Graco Inc: Form 10-Q for the period ended Jun 30, 2023

MANAGEMENT'S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

The Company supplies technology and expertise for the management of fluids and coatings in both industrial and commercial applications. It designs, manufactures and markets systems and equipment to move, measure, control, dispense and spray fluid and coating materials. Management classifies the Company’s business into three reportable segments: Contractor, Industrial and Process. Key strategies include developing and marketing new products, leveraging products and technologies into additional, growing end-user markets, expanding distribution globally and completing strategic acquisitions that provide additional channel and technologies.

The Company continued to experience supply chain disruptions and the associated effects of inflation in the first half of 2023; however, the impact was not as significant as compared to the same period in the prior year. Pricing actions implemented have generally mitigated the effects of increased costs and expenses. The Company expects isolated supply chain disruptions and an overall inflationary environment to continue through the remainder of 2023.

The following Management’s Discussion and Analysis reviews significant factors affecting the Company’s results of operations and financial condition. This discussion should be read in conjunction with the financial statements and the accompanying notes to the financial statements.

Consolidated Results

A summary of financial results follows (in millions except per share amounts):

(1) See below for a reconciliation of adjusted non-GAAP financial measures to GAAP.

Sales increased 2 percent for the quarter. Strong growth in the Process segment more than offset a decrease in the Contractor segment. Sales increases in the Americas and EMEA were partially offset by a decrease in Asia Pacific. Changes in currency translation rates decreased sales and net earnings by approximately $3 million and $2 million, for the quarter and $14 million and $8 million for the year to date, respectively.

Gross profit margin rate for the quarter was more than 3 percentage points higher than the second quarter last year mainly due to the realized pricing and favorable product and channel mix.

Total operating expenses increased 12 percentage points and increased as a percentage of sales by 2 percentage points.

Excluding the impact of excess tax benefits related to stock option exercises presents a more consistent basis for comparison of financial results. A calculation of the non-GAAP measurements of adjusted income taxes, effective income tax rates, net earnings and diluted earnings per share follows (in millions except per share amounts):

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The following table presents an overview of components of net earnings as a percentage of net sales:

Net Sales

The following table presents net sales by geographic region (in millions):

(1) North, South and Central America, including the United States

(2) Europe, Middle East and Africa

The following table presents the components of net sales change by geographic region:

Gross Profit

Gross profit margin rates for the quarter and year to date increased approximately 3 percentage points from the comparable periods last year. Strong price realization and favorable product and channel mix more than offset higher product costs.

Operating Expenses

Total operating expenses for the quarter increased $14 million (12 percent) from the comparable period last year. The increase includes $4 million of incremental share-based compensation and $3 million of increased spending related to product development and other growth initiatives. Total operating expenses for the year to date increased $16 million (7 percent) from the comparable period last year. Volume and rate-related increases, higher product development spending and incremental share-based compensation accounted for most of the increase. Partially offsetting the year-to-date increase were $3 million of credit losses on customer receivables in Russia in the prior year that did not repeat and $2 million from favorable changes in currency translation rates.

Interest and Other (Income) Expense

Interest expense was flat for the quarter and for the year to date decreased $4 million as private placement debt was repaid in the first quarter last year. Other non-operating expenses decreased $5 million for the quarter and $7 million for the year-to-date mostly due to increased interest income and favorable market valuation changes on investments held to fund certain retirement benefits.

Income Taxes

The effective income tax rate was 16 percent for the quarter and 17 percent for the year to date, down 4 percentage points and 2 percentage points, respectively, from the comparable periods last year, primarily due to increases in excess tax benefits from stock option exercises.

Segment Results

Certain measurements of segment operations compared to last year are summarized below:

Contractor Segment

The following table presents net sales and operating earnings as a percentage of sales for the Contractor segment

(dollars in millions):

The following table presents the components of net sales change by geographic region for the Contractor segment:

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Slower economic activity in construction markets in the Americas and Asia Pacific drove Contractor segment sales down 4 percent for the quarter. For the year to date, favorable response to new product offerings and improved product availability were able to offset reduced demand. Operating margin rates for the quarter and year to date increased 1 percentage point and 3 percentage points, respectively, as price realization and favorable product and channel mix more than offset higher product costs and increased spending on product development and growth initiatives.

Industrial Segment

The following table presents net sales and operating earnings as a percentage of sales for the Industrial segment

(dollars in millions):

The following table presents the components of net sales change by geographic region for the Industrial segment:

Sales growth in the Americas and EMEA for the quarter and year to date was partially offset by weakness in Asia Pacific, where declines in finishing system sales and other project activity continued. The unfavorable effects of currency translation drove a 1 percentage point decrease in the operating margin rate for the quarter and year to date.

Process Segment

The following table presents net sales and operating earnings as a percentage of sales for the Process segment

(dollars in millions):

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The following table presents the components of net sales change by geographic region for the Process segment:

Double-digit sales growth continued in the Process segment for the quarter and year to date from the comparable periods last year. Sales growth for the quarter and year to date was particularly strong in the automatic lubrication, vehicle service and semiconductor product applications. The operating margin rate for this segment increased 6 percentage points for the quarter and 7 percentage points year to date from the comparable periods last year primarily due to price realization and expense leverage.

