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Graco Inc  (NYSE:GGG)
Q3 2018 Earnings Conference Call
Oct. 25, 2018, 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day, and welcome to the Graco Incorporated Third Quarter 2018 Earnings Conference call. Today's conference is being recorded.

And at this time, I'd like to turn today's call over to Ms. Caroline Chambers. Please go ahead, ma'am.

Caroline M. Chambers -- Executive Vice President, Corporate Controller and Information Systems

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

We saw sales growth this quarter in all segments and regions with an increase of 10% from the prior year, including 3 percentage points of growth from acquisitions. Reported net earnings totaled $93 million in the third quarter or $0.54 per diluted share. After adjusting for the impact of excess tax benefits from stock option exercises and the non-recurring tax benefit related to the $40 million pension contribution made in the third quarter, net earnings totaled $86 million or $0.50 per diluted share.

Unfavorable currency translation reduced operating earnings by approximately $2 million and exchange losses on net assets of foreign operations also increased other expense by $2 million. Overall, a headwind of $4 million on pre-tax earnings this quarter.

Gross margin rates remained strong, though slightly lower than the third quarter last year due to lower margin rates of acquired operations. Pricing continued to offset material price increases this quarter. Channel mix was unfavorable in the Contractor segment. While tariffs did not significantly affect gross margin rates during the third quarter, we expect to see an acceleration of tariff-related cost increases, which could have an effect of 50 basis points to 75 basis points on gross margin rates in the fourth quarter of 2018. There are a lot of moving pieces and we are working closely with our supply chain to minimize the overall tariff costs for Graco.

Looking into 2019, we expect that pricing will fully offset the dollar value of tariffs. The gross margin rates as a percentage of sales could be slightly lower. Our factories are performing well, and our year-in year-out continuous improvement projects will continue to provide opportunities to improve efficiencies and manage costs.

Operating expense increased by $4 million compared to the third quarter of last year, including $1 million from acquired operations. Our as reported tax rate was 14%, down 7.5 percentage points from the third quarter of last year. Adjusted to exclude the impact of excess tax benefits related to stock option exercises and the non-recurring tax benefit related to the third quarter pension contribution, the effective income tax rate was approximately 21% in the third quarter or 10 percentage points lower than last year, primarily due to the net effects of U.S. federal income tax reform.

Cash operations (ph) from operations totaled $254 million year-to-date 2018 compared to $246 million year-to-date last year. Share repurchases, net of shares issued, totaled $148 million through the third quarter, so we have been making opportunistic share repurchases in the fourth quarter. Capital expenditures totaled $40 million year-to-date 2018. We expect usual capital expenditures for machinery and equipment of approximately $35 million for the full year.

Our current estimate for building projects to increase production and distribution capacity is expected to be approximately $40 million this year as various projects move along. An additional $100 million to $120 million is expected to be invested in building projects over 2019 and 2020. Unallocated corporate expense is expected to be approximately $27 million for the full year in 2018.

Our expected tax rate for the fourth quarter is approximately 21%, and for the full year, we expect approximately a rate of 20%, excluding any effect from excess tax benefits related to stock option exercises or other one-time items.

I'll turn the call over to Pat now for further segment and regional discussion.

Patrick J. McHale -- President and Chief Executive Officer

Thank you, Caroline. Good morning, everyone. All of my comments this morning are on an organic constant currency basis. Caroline has covered the details on our third quarter and nine-month earnings adjustments. So, any references to profitability will be on an as adjusted basis.

The macro environment continued to provide growth opportunities in Q3, and despite tough comparisons, we delivered a good quarter with solid organic revenue growth, margin expansion, double-digit earnings growth and solid cash flow generation.

Some color around the segments. The Industrial segment delivered mid single-digit growth in the quarter against difficult comp from Q3 of last year where we had double-digit growth. As expected, there was an increase in finishing systems sales and project activity in the quarter. Business remains consistent with our full-year outlook for 2018.

The Process segment delivered double-digit growth in the quarter. Demand continues to be broad-based and favorable across most of our end markets.

The Contractor segment delivered mid single-digit growth in the quarter against a tough comp of high-teens single -- excuse me, high-teens double-digit growth in the third quarter of last year. There was significant variability between geographies, so I'll make a few additional comments on Contractor by geography.

