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 September 23, 2016
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    

55,684,000 shares of the Registrant’s Common Stock, $1.00 par value, were outstanding as of October 12, 2016.


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
 
Nine Months Ended
 
September 23,
2016
 
September 25,
2015
 
September 23,
2016
 
September 25,
2015
Net Sales
$
327,192

 
$
318,986

 
$
980,230

 
$
960,928

Cost of products sold
150,594

 
148,790

 
456,695

 
447,980

Gross Profit
176,598

 
170,196

 
523,535

 
512,948

Product development
14,671

 
14,783

 
44,964

 
44,980

Selling, marketing and distribution
49,269

 
48,374

 
158,106

 
149,924

General and administrative
31,194

 
30,112

 
99,710

 
91,995

Operating Earnings
81,464

 
76,927

 
220,755

 
226,049

Interest expense
4,432

 
4,025

 
13,468

 
13,453

Held separate investment (income), net
—

 
(2,388
)
 
—

 
(190,744
)
Other expense (income), net
416

 
1,389

 
(338
)
 
1,661

Earnings Before Income Taxes
76,616

 
73,901

 
207,625

 
401,679

Income taxes
22,228

 
23,210

 
62,738

 
109,510

Net Earnings
$
54,388

 
$
50,691

 
$
144,887

 
$
292,169

Per Common Share
 
 
 
 
 
 
 
Basic net earnings
$
0.98

 
$
0.88

 
$
2.61

 
$
5.02

Diluted net earnings
$
0.95

 
$
0.86

 
$
2.55

 
$
4.90

Cash dividends declared
$
0.33

 
$
0.30

 
$
0.99

 
$
0.90

See notes to consolidated financial statements.


CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited) (In thousands)
 
Three Months Ended
 
Nine Months Ended
 
September 23,
2016
 
September 25,
2015
 
September 23,
2016
 
September 25,
2015
Net Earnings
$
54,388

 
$
50,691

 
$
144,887

 
$
292,169

Components of other comprehensive
income (loss)
 
 
 
 
 
 
 
Cumulative translation adjustment
(6,642
)
 
(13,572
)
 
(16,679
)
 
(4,179
)
Pension and postretirement medical
liability adjustment
1,707

 
2,537

 
4,957

 
6,894

Income taxes - pension and postretirement
medical liability adjustment
(619
)
 
(837
)
 
(1,823
)
 
(2,478
)
Other comprehensive income (loss)
(5,554
)
 
(11,872
)
 
(13,545
)
 
237

Comprehensive Income
$
48,834

 
$
38,819

 
$
131,342

 
$
292,406

See notes to consolidated financial statements.

3
Table of Contents

GRACO INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited) (In thousands)
 
September 23,
2016
 
December 25,
2015
ASSETS
 
 
 
Current Assets
 
 
 
Cash and cash equivalents
$
53,322

 
$
52,295

Accounts receivable, less allowances of $12,100 and $10,400
223,257

 
225,509

Inventories
201,553

 
202,136

Other current assets
20,111

 
29,077

Total current assets
498,243

 
509,017

Property, Plant and Equipment
 
 
 
Cost
487,496

 
461,173

Accumulated depreciation
(296,973
)
 
(282,736
)
Property, plant and equipment, net
190,523

 
178,437

Goodwill
411,594

 
394,488

Other Intangible Assets, net
233,947

 
227,987

Deferred Income Taxes
62,019

 
56,976

Other Assets
24,876

 
24,447

Total Assets
$
1,421,202

 
$
1,391,352

LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Current Liabilities
 
 
 
Notes payable to banks
$
8,380

 
$
15,901

Trade accounts payable
40,951

 
40,505

Salaries and incentives
37,681

 
44,673

Dividends payable
18,381

 
18,447

Other current liabilities
71,829

 
75,090

Total current liabilities
177,222

 
194,616

Long-term Debt
355,780

 
392,695

Retirement Benefits and Deferred Compensation
141,094

 
137,457

Deferred Income Taxes
26,711

 
22,303

Other Non-current Liabilities
8,630

 
8,730

Shareholders’ Equity
 
 
 
Common stock
55,706

 
55,766

Additional paid-in-capital
440,823

 
398,774

Retained earnings
333,278

 
285,508

Accumulated other comprehensive income (loss)
(118,042
)
 
(104,497
)
Total shareholders’ equity
711,765

 
635,551

Total Liabilities and Shareholders’ Equity
$
1,421,202

 
$
1,391,352

See notes to consolidated financial statements.