Liquidity and Capital Resources

Net cash provided by operating activities of $282 million increased $147 million compared to the first half of last year, mostly driven by higher net earnings, decreased inventory purchases and lower salary and incentive payments. Inventory purchases were lower in the first six months of 2023 compared to the same period last year as logistical and production constraints from disruptions in the supply chain improved. Increases in accounts receivable reflect growth in business activity in the first half of 2023. Significant uses of cash in 2023 included plant and equipment additions of $92 million and dividend payments of $79 million. Net proceeds from shares issued in 2023 totaled $52 million, which was partially offset by share repurchases of $8 million.

In 2022, significant uses of cash included share repurchases of $120 million, plant and equipment additions of $89 million, long-term debt payments of $75 million, dividend payments of $71 million, and $25 million to acquire businesses that were not material to the consolidated financial statements. Proceeds from shares issued in 2022 totaled $23 million.

As of June 30, 2023, the Company had available liquidity of $1,280 million, including cash and cash equivalents of $521 million, of which $206 million was held outside of the U.S., and available credit under existing committed credit facilities of $759 million.

Cash balances and unused financing sources are expected to provide the Company with the flexibility to meet its liquidity needs in 2023, including its capital expenditure plan, planned dividends, share repurchases, acquisitions and operating requirements. Capital expenditures for 2023 are expected to be approximately $200 million, including $130 million in facility expansion projects. The Company may make opportunistic share repurchases going forward.

Outlook

Incoming order rates are in line with the Company's expectations of revenue growth for the full year of low single-digits on an organic, constant currency basis.

Cautionary Statement Regarding Forward-Looking Statements

The Company desires to take advantage of the “safe harbor” provisions regarding forward-looking statements of the Private Securities Litigation Reform Act of 1995 and is filing this Cautionary Statement in order to do so. From time to time various forms filed by our Company with the Securities and Exchange Commission, including our Form 10-K, Form 10-Qs and Form 8-Ks, and other disclosures, including our 2022 Overview report, press releases, earnings releases, analyst briefings, conference calls and other written documents or oral statements released by our Company, may contain forward-looking statements. Forward-looking statements generally use words such as “expect,” “foresee,” “anticipate,” “believe,” “project,” “should,” “estimate,” “will,” and similar expressions, and reflect our Company’s expectations concerning the future. All forecasts and projections are forward-looking statements. Forward-looking statements are based upon currently available information, but various risks and uncertainties may cause our Company’s actual results to differ materially from those expressed in these statements. The Company undertakes no obligation to update these statements in light of new information or future events.

Future results could differ materially from those expressed due to the impact of changes in various factors. These risk factors include, but are not limited to: the impact of the COVID-19 pandemic on our business; Russia's invasion of Ukraine, and the sanctions and actions taken against Russia and Belarus in response to the invasion; economic conditions in the United States and other major world economies; our Company’s growth strategies, which include making acquisitions, investing in new products, expanding geographically and targeting new industries; changes in currency translation rates; the ability to meet our customers’ needs and changes in product demand; supply interruptions or delays; security breaches; new entrants who copy our products or infringe on our intellectual property; risks incident to conducting business internationally; catastrophic events; changes in laws and regulations; compliance with anti-corruption and trade laws; changes in tax rates or the adoption of new tax legislation; the possibility of asset impairments if acquired businesses do not meet performance expectations; political instability; results of and costs associated with litigation, administrative proceedings and regulatory reviews incident to our business; our ability to attract, develop and retain qualified personnel; the possibility of decline in purchases from a few large customers of the Contractor segment; variations in activity in the construction, automotive, mining and oil and natural gas industries; and the impact of declines in interest rates, asset values and investment returns on pension costs and required pension contributions. Please refer to Item 1A of our Annual Report on Form 10-K for fiscal year 2022 and Item 1A of this Form 10-Q for a more comprehensive discussion of these and other risk factors. These reports are available on the Company’s website at www.graco.com (http://www.graco.com) and the Securities and Exchange Commission’s website at www.sec.gov (http://www.sec.gov). Shareholders, potential investors and other readers are urged to consider these factors in evaluating forward-looking statements and are cautioned not to place undue reliance on such forward-looking statements.

Investors should realize that factors other than those identified above and in Item 1A might prove important to the Company’s future results. It is not possible for management to identify each and every factor that may have an impact on the Company’s operations in the future as new factors can develop from time to time.

There have been no material changes related to market risk from the disclosures made in the Company’s 2022 Annual Report on Form 10-K.

Evaluation of disclosure controls and procedures

As of the end of the fiscal quarter covered by this report, the Company carried out an evaluation of the effectiveness of the design and operation of its disclosure controls and procedures. This evaluation was done under the supervision and with the participation of the Company’s President and Chief Executive Officer and the Chief Financial Officer and Treasurer. Based upon that evaluation, the Company's President and Chief Executive Officer and the Chief Financial Officer and Treasurer concluded that the Company’s disclosure controls and procedures are effective.

Changes in internal controls

During the quarter, there was no change in the Company’s internal control over financial reporting that has materially affected or is reasonably likely to materially affect the Company’s internal control over financial reporting.

PART IIOTHER INFORMATION

There have been no material changes to the Company’s risk factors from those disclosed in the Company’s 2022 Annual Report on Form 10-K.