Oct 24, 2013
Executives
Caroline M. Chambers - Principal Accounting Officer, Vice President and Controller Patrick J.
McHale - Chief Executive Officer, President and Director James A. Graner - Chief Financial Officer Christian E.
Rothe - Vice President and Treasurer
Analysts
Joseph Ritchie - Goldman Sachs Group Inc., Research Division Michael Halloran - Robert W. Baird & Co.
Incorporated, Research Division Charles D. Brady - BMO Capital Markets U.S.
Matt J. Summerville - KeyBanc Capital Markets Inc., Research Division John Franzreb - Sidoti & Company, LLC James Krapfel - Morningstar Inc., Research Division Liam D.
Burke - Janney Montgomery Scott LLC, Research Division Kevin R. Maczka - BB&T Capital Markets, Research Division James Giannakouros - Oppenheimer & Co.
Inc., Research Division Walter S. Liptak - Global Hunter Securities, LLC, Research Division
Operator
Good morning, and welcome to the third quarter 2013 conference call for Graco Inc. If you wish to access the replay for 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 4643781.
The replay will be available through October 27, 2013. 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 the conference call 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 provisions 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 the company's 2012 annual report on Form 10-K; and in Item 1A of the company's most recent quarterly report on Form 10-Q.
These reports are 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 as of the time they are made.
The company undertakes no obligation to update these statements in light of new information or future events. I will now turn the conference over to Ms.
Caroline Chambers, Vice President and Controller. Please go ahead, ma'am.
Caroline M. Chambers
Good morning, everyone. I'm here this morning with Pat McHale, Jim Graner and Christian Rothe.
I'll provide some top-level discussion on our overall financial results for the third quarter, and then we'll turn the call over to Pat. Slides are available to accompany our call and can be accessed on our website.
The slides include information about our consolidated financial results for the third quarter in our usual format. Sales this quarter totaled $277 million, an increase of 8% from the prior year, with varying trends by division and region.
Sales in the Contractor segment grew by 24%, along with modest increases in the Industrial and Lubrication segments. Regionally sales in the Americas grew by 15%; sales in EMEA increased by 8%, or 4% at consistent translation rates, and sales declined by 9% in Asia Pacific, or 6% at consistent translation rates.
Pat will give more detail by region and segments in a moment. Net changes in currency translation rates from the prior year did not have a significant effect on sales or operating results for the quarter overall.
Unfavorable currency translation change from Asian currencies was nearly offset by favorable currency translation from the euro. A table showing impact of volume, acquisitions and currency by segment and region is included on Page 5 of the slides.
Net earnings totaled $56 million or $0.89 per diluted share for the quarter. Page 8 of the slide deck provides a quarter-over-quarter overview of changes in operating earnings.
Gross profit margin as a percent of sales was 54.5% for the quarter, consistent with the prior year. Realized pricing and manufacturing cost improvements were offset by significant growth in the Contractor segment during the third quarter and other changes in mix.
Operating earnings improved in the Industrial and Contractor segments though were flat in the Lubrication segment. Acquisition/divestiture costs were insignificant in the quarter as compared to $3 million for the third quarter of last year.
Other unallocated corporate expenses were consistent with the prior year and consistent with our expectation that they will be in the range of $5 million to $7 million per quarter, excluding acquisition and divestiture expense. Other income includes dividends from the Liquid Finishing business of $9 million for the quarter and $24 million year-to-date.
Once again, a brief reminder on the background of this investment and the dividends. The Liquid Finishing business was purchased in April 2012.
It is reflected as a cost investment on our balance sheet, and the financial results are not consolidated. Under terms of the whole separate order from the Federal Trade Commission, we cannot exercise direction or control the operations of Liquid Finishing, nor can we exert significant influence over the Liquid Finishing operations.
Income is recognized based on dividends received from after-tax earnings and is included in the income -- in other income in Graco's income statement. To reduce cash and undistributed earnings in the Hold Separate operation, a higher level of dividends were distributed in the second and third quarters this year as compared to the usual $4 million received in previous quarters.
We expect dividends to be approximately $4 million in the fourth quarter. We have not yet received the final order from the FTC requiring the divestiture of Liquid Finishing.
Of course, when the final order is received and the sale of this investment is completed, there will be no further dividends or income stream from the Liquid Finishing investment. The effective tax rate for the quarter was 24% as compared to 32% last year, reflecting the effect of the federal R&D tax credit that wasn't renewed until the first quarter of 2013; the effect of the higher level of after-tax dividend income received from the Liquid Finishing business is held separate; additional benefit from U.S.
business credits; and deduction and greater foreign earnings that are taxed at lower rates than in the U.S. We've included our usual slide of segment results in the slide deck, starting on Page 12.
Net cash provided by operating activities was $81 million for the quarter, with changes in working capital in line with the business volumes and consistent with prior quarterly trends. Capital expenditures were $6 million, and we paid dividends of $15 million.
