Document

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

Quarterly Report Pursuant to Section 13 or 15 (d) of the
Securities Exchange Act of 1934

For the quarterly period ended March 31, 2017

Commission File Number:  001-09249

 
GRACO INC.
(Exact name of registrant as specified in its charter)     
 
Minnesota
 
41-0285640
(State of incorporation)  
 
(I.R.S. Employer Identification Number)     
 
88 - 11th Avenue N.E.
Minneapolis, Minnesota
 
55413
(Address of principal executive offices)    
 
(Zip Code)     
(612) 623-6000
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
 
Yes
X
 
No
 
 


Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
 
Yes
X
 
No
 
 


Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large Accelerated Filer
X
Accelerated Filer
 
Non-accelerated Filer
 
Smaller reporting company
 


Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
 
Yes
 
 
No
X
 

55,552,000 shares of the Registrant’s Common Stock, $1.00 par value, were outstanding as of April 19, 2017.


TABLE OF CONTENTS 
 
 
 
 
Page
PART I - FINANCIAL INFORMATION
 
 
 
 
 
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
 
 
 
 
Item 3.
 
 
 
 
 
 
 
Item 4.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
PART II - OTHER INFORMATION
 
 
 
 
 
 
 
Item 1A.
 
 
 
 
 
 
 
Item 2.
 
 
 
 
 
 
 
Item 6.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
EXHIBITS
 

2
Table of Contents

PART I     Item 1.
GRACO INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF EARNINGS
(Unaudited) (In thousands except per share amounts)
 
Three Months Ended
 
March 31,
2017
 
March 25,
2016
Net Sales
$
340,590

 
$
304,912

Cost of products sold
155,317

 
143,116

Gross Profit
185,273

 
161,796

Product development
14,499

 
14,686

Selling, marketing and distribution
54,911

 
52,701

General and administrative
30,042

 
33,460

Operating Earnings
85,821

 
60,949

Interest expense
4,055

 
4,493

Other expense (income), net
191

 
(1,146
)
Earnings Before Income Taxes
81,575

 
57,602

Income taxes
20,843

 
18,050

Net Earnings
$
60,732

 
$
39,552

Per Common Share
 
 
 
Basic net earnings
$
1.09

 
$
0.71

Diluted net earnings
$
1.05

 
$
0.70

Cash dividends declared
$
0.36

 
$
0.33

See notes to consolidated financial statements.


CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited) (In thousands)
 
Three Months Ended
 
March 31,
2017
 
March 25,
2016
Net Earnings
$
60,732

 
$
39,552

Components of other comprehensive income (loss)
 
 
 
Cumulative translation adjustment
6,318

 
(2,402
)
Pension and postretirement medical liability adjustment
2,000

 
1,473

Income taxes - pension and postretirement medical liability adjustment
(766
)
 
(569
)
Other comprehensive income (loss)
7,552

 
(1,498
)
Comprehensive Income
$
68,284

 
$
38,054

See notes to consolidated financial statements.

3
Table of Contents

GRACO INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited) (In thousands)
 
March 31,
2017
 
December 30,
2016
ASSETS
 
 
 
Current Assets
 
 
 
Cash and cash equivalents
$
76,568

 
$
52,365

Accounts receivable, less allowances of $13,300 and $12,700
244,395

 
218,365

Inventories
214,946

 
201,609

Other current assets
20,739

 
31,023

Total current assets
556,648

 
503,362

Property, Plant and Equipment
 
 
 
Cost
499,014

 
489,642

Accumulated depreciation
(307,066
)
 
(300,046
)
Property, plant and equipment, net
191,948

 
189,596

Goodwill
269,328

 
259,849

Other Intangible Assets, net
182,846

 
178,336

Deferred Income Taxes
87,175

 
86,653

Other Assets
25,905

 
25,313

Total Assets
$
1,313,850

 
$
1,243,109

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Current Liabilities
 
 
 
Notes payable to banks
$
9,380

 
$
8,913

Current portion of long-term debt
75,000

 
—

Trade accounts payable
43,908

 
39,988

Salaries and incentives
26,755

 
37,109

Dividends payable
20,160

 
20,088

Other current liabilities
78,504

 
71,887

Total current liabilities
253,707

 
177,985

Long-term Debt
302,655

 
305,685

Retirement Benefits and Deferred Compensation
161,562

 
159,250

Deferred Income Taxes
20,218

 
17,672

Other Non-current Liabilities
8,697

 
8,697

Shareholders’ Equity
 
 
 
Common stock
55,538

 
55,834

Additional paid-in-capital
481,179

 
453,394

Retained earnings
164,970

 
206,820

Accumulated other comprehensive income (loss)
(134,676
)
 
(142,228
)
Total shareholders’ equity
567,011

 
573,820

Total Liabilities and Shareholders’ Equity
$
1,313,850

 
$
1,243,109

See notes to consolidated financial statements.

