Graco : 3rd QUARTER 2020 EARNINGS CONFERENCE CALL (Transcript)

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EDITED TRANSCRIPT

Q3 2020 Graco Inc Earnings Call

EVENT DATE/TIME: OCTOBER 22, 2020 / 3:00PM GMT

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OCTOBER 22, 2020 / 3:00PM GMT, Q3 2020 Graco Inc Earnings Call

CORPORATE PARTICIPANTS

Kathryn L. Schoenrock Graco Inc. - Executive VP, Corporate Controller & Principal Accounting Officer

Mark W. Sheahan Graco Inc. - CFO & Treasurer

Patrick J. McHale Graco Inc. - President, CEO & Director

CONFERENCE CALL PARTICIPANTS

Andrew Edouard Buscaglia Joh. Berenberg, Gossler & Co. KG, Research Division - Analyst Brett Kearney G. Research, LLC - Research Analyst

Bryan Francis Blair Oppenheimer & Co. Inc., Research Division - Director & Senior Analyst

Deane Michael Dray RBC Capital Markets, Research Division - MD of Multi-Industry & Electrical Equipment & Analyst Jeffrey David Hammond KeyBanc Capital Markets Inc., Research Division - MD & Equity Research Analyst

Joseph Alfred Ritchie Goldman Sachs Group, Inc., Research Division - VP & Lead Multi-Industry Analyst Matt J. Summerville D.A. Davidson & Co., Research Division - MD & Senior Analyst

Michael Patrick Halloran Robert W. Baird & Co. Incorporated, Research Division - Associate Director of Research & Senior Research Analyst

Saree Emily Boroditsky Jefferies LLC, Research Division - Equity Analyst

Walter Scott Liptak Seaport Global Securities LLC, Research Division - MD & Senior Industrials Analyst

PRESENTATION

Operator

Good morning, and welcome to the third quarter conference call for Graco Inc. If you wish to access the replay for this call, may be so by doing 1 [phone] within the United States or Canada. The dial-in number for international callers is [phone]. The conference ID number is 8334616. The replay will be available through 1:00 p.m. Eastern Time, Wednesday, October 28, 2020.

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 up 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 2019 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 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 Kathy Schoenrock, Executive Vice President, Corporate Controller.

Kathryn L. Schoenrock Graco Inc. - Executive VP, Corporate Controller & Principal Accounting Officer

Good morning. I'm here today with Pat McHale and Mark Sheahan. Our conference call slides have been posted on our website and provide additional information that may be helpful.

Sales totaled $439 million for the third quarter, an increase of 10% from the third quarter last year and an increase of 9% at consistent currency translation rates. Acquisitions added 1 percentage point of growth in the quarter. Net earnings totaled $114 million for the quarter or $0.66 per diluted share. After adjusting for the impact of excess tax benefits from stock option exercises and other nonrecurring tax items, net earnings totaled $102 million or $0.59 per diluted share.

The sale of the company's U.K.-based valve business, Alco, was finalized in July of 2020. Impairment charges totaled $300,000 in the quarter and $35.2 million year-to-date. No additional impairment charges are expected from the sale.

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OCTOBER 22, 2020 / 3:00PM GMT, Q3 2020 Graco Inc Earnings Call

Our gross margin rate was up slightly compared to the third quarter last year. Improved factory volumes, lower material cost, the favorable impact of currency and realized pricing more than offset the unfavorable effect of product and channel mix, as sales in the Contractor segment increased, while sales in the Industrial and Process segments declined.

Given the growth in certain products in the Contractor segment, particularly products for the home center channel, factory capacity is strained. We've managed the increase in demand levels by investing in additional production lines, moving employees from other factories, increasing contract labor and working overtime. We are making progress towards meeting current demand levels and continue to monitor the situation closely.

Operating expenses in the quarter were comparable to the third quarter last year as reductions in volume and earnings based expenses offset higher product development costs. The reported tax rate was 6% for the quarter, down 7 percentage points from last year. On an adjusted basis, the rate in the quarter was 16% as compared to 20% in the first half of 2020. The decrease in the rate from the first half is due to the impact of lower foreign earnings and earnings in countries with lower tax rates than the U.S. rate.

Excluding the effects from excess tax benefits related to stock option exercises and other onetime items, our tax rate is expected to be 18% to 19% for both the fourth quarter and the full year.

Cash flow from operations totaled $263 million year-to-date as compared to $299 million last year, primarily due to lower operating earnings and increases in working capital. Capital expenditures totaled $46 million year-to-date as we continue to invest in manufacturing capabilities as well as the expansion of several locations. For the full year 2020, capital expenditures are expected to be approximately $85 million, including approximately $50 million for facility expansion projects.

