Add Graco to Your Watchlist

You may not have heard of Graco (NYSE: GGG), but you've seen its work. Graco fills the liquids niche -- everything from peanut butter to spray paint to glue, and more in between. What makes a behind-the-scenes industrials company worth a whole episode of Industry Focus, you ask? A 6,000% return over the last 25 years is one aspect, a recession-proof track record is another, and you'll have to tune in for the rest.

Foolish analyst John Rotonti and host Nick Sciple explain exactly what Graco does, how it's established a more or less impenetrable moat around its market, why this company is such an exciting buy for investors, and more.

A full transcript follows the video.

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This video was recorded on March 21, 2019.

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, March 21st, and we're talking Graco. I'm your host, Nick Sciple, and today I'm joined by senior Motley Fool analyst John Rotonti via Skype. How are you doing, John?

John Rotonti: I'm doing good, Nick! Thanks for having me on the show!

Sciple: John, it's great to have you on the podcast today! Before we dive into Graco, which is the company we're discussing today, why don't you tell the listeners a little bit about what you do at The Fool and a little bit about what your investing style and strategy is?

Rotonti: Awesome! I'm a senior analyst at The Motley Fool on the investing team. I've been here for almost five years. I basically just try to cover as many high-quality growing companies that I can handle. Right now, that's about 30 companies. In general, I look for companies that have a strong balance sheet and that generate high returns on invested capital and that I think can generate high returns on future capital and that have opportunities to reinvest in future growth at high returns, and a company that's growing organically and I think can generate earnings per share and free cash flow per share of about 10% or more going forward. That's basically what I look for.

Sciple: Awesome! We're going to talk about a company today that really seems to check a lot of those boxes. That's Graco. I'll tell you, John, when I heard the name Graco, the first thing I thought about was high chairs and strollers. This is not that Graco. Why don't you tell our listeners a little bit about what Graco does, and maybe how you came across this company in the first place?

Rotonti: That high-chair and stroller company must have a fantastic brand because I mentioned this company to Buck Hartzell, as well, another member of our investing team, and he asked me the same question: "Is that the company that makes strollers?" I may have to look into that one.

This Graco is a world-class business. It was founded in 1926 by the Gray brothers. It's headquartered in Minnesota. It's nearly 100 years old -- it's 93 years old. And ever since day one, this company has focused on the liquids niche. Graco makes products that mix, meter, dispense, and spray liquids and other materials such as foams, epoxies, adhesives, and things like that.

Sciple: The quote they have, I believe it's from their 10-K, they say, "We pump the peanut butter into your jar and the oil into your car, we glue the soles of your shoes, the glass in your windows, pump the ink onto your bills, spray the finish on your vehicle, coatings on your pills, the paint on your house, texture on your walls." Really, anything that needs to get painted, coated, sprayed, Graco is right there to help these companies do that. Most of their business comes from industrial business, but they also sell to contractors, things like that. Their largest customer is Sherwin-Williams, I believe over 10% of their revenue. They're really all over the place.

They've really driven significant returns. Over the past 25 years, the cumulative total shareholder return for Graco has been 6,245% vs. the S&P [500]'s 433%. That's obviously an incredible return over the past 25 years. John, do you want to talk about, from a financial perspective, how Graco has driven those returns over the past couple of decades?

Rotonti: Sure. Like I said, this is a world-class business. It's a super-high-quality, growing business. One of the most amazing things about this company is that it's 93 years old, and it's still growing at the rates that it is and crushing the market like the numbers that you just provided. Over 6,000% total shareholder return compared to the S&P, which over the time frame did 433%; the Dow Jones, which did nearly 600%. That's nowhere close to the 6,000% returns Graco has provided shareholders.

Like you said, Graco is an industrial business, but it touches consumers in so many ways. It sells these mission-critical products that companies across all verticals need to use. If a company is using liquids, adhesives, or foam in any way, there's very likely a Graco product there, because Graco has either the leading market share or top-three market share in every niche that it serves.

You mentioned Sherwin-Williams. I'll talk about a few of the products and then its financial profile. Maybe its most popular product, or the product that consumers may be most familiar with, are its spray painters, these spray guns that are used to paint homes inside and out instead of using a brush or roller. Obviously much more efficient, saves on waste, gets the job done quicker. These contractor products, these spray-paint guns, can be bought through retailers like Home Depot and Lowe's.