In the Americas, Contractor sales were up 8%, fairly consistent with year-to-date results. Out-the-door sales in both the paint store and home center channels remains robust.

In EMEA, the Contractor business was up against a huge Q3 of last year, where sales were up nearly 30%. Despite the tough comps, Contractor EMEA was able to post slight growth with good growth in Western Europe, largely offset by significant declines in emerging countries.

Asia Pacific Contractor was down for the quarter and although up year-to-date, this continues our trend of inconsistent revenue performance for Contractor in that region.

Now, I'll make some comments on overall regional performance. EMEA delivered low single-digit growth with solid double-digit gains in our Process segment, offset by sluggishness in the Industrial and Contractor segments. Western Europe has outperformed the emerging countries this year, a trend we expect will continue for the near-term. Africa, Turkey and the Gulf States have been particularly weak.

In Asia Pacific, we delivered double-digit growth with the Industrial and Process segments leading the way. Demand in the region remained strong and end markets appear stable. The Americas had high single-digit growth in the quarter with growth in every segment. The economic conditions in North America remain broadly favorable, while South and Central America are a drag in our results.

A few comments about profitability. Sales growth and expense control produced positive leverage in worldwide operating earnings. Our incremental margins, excluding acquisitions, were 50% in the quarter and 40% year-to-date. Margin performance in the Contractor segment was challenged due primarily to unfavorable product mix with higher growth coming from our lower-priced, lower-margin products, as well as a significant planned increase in product development spending. We anticipate this higher rate of new product spending will continue through Q4 as we get ready for 2019 product launches.

Moving on to our outlook, incoming order rates across the segments continue to look good as we head into the next quarter. We confirm our full-year outlook of mid to high single-digit organic sales growth on a constant currency basis for the full year 2018. While we expect to face headwinds from tariffs, material costs and currency translation in the fourth quarter, I believe we are well positioned to deliver another year of record sales and earnings in 2018.

In closing, I want to say thank you to all of our employees, suppliers, channel partners, and end users for another good quarter.

Operator, we're ready for questions.

Questions and Answers:

Operator

Thank you. At this time, we would like to open the floor for questions. (Operator Instructions) Our first question will be from Deane Dray with RBC Capital Markets.

Deane Dray -- RBC Capital Markets -- Analyst

Thanks. Good morning, everyone.

Patrick J. McHale -- President and Chief Executive Officer

Good morning, Deane.

Caroline M. Chambers -- Executive Vice President, Corporate Controller and Information Systems

Good morning.

Deane Dray -- RBC Capital Markets -- Analyst

Hey, maybe we can start with pricing because that was one of the sensitive spots last quarter, where you were consciously holding off on not disrupting the Contractor channel. And it sounds like this quarter, you're talking about the ability to put through price and that's on track. So, maybe just talk about how that decision came about and the timing of price increases and how much do you expect to realize?

Patrick J. McHale -- President and Chief Executive Officer

Yes, Deane. Yes, we don't view it as a sensitive topic. We've got our tempo for our price increases and we do those on an annual basis. It's disruptive to our channel put through mid-year price increases, and we have continued to be focused on making sure that we put our price increase through in the early part of 2019 as we would have normally planned.

Deane Dray -- RBC Capital Markets -- Analyst

And any pushback on that in terms of how much you expect to stick? And did you quantify the pricing for the quarter? What you expect to get for the year?

Patrick J. McHale -- President and Chief Executive Officer

Any color there would be helpful.Yes. So, normally, we realize 1.5 points to 2 points on price on an annualized basis. We anticipate that we'll have to get a little bit more going into next year due to the fact that we've got the pressure on tariffs, but we anticipate that we'll cover the dollar value of the increase in tariffs and material costs with pricing in 2019.

Deane Dray -- RBC Capital Markets -- Analyst

Got it. And we appreciate the precision on the gross margin pressure in the fourth quarter, the 50 basis points to 75 basis points. Is there any way you can separate out how those impact each, the tariffs, material costs and FX? That would be helpful.

