Graco Inc.

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 4/5

Graco Inc. is a global manufacturer and marketer of fluid handling systems and equipment used to move, measure, control, dispense, and spray fluid and powder materials, and markets them through a global distribution network to a wide range of end-user customers.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Graco’s business is spread across three operating segments: Contractor, Industrial, and Process.

Business Overview

Graco Inc. operates in a niche yet diversified space within fluid handling. It’s a company that doesn’t deal directly with consumers on a large scale. Instead, its products are components used in larger systems. Let’s break down its different segments.

  • Contractor Segment: This segment primarily offers equipment for the spray application of paint, texture, and other coatings. Products from this segment are used in building maintenance, wall, roof, and floor coating, as well as insulation and fireproofing for various structures. This segment accounts for the highest portion of sales.

  • Industrial Segment: This segment offers engineered systems for fluid transfer, dispensing, and application within industrial settings. These include equipment for lubrication, adhesives, sealants, and other specialized fluids for the automotive, aerospace, and appliance industries.

  • Process Segment: This segment caters to industries including food and beverage, pharmaceuticals, water, and oil and gas. This sector focuses on dispensing and spraying a wide range of viscous and corrosive materials.

Graco is not your typical consumer brand but rather a B2B manufacturer that supplies to various industries.

  • Cyclicality: Many of the industries that Graco serves are susceptible to broader economic cycles, affecting order volumes. During economic downturns, capital expenditure, which is a key purchase driver for Graco’s products, typically slows down, thus causing a decline in revenues and earnings.

  • Technological Advancements: Graco needs to keep pace with advancements in technology relating to materials, electronics, automation, and connectivity. Failure to integrate advanced tech into their product line could jeopardize market share.

  • Globalization and Emerging Markets: The trend of globalization provides a means for companies to reach new markets and customers and to diversify their supply chain and revenues. Growth opportunities in Asia-Pacific are a big part of the company’s growth plan.

  • Focus on Sustainability: Environment consciousness has increased and customers are increasingly looking for equipment that helps them meet these initiatives. Graco has been pursuing initiatives like efficient product designs and waste reduction.

Competitive Landscape

  • Diversified Market: The markets they participate in are diverse, and they typically face competition on a range of levels, from small local suppliers to much larger, diversified companies. Competition in industrial and process often arises from other manufacturers of specialized pumping and application equipment.

  • Stronger Competitors: For the contractor segment, Graco faces stiff competition from several smaller competitors, and from large companies who are focusing on their paint application systems.

  • Price and Performance: Across all segments, competition focuses heavily on price and performance. Competitors with innovative solutions at lower prices are the biggest threats in the markets where price is a core value driver.

Although Graco has some big competitors, the specialized nature of some of their products and the niche areas of several industries in which they operate provide them with a level of protection from heavy competition.

What Makes Graco Different?

  • Brand Recognition & Reputation: Graco has built a reputation for quality and durability, allowing it to earn premium prices in several areas. The brand is most notably recognized in the Contractor segment.

  • Extensive Distribution Network: The company boasts a large network of sales and distribution centers, primarily in North America, Europe and Asia-Pacific, providing them with a key advantage over competitors with little-to-no global presence. Their specialized dealers can service customers, source components, and do repairs on-demand.

  • Proprietary Technology: The company’s product development often results in new and unique product offerings that help them to stand apart from the competition.

  • Strong Relationships: Graco has cultivated strong relationships with key stakeholders within the industries that they serve and they provide reliable and consistent products and customer service.

Financial Analysis

  • Revenue Overview: In 2023, Graco reported net sales of $2.15 billion, a solid performance in a challenging global economy. The growth was 3% over 2022, and is down from their average historical growth rates. Their top line was driven by an increase in sales in the Industrial and Process segments while the Contractor segment saw reduced sales volume.

  • Profitability: Graco has historically high margins, due to their niche industries, strong value proposition and good customer relationship. While their margins have fallen slightly YoY, their operating margins in Q3 2023 were at ~23.9% which indicates profitability. Their high margins can be attributed to both their higher prices as well as efficient operations.

  • Return on Invested Capital (ROIC): The company has consistently high return on invested capital. The ROIC calculated using 2023 financials are at 19%, well above the cost of capital. This means the business can generate profits higher than what is needed for the company’s operations.

  • Cash Flows: Graco has demonstrated a very strong positive cash generation. In 2023, the company’s operating activities generated positive free cash flow (FCF) of $371.8 million. This means the company has a high capability to fund operations and reinvest into growth.

  • Balance Sheet: Graco maintains a healthy balance sheet. As of the end of 2023, their current assets stand at $1.35 billion, while the current liabilities are a much lower $588.7 million. Their long term debt is very manageable, and the company currently has cash equivalents of $637 million.

  • Share Repurchase: Over the course of 2023, the company has aggressively repurchased shares to the extent of ~13 million, for an average price of $74, which has lowered the total number of shares outstanding. This was to offset dilution from their stock based compensation.