Most of its products, however, are larger and pricier industrial products that are worked into a company's industrial process or its assembly line. Once that product is in that assembly line, it's really not going anywhere, for two main reasons. One is that Graco's brand is known for quality, customer service, reliability, and quick delivery of parts when necessary. Two, downtime for a factory is really not good, because then the whole assembly line shuts down and that factory can't leverage its fixed costs. So downtime is really lost money. Once a Graco product is in that industrial process, it stays there. Very high switching costs, high barriers to entry.

What Graco does is, it sells these products, and over time -- a lot of these liquids that are in these products are abrasive or corrosive in some way. Over time, any part of that product, any part of that hardware, that touches the abrasive materials ends up wearing down and needs to be replaced. About 40% of Graco's total revenue comes from these aftermarket replacement parts, 40% of its revenue enterprisewide is recurring, which gives a degree of predictability to the business. These parts that need to be replaced -- we talked about these spray painters. The tip of that spray gun where the paint comes out will eventually get gummed up, just because paint eventually clogs it up. But these spray guns give precise ratio control, precise amount of paint and pattern. So when that happens, that tip needs to be replaced. Other parts that need to be replaced are the pumps, the filters that filter these liquids, the O rings and other seals that keep liquids out from other parts of the product. So there's a nice recurring component to the business model, 40% of revenue is recurring.

Another thing that I really like is that Graco has pricing power. It has historically been able to increase prices between 1.5% and 2% every single year. Right there, you have 2% growth coming just from pricing.

Sciple: It's really powerful, this ongoing relationship they can maintain with their customers, these big industrial companies. It's not that you just sell this machine and the transaction is over. It's a key cog in their production facilities; you can't have it go down. You're constantly servicing these machines and maintaining those relationships. The other number that I thought was significant is, over half of their revenue comes from products that sell zero or one unit per day. The volume is not super-high, so that doesn't incentivize other competition to come in. Then, you're really driving a lot of revenue not from this initial sale, but from these resales of parts, which is really powerful.

You mentioned, they're in this niche, they have this large scale, they have these really important relationships with their customers. All that builds together to create their moat, like what you were talking about with pricing power. Do you want to talk some about their operating leverage? They've really been able to drive a lot of value by finding their niche and really building a moat around it.

Rotonti: Exactly right, Nick. Graco's niche strategy really is key to its success. How many companies can you name -- I can't name one -- that want to compete with Graco when they're competing to sell one or zero products per day? Fifty percent of Graco's revenue, like you mentioned, comes from products that it shifts either zero or one of per day.

First of all, very few companies want to go after one or zero per day. Second of all, those new entrants just don't have the scale to compete with Graco. Graco has built, over decades, manufacturing prowess and manufacturing efficiencies, and really manufacturing expertise that allows them to be highly efficient and generate very high returns on capital at very low volumes for their industrial business. To counter that -- there's a nice balancing act here -- Graco's contractor business, that has higher inventory turns. They sell more product there. So there's a nice balance. But like you said, 50% of their revenues are coming from extremely niche products. There's not a lot of competition.

Graco does have competitors, but over time, it has built a massive moat based on its brand known for quality, reliability, timely delivery, and A+ customer service. They've actually trademarked that, "A+ Customer Service," because it's so integral to their strategy and their success. Like I said, they have global scale from a distribution and cost standpoint. They've got these manufacturing efficiencies that are vertically integrated.

They're also a very metric-driven organization. Two of those metrics, one I've mentioned a lot is return on invested capital. Another one is a metric that they came up with called "cost to produce." Basically, they have every single factory that they own -- like I said, they're vertically integrated -- they ask that factory to see if they can produce the same exact basket of goods as they did in the prior year with zero cost increased. That's called cost to produce.

And then when you look at it, they have an installed base that's almost 100 years old. You look at the recurring revenue that they're selling in, and you look in their pricing power, it all just comes together to create this fantastic moat.