A few final comments looking forward to the rest of the year. On Page 11 of our slide deck, we note our 6-week booking average through October 16 by segment. I would point out that there is an inherent volatility in order rates reflected in such a short period of time. Nonetheless, we thought it would be helpful to provide current order rate data, so you can see what we are experiencing heading into the fourth quarter.

Similar to the last 2 quarters, our Industrial and Process businesses are still experiencing declines from a year ago, although less severe than they were in Q2, while our Contractor business remains strong.

As the U.S. dollar continues to weaken, the effect of currency translation will continue to be favorable. At current rates, the impact would have been negligible on sales and earnings for the full year and have a favorable impact to the fourth quarter of approximately 2% on sales and 3% on earnings assuming the same mix of business as the prior year.

I'll turn the call over to Pat now for further comments.

Patrick J. McHale Graco Inc. - President, CEO & Director

Thank you, Kathy. Good morning, everyone. All of my comments this morning will be on an organic constant currency basis. Despite the unusual operating environment, we achieved record quarterly sales, driven by the strength of the North American construction market and a gradually improving Asia Pacific region.

The Contractor segment single-handedly accounted for the company's sales growth for the quarter. I want to thank our employees who've been working tirelessly to meet this unprecedented demand, a special thanks to the management, shop floor and temporary employees who have been working incredibly long hours, along with all the employees from other Graco factories who relocated to the Contractor factory to assist. It's been Graco team work on full display.

Contractor grew in all regions during the quarter as customers have responded favorably to our new product offerings, residential construction activity has been solid and the home improvement market has been robust.

The Industrial segment declined low single digits for the quarter, although improved from Q2, business activity remains muted across

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OCTOBER 22, 2020 / 3:00PM GMT, Q3 2020 Graco Inc Earnings Call

most of our major end markets. Access to Industrial facilities is limited, factory demand in many industries remains well below last year and appetite for capital spending is constrained. Some specific areas showing signs of life, such as spray foam, electronics and battery, aren't large enough to offset declines elsewhere.

Asia Pacific improved during the quarter, although it was up against an easier comp from last year, as you'll recall, that Industrial demand softened in the second half of 2019. Reduced spending on travel, sound discretionary expense management, good factory performance and solid price realization resulted in improved Industrial operating earnings for the quarter despite the lower sales.

The Process segment declined low teens for the quarter and for the year. Demand in this segment varies significantly by end market with growth in our semiconductor and environmental businesses, more than offset by declines in our diaphragm pump and lubrication businesses.

While it's difficult to predict near-term economic conditions, we expect things to remain challenging for the short term. As we've done throughout 2020 and through prior downturns, we intend to continue to fully execute against our strategies. We're full steam ahead on our new product development initiatives, continue to make solid ROI capital investments in our factories, are adding channel globally and are focused on finding profitable growth opportunities in attractive niche markets, whether organically or by acquisition.

We've kept our workforce intact, morale is good, and we expect to do well as economic conditions improve.

Operator, we're ready for questions.

QUESTIONS AND ANSWERS

Operator

(Operator Instructions)

Our first question comes from Deane Dray with RBC Capital Markets.

Deane Michael Dray RBC Capital Markets, Research Division - MD of Multi-Industry & Electrical Equipment & Analyst

Just to start off with an observation that Graco's concentration of manufacturing purposely in Minnesota as opposed to spread all over the globe, like many of your manufacturing counterparts, really gives you the option and the flexibility this quarter as you've explained that you shifted employees around. So I really like seeing that.

But here's the question. What's your take on the monthly -- the cadence of monthly slowing? Is this segment volatility? Are there comps issues? Because we've been seeing a steady -- within the Industrials monthly improvement, but there's a bit of slowing in your numbers here. I'd love to get some context.

Patrick J. McHale Graco Inc. - President, CEO & Director

So I wouldn't read too much into it. As we've talked about in the past, we have variability even quarter-to-quarter in our Industrial business as we've got a fair number of projects that can influence the timing of sales and the timing of incoming orders. I think it's more just reflective of the fact that you should be thinking that the industrial activity is still challenging and that going into the fourth quarter, we're not seeing the kind of strong rebound in industrial like we're seeing -- like we saw in our Contractor business here in Q2.

Deane Michael Dray RBC Capital Markets, Research Division - MD of Multi-Industry & Electrical Equipment & Analyst

That's helpful. Just on that point, what's your expectation of this contractor strength? I mean, we really have seen this work from home, work on home mega trend but can you address the sustainability of this?

And then the 2021 outlook in terms of new product introductions, are you still going to do your pricing increase? Typically, you would get that in the first quarter, but some color there would be helpful.

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