We resumed modest share repurchases earlier this year with $28 million of repurchases through the end of the third quarter. Our outstanding long-term debt was $404 million at the end of the quarter, with net repayments year-to-date of $152 million.
We anticipate that the total future cost of the divestiture will be approximately $10 million, though the timing of expense and final amount will be affected by the sale and regulatory review process and duration. The tax quarter for the fourth quarter -- or the tax rate for the fourth quarter is expected to be at 28% or 29%, and the full year rate is expected to be approximately 27% to 28%.
Capital expenditures for the year are expected to be in the range of $20 million, and we expect to continue a moderate rate of share repurchases in coming quarters. With that, I'll turn the call over to Pat for more comments on our quarter.
Patrick J. McHale
Thanks, Caroline. Good morning.
This morning, I'll provide some commentary on the trends we saw in our business in the third quarter and our outlook on the fourth quarter. I will also touch on some early thoughts on 2014.
Overall sales growth for the third quarter was solid at 8%, and we posted another record for third quarter sales. Similar to the last couple of quarters, we still aren't hitting on all cylinders.
The Americas outperformed our own expectations due to the Contractor segment performance. Asia Pacific underperformed in both the Industrial and Contractor segments, and there were some bright spots in the EMEA region.
I will call each of these out as we go through the recap. From a profitability standpoint, we set a record for third quarter net income for the company.
As you know, that figure is impacted by the dividends of the Hold Separate business. A more appropriate earnings figure for the core Graco business is the operating earnings, which grew by $13 million compared to the third quarter of last year, an increase of 24%.
This was on sales growth of $21 million. If we adjust for the $3 million in acquisition expenses that were in the third quarter of 2012, incremental margins are near 50%.
Now we'll walk through each of the regions and the segments. My comments are based on year-over-year performance for the quarter and year-to-date on a constant currency basis and exclude the impact of acquisitions.
First, Asia Pacific. Overall Asia Pacific was down 6% versus Q3 2012 and performed worse than anticipated in the quarter.
Year-to-date performance is negative 3%, which is also worse than we expected it to be at this point of the year. Our Asia Pacific team continues to find the macro environment challenging, although we do have product lines that are performing well.
Geographically we're seeing strength in Japan and Southeast Asia, while China and India remain weak. We also noted deterioration in Australia in the third quarter due to mining activity levels dropping.
As we discussed in the second quarter call and remaining relatively unchanged in Q3, currency headwinds are hurting profitability somewhat in this region. The Industrial segment in Asia Pacific declined 9% in the quarter, and our Contractor segment decreased 7% and now is flat on the year.
In Contractor, we continue to see good growth in texture and pavement products, offset by weakness in paint equipment. Our Lube business returned to growth in Asia for the first time in a year.
We saw a significant dropoff in the second half of 2012 due to weakness in certain key mining accounts. Those comps are now easier, and we finally saw some orders from those accounts this quarter, although at reduced levels.
Demand continues to be highly variable from country to country and across product lines for our Asia Pacific region. We are seeing pockets of growth, but it's difficult to point to many clear upward trends.
Moving on to EMEA. We grew 4% in EMEA in the third quarter and are now showing positive organic growth year-to-date.
For the legacy Graco business, we were flat in the West, and our growth came from the East. The Powder business saw the reverse situation with several large powder systems orders shipping into the West during the quarter.
Similar to what we're seeing in Asia, there's a high level of variability in the performance of products and geographies from quarter-to-quarter. In the case of EMEA, however, the pockets of strength are winning the day and resulting in an overall growth for the region.
Every segment is either flat or up year-to-date in EMEA, not an easy accomplishment in this economic environment. Moving on to the Americas.
Our Contractor segment remains strong with solid double-digit growth during the quarter. Both the paint store and home center grew at double-digit pace in the third quarter, and most customers saw a strong sell-through.
As such, inventory levels in the channel appear to be appropriate. So far this year, the base business grew in the low double digits, with the remainder of the growth coming from new products, increased SKUs with certain retailers and selling initiatives.
A strong year-over-year increase in contractor sales has resulted in a higher-than-anticipated growth incentive achievements. This was a slight drag on profitability during the quarter and will continue to be a factor in the fourth quarter.
Our Industrial segment in the Americas grew at a 3% pace in the third quarter, identical to the first half and in line with our expectations as customers remain cautious on capital spending. Our Lubrication segment in the Americas was flat in the third quarter, similar to the pace we've experienced throughout the year.
This is a result of the ongoing trend in the Americas of growth in our Legacy Vehicle Service business, offset by declines in our Industrial Lube business. Industrial Lube is impacted by lower demand in both on-road and off-road mobile applications.
In the last few months, we've made good progress on some specific long-cycle selling initiatives in the Lubrication segment, both domestically and internationally. We also recently launched additional new products.
