Caroline M. Chambers - VP, Corporate Controller and Information Systems Patrick J. McHale - President and CEO Christian E. Rothe - CFO and Treasurer.

Deane Dray - RBC Capital Markets Saree Boroditsky - Deutsche Bank Securities Jeff Hammond - KeyBanc Capital Markets Charley Brady - Suntrust Robinson Humphrey Matt Summerville - Alembic Global Advisors Walt Liptak - Seaport Global Securities Liam Burke - Wunderlich Securities Jim Foung - Gabelli & Company Jim Giannakouros - Oppenheimer & Co..

Good morning and welcome to the Fourth Quarter and Year-End 2016 Conference Call for Graco Inc. If you wish to access the replay for this call, you may do so by dialing 1-888-203-1112 within the United States or Canada. The dial-in number for international callers is 719-457-0820. The conference ID is 9371987.

The replay will be available through February 4, 2017. Graco has additional information available in a PowerPoint slide presentation which is available as part of the Webcast player. At the request of the Company, we will open the conference up for questions and answers after the opening remarks from management.

During this call, various remarks may be made by management about their expectations, plans and prospects for the future. These remarks constitute forward-looking statements for the purposes of the Safe Harbor provision of the Private Securities Litigation Reform Act.

Actual results may differ materially from those indicated as a result of various risk factors, including those identified in Item 1A of the Company's 2015 annual report on Form 10-K and in Item 1A of the Company's most recent quarterly report on Form 10-Q.

These reports are available on the Company's Web-site at www.graco.com and the SEC's Web-site at www.sec.gov. Forward-looking statements reflect management's current views and speak only as of the time they are made. The Company undertakes no obligation to update these statements in light of new information or future events.

At this time, all participants are in a listen-only mode. Later you will have the opportunity to ask questions during the question-and-answer session. [Operator Instructions] Please note this call is being recorded. I will now turn the conference over to Caroline Chambers, Vice President, Corporate Controller and Information Systems.

Please go ahead, ma'am..

Good morning, everyone. I'm here this morning with Pat McHale and Christian Rothe. Our conference call slides are on our Web-site and provide additional information on our quarter. Last evening, Graco released fourth quarter results with sales totaling $349 million, an increase of 7% from the prior year.

To note, the fiscal fourth quarter of 2016 included 14 weeks as compared to 13 weeks in 2015. On a U.S. GAAP basis, we realized a quarterly loss of $104 million. Our fourth quarter included a non-cash charge for the impairment of goodwill and intangible assets related to our Oil and Natural Gas business.

Adjusting for the net of tax effect of the impairment, earnings were $57 million, or $1 per diluted share. I'll address the impairment first and then we'll provide some comments on our underlying operating results for the quarter.

As we discussed at the end of the third quarter, the operating results of our Oil and Natural Gas reporting unit, which is within our Process segment, fell short of expectations due to ongoing weakness in oil and natural gas market.

As we consider the 2016 shortfall in revenues and operating results as compared to expectations, on projection showing the 2017 planning process, we determine that the goodwill and intangible assets related to this business were impaired and we recorded a charge of $192 million in the fourth quarter.

The tax effect of the impairment includes the deferred tax benefit of $31 million for a net effect of $161 million. Intangible assets of $27 million remain on our balance sheet representing customer relationships and trade names.

In 2017, amortization expense related to these intangible assets is expected to be reduced by $3 million as compared to 2016.

We remain committed to the long-term profitability of our oil and natural gas business and believe that improvements in facilities, manufacturing capabilities and commercial resources position the business to benefit strongly when recovery will come.

Foreign exchange continued to be a slight headwind in the quarter and the effect of foreign translation rates reduced sales by approximately $4 million and net income by $1 million. Sales from businesses acquired in the past 12 months increased sales in the fourth quarter by $4 million.

A reconciliation of our operating earnings is included on Page 8 of our slide deck. Gross profit margins for the quarter were consistent with the prior year as favorable realized pricing and mix offset the unfavorable effects of lower factory volumes.

