Good morning, and welcome to the Second Quarter Conference Call for Graco Inc. If you wish to access the replay for this call, you may do so by visiting the company's website at www.graco.com. Graco has additional information available in a PowerPoint slide presentation, which is part of the webcast player. During this call, various remarks may be made by management about their expectations, plans, and prospects for the future. These remarks include forward-looking statements as defined by the safe harbor provisions of the Private Securities Litigation Reform Act. Actual results may differ materially from those indicated due to various risk factors, including those identified in Item 1A of the company's 2022 Annual Report on Form 10-K and in Item 1A of the company's most recent quarterly report on Form 10-Q. These reports can be found on the company's website at www.graco.com and on the SEC's website at www.sec.gov. Forward-looking statements reflect management's current views and speak only as of the time they are made. The company does not undertake any obligation to update these statements in light of new information or future events. I will now turn the conference over to Chris Knutson, Executive Vice President, Corporate Controller.

Good morning, everyone, and thank you for joining our call. I'm here today with Mark Sheahan and David Lowe. I will provide a brief overview of our quarterly results before turning the call over to Mark for additional discussion. Yesterday, Graco reported second quarter sales of $560 million, an increase of 2% from the second quarter of last year. The effect of currency translation decreased sales by 1 percentage point or approximately $3 million. Reported net earnings increased 14% to $134 million for the second quarter. Diluted net earnings per share was $0.78, an increase of 15% over last year. After adjusting for the impact of excess tax benefits from stock option exercises, diluted net earnings per share was $0.75. Based on current exchange rates, currency translation should have no effect on full year net sales or earnings. We expect the unfavorable effects of currency that we saw in the first half of the year will be offset by favorable impacts in the second half. The gross margin rate increased 310 basis points in the quarter. Strong price realization plus favorable product and channel mix, mainly in the Contractor segment, was more than enough to offset higher product costs. While material cost increases have moderated compared to what we experienced last year, headwinds from lower factory volumes and increased factory spending have put pressure on the gross margin rate for the quarter and year-to-date. Factory volumes have softened as the year progressed, as lead times, supply chains and customer order trends start to normalize. Total operating expenses increased $14 million or 12% in the quarter, primarily from rate-based increases of $6 million and incremental share-based compensation of $4 million. Gross margin rate improvement more than offset these increased operating expenses during the quarter, resulting in operating margin rate growth of 1 percentage point. Contractor operating margin increased 1 percentage point compared to the second quarter last year. Sequentially, Contractor operating margin decreased 3 percentage points from the first quarter, largely due to new product development spending, unfavorable channel mix and unfavorable factory volume related to inventory reduction initiatives. For the full year, we expect unallocated corporate expenses to be approximately $34 million to $37 million, but timing can vary by quarter. Nonoperating expenses decreased $5 million as a result of increased interest income on cash held and the favorable effect of market valuation changes on investments held to fund certain retirement benefits. The adjusted tax rate was 19% for the quarter, which is consistent with our expected full year tax rate of approximately 19% to 20% on an as-adjusted basis. Cash provided by operations totaled $282 million for the year, an increase of $147 million from last year, mostly driven by higher net earnings and a reduction in inventory purchases. Cash provided by operations as a percent of net earnings is 107% for the year. Significant uses of cash year-to-date were dividend payments of $79 million and capital expenditures of $92 million. We estimate capital expenditures for the year to be $200 million, with $130 million related to facility expansion projects. Finally, subsequent to year-end, or quarter-end, we repaid $75 million of our private placement debt, including a prepayment fee of $700,000, which will be recognized as interest expense in the third quarter of this year. I'll now turn the call over to Mark for further segment and regional commentary.

Thank you, Chris, and good morning, everybody. All of my comments this morning will be on an organic, constant currency basis. Sales were up 3% for the quarter. We achieved record second quarter revenue and operating earnings, driven by strong results in both the Process and Industrial segments. Contractor performance remained mixed, with growth in pavement protective coatings and spray foam unable to offset softer sales in the home center and pro paint channels. EMEA was a bright spot during the quarter, growing 5% compared to last year, with growth in all reportable segments. Incoming order rates in many key product categories have been solid, and sales have improved as many of the adverse component and product availability issues that impacted EMEA last year have improved. Operating margins were strong for the quarter, as we continue to benefit from our pricing actions in 2022 and 2023. Price realization in the businesses and regions accounted for nearly all of our revenue growth and significantly contributed to our company-wide incremental margins of 75%. With similar volumes and costs for the rest of the year, we expect to continue to see solid margin performance for the remainder of 2023. Our consolidated backlog, with $330 million at the end of the quarter, down $20 million from the end of last quarter. Issues with supply chain and component availability have improved modestly. Better component availability has allowed us to increase our customer service levels, although we still have room for improvement. Now turning to some commentary on our segments. The Contractor segment experienced a low-single-digit revenue decline in the second quarter, driven by less demand in the home center channel, slowing construction markets in China and softer demand in the North America pro paint channel. Somewhat offsetting these headwinds were growth in our Payment and High Performance Coatings and Spray Foam businesses. New product introductions were also incrementally favorable for both the quarter and on a year-to-date basis. We believe that the current inventory levels within the home center channel are reflective of foot traffic in the stores and out-the-door sales. The decline in the North America pro paint channel compares to strong second quarter sales last year, when we made a significant dent in our backlog back orders to key customers after component shortages started to ease. Growth in EMEA during the quarter was largely due to improved product availability and strong price realization. Asia Pacific, on the other hand, declined 6% as the shipping container business and construction markets were weaker than a year ago, especially in China. Despite the soft quarter, we are optimistic for the balance of the year as contractor activity remains solid, and we are seeing improvement in key economic data related to U.S. housing starts and existing home sales, along with continued strength in commercial construction spending. The Industrial segment grew 4%, resulting in record second quarter revenue and operating earnings. Activity in key end markets such as alternative energy, electronics and battery has been robust. Incoming orders in our liquid finishing and sealant and adhesive businesses remain solid, but were somewhat offset by continued softer demand in our powder finishing business, especially in Asia Pacific. However, backlogs in powder equipment and systems remain elevated, giving us confidence for a better second half of the year. The Process segment grew sales 14%, resulting in second quarter records for both revenue and operating earnings. This is the tenth consecutive quarter that Process has set these records. We saw continued broad-based sales growth in all product categories. However, vehicle service, automatic lubrication and semiconductor were the key drivers of the impressive performance this quarter. Steady volume, strong pricing and good expense management resulted in incremental margins of 76% for the quarter and operating earnings of 31%, which is another record for the segment. At similar volumes, we believe the current operating margin rate is sustainable, and we are pleased with the strong margin progression that has occurred in this segment the last 2 years. Moving to our outlook. Our results for the first 6 months were essentially in line with our expectations. End market activity can be broadly characterized as having pockets of both strength and weaknesses. Overall, we're seeing modest sales growth drive strong earnings leverage. Current order rates, along with elevated backlogs, give us confidence that we will attain our full year revenue guide of low-single-digit organic growth on a constant currency basis. That concludes our prepared remarks. Operator, we're ready for questions.

And our first question comes from Deane Dray from RBC Capital Markets.

Could you elaborate on the pro paint channel? It seems like there was a significant amount of back order inventory that you were able to ship. Did this affect the quarter, given the increased product availability? It sounded like there was some sort of accumulation of product going into the channel. I would appreciate some clarification on this.

Yes, I believe David and Chris can share their insights as well. We wanted to emphasize that a year ago, we faced significant back orders. We managed to release some components in the factory to expedite product delivery in Q2. This may have resulted in higher output than usual due to the large volume we had. Therefore, when you compare it to last year, that is why I think we encountered a tougher comparison.

Yes, this is David. I would just add that in the mindset of the buyers in the contractor channel, both pro paint and home center, we have our most advanced point-of-sale systems and personnel. A year ago, upon reviewing our fulfillment rates, it's reasonable to conclude, and I have verified this with our factory team, that they were placing extra orders due to concerns about when we and other vendors would deliver products to them. Therefore, it seems that the orders were exceptionally aggressive, likely exceeding actual sales last year, and, as Mark mentioned, we saw significant improvements in some of the key components that had been hindering shipments about a year ago.

All right. That's really helpful. And then just to clarify on the home center, it sounds though, the destocking, has that run its course? So selling versus sell-through is now more balanced?

Yes. I think when we talk to the teams that actually are in the field and they're looking at what inventories are in the stores, they feel like, right now, they're in a good spot given the level of activity that they're seeing in foot traffic and activity within the stores. So you never really know, Deane, right? I mean, things can change. But at least for now, we think that the major home centers are at an inventory level that's acceptable, given what they're seeing.

