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Item 7. Management’s Discussion and Analysis

2024-02-20 compared with 2023-02-21 · 73 added, 77 removed, 227 unchanged (40% of the section changed)

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This discussion should be read in conjunction with our financial statements and the accompanying notes to the financial statements.

A discussion of changes in our financial condition and the results of operations from the year ended December 31, 2021 to December 25, 2020 can be found in Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations of our Annual Report on Form 10-K for the year ended December 31, 2021.

Certain prior year disclosures have been revised to conform with current year reporting.

A discussion of changes in our financial condition and the results of operations from the year ended December 30, 2022 compared to December 31, 2021 can be found in Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations of our Annual Report on Form 10-K for the year ended December 30, 2022.

The discussion is organized in the following sections:

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Graco’s business is classified by management into three reportable segments:

Industrial, Process and Contractor.

Contractor, Industrial and Process.

Each segment is responsible for product development, manufacturing, marketing and sales of their products.

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Our largest manufacturing facilities are in the U.S.

We also manufacture some of our products in Switzerland (Industrial segment), Italy (Industrial segment), the United Kingdom (Process segment), the People’s Republic of China (“P.R.C.”) (all segments), Belgium (all segments) and Romania (Industrial segment).

We also manufacture some of our products in Switzerland (Industrial segment), Italy (Industrial segment), the United Kingdom (Process segment), the People’s Republic of China (all segments), Belgium (all segments) and Romania (Industrial segment).

Our primary distribution facilities are located in the U.S., Belgium, Switzerland, United Kingdom, P.R.C., Japan, Italy, Korea, India, Australia and Brazil.

Russia's Invasion of Ukraine

The Company has historically sold products to customers located in or associated with Russia and Belarus.

In response to Russia's invasion of Ukraine, the United States, the United Kingdom, the European Union, Switzerland and others have implemented sanctions and export controls targeting Russia and Belarus and entities associated with those countries, which significantly limits our ability to sell certain products, serve certain customers and collect on our outstanding receivables in those countries.

In April of 2022, we decided to suspend sales into Russia and Belarus indefinitely.

Sales to Russia and Belarus accounted for approximately 1.5% of our 2021 net sales and were not material for 2022.

In connection with the effect of these sanctions and export controls, we recognized $3 million of allowances for credit losses on customer receivables in Russia in 2022.

The duration and extent to which trade sanctions against Russia and Belarus affect the Company's business will depend on future developments, which still remain uncertain.

Supply Chain and Inflation

In 2022, the Company experienced logistical and production constraints due to limited raw material and component availability, reduced freight capacity, shipping delays, labor shortages and other supply chain disruptions.

These supply chain disruptions have increased the Company's product costs and extended lead times.

The Company has undertaken steps to mitigate these impacts, including implementing interim price increases, maintaining higher inventory levels,

qualifying additional suppliers and making strategic component purchases.

While freight capacity and shipping delays improved by the end of 2022, we expect these other challenges to continue into 2023.

In connection with the supply chain disruptions described above, the Company has also experienced the effects of inflation related to raw materials, components and other expenses, including freight, labor and energy.

In 2022, the cost of raw materials and components was significantly higher compared to the cost of raw materials and components in 2021.

We expect cost increases from purchases of raw materials and components to moderate in 2023.

The supply chain disruptions and associated effects of inflation have adversely impacted profitability in the near-term and limited our ability to satisfy customer demand.

To the extent our pricing actions are unable to offset these supply chain disruptions and effects of inflation, our profitability could continue to be adversely impacted in 2023.

In 2023, the Company's supply chain stabilized, and the associated effects of inflation largely subsided.

While the Company experienced isolated supply chain disruptions in 2023, the impact was not as significant as compared to previous years in 2022 and 2021.

Pricing actions implemented in 2022 and 2023 have generally mitigated the effects of inflation.

