Graco's Form 10-Q, Second Quarter 2007

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 June 29, 2007

Commission File Number: 001-9249

  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, and (2) has been subject to such filing requirements for the past 90 days.

  Yes        X          No                 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Large Accelerated Filer       X       Accelerated Filer               Non-accelerated Filer             

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

  Yes                  No        X         

65,286,000 shares of the Registrant’s Common Stock, $1.00 par value were outstanding as of July 18, 2007.

GRACO INC. AND SUBSIDIARIES

INDEX

      Page Number
PART I FINANCIAL INFORMATION  
         
  Item 1. Financial Statements  
         
          Consolidated Statements of Earnings 3
          Consolidated Balance Sheets 4
          Consolidated Statements of Cash Flows 5
          Notes to Consolidated Financial Statements 6-13
         
         
  Item 2. Management's Discussion and Analysis  
        of Financial Condition and Results of Operations 14-16
         
  Item 3. Quantitative and Qualitative Disclosures About Market Risk 17
         
  Item 4. Controls and Procedures 17
         
         
PART II OTHER INFORMATION  
         
  Item 1A. Risk Factors 18
         
  Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 18
         
  Item 4. Submission of Matters to a Vote of Security Holders 19
         
  Item 6. Exhibits 20
         
         
         
SIGNATURES    
         
         
EXHIBITS    
  PART I  
     
  GRACO INC. AND SUBSIDIARIES  
Item 1. CONSOLIDATED STATEMENTS OF EARNINGS  
  (Unaudited)  
  (In thousands except per share amounts)  


               Thirteen Weeks Ended                Twenty-Six Weeks Ended
June 29,
2007
  
  June 30,
2006
  
    June 29,
2007
  
  June 30,
2006
  
 
                             
Net Sales     $ 231,384   $ 218,632     $ 428,879   $ 410,848  
                               
     Cost of products sold       109,152     101,686       201,785     190,675  
     
 

 
 
 

 
   
 

 
 
 

 
 
Gross Profit       122,232     116,946       227,094     220,173  
                               
     Product development       7,544     7,538       15,816     14,750  
     Selling, marketing and distribution       31,917     30,524       61,180     58,466  
     General and administrative       15,057     15,056       30,297     28,477  
     
 

 
 
 

 
   
 

 
 
 

 
 
Operating Earnings       67,714     63,828       119,801     118,480  
                               
     Interest expense       642     189       900     314  
     Other expense (income), net       92     4       (14 )   9  
     
 

 
 
 

 
   
 

 
 
 

 
 
Earnings Before Income Taxes       66,980     63,635     118,915     118,157  
                               
     Income Taxes       22,800     22,300       41,000     41,400  
     
 

 
 
 

 
   
 

 
 
 

 
 
                               
Net Earnings     $ 44,180   $ 41,335     $ 77,915   $ 76,757  
     
 

 
 
 

 
   
 

 
 
 

 
 
Basic Net Earnings                            
     per Common Share     $ 0.67   $ 0.61     $ 1.17   $ 1.12  
                               
Diluted Net Earnings                              
   per Common Share     $ 0.66   $ 0.60     $ 1.16   $ 1.11  
                               
Cash Dividends Declared                              
   per Common Share     $ 0.17   $ 0.15     $ 0.33   $ 0.29  



See notes to consolidated financial statements.

  GRACO INC. AND SUBSIDIARIES  
  CONSOLIDATED BALANCE SHEETS  
  (Unaudited)  
  (In thousands)  

  June 29, 2007 Dec. 29, 2006
ASSETS                
                 
Current Assets    
       Cash and cash equivalents   $ 4,689   $ 5,871  
       Accounts receivable, less allowances of  
                $6,300 and $5,800    159,874    134,105  
       Inventories    81,833    76,311  
       Deferred income taxes    21,883    20,682  
       Other current assets    2,039    2,014  
            Total current assets    
 

270,318
 
 

238,983
 
                 
Property, Plant and Equipment  
       Cost    295,848    278,318  
       Accumulated depreciation    (159,166 )  (153,794 )
            Total property, plant and equipment, net    
 

136,682
 
 

124,524
 
                 
Prepaid Pension    28,503    26,903  
Goodwill    67,206    67,174  
Other Intangible Assets, net    46,157    50,325  
Other Assets       4,485     3,694  
            Total Assets  
$

553,711
 
$

511,603
 
     
 

 
 
 

 
 
LIABILITIES AND SHAREHOLDERS' EQUITY   
                 
Current Liabilities  
       Notes payable to banks   $ 65,168   $ 18,363  
       Trade accounts payable    31,330    27,442  
       Salaries, wages and commissions    16,132    26,303  
       Dividends payable    10,841    11,055  
       Other current liabilities    39,594    45,766  
            Total current liabilities    
 

163,065
 
 

128,929
 
                 
Retirement Benefits and Deferred Compensation    38,023    36,946  
Uncertain Tax Positions    6,100      
Deferred Income Taxes    11,651    14,724  
                 
Shareholders' Equity  
       Common stock    65,633    66,805  
       Additional paid-in-capital    154,186    130,621  
       Retained earnings    119,982    138,702  
       Accumulated other comprehensive income (loss)  
          Cumulative translation adjustment    54    (60 )
          Pension liability adjustment       (4,983 )   (5,064 )
            Total shareholders' equity    
 

334,872
 
 

331,004
 
            Total Liabilities and Shareholders' Equity  
$

553,711
 
$

511,603
 
     
 

 
 
 

 
 

See notes to consolidated financial statements.

  GRACO INC. AND SUBSIDIARIES  
  CONSOLIDATED STATEMENTS OF CASH FLOWS  
  (Unaudited)  
  (In thousands)  
  Twenty-six Weeks Ended
  June 29, 2007   June 30, 2006  
Cash Flows from Operating Activities            
                 
   Net Earnings    $ 77,915   $ 76,757  
     Adjustments to reconcile net earnings to  
      net cash provided by operating activities:  
        Depreciation and amortization    13,994    12,093  
        Deferred income taxes    (4,312 )  (2,850 )
        Share-based compensation    4,351    4,637  
        Excess tax benefit related to share-based  
         payment arrangements    (3,848 )  (2,400 )
        Change in:  
          Accounts receivable    (24,733 )  (13,780 )
          Inventories    (5,358 )  (10,147 )
          Trade accounts payable    1,465    2,411  
          Salaries, wages and commissions    (10,313 )  (5,178 )
          Retirement benefits and deferred compensation    (713 )  139  
          Other accrued liabilities    (1,270 )  2,625  
          Uncertain tax positions    6,100      
          Other    (114 )  220  
Net cash provided by operating activities    
 

53,164
 
 

64,527
 
     
 

 
 
 

 
 
Cash Flows from Investing Activities   
                 
   Property, plant and equipment additions    (21,646 )  (9,467 )
   Proceeds from sale of property, plant and equipment    207    86  
   Investment in life insurance    (1,499 )    
   Capitalized software and other intangible asset additions    (5 )  (73 )
Net cash used in investing activities    
 

(22,943
)
 

(9,454
)
     
 

 
 
 

 
 
Cash Flows from Financing Activities   
                 
   Borrowings on notes payable and lines of credit    96,557    21,912  
   Payments on notes payable and lines of credit    (49,812 )  (23,592 )
   Excess tax benefit related to share-based  
    payment arrangements    3,848    2,400  
   Common stock issued    19,194    11,101  
   Common stock retired    (78,470 )  (45,839 )
   Cash dividends paid    (21,984 )  (19,841 )
Net cash provided by (used in) financing activities    
 

(30,667
)
 

(53,859
)
Effect of exchange rate changes on cash    
 

(736
)
 

(1,509
)
Net increase (decrease) in cash and cash equivalents    
 

(1,182
)
 

(295
)
                 
Cash and cash equivalents  
   Beginning of year    5,871    18,664  
   End of period    
$

4,689
 
$

18,369
 
     
 

 
 
 

 
 

See notes to consolidated financial statements.

GRACO INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. The consolidated balance sheet of Graco Inc. and Subsidiaries (the Company) as of June 29, 2007 and the related statements of earnings for the thirteen and twenty-six weeks ended June 29, 2007 and June 30, 2006, and cash flows for the twenty-six weeks ended June 29, 2007 and June 30, 2006 have been prepared by the Company and have not been audited.

  In the opinion of management, these consolidated statements reflect all adjustments (consisting of only normal recurring adjustments) necessary to present fairly the financial position of Graco Inc. and Subsidiaries as of June 29, 2007, 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 2006 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. The following table sets forth the computation of basic and diluted earnings per share (in thousands, except per share amounts):

               Thirteen Weeks Ended             Twenty-six Weeks Ended
  June 29,
2007
   
  June 30,
2006
   
  June 29,
2007
   
  June 30,
2006
   
 
                             
Net earnings available to
   common shareholders
    $ 44,180   $ 41,335   $ 77,915   $ 76,757  
         
Weighted average shares
   outstanding for basic
   
   earnings per share       66,045     68,121     66,356     68,275  
         
Dilutive effect of stock
   options computed using the
  
   treasury stock method and  
   the average market price    1,025    1,199    1,036    1,159  
     
Weighted average shares
   outstanding for diluted
  
   earnings per share       67,070     69,320     67,392     69,434  
           
Basic earnings per share   $0.67   $0.61   $1.17   $1.12  
           
Diluted earnings per share    $0.66   $0.60   $ 1.16   $ 1.11  

  Stock options to purchase 1,228,000 and 619,000 shares are not included in the 2007 and 2006 calculations of diluted earnings per share, respectively, because they would have been anti-dilutive.

3. Information on option shares outstanding and option activity for the twenty-six weeks ended June 29, 2007 is shown below (in thousands, except per share amounts):

  Option
Shares
Weighted 
Average 
Exercise 
Price 
Options
Exercisable
Weighted
Average
Exercise
Price
                 
Outstanding, December 29, 2006       3,956   $ 24.79     2,272   $ 16.94  
     Granted       648     41.23  
     Exercised       (652 )   18.49  
     Canceled       (353 )   39.10  
Outstanding, June 29, 2007      
3,599
  $ 27.48     2,112   $ 20.10  
       
 
       

  The aggregate intrinsic value of exercisable option shares was $42.8 million as of June 29, 2007, with a weighted average contractual term of 4.9 years. There were approximately 3.5 million vested share options and share options expected to vest as of June 29, 2007, with an aggregate intrinsic value of $47.0 million, a weighted average exercise price of $27.19 and a weighted average contractual term of 6.3 years.

  Information related to options exercised in the first six months of 2007 and 2006 follows (in thousands):

       Twenty-six Weeks Ended
  June 29, 2007 June 30, 2006
Cash received $12,046 $4,197
Aggregate intrinsic value 14,535 7,802
Tax benefit realized 5,300 2,800

  The Company recognized year-to-date share-based compensation of $4.4 million in 2007 and $4.6 million in 2006. As of June 29, 2007, there was $12.2 million of unrecognized compensation cost related to unvested options, expected to be recognized over a weighted average period of 2.2 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:

Twenty Six Weeks Ended
  June 29, 2007    June 30, 2006   
Expected life in years 6.0    6.3   
Interest rate 4.7% 4.6%
Volatility 26.1% 27.8%
Dividend yield 1.6% 1.4%
Weighted average fair value
   per share of options granted
$12.01    $12.97   

  Under the Company’s Employee Stock Purchase Plan, the Company issued 202,000 shares in 2007 and 204,000 shares in 2006. 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:

Twenty-six Weeks Ended
  June 29, 2007    June 30, 2006   
Expected life in years 1.0    1.0   
Interest rate 4.9% 4.6%
Volatility 24.4% 24.0%
Dividend yield 1.6% 1.4%
Weighted average fair value
   per share of options granted
$9.79    $10.18   

4. The components of net periodic benefit cost for retirement benefit plans were as follows (in thousands):

             Thirteen Weeks Ended        Twenty-six Weeks Ended
June 29,
2007
    
June 30,
2006
    
June 29,
2007
    
June 30,
2006
    
Pension Benefits    
Service cost     $ 1,501   $ 1,634   $ 2,980   $ 3,074  
Interest cost   2,885     2,609     5,767     5,217  
Expected return on assets       (4,800 )   (4,175 )   (9,600 )   (8,350 )
Amortization and other       291     100     546     292  
Net periodic benefit cost (credit)  
$

(123
)
$

168
 
$

(307
)
$

233
 
     

 

 

 

 
Postretirement Medical   
Service cost   $ 150   $ 250   $ 300   $ 500  
Interest cost    315    420    615    840  
Amortization of net loss    623    79    573    265  
Net periodic benefit cost    
$

1,088
 
$

749
 
$

1,488
 
$

1,605
 
     

 

 

 

 

  In June 2007, the Company paid $1.5 million for contracts insuring the lives of certain employees who are eligible to participate in certain non-qualified pension and deferred compensation plans. These insurance contracts will be used to informally fund the non-qualified pension and deferred compensation arrangements. The insurance contracts are held in a trust and are available to general creditors in the event of the Company’s insolvency. Cash surrender value of $1.4 million is included in other assets in the consolidated balance sheet as of June 29, 2007.