Sciple: Right. Warren Buffett has this quote where he says hey, "If you gave me $100 million and said, 'Disrupt Coca-Cola,' I couldn't go do it." This feels like one of those companies. You have hundred-year-long relationships. There's not a huge market to take away, and for somebody to do that would require so much capital expenditure up front to disrupt them, it just wouldn't make rational sense. And then, I saw a stat that they're spending far above what their peer group does in R&D [research and development], so when it comes to staying a step ahead of the competition from a technological point of view, they're making the right allocations of capital to do that. They really seem to be in a strong position.

The other thing I want to call out, too, is: Their management has been there for a really long time. I mean, the CEO has been there since 1989. The CFO [chief financial officer] has been there since '95. The VP [vice president] of operations has been there since '93. Everybody in a leadership position has been there pushing three decades, really committed to this business. When you look at that, a management that is that ingrained in the company over a long period of time, what does that tell you as an investor? Is that an exciting thing to see?

Rotonti: It's very exciting for me. Like you said, this is an extremely tenured, extremely experienced management team. The CEO has been there for 30 years, he's been the CEO for 12 years. We can talk a little bit more about his fantastic track record. Not only is this management team ingrained in Graco, but Graco's culture, this metric-driven culture, is ingrained in this management team.

Three of those metrics that are quintessential to Graco: We talked about this cost-to-produce metric, that gives them their manufacturing efficiencies. We've talked about ROIC, return on invested capital; they benchmark every single investing decision on ROIC, whether it's a headcount addition, R&D, capital expenditures, or an acquisition. And that's the main reason why Graco does make some acquisitions on a fairly regular basis to supplement their organic growth; but unlike most companies that make acquisitions, Graco's returns on invested capital are not being diluted. They're not paying too much. In fact, over the last three years, Graco's returns have actually increased. And then that third metric that is key to this culture, you mentioned, is research and development, or what they call new product development spend. They spend more than their competition.

A couple of other interesting facts, their sales growth is always pretty much faster than their growth in research and development spending. It's paying off. Over a cycle, I think about 2% of their sales growth comes from new product development. Perhaps most impressively, to demonstrate their commitment and this culture to research and development, to investing in long-term growth -- in 2009, in the depths of the Great Recession, the global financial crisis, their sales fell 29%. They actually increased research and development spending in 2009. They're just completely committed to investing in long-term growth and investing in products that their customers need.

Sciple: I was just going to say, to combine that with what we've described structurally as their moat being in the business that they operate in, to also have that commitment from a capital allocation point of view, advancing R&D, it really just augments the power of their moat even more that their management is navigating the ship in that type of way. It's really exciting to see.

Rotonti: It's an amazing management team. Pat McHale, he's 57 years old, he's been with the company for 30 years. He's been CEO for 12 years. He became CEO in 2007, June of 2007, I believe, before the global financial crisis. When he took over as CEO, the company had a moat. It was already a great company. But it wasn't growing as fast as it could have. McHale came in and he accelerated growth by doing several things: increasing investments in new product development, so this culture around R&D; personally overseeing improving product quality; personally overseeing this culture around customer service. They actually put an "email the CEO" link on their website, which is still up. To this day, Pat McHale fields every single one of those emails himself without a go-between. They trademarked this "A+ Customer Service" mantra that they have. And then he also increased acquisitions to expand into new products, new niches, and new geographies. He's been fantastic!

I mentioned that the company's sales fell 29% in 2009. Let me put a little perspective around that. 2009 was the depths of the worst financial crisis since the Great Depression. Graco's sales, going back to 1998, have only fallen in three other years. They fell in 1991, when there was a recession; they only fell 3%. They fell in 2001, when the dot-com bubble burst, so a big recession, and they only fell (I think) 5%. In 2008, the start of the global financial crisis, Graco's sales only fell 3%. So, going back to 1998, which is just as far back as I've looked, their sales have only fallen in four years. In 2009, when their sales fell 29%, they still generated positive net income -- GAAP [generally accepted accounting principles] earnings, basically. They still generated positive operating cash flow and positive free cash flow. In that year, they paid off $100 million worth of debt, and they increased their dividend. That just speaks to the financial resiliency and strength of this business. Sales were down in 2009; they rebounded in 2010. I think they grew over 20%. In 2011, I think they grew over 10%. So they rebounded extremely nicely coming out of the Great Recession. Basically, they were able to, like we said, maintain investment in new product development when a lot of competitors couldn't. Coming out of the down cycle, they took market share, and their sales exploded.