It appears that conditions in Asia have deteriorated slightly, but this has not led you to alter the sales outlook for the year for the entire company?

I think that's accurate. When we look at Asia, the majority of it is really the Industrial business. We do have CED, which is meaningful, but when considering all the activity in Industrial, particularly with alternative energy initiatives, we see positive movement outside of China, particularly in Korea, Japan, Southeast Asia, and also Australia. Overall, I think we're quite comfortable with our position there.

And our next question comes from Michael Halloran from Baird.

Good morning, everyone.

Hey, Mike.

So following up one of Deane's questions. Just if you look at the back half of the year, is the thought process then on the Contractor side sequential stability from current levels, kind of following normal seasonality? Or is there some other assumption I should be thinking about?

Yes. I think when we look at the level of incoming orders that we have and the backlogs that we still have, our backlogs are down, but they're still higher than what they would normally be. We feel pretty good that the outlook should hold up for the back half of the year.

Yes. I would add that, in my opinion, we definitely have back orders. If we look at our segments, I believe that the process and industrial segments currently have backlogs that are somewhat higher than what we see in the Contractor segment. On the Contractor side, I hesitate to say things are normal after the past few years. However, after conversations with our field and operating teams, I sense that in the main product categories like pro paint, home center, and the protective coatings area, our backlogs are much closer to the historical levels than they have been since 2019.

The margins on the process side have been outstanding. Could you provide more detail on what is driving the strength in the top line? There are several factors at play and we lack visibility on many of them. You mentioned that vehicle services is performing well, seemingly stronger than the overall environment would suggest. It would be helpful to get additional context not just about vehicle services, but also regarding everything happening behind the scenes. What role does Graco play? How much of this is influenced by the markets? Is dynamic pricing a significant factor? Please give us a broader view of the situation.

Yes. I'll take that. I appreciate the question because I do believe that it's just been a wonderful success story within Graco, what's happened within that segment over the last couple of years. I mean, it wasn't that long ago, I remember the operating margins were in the teens. So they're 31%. And it looks like we still got some runway there to expand beyond that. But it's been good growth across really multiple different business units and product categories, including a number of the ones that we've acquired over the last 5 years or so. So our white night Semiconductor business has remained strong, and the outlook for Semiconductor at least next year looks to be fairly good. So that's been a nice development there. Our environmental businesses, where we're moving fluids around in landfills, they are spending more money this year than what we've seen over the last couple of years. So if you look at the Republic Services, Waste Management, they are a little bit more inclined to make investments. And so we're realizing some of those benefits. Lubrication has been a really nice business for us. The team there is executing extremely well. It's not just the vehicle service side, it's also our industrial lubrication business, which competes in about a $1 billion revenue market, and we are growing nicely in that market by expanding our product line and improving our service levels. And hopefully, we can continue to gain OEM presence and drive that business higher. I feel like there's a fair amount of runway for growth there that that team has. And vehicle service, all I can tell you is that dealers make money on getting people into the dealership. And the best way they can do that is to have you come in for an oil change. And when you go in, they want to make sure that the amount of oil that they put into your vehicle is tracked, it's monitored and it's put in accurately, because a lot of these oils are pretty expensive. And so they're driving more customers into the dealership doing an oil change and then, of course, hopeful that they'll be able to find other things to sell you as well. So again, I appreciate the question. I think that our Process segment is really a great story within Graco. We're really excited about it, and all the teams there are executing extremely well.

No, that was great. Last one. Maybe just talk to what your inventory levels are, Graco's inventory levels are. And how you see that trending and what it means for cash flow as it will go over the next 6 to 18 months?

I'm going to let Chris take this one.

Our inventory levels are currently stable compared to the beginning of the year. We have initiatives in place to reduce inventory, particularly in our legacy businesses, which are already beginning to decrease those levels. For the remainder of the year, we plan to continue minimizing inventory purchases as we aim to lower our inventory to a level that is historically lower, thanks to improvements in supply chain and component availability.

Great. Thanks, everybody. Really appreciate it.

All right. Thanks, Mike.

Our next question comes from Saree Boroditsky from Jefferies.

I just want to kind of focus a little bit more on the margins. Gross margin stepped down sequentially despite the higher dollar. So like, what drove that? And what do you need to see for margins to accelerate from here?

