About half a year ago, I stated that Graco (NYSE:GGG) is probably fairly valued, and I calculated an intrinsic value close to $70 in October 2021. In the following article, I will provide an update on Graco, and I will calculate an intrinsic value once again – but the result is pretty much the same as last time.
Nevertheless, we will look at the last annual results and talk about the wide economic moat again and how it will ensure growth in the years to come. And as there are first warning signs, that another recession might be upon us (not right now, but maybe in 2023), we also must think about Graco in a potential recession scenario.
Annual Results Fiscal 2021
After a rather stagnating business in fiscal 2020, Graco reported strong growth rates again in fiscal 2021. Net sales increased from $1,650 million in fiscal 2020 to $1,988 million in fiscal 2021 – 20.5% year-over-year growth. Operating earnings increased even 35.5% year-over-year from $392 million in fiscal 2020 to $531 million in fiscal 2021. And diluted net earnings per common share improved from $1.92 in fiscal 2020 to $2.52 in fiscal 2021 – resulting in 31.3% year-over-year growth.
And not very surprisingly, Graco improved its margins with gross margin increasing from 51.8% in 2020 to 52.0% in 2021 and operating margin increasing from 23.7% in 2020 to 26.7% in 2021.
When looking at the different regions, Americas is still responsible for 58% of total revenue. And when looking at the three different segments, all three contributed to growth with “Contractor” growing only 16.0% YoY, “Process” growing 21.9% YoY and “Industrial” growing 24.0% YoY.
Economic Moat Ensuring Growth
And not only did Graco report high growth rates in fiscal 2021, but we are also looking at a great business. In past articles (see here and here) I already described the wide economic moat in more detail, and I will only recap some headlines and keywords here. First, Graco has a wide economic moat based on switching costs. In my 2020 article I wrote:
The different products that Graco sells, especially in the Industrial segment and Process segment, are often embedded in a company’s assembly line and in the industrial process. That means once the product is embedded with the company it is very difficult to replace it – even if competitors should offer a cheaper product.
And not only can Graco rely on switching costs, but it is also operating in a niche and is among the market leaders in this niche. Second, Graco is focused on research and development (and the last few years, the company was spending 4.1% of sales on R&D – about 2.2 times the peer group spending) and on service excellence. Third, Graco is selling high-value products at low volumes as 43% of the company’s revenue stems from products the company is selling zero to one times per day. Or to put it differently: 62,700 SKUs of 67,500 total SKUs are sold only zero to one times a day and a competitor will have to spend a lot of time and money to create a similar portfolio. But when selling these items only a few hundred times per year it might not be worth the time or the money for a competitor.
When considering all these strengths of Graco, we can be optimistic that the business can continue to grow with a high pace and Graco’s own earnings CAGR target of 12% for the years to come might be realistic.
However, analysts are not so optimistic for the next few years and expect only growth in the high single digits – below Graco’s own targets. And in the past, Graco could not grow every single year, but we saw a solid performance in the past.
In the last 20 years, Graco grew with a CAGR of 11.05%, and in the past 40 years Graco grew even with a CAGR of 11.71%. And for an accurate return, we would have to include the dividend somehow as it is money the business was distributing to shareholders and could not compound over the years. I would not put my hands into the fire for 12% annual growth, but high single digit growth or low double-digit growth (10-11%) should be achievable.
Growing Dividend, Improving Balance Sheet
When looking at positive aspects, we can mention the increased dividend. Right now, Graco is paying a quarterly dividend of $0.21, which is resulting in a dividend yield of 1.27% right now. However, Graco is not so much interesting for its dividend yield, but rather for the dividend growth we can expect in the years to come. In the last five years, the dividend CAGR was 11.56% for Graco and I expect similar growth rates for the years and decades to c
ome. And when calculating with a current dividend of $0.84 and compare it to the trailing twelve months EPS of $2.52 we get a payout ratio of 33% and this makes the dividend well covered and enables the company the increase its dividend.
Aside from the increasing the dividend, the company also improved its balance sheet in the last twelve months. On December 31, 2021, the company had $150 million in total debt on its balance sheet, but Graco will repay $75 million within the next 12 months. In the last twelve months, total shareholder’s equity increased from $1,284 million in December 2020 to $1,709 million in December 2021. And while Graco is decreasing its debt, it increased its cash and cash equivalents from $379 million one year ago to $624 million on December 31, 2021. The only negative aspect on the balance sheet is $356 million in goodwill. But we should neither worry about solvency nor liquidity as Graco has a great balance sheet.