5. Total comprehensive income was as follows (in thousands):

             Thirteen Weeks Ended        Twenty-six Weeks Ended
June 29,
2007
    
June 30,
2006
    
June 29,
2007
    
June 30,
2006
    
Net Income     $ 44,180   $ 41,335   $ 77,915   $ 76,757  
Foreign currency translation
   adjustments
  121     1,225     114     1,740  
Pension liability adjustment,
   net of tax
      90     (37 )   81     (56 )
Comprehensive income  
$

44,391
 
$

42,523
 
$

78,110

$

78,441
 
     

 

 

 

 

6. The Company has three reportable segments: Industrial, Contractor and Lubrication. The Company does not track assets by segment. Sales and operating earnings by segment for the thirteen and twenty-six weeks ended June 29, 2007 and June 30, 2006 were as follows (in thousands):

             Thirteen Weeks Ended        Twenty-six Weeks Ended
June 29,
2007
    
June 30,
2006
    
June 29,
2007
    
June 30,
2006
    
Net Sales    
Industrial     $ 114,281   $ 104,555   $ 219,346   $ 204,715  
Contractor   94,231     96,507     163,982     170,859  
Lubrication       22,872     17,570     45,551     35,274  
Consolidated  
$

231,384
 
$

218,632
 
$

428,879
 
$

410,848
 
     

 

 

 

 
Operating Earnings   
Industrial   $ 39,555   $ 32,479   $ 73,973   $ 64,652  
Contractor    28,619    29,521    45,646    50,563  
Lubrication    2,196    4,466    5,260    9,221  
Unallocated Corporate    (2,656 )  (2,638 )  (5,078 )  (5,866 )
Consolidated    
$

67,714
 
$

63,828
 
$

119,801
 
$

118,480
 
     

 

 

 

 

7. Major components of inventories were as follows (in thousands):

  June 29, 2007   Dec. 29, 2006  
                 
Finished products and components   $ 51,073   $ 44,969  
Products and components in various stages  
     of completion    26,893    26,841  
Raw materials and purchased components    34,728    35,258  
   
 

112,694
 
 

107,068
 
Reduction to LIFO cost    (30,861 )  (30,757 )
Total  
$

81,833
 
$

76,311
 





8. Information related to other intangible assets follows (dollars in thousands):

  Estimated
Life
(Years)
Original
Cost
Accumulated
Amortization
Foreign
Currency
Translation
Book
Value
June 29, 2007                          
Customer relationships and     
    distribution network   4 - 8      $ 26,102   $ (9,215 ) $ 32   $ 16,919  
Patents, proprietary technology  
  and product documentation   5 - 15    22,243    (6,082 )  17    16,178  
Trademarks, trade names                          
   and other   3 - 10    4,684    (1,908 )  24    2,800  
           
 

53,029
 
 

(17,205
)
 

73
 
 

35,897
 
Not Subject to Amortization:  
   Brand names             10,260             10,260  
Total          
$

63,289
 
$

(17,205
)
$

73
 
$

46,157
 








December 29, 2006    
Customer relationships and    
  distribution network     4 - 8      $ 26,102   $ (7,335 ) $ 6   $ 18,773  
Patents, proprietary technology    
  and product documentation     5 - 15       22,243     (4,443 )   5     17,805  
Trademarks, trade names and    
  other     3 - 10       5,114     (1,641 )   14     3,487  
           
 

53,459
 
 

(13,419
)
 

25
 
 

40,065
 
Not Subject to Amortization:  
   Brand names        10,260            10,260  
Total          
$

63,719
 
$

(13,419
)
$

25
 
$

50,325
 









  Amortization of intangibles was $2.1 million in the second quarter of 2007 and $4.2 million year-to-date. Estimated annual amortization expense is as follows: $8.2 million in 2007, $7.8 million in 2008, $6.9 million in 2009, $5.8 million in 2010, $4.9 million in 2011 and $6.4 million thereafter.

