March 24, 2008

Graco: Boring business with potential for good returns

Graco (GGG):

Graco offers systems, products and technology that set quality and production standards in a wide range of fluid handling applications including spray finishing and paint circulation, lubrication, sealant and adhesives, processing, as well as power application equipment for the contractor industry. Founded in 1926, Graco’s ongoing investment in fluid management and control will continue to provide innovative solutions to a diverse global market.

The company is not well known to main stream or to analysts; it only has 5 analysts' recommendations. Also it has a small size market cap of $2.7 Billion. However it has a wonderful business with strong return on investment. In my opinion, it has all the criteria to look for in an investment that will outperform the market in the long run. The company is also similar to some of the industrial businesses purchased by Buffett, that is very boring and steady business. A comparable company in his holding to this one is the recently purchased Iscarr.

The company fluid handling products sells mostly for commercial uses to two distinct user groups: the Housing Contractor and the industrial user. Its products are used for various applications in the industries mentioned including: painting, finishing and foam spraying and industrial greasing and lubrication in automotive shops and equipment building. The company operates, organizes and sells its products through 3 different divisions: Industrial, Contractor (housing), and Lubrication (industrial).

Business Economics

  • International sales driven strategy: the company is pursuing International sales and distribution aggressively. Currently international sales accounts for 34% of its gross sales.
  • Market share: established a factory in China to sell to its customer in the growing Asia Pacific segment of the business. the Chinese are adding 1000 cars a day to the their streets and the lubrication division sell products for service garages and car maintenance shops. The need in that market will be large. Although it assembles small part of the company products but I expect management to expand this strategy to include more products that specifically manufactured for Asia. The company has been expanding its distribution channels throughout the world by acquiring smaller companies. Most of these acquisition has solidified its market share and presence through the different application segments it operates in.
  • Revenue growth: The company has experienced decline in 2007 sales in the contractor division on the basis of weaknesses in the housing market. Most of their sales channels, paint stores and home centres, were weak and it is expected to be weak until the housing market stabilizes. This division accounts for 36% of total sales in 2007 down from 39% in 2006. A combination of lower sales and growth in its industrial division. With slowing economy I expect that the industrial division to slow down as well. The industrial division has been offsetting the decline in its contractor division so far with good growth in revenues and operating profits.
  • Product Development and R&D: The company maintains a healthy spending on research and development. The company spends 4% of sales on R&D annually. It also have a new product introduction cycle of 3 years, that means that there is a 3 year replacement cycle for existing customers.
  • Operational efficiency: The company has managed to reduce its cost of manufacturing from 50% in 2001to 46% on TTM basis. Moreover net margins have grown from 13% in 2001 to 19% on TTM basis.
  • Competitive Advantage in the quality and the brand the company has built over the years. Additional competitive advantage is the size of Graco in its target markets. The company has a size advantage over competitors and have actually bought some of its competitors in the past. Additional advantage is its extensive distribution network that the company has put through acquisitions.

Management Quality

The company management's track record has been outstanding and enriching to shareholders. The company's return on invested capital (ROIC) is consistent and higher than its peers. Currently its ROIC stands at 51% and if you refine it more for return on intangible assets the ratio shoots up to 90%.

A similar result can be obtained from its return on assets and equity. As you can see from chart, the 10 yr trend for its return on assets and equity is consistently strong.

The average growth rate in equity value over the last decade was 25% annually.

Recently there was a management change at the top. The new CEO is home grown, which is always a good sign. The new CEO has served 17 years with the company and has served in almost every department of the company. A good sign also as the experience will give him a complete understanding of the strength and weaknesses of the company so he can leverage them to peruse growth opportunities.

Management has been buying back the stock at furious pace in the form of shares buybacks and insider buying. The company even leveraged an always pristine balance sheet from 0 debt to equity ratio to 43% to buy back its own stock. The company purchased 3.9 million shares or 6.4% of outstanding shares during the last two quarters of 2007.

Insiders control 0.84% of GGG through the 1,110,257 shares that they hold. This level of ownership is below the Machinery industry norm. However, insider trading has been bullish recently with net buying activity of 451.8K shares, which is above the 2-year quarterly average where insiders typically buy 125.6K shares.


The company is not cheap or expensive. I beg it is fairly valued at current market prices. I missed my opportunity few weeks ago to buy it at a great price of $32 but I was still conducting my analysis. I hope it will revisit that price soon.

I have a valuation for the company between $36-$44 per share based on very conservative estimates of growth rates and operations. The company international growth rates if materialized ill justify higher valuation. Another upside for valuation is the recovery in the US housing market. The analyst community is estimating 15% growth rate in revenues over the next 5 years. I have used 4-10% growth rate range throughout my analysis.

The company has leveraged itself in Q4 to implement its repurchase program. I do not have a problem with leveraging the company to do acquisitions but the wisdom to leverage the company to implement a repurchase program is not the most optimal course of action to me. However some may argue that there is an optimal capital structure of debt to equity to maximize shareholders value and recapitalization of the firm capital structure is needed for companies with less than optimal debt.

I am a buyer of Graco at $33 or below. I am willing to buy at fair market value and sacrifice the margin of safety for an excellent run business.

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