Operating expenses were $4 million higher than the prior year, with $2 million related to acquired businesses. Unallocated corporate expenses were approximately $1 million lower than last year and included a $2 million increase related to an employee option grant that was issued in the fourth quarter of 2016.

The employee grant from 2013 was fully vested in 2016 and the program to grant options to non-executive, non-managerial employees has historically been put in place on a three-year cycle. The fourth quarter expense related to the option grant was more than offset by a favorable legal settlement.

Excluding the effect of the impairment, the effective tax rate for the quarter was 29% as compared to 27% last year. The 2015 rate included the favorable impact from the full-year federal R&D tax credit, which was not available until the fourth quarter last year.

Cash provided by operating activities was $269 million for the year as compared to $190 million last year. A brief reminder regarding comparables to 2016, last year included year to date net investment income of $141 million, or $2.40 per diluted share, related to the Liquid Finishing businesses that were held separate and sold in April 2015.

2015 year-to-date results also included $9 million, or $0.15 per diluted share, related to nonrecurring tax benefits. Looking at 2017, foreign exchange is expected to continue to be a headwind for us.

At today's exchange rate and assuming the same volume, mix of products and mix of business by currency, we expect to see an unfavorable effect of currency translation of approximately 1% on sales and 3% on earnings, with the greatest effect in the first three quarters.

Also, going into 2017, we expect to realize modest price increases and improved factory efficiencies. The factory performance is dependent on volume. As noted earlier, amortization expense related to Oil and Natural Gas intangibles is expected to be $3 million lower in 2017 as compared to 2016.

Full-year unallocated corporate expenses in 2017 are expected to be $2 million higher than 2016. The tax rate is expected to be approximately 30% in 2017. Capital expenditures are expected to be approximately $40 million.

We currently plan to repurchase enough shares to maintain our current outstanding share count, though the count may vary from quarter to quarter and we may make further share repurchases on an opportunistic basis. I'll turn the call over to Pat now for further discussion..

Thank you, Caroline. Good morning, everyone. All my comments this morning are on organic constant currency basis. Operating margins expanded by 1 percentage point in the quarter, reflecting the higher top line growth rate. The Process segment was up 2 points, Contractor was up 1 point and Industrial held its 34% operating margin from a year ago.

The Contractor segment was up against very difficult comps from last year's fourth quarter and still managed a double-digit revenue growth rate. With strong performance from the Americas and EMEA, Contractor hit $100 million in fourth quarter sales for the first time in the Company's history.

Every segment and region posted growth in the fourth quarter and for the full year 2016, with the exception of the Process segment. As Caroline mentioned in her prepared comments, Graco had an extra week in the fourth quarter of 2016, a natural catch-up that happens every half a dozen years or so due to our week-based fiscal periods.

Using simple math to adjust out the extra week, the fourth quarter was relatively flat on an apples-to-apples basis. Frankly, I believe that simple math sure changes the quarter as Q4 of last year had a backlog reduction of $8 million while this year we added $3 million of backlog during the quarter.

So based on weekly average order activity, we had a low single-digit growth rate, and that's how it felt to me during the quarter. During the second half of 2015, we shipped about $17 million more of backlog than we did in the second half of 2016.

I'm not going to go through the regions and segments individually but want to hit on some of the data points that we typically provide in a quarterly conference call that aren't included in the press release or call slides.

In Contractor Americas, we had high single-digit growth on our paint store channel while the home center channel was up solid double digits. As has been the case all year, out-the-door sales for both home center and paint stores were solid. In the EMEA region, we had good growth from both the developed and emerging markets.

Russia appears to have stabilized for us. The Middle East remains a concern. Our Asia-Pacific region, China was our strongest performing country throughout the year. We do remain cautious about the project spending and capital equipment environment Asia-wide.

We expect our normal modest price increases in 2017 and should be okay on price/cost mix this year. Orders were favorable to the prior year throughout the quarter, with November being closer to flat and December's pace above the quarterly average. The first few weeks of 2017 are in positive territory and support our outlook.

Before discussing the outlook, I want to make a quick comment about tax reform. We have provided a slide with some key data points that could be germane to your analysis around what the impact of certain tax proposals could be on Graco's future tax obligations. I'll leave it to you to try to predict what might happen regarding tax policy.