4
Table of Contents

GRACO INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited) (In thousands)
 
Nine Months Ended
 
September 23,
2016
 
September 25,
2015
Cash Flows From Operating Activities
 
 
 
Net Earnings
$
144,887

 
$
292,169

Adjustments to reconcile net earnings to net cash provided
by operating activities
 
 
 
Depreciation and amortization
36,846

 
33,286

Deferred income taxes
(8,470
)
 
(13,723
)
Share-based compensation
16,143

 
15,488

Excess tax benefit related to share-based payment arrangements
(5,800
)
 
(1,200
)
Gain on sale of business, net
—

 
(149,003
)
Change in
 
 
 
Accounts receivable
6,100

 
(21,195
)
Inventories
1,628

 
(28,648
)
Trade accounts payable
1,057

 
3,124

Salaries and incentives
(6,914
)
 
(2,759
)
Retirement benefits and deferred compensation
7,431

 
8,802

Other accrued liabilities
9,379

 
19,556

Other
(367
)
 
(20,665
)
Net cash provided by operating activities
201,920

 
135,232

Cash Flows From Investing Activities
 
 
 
Property, plant and equipment additions
(34,347
)
 
(28,860
)
Acquisition of businesses, net of cash acquired
(48,643
)
 
(187,853
)
Proceeds from sale of assets
—

 
610,162

Investment in restricted assets
150

 
(8,580
)
Other
(130
)
 
(43
)
Net cash provided by (used in) investing activities
(82,970
)
 
384,826

Cash Flows From Financing Activities
 
 
 
Borrowings (payments) on short-term lines of credit, net
(7,349
)
 
4,265

Borrowings on long-term line of credit
532,724

 
595,400

Payments on long-term line of credit
(569,639
)
 
(835,400
)
Excess tax benefit related to share-based payment arrangements
5,800

 
1,200

Common stock issued
25,564

 
16,768

Common stock repurchased
(48,050
)
 
(224,730
)
Cash dividends paid
(55,058
)
 
(52,658
)
Net cash provided by (used in) financing activities
(116,008
)
 
(495,155
)
Effect of exchange rate changes on cash
(1,915
)
 
3,354

Net increase (decrease) in cash and cash equivalents
1,027

 
28,257

Cash and cash equivalents
 
 
 
Beginning of year
52,295

 
23,656

End of period
$
53,322

 
$
51,913

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 September 23, 2016 and the related statements of earnings and comprehensive income for the three and nine months ended September 23, 2016 and September 25, 2015, and cash flows for the nine months ended September 23, 2016 and September 25, 2015 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 September 23, 2016, 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 2015 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
 
Nine Months Ended
 
September 23,
2016
 
September 25,
2015
 
September 23,
2016
 
September 25,
2015
Net earnings available to
common shareholders
$
54,388

 
$
50,691

 
$
144,887

 
$
292,169

Weighted average shares outstanding for
basic earnings per share
55,684

 
57,325

 
55,571

 
58,180

Dilutive effect of stock options computed
using the treasury stock method and the
average market price
1,285

 
1,339

 
1,335

 
1,410

Weighted average shares outstanding for
diluted earnings per share
56,969

 
58,664

 
56,906

 
59,590

Basic earnings per share
$
0.98

 
$
0.88

 
$
2.61

 
$
5.02

Diluted earnings per share
$
0.95

 
$
0.86

 
$
2.55

 
$
4.90


Stock options to purchase 1,034,000 and 1,391,000 shares were not included in the September 23, 2016 and September 25, 2015 computations of diluted earnings per share, respectively, because they would have been anti-dilutive.


6
Table of Contents

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 25, 2015
5,165

 
$
48.16

 
3,583

 
$
38.49

Granted
700

 
72.24

 
 
 
 
Exercised
(600
)
 
37.98

 
 
 
 
Canceled
(17
)
 
70.45

 
 
 
 
Outstanding, September 23, 2016
5,248

 
$
52.46

 
3,494

 
$
42.30


The Company recognized year-to-date share-based compensation of $16.1 million in 2016 and $15.5 million in 2015. As of September 23, 2016, there was $9.5 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:
 
Nine Months Ended
 
September 23,
2016
 
September 25,
2015
Expected life in years
7.0

 
6.5

Interest rate
1.4
%
 
1.7
%
Volatility
30.1
%
 
35.0
%
Dividend yield
1.8
%
 
1.6
%
Weighted average fair value per share
$
19.00

 
$
23.18


Under the Company’s Employee Stock Purchase Plan, the Company issued 170,000 shares in 2016 and 166,000 shares in 2015. 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:
 
Nine Months Ended
 
September 23,
2016
 
September 25,
2015
Expected life in years
1.0

 
1.0

Interest rate
0.7
%
 
0.2
%
Volatility
24.6
%
 
18.9
%
Dividend yield
1.7
%
 
1.6
%
Weighted average fair value per share
$
19.14

 
$
16.51



7
Table of Contents

4.Retirement Benefits

The components of net periodic benefit cost for retirement benefit plans were as follows (in thousands):
 
Three Months Ended
 
Nine Months Ended
 
September 23,
2016
 
September 25,
2015
 
September 23,
2016
 
September 25,
2015
Pension Benefits
 
 
 
 
 
 
 
Service cost
$
1,968

 
$
2,265

 
$
5,880

 
$
6,268

Interest cost
3,902

 
3,741

 
11,765

 
11,121

Expected return on assets
(4,504
)
 
(5,010
)
 
(13,509
)
 
(14,586
)
Amortization and other
2,491

 
2,291

 
7,410

 
7,070

Net periodic benefit cost
$
3,857

 
$
3,287

 
$
11,546

 
$
9,873

Postretirement Medical
 
 
 
 
 
 
 
Service cost
$
136

 
$
107

 
$
407

 
$
407

Interest cost
271

 
263

 
813

 
716

Amortization
(120
)
 
(63
)
 
(360
)
 
(265
)
Net periodic benefit cost
$
287

 
$
307

 
$
860

 
$
858


5.Shareholders’ Equity

Changes in components of accumulated other comprehensive income (loss), net of tax were (in thousands):
 
Pension and Post-
retirement Medical
 
Cumulative
Translation
Adjustment
 
Total
Balance, June 26, 2015
$
(73,868
)
 
$
(14,759
)
 
$
(88,627
)
Other comprehensive income before reclassifications
—

 
(13,572
)
 
(13,572
)
Amounts reclassified from accumulated other comprehensive income
1,700

 
—

 
1,700

Balance, September 25, 2015
$
(72,168
)
 
$
(28,331
)
 
$
(100,499
)
Balance, June 24, 2016
$
(67,876
)
 
$
(44,612
)
 
$
(112,488
)
Other comprehensive income before reclassifications
—

 
(6,642
)
 
(6,642
)
Amounts reclassified from accumulated other comprehensive income
1,088

 
—

 
1,088

Balance, September 23, 2016
$
(66,788
)
 
$
(51,254
)
 
$
(118,042
)
Balance, December 26, 2014
$
(76,584
)
 
$
(24,152
)
 
$
(100,736
)
Other comprehensive income before reclassifications
—

 
(4,179
)
 
(4,179
)
Reclassified from accumulated other comprehensive income
4,416

 
—

 
4,416

Balance, September 25, 2015
$
(72,168
)
 
$
(28,331
)
 
$
(100,499
)
Balance, December 25, 2015
$
(69,922
)
 
$
(34,575
)
 
$
(104,497
)
Other comprehensive income before reclassifications
—

 
(16,679
)
 
(16,679
)
Reclassified from accumulated other comprehensive income
3,134

 
—

 
3,134

Balance, September 23, 2016
$
(66,788
)
 
$
(51,254
)
 
$
(118,042
)

8
Table of Contents


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
 
Nine Months Ended
 
September 23,
2016
 
September 25,
2015
 
September 23,
2016
 
September 25,
2015
Cost of products sold
$
611

 
$
959

 
$
1,776

 
$
2,604

Product development
241

 
418

 
706

 
1,120

Selling, marketing and distribution
578

 
718

 
1,633

 
1,950

General and administrative
277

 
442

 
842

 
1,220

Total before tax
$
1,707

 
$
2,537

 
$
4,957

 
$
6,894

Income tax (benefit)
(619
)
 
(837
)
 
(1,823
)
 
(2,478
)
Total after tax
$
1,088

 
$
1,700

 
$
3,134

 
$
4,416


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
 
Nine Months Ended
 
September 23,
2016
 
September 25,
2015
 
September 23,
2016
 
September 25,
2015
Net Sales
 
 
 
 
 
 
 
Industrial
$
150,893

 
$
152,164

 
$
454,978

 
$
448,932

Process
67,077

 
64,710

 
196,068

 
204,337

Contractor
109,222

 
102,112

 
329,184

 
307,659

Total
$
327,192

 
$
318,986

 
$
980,230

 
$
960,928

Operating Earnings
 
 
 
 
 
 
 
Industrial
$
50,573

 
$
50,822

 
$
147,419

 
$
144,500

Process
10,394

 
10,437

 
25,305

 
34,923

Contractor
25,593

 
24,135

 
71,700

 
70,550

Unallocated corporate (expense)
(5,096
)
 
(8,467
)
 
(23,669
)
 
(23,924
)
Total
$
81,464

 
$
76,927

 
$
220,755

 
$
226,049


Assets by segment were as follows (in thousands): 
 
September 23,
2016
 
December 25,
2015
Industrial
$
558,228

 
$
558,799

Process
513,186

 
481,677

Contractor
212,958

 
205,632

Unallocated corporate
136,830

 
145,244

Total
$
1,421,202

 
$
1,391,352



9
Table of Contents

Geographic information follows (in thousands):
 
Three Months Ended
 
Nine Months Ended
 
September 23,
2016
 
September 25,
2015
 
September 23,
2016
 
September 25,
2015
Net sales (based on customer location)
 
 
 
 
 
 
 
United States
$
171,988

 
$
166,602

 
$
511,273

 
$
496,851

Other countries
155,204

 
152,384

 
468,957

 
464,077

Total
$
327,192

 
$
318,986

 
$
980,230

 
$
960,928

 
September 23,
2016
 
December 25,
2015
Long-lived assets
 
 
 
United States
$
153,160

 
$
144,571

Other countries
37,363

 
33,866

Total
$
190,523

 
$
178,437


7.Inventories

Major components of inventories were as follows (in thousands):
 
September 23,
2016
 
December 25,
2015
Finished products and components
$
112,949

 
$
112,267

Products and components in various stages of completion
51,064

 
51,033

Raw materials and purchased components
83,582

 
82,894

 
247,595

 
246,194

Reduction to LIFO cost
(46,042
)
 
(44,058
)
Total
$
201,553

 
$
202,136



10
Table of Contents

8.Intangible Assets

Information related to other intangible assets follows (dollars in thousands):
 
Estimated Life
(years)
 
Cost      
 
Accumulated
Amortization
 
Foreign
Currency Translation  
 
Book
Value
September 23, 2016
 
 
 
 
 
 
 
 
 
Customer relationships
3 - 14
 
$
218,227

 
$
(49,383
)
 
$
(12,316
)
 
$
156,528

Patents, proprietary technology and product documentation
3 - 11
 
17,422

 
(5,731
)
 
(705
)
 
10,986

Trademarks, trade names and other
3 - 5
 
895

 
(284
)
 
(58
)
 
553

 
 
 
236,544

 
(55,398
)
 
(13,079
)
 
168,067

Not Subject to Amortization:
 
 
 
 
 
 
 
 
 
Brand names
 
 
70,528

 
—

 
(4,648
)
 
65,880

Total
 
 
$
307,072

 
$
(55,398
)
 
$
(17,727
)
 
$
233,947

December 25, 2015
 
 
 
 
 
 
 
 
 
Customer relationships
3 - 14
 
$
197,900

 
$
(36,852
)
 
$
(9,738
)
 
$
151,310

Patents, proprietary technology and product documentation
3 - 11
 
20,400

 
(8,952
)
 
(658
)
 
10,790

Trademarks, trade names and other
5
 
495

 
(132
)
 
(94
)
 
269

 
 
 
218,795

 
(45,936
)
 
(10,490
)
 
162,369

Not Subject to Amortization:
 
 
 
 
 
 
 
 
 
Brand names
 
 
69,514

 
—

 
(3,896
)
 
65,618

Total
 
 
$
288,309

 
$
(45,936
)
 
$
(14,386
)
 
$
227,987


Amortization of intangibles for the quarter was $4.6 million in 2016 and $4.4 million in 2015 and for the year-to-date was $14.3 million in 2016 and $12.9 million in 2015. Estimated annual amortization expense is as follows: $18.7 million in 2016, $18.6 million in 2017, $18.5 million in 2018, $18.0 million in 2019, $17.9 million in 2020, and $90.7 million thereafter.

Changes in the carrying amount of goodwill in 2016 were as follows (in thousands): 
 
Industrial    
 
Process    
 
Contractor    
 
Total    
Balance, December 25, 2015
$
153,283

 
$
228,473

 
$
12,732

 
$
394,488

Additions from business acquisitions
—

 
27,881

 
—

 
27,881

Foreign currency translation
1,585

 
(12,360
)
 
—

 
(10,775
)
Balance, September 23, 2016
$
154,868

 
$
243,994

 
$
12,732

 
$
411,594


Goodwill is reviewed for impairment annually or more frequently if events or changes in circumstances indicate that the carrying value of the goodwill may not be recoverable. In completing the goodwill impairment analysis for 2015, the estimated fair value of all reporting units substantially exceeded carrying value except for our Oil and Natural Gas reporting unit (“ONG”), which exceeded its carrying value by 14 percent. In 2016, operating results of ONG have fallen short of expectations due to weakness in oil and natural gas markets. After considering third quarter operating results and preliminary projections from our 2017 planning process, we concluded that the depth and length of industry weakness, and its continuing impact on ONG results, were greater than previously expected. Consequently, we initiated an impairment analysis at the end of the third quarter. Preliminary analysis indicated potential impairment of ONG goodwill as of September 23, 2016. Due to the amount of time and effort required to determine the implied fair value of ONG goodwill, we are unable to provide a reasonable estimate or a range of estimates for the potential non-cash impairment charge at this time. The carrying value of ONG goodwill was $147 million and the carrying value of other identifiable intangible assets of ONG totaled $73 million as of September 23, 2016. The valuation to determine the amount of impairment will be completed in the fourth quarter.


11
Table of Contents

9.
Other Current Liabilities
Components of other current liabilities were (in thousands):
 
September 23,
2016
 
December 25,
2015
Accrued self-insurance retentions
$
7,000

 
$
6,908

Accrued warranty and service liabilities
8,384

 
7,870

Accrued trade promotions
6,375

 
8,522

Payable for employee stock purchases
6,678

 
8,825

Customer advances and deferred revenue
13,577

 
9,449

Income taxes payable
3,581

 
1,308

Other
26,234

 
32,208

Total
$
71,829

 
$
75,090


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 25, 2015
$
7,870

Charged to expense
5,057

Margin on parts sales reversed
1,307

Reductions for claims settled
(5,850
)
Balance, September 23, 2016
$
8,384


The Company manages certain self-insured loss exposures through a wholly-owned captive insurance subsidiary established in 2015. At September 23, 2016, cash balances of $9 million were restricted to funding of the captive's loss reserves. Restricted cash is included within other current assets on the Company's consolidated balance sheet.

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   
 
September 23,
2016
 
December 25,
2015
Assets
 
 
 
 
 
Cash surrender value of life insurance
2
 
$
13,659

 
$
12,856

Forward exchange contracts
2
 
—

 
107

Total assets at fair value
 
 
$
13,659

 
$
12,963

Liabilities
 
 
 
 
 
Contingent consideration
3
 
$
4,081

 
$
9,600

Deferred compensation
2
 
3,190

 
2,958

Forward exchange contracts
2
 
58

 
—

Total liabilities at fair value
 
 
$
7,329

 
$
12,558


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.


12
Table of Contents

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.

Long-term notes payable with fixed interest rates have a carrying amount of $300 million and an estimated fair value of $335 million as of September 23, 2016 and $320 million as of December 25, 2015. 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.Divestiture in 2015

In the second quarter of 2015, the Company sold the Liquid Finishing business assets that were held as a cost-method investment. The $149 million pre-tax gain, net of transaction and other related expenses, was included in investment income in the Company's consolidated statements of earnings. Net earnings for the third quarter of 2015 included after-tax net gain from post-closing purchase price adjustments of $2 million and year-to-date after-tax gain and dividends totaling $141 million. Prior to the sale, income was recognized on dividends received from after-tax earnings of Liquid Finishing and also included in investment income. Net earnings in 2015 included no dividend income for the quarter and $42 million for the year-to-date.

12.Recent Accounting Pronouncements

In February 2016, the Financial Accounting Standards Board (FASB) issued a final standard on accounting for leases. The new standard is effective for the Company in fiscal 2019 and requires most leases to be recorded on the balance sheet. The Company is evaluating the effect of the new standard on its consolidated financial statements and related disclosures and accounting systems.

In March 2016, FASB issued a new standard that changes the accounting for share-based payments. The standard is effective for the Company in fiscal 2017 and early adoption is permitted. It simplifies several aspects of accounting for share-based payments, including the accounting for income taxes, forfeitures, and classification in the statement of cash flows. Under the new standard, excess tax benefits on the exercise of stock options currently credited to equity will reduce the current tax provision, potentially creating volatility in the Company's effective tax rate. The Company is evaluating the effect of the new standard on its consolidated financial statements and related disclosures and will adopt for fiscal 2017.

13
Table of Contents

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

Net sales, net earnings and earnings per share were as follows (in millions except per share amounts and percentages):
 
Three Months Ended    
 
Nine Months Ended
 
September 23,
2016
 
September 25,
2015
 
%
 Change 
 
September 23,
2016
 
September 25,
2015
 
%
 Change 
Net Sales
$
327.2

 
$
319.0

 
3
%
 
$
980.2

 
$
960.9

 
2
 %
Operating Earnings
81.5

 
76.9

 
6
%
 
220.8

 
226.0

 
(2
)%
Net Earnings
54.4

 
50.7

 
7
%
 
144.9

 
292.2

 
(50
)%
Diluted Net Earnings per Common Share
$
0.95

 
$
0.86

 
10
%
 
$
2.55

 
$
4.90

 
(48
)%

Net earnings in 2015 included net investment income from the Liquid Finishing businesses sold in the second quarter of 2015. Results excluding Liquid Finishing investment income and expense provide a more consistent base of comparison of ongoing financial results. A calculation of the non-GAAP measurement of net earnings excluding investment income and expense follows (in millions except per share amounts):
 
Three Months Ended   
 
Nine Months Ended
 
September 23,
2016
 
September 25,
2015
 
September 23,
2016
 
September 25,
2015
Net Earnings, as reported
$
54.4

 
$
50.7

 
$
144.9

 
$
292.2

Held separate investment (income), net
—

 
(2.4
)
 
—

 
(190.7
)
Income tax effect
—

 
0.8

 
—

 
49.7

Net Earnings, adjusted
$
54.4

 
$
49.1

 
$
144.9

 
$
151.2

Diluted earnings per share
 
 
 
 
 
 
 
As reported
$
0.95

 
$
0.86

 
$
2.55

 
$
4.90

Adjusted
$
0.95

 
$
0.84

 
$
2.55

 
$
2.54


14
Table of Contents

The following table presents components of changes in sales:
 
Quarter
 
Segment
 
Region
 
Total    
 
Industrial  
 
Process  
 
Contractor  
 
Americas(1)
 
EMEA(2)
 
Asia Pacific  
 
Volume and Price
(1)
 %
 
0
 %
 
7
%
 
2
%
 
2
 %
 
3
%
 
2
%
Acquisitions
0
 %
 
5
 %
 
0
%
 
0
%
 
2
 %
 
1
%
 
1
%
Currency
0
 %
 
(1)
 %
 
0
%
 
0
%
 
(2)
 %
 
0
%
 
0
%
Total
(1)
 %
 
4
 %
 
7
%
 
2
%
 
2
 %
 
4
%
 
3
%
 
Year-to-Date
 
Segment
 
Region
 
Total    
 
Industrial  
 
Process  
 
Contractor  
 
Americas(1)
 
EMEA(2)
 
Asia Pacific  
 
Volume and Price
2
 %
 
(9)
 %
 
7
%
 
0
%
 
5
 %
 
2
 %
 
1
 %
Acquisitions
0
 %
 
6
 %
 
0
%
 
1
%
 
3
 %
 
2
 %
 
2
 %
Currency
(1)
 %
 
(1)
 %
 
0
%
 
0
%
 
(2)
 %
 
(2)
 %
 
(1)
 %
Total
1
 %
 
(4)
 %
 
7
%
 
1
%
 
6
 %
 
2
 %
 
2
 %
(1) North and South America, including the United States
(2) Europe, Middle East and Africa

Sales by geographic area were as follows (in millions):
 
Three Months Ended   
 
Nine Months Ended
 
September 23,
2016
 
September 25,
2015
 
September 23,
2016
 
September 25,
2015
Americas
$
194.4

 
$
190.0

 
$
575.3

 
$
572.1

EMEA
73.6

 
72.2

 
229.4

 
216.6

Asia Pacific
59.2

 
56.8

 
175.5

 
172.2

Consolidated
$
327.2

 
$
319.0

 
$
980.2

 
$
960.9


Changes in currency translation rates had no significant effect on results for the quarter, and decreased year-to-date sales and net earnings by approximately $9 million and $2 million, respectively.

Sales for the quarter increased 3 percent, with 2 percent increases in the Americas and EMEA and a 4 percent increase in Asia Pacific. Incremental sales from operations acquired within the last 12 months totaled $4 million, contributing 1 percentage point of growth. Organic sales at consistent translation rates increased 2 percent, with increases in all regions.

Sales for the year to date increased 2 percent, driven by a 6 percent increase in EMEA. Incremental sales from operations acquired within the last 12 months totaled $15 million, contributing 2 percentage points of growth. Organic sales at consistent translation rates increased 1 percent, with increases of 5 percent in EMEA and 2 percent in Asia Pacific.

Gross profit margin rates were slightly higher for the quarter and flat for the year to date. The favorable effects of realized pricing and product and channel mix offset the unfavorable impacts of lower factory volume. Gross margin rate for the year to date also included the favorable impact of reduced acquisition-related purchase accounting effects.

Total operating expenses for the quarter were $2 million (2 percent) higher than the third quarter last year, including $2 million of incremental expenses of acquired operations. Unallocated corporate expenses decreased $3 million, mostly from changes in market-driven components of pension and stock compensation. Total operating expenses for the year to date were $16 million (6 percent) higher than the comparable period last year, including $7 million of incremental expenses of acquired operations.

15
Table of Contents


The effective income tax rate for the quarter was 29 percent, 2 percentage points lower than the comparable period last year. The 2016 rate included the impact of the federal R&D credit that was not available until the fourth quarter of 2015, and the favorable effect of foreign earnings taxed at lower rates than in the U.S. The effective rate for the year to date was 30 percent, 3 percentage points higher than the comparable period last year. Last year's rate included the favorable impact of non-recurring tax benefits, mostly related to a change in assertion as to reinvestment of foreign earnings, and the impact of post-tax dividend income, partially offset by the tax rate effect of the gain on the sale of the Liquid Finishing assets.

