GRACO INC (GGG) FY 2022 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following Management’s Discussion and Analysis reviews significant factors affecting the Company’s consolidated results of operations, financial condition and liquidity. 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. The discussion is organized in the following sections:

•Overview

•Results of Operations

•Segment Results

•Financial Condition and Cash Flow

•Critical Accounting Estimates

Overview

Graco designs, manufactures and markets systems and equipment used to move, measure, control, dispense and spray fluid and powder materials. The Company specializes in equipment for applications that involve difficult-to-handle materials with high viscosities, materials with abrasive or corrosive properties and multiple-component materials that require precise ratio control. Graco sells primarily through independent third-party distributors worldwide to industrial and contractor end users. Graco’s business is classified by management into three reportable segments: Industrial, Process and Contractor. Each segment is responsible for product development, manufacturing, marketing and sales of their products.

Graco’s 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. Long-term financial growth targets accompany these strategies, including our objectives of 10 percent revenue growth and 12 percent consolidated net earnings growth per annum. We continue to develop new products in each operating division that are expected to drive incremental sales growth, as well as continued refreshes and upgrades of existing product lines. Graco has made a number of strategic acquisitions that expand and complement organically developed products and provide new market and channel opportunities.

Manufacturing is a key competency of the Company. Our management team in Minneapolis provides strategic manufacturing expertise, and is also responsible for factories not fully aligned with a single division. 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). 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,

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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.

Results of Operations

A summary of financial results follows (in millions except per share amounts):

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

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Multiple events in the last two years caused fluctuations in financial results. Excess tax benefits related to stock option exercises reduced income taxes by $5 million in 2022 and $12 million in 2021. Other expense for 2021 included a $12 million non-cash pension settlement loss. Other benefits from tax planning activities further reduced income taxes in 2021. 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):

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Components of Net Earnings as a Percentage of Sales:

The following table presents an overview of components of net earnings as a percentage of net sales:

Net Sales

The following table presents net sales by geographic region (in millions):

(1)     North, Central and South America, including the U.S. Sales in the U.S. were $1,116 million in 2022 and $1,004 million in 2021.

(2)    Europe, Middle East and Africa

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

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

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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.

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. Investment in new product development in 2022 was $80 million, approximately 4 percent of sales.

Operating Earnings

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.

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.

Income Taxes

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.

Segment Results

The Company has five operating segments which are aggregated into three reportable segments: Contractor, Industrial and Process. Refer to Part I Item 1. Business, for a description of the Company’s three reportable segments. Management assesses performance of segments by reference to operating earnings excluding unallocated corporate expenses and asset impairments.

The following table presents net sales and operating earnings by reporting segment (in millions):

(1)    Unallocated corporate (expense) includes such items as stock compensation, certain acquisition transaction items, bad debt expense, charitable contributions, and certain facility expenses.

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Contractor Segment

The following table presents net sales and operating earnings as a percentage of sales for the Contractor segment (dollars in millions):

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

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. Management also reviews gross domestic product for the regions and the level of the U.S. dollar versus the euro and other currencies.

Industrial Segment

The following table presents net sales and operating earnings as a percentage of sales for the Industrial segment (dollars in millions):

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

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.

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. dollar versus the euro, the Swiss franc, the Canadian dollar, the Chinese renminbi and various other Asian currencies.

Process Segment

The following table presents net sales and operating earnings as a percentage of sales for the Process segment (dollars in millions):

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

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.

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Financial Condition and Cash Flow

Working Capital. The following table highlights several key measures of asset performance (dollars in millions):

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

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.

Capital Structure. 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 $150 million in 2022. 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.

Liquidity and Capital Resources. The Company evaluates liquidity as its ability to generate cash to fund its operating, investing and financing activities. Historically the Company has funded cash requirements for working capital, capital expenditures, businesses acquisitions, repayment of debt obligations, retirement plans, dividends, and common stock repurchases, all as applicable, through cash provided by its operations. The Company's other primary source of liquidity includes funds available through various debt financing arrangements.

As of December 30, 2022, the Company had available liquidity of $884 million, including cash held in deposit accounts of $339 million, of which $111 million was held outside of the U.S., and available credit under existing committed credit facilities of $545 million.

Internally generated funds and unused financing sources are expected to provide the Company with the flexibility to meet its liquidity needs in 2023, including its capital expenditure plan of approximately $200 million, including $130 million for building projects to expand production capacity, planned dividends estimated at $158 million, share repurchases and acquisitions. If acquisition opportunities increase, the Company believes that reasonable financing alternatives are available for the Company to execute on those opportunities. The Company has no significant off-balance sheet debt or other unrecorded obligations. 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.