We'll continue to make our decisions using our standard ROI processes and we'll reflect any policy changes in our models if and when they are implemented. Moving on to our outlook, we initiated our 2017 outlook last evening in our Q4 earnings release.

Our worldwide outlook for 2017 is for low single-digit growth, with similar growth rates throughout the geographic regions. We believe we will see growth in all segments, but see the most risk to our outlook in the Process segment where we have the most exposure to oil and gas and mining end markets.

We expect Contractor to grow for an eighth consecutive year, but think the growth is likely to moderate to mid-single-digits. Our outlook for the first quarter of 2017 is similar to our outlook for the full year. With that, operator, we're ready for questions..

[Operator Instructions] We'll take our first question from Deane Dray. Please go ahead..

Just let me start off with, did I miss last quarter the heads-up that you were going to have this calendar difference with the extra week this quarter, because that was a surprise to us, I think it was a surprise to a number of people, and just kind of would like to know why it ended up being disclosed so late in the game here?.

No, you didn't miss anything. It was probably a miss on our part to not give you a heads-up on that..

So I can just – so you said, it happens every half dozen years, so we can file that one away, no other days issues in the near-term we should be aware of?.

That will be correct. Hopefully, six years from now we'll remember to tell you again..

All right.

And then the extent to which you get, I'll throw a flag at that, I do have to praise you that Page 13, out of all the industrial companies, that is a best practice in terms of profiling your business and I guess it's up to us to figure out for the crystal ball how the cross-border tax plays out, but we really appreciate that level of detail that you have provided..

I'm glad you like that. I've never actually got flagged on a conference call before. I've been here for years, so that will be the first..

No, that's a [indiscernible]. All right.

And then just on the business on the Contractor side, just kind of put this into context, you've had consecutive growth and expecting some moderation, is that because of tougher comps, is there more competition, just give us a sense of how you are modeling and expecting some moderation of growth?.

That's been a pretty big rebound coming of the bottom of the housing market. In fact, if you take a look at revenue for the division compared to where construction activity is, it's been pretty amazing. We also had a really big year in EMEA. So I think it's just wise for us at this point to anticipate a return to maybe more normal market growth rate.

There's really nothing more than that behind it..

I would add to that, Deane, this is Christian, that we also had the load in the [indiscernible] Q2 of this year. So that also makes the comps a little bit more difficult too..

And then just one more question if I could, pretty positive comments on China, and then maybe just kind of broadly what you're seeing there on the Industrial side and tie that to the Finishing and whether any change in the adoption rate of the technology?.

So we did have a good year in China really across the majority of our product lines. Still, I think we're a little bit cautious in terms of the project activity there going into 2017.

We've been cautious on Asia-Pacific and even in China in particular throughout most of the last year, year and a half and have still managed to be able to put up some numbers.

Specifically, on the conversion issue, I think that's related to our Contractor business, the question related to our Contractor business?.

Yes..

Yes, so we had a better quarter at our Contractor business in Q4, but that really just brought us back to about flat for the year. We have now made another leadership change. I know we went through this here a couple of years ago, but we didn't feel that that was working.

We took someone who's been within the organization and we think is tried and true and we've got a new leader for that business here, and we've got new ideas and we're going to go pushing again in 2017 to try to get that going. We really believe there's upside opportunity for our Contractor business in Asia that we are not getting at..

Understood. Thank you..

We'll take our next question from Saree Boroditsky. Please go ahead..

Congratulations on the quarter. In Industrial America, you've talked about the capital spending environment being weaker this past year, and I just want to get your thoughts if you've seen that improving. There's just been some more positive manufacturing data..

It still seems to me to be on a kind of a flat trend going forward. We continue to see tough sliding in the ag market, energy, mining. Aerospace has been okay, but it's really for us been mostly replacement of business, not a lot of new investment. Automotive was okay for the year. Heavy machinery and general industrial a little bit soft.

And I would say, so far, the trends kind of look a lot like 2016. So we are hearing some positive things but I think we're going to wait till we actually see it make positive comments..