We remain positive on the growth potential for the segment for the long term. Before moving on to our outlook for the fourth quarter, I'd like to give a recap of some general thoughts and trends about our Industrial business worldwide.
Right now, we're seeing a mixed bag worldwide and high variability between product lines and geographies. As stated a moment ago, we see generally cautious spending on capital expansion projects globally.
This has resulted in a modestly unfavorable change in product mix as product lines associated with capital expansion have been soft. In addition, profitability for Industrial has been impacted somewhat by the currency headwinds in Asia that began in the second quarter and continue today.
Automotive production levels are relatively healthy in the Americas and Asia Pacific, but they're very soft in Europe. Graco sales by product line have been mixed in automotive.
Our fluid dispense products have been generally strong, while finishing applications aren't as favorable against several years of robust growth. The full market has been solid globally, as has our Sanitary business, which is small but growing.
Our new Hot Melt initiative is meeting expectations and adding some incremental revenue to our top line. On the negative side, mining, shipbuilding, container manufacturing and heavy machinery are generally soft.
Now for some comments about our outlook. Our outlook for the year 2013 is relatively unchanged from last quarter with 1 exception.
Overall we had expected full year growth in every region. Year-to-date, we're 3% below the prior year in our Asia Pacific region, so we now believe that full year growth is unlikely.
We do believe we can grow this region in the fourth quarter, however, against the easiest comp of the year, albeit at a low single-digit pace. In the Americas, the Contractor segment should grow double digits in the fourth quarter, but the rate of growth will decrease -- will decelerate as Q4 2012 was a pretty strong quarter.
I'll also note the Contractor spending in Q4 will be up as we prepare for a number of new products that will launch in the first half of 2014. For our Industrial and Lubrication businesses in the Americas, we continue to expect low single-digit growth.
We also expect growth in EMEA in Q4 but also at a low single-digit pace. Our factories continue to perform well and incremental profit on our sales growth this year has been outstanding.
2013 will be a record year for Graco in sales, operating earnings, net income and diluted earnings per share. We've had our share of struggles, no doubt, but the overall company performance this year has been very strong.
My initial thoughts on 2014. For 2014 we plan to achieve growth in every segment and every region of the world.
Our plan relies on a continued focus on new products, new markets, expanded distribution and end-user conversion. Most of the resources we need are already in place.
Where there are gaps, and that's primarily in Asia Pacific and South America, we will be adding resources to help achieve our goals. Our product development spending is already pretty well aligned with our business plan, and we expect spending will remain at similar levels to 2013 with the exception of wage inflation.
Our new product pipeline is solid with a greater focus on incremental opportunities more than product upgrades. We expect the U.S.
construction environment will continue to improve and that our contractor business will grow nicely again in 2014. There isn't much more I can offer on 2014 at this point.
A few comments on the Liquid Finishing divestiture process. The government shutdown did impact the personnel at the FTC that are working our case, so there are very few updates to share.
The business continues to perform well as evidenced by the $9 million in whole separate dividends that flowed through to Graco in the third quarter. When the time comes to sell the business, we're prepared to go to market quickly.
The ongoing question for our shareholder base, of course, is what will we do with the cash? Overall we feel that our organic growth initiatives are well funded today.
Our priority has been and will be to find good M&A opportunities, but the key is to remain disciplined in our approach. With or without acquisitions though, share repurchases will be considered in the mix.
This concludes my prepared remarks. Operator, we're ready for questions.
Operator
[Operator Instructions] Our first question comes from the line of Joe Ritchie with Goldman Sachs.
Joseph Ritchie - Goldman Sachs Group Inc., Research Division
Just so -- Pat, on your comments regarding construction spending being up or Contractor spending being up in that fourth quarter, due to the new product launches, there's been a lot of volatility in the margins historically, I think, because of that fact. Can you quantify how much of a headwind or how much spending is going to be up in 4Q?
Patrick J. McHale
I'm not sure exactly. I'd say a good number to use would be between $1 million and $2 million.
Joseph Ritchie - Goldman Sachs Group Inc., Research Division
Okay. Helpful.
And then, I guess, a follow-up question on -- you mentioned earlier how your investor base is clearly interested on what you're going to do with the cash from an eventual divestiture of the liquid business. Can you talk a little bit about the pipeline opportunities and also the timing?
So for example, I think that there's a view that if you were to sell Liquid today, or had the opportunity to, that it would have a dilutive impact on your earning stream. However it doesn't seem like there's a lot of earnings that are really coming through today on the Liquid side.
And so, just help us understand the potential accretive opportunity if you were to divest Liquid and have -- be able to put that cash to use on an accretive opportunity.
James A. Graner
So Joe, this is Jim Graner. I'll answer the last part of that question while Pat things about the pipeline.
So on Page 4 of the slides that accompany the call, we break out the impact of the dividends on our EPS on the bottom. And you can see there, for the quarter, we got $9 million, or $0.14 year-to-date, $0.24 or $0.38.