Goodwill Impairment Analysis

In 2016, operating results of our Oil and Natural Gas reporting unit ("ONG") within the Process segment have fallen short of expectations due to weakness in oil and natural gas markets. After considering third quarter operating results and preliminary projections from our 2017 planning process, we concluded that the depth and length of industry weakness, and its continuing impact on ONG results, were greater than previously expected. While management is committed to long-term profitability in ONG, and believes its investment in facility improvements, manufacturing capabilities and commercial resources have positioned the unit to benefit strongly from a recovery when it occurs, we initiated an impairment analysis at the end of the third quarter. Preliminary analysis indicated potential impairment of ONG goodwill as of September 23, 2016. Due to the amount of time and effort required to determine the implied fair value of ONG goodwill, we are unable to provide a reasonable estimate or a range of estimates for the potential non-cash impairment charge at this time. The carrying value of ONG goodwill was $147 million and the carrying value of other identifiable intangible assets of ONG totaled $73 million as of September 23, 2016. The valuation to determine the amount of impairment will be completed in the fourth quarter.


Segment Results

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

Industrial
 
Three Months Ended  
 
Nine Months Ended
 
September 23,
2016
 
September 25,
2015
 
September 23,
2016
 
September 25,
2015
Net sales (in millions)
 
 
 
 
 
 
 
Americas
$
66.8

 
$
69.8

 
$
201.3

 
$
209.1

EMEA
44.4

 
45.6

 
134.2

 
128.0

Asia Pacific
39.7

 
36.8

 
119.5

 
111.8

Total
$
150.9

 
$
152.2

 
$
455.0

 
$
448.9

Operating earnings as a percentage
 of net sales
34
%
 
33
%
 
32
%
 
32
%

Industrial segment sales for the quarter decreased 1 percent. An increase of 8 percent in Asia Pacific offset decreases of 4 percent in the Americas and 3 percent in EMEA. Year-to-date sales increased 1 percent (2 percent at consistent translation rates), including increases of 5 percent in EMEA (6 percent at consistent translation rates) and 7 percent in Asia Pacific (8 percent at consistent translation rates), partially offset by a decrease of 4 percent in the Americas. Operating margin rates for the Industrial segment were slightly higher than last year.


16
Table of Contents

Process
 
Three Months Ended   
 
Nine Months Ended
 
September 23,
2016
 
September 25,
2015
 
September 23,
2016
 
September 25,
2015
Net sales (in millions)
 
 
 
 
 
 
 
Americas
$
43.0

 
$
41.0

 
$
124.3

 
$
128.3

EMEA
12.7

 
12.7

 
40.1

 
41.5

Asia Pacific
11.4

 
11.0

 
31.7

 
34.5

Total
$
67.1

 
$
64.7

 
$
196.1

 
$
204.3

Operating earnings as a percentage
of net sales
15
%
 
16
%
 
13
%
 
17
%

Process segment sales for the quarter increased 4 percent (5 percent at consistent translation rates), including increases of 5 percent in the Americas and 4 percent in Asia Pacific. Sales were flat in EMEA, but increased 7 percent at consistent translation rates. Year-to-date sales in this segment were down 4 percent (3 percent at consistent translation rates), including decreases of 3 percent in the Americas, 4 percent in EMEA (flat at consistent translation rates) and 8 percent in Asia Pacific (6 percent at consistent translation rates). Operating margin rate recovered in the third quarter with higher sales volume and improved gross margin rate. For the year to date, operating margin rate decreased compared to last year due to lower sales volume and unfavorable expense leverage.

Contractor
 
Three Months Ended   
 
Nine Months Ended
 
September 23,
2016
 
September 25,
2015
 
September 23,
2016
 
September 25,
2015
Net sales (in millions)
 
 
 
 
 
 
 
Americas
$
84.6

 
$
79.2

 
$
249.7

 
$
234.7

EMEA
16.5

 
13.9

 
55.2

 
47.1

Asia Pacific
8.1

 
9.0

 
24.3

 
25.9

Total
$
109.2

 
$
102.1

 
$
329.2

 
$
307.7

Operating earnings as a percentage
of net sales
23
%
 
24
%
 
22
%
 
23
%

Contractor segment sales for the quarter increased 7 percent, with increases of 7 percent in the Americas and 20 percent in EMEA, partially offset by a decrease of 11 percent in Asia Pacific. Year-to-date sales increased 7 percent, with increases of 6 percent in the Americas and 17 percent in EMEA, partially offset by a 6 percent decrease in Asia Pacific. Operating margin rates decreased slightly compared to last year due to unfavorable expense leverage and product and channel mix.

