. It's partially that are operating expenses generally are waited more to the first three quarters of the year versus the fourth quarter.
Christopher Glynn – Oppenheimer & Co.
OK. Thanks, that’s all I have.
Operator
Thank you. Once again, ladies and gentlemen if there are any additional questions at this time please press star followed by the one and our next question is from the line of Matt Summerville with Key Bank.
Please go ahead.
Matt Summerville – Key Bank
I have a question. I want to follow up on Asian a little bit Pat.
Do you know how much for the year over year growth? I think organically was 55% in a quarter.
How much of that would you say was relegated to China and are you seeing any signs over there in your business that some of the efforts that are at least being talked about with regards to the government are starting to slow things down over there at all?
Pat McHale
So you know what's interesting. First of all back to that, you know where is the growth comes from China.
We had a big quarter in China. We also had a big quarter in Southeast Asia and in Korea.
And we saw again double digit growth in India, Australia, New Zealand and Japan so it's not just China. The whole region seems to be running rather well right now.
You know from a Chinese government's efforts to slow the things down we've been hearing that now year over year for quite some period of time and they seem to be fairly unsuccessful and being able to do that. Again, I wouldn't be building in to any kind of a model of 55% growth rate for the rest of the year over the tougher comparisons but the team over there is pretty confident that if there is a bubble building in China, it's probably not going to burst this year.
They see a pretty strong demand in auto motor segments last and at least another two or three years. And, so you know we're more optimistic I think that we're not going to see the thing clamp down too much here this year
Matt Summerville – Key Bank
Speaking with Asia and this is kind of a fall to someone else's question Pat. Do you know out of the magnitude growth you're talking was pretty phenomenal?
How much of that do you think is kind of great making its own luck with the strategic investments that you kept on making through this down turn versus the overall improvement in kind of the macro environment. And at the same time, do you feel that there's anymore inventory being built among your customer based there than what you’re seeing another parts of your businesses?
Pat McHale
Up by here in 2009. I'd love to say that the quarter in Asia because we're all geniuses and everything we did work perfectly but I don't think in reality that's probably the case I think the reality is the combination of a very strong economic situation and hopefully the fact that we have continued to invest and grow our channel is having a payback.
There's really no way for us to sort that out over the short term over a longer period of time. We can get some baseline metrics on our initiatives but quarter to quarter, that's not really – not really possible to do.
Matt Summerville – Key Bank
You've mentioned in contractor. I believe domestically that the Home Center Channel was up in the load team's range I think part of that being related to a new product roll out to 1700 stores some part of one of your customers.
I guess we kind of exclude that, how would the underline order tempo look in the Home Center Channel versus the professional paint side?
Pat McHale
I don't know, I haven’t done that calculation. Sorry.
Matt Summerville – Key Bank
OK. Thanks Pat.
Operator
Thank you. Ladies and gentlemen if there are any additional questions please press star followed by the one at this time as a reminder if you're using a speaker equipment today please lift the handset before making your selection.
And one moment please. And if there's no further question, I'll now turn the conference over to Pat McHale, President and Chief Executive Officer.
Pat McHale
All right, I'll give my normal long speech at the end of the call. Thanks for joining us this morning and have a good day.
Operator
This concludes our conference for today. Thank you all for participating and have a nice day.
All parties may now disconnect.