  • Dividends: Graco has increased dividends to shareholders in 2023, to the tune of ~$212 million, which reflects their strong financials, a history of dividend payouts, and a future outlook of the company. The current dividend yield of 0.89% is much lower than what would be considered a high dividend, but is a good yield for a company with steady growth and high valuation multiples.

While Graco is performing well, many of the above numbers, most notably revenue growth have shown a significant slowdown and are not reflective of historical numbers, or analyst expectations.

Recent Concerns and Controversies

  • Economic Slowdown: A key risk faced by Graco in 2023 is the economic slowdown and lower growth across many of the industries in which they operate. As mentioned earlier, the Contractor segment was hit particularly hard due to decreasing construction demand. Although sales volume and revenues have been able to keep pace with some of this slowdown, the impact on profit margins and stock valuations have been apparent.

  • Supply Chain Issues: There have been occasional disruptions in the supply chain that have increased costs and caused slowdowns in meeting demand, further impacting margins and revenues. The management has stated they have found alternative solutions, but these problems persist.

  • Geopolitical Instability: Events like Russia’s invasion of Ukraine have increased input costs due to price spikes and transportation issues. Graco has been largely able to circumvent these issues, but this does introduce further uncertainty in the long-term and increases operational expenses.

  • Currency Fluctuations: International currency fluctuations do influence sales and profits for Graco, since roughly 65% of the revenues are generated outside of North America. Any strengthening of the US Dollar would reduce revenues as reported in USD and vise versa.

Management has acknowledged these risks, but they also maintain that their long term outlook is positive given the demand from customers for their high-quality products. Furthermore, they are taking steps to mitigate the impact of the above challenges, including expanding their international presence, developing more resilient supply chains, and focusing more on product development and R&D.

Moat Rating: 3/5

Based on the analysis, Graco has a narrow moat. Here’s the justification:

  • Brand Recognition and Reputation: While Graco does have some brand recognition, they don’t have an incredibly sticky brand such as consumer brands like Coca-Cola or Apple. The brand also mostly exists in the construction sector (which is a very price sensitive market), and not across all industries they operate in.

  • Distribution Network: Their distribution network is definitely an important moat and provides a big edge over smaller competitors, but many bigger competitors like ITW and other major industrial conglomerates have comparable and sometimes better networks.

  • Switching Costs: The fact that many of their components are sold in larger systems and that their products are integrated into their customer’s processes means that they will have relatively higher switching costs which favors moat protection. These switching costs are much more apparent in the Industrial and Process segments, as opposed to the Contractor segment.

  • Economies of Scale and Cost Leadership: Although Graco has a lot of scale, it is not particularly a scale-advantage moat. They are not able to deliver a consistently superior product at far lower costs than competitors in the same industry. That is they don’t have a clear, and sustainable, cost leadership advantage. Instead their pricing premiums and margins are derived from the above described factors.

  • Intangible Assets: The company does have a history of patents and innovation, and they are one of the leaders in their field, but I don’t see this translating to incredible defensibility against all competition.

In short, Graco has some competitive advantages, but not so strong as to be considered a wide moat. Their brand recognition, switching costs, and distribution network do help, but are not insurmountable by competitors. Their moat seems likely to persist in some of their segments, but will almost certainly come under pressure in areas such as consumer contracting where brand recognition does not mean as much as price and value.

Understandability Rating: 2 / 5

Graco’s business is quite complex, especially for an investor who has not had experience with industrial or manufacturing companies. Here’s why it gets a 2/5:

  • Specialized Products: Many of Graco’s products, which serve several different industries, are difficult to understand without significant research or industry-specific knowledge.

  • Complex Business Model: The B2B nature of Graco’s business, often with indirect customer relationships and several layers of manufacturing and distribution makes it difficult to understand where their actual value is derived. The complexity of the many types of machinery and its use cases only increases this further.

  • Varied Segments: The three segments they operate in are quite different and require a different understanding of their respective market dynamics and competitive environments.

Although the financials are easy to interpret using standardized metrics, and although the management communicates its goals well, the complexity of the business model and the several segments they operate in make it more challenging to fully and adequately understand for any investor.

Balance Sheet Health: 4 / 5

Graco has a strong balance sheet and is in good financial health. Here’s the justification for the rating:

  • Liquidity: The current ratio is very high, at 2.3, indicating that their current assets more than cover their current liabilities. This shows the company has sufficient liquidity.

  • Low Leverage: Graco’s debt-to-equity ratio is low (0.35), suggesting that the company is not heavily leveraged, further providing a cushion during economic downturns.

  • Strong Cash Position: The company has over $600 million in cash, which is a strong level and provides a cushion against business downturns and ensures they have liquidity for any operations.

  • Consistent FCF: The company has been generating free cash flows over the past few years, and the trend is expected to continue in the future as well, which allows them to reinvest into growth, and return capital to shareholders through dividends and buybacks.

However, their debt is not as low as some other high-quality businesses, and their revenues have slowed recently, which is why it is not a 5/5.