So those earnings will disappear. That dividend stream will disappear when the sale takes place.
And I'll let Pat comment on the pipeline of what we're looking at for potential acquisitions.
Patrick J. McHale
Yes, we got a number of people working in different areas that we've targeted for interest. And we've had some things to look at, and I would say our pipeline is at least average, maybe a little bit better than average, probably more driven by the fact that we've got more resources on it than we have in the past than necessarily anything happening out there in the market.
One of the things that we do see is we see people paying up pretty significantly for assets out there. And we're not just going to go buy something just to fill a hole.
We want to make sure that we get a good ROI. We're a cash-on-cash kind of company, and we'd also like to make sure that the deal that we do we can add some value to.
So I don't think it's a given at this point that we're going be able to put all that cash to work on M&A, and that's why share repurchases are and will remain in the mix. But we're going to do what we can to find an opportunity that we think our shareholders will be pleased with.
Joseph Ritchie - Goldman Sachs Group Inc., Research Division
Okay, that's helpful color, Pat. Just 1 clarification, Jim.
On the EPS impact on Slide 4, that excludes the interest costs associated with the current debt levels, correct? So that number's -- not $0.38 wouldn't go away.
It would be a number a little bit lower than that, correct?
James A. Graner
Correct. Again, we've got, today, about $100 million borrowed at LIBOR plus a few points.
So we'll have $1 million or $2 million on an annual impact in reduction and interest expense. As you know, cash balances these days don't earn what they used to.
So you're correct in your calculation. It will be somewhat less than the $0.38 but not significantly.
Operator
Our next question comes from the line of Mike Halloran from Robert W. Baird.
Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division
So just piggybacking a little bit on the Contractor margin question there, could you maybe just talk about the moving pieces in the third quarter for the Contractor margins? If there was any kind of residual impact there from new product introductions, mix swings, things like that?
James A. Graner
Yes. So on a mix basis, you know, Pat talked about the SKUs being higher in the home center with 1 home center customer.
As you know, the home center tends to sell our lower priced equipment, and the margins for that are less than ours. So we're still not seeing the swing in our overall business to the bigger units.
The smaller units continue to dominate. And as such, on a sequential basis, there wasn't much margin improvement.
We did have a little bit of catch-up to do on our accruals for those things that are calculated on growth, sales incentives and customer incentives. So that maybe took 1 or 2 points out of the current quarter operating profit as we caught up the year-to-date numbers.
Should have less impact on the fourth quarter. Of course, as you know, the fourth quarter is our seasonal low for this business, and you generally see a drop-off in operating profits as a percent of sales, and we're expecting that same trend to happen this year.
Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division
Makes sense. And then on the Industrial side of the business, maybe just some thoughts on how demand tracked through the quarter.
Any shifts or variability that you saw sequentially? I know you're saying the macro's still pretty mixed on that side, but just wouldn't mind hearing how things kind of have tracked over the last few months.
James A. Graner
Yes, so, I'll give you an overview in total of our order rates. So September was a strong order rate for us on a weekly basis that equaled our strongest period during the year.
The first 3 weeks of October looked better than August and July, both of which, I think, are slightly positive given that the Contractor business trails off sequentially, as I mentioned earlier. And so what we're seeing is a replacement of that, I'll call it, sequential decline in Contractor order rate by Industrial.
And Industrial and, in particular, nice, I should say, modest growth in EMEA. So the mix, the volume is tracking sequentially okay, with Industrial picking up the seasonality drop in Contractor.
Michael Halloran - Robert W. Baird & Co. Incorporated, Research Division
And then last 1 for me, just on the tax rate for next year. Assuming that there are no more dividends associated with the ITW piece, should we be expecting this to track kind of back towards that historical norm in the low 30s?
Christian E. Rothe
Yes. This is Christian.
It's going to be in that 32% to 33% range. The big assumption around that is that the R&D tax credit is renewed, which hasn't been renewed yet.
So if that doesn't happen, you're going to see about a percentage point increase in rate.
Operator
Our next question comes from the line of Charles Brady with BMO Capital Markets.
Charles D. Brady - BMO Capital Markets U.S.
On the Contractor business, you talked about a new product rollout. I'm just wondering, timing wise, when that hits in 2014?
I'm assuming it's kind of a normal seasonality when you're all stocked up, but is there anything -- kind of outsized product, new product that's coming out that might be larger than normal?
Patrick J. McHale
We think it's going to be a good new product year in Contractor. Probably a stronger -- well, not probably.
For sure a stronger new product year in 2014 than 2013 for us. Those products should launch -- the majority of them will launch in the first half of next year, and we typically will stagger our launch between the regions just so that we can smooth production.
You should see some of those in the first quarter, and some of those will be in the second quarter.
Charles D. Brady - BMO Capital Markets U.S.
Okay, great. And just back on the mix question, again.
I was wondering if we can get more granular on it. If you kind of dice it between low, medium, high kind of margin or low, medium, high price, can you give us a sense of how that mix kind of segments out?