Okay, that's fair. And then just to follow-up, and it might be early, but do you think that the proposed tax changes could be a catalyst to boost U.S.

manufacturing investment?.

We have discussions of course around here from time to time.

I personally try not to engage too deeply and I think it's hard to predict how well the dynamics are going to play out, and I can create scenarios that are great and I can create scenarios that are disastrous, and I think that that was in the details and we're just going to continue to do what we do, and as the picture becomes clearer, we'll make sure that we are making our decisions in context of whatever the environment is..

Okay, that's helpful. I appreciate it. I'll get back in queue..

We'll take our next question from Jeff Hammond. Please go ahead..

So just in the two end markets, auto CapEx cycle has been really healthy, what are you thinking about that prospectively? And then, I think you mentioned non-res, lot of debate earlier in 2015 about where we are in the cycle, but seems to have stabilized.

What are you seeing there in terms of rate moderation?.

So automotive has been pretty good globally, I mean 2016 was a pretty good year and obviously in some of the areas we are approaching peak. I think investment is still going to be okay in 2017. I'm not worried about a big collapse.

The numbers of EMEA look like they were pretty strong finishing up the year and they are forecasted for continued growth going into 2017. North America is at high levels but there still seems to be some activity. So I feel okay about automotive. And I agree non-res seems to have stabilized.

Construction markets in Europe actually are moving incrementally the right direction. I think that's positive for us. And of course the challenge for us in Asia related to construction is really market share and market penetration and user conversion, not so much the overall construction rate.

So, I don't think that it's likely that things are going to get worse in those markets in 2017. They ought to give us the room to succeed..

Okay, great. And then, Process you mentioned is still the area of caution, but we have gotten better, moves in oil and gas and data points and activity at least in the upstream.

Just maybe expand on any optimism you're seeing out there or what do you need for that business to more meaningful turn?.

So some of the things that we are reading are definitely headed in the right direction and some of the feedback that we are getting from the field sales team is also positive. From my perspective, really still not seeing that in incoming order rate yet. Hopefully, we'll see that soon.

But I think it's just a little early for us to be calling out a change to a positive trend there..

Okay. Thanks, Pat..

We'll take our next question from Charley Brady. Please go ahead..

Just a couple of questions on Contractor, it sounds though the home center channel, that sounds like a pretty strong number coming out of Q4, and I'm just wondering what's your sense on what's really driving that, was it just kind of a seasonal type of thing or you had some product load going earlier in the year and just getting a lot more traction now to the end of the year?.

It's Christian. I think it's partially that, we did have some good load that happened earlier on in the year and there's definitely the follow-through that happens as those products get reordered. We've seen this I guess for a number of quarters now though where we'll have a lighter quarter and then we follow it up with a stronger quarter.

That's really more the effect when compared against last year where home center was not quite as strong in the fourth quarter. So it's not necessarily that we're seeing something trend-wise, it's really differentiated there.

I would know that, again we see the out-the-door sales and the out-the-door sales are probably the more important factor for us, and so we are seeing growth of the out-the-door, which is nice but it's not all that differentiated from what we're seeing on the paint store side..

Thanks.

And just one more for me, I know it's not a huge piece, but on the hot melt adhesive side of the business, can you just maybe give us an update on kind of where you are strategically on – where you sit with that business, how it's playing out and is it gaining more traction than you've had previously in it?.

I don't want to get into detail on that for competitive reasons, but I would say we remain committed to that initiative and we're going to continue to push forward..

Great. Thanks Pat..

We'll take our next question from Matt Summerville. Please go ahead..

Just one follow-up on Contractor, is there anything to be gleamed as far as what you're seeing from an average price point kind of out-the-door, have you seen that migrate higher in particular through the pro paint channel, and also, do you have any major product line recapitalizations or new product launches that we should be aware of, given the timing associated with spend to be followed by volumes like what you had in 2016?.

So in terms of the average unit that's going out the door, we saw a nice but slow trend coming out of the recession.

You'll remember that our units at the bottom of the range really rebounded the quickest and the units that are the higher price points took longer to come back, but we have seen over the course of last two or three years the larger units coming back. So that's been a good trend for us.