This is a company with extremely good financials. If you look over the past five years -- 2014 through year-end 2018 -- their five-year average free cash flow margin is 17%. Their five-year average return on assets is 15%. Their five-year average return on invested capital is 21%. And their five-year average return on equity is 37%. Even more impressive is that those numbers are increasing. Their 2018 numbers were higher in each of those categories -- free cash flow margin, return on assets, return on capital, and return on equity -- their 2018 numbers were higher than their five-year averages.

This company also has an extremely strong balance sheet. It has modest net debt of $150 million. That's down from net debt of $350 million in 2015. They generate over $300 million a year in free cash flow, so they could pay off their net debt in half a year if they wanted to. Their interest coverage ratio is 30. That's the highest since 2011, I believe. Really a company that is firing on all cylinders right now, Nick.

Sciple: Right. As you said, they've been able to withstand downturns in the economy. For these industrial companies, that's something that's concerning. Particularly now, we have tariffs, we're starting to see the auto and housing markets maybe start to turn over. But management has really been strong, saying, "We still expect our increases in prices will be more able to offset any headwinds we see from those sorts of issues." They have a strong dividend that they've increased over 19 straight years, and they're buying back stock.

When you look at the opportunities for this company going forward, is it full speed ahead? Where are the opportunities for this company to continue to grow?

Rotonti: I think so, Nick. I'll get to the growth opportunities, but you mentioned industrial recession. I'd like to separate broader economic recessions, broader economic downturns, that hit all industries, from an industrial-specific recession. In those four years that I mentioned that Graco's sales fell -- 1991, 2001, 2008 and 2009 -- those were broad recessions. Those were broad economic downturns, hitting all industries. But when there have been sector-specific manufacturing recessions that hit a lot of industrial companies, Graco grew right through them.

As an example, most recently, there was a significant industrial recession in 2015 and 2016 brought on by an oil shock. Oil prices fell almost out of nowhere. We had an oil and natural gas shock. Also, Brazil was going through the worst recession they had experienced in 100 years. China's industrial output was slowing. And then industrial companies were experiencing very strong FX, or foreign exchange, headwinds. Those three or four factors really took a toll on the industrial-specific companies. I cover a lot of them. What happened was, their sales fell and earnings fell faster because of negative operating leverage. Graco grew right through that. In 2015, its sales were up 3% or 4%. In 2016, sales were up 4% or 5%. So its growth slowed, but it still grew right through it. It has a great track record there.

Going forward, I think we can actually model out its revenue on this podcast. Let's assume that global GDP grows at 3%; that's 3% right there. Let's assume Graco takes 1% market share over time; that's 4% long-term revenue growth. Let's add in 2% from pricing; that's 6% organic revenue growth right there. And then, I think, about a point will come from acquisitions over time. So I think over the long term, let's say the next five to seven years, Graco can grow its revenue at around 7% CAGR [compound annual growth rate], with 6% of that being organic.

Then, one metric we didn't talk about was its operating leverage. This company, because it has a fixed-cost business model -- it owns its manufacturing and its plants, it's vertically integrated -- the more organic sales volume it can drive through those factories, the more it can leverage its fixed costs. Over time, Graco has very strong operating leverage. It generates incremental operating margins of about 35% to 40%. That just means that earnings grow a little faster than revenue. If I think revenue can grow about 7%, there will be some margin improvement, which can bring, let's say, net income growth to 8% or 9%. And then, when you add in, historically, the company buys back or reduces its share count by about 2% annually, you can get earnings per share and free cash flow per share of at least 10% over the long term.

Management is actually shooting for 12% long-term earnings-per-share growth. I'm being really conservative with my minimum of 10% number. But it's in that ballpark. I think this company can grow revenue at a high-single-digit CAGR, compounded annual growth rate. And I think it can grow earnings per share and free cash flow per share -- which is ultimately what we're after -- by at least 10% and very likely 12% over the long term.

Sciple: Yeah, John. I think today, just looking at the moat that Graco has, what its management's been able to do, its history of riding through recessions, you painted a really powerful picture of where this business lies and its opportunities to continue moving forward.