Patrick J. McHale -- President and Chief Executive Officer

Yes, Deane. That's mostly just our best guess at this point. A lot of things happen over the course of the quarter that can affect those numbers that could be higher or lower, but it's the order of magnitude, so you can throw it into your model. We've got manufacturing opportunities to make improvements. We're working with our supply chain to hold off impacts as long as we can. So, it's hard to say. We didn't see a lot in the third quarter. We're anticipating that it's coming, so we gave you a number.

Deane Dray -- RBC Capital Markets -- Analyst

Got it. I appreciate it. Just last one on Contractor, maybe some color in APAC, what some of the dynamics in the quarter were there, please?

Patrick J. McHale -- President and Chief Executive Officer

Yes, it was just down. That was primarily a China issue. We had other countries where we did well. And, again, it's not different than the struggles we've had the last few years, in getting consistent growth particularly out of China. We've been up and down quarter to quarter. We'd like to see some consistency there but, unfortunately yet we haven't.

Deane Dray -- RBC Capital Markets -- Analyst

It's probably -- I could figure the answer, but since everyone is getting asked, is this related at all to just slowing in China, slower demand, or is this more product line specific and timing and channel and so forth?

Patrick J. McHale -- President and Chief Executive Officer

No, I don't think that what's happened with Contractor in China has much to do with what's happening with the economy over there. That penetration rate of spray equipment in China is still pretty low. So, the opportunity for us is to convert people to use an equipment from using brush and roller. There's also the dynamic in the marketplace over there of the low-price copiers. But, again, we believe that opportunity for us remains good if we can execute, and that's what we're focused on trying to execute conversion.

Deane Dray -- RBC Capital Markets -- Analyst

Got it. Thanks for all your help.

Operator

Thank you. Our next question will be from Brett Kearney with Gabelli & Company.

Brett Kearney -- Gabelli & Company -- Analyst

Hi, guys. Good morning. Thanks for taking my question.

Patrick J. McHale -- President and Chief Executive Officer

Good morning.

Brett Kearney -- Gabelli & Company -- Analyst

Just wanted to ask on your project funnels and the project activity you're tracking, if you could provide by geography. I know you noted in the slide deck some spotty activity in the Asia Pacific region, but overall how your project funnels are looking across the business?

Patrick J. McHale -- President and Chief Executive Officer

Yes. I think generally what we see in most of our markets is activity that's consistent with our outlook. And orders continue to be good here in the month of October. And we think that we're going to have a decent fourth quarter as our outlook would suggest.

Brett Kearney -- Gabelli & Company -- Analyst

Okay. Great. Thank you.

Operator

Thank you. Our next question will be from Jeffrey Hammond with KeyBanc.

Jeffrey Hammond -- KeyBanc Capital Markets -- Analyst

Hey. Good morning.

Patrick J. McHale -- President and Chief Executive Officer

Good morning.

Caroline M. Chambers -- Executive Vice President, Corporate Controller and Information Systems

Good morning.

Mark W. Sheahan -- Chief Financial Officer and Treasurer

Good morning.

Jeffrey Hammond -- KeyBanc Capital Markets -- Analyst

Can you just talk about our auto OE? We've been seeing some choppiness in Europe, Asia and just kind of this worry of peak auto in U.S. Just how are you seeing spending there?

Patrick J. McHale -- President and Chief Executive Officer

Yeah. I mean, the activity is OK. Obviously, you can look at the same numbers that we look at. But in general, we're still seeing investments being made and, of course, about 40% of our legacy business is parts and accessories. So, as long as volume pulls up, we're going to continue to see orders coming on that piece of the business. But in general, I'd say it's OK.

Jeffrey Hammond -- KeyBanc Capital Markets -- Analyst

Okay. And then can you dig in a little bit more about the kind of downgrading outlook in EMEA, and how long do you think that persists?

Patrick J. McHale -- President and Chief Executive Officer

Yes. You know, really, what we're seeing there is we're seeing, I'd say, not great growth in Western Europe, but certainly, the pain that we're feeling right now is coming from some of the emerging markets. Of course, South Africa has got its problems. Turkey, we're seeing declines in Turkey. Some of the countries in the Middle East, we're seeing declines. And so a little bit of tale of two stories, and then we have some concern looking forward into what may happen with Russia. We're still doing OK there.

But the team in EMEA is concerned with some of the topics going back and forth on the political front that we could see some slowdown happen in Russia. So, I'm not overly concerned about Europe. I don't view that it's getting ready to go into the tank, but I think we're slightly less positive in aggregate than we would have been here three months ago.