Results of Operations

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Adjusted (non-GAAP) (1) :

Operating Earnings, adjusted $ 646.0 $ 572.7

Net Earnings, adjusted 523.9 455.5

Diluted Net Earnings per Common Share, adjusted $ 3.04 $ 2.63

(1) Excludes impacts of excess tax benefits from stock option exercises, prior year non-recurring tax provision adjustments and a prior year pension settlement loss.

(1) Excludes the impact of a pension settlement loss, contingent consideration fair value adjustment, impairment charge, excess tax benefits from stock option exercises and certain non-recurring tax provision adjustments.

See Financial Results Adjusted for Comparability below for a reconciliation of adjusted non-GAAP financial measures to GAAP

Multiple events in the last two years caused fluctuations in financial results.

Certain events in the last two years caused fluctuations in financial results.

Excess tax benefits related to stock option exercises reduced income taxes by $10 million in 2023 and $5 million in 2022.

Other expense for 2023 included a $42 million non-cash pension settlement loss.

In 2023, the Company recorded a goodwill impairment and contingent consideration adjustment related to an acquisition that was not material to the financial statements.

Other benefits from tax planning activities further reduced income taxes in 2023.

Excluding the impacts of those items presents a more consistent basis for comparison of financial results.

A calculation of the non-GAAP measurements of earnings before income taxes, income taxes, effective income tax rates, net earnings and diluted earnings per share follows (in millions except per share amounts):

A calculation of the non-GAAP adjusted measurements of operating earnings, earnings before income taxes, income taxes, effective income tax rates, net earnings and diluted earnings per share follows (in millions except per share amounts):

Operating earnings, as reported $ 646.8 $ 572.7

Contingent consideration (8.6) —

Impairment 7.8 —

Operating earnings, adjusted $ 646.0 $ 572.7

Earnings before income taxes, as reported $ 608.8 $ 565.7

Pension settlement loss 42.1 —

Contingent consideration (8.6) —

Impairment 7.8 —

Earnings before income taxes, adjusted $ 650.1 $ 565.7

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Pension settlement tax effect 8.8 —

Excess tax benefit from option exercises 5.1 11.5

Other non-recurring tax benefit 4.8 —

Excess tax benefit from option exercises 10.3 5.1

Income taxes, adjusted $ 126.2 $ 110.2

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Pension settlement loss, net 33.3 —

Excess tax benefit from option exercises (5.1) (11.5)

Contingent consideration (8.6) —

Impairment 7.8 —

Other non-recurring tax benefit (4.8) —

Excess tax benefit from option exercises (10.3) (5.1)

Net Earnings, adjusted $ 523.9 $ 455.5

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General and administrative 7.8 7.2

Contingent consideration (0.4) —

Impairment 0.4 —

Operating earnings 29.5 26.7

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

Volume and Price Acquisitions Currency Total Volume and Price Acquisitions/Divestitures Currency Total

Volume and Price Acquisitions Currency Total Volume and Price Acquisitions Currency Total

Americas 4% 0% 0% 4% 11% 1% (1)% 11%

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Consolidated 2% 0% 0% 2% 11% 1% (4)% 8%

Sales in the Americas were up solidly again in 2022, as economic conditions in North America remained broadly favorable.

Sales growth in EMEA varied between products and countries in 2022, as the region experienced unfavorable geopolitical conditions.

Solid sales growth to customers in Western Europe and emerging countries was partially offset by fewer sales to customers in Russia and Belarus.

Sales growth in Asia Pacific was more broadly based across products and countries, as pandemic-related restrictions eased in 2022 compared to 2021.

There were 52 weeks in 2022, compared to 53 weeks in 2021.

Gross profit margin rate for 2022 decreased approximately 3 percentage points compared to 2021, as realized pricing was unable to offset higher product costs and the adverse impacts of changes in currency translation rates.

Sales in the Americas were up modestly in 2023, as conditions varied by end market.

Sales of industrial products remained favorable, however rising interest rates and other economic conditions adversely impacted sales in construction markets.

EMEA sales growth in 2023 benefited mostly from favorable changes in currency translation rates.