Well, I mean, there's a couple of things. I think that for sure, mix, particularly in Contractor wasn't as favorable as it was in Q1, for example. So a little bit higher coming out of the home center as a percentage of their total revenue. The price realization has been good. We are offsetting our cost. I will tell you that Chris' comments upfront about factory volumes being down is something that's putting a little bit of pressure on the gross margin. And if you look sequentially at what happened between Q1 and Q2, we did drive inventory down by about $20 million. And the factories are very cognizant that our inventory levels have grown by quite a bit over the last 2 years as we wrestled with all the supply chain. So we are really pushing the teams there to make sure that we're producing what we're selling and take concerted action to try to pull some of that inventory back. And I think you see that showing up on the cash flow statement, where our cash flow is dramatically better than it was last quarter and a year ago. So overall, margin rates are decent, and I feel like we're in a good spot for the rest of the year to maybe put some more points on the board there.

The incremental margin in Industrial was lower than we expected. I'm not sure if that's due to factory volumes, lower growth in APAC, or something else that affected it.

I think that the overall Industrial results were down like 100 basis points for the quarter-over-quarter. And what I would tell you is that in any 13-week time period, there's going to be some volatility in there. I don't think there's anything systematically different in terms of what's going on in that business than others. So again, I feel like, overall, absolute levels of profitability there are really good. There might be a little bit of variation from time to time, but no problems.

Our next question comes from Matt Summerville from D.A. Davidson & Company.

Mark, I want to return to the topic of Process and discuss how sustainable you believe the demand is in this segment over the next few quarters. Considering where you think this segment currently stands in the cycle, should we view the $140 million you achieved in the second quarter as a new baseline for the business? Looking back, this business has shown remarkable performance with seven consecutive quarters of growth. I'm trying to understand your outlook based on the performance from the second quarter.

Yes. I really like what we're doing there across really all of the different product categories, the ones that I mentioned in particular. The one I didn't mention, which is also exciting, is the big push by every factory in the world to reduce energy costs. And as a result of that, moving to electric drive diaphragm pumps is an area where we think we have a very good competitive advantage. We launched a product called Quantum. It's on our website. You can look at it. Nobody else has that technology, because we own the motor technology that goes into that pump. And so that is a trend that's going to play out for several years. And I think we're really, really well positioned there. And also, that segment, whether it's in the industrial applications or the lubrication applications, or really all the sanitary food and beverage, all the stuff they get into, it's probably the most fertile ground for us when it comes to M&A hunting. And we've built a business there now that I think can be leveraged to the extent that we find attractive targets that we can bolt into the operations there. Very pleased with the team. We built a new factory for them last year. They moved up there. It's up in Dayton, I'd encourage anybody to come and visit that wants to see it. A lot of good things happening in the process.

Appreciate that color. And then I just want to put a finer point on Contractor to make sure I have the picture, right? So can you talk about the relative performance of the pro paint business versus home center in North America? And I think you mentioned sell-through looked like it was kind of matching sell-in with home centers. Is the same true in the pro paint side of things?

Yes, regarding the latter question, the inventory levels in the pro paint segment reflect the current business activity. Both segments, pro and home center, experienced declines this quarter, which I don’t want to downplay. However, conversations with pro painters and contractors indicate they are still quite active, especially in commercial work. Despite the challenges posed by rising interest rates and a slowdown in housing activity, we are managing well. Additionally, our involvement in niches like line striping, texture, spray foam, and protective coatings helps to offset some of the volatility associated with residential housing, so overall, the situation is not too bad.

I should refrain from adding anything since I agree with Mark's summary. When we discuss construction and contractor activity in North America, the macro data is showing stronger trends on both the commercial and residential sides. The recent forecasts indicate that nearly every category of investment in both areas is performing better than previously expected. Additionally, at the point of sale, our channel partners and salespeople generally believe that wholesale and retail inventory levels are appropriate. This is significant because if this is mostly accurate, it suggests that our model has largely returned to the state it was in three or four years ago. This is a positive development for Graco, as it highlights our strategic advantage of achieving high fulfillment levels. If this trend continues, we are indeed returning to a model where results are driven by short cycles and direct outcomes. Overall, the underlying fundamentals are encouraging, and I feel optimistic about our position.

Our next question comes from Jeff Hammond from KeyBanc Capital Markets.