Jeffrey Hammond -- KeyBanc Capital Markets -- Analyst

Okay. And then just finally, it looks like mix was a headwind in Contractor. How do you think that trends into 4Q and 2019?

Patrick J. McHale -- President and Chief Executive Officer

Yes, I think, it's hard to trend that bounces around quarter to quarter depending upon which one of the channels or which segment of the product line we happen to shift more of in a particular quarter. So, again there, I view it a little bit more as noise than a trend and I'm not expecting at this point it to be something that's going to be long term. I think you'll see that move around quarter to quarter.

Jeffrey Hammond -- KeyBanc Capital Markets -- Analyst

Okay. I'll get back in queue. Thanks.

Operator

Thank you. Our next question will be from Charles Brady with SunTrust Robinson Humphrey.

Charles Brady -- SunTrust Robinson Humphrey -- Analyst

Hey. Good morning, guys.

Patrick J. McHale -- President and Chief Executive Officer

Good morning.

Charles Brady -- SunTrust Robinson Humphrey -- Analyst

Just back on the tariff question, yes, and echo, sort of appreciated the quantification there. But if we look to 2019, you've really said it was 100 basis point potential impact on tariffs in 2019. Is that number still an accurate number to go by or has that crept up a little bit? It sounds like the 2018 number has gone up, because it was 50 basis points for second half and now it's little bit higher than that. So, I'm wondering if 2019 is crept up as well?

Caroline M. Chambers -- Executive Vice President, Corporate Controller and Information Systems

Let me just give you a little color on that. Part of the reason why it's creeping up in the fourth quarter is because we had actually so little realized pricing effect in the third quarter. So we brought down our overall estimate for the second half this year.

Patrick J. McHale -- President and Chief Executive Officer

Tariff effects.

Caroline M. Chambers -- Executive Vice President, Corporate Controller and Information Systems

Tariff effects, correct. And then for 2019, it's actually about the same. It is our expectation or estimate on the actual tariff cost, but at this point, we're taking a look at our pricing, and saying dollar for dollar, we should cover it with pricing.

Charles Brady -- SunTrust Robinson Humphrey -- Analyst

Okay. That's helpful. Thanks. And I just want to switch gears, on the Process business, I mean, that was some very strong results in that. And maybe can you dive a little bit deeper about what's really driving a lot of that growth? Is it -- it means coming off, I guess, a lower year-ago comp, but it sounds -- I mean, it's pretty broad-based. I'm just trying to get a better sense of what's really driving the process growth.

Mark W. Sheahan -- Chief Financial Officer and Treasurer

Yes. We have a bunch of businesses in there and looking across all the different product categories and the segments, whether it's our classic air-operated diaphragm pump business, our lube business, some of the businesses that we've acquired, I would just say it's fairly broad-based across a lot of those product categories. And as the revenues have come up there in that segment, their margins are coming up as we had expected. So, they're over 20% now, where a year ago they were in the teens. And as long as they can continue to drive the top line, there's a lot more room there for them to improve their profitability.

Charles Brady -- SunTrust Robinson Humphrey -- Analyst

All right. Thanks. One more for me then. Just on supply chain, there's obviously some constraints in the supply chain, freight being only one of many, but I'm wondering can you just comment on what you're seeing in terms of supply chain and is that crimping any kind of shipments or how is that holding up?

Patrick J. McHale -- President and Chief Executive Officer

No, we're fine. I think we have our normal amount of production problems, but nothing unusual.

Charles Brady -- SunTrust Robinson Humphrey -- Analyst

Thanks.

Operator

Thank you. Our next question will be from Walter Liptak from Seaport Global Securities.

Walter Liptak -- Seaport Global Securities -- Analyst

Hi. Thanks. Good morning, guys.

Patrick J. McHale -- President and Chief Executive Officer

Good morning.

Mark W. Sheahan -- Chief Financial Officer and Treasurer

Good morning.

Walter Liptak -- Seaport Global Securities -- Analyst

Just a follow-up on that process question. I think some of those businesses are a little bit longer cycle. I guess, we have visibility on some things like offshore picking up or any other longer-cycle projects. What are you seeing from those?