9. Components of other current liabilities were (in thousands):

  June 29, 2007 Dec. 29, 2006
     
Accrued insurance liabilities $  8,002 $  7,833
Accrued warranty and service liabilities 6,405 6,675
Accrued trade promotions 4,706 7,265
Payable for employee stock purchases 2,793 5,846
Income taxes payable 1,177 3,920
Other 16,511 14,227
  Total
$39,594

$45,766
   
 

 

  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):

  Twenty-six  
Weeks Ended
June 29, 2007
  Year Ended  
Dec. 29, 2006
 
                 
Balance, beginning of year     $ 6,675   $ 7,649  
Charged to expense    2,432    4,442  
Margin on parts sales reversed    1,481    1,944  
Reductions for claims settled    (4,183 )  (7,360 )
Balance, end of period  
$

6,405
 
$

6,675
 





10. Effective at the beginning of 2007, the Company adopted the provisions of FASB Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes.” The adoption of FIN 48 resulted in no adjustment to beginning retained earnings.

  At the beginning of 2007, the Company’s liability for uncertain tax positions was $5.5 million. Unrecognized tax benefits of $4.9 million would affect the Company’s effective tax rate if recognized. The Company records penalties and accrued interest related to uncertain tax positions in income tax expense. At the beginning of 2007, approximately $0.6 million was included in the liability for uncertain tax positions for the possible payment of interest and penalties. There were no significant changes in components of the liability in the first half of 2007.

  With few exceptions, the Company is no longer subject to U.S. federal, state and local, or foreign income tax examinations by tax authorities for years prior to 2001. The Company’s U.S. income tax returns for 2004 and 2005 are currently under examination by the IRS. An estimate of the range of possible changes that may result from the examination cannot be made at this time.

  Approximately $1 million of unrecognized tax benefits relate to items that are affected by expiring statute of limitations within the next 12 months.

11. In July 2007, the Company entered into an agreement with a syndicate of lenders providing an unsecured credit facility for 5 years. The new credit facility provides $250 million of unsecured committed credit with an option for an additional $150 million. The facility is available for general corporate purposes, working capital needs, share repurchases and acquisitions. Borrowings under the facility bear interest at either the bank’s prime rate, the federal funds effective rate plus 0.5 percent or the London Interbank Offered Rate plus a spread of between 0.23 percent and 0.57 percent, depending on the Company’s cash flow leverage ratio (debt to earnings before interest, taxes, depreciation and amortization.) The Company is also required to pay a facility fee on the full amount of the loan commitment at an annual rate ranging from 0.07 percent to 0.15 percent, depending on the Company’s cash flow leverage ratio. The agreement requires the Company to maintain certain financial ratios as to cash flow leverage and interest coverage.

  Upon securing the new facility, certain committed lines of credit totaling $50 million were terminated. Additional uncommitted lines totaling $55 million will expire at the end of July 2007.

Item 2.    
  GRACO INC. AND SUBSIDIARIES  
     
  MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 

Results of Operations

Net earnings of $44.2 million for the quarter were 7 percent higher than net earnings in the second quarter last year. Sales of $231.4 million were 6 percent higher than the same period last year. Year-to-date net earnings of $77.9 million were 2 percent higher than last year and sales of $428.9 million were up 4 percent. Higher sales in Europe and Asia were offset to a great extent by lower sales in the Americas.

Foreign currency translation rates had a favorable impact on sales and net earnings. Translated at consistent exchange rates, net earnings and sales for the quarter were each up 4 percent, and year-to-date net earnings and sales increased 1 percent and 3 percent, respectively.

Results include the operations of Lubriquip, which was acquired in July 2006. Sales of Lubriquip products contributed over 2 percentage points of sales growth for both the quarter and year-to-date. Year-to-date costs and expenses related to moving and consolidation activities (including the consolidation of Gusmer operations completed in the first quarter) totaled approximately $1.5 million.