Some of that can be also – can move around quarter to quarter and even year to year based upon promotional activity, and we saw some differences in 2016 and 2015 that moved the numbers around a little bit. But I think the trends are good in terms of seeing more of our bigger, higher ticket units getting sold.

Second part of the question?.

It was more around just product launches slated for 2017..

So we have a good slate of products for the Contractor division. We just had a big vendor show a couple of weeks ago here and we showed the products that we had. We had a number of demo booths set up. The feedback on those was pretty positive.

I don't anticipate a big zero load kind of a thing, like we had going into the home center in the second quarter, but I think our new products that we've got for 2017 in Contractor are solid and should support our mid-single-digit growth outlook for the year..

And then just one follow-up, can you remind us what your price realization was in 2016, and it sounds like you have a similar expectation, unless I misunderstood something, for 2017?.

For 2016, it was in the number that we target, which is kind of that 1.5% to 2%. As we go into 2017, the prices are out there and we're starting to realize that now. Our expectation is in that ballpark, maybe a little bit on the lower end..

Got it. Thanks..

We'll take our next question from Walter Liptak. Please go ahead..

You called out some of the political risk to 2017, and we've all been reading the papers, so I wonder if in the fourth quarter in the Industrial business if you did see any volatility right around prior to or after the election, maybe how you finished the year in December in Industrial?.

Again, if you kind of take out the impact of the extra week and then you also take a look at the fact that we shipped less backlog than a year before, I would say that there was probably some – I felt some optimism talking to some of our salespeople and a few of our channel partners, but I would say from a run rate perspective, it seemed like more of the same.

I don't think there was any kind of a dramatic reaction either way in terms of actual orders..

Okay. And I know you sell a lot of product through distribution.

So I wonder if you've had any discussions with large customers, et cetera, that might be looking at refreshing on capital spending, especially in the U.S.?.

I've not heard anything out of the ordinary or different than I heard in 2016, at least so far..

All right. Okay, all right, thank you..

We'll take our next question from Liam Burke. Please go ahead..

Pat, on the competitive front, you mentioned that you anticipate some price increases.

Are you seeing any change either on the national or the global or regional front on competition?.

No, not significantly. We've got a pretty solid group of competitors that are typically successful in good times and bad, pretty much like we are, and I think everybody in our space is really focused on trying to make the best products for the customer that they can and dynamics really haven't changed a lot.

I think our pricing environment has been pretty stable. We've been able to generate our annual price increase in that normal range for a number of years now and I think that the competitive market dynamics aren't dramatically different.

You can pick out a few product lines where maybe you could see some things different regionally, but I'd say overall in aggregate it's more the same..

Great.

And are you seeing any significant shift or move from liquid to powder at the product level?.

That's always hard to tell. Certainly, and this is just anecdotal evidence, but when I'm traveling around, I do see more facilities that have both, which is an interesting dynamic.

Whereas generally at our facilities it used to seem like it would be powder or it would be liquid, now I'm seeing particularly in some of the ag and heavy equipment places where they are putting in both depending on what kind of parts that they want to coat.

The powder business, and I think we communicated back when we bought it, had been growing about a point faster than the liquid business. So I'm guessing that there's probably still some conversion happening. I don't think it's dramatic..

Great. Thank you, Pat..

We'll take our next question from Jim Giannakouros. Please go ahead. Mr. Giannakouros, your line is open. We'll take our next question from Jim Foung. Please go ahead..

It seems like Trump is carrying out most of his promises made during the elections.

So I just wanted to hear, if he get this infrastructure built, how quickly could you benefit from that?.

Again, I mean we get into a lot of predictions and stuff in terms of what may or may not happen, and again, we're excluding our 2017 plan and whatever happens, happens. We went through this whole shovel-ready thing a few years ago and things weren't as shovel-ready as everybody thought.

Obviously any time there's construction activity, it's going to be great for Graco. I haven't built that into my forecast. My forecast assumes that things are running pretty much like they are today.

So if you view that there's going to be a lot of infrastructure activity that's going to happen already in 2017, you got to view that as favorable for us..