Patrick J. McHale -- President and Chief Executive Officer

In the oil and gas sector, for us, we're still seeing more of our improvement happen on the onshore piece. But we're pretty far down the pipeline of a project before we would actually get any business on the offshore stuff, so we're probably not the right people to ask on that. And then, I would just reinforce what Mark said. The rest of the product lines within that category seemed to be generally healthy as we look around the globe.

Walter Liptak -- Seaport Global Securities -- Analyst

Okay. Good. And then, switching over to Contractor, everything looks pretty good through the end of this year. But I wonder, with interest rates coming up, if you've got any thoughts about what next year could look like, I know a lot of this is just rehab on the existing homes or that kind of work, but weakness in -- potential weakness in the housing construction markets, how do you benchmark that?

Patrick J. McHale -- President and Chief Executive Officer

So, obviously, nobody really knows. But I have seen some of the comments about concern that the housing market here may be approaching a peak. And we don't believe that, and I personally don't believe that. We've been pretty confident all along coming out of the recovery that we ought to be headed back to $1.5 million. And so, I think that there's still some runway to go. There's still some labor shortages out there. The supply of new homes still remains low. And I think that the concerns that the housing market is falling apart are premature and overblown, but that's just my opinion.

Walter Liptak -- Seaport Global Securities -- Analyst

Okay. Appreciate it. Thank you.

Operator

Thank you. Our next question will be from Matt Summerville with D.A. Davidson & Co.

Matt Summerville -- D.A. Davidson & Co. -- Analyst

Good morning. Thank you. A couple first clarifications. Can you remind us when you look at the EMEA region how much revenue is being driven by emerging markets? And then secondarily, the tariff comments you made regarding 2019, is that inclusive of the step-up that we could see beginning January 1, or do your comments not adjust for that?

Patrick J. McHale -- President and Chief Executive Officer

So I'll take the EMEA piece first. We generally don't break out the West versus East. I'll just say that they're both important. And Caroline can maybe address your 2019 tariff question again.

Caroline M. Chambers -- Executive Vice President, Corporate Controller and Information Systems

So, we've looked at that, we haven't considered that when we're taking a look at what the overall effect could be. But again, there's a lot of moving pieces and including exactly where we source particular products and the tariff rates, et cetera. So, it's still -- at this point, still really an estimate.

Matt Summerville -- D.A. Davidson & Co. -- Analyst

Got it. And then I apologize if I missed this, Pat. In your prepared remarks, did you comment as to the performance in the propane versus the home center channels in the third quarter? And maybe talk a little bit about how the new product pipeline in particular for Contractor looks for 2019. And if we have -- should be expecting some major launches either in the first or second quarter of next year?

Patrick J. McHale -- President and Chief Executive Officer

Yes. So, the out-the-door sales in both channels here in the Americas were good. So, we feel pretty good going into Q4 and into next year that we still got some opportunities there. In terms of the new product pipeline, that division has historically done a really nice job of launching the pretty exciting new products every year and we like what we've got coming for 2019. So, we think we're pretty well-positioned from a new product launch standpoint in 2019 to continue our momentum as long as the end markets give us something to work with.

Matt Summerville -- D.A. Davidson & Co. -- Analyst

Thank you.

Operator

Thank you. (Operator Instructions) All right. I'm showing no further questions in the queue at this time.

Patrick J. McHale -- President and Chief Executive Officer

All right. Thanks, everybody, for your time joining the call this morning, and we'll get back to work and we'll talk to you again at the end of January. Thanks.

Operator

Thank you. Ladies and gentlemen, this concludes today's teleconference. You may now disconnect.

Duration: 22 minutes

Call participants:

Caroline M. Chambers -- Executive Vice President, Corporate Controller and Information Systems

Patrick J. McHale -- President and Chief Executive Officer

Deane Dray -- RBC Capital Markets -- Analyst

Brett Kearney -- Gabelli & Company -- Analyst

Jeffrey Hammond -- KeyBanc Capital Markets -- Analyst

Mark W. Sheahan -- Chief Financial Officer and Treasurer

Charles Brady -- SunTrust Robinson Humphrey -- Analyst

Walter Liptak -- Seaport Global Securities -- Analyst

Matt Summerville -- D.A. Davidson & Co. -- Analyst

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