Lower finishing system sales in EMEA for 2023 offset broad-based sales growth in Western Europe and emerging countries.

In the Asia Pacific region, economic conditions in China and unfavorable changes in currency translation rates more than offset underlying growth in the rest of the region for 2023.

The gross profit margin rate for 2023 increased approximately 4 percentage points compared to 2022 mostly due to realized pricing.

Operating Expenses

Total operating expenses for 2022 decreased $18 million compared to 2021.

Reductions of $16 million from lower sales and earnings-based expenses and $14 million from the impact of currency translation were partially offset by $3 million of allowances for credit losses on customer receivables in Russia and volume and rate related increases.

Total operating expenses for 2023 increased $29 million compared to 2022.

The increase includes increased spending on product development and other growth initiatives of $7 million, incremental share-based compensation of $6 million and higher sales and earnings-based expenses of $4 million.

Investment in new product development in 2023 was $83 million, approximately 4 percent of sales.

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Sales growth led to an 8 percent increase in operating earnings.

Operating earnings as a percentage of sales in 2022 was flat compared to 2021 as higher product costs and unfavorable changes in currency translation rates were offset by lower sales and earnings-based costs and the effects of expense leverage.

Operating earnings expressed as a percentage of sales in 2023 increased 3 percentage points compared to 2022 as realized pricing more than offset higher product costs and operating expenses.

Other Expense

Other expense decreased $16 million for 2022.

Other expense in 2021 included a non-cash pension settlement loss of $12 million in connection with the transfer of certain pension obligations to an insurance company.

Increased investment income in 2022 further reduced other expense by $4 million.

The effective income tax rate for 2022 was 19 percent, up 6 percentage points from 2021.

The increase was due to non-recurring foreign-related tax benefits in 2021, a decrease in excess tax benefits from stock option exercises and the unfavorable effects of foreign earnings taxed at higher rates than the U.S.

Interest expense decreased $5 million compared to 2022 as private placement debt was repaid in the first quarter of 2022 and in the third quarter of 2023.

Other non-operating expenses for 2023 included a non-cash pension settlement loss of $42 million in connection with the transfer of certain pension obligations to an insurance company.

Partially offsetting the pension settlement loss was an increase in interest income of approximately $11 million for the year.

The effective income tax rate for 2023 was 17 percent, down 2 percentage points from 2022.

The decrease in 2023 was due to additional non-recurring tax benefits and excess tax benefits from stock option exercises.

Segment Results

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(38.7) (30.8)

Contingent consideration 8.6 —

Impairment (7.8) —

Total $ 646.8 $ 572.7

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Segment Total (1)% 0% 0% (1)% 4% 0% (3)% 1%

Contractor segment sales growth slowed in 2022, as the on-going favorable construction market environment in North America moderated due to increases in interest rates and lower levels of new construction activity.

The operating margin rate decreased 2 percentage points in 2022 primarily due to higher product costs and the adverse impacts of currency translation.

Sales in the Americas represents the substantial majority of sales for the Contractor segment.

Management regularly reviews economic and financial indicators in North America, including levels of residential, commercial and institutional construction, remodeling rates and interest rates.

Contractor segment sales decreased 1 percent for the year.

Favorable response to new product offerings was more than offset for the year by slower economic activity in worldwide construction markets.

The operating margin rate for this segment improved 4 percentage points for the year.

Realized pricing drove most of the improvement in the operating margin rate for the year.

Sales in the Americas represents the majority of sales for the Contractor segment.

Management regularly reviews economic and financial indicators for North America, including levels of residential, commercial and institutional construction, remodeling rates and interest rates.

Management also reviews gross domestic product for the regions and the level of the U.S.

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Segment Total 2% 0% 0% 2% 14% 0% (6)% 8%

The Industrial segment experienced solid sales growth in all regions for the year.

Generally favorable economic activity across many end markets, including general industry, automotive, electrical equipment and alternative energy drove demand in all regions.

Finishing system sales contributed to sales growth in the Americas and EMEA, while improvement in automotive end markets contributed to sales growth in Asia Pacific.