Net Sales

Sales by reportable segment and geographic area were as follows (in thousands):

Thirteen Weeks Ended       Twenty-six Weeks Ended    
  June 29,
2007   
June 30,
2006   
June 29,
2007   
June 30,
2006   
By Segment    
Industrial $114,281 $104,555 $219,346 $204,715
Contractor 94,231 96,507 163,982 170,859
Lubrication 22,872 17,570 45,551 35,274
Consolidated
$231,384

$218,632

$428,879

$410,848




By Geographic Area
Americas1 $141,482 $144,371 $262,027 $276,583
Europe2 58,667 45,355 108,045 84,901
Asia Pacific 31,235 28,906 58,807 49,364
Consolidated
$231,384

$218,632

$428,879

$410,848




1

North and South America, including the U.S.

2

Europe, Africa and Middle East


Industrial segment sales increased 9 percent for the quarter and 7 percent year-to-date. For the quarter, segment sales were up in all geographic regions, with 28 percent growth in Europe. Year-to-date, a 5 percent decrease in the Americas was more than offset by double-digit percentage growth in Europe and Asia.

Contractor segment sales decreased 2 percent for the quarter and 4 percent year-to-date. Strong increases in Europe and Asia were not enough to offset the decrease in the Americas. Most of the decrease in the Americas for the quarter resulted from lower sales to the home center channel. Year-to-date, sales were down in both the home center and the professional paint store channels.

Lubrication segment sales increased 30 percent for the quarter and 29 percent year-to-date due to sales of Lubriquip products, acquired in mid-2006. Sales in this segment increased in all geographic areas.

Gross Profit

Gross profit as a percentage of sales was 52.8 percent for the quarter compared to 53.5 percent for the second quarter last year. Year-to-date gross profit percentage was 53.0 percent in 2007 compared to 53.6 percent in 2006. The decrease for both the quarter and year-to-date was due mainly to lower margin rates on Lubriquip products, consolidation costs and higher material costs, offset somewhat by the favorable impacts of currency translation and pricing.

Operating Expenses

Total operating expenses for the quarter increased 3 percent. Product development and general and administrative expenses were flat while higher selling, marketing and distribution spending was in line with the sales increase. Year-to-date operating expenses increased 6 percent, mostly due to expenses related to Lubriquip.

Income Taxes

The effective income tax rate of 34 percent for the quarter was 1 percentage point lower than last year’s rate due to the recognition of benefits from foreign entities.

Liquidity and Capital Resources

Significant uses of cash in the first half of 2007 included $78 million for purchases and retirement of Company common stock, $22 million for capital additions and $22 million for payment of dividends. The largest sources of cash in the first half of 2007 were from operations and borrowings. During the first half of 2006, significant uses of cash included $46 million for purchases and retirement of Company common stock, $9 million for capital additions and $20 million for dividends. The largest source of cash in the first half of 2006 was from operations.

At June 29, 2007, the Company had various lines of credit totaling $148 million, of which $86 million was unused. In July 2007, the Company entered into an agreement with a syndicate of lenders providing $250 million of unsecured committed credit with an option for an additional $150 million. Upon securing the new facility, certain committed lines of credit totaling $50 million were terminated. Additional uncommitted lines totaling $55 million will expire at the end of July 2007.

The Company intends to use the new credit facility for general corporate purposes including acquisitions and share repurchases. The Company has authorization from its Board of Directors to repurchase up to 7 million shares of common stock. As of June 29, 2007, 3 million shares remained available for purchase under this authorization, which expires on February 29, 2008.

Internally generated funds and unused financing sources provide the Company with the financial flexibility to meet liquidity needs.

Outlook

While encouraged about the continued strength of the Company’s international business and the improvement in the Industrial business in the second quarter, management believes that difficult conditions will persist for the Contractor business in the Americas for at least the rest of this year. The integration of Lubriquip is on track for completion by the end of the year and the consolidation of Gusmer operations was completed in the first quarter. These integration activities will improve the contribution of the acquired products. Management believes it can continue to drive the business to higher sales and earnings by making long-term investments in key growth strategies including new product development, expanding distribution, entering new markets and pursuing strategic acquisitions.

SAFE HARBOR CAUTIONARY STATEMENT

A forward-looking statement is any statement made in this report and other reports that the Company files periodically with the Securities and Exchange Commission, or in press or earnings releases, analyst briefings and conference calls, which reflects the Company’s current thinking on market trends and the Company’s future financial performance at the time they are made. All forecasts and projections are forward-looking statements.