Liquidity and Capital Resources

Net cash provided by operating activities through the first nine months of 2016 was $202 million, compared to $135 million in the same period of 2015. Net cash from operating activities in 2015 was affected by increases in accounts receivables balances from growth in business activity, build up of inventory levels to improve customer service and transaction costs related to the sale of Liquid Finishing business assets. In the first quarter of 2016, the Company used proceeds from borrowings under its revolving line of credit to complete acquisitions of two related businesses that were not material to the consolidated financial statements. Other significant uses of cash in 2016 included share repurchases of $48 million (partially offset by $26 million of proceeds from shares issued), cash dividends of $55 million and property, plant and equipment additions of $34 million. In 2015, proceeds of $610 million from the sale of Liquid Finishing assets were principally used to retire debt.

At September 23, 2016, 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.


17
Table of Contents

At September 23, 2016, the Company had various lines of credit totaling $547 million, of which $484 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 2016.

Outlook

We are holding to our outlook of low single-digit sales growth for Graco worldwide for the full year 2016. The Industrial segment continues to experience a spotty environment for capital equipment spending worldwide, with ongoing weakness most notable in the Americas region. Construction activity remains solid in the EMEA and Americas regions. While the Process segment saw modest growth sequentially in the third quarter, we are cautious about ongoing headwinds. Regionally, we anticipate the Americas region will finish the full year 2016 flat compared with the prior year, below our prior outlook of low single-digit growth. In the EMEA region, we reiterate our low-to-mid single-digit growth expectations for the full year. Our outlook for the Asia Pacific region continues to be low single-digit growth for 2016. The fourth quarter of 2015 was the highest growth quarter of the year, with 6 percent growth on an organic, constant currency basis, providing a difficult comparable for the last quarter of the year.

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 2015 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 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 2015 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.


18
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 2015 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.

19
Table of Contents

PART IIOTHER INFORMATION

Item 1A.Risk Factors

Except as noted below, there have been no material changes to the Company’s risk factors from those disclosed in the Company’s 2015 Annual Report on Form 10-K.

Impairment - If acquired businesses do not meet performance expectations, assets acquired could be subject to impairment.

Our total assets reflect goodwill from acquisitions, representing the excess cost over the fair value of the identifiable net assets acquired. We test annually whether goodwill has been impaired, or more frequently if events or changes in circumstances indicate the goodwill may be impaired. If future operating performance at one or more of our operating units were to fall significantly below forecast levels or if market conditions for one or more of our acquired businesses were to decline, we could be required to incur a non-cash charge to operating income for impairment. Any impairment in the value of our goodwill would have an adverse non-cash impact on our results of operations and reduce our net worth. In 2016, operating results of our Oil and Natural Gas reporting unit ("ONG") have fallen short of expectations due to weakness in oil and natural gas markets. After considering third quarter operating results and preliminary projections from our 2017 planning process, we concluded that the depth and length of industry weakness, and its continuing impact on ONG results, were greater than previously expected. Consequently, we initiated an impairment analysis at the end of the third quarter. Preliminary analysis indicated potential impairment of ONG goodwill as of September 23, 2016. Due to the amount of time and effort required to determine the implied fair value of ONG goodwill, we are unable to provide a reasonable estimate or a range of estimates for the potential non-cash impairment charge at this time. The carrying value of ONG goodwill was $147 million and the carrying value of other identifiable intangible assets of ONG totaled $73 million as of September 23, 2016. The valuation to determine the amount of impairment will be completed in the fourth quarter.

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.

No shares were purchased in the third quarter of 2016. As of September 23, 2016, there were 3,852,367 shares that may yet be purchased under the Board authorization.



20
Table of Contents

Item 6.Exhibits
3.1

 
Restated Articles of Incorporation as amended June 13, 2014. (Incorporated by reference to Exhibit 3.1 to the Company’s Report on Form 8-K filed June 16, 2014.)
 
 
 
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 Third Quarter Earnings dated October 19, 2016.
 
 
 
101

 
Interactive Data File.

21
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:
 
October 19, 2016
 
By:
 
/s/ Patrick J. McHale
 
 
 
 
 
 
Patrick J. McHale
 
 
 
 
 
 
President and Chief Executive Officer
 
 
 
 
 
 
(Principal Executive Officer)
 
 
 
 
Date:
 
October 19, 2016
 
By:
 
/s/ Christian E. Rothe
 
 
 
 
 
 
Christian E. Rothe
 
 
 
 
 
 
Chief Financial Officer and Treasurer
 
 
 
 
 
 
(Principal Financial Officer)
 
 
 
 
Date:
 
October 19, 2016
 
By:
 
/s/ Caroline M. Chambers
 
 
 
 
 
 
Caroline M. Chambers
 
 
 
 
 
 
Vice President, Corporate Controller
     and Information Systems
 
 
 
 
 
 
(Principal Accounting Officer)