The operating margin rate increased for the year as strong realized pricing and expense leverage more than offset higher product costs and the adverse impacts of currency translation.

Industrial segment sales increased 2 percent for the year as continued strength in the automotive, industrial and machinery end markets in the Americas was mostly offset by lower finishing system sales in EMEA and Asia Pacific.

The operating margin rate for this segment decreased 1 percentage point for the year as realized pricing and lower product costs were offset by unfavorable changes in currency translation rates and higher operating expenses.

In this segment, sales in each geographic region are significant, and management looks at economic and financial indicators in each region, including gross domestic product, industrial production, capital investment rates, automobile production, building construction and the level of the U.S.

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

Volume and Price Acquisitions Currency Total Volume and Price Acquisitions/Divestitures Currency Total

Volume and Price Acquisitions Currency Total Volume and Price Acquisitions Currency Total

Americas 13% 0% 0% 13% 22% 3% 0% 25%

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Segment Total 11% 0% 0% 11% 25% 2% (2)% 25%

The Process segment had double-digit sales growth in all product applications in 2022, reflecting favorable conditions in many end markets, such as vehicle services, industrial pumps, oil and gas, mining, industrial lubrication and semi-conductors.

Sales from acquired operations contributed approximately $9 million of growth in the Process segment.

The operating margin rate for this segment increased 2 percentage points for the year as increased volume and expense leverage offset higher product costs and the adverse impacts of currency translation.

Although the Americas represent the substantial majority of sales for the Process segment, and indicators in that region are the most significant, management monitors indicators such as levels of gross domestic product, capital investment, industrial production, oil and natural gas markets and mining activity worldwide.

Process segment sales increased in all businesses and regions for the year, reflecting continued favorable conditions in many end markets, such as vehicle services, industrial pumps, oil and gas, mining, industrial lubrication and semi-conductors.

The operating margin rate for this segment increased 5 percentage points for the year, primarily due to realized pricing, lower product costs and expense leverage.

Although the Americas represent the majority of sales for the Process segment, management monitors indicators such as levels of gross domestic product, capital investment, industrial production, oil and natural gas markets and mining activity worldwide.

Financial Condition and Cash Flow

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Inventory turnover (LIFO) 2.2 2.5

Lower cash and cash equivalent balances primarily drove decreases in working capital in 2022.

receivables were consistent with higher sales levels.

Inventories increased to meet higher demand and service levels and to accommodate for disruptions in the supply chain.

The current ratio increased in 2022 due to increases in receivables and inventories as well as lower sales and earnings based accruals.

The repayment of a current debt obligation in 2022 partially offset the increase in the current ratio.

Higher cash and cash equivalent balances primarily drove increases in working capital in 2023.

Changes in receivables were consistent with higher sales levels.

Inventories decreased as supply chain disruptions eased and the associated effects of inflation subsided.

As inventory purchases decreased, trade accounts payable decreased.

The current ratio increased in 2023 in line with the changes in working capital.

Capital Structure.

At December 29, 2023, the Company’s capital structure included current notes payable of $30 million and shareholders’ equity of $2,224 million.

At December 30, 2022, the Company’s capital structure included current notes payable of $21 million, long-term debt of $75 million and shareholders’ equity of $1,860 million.

At December 31, 2021, the Company’s capital structure included current notes payable of $43 million, long-term debt, including current portion, of $150 million and shareholders’ equity of $1,709 million.

Shareholders’ equity increased by $365 million in 2023.

The increase from current year earnings of $461 million was offset by share repurchases of $233 million and dividends of $146 million.

Increases related to shares issued, stock compensation and other comprehensive income totaled $69 million.

The increase provided by current year earnings of $507 million was primarily offset by dividends of $161 million and share repurchases of $102 million.

Other increases in shareholders' equity included share issuances, stock compensation and other comprehensive income of $122 million.

Liquidity and Capital Resources .

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The Company believes it has the ability to meet its long-term cash requirements by using available cash and internally generated funds and to borrow under its committed and uncommitted credit facilities.

In December 2022, the Board of Directors increased the Company’s regular quarterly dividend to $0.235 from $0.21 per share, an increase of 12 percent.

In December 2023, the Board of Directors increased the Company’s regular quarterly dividend from $0.235 to $0.255 per share, an increase of 9 percent.

A summary of cash flow follows (in millions):

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Cash Flows From Operating Activities .

Net cash provided by operating activities was $377 million in 2022, down $80 million compared to 2021.

The impact of the increase in net earnings in 2022 was offset by increases in working capital that reflect growth in business activity.

Net cash provided by operating activities was $651 million in 2023, up $274 million compared to 2022, due primarily to higher net earnings and fewer inventory purchases in 2023.

Other decreases in working capital further contributed to the increase in cash provided by operating activities in 2023.

Cash Flows Used in Investing Activities.

Cash flows used in investing activities totaled $227 million in 2022, including $201 million for capital additions and $25 million for business acquisitions.

Cash flows used in investing activities totaled $185 million in 2023, including $185 million for capital additions.

Cash flows used in investing activities totaled $227 million in 2022 including $201 million for capital additions and $25 million for business acquisitions.

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As of December 29, 2023, approximately 14 million shares remain available for purchase under the authorization.

The Company repurchased and retired 3.6 million shares in 2022.

The Company did not repurchase and retire shares in 2021, and repurchased and retired 2.3 million shares in 2020.

The Company repurchased and retired 1.4 million shares in 2023 and 3.6 million shares in 2022.

The Company did not repurchase and retire shares in 2021.

The Company has made and may continue to make opportunistic share repurchases in 2024 via open market transactions or short-dated accelerated share repurchase (“ASR”) programs.

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For 2024, the Company will use an investment return assumption of 7.6 percent for the funded U.S.

plan, up 1.35 percentage points from the rate assumed for 2022.

plan, consistent with the rate assumed for 2023.

Mortality rates are based on current common group mortality tables for males and females.

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The Company estimates the fair value of the reporting units using a present value of future cash flows calculation cross-checked by an allocation of market capitalization approach.

The impairment test is performed using a two-step process.

In the first step, the fair value of each reporting unit is compared with the carrying amount of the reporting unit.

If the estimated fair value exceeds its carrying value, step two of the impairment analysis is not required.

If the estimated fair value is less than its carrying amount, impairment is indicated and the second step must be completed in order to determine the amount, if any, of the impairment.

In the second step, an impairment loss is recognized for the difference between the implied value of goodwill and the carrying value.

The goodwill impairment test is performed by comparing the fair value of the relevant reporting unit with its carrying amount.

An impairment charge is recognized for the amount by which the carrying amount exceeds the reporting unit’s fair value.

The Company’s primary identifiable intangible assets include customer relationships, trademarks, trade names, proprietary technology and patents.

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A considerable amount of management judgment and assumptions are required in performing the impairment tests.

Management makes several assumptions, including earnings and cash flow projections, discount rate, product offerings and market strategies, customer attrition, and royalty rates, each of which have a significant impact on the estimated fair

Though management considers its judgments and assumptions to be reasonable, changes in these assumptions could impact the estimated fair value.

In 2022, we completed our annual impairment testing of goodwill and other intangible assets in the fourth quarter.

No impairment charges were recorded as a result of that test.

In the third quarter of 2023, the Company recognized a goodwill impairment related to the reorganization of a business acquired in 2020 that is not material to the consolidated financial statements.

We completed our annual impairment testing of goodwill and other intangible assets in the fourth quarter of 2023.

No additional impairment charges were recorded as a result of that test.

Income Taxes.

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Compared sentence by sentence after normalising whitespace, quotation marks, case and digits, so re-formatting and restated figures do not read as changed language. Wording changes appear as one removal and one addition. The current filing and the prior one are authoritative.

What changed 10-K

Item 7. Management’s Discussion and Analysis