What, though, would have to occur for this thesis not to play out the way we've described today? What outside facts would have to come into play to disrupt Graco's growth story and the trajectory it's on today?

Rotonti: There's a couple, probably. I just gave you my rough estimates over the next five to seven years. If, during that time frame, we do have a broad economic downturn, in which sales fall 3% or 4% or 5% in one year, that could maybe lower my numbers a little bit over that five- to seven-year time frame. So, a broad economic downturn.

To counter that, though, like I said, Graco has the free cash flow and the balance sheet to really use a downturn to its advantage. What do I mean by that? I mean that during a downturn, a company like Graco can manage its inventories, manage its working capital, still generate very, very strong free cash flows -- and during a downturn, use those free cash flows to its advantage by either buying back cheap stock or making acquisitions or investing heavily in new product development, and gaining share coming out of the downturn. Whereas a downturn would affect numbers over the next five years somewhat, it could also strengthen -- believe it or not -- Graco's long-term growth profile if it really takes advantage of the downturn and invests at the bottom of the downturn when a lot of other companies can't. So, that's one thing. They do sell into cyclical markets, so a broad economic downturn would hurt the stock, for sure, in the short term.

Another thing, as you said, Sherwin-Williams is a 10% customer. Honestly, overdependence on a single customer or supplier is something I look for in my risk analysis; I'm not really worried about that here, because Graco makes the best products and they have a great long-term relationship with Sherwin-Williams. And, there's not a whole lot of competitors in the spray-paint-gun space. There's Wagner, there's a few others. But, based on the research I've done, Graco makes the highest-quality, most reliable products. So I'm not worried about that Sherwin-Williams relationship. If I'm wrong about that, that could dent their revenue in the short term, if they for some reason lose some of that Sherwin-Williams business. But I think they would be able to replace it. That's something else.

Graco makes acquisitions, but they don't overpay. Like I said, they benchmark every single investing decision that they make on return on invested capital. If you look at their fourth-quarter 2018 earnings call, their most recent earnings call, one of the analysts asked Pat McHale, Graco's CEO, how he would characterize the current M&A environment -- or mergers-and-acquisitions environment. He gave a one-sentence answer. He said, "I think it's expensive." He's not going to overpay. They just don't do that. He did make a mistake, and he outright admitted it in 2015 or 2016. He bought some oil and gas assets at the top of the market, when oil prices were really high. They had to write those down. They don't often make mistakes. That was one. They admitted it and I think they learned from it. But if they get overly aggressive for some reason and bite off more than they can chew and overpay for an acquisition, that could hurt their returns. Once again, I don't see that happening.

And then, McHale is a great CEO. He's been with the company for 30 years. At some point, he's going to want to retire. I hope it's not anytime soon. But at some point, he will. I'm not too concerned just because, like you said, it's an extremely tenured management team. That management team lives and breathes the Graco way of doing things. What I mean by that is, they're metric-driven, they have a playbook, they manage and measure everything they do by metrics. I just don't see the next CEO veering outside of that playbook. I do think the next CEO will be appointed from someone inside the company. I think they're going to stick to the playbook.

There's things on the horizon, in the short term. Maybe an economic downturn. But I'm just not too concerned right now.

Sciple: Yeah, John, I think when you can list the main risks to the company as those standard risks that every company has to list on their 10-K -- every company has to say, "A recession would really hurt us; if our CEO resigned abruptly," or any other sorts of things. Graco's advantages are very, very unique and particular to their business. The risks of this business are the same risks that you face with every company. I think the moat they have, the culture they have through their management, their ability to raise prices over time, is really powerful. And definitely a company that I think our listeners should be adding to their watch lists.

John, thanks so much for coming on the show! Any last things you want to say to our listeners before we hit the road?

Rotonti: Nick, just thanks for having me! I would love to come back soon!

Sciple: Yeah, thanks so much! Enjoyed having you on so much and look forward to having you on again soon!

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass! For John Rotonti, I'm Nick Sciple. Thanks for listening and Fool on!

John Rotonti owns shares of HD. Nick Sciple has no position in any of the stocks mentioned. The Motley Fool recommends HD, LOW, and SHW. The Motley Fool has a disclosure policy.