4
Table of Contents

GRACO INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited) (In thousands)
 
Three Months Ended
 
March 31,
2017
 
March 25,
2016
Cash Flows From Operating Activities
 
 
 
Net Earnings
$
60,732

 
$
39,552

Adjustments to reconcile net earnings to net cash
provided by operating activities
 
 
 
Depreciation and amortization
11,094

 
12,010

Deferred income taxes
(864
)
 
(2,688
)
Share-based compensation
5,477

 
6,093

Change in
 
 
 
Accounts receivable
(23,207
)
 
3,100

Inventories
(12,209
)
 
(8,127
)
Trade accounts payable
2,806

 
119

Salaries and incentives
(12,124
)
 
(17,191
)
Retirement benefits and deferred compensation
3,715

 
669

Other accrued liabilities
16,149

 
(3,233
)
Other
(1,345
)
 
(1,426
)
Net cash provided by operating activities
50,224

 
28,878

Cash Flows From Investing Activities
 
 
 
Property, plant and equipment additions
(8,200
)
 
(13,121
)
Acquisition of businesses, net of cash acquired
(9,968
)
 
(48,881
)
Change in restricted assets
638

 
876

Other
(62
)
 
320

Net cash provided by (used in) investing activities
(17,592
)
 
(60,806
)
Cash Flows From Financing Activities
 
 
 
Borrowings (payments) on short-term lines of credit, net
261

 
(1,461
)
Borrowings on long-term line of credit
191,120

 
298,709

Payments on long-term line of credit
(119,150
)
 
(233,734
)
Common stock issued
30,127

 
20,111

Common stock repurchased
(90,160
)
 
(48,050
)
Cash dividends paid
(20,118
)
 
(18,332
)
Net cash provided by (used in) financing activities
(7,920
)
 
17,243

Effect of exchange rate changes on cash
(509
)
 
(1,120
)
Net increase (decrease) in cash and cash equivalents
24,203

 
(15,805
)
Cash and Cash Equivalents
 
 
 
Beginning of year
52,365

 
52,295

End of period
$
76,568

 
$
36,490

See notes to consolidated financial statements.

5
Table of Contents

GRACO INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1.Basis of Presentation

The consolidated balance sheet of Graco Inc. and Subsidiaries (the “Company”) as of March 31, 2017 and the related statements of earnings and comprehensive income for the three months ended March 31, 2017 and March 25, 2016, and cash flows for the three months ended March 31, 2017 and March 25, 2016 have been prepared by the Company and have not been audited.

In the opinion of management, these consolidated financial statements reflect all adjustments (consisting of only normal recurring adjustments) necessary to present fairly the financial position of the Company as of March 31, 2017, and the results of operations and cash flows for all periods presented.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. Therefore, these statements should be read in conjunction with the financial statements and notes thereto included in the Company’s 2016 Annual Report on Form 10-K.

The results of operations for interim periods are not necessarily indicative of results that will be realized for the full fiscal year.

2.Earnings per Share

The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share amounts):
 
Three Months Ended
 
March 31,
2017
 
March 25,
2016
Net earnings available to common shareholders
$
60,732

 
$
39,552

Weighted average shares outstanding for basic earnings per share
55,768

 
55,394

Dilutive effect of stock options computed using the treasury stock
method and the average market price
1,944

 
1,315

Weighted average shares outstanding for diluted earnings per share
57,712

 
56,709

Basic earnings per share
$
1.09

 
$
0.71

Diluted earnings per share
$
1.05

 
$
0.70


Stock options to purchase 885,000 and 1,909,000 shares were not included in the March 31, 2017 and March 25, 2016 computations of diluted earnings per share, respectively, because they would have been anti-dilutive.

3.Share-Based Awards

Options on common shares granted and outstanding, as well as the weighted average exercise price, are shown below (in thousands, except exercise prices):
 
Option
Shares
 
Weighted Average
Exercise Price
 
Options
Exercisable
 
Weighted Average
Exercise Price
Outstanding, December 30, 2016
5,535

 
$
55.26

 
3,672

 
$
45.40

Granted
539

 
91.02

 
 
 
 
Exercised
(387
)
 
48.38

 
 
 
 
Canceled
(11
)
 
77.19

 
 
 
 
Outstanding, March 31, 2017
5,676

 
$
59.09

 
3,769

 
$
48.24



6
Table of Contents

The Company recognized year-to-date share-based compensation of $5.5 million in 2017 and $6.1 million in 2016. As of March 31, 2017, there was $21.5 million of unrecognized compensation cost related to unvested options, expected to be recognized over a weighted average period of 2.1 years.

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions and results:
 
Three Months Ended
 
March 31,
2017
 
March 25,
2016
Expected life in years
7.0

 
7.0

Interest rate
2.3
%
 
1.4
%
Volatility
26.7
%
 
30.3
%
Dividend yield
1.6
%
 
1.9
%
Weighted average fair value per share
$
23.93

 
$
18.89


Under the Company’s Employee Stock Purchase Plan, the Company issued 167,000 shares in 2017 and 170,000 shares in 2016. The fair value of the employees’ purchase rights under this Plan was estimated on the date of grant. The benefit of the 15 percent discount from the lesser of the fair market value per common share on the first day and the last day of the plan year was added to the fair value of the employees’ purchase rights determined using the Black-Scholes option-pricing model with the following assumptions and results:
 
Three Months Ended
 
March 31,
2017
 
March 25,
2016
Expected life in years
1.0

 
1.0

Interest rate
0.9
%
 
0.7
%
Volatility
22.3
%
 
24.6
%
Dividend yield
1.5
%
 
1.7
%
Weighted average fair value per share
$
21.97

 
$
19.14


4.Retirement Benefits

The components of net periodic benefit cost for retirement benefit plans were as follows (in thousands):
 
Three Months Ended
 
March 31,
2017
 
March 25,
2016
Pension Benefits
 
 
 
Service cost
$
2,061

 
$
1,997

Interest cost
3,930

 
4,017

Expected return on assets
(4,352
)
 
(4,637
)
Amortization and other
2,325

 
2,300

Net periodic benefit cost
$
3,964

 
$
3,677

Postretirement Medical
 
 
 
Service cost
$
175

 
$
150

Interest cost
275

 
262

Amortization
50

 
(138
)
Net periodic benefit cost
$
500

 
$
274



7
Table of Contents

5.Shareholders’ Equity

Changes in components of accumulated other comprehensive income (loss), net of tax were (in thousands):
 
Pension and
Postretirement
Medical
 
Cumulative
Translation
Adjustment
 
Total
Balance, December 25, 2015
$
(69,922
)
 
$
(34,575
)
 
$
(104,497
)
Other comprehensive income before reclassifications
—

 
(2,402
)
 
(2,402
)
Amounts reclassified from accumulated other comprehensive income
904

 
—

 
904

Balance, March 25, 2016
$
(69,018
)
 
$
(36,977
)
 
$
(105,995
)
Balance, December 30, 2016
$
(76,426
)
 
$
(65,802
)
 
$
(142,228
)
Other comprehensive income before reclassifications
—

 
6,318

 
6,318

Amounts reclassified from accumulated other comprehensive income
1,234

 
—

 
1,234

Balance, March 31, 2017
$
(75,192
)
 
$
(59,484
)
 
$
(134,676
)

Amounts related to pension and postretirement medical adjustments are reclassified to pension cost, which is allocated to cost of products sold and operating expenses based on salaries and wages, approximately as follows (in thousands):
 
Three Months Ended
 
March 31,
2017
 
March 25,
2016
Cost of products sold
$
708

 
$
528

Product development
298

 
204

Selling, marketing and distribution
646

 
486

General and administrative
348

 
255

Total before tax
$
2,000

 
$
1,473

Income tax (benefit)
(766
)
 
(569
)
Total after tax
$
1,234

 
$
904


On February 21, 2017, the Company entered into an accelerated share repurchase arrangement (“ASR”) with a financial institution. In exchange for an up-front payment of $90 million, the financial institution delivered 850,000 shares of Company common stock with a fair value of $78 million. The total number of shares ultimately delivered under the ASR will be determined at the end of the purchase period (up to five months, but not less than two months) based on the volume weighted-average price (“VWAP”) of the Company’s common stock during that period. If there were no change in the market price of the Company’s stock during the purchase period, the Company would receive approximately 135,000 additional shares at the end of the purchase period.

The Company accounted for the up-front payment as a reduction of shareholders’ equity in the period made. Shares received under the ASR were retired and reflected as a reduction of outstanding shares on the date delivered for purposes of calculating earnings per share. The forward contract aspect of the ASR met all of the applicable criteria for equity classification, and therefore, was accounted for as a derivative indexed to the Company's equity.


8
Table of Contents

6.
Segment Information

The Company has three reportable segments, Industrial, Process and Contractor. Sales and operating earnings by segment were as follows (in thousands): 
 
Three Months Ended
 
March 31,
2017
 
March 25,
2016
Net Sales
 
 
 
Industrial
$
156,390

 
$
147,088

Process
70,029

 
64,285

Contractor
114,171

 
93,539

Total
$
340,590

 
$
304,912

Operating Earnings
 
 
 
Industrial
$
53,735

 
$
45,794

Process
13,463

 
7,277

Contractor
26,019

 
16,743

Unallocated corporate (expense)
(7,396
)
 
(8,865
)
Total
$
85,821

 
$
60,949


Assets by segment were as follows (in thousands): 
 
March 31,
2017
 
December 30,
2016
Industrial
$
556,290

 
$
546,366

Process
324,378

 
318,444

Contractor
244,759

 
208,016

Unallocated corporate
188,423

 
170,283

Total
$
1,313,850

 
$
1,243,109


Geographic information follows (in thousands):
 
Three Months Ended
 
March 31,
2017
 
March 25,
2016
Net Sales (based on customer location)
 
 
 
United States
$
174,854

 
$
153,001

Other countries
165,736

 
151,911

Total
$
340,590

 
$
304,912

 
March 31,
2017
 
December 30,
2016
Long-lived Assets
 
 
 
United States
$
153,982

 
$
151,911

Other countries
37,966

 
37,685

Total
$
191,948

 
$
189,596



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Table of Contents

7.Inventories

Major components of inventories were as follows (in thousands):
 
March 31,
2017
 
December 30,
2016
Finished products and components
$
113,716

 
$
113,643

Products and components in various stages of completion
56,575

 
50,557

Raw materials and purchased components
92,005

 
84,631

Subtotal
262,296

 
248,831

Reduction to LIFO cost
(47,350
)
 
(47,222
)
Total
$
214,946

 
$
201,609


8.Intangible Assets

Components of other intangible assets were (dollars in thousands):
 
Finite Life
 
Indefinite Life
 
 
 
Customer
Relationships
 
Patents and
Proprietary
Technology
 
Trademarks,
Trade Names
and Other
 
Trade
Names
 
Total
As of March 31, 2017
 
 
 
 
 
 
 
 
 
Cost
$
174,884

 
$
17,921

 
$
895

 
$
57,853

 
$
251,553

Accumulated amortization
(44,700
)
 
(6,538
)
 
(388
)
 
—

 
(51,626
)
Foreign currency translation
(11,860
)
 
(899
)
 
(54
)
 
(4,268
)
 
(17,081
)
Book value
$
118,324

 
$
10,484

 
$
453

 
$
53,585

 
$
182,846

Weighted average life (years)
13

 
10

 
4

 
N/A

 
 
As of December 30, 2016
 
 
 
 
 
 
 
 
 
Cost
$
170,284

 
$
17,321

 
$
895

 
$
57,853

 
$
246,353

Accumulated amortization
(41,599
)
 
(6,088
)
 
(337
)
 
—

 
(48,024
)
Foreign currency translation
(13,630
)
 
(1,055
)
 
(59
)
 
(5,249
)
 
(19,993
)
Book value
$
115,055

 
$
10,178

 
$
499

 
$
52,604

 
$
178,336

Weighted average life (years)
13

 
10

 
4

 
N/A

 
 

Amortization of intangibles for the quarter was $3.6 million in 2017 and $4.8 million in 2016. Estimated future amortization expense based on the current carrying amount of other intangible assets is as follows (in thousands):
 
2017
 
2018
 
2019
 
2020
 
2021
 
Thereafter
Estimated Amortization Expense
$
14,558

 
$
14,303

 
$
13,974

 
$
13,798

 
$
13,635

 
$
62,595


Changes in the carrying amount of goodwill for each reportable segment were (in thousands): 
 
Industrial    
 
Process    
 
Contractor    
 
Total    
Balance, December 30, 2016
$
150,556

 
$
96,561

 
$
12,732

 
$
259,849

Additions from business acquisitions
7,152

 
—

 
—

 
7,152

Foreign currency translation
2,066

 
261

 
—

 
2,327

Balance, March 31, 2017
$
159,774

 
$
96,822

 
$
12,732

 
$
269,328



10
Table of Contents

9.
Other Current Liabilities
Components of other current liabilities were (in thousands):
 
March 31,
2017
 
December 30,
2016
Accrued self-insurance retentions
$
7,146

 
$
7,105

Accrued warranty and service liabilities
9,303

 
8,934

Accrued trade promotions
4,774

 
6,007

Payable for employee stock purchases
1,499

 
9,328

Customer advances and deferred revenue
15,894

 
9,400

Income taxes payable
16,491

 
8,608

Other
23,397

 
22,505

Total
$
78,504

 
$
71,887


The Company manages certain self-insured loss exposures through a wholly-owned captive insurance subsidiary. Cash balances of $8.6 million as of March 31, 2017 and $9.2 million as of December 30, 2016 were restricted to funding of the captive's loss reserves and are included within other current assets on the Company's Consolidated Balance Sheets.

A liability is established for estimated future warranty and service claims that relate to current and prior period sales. The Company estimates warranty costs based on historical claim experience and other factors including evaluating specific product warranty issues. Following is a summary of activity in accrued warranty and service liabilities (in thousands):
Balance, December 30, 2016
$
8,934

Charged to expense
1,855

Margin on parts sales reversed
708

Reductions for claims settled
(2,194
)
Balance, March 31, 2017
$
9,303


10.Fair Value

Assets and liabilities measured at fair value on a recurring basis and fair value measurement level were as follows (in thousands):
 
Level   
 
March 31,
2017
 
December 30,
2016
Assets
 
 
 
 
 
Cash surrender value of life insurance
2
 
$
14,467

 
$
13,785

Forward exchange contracts
2
 
—

 
571

Total assets at fair value
 
 
$
14,467

 
$
14,356

Liabilities
 
 
 
 
 
Contingent consideration
3
 
$
4,081

 
$
4,081

Deferred compensation
2
 
3,414

 
3,265

Forward exchange contracts
2
 
546

 
—

Total liabilities at fair value
 
 
$
8,041

 
$
7,346


Contracts insuring the lives of certain employees who are eligible to participate in certain non-qualified pension and deferred compensation plans are held in trust. Cash surrender value of the contracts is based on performance measurement funds that shadow the deferral investment allocations made by participants in certain deferred compensation plans. The deferred compensation liability balances are valued based on amounts allocated by participants to the underlying performance measurement funds.

Contingent consideration liability represents the estimated value (using a probability-weighted expected return approach) of future payments to be made to previous owners of an acquired business based on future revenues.


11
Table of Contents

Long-term notes payable with fixed interest rates have a carrying amount of $300 million and an estimated fair value of $325 million as of March 31, 2017 and $325 million as of December 30, 2016. The fair value of variable rate borrowings approximates carrying value. The Company uses significant other observable inputs to estimate fair value (level 2 of the fair value hierarchy) based on the present value of future cash flows and rates that would be available for issuance of debt with similar terms and remaining maturities.

11.Recent Accounting Pronouncements

A new accounting standard that changed certain aspects of accounting for share-based payments became effective for the Company in the first quarter of 2017. Excess tax benefits on exercised stock options that were previously credited to equity now reduce the current income tax provision. The change in accounting for excess tax benefits decreased the current income tax provision and increased net earnings for the first quarter by $3.7 million, reduced the effective income tax rate by 4 percentage points, increased the number of diluted average shares outstanding by 0.4 million and increased diluted earnings per share by $0.05. Under the new standard, excess tax benefits are no longer reclassified out of cash flows from operating activities to financing activities in the Consolidated Statements of Cash Flows. We elected to apply the cash flow presentation requirements retrospectively to all periods presented, which resulted in an increase in previously reported net cash provided by operating activities and a decrease in net cash provided by financing activities of $3.3 million for the quarter ended March 25, 2016. Also under the new standard, the Company elected to account for share-based grant forfeitures as they occur. The impact of the change in accounting for forfeitures was not significant, and was reflected in share-based compensation cost in the first quarter.

In May 2014, the Financial Accounting Standards Board (FASB) issued a final standard on revenue from contracts with customers. The new standard sets forth a single comprehensive model for recognizing and reporting revenue. The new standard is effective for the Company in its fiscal year 2018 and permits the use of either a retrospective or a modified retrospective transition method.

We have established an implementation team and engaged a third-party consultant to assist with our assessment of the impact of the new revenue guidance on our operations, consolidated financial statements and related disclosures. To date, this assessment has included (1) utilizing questionnaires to assist with the identification of our revenue streams, (2) performing sample contract analyses for each revenue stream identified, and (3) assessing the noted differences in recognition and measurement that may result from adopting this new standard. Based on the preliminary results of the evaluation, which is still in process, nothing has come to our attention that would indicate that adoption of the new standard will have a material impact on our consolidated financial statements. However, given our acquisition strategy, there may be additional revenue streams acquired prior to the adoption date. We currently believe the most significant potential changes relate to variable consideration and whether certain contracts' revenues will be recognized over time or at a point in time, although our technical analysis of these potential impacts is still on-going. We also anticipate changes to the consolidated balance sheet related to accounts receivable, contract assets, and contract liabilities.

We are in the process of evaluating and designing the necessary changes to our business processes, systems and controls to support recognition and disclosure under the new standard. Further, we are continuing to assess what incremental disaggregated revenue disclosures will be required in our consolidated financial statements, and we continue to evaluate transition methods.

In March 2017, the FASB issued a final standard that changes the presentation of net periodic benefit cost related to defined benefit plans. The Company will adopt the standard when it becomes effective in fiscal 2018 and it will be applied retrospectively to all periods presented. Under the new standard, net periodic benefit costs are required to be disaggregated between service costs presented as operating expenses and other components of pension costs presented as non-operating expenses. The Company currently charges service costs to segment operations and includes other components of pension cost in unallocated corporate operating expenses. Under the new standard, unallocated corporate operating expenses will decrease, operating earnings will increase and other expense will increase by the amount of other (non-service) components of pension cost. There will be no impact on reported segment earnings, net earnings or earnings per share.

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Item 2. GRACO INC. AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

The Company 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: Industrial, Process and Contractor. 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 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):
 
Three Months Ended    
 
March 31,
2017
 
March 25,
2016
 
%
 Change 
Net Sales
$
340.6

 
$
304.9

 
12
%
Operating Earnings
85.8

 
60.9

 
41
%
Net Earnings
60.7

 
39.6

 
54
%
Diluted Net Earnings per Common Share
$
1.05

 
$
0.70

 
50
%
Strong sales increases in all segments and regions along with improved gross margin rate and operating expense leverage drove increases in operating and net earnings. The increase in diluted earnings per share includes $0.05 from a required change in accounting for stock compensation, and $0.01 from reduced intangible amortization expense resulting from the non-cash impairment charge recorded in the fourth quarter of 2016.

The following table presents an overview of components of net earnings as a percentage of net sales:
 
Three Months Ended   
 
March 31,
2017
 
March 25,
2016
Net Sales
100.0
%
 
100.0
 %
Cost of products sold
45.6

 
46.9

Gross profit
54.4

 
53.1

Product development
4.3

 
4.8

Selling, marketing and distribution
16.1

 
17.3

General and administrative
8.8

 
11.0

Operating earnings
25.2

 
20.0

Interest expense
1.2

 
1.5

Other expense (income), net
0.1

 
(0.4
)
Earnings before income taxes
23.9

 
18.9

Income taxes
6.1

 
5.9

Net Earnings
17.8
%
 
13.0
 %



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Net Sales

The following table presents net sales by geographic region (in millions):
 
Three Months Ended   
 
March 31,
2017
 
March 25,
2016
Americas(1)
$
200.0

 
$
173.4

EMEA(2)
79.1

 
75.7

Asia Pacific
61.5

 
55.8

Consolidated
$
340.6

 
$
304.9

(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:
 
Three Months Ended   
 
Volume and Price
 
Acquisitions
 
Currency
 
Total
Americas
15%
 
0%
 
0%
 
15%
EMEA
9%
 
0%
 
(5)%
 
4%
Asia Pacific
11%
 
1%
 
(2)%
 
10%
Consolidated
13%
 
0%
 
(1)%
 
12%

Gross Profit

Gross profit margin rate increased by more than 1 percentage point compared to the first quarter of last year. Favorable effects from realized pricing and higher production volume were partially offset by unfavorable impacts of product mix.

Operating Expenses

Total operating expenses were slightly lower than the first quarter last year. Reductions from the impact of currency translation, decreased amortization expense and lower unallocated corporate expenses (mostly stock compensation and central warehouse) more than offset volume and rate related increases.

Income Taxes

The effective income tax rate for the quarter was 26 percent, down from 31 percent last year. Adoption of a new accounting standard, requiring excess tax benefits related to stock option exercises to be credited to the income tax provision (formerly credited to equity), reduced the effective tax rate by 4 percentage points. The tax rate benefit from foreign earnings taxed at lower rates than the U.S. rate was also higher compared to the first quarter last year.


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Segment Results

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

Industrial Segment

The following table presents net sales and operating earnings as a percentage of sales for the Industrial segment
(dollars in millions):
 
Three Months Ended  
 
March 31,
2017
 
March 25,
2016
Net sales
 
 
 
Americas
$
69.0

 
$
65.1

EMEA
44.1

 
44.2

Asia Pacific
43.3

 
37.8

Total
$
156.4

 
$
147.1

Operating earnings as a percentage of net sales
34
%
 
31
%

The following table presents the components of net sales change by geographic region for the Industrial segment:
 
Three Months Ended   
 
Volume and Price
 
Acquisitions
 
Currency
 
Total
Americas
6%
 
0%
 
0%
 
6%
EMEA
3%
 
1%
 
(4)%
 
0%
Asia Pacific
16%
 
1%
 
(3)%
 
14%
Segment Total
7%
 
1%
 
(2)%
 
6%

Improved conditions in Asia Pacific, strong project activity and timing of promotions in the Americas contributed to the increase in Industrial segment sales. Operating margin rates for the Industrial segment increased 3 percentage points compared to last year due to higher sales volume, improved gross margin rate and favorable expense leverage.