The Company desires to take advantage of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995 by making cautionary statements concerning any forward-looking statements made by or on behalf of the Company. The Company cannot give any assurance that the results forecasted in any forward-looking statement will actually be achieved. 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: economic conditions in the United States and other major world economies, currency fluctuations, political instability, changes in laws and regulations, and changes in product demand. Please refer to Item 1A of, and Exhibit 99 to, the Company’s Annual Report on Form 10-K for fiscal year 2006 for a more comprehensive discussion of these and other risk factors.

Investors should realize that factors other than those identified above and in Item 1A and Exhibit 99 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.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

There are no material changes related to market risk from the disclosures made in the Company’s 2006 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 and Controller, and the Vice President, General Counsel and Secretary. Based upon that evaluation, they concluded that the Company’s disclosure controls and procedures are effective in gathering, analyzing and disclosing information needed to satisfy the Company’s disclosure obligations under the Exchange Act.

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 II OTHER INFORMATION

Item 1A. Risk Factors

There have been no material changes to the Company’s risk factors from those disclosed in the Company’s 2006 Annual Report on Form 10-K.

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

Issuer Purchases of Equity Securities

On February 17, 2006, the Board of Directors authorized the Company to purchase up to a total of 7,000,000 shares of its outstanding common stock, primarily through open-market transactions. This authorization expires on February 29, 2008.

In addition to shares purchased under the Board authorization, the Company purchases shares of common stock held by employees who wish to tender owned shares to satisfy the exercise price or tax withholding on option exercises.

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)
                    
Mar 31, 2007 — Apr 27, 2007 59,900 $  39.67 59,900 4,414,700
                    
Apr 28, 2007 — May 25, 2007 842,063 $  39.43 838,900 3,575,800
                    
May 26, 2007 — Jun 29, 2007 541,000 $  40.15 541,000 3,034,800

Item 4. Submission of Matters to a Vote of Security Holders

At the Annual Meeting of Shareholders held on April 20, 2007, three directors were elected to the Board of Directors with the following votes:

  For Withheld
J. Kevin Gilligan
58,434,030

1,651,530
Mark H. Rauenhorst 58,414,542 1,671,019
William G. Van Dyke 52,699,744 7,385,817

At the same meeting, the following proposals were voted upon and approved, with the votes on each proposal as indicated below:

Ratification of Appointment of Deloitte & Touche LLP as the Independent Registered Public Accounting Firm:

For Against Abstentions Broker Non-Vote

58,078,860

1,873,902

132,799

Approval of the Executive Officer Annual Incentive Bonus Plan:

For Against Abstentions Broker Non-Vote

56,263,012

1,965,172

1,857,377


Item 6. Exhibits

  3.1 Restated Articles of Incorporation as amended June 14, 2007.

  4.1 Credit Agreement dated April 1, 2006, between the Company and Wachovia Bank, N.A. (Promissory Note); as extended by letter from Wachovia Bank, N.A. to Graco Inc., dated May 23, 2007.

  10.1 Graco Inc. Executive Officers Annual Incentive Bonus Plan effective January 1, 2008. (Incorporated by reference to Appendix A to the Company’s Proxy Statement for the Annual Meeting of Shareholders held on April 20, 2007.)

  10.2 Deferred Compensation Plan (1992 Restatement) Amendment 4 adopted June 14, 2007.

  10.3 Stock Option Agreement. Form of agreement used for award of nonstatutory stock options to nonemployee directors under the Graco Inc. Amended and Restated Stock Incentive Plan (2006).

  10.4 Election form. Amended form of agreement used for the 2006 plan year issuance of stock or deferred stock in lieu of cash payment of retainer and/or meeting fees to nonemployee directors under the Graco Inc. Stock Incentive Plan.

  10.5 Election form. Form of agreement used for the 2007 plan year for issuance of stock or deferred stock in lieu of cash payment of retainer and/or meeting fees to nonemployee directors under the Graco Inc. Amended and Restated Stock Incentive Plan (2006).

  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.

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:  July 25, 2007 By: /s/Patrick J. McHale
 
 
Patrick J. McHale
    President and Chief Executive Officer
      (Principal Executive Officer)
 
 
Date:  July 25, 2007 By: /s/James A. Graner
 
 
James A. Graner
    Chief Financial Officer and Treasurer
      (Principal Financial Officer)