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Cash Flow. A summary of cash flow follows (in millions):

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.

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 $153 million in 2021 including $134 million for capital additions and $19 million for business acquisitions.

Cash Flows Used in Financing Activities. Cash flows used in financing activities totaled $434 million in 2022 and included share repurchases of $233 million (partially offset by net proceeds from share issuances of $36 million), dividends of $142 million, and net payments on long-term debt and outstanding lines of credit of $93 million.

Cash flows used in financing activities totaled $57 million in 2021 and included dividends of $127 million and net proceeds from share issuances totaling $51 million.

On December 7, 2018, the Board of Directors authorized the purchase of up to 18 million shares of common stock, primarily through open market transactions. The authorization is for an indefinite period of time or until terminated by the Board. As of December 30, 2022, approximately 15 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 has made and may continue to make opportunistic share repurchases in 2023 via open market transactions or short-dated accelerated share repurchase (“ASR”) programs.

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Critical Accounting Estimates

The Company prepares its consolidated financial statements in conformity with generally accepted accounting principles in the United States of America (“U.S. GAAP”). The Company’s most significant accounting policies are disclosed in Note A (Summary of Significant Accounting Policies) to the consolidated financial statements. The preparation of the consolidated financial statements, in conformity with U.S. GAAP, requires management to make estimates and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual amounts will differ from those estimates. The Company considers the following policies to involve the most judgment in the preparation of the Company’s consolidated financial statements.

Retirement Benefits. The measurements of the Company’s pension and postretirement medical obligations are dependent on a number of assumptions including estimates of the present value of projected future payments, taking into consideration future events such as salary increases and demographic experience. These assumptions may have an impact on the expense and timing of future contributions.

The assumptions used in developing the required estimates for pension obligations include discount rate, inflation, salary increases, retirement rates, expected return on plan assets and mortality rates. The assumptions used in developing the required estimates for postretirement medical obligations include discount rates, rate of future increase in medical costs and participation rates.

For U.S. plans, the Company establishes its discount rate assumption by reference to a yield curve published by an actuary and projected plan cash flows. For plans outside the U.S., the Company establishes a rate by country by reference to highly rated corporate bonds. These reference points have been determined to adequately match expected plan cash flows. The Company bases its inflation assumption on an evaluation of external market indicators. The salary assumptions are based on actual historical experience, the near-term outlook and assumed inflation. Retirement rates are based on experience. The investment return assumption is based on the expected long-term performance of plan assets. In setting this number, the Company considers the input of actuaries and investment advisers, its long-term historical returns, the allocation of plan assets and projected returns on plan assets. For 2023, the Company will use an investment return assumption of 7.60 percent for the funded U.S. plan, up 1.35 percentage points from the rate assumed for 2022. Mortality rates are based on current common group mortality tables for males and females.

At December 30, 2022, a one-half percentage point decrease in the indicated assumptions would have the following effects (in millions):

Goodwill and Other Intangible Assets. The Company performs impairment testing for goodwill annually in the fourth quarter or more frequently if events or changes in circumstances indicate that the asset might be impaired. 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 Company’s primary identifiable intangible assets include customer relationships, trademarks, trade names, proprietary technology and patents. Finite lived intangibles are amortized and are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Indefinite lived intangibles are reviewed for impairment annually in the fourth quarter, or more frequently if events or changes in circumstances indicate the asset might be impaired.

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

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values. 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.

Income Taxes. In the preparation of the Company’s consolidated financial statements, management calculates income taxes. This includes estimating current tax liability as well as assessing temporary differences resulting from different treatment of items for tax and financial statement purposes. These differences result in deferred tax assets and liabilities, which are recorded on the balance sheet using statutory rates in effect for the year in which the differences are expected to reverse. These assets and liabilities are analyzed regularly, and management assesses the likelihood that deferred tax assets will be recoverable from future taxable income. A valuation allowance is established to the extent that management believes that recovery is not likely. Liabilities for uncertain tax positions are also established for potential and ongoing audits of federal, state and international issues. The Company routinely monitors the potential impact of such situations and believes that liabilities are properly stated. Valuations related to amounts owed and tax rates could be impacted by changes to tax codes and the Company’s interpretation thereof, changes in statutory rates, the Company’s future taxable income levels and the results of tax audits.