Slowdown During Recession
Graco is without much doubt a great business, but when looking at the last recession, the stock and earnings per share declined extremely steep. And considering, that another recession might be upon us in 2023 or 2024, we should be cautious about Graco in the next few years and the stock (as well as the business) could once again be hit rather hard. The stock has dropped already 18% right now and compared to the last few years this is a rather steep decline. However, during the Great Financial Crisis, the stock declined about 70%.
And the stock dropped not only because the P/E ratio contracted during these quarters (and was as low as 7.3 in 2009), but also because earnings per share declined from $0.81 to only $0.273 (trailing twelve months numbers in both cases).
If we assume, that earnings per share will decline about 75% again (similar to the last recession) and when we also assume, that the P/E ratio will decline to 10 (or even single digit numbers), it would result in earnings per share of $0.63 and a stock price of $6.30 (when assuming a P/E ratio of 10). This would result in a decline of 90% for the stock. And of course, the 2009 share price for Graco was not a fair intrinsic value and if you would have invested in Graco at the bottom, the stock would have returned 25% annually for the next 12 years (not including dividends) – without doubt a great investment.
And while the stock price in 2009 was not a reflection of the fair intrinsic value of Graco, a stock price between $6 and $7 (in my hypothetical scenario) would also not be a fair value for Graco for two different reasons:
- Even if earnings per share would decline steep, they will also improve again pretty quickly (as they did in the years following 2009) and we have to look at the free cash flow a business can generate in the future and not just in one single year.
- And as we must look at the free cash flow a business can generate in the years to come, a P/E ratio of 10 would be too low for Graco considering the growth rates we will most likely see in the years to come.
And although such a low stock price for Graco would not be justified, it could happen. Of course, we also must consider why Graco might have dropped so steep during the Great Financial Crisis. Graco is generating a huge part of its sales from “Construction” (48% of total sales in fiscal 2021). And when considering that the Great Financial Crisis was triggered by the collapse of the housing market, it is not surprising that a business like Graco will struggle in such a scenario.
And although the housing market is probably not the same as in 2005 and 2006, there are clear warning signs again that the housing market is running hot and we might see another steep collapse, which will affect Graco once again.
Intrinsic Value Calculation
Right now, Graco is trading for 26 times earnings and for 36 times free cash flow and the stock seems to be more expensive right now than before the Great Financial Crisis. And especially the P/FCF right now is clearly above the average P/FCF ratio of the last 10 years (which was 26.49) and close to the highest ratio we saw in the last 10 years (43.52).
But instead of looking at simple valuation metrics, we should rather use a discount cash flow calculation as it will reflect the different amounts of free cash flow a business can generate in each year.
As basis of our calculation, we can take the free cash flow of the last four quarters, which was $323 million. And although Graco is a bit more optimistic with its long-term targets, I would assume 10% growth for the next 10 years in my base scenario followed by 6% growth till perpetuity. When taking a 10% discount rate and 174.9 million outstanding shares, we get an intrinsic value of $61.24 for Graco.
We can also be more optimistic and assume 12% growth for the next decade – in line with Graco’s long-term targets. With all other assumptions the same, this would lead to an intrinsic value of $70.51 for Graco.
And we must point out, that capital expenditures in fiscal 2021 were rather high, which led to a lower free cash flow. In the last 10 years, Graco spent on average 18.75% of its operating cash flow as capital expenditures. In fiscal 2021 however, Graco spent 29.3% of its operating cash flow as capital expenditures. And as we can assume, capital expenditures will be lower again in the years to come, the free cash flow might be higher. On the other hand, in case of a recession, free cash flow will be much lower for one year or two and when assuming a rather low free cash flow for fiscal 2023 and maybe fiscal 2024, the intrinsic value should be about $5 lower.
In my opinion, Graco is still fairly valued at this point and when buying the stock right now, we can expect about 10% annual return. When buying the stock right now, we are probably not purchasing a bargain. On the other hand, I see the risk of missing out on a great business. Nevertheless, I will still wait for cheaper prices before I purchase shares of Graco – especially as lower stock prices are likely in case of a recession.
But Graco has one of the top spots on my watchlist and is definitely a company I want to own for the long term as we are talking about a great business with a wide economic moat, that is operating in a niche (and often overlooked).