Process Segment

The following table presents net sales and operating earnings as a percentage of sales for the Process segment
(dollars in millions):
 
Three Months Ended   
 
March 31,
2017
 
March 25,
2016
Net sales
 
 
 
Americas
$
44.6

 
$
40.0

EMEA
14.9

 
13.9

Asia Pacific
10.5

 
10.4

Total
$
70.0

 
$
64.3

Operating earnings as a percentage of net sales
19
%
 
11
%


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The following table presents the components of net sales change by geographic region for the Process segment:
 
Three Months Ended   
 
Volume and Price
 
Acquisitions
 
Currency
 
Total
Americas
11%
 
0%
 
1%
 
12%
EMEA
15%
 
0%
 
(8)%
 
7%
Asia Pacific
3%
 
0%
 
(2)%
 
1%
Segment Total
11%
 
0%
 
(2)%
 
9%

The Process segment had solid sales growth across most product applications. Operating margin rates for this segment increased 8 percentage points compared to last year due to higher sales volume, favorable expense leverage and a decrease in intangible amortization related to the non-cash impairment recorded in the fourth quarter of 2016.

Contractor Segment

The following table presents net sales and operating earnings as a percentage of sales for the Contractor segment (dollars in millions):
 
Three Months Ended   
 
March 31,
2017
 
March 25,
2016
Net sales
 
 
 
Americas
$
86.4

 
$
68.3

EMEA
20.1

 
17.6

Asia Pacific
7.7

 
7.6

Total
$
114.2

 
$
93.5

Operating earnings as a percentage of net sales
23
%
 
18
%

The following table presents the components of net sales change by geographic region for the Contractor segment:
 
Three Months Ended   
 
Volume and Price
 
Acquisitions
 
Currency
 
Total
Americas
26%
 
0%
 
0%
 
26%
EMEA
18%
 
0%
 
(4)%
 
14%
Asia Pacific
1%
 
0%
 
0%
 
1%
Segment Total
23%
 
0%
 
(1)%
 
22%

New product launches and strong customer out-the-door sales drove double-digit percentage growth in both Paint and Home Center channels in North America. Operating margin rates for the Contractor segment increased 5 percentage points compared to last year due to higher sales volume, improved gross margin rate and favorable expense leverage.

Liquidity and Capital Resources

Net cash provided by operating activities of $50 million increased $21 million compared to the first quarter last year, corresponding to the increase in net earnings. Increases in accounts receivable, inventories and other accrued liabilities reflect growth in business activity in the first quarter of 2017. The Company used cash of $10 million in 2017 and $49 million in 2016 to acquire businesses that were not material to the consolidated financial statements. Other significant uses of cash in 2016 included share repurchases of $90 million (partially offset by $30 million of proceeds from shares issued), cash dividends of $20 million and property, plant and equipment additions of $8 million.

At March 31, 2017, cash balances of $9 million were restricted to funding of certain self-insured loss reserves. Restricted cash is included within other current assets on the Company's consolidated balance sheet.


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At March 31, 2017, the Company had various lines of credit totaling $545 million, of which $459 million was unused. Internally generated funds and unused financing sources are expected to provide the Company with the flexibility to meet its liquidity needs in 2017.

Outlook

Demand in the first quarter was broad-based across products and geographies and exceeded our expectations. We are raising our full-year 2017 outlook to mid single-digit organic sales growth on a constant currency basis worldwide, from a prior outlook of low single-digit growth. We expect to achieve mid single-digit growth in each geographic region in 2017.

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 2016 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: our Company’s growth strategies, which include making acquisitions, investing in new products, expanding geographically and targeting new industries; economic conditions in the United States and other major world economies; changes in currency translation rates; changes in laws and regulations; compliance with anti-corruption and trade laws; new entrants who copy our products or infringe on our intellectual property; risks incident to conducting business internationally; the ability to meet our customers’ needs and changes in product demand; supply interruptions or delays; security breaches; 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 as well as indemnification claims under our asset purchase agreement with Carlisle Companies Incorporated, Carlisle Fluid Technologies, Inc., and Finishing Brands Holdings Inc.; the possibility of decline in purchases from few large customers of the Contractor segment; variations in activity in the construction, automotive, mining and oil and natural gas industries; our ability to attract, develop and retain qualified personnel; and catastrophic events. Please refer to Item 1A of our Annual Report on Form 10-K for fiscal year 2016 for a more comprehensive discussion of these and other risk factors. These reports are available on the Company’s website at www.graco.com and the Securities and Exchange Commission’s website at 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.