A normalized market is kind of 1/3, 1/3, 1/3 roughly. It's been creeping up more towards the higher end, but I'm wondering where we are today on that.
Is it still kind of moving towards the right to the higher end? Or is it kind of staying where it is?
Patrick J. McHale
Well, there are some variability in there just because of some of our sales initiatives. And we've had some good selling initiatives and SKU expansion.
I was in the home center channel. So the mix issue in Contractor, of course, part of it's going to be market-driven, but also a part of it's driven by that dynamic.
And we've had some good success in the home center channel this year. And as Jim has said earlier, that's helped keep our product mix leaning more towards the smaller units.
Charles D. Brady - BMO Capital Markets U.S.
If you jump at the professional side of it, focus on just the professional paint there for a second, are you seeing those type of painters migrate or having more acceptance to buy a higher margin product? Are they still a bit more hesitant to go that far out?
Patrick J. McHale
Our product lines that are our larger sprayers are definitely, we're seeing improvement in those. There's no doubt about it.
They're nowhere near back to the levels that they were when the housing market was at its peak. But certainly those production lines are running a lot stronger than they were running here a couple of years ago.
Operator
Our next question comes on the line of Matt Summerville with KeyBanc.
Matt J. Summerville - KeyBanc Capital Markets Inc., Research Division
Along the lines of the last question, if you guys have been pretty clear historically that it's much more accretive to profitability when Pro Paint, the mix in Pro Paint is moving upward relative to the home center. If you go back and look just in the U.S.
business, Pat, over the last cycle maybe, is -- I guess, where's the mix today in the U.S. in terms of Pro Paint versus home center as a percent of revenue?
And where was it when it was most lucrative to Graco in the past is what I'm trying to ask.
Patrick J. McHale
I'll let Jim chime in, if he's got any data, but I'd have to go back and do some math on that. We've had sort of a peak trough and then improvement situation in terms of how that's shook out.
Our Home Center business declined really more due to decisions that were made in that '07, '08 timeframe. So while the housing market was just coming off of its peak, our Home Center business definitely had experienced sort of a trough in that point in time.
Where our Home Center business had a peak, that was back in that '99, 2000, 2001 timeframe. It hasn't lined up with market dynamics.
It's had more to do with things that were happening with particular customers. And I don't have a calculation for you.
I'll let Jim chime in if he's got anything more concrete than that.
James A. Graner
Yes. So Matt, we're comfortable with our, of course, our nice increase in the dollars of profits in this segment, tracking along with the sales increases.
Your question is more on the expansion of the percent. And right now, we're on a spurt here of nice growth in the Home Center business with the additional SKUs that we've talked about in the last couple of quarters.
We are seeing the mix change in the professional but just the size of the increase in the Home Center being more than professional is dampening our percent of sales.
Matt J. Summerville - KeyBanc Capital Markets Inc., Research Division
Okay. With respect to the final decision order in that process, I think, Pat, last conference call, you're maybe a little optimistic.
I think you said that there were sort of 2 issues out there. One of which you guys have sort of come to, I'll call it an agreement on, or at least put it behind you, and then there's still sort of 1 issue, which I guess I was under the impression it was the least complicated of the 2.
So perhaps can you talk about where that process is? I get the government was shut down, but do you have any sort of idea when this thing -- when you get the final DO [ph]?
Patrick J. McHale
I don't think we really do. I mean, if we were guessing, we'd be guessing wrong a lot, so I just prefer not to guess.
But there was work -- until the government got shut down, there was work being done. It's not like it's sitting on the back burner somewhere, nobody's working on it.
I know that folks in the FTC that are working on our case are engaged in the issue. It's just taking longer than I guess any of us thought.
Matt J. Summerville - KeyBanc Capital Markets Inc., Research Division
1 last question. With respect to China, can you maybe provide just, I don't know if you guys have been over there recently, but just more -- a more detailed assessment of what you're seeing on the ground there on a day-to-day basis, what you're seeing in terms of credit availability or what your customers are telling you?
What's the sort of the state of discussions you're having with customers on their propensity to expand capacity as we head through 2014?
Patrick J. McHale
We'll give a couple of different data points here. I'll give you some observations, and Jim can chime in.
I think we were over there together in late August is the last time we were on the ground. But we actually had our AP folks here about 2 weeks ago for our 2014 planning session for a week, so we've had a lot of interactions.
You know, when you're over there, there's still lots of activity. There's lots of things that are going on, and the economy to me doesn't look like it's in the tank.
But I think what's happened is, is that, particularly in a few industries, they had a pretty big rush of -- inrush of capital on some capacity expansion, and they just need to absorb that. So the GDP numbers still look okay, again the economy looks like it's still ticking along.
My belief is, is that the story there is still good over the longer term. And that it just -- people wish it was a straight line up, and it's not.