I noticed you mentioned a backlog figure that declined by $20 million sequentially, now at $330 million. I'm curious about what you consider to be a typical backlog and how long it might take for us to return to normal order levels. Additionally, you indicated that underproduction was used to reduce inventories, which affected the gross margin. How much more of that is remaining? Will this situation continue into the second half, or have you reached a reset point?

Yes. I think on the backlog question, it's hard for us to peg a number, but I will just tell you that there's room to go there. We still have lead times with certain customers that we need to get better on. And the biggest wildcard within any given time period on our backlog is really the powder finishing business that we have, where they do book large projects. And so their backlog can kind of move around significantly. So I don't have a number for you, but I would say that we still got a substantial amount that we can take out of the backlog to get back to our normal customer service levels. On the inventory front, we have really built up a bunch of inventory over the last couple of years. So as a management team, we want to make a dent into that, and we've actually got some initiatives going on in the factories with targets and incentives and things of that nature to pull inventory back. And that's a good thing. I think it makes a business more efficient and more effective to be a little bit leaner on inventory. And obviously, the cash flow implications are very nice. We're not doing anything to sacrifice our ability to deliver product that our customers need. We're really just making sure that when it comes to buying components and being smart about what we do put on the shelf, that we're doing it with a mindful eye. We just went through this period where, for the last couple of years, it's been crazy. If you find a component, you're not just buying the 1 or 2 that you need, you might buy 10. So it's a little bit of a reset there. Again, it's not going to really impact our ability to deliver the products that our customers need.

I appreciate the insight on Contractor and the various elements at play. However, I'm focused on the third quarter, as you experienced significant growth in that period last year. I would like to better understand the various factors from last year to grasp the comparison dynamics.

Well, again, I think that what we have tried to do with our outlook, rather than try to nail a quarter is really give a global outlook for the business for the full year. And we take a hard look at what the order rates look like. What we've been able to deliver out of the factory, reasonable assumptions there. Some reasonable assumptions on backlog reduction. And then we also overlay that with the forecast that we get from our business units and what they expect from customers in the marketplace. When we put all of those things together, again, I think we feel confident in our guide for the full year. We provide a global revenue outlook for the entire company and do not share specific revenue projections by segment.

Our next question comes from Lawrence De Maria from William and Blair.

You took some price this year earlier in the year. Can you update us on what your expectation is for the year and your ability you think to drive further price increases? And especially with respect to Contractor and then into 2024, considering some of the weakness that you're seeing.

Yes. This year, we raised prices early in some of our segments. We're still not past some of the larger increases we implemented last year in the third quarter. Overall, I don't have a specific target for price realization for the full year, but I can tell you it will be similar to what you've experienced so far this year. As we look ahead to next year, our teams are beginning to analyze the data. We do anticipate raising prices again early in 2024, and I expect it will be a more typical year than we've had in the past. However, inflationary pressures persist, and although it's lower than before and some component shortages have improved, we fully expect to adjust our pricing again early in 2024.

I would like to emphasize that it is my hope we will consider costs and market conditions when making decisions. Ideally, the price adjustments we implement at the beginning of the year would remain in place for the rest of the year. This allows our channel to have a clear understanding of their costs while they engage with their customers. However, last year's experience taught us to keep all options open for the future.

That's great. Regarding new products and processes, how do we balance the introduction of new products with start-up and marketing costs? You mentioned that margins in Process are sustainable, so could you elaborate on that a bit?

At any given time in any business, we have new products being launched in various categories, each with different margin rates based on the specific business. We pay attention to the level of demand for these products in terms of incremental growth. As we've publicly stated, we anticipate our growth to be about twice the underlying market growth over the cycle. A significant portion of this growth will come from the new products we're introducing. We're not only innovating with technology, such as transitioning from air pumps to electric pumps, which results in substantial energy savings, but we also expect to see pricing benefits and potential margin expansion with these new launches. The company has a solid organic growth profile, primarily driven by our engineering and marketing teams who focus on identifying the right products to develop. Each business unit at Graco has a strong 5-year product plan that they consistently follow. While I'd like to provide more clarity, it is a niche and complex business across multiple segments. However, it's important to know that we have many promising product ideas in development.

Okay. But I guess where I was going with it was whether they would have any impact on margins, but you've also noted that those are sustainable. So thank you.

I am showing no further questions. I would now like to turn the conference back to Mark Sheahan for closing.

Okay. Well, thank you very much for your participation today on today's phone call, and we hope to see you soon.

This concludes today's conference call. Thank you for participating. You may now disconnect.