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Table of Contents

Item 3.Quantitative and Qualitative Disclosures About Market Risk

There have been no material changes related to market risk from the disclosures made in the Company’s 2016 Annual Report on Form 10-K.

Item 4.Controls and Procedures

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, the Chief Financial Officer and Treasurer, the Vice President, Controller and Information Systems, and the Vice President, General Counsel and Secretary. Based upon that evaluation, they 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.

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PART IIOTHER INFORMATION

Item 1A.Risk Factors

There have been no material changes to the Company’s risk factors from those disclosed in the Company’s 2016 Annual Report on Form 10-K.

Item 2.Unregistered Sales of Equity Securities and Use of Proceeds

Issuer Purchases of Equity Securities

On April 24, 2015, the Board of Directors authorized the Company to purchase up to 6,000,000 shares of its outstanding common stock, primarily through open-market transactions. The authorization is for an indefinite period of time or until terminated by the Board.

In addition to shares purchased under the Board authorizations, the Company purchases shares of common stock held by employees who wish to tender owned shares to satisfy the exercise price or tax due upon exercise of options or vesting of restricted stock.

Information on issuer purchases of equity securities follows: 
Period
 
Total Number
of Shares Purchased  
 
Average Price
Paid per Share
 
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs
 
Maximum Number of Shares that May Yet Be
Purchased Under the Plans or Programs
(at end of period)
Dec 31, 2016 - Jan 27, 2017
 
—

 
$
—

 
—

 
3,817,367

Jan 28, 2017 - Feb 24, 2017 (1)
 
1,774

 
$
90.64

 
—

 
3,817,367

Feb 2017 ASR (2)
 
850,000

 
(2
)
 
850,000

 
2,967,367

Feb 25, 2017 - Mar 31, 2017
 
—

 
$
—

 
—

 
2,967,367


(1) Includes 1,457 shares forfeited to the Company in satisfaction of tax withholding obligations by employees who vested in restricted stock under employee stock compensation plans.

(2) On February 21, 2017, the Company entered into an accelerated share repurchase arrangement (“ASR”) with a financial institution. In exchange for an up-front payment of $90 million, the financial institution delivered 850,000 shares of Company common stock with a fair value of $78 million. The total number of shares ultimately delivered under the ASR will be determined at the end of the purchase period (up to five months, but not less than two months) based on the volume weighted-average price (“VWAP”) of the Company’s common stock during that period. If there were no change in the market price of the Company’s stock during the purchase period, the Company would receive approximately 135,000 additional shares at the end of the purchase period.



19
Table of Contents

Item 6.Exhibits
3.1

 
Restated Articles of Incorporation as amended December 9, 2016. (Incorporated by reference to Exhibit 3.1 to the Company’s Report on Form 8-K filed December 9, 2016.)
 
 
 
3.2

 
Restated Bylaws as amended February 14, 2014. (Incorporated by reference to Exhibit 3.2 to the Company’s 2013 Annual Report on Form 10-K.)
 
 
 
31.1

 
Certification of President and Chief Executive Officer pursuant to Rule 13a-14(a).
 
 
 
31.2

 
Certification of Chief Financial Officer and Treasurer pursuant to Rule 13a-14(a).
 
 
 
32

 
Certification of President and Chief Executive Officer and Chief Financial Officer and Treasurer pursuant to Section 1350 of Title 18, U.S.C.
 
 
 
99.1

 
Press Release Reporting First Quarter Earnings dated April 26, 2017.
 
 
 
101

 
Interactive Data File.

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Table of Contents

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

GRACO INC.
 
 
 
 
 
 
 
Date:
 
April 26, 2017
 
By:
 
/s/ Patrick J. McHale
 
 
 
 
 
 
Patrick J. McHale
 
 
 
 
 
 
President and Chief Executive Officer
 
 
 
 
 
 
(Principal Executive Officer)
 
 
 
 
Date:
 
April 26, 2017
 
By:
 
/s/ Christian E. Rothe
 
 
 
 
 
 
Christian E. Rothe
 
 
 
 
 
 
Chief Financial Officer and Treasurer
 
 
 
 
 
 
(Principal Financial Officer)
 
 
 
 
Date:
 
April 26, 2017
 
By:
 
/s/ Caroline M. Chambers
 
 
 
 
 
 
Caroline M. Chambers
 
 
 
 
 
 
Vice President, Corporate Controller
     and Information Systems
 
 
 
 
 
 
(Principal Accounting Officer)