It's going to be choppy, and there's going to be times when they're expanding industries and putting new lines in, and then there's going to be years here or there where they're going to have to absorb that capacity through demand. And I think we're in 1 of those periods right now.
But I'm not overly negative about it, and I think if we just got a little bit of patience here, things are going to be fine. I'll let Jim give you his comments.
James A. Graner
Again, we were impressed that there are still cranes. There are office buildings going up.
There are factories going up in the industrial parks that we visited. So we think there's opportunities.
The government, it still wants to provide housing for the vast majority of the people there, and those activities are progressing. So as Pat says, we think it's a good economy, and we've been trying to make the call quarter-by-quarter here, and I think we just got burned here a couple of quarters.
So we're still optimistic on 2014.
Operator
Our next question comes from the line of John Franzreb with Sidoti & Company.
John Franzreb - Sidoti & Company, LLC
So just sticking with the Asia Pacific region, the relative underperformance there, would you attribute that mostly to what's going on in the mining market in Australia?
Patrick J. McHale
That's a piece of it. It's not just the mining market in Australia.
We've seen pockets of weakness in China and India as well in certain end markets and across certain product lines. And again, it's not an across-the-board kind of thing where every product line in China is struggling, but we do have some product lines, particularly associated with capital expansion projects that have been weak.
So I think it's more of a mixed bag than that. I don't think it's just as simple as saying it's 1 industry.
John Franzreb - Sidoti & Company, LLC
Okay. And regarding the Lube business, Pat, it seems like it's stuck at the current threshold as far as revenue's concerned.
Are there any potential catalysts that you could point to that might get that business humming again? Can you provide some color on what you think the growth opportunity is in Lube going forward?
Patrick J. McHale
Yes, again, my expectation for Lube over the next number of years is that it should be able to put up organic growth numbers that are in that 10% range. Certainly we're not doing that this year.
But the products that we've just launched that we're pretty excited about, and as I mentioned in my prepared comments, we've been working on some selling initiatives that really have a long cycle through them, and some of those appear to be gaining traction. So I haven't lost my belief that that's still 10% kind of organic growth story over the longer term both with products and with selling initiatives.
They've actually done some things that are positive this year. Unfortunately with some of the big drop-offs in our key mining accounts, it shows as flat.
So you can say, well, gee, they're stuck and haven't done anything. But on the flip side, if you take a look where the business has come from, they've added some business that have filled some holes from the mining drop-off.
So generally, although I'm not happy about them being flat, I'm satisfied with where we're at, and I'm still positive about where we're going.
John Franzreb - Sidoti & Company, LLC
So if you X-ed out the mining drop-off in Lube, would the business be performing at a higher single-digit rate?
Patrick J. McHale
You know, I haven't done that calculation, so I'm not going to comment.
Operator
Our next question comes from the line of Jim Krapfel with Morningstar.
James Krapfel - Morningstar Inc., Research Division
What gives you the optimism long term in regards to Industrial Lube? And what applications are you most excited about?
Patrick J. McHale
Well, you know that we've got a pretty broad product line now. We made a couple of small acquisitions here 6 or 7 years ago, and the product line was -- had a lot of gaps and a lot of holes that needed some quality improvement.
And we spent a lot of time getting the product line in order investing in engineering. We're now launching products that are actually incremental to that.
We've basically fixed the product offering that we have, and we're launching new things still. I like the product portfolio.
I think it's strong. I think it's going to continue to be strengthened over time and that we're going be in a real positive position from a product standpoint.
The challenge that we have in that marketplace where we have very low share is the fact that the leaders are entrenched in the specs. And to try to knock somebody out of the spec takes a lot of work and a lot of time.
And that's what we've got our focus on right now. We're focused in particular in some of the energy markets, wind energy, natural gas market.
We're doing some things in oil and gas. And I just think that the Graco model works, and that we've got patience, and we're going to grind it out.
James Krapfel - Morningstar Inc., Research Division
Okay, thanks. And then, do you expect on a firm-wide level to keep your foot on the pedal when it comes to product development spend?
And do you look at the vitality index at all?
Patrick J. McHale
I'll let Jim kick in to give you a little bit about what we do in terms of that review. But my view is our current level of spending is appropriate.
We may have some more things on the margins that we may want to invest in. But I think that the number that you see for us today, if you adjust that by wage inflation, is probably a number that we're going to be around the next couple of years.
[indiscernible] major pullback or a major expansion. Jim can talk to you about the vitality review that we do.
James A. Graner
So again, Jim, we're a cash-on-cash kind of measuring return here, so we have a process where we rate every product -- project in every group on their expected revenue growth or achieved revenue growth and the return on the investment. So we're doing a little bit more now with respect to -- rather than product refresh, we're doing more on incremental.
So we're in the process of changing our metrics to have 2 metrics. One is, I'll call the historical Graco metric on product refresh, where we measure product growth over a 3-year cycle, and as compared to Incremental Products.