Okay.

And then just back on the Process segment, I mean when that snapped back, I mean I guess what kind of upside can we see now that you've kind of taken all the cost out of that business? I mean, how big is the leverage when it comes back for you?.

So we haven't been through a cycle with our direct Oil and Gas business. We bought that when the market was hot and now we've been through the downturn but we haven't been through the upswing. Certainly we've invested into equipment and some facility consolidation that should help. I don't think we really know.

I would expect that incremental margins should be pretty decent, but in terms of how exactly it all plays out, I don't know. Christian, you can weigh in if you have some thoughts..

These businesses when we bought them were the high 20s, low 30s on EBITDA margin. [Indiscernible] that we've made, we should expect that we're going to be above those numbers when we get back to the same kind of volume level, but we got ways to go still..

Right. So that could be actually very [indiscernible] in terms of when we see a quick recovery, those things could hit the bottom line very quickly for you. Okay, that's all I had. Thank you..

And we'll try again with Jim Giannakouros. Please go ahead, sir..

Sorry about that.

So, Pat, you mentioned that doing the rough math on the extra week given the 7% to 8% bump year-over-year, not a fair handicap given the weekly sales data that you were looking at, was that a December comment or was that the full quarter, could you just dive into that a little bit just so I could better understand what you were seeing during the quarter?.

That was a full quarter comment. There is always noise week to week and we are pretty fast book-and-ship kind of a business in most of our product lines.

In terms of order trends through the quarter, November was somewhat of a flatfish and December was stronger, but I tend not to get too worked up over what happens these two weeks versus those two weeks just because our business does definitely have some noise in it. And the quarter overall kind of fell low single digits.

That's what the incoming order rate was really reflective of. And I feel like we're exiting the year in a similar fashion that what we've seen the last few quarters in terms of overall activity..

Got it, okay. And then a follow-up on the incremental margin discussion. I'm assuming input costs are rising. I assume that pricing is pretty broad-based.

But can you, Pat or Christian, kind of get a little granular as far as where you're getting more price, where it's not as easy to get price and where mix might work against you, just to get a better understanding of the incremental margin progression in 2017?.

So again, we feel pretty good about the price/cost mix and we're not going to break out what our price realization is by product line or by geography, but I think you're pretty safe to put in a number in that 1.5% to 2% kind of range in terms of realized pricing. That's what we have done historically and I don't see a dramatic difference for 2017.

Our factories actually performed halfway decent this year given big pressures on them in terms of the lower volumes. With a little bit of volume improvement, certainly we could see some improved factory performance. But overall, I don't think that based upon what we see today in input cost and pricing, we should be fine..

Thank you. That's all I had..

[Operator Instructions] We'll take our next question from Walter Liptak. Please go ahead..

As a follow-up on the Process segment, I wonder if you could give us an update at the end of 2016, how much is your revenue that's related to Oil and Gas?.

So at the end of 2016, we haven't done the exact analysis. Because we sell through distribution and the Oil and Gas businesses have an aspect to that as well, it takes some time to go back and pull the data apart to get that information.

But just broadly speaking, as we look at our overall, what we think our Oil and Gas exposure is and where we stand for 2016 on sales, we're probably in the neighborhood of I'm guessing about 20% type of exposure in the Process segment for Oil and Gas..

Low 20% of Process is Oil and Gas, okay.

And your businesses I imagine it were down in 2016, kind of on a pro forma or whatever, 50%, something like that?.

On the Oil and Gas side of it?.

Yes, on the Oil and Gas side..

Overall, no, it wasn't that bad. It was but it wasn't that bad..

Oh, good, all right. Okay, thank you..

[Operator Instructions] It appears we have no further questions at this time. So I will now turn the conference over to Pat McHale..

Thanks everybody for joining us on the call this morning. We're excited to get going on 2017 here, got some products launching in our business units, and hopefully some of the hard work and activities that we did in 2016 will pass in 2017. So, we'll see how it goes and we'll be back to catch you at the end of the quarter. Thanks..

This concludes your conference today. Thank you all for participating and have a nice day. All parties may now disconnect..