GGG - Graco: Well-Diversified But Due For A Correction

Summary

• Graco posted strong Q4 2022 results, beating expectations and providing strong guidance.
• Strategic acquisitions and innovations will drive Graco forward.
• Interest rate hikes or delays of pivot will hurt a large portion of Graco's core business.
• Graco's balance sheet is strong and may partially protect Graco.
• Graco stock is far too overvalued, exemplified by my DCF valuation, accompanied by little short-term growth prospects.

Graco Inc. ( GGG ) has experienced exceptional growth for several decades accompanied by constant innovation and further product diversification. Despite acknowledging Graco's potential for strong growth in the future, I would rate the company as a 'Hold' due to concerns about the impact of economic headwinds, such as interest rate hikes, on the housing market, in which Graco has a significant presence due to its exposure in the construction segment. I believe that Graco stock will be able to partially offset this downturn through their past acquisitions, further diversifying themselves away from the construction segment.

Business Overview

Graco supplies technology and expertise for the management of fluids and coatings in both industrial and commercial applications. Pumps, sprayers, meters, mixers, and systems for the management of fluids including paint, coatings, adhesives, lubricants, and chemicals are among Graco's products. The company operates across the world, with its primary revenue source and headquarters in the United States.

1. Graco operates in three main segments:

   1. Industrial segment: This segment offers products such as pumps, spray equipment, fluid handling systems, and lubrication equipment for use in industries such as manufacturing, automotive, and processing.

   2. Process segment: This segment offers precision fluid handling equipment and systems for industries such as food and beverage, pharmaceuticals, and cosmetics. Products in this segment include sanitary pumps, valves, and meters.

   3. Contractor segment: The contractor segment sells equipment such as paint sprayers, texture sprayers, and pressure washers for use in construction, property maintenance, and home improvement applications.

Overall, Graco's products are designed to help customers increase productivity, reduce waste, and improve product quality.

With a market capitalization of $11.8 billion, an exceptional ROIC of 27%, a 52-week high of $72.87, and a low of $56.48, a price of $70.42 accompanied by a 26.37 P/E seems rather high to me, especially with interest rates threatening growth for possibly several years and rather moderate revenue growth as displayed below.

Graco also yields a healthy dividend of 1.34% representing a payout ratio of 32.45% leaving large room for CapEX and R&D to continue their strong growth as exemplified in their previous performance.

Strong growth fueled by innovation and a solid moat was exemplified in their Q4 2022 earnings report, where they beat on top and bottom by 6.36% on earnings and 0.1% on revenue. Graco also displayed strong revenue and earnings growth of high-single-digit, indicating possible resilience to the high-rate environment. One part of the report that I found of great importance was that CEO, Mark Sheahan, mentioned that Graco must closely monitor order rates and business tempo in 2023. With forward guidance of low single-digit growth for 2023, failure to meet such expectations with a relatively high valuation due to housing market declines would send the stock falling further solidifying my Hold rating.

Outperforming the Broader Market

Graco's successful reinvestment into the company accompanied by their existing high-quality products has been exemplified by their stock price, outperforming the S&P 500 for decades as shown below.

Graco's Exposure to the Slowing Housing Market

With a decline on an annual basis, of 28.4% in U.S. home sales and inflation beginning to push back, persistent rate hikes may be on the way resulting in large decreases in home purchases and the construction of homes. With 48% of Graco's revenue concentrated in the construction segment, further rate hikes will only hurt their future sales, resulting in a large decline in stock price. Although the company still projects low single-digit growth in 2023, I believe that rates will continue to rise and do not expect a pivot from the fed in 2023. Taking a cautious short-term outlook, it appears that Graco may be susceptible to a decline from its current highs.

Strategic Acquisitions of key Companies Might Help Offset Housing Market Slowdown

Graco has a promising long-term future thanks to its strategic acquisitions and ongoing innovation. Recent purchases like Novac in 2020 and iPolymer in 2022 have bolstered the company's process and industrial segments, while previous acquisitions - including High-Pressure Equipment in 2015 for $160 million - have expanded its revenue streams and opened up new markets. These acquisitions have also helped Graco diversify its business and offset any potential declines in the construction segment. By integrating these new businesses into its core model, Graco has improved efficiency and customer retention while continuously expanding its moat through high entrance costs. As a result, the company's new segment entrants are experiencing significant growth. These acquisitions are a likely occurrence in the future as Graco has mentioned in their last quarterly report that it is important to growth.

This is very feasible as the company's free cash flow remains steady around the $400 million mark, with only slight fluctuations in the past five years. Along with solid free cash flows, Graco also has a fantastic balance sheet with debt decreasing steadily over the years, presenting opportunities for further acquisitions. Lastly, Graco has a current ratio of 3.02, indicating solidifying that they can take on more debt to expand or protect itself from the looming recession by stabilizing the company.

Analyst Consensus

Analysts have also expressed their mixed opinions about Graco, with seven rating the stock as a "hold" but also noting its potential for significant upside reflected in their price targets, which on average show an average stock appreciation of 8.16%.

Valuation

Prior to performing my DCF analysis, I calculated Graco's WACC using their Cost of Equity, which I found with the Capital Asset Pricing Model. Factoring in a risk-free rate of 3.83%, I was able to conclude that the Cost of Equity was 8.81% as displayed below.

Assuming this Cost of Equity value, I was able to calculate the WACC to be 8.73% as shown below, which is under the industry average of 11.39% .

After conducting an unleveled DCF analysis, I have determined that Graco is currently overvalued by 12% based on a fair value of ~$62.45. To arrive at this value, I used a discount rate of 8.73% over a 10-year period, reflecting my intention to hold the investment for the long term. In terms of revenue assumptions, I estimated high-single-digit growth after 2023, with growth plateauing to mid-single digits in later years as the company becomes larger and more challenging to grow. I also estimated that the company's strategic acquisitions would pay off and efficiency would improve thus an increase in their operating margin over time.

Finally, I assumed that Graco's net capital expenditures would continue to increase, given the company's stated interest in acquisitions and vertical integration, which could lead to higher expenditures.

Risks

Housing Market Weakness: Any further deterioration of the housing market will result in fewer construction projects due to the uncertainty of success and homebuyer sentiment decreasing. With inflation pushing back, rates may not pivot as quickly as we may think, making this problem potentially long-term. As construction is a key component of their business model, this risk could result in large declines in the stock.

Competition: Graco may face challenges if macroeconomic headwinds continue to increase and sales decline, potentially resulting in signs of weakness that could allow new competitors to enter the market and take market share, thereby reducing Graco's growth prospects in the future. Given that the construction industry is expected to grow at a CAGR of 4.05%, it remains an industry with substantial profit margins. However, this industry is also susceptible to risks, particularly during economic downturns or a housing market pullback, which could negatively impact Graco's business operations.

Conclusion

In conclusion, I believe Graco is a Hold because although the company has exemplified strong growth through innovation and acquisitions, the stock is overvalued which presents a high risk, especially during a housing slowdown which represents a large chunk of their core business operations. Thus, revisiting the stock in the future when the valuation becomes more attractive or macroeconomic trends cool down would be the best course of action.

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