And we're thinking we're going to change that to a 6-year kind of measure. So once we've got that completed, you'll see our vitality measures be a little bit different than we've been in the past.
Operator
[Operator Instructions] Our next question comes from the line of Liam Burke with Janney Montgomery Scott.
Liam D. Burke - Janney Montgomery Scott LLC, Research Division
Pat, in the Industrial segment, you mentioned that you saw a growth order increase in the Powder Coatings business or the Powder Coatings product line. How has that done in Asia Pacific?
Have we got any traction there?
James A. Graner
So I think the comment was with respect to EMEA where we had growth in the West in Powder. We're seeing similar kinds of things this year.
In the first half, we had some I'll say greater growth in the U.S., building off of what I'll say is our weaker position in the U.S. So we're pleased with that activity.
And also, we've got some projects in backlog in Asia Pacific that we should get some revenue recognition in the fourth quarter. So I would say our geographic mix is changing from when we acquired the business.
More growth in the U.S. and more growth in Asia Pacific.
And the comment Pat made earlier was really with respect to the mix within the EMEA region.
Liam D. Burke - Janney Montgomery Scott LLC, Research Division
Okay. And on the Sanitary front, I know it's a small part of the Industrial business, but one of your growth engines.
How is that progressing? Is it -- are you comfortable with how it's been developing?
Patrick J. McHale
Yes, we're really happy with how that's progressing, both from a product portfolio standpoint and trying to build some specific channel. Our -- I'll say our normal process distributors don't necessarily get into those accounts.
And so, part of what we're doing is trying to build a channel out there worldwide of distributors that actually call on the Sanitary end customers as part of their normal business model. Growth is good and, again, it's still small, but we're pleased with that.
Also from an M&A perspective, that is one of the, I'll call it, segments that we would be interested in doing a deal if we could find the right one.
Operator
Our next question comes from the line of Kevin Maczka with the BB&T Capital Markets.
Kevin R. Maczka - BB&T Capital Markets, Research Division
Pat, back to your comment on adding resources in Asia and South America. It sounds like your product development spend is appropriate.
I don't think you've really been capacity-constrained anywhere, and Asia Pac is not going right now. Can you say a little bit more about what you need to do to position yourself for the next few years in Asia and South America?
Patrick J. McHale
You know, we're not ill-positioned in Asia Pacific by any stretch of the imagination. But it is a pretty big geography, and we've got a lot of product lines.
And 1 of our goals is try to continue to specialize so that we can have people that are deep in product categories and have them setting up channel partners that are also deep in those categories, versus trying to have somebody carry a broad product offering and have it distributed. It does the same thing.
So the additions that I can envision for Asia Pacific in terms of sales resources in 2014 tend to be a support that specialization initiative. South America is a little bit different.
We've covered that sort of as an export market out of the U.S. with U.S.
leadership for a long time. Effective January 1, we took a couple of our strong, high-performing folks and put them down in country from our European organization down into South America.
And we've given them the charter to go ahead and invest more heavily down there, and let's try to get higher level of growth. So they've been doing their work the last 9 or 10 months to understand the market and our coverage and our opportunities.
And they've got fairly aggressive plans in 2014 to get us more sales coverage down there. So I anticipate that we'll be adding some people as well.
So when I talk about resources in Asia and South America, I'm really talking about salespeople.
Operator
We have a follow-up question from the line of Matt Summerville with KeyBanc.
Matt J. Summerville - KeyBanc Capital Markets Inc., Research Division
I just want to make sure I understand something. So you -- Pat, you were talking about incoming order rates, or Jim maybe, in the first couple weeks of October, referenced July and August, talked about a pickup in industrial kind of offsetting the typical negative seasonality you have in Contractor.
I guess I want to be sure of something. So are you expecting that step-up you're seeing in industry completely offsets the normal kind of fourth quarter seasonality?
James A. Graner
No, not really, Matt. It's just, I'll say, a slight positive on the Industrial business.
And then on EMEA, the sequential on Asia was pretty flat. But there was a pickup on EMEA and a pickup in the Industrial.
Matt J. Summerville - KeyBanc Capital Markets Inc., Research Division
So we're seeing Europe on the Industrial side. Are there certain end markets that are driving that, or is this something that you're seeing more broad-based?
Is this projects that were deferred that are now starting to hit the order book?
James A. Graner
I'll say it's a modest improvement on a broad base of our product offering. And there's some things happening in the Middle East from -- that probably are spiking the current activity for the last few weeks.
As that -- those economies or those governments get calmed down a little bit. That I can't really pinpoint any specific thing that's happening in the -- any industry.
Operator
Our next question is from the line of Jim Giannakouros from Oppenheimer & Co.
James Giannakouros - Oppenheimer & Co. Inc., Research Division
I just have 1 question on industrial margins, and I'm sorry if I missed all the puts and takes. But when you entered, I guess after 1Q '13 we had a 33.5 operating margin.
And I believe this ends with that we could -- you guys could do maybe slightly better or hold that line for the remainder the year. We've been trending down for the last 2 quarters.
Outside of Asia Pac Industrial volumes being lower than expected, what do you attribute to that decline, and how should we be thinking about what your, I guess, when volumes normalize in Asia Pac industrial, where you think things will source out [ph] in the near term there?
James A. Graner
So Jim, I did a little reconciliation. I'll take you through that, and then we'll talk about what I think is a quick change in the next quarter.
So again, your comparison to the first quarter is what I did. The third -- I compared the third quarter to the first quarter.
So in the Industrial segment, our sales were down about $7.5 million third versus first. And if you take that at our normal gross profit rate in the Industrial segment, that represents about 1.2 percentage points decline in operating profit.
ForEx, specifically in Asia Pac, has been a headwind since the first quarter. That represents about 4/10 of a percentage point decline.
And lastly, we had some volume and spending impact through our factories here in the third quarter that we didn't have in the first quarter that reduced our margins about 1 percentage -- 1 full percentage point. So on those, on ForEx, you know, the euro is strengthening, and I think ForEx could be a little bit of a tailwind for us in the fourth quarter, specifically on the euro.
The spending issue shouldn't repeat in the factory to the extent that it did. And then hopefully, the volumes come back replacing that $7.5 million, and the volumes through our factory come up as a result.
So none of what we're talking about is a permanent change in the operating profitability of that segment. They're volume-related and currency-related.
James Giannakouros - Oppenheimer & Co. Inc., Research Division
That's very helpful. And one follow up, if I may.
You've mentioned we're waiting or anticipating a migration to higher-margin equipment in Contractor. Can you put some numbers to how higher margin are we talking about versus segment average for that type of equipment?
And I believe you sized it somewhere in the $80 million or so in sales versus previous peak that is, I guess, waiting to happen when we get further into the housing cycle.
James A. Graner
As we introduce more products, and we introduce more products, I'll call them, in the lower price point in that segment, we're going to have a little distraction from where we were historically. So the -- If we talk specifically to the $80 million in the higher end proportion of those units, we should see, if everything else was flat eventually, a 200- or 300 basis-point improvement in the segment margins.
If we continue to get nice volumes of the lower-end units through both the Paint and Home Center channel, we may not get there at the level that you see it. It'll be there, but it'll be masked by these profits on these, I'll call them, lower-priced units.
Operator
Our next question comes from the line of Walt Liptak with Global Hunter Securities.
Walter S. Liptak - Global Hunter Securities, LLC, Research Division
I want to ask about -- most of my questions have been answered already. But I wanted to just ask kind of a 2014 number on incremental margin.
You pointed out early on in the commentary the very nice 50% incremental margins. And I wonder if you could just provide some color, generally, about what's happening at the factories in terms of that.
Is it sustainable? And maybe the profitability of the Powder business, and how that -- whatever cost-out programs or improvement that you're doing or going.
James A. Graner
So again, we've been guiding for a few quarters here that, on the long term, you should be looking at a 35% to 45% incremental margin depending upon whether the growth comes in the Industrial or the other 2 segments. We still feel that that's the right range.
Of course, for all of our product lines, we're looking at improving costs. We've got some price increases planned for 2014.
Our factory plans are lining up again for zero cost change. In Powder, we've got some initiatives that may get us a little bit better performance on that.
So again, overall, we feel solid about our business model. We feel solid about our incremental margins.
But as you could see on our Industrial segment, when you lose $8 million in revenue a quarter, it cuts the other way as well. But we're pleased with the 50% we got this quarter, and we guide you a little bit lower if you're looking at 2014.
Walter S. Liptak - Global Hunter Securities, LLC, Research Division
Okay, got it. And I wanted to ask too about the -- and see if this works in terms of a question.
But industrial CapEx has been sort of constrained this year. There's a lot of sectors that have been down.
And I wonder, with things starting to pick up, the ISM industrial production, do you ever see CapEx budgets coming through in the fourth quarter, especially in the industrial side that might provide for a lift in revenue in the fourth?
Patrick J. McHale
There are certain customers out there that do have sort of a history of fourth quarter CapEx coming through. From what I'm picking up, for most of my team, I don't anticipate anything big in the fourth quarter.
Like all of a sudden, 2013 pent-up demand is just going to bust loose in the fourth quarter. I'm anticipating that the uptick in capital in fourth quarter, should we see one, will be more in line with what you might expect to see in any normal year and not a release of pent-up demand.
I just don't see the pent-up demand at this point for cap spending.
Operator
If there are no further questions, I will now turn the conference over to Mr. Pat McHale.
Please go ahead, sir.
Patrick J. McHale
All right. Well, thank you for joining us this morning.
And have a good day.
Operator
This concludes our conference for today. Thank you for all your participation, and have a nice day.
All parties will now disconnect.