GGG - Graco: Good Near And Long-Term Growth Prospects

2023-11-06 11:03:52 ET

Summary

• Graco's revenue is expected to benefit from easier year-over-year comparisons.
• Channel inventory normalization and price increases are expected to further boost revenues.
• The company's margin growth is supported by price increases, moderating commodity prices, and improved supply chain management.

Investment Thesis

Graco Inc.'s ( GGG ) revenue is poised to benefit from easier year-over-year comparisons in Q4, investments in new product introductions, and increasing distribution. In addition, channel inventory normalization and benefits from carryover price increases and potential price increases ahead should benefit revenue moving forward. In the medium to long term, a recovery in the construction end market as the interest rate cycle reverses coupled with long-term tailwinds from government stimulus funding should drive revenue growth. Besides organic growth, inorganic growth opportunities from strategic M&A should help revenue growth in both the near and the long term.

On the margin front, benefits from price increases, moderating commodity prices, and continued improvement in the supply chain should boost margin growth. The stock is trading at lower than historical averages which coupled with good growth prospects makes GGG's stock a buy.

Revenue Analysis and Outlook

Graco has seen good growth over the last couple of years benefiting from strong demand and price increases. However, the company's growth turned negative in Q3 2023 as a result of tough comparisons and a slowdown in the global construction market due to the high interest rate environment.

In the third quarter of 2023, the company's Contractor segment sales declined 7.1% Y/Y driven by sales declines across all geographic regions due to lower demand from slower economic activity in worldwide construction markets. In EMEA, the sales were impacted by tough Y/Y comparisons while in Asia Pacific, sales declined from weaker container and construction markets in China more than offset the sales growth across other regions.

In the Industrial segment, sales grew 0.7% Y/Y but declined 1% Y/Y on an organic basis as improved project activity in Asia Pacific and strength in key end markets such as alternative energy, electronics and battery in Americas was offset by a sales decline in EMEA. However, the Process segment's sales increased 9.5% Y/Y with sales growth across all regions attributed to double-digit growth in vehicle services and semiconductors, and strength in automatic lubrication product application.

On a consolidated basis, the company's sales declined 1.2% Y/Y to $539.7 million with a 2% Y/Y sales decline on an organic basis as sales growth in the Process segment and a 1% favorable impact from FX translation was more than offset by a decline in sales in the Contractor segment.

Looking forward, while the weak construction markets remain a headwind, I am optimistic about the company's near as well as long-term growth prospects. The company faced tough Y/Y comps last quarter as Q3 2022 benefitted from the easing of supply chain constraints and pre-buys ahead of the company's price increases which shifted some demand from Q4 2022 to Q3 2022. This resulted in a very strong growth rate of 12.2% Y/Y in Q3 2022 which slowed to 2.9% Y/Y in Q4 2022. So, the company should see meaningfully easier comparisons in Q4 2023 compared to last quarter which should help Y/Y sales growth.

The company also has a good execution track record and continues to gain share through new product launches and increasing distribution reach which should help it outperform despite the tough macroeconomic environment. Over the past few quarters, inventory destocking was also an additional headwind for the company but on its recent earnings call management mentioned that Channel Inventory levels have now reached normalized levels which should help sales in the coming quarter. Further, management is planning to implement a 1.5% to 2% price increase in January in line with the company's historical price increases. The upcoming price increase coupled with the carryforward impact of past price increases should also help sales.

In the medium to long run, the company should benefit from increased manufacturing and construction activity in the U.S. helped by the federal stimulus funding from various programs like Infrastructure Investment and Jobs Act (IIJA), CHIPS and Science Act, and Inflation Reduction Act (IRA). Also, we are likely near peak interest rates and once the interest rate cycle reverses, the construction end market should eventually pick up helping sales growth in the medium to long run.

The company also has a healthy balance sheet with net total cash and cash equivalents of ~ $525.8 mn and only ~$75 mn in long-term debt. The company's healthy balance sheet should enable it to pursue M&A which should add to the inorganic growth. According to management , the company has a pipeline of over 100 fully vetted bolt-on acquisition targets which they continue to evaluate for inorganic growth opportunities.

Overall, I remain optimistic about the company's near as well as long-term growth prospects.

Margin Analysis and Outlook

In Q3 2023, the company saw an impressive 490 bps Y/Y improvement in gross margin to 52.7% driven by strong price realization and lower product costs which more than offset the impact of lower factory volumes. The increase in gross margin and favorable impact of currency translation rates effectively offset the increase in operating expenses and resulted in a 390 bps Y/Y expansion in operating margin to 30.2%.

Looking forward, the carryforward impact of past price increases as well as upcoming price increases should continue to help gross margins in the coming quarters. Commodity prices are also stabilizing and the supply chain situation continues to improve which should also help margins. The company did a really good job in terms of managing operating expenses and was able to post an all-time high operating margin despite lower volumes. Once the volume starts recovering, this good execution in terms of expense control should help the company post solid incremental margins. So, I remain optimistic about the company's margin growth prospects.

Valuation and Conclusion

GGG is currently trading at a 25.43x FY23 consensus EPS estimate of $3.03 and a 24.43x FY24 consensus EPS estimate of $3.15. This is a discount versus the company's 5-year average forward P/E of 28.04x.

I believe GGG should be able to post good revenue growth benefiting from easier Y/Y comps, new product launches, accretive M&A, and long-term growth opportunities from federal funding. Further, the carryforward impact of previous price increases as well as future price increases should help both the revenues and margins moving forward. The margins should also see gains from stabilizing commodity costs, continued supply chain improvement, and good expense management. Also, the company has a good long-term track record of growth and, once the interest rate cycle turns, I believe the growth rate will accelerate and the stock will re-rate to its historical valuation levels. Considering the good revenue growth prospects, the margin expansion potential, and a lower-than-historical valuation, I have a buy rating on the stock.

For further details see: