No. of Recommendations: 38
Hi all,

Since there are several interested in GGG, I thought this old (wrote at least several months ago so data is not up to date) post I did for the IV boards might be of some interest. FWIW, the IV estimates are probably a low.

Graco designs, manufacturers and markets an assortment of fluid handling products including air-diaphragm pumps, sprayers, nozzles and related equipment for commercial and industrial applications. Some have called this a boring business. Maybe, but the returns to shareholders have been wide-eyed huge. A $10,000 investment in Graco shares 10 years ago would be worth over $138,000 today, a 1,288% increase, a compound annual growth rate of about 30% per year!

Sales totaled $730 million over the trailing twelve months (TTM) and Graco sports a $2.6 billion market cap and a $2.7 billion enterprise value.

Sales broken-down by world regions are shown in the table below and are taken from the latest 10K:
                    2005
Sales
Source: (millions) Percent
Americas $ 486 66%
Europe $ 151 21%
Asia Pacific $ 95 13%
Total $ 732 100%

Graco has a toehold in the Asia Pacific region and since the population there is significantly greater than in the Americas (more than 10x), it isn't too much of stretch to conclude that many years of growth are possible by simply expanding in this region, alone. As it is one of the worlds fast growing regions, it bodes well for Graco's prospects.

It is enlightening to read management's stated goals for Graco (from the 10K):


The Company's long term financial targets include: growing revenue by 10 percent and net earnings by 12 percent per year; achieving returns on sales exceeding 10 percent, on assets of at least 15 percent and on equity of at least 20 percent; generating at least 30 percent of each year's sales from products introduced in the last three years; and generating at least 5 percent of each year's sales from markets entered in the last three years. Initiatives for 2006 include, among other objectives, investment in emerging markets, expansion of global sourcing, and commencement of production at the Company's new manufacturing plant in Suzhou, People's Republic of China ("P.R.C.").


This simple paragraph speaks volumes about the management at Graco. It shows that management is committed to growth, not growth at all costs, but profitable organic growth (some acquisitions, but it doesn't overdo it). Graco has its eye on expanding into world markets, giving particular attention to China at present. Finally, management is devoted to developing new products on a regular basis to drive additional growth in existing markets, as well as in new markets. This paragraph, alone, makes me want to own shares in Graco. However, a company must be able to execute. As we will see in the Appendix at the end of the post, Graco delivers results. Results that far exceed managements stated goals.

I believe Graco is strategically positioned to blossom in the coming decades into one of the very rare companies on which fortunes are made.

APPENDIX

Rate of Returns

In my book, it is very important for a company to earn rates of return higher than the “market” as a whole and better than the industry and sector averages. As the following table shows, Graco beats them all, not to mention its own goals, by a wide margin.
Management Effectiveness (%)       Company  Industry  Sector  S&P 500
Return On Assets (TTM) 30.11 9.17 7.52 8.07
Return On Assets - 5 Yr. Avg. 26.28 7.02 5.6 6.32

Return On Investment (TTM) 41.82 12.16 10.71 11.91
Return On Investment - 5 Yr. Avg. 37.97 9.09 7.96 9.86

Return On Equity (TTM) 48.64 21.86 20.33 19.68
Return On Equity - 5 Yr. Avg. 45.3 18.82 17.22 17.75

Notice too, that Graco's TTM numbers exceed the 5 year averages – so, things are great and getting better.

ROE Components

The component parts making up ROE are shown below. Remember that

ROE = Net Margin * Asset Turnover * Leverage
ROE Components                      Company     Industry    Sector    S&P 500
Net Profit Margin (TTM) 17.83 7.39 7.76 13.98
Net Profit Margin - 5 Yr. Avg. 16.14 5.78 5.31 11.44
Asset Turnover (TTM) 1.69 1.32 1.04 0.98
Leverage Ratio (Avg.) 1.72 N/A N/A N/A

Graco enjoys a superior net profit margin compared to the industry, sector and the S&P and well above its stated goal of 10-percent. The turnover ratio is relatively high, for a manufacturer, indicating that it deploys its assets efficiently and minimizes waste. Leverage is not excessive and quite attractive after realizing that Graco has minimal debt and no long-term debt (see table below).

Debt

Graco is able to achieve its superior returns on equity without the aid of debt.
Financial Strength          Company  Industry  Sector  S&P 500
Quick Ratio (MRQ) 1.4 1.29 1.03 1.27
Current Ratio (MRQ) 2.13 2.19 1.71 1.78
LT Debt to Equity (MRQ) 0 0.47 0.69 0.59
Total Debt to Equity (MRQ) 0.01 0.56 0.89 0.74
Interest Coverage (TTM) 176.34 14.23 12.02 13.22

And, interest coverage is comfortably in triple digits – just where I like them.

Working Capital Management
 Efficiency            1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Days Sales Outstanding 73 74.8 70.2 65.9 61.1 66.1 67.1 65.6 62.7 57.9
Days Inventory 77.6 74 66.9 61.9 53 48.6 46.7 42.9 45.7 50.1
Payables Period 25.8 22.8 21 22 19.8 18.1 18.3 20.8 22.7 22.4
Cash Conversion Cycle 125 126 116 106 94.4 96.7 95.6 87.7 85.7 85.5
Receivables Turnover 5 4.9 5.2 5.5 6 5.5 5.4 5.6 5.8 6.3
Inventory Turnover 4.7 4.9 5.5 5.9 6.9 7.5 7.8 8.5 8 7.3
Fixed Asset Turnover 4.6 4.3 4.4 4.8 5.8 5.2 5 5.7 6.4 7.3
Asset Turnover 1.7 1.6 1.7 1.9 2.1 1.8 1.5 1.4 1.6 1.8

Notice the steadily decreasing DSO and CCC over the last 10 years.


Growth

Historically, Graco's growth rates have not disappointed and have been improving in recent years. The dividend (1.5% yield) has been growing faster than both sales and EPS suggesting that Graco hasn't outgrown its shareholder's.
            1 Year  3 Years  5 Years
Sales % 20.94 14.53 8.16
EPS % 16.48 19.88 12.32
Dividend % 31.71 39.25 26.17

Looking forward, analysts projected growth rates for the next 5 years is:
                    # of   Mean  High  Low   Std.
Ests. Est. Est. Est. Dev.
LT Growth Rate (%) 3.0 14.7 18.0 11.0 2.9

One final aspect of growth, necessary for the valuation, is my estimate of growth from fundamentals. To be conservative I adjusted the ROE to account for share buybacks (add back the value of share repurchases over the last ten years back to shareholder equity, then recalculate the ROE). When I do this I get a ROE of about 23.5%. Armed with an EPS of $1.93 and a dividend of $0.58 I calculate a payout ratio of 30% and a reinvestment rate of 70%.

Therefore,

Growth = Reinvestment Rate * ROE

Growth = 0.70 * 23.5 = 16.45 %

This exceeds analysts mean estimate of growth (14.7), so I will base my valuation on 12% growth going forward. This is the rate the company states is its goal and is conservative when compared with historical growth and analysts estimates.


Other

Graco has been listed (No. 85) in Business Ethics magazine's top 100 Best Corporate Citizens http://biz.yahoo.com/bizj/060502/1282731.html?.v=1

and is not likely to fall under the dark cloud raised by options abuse. The share count has hovered between 68 and 71 million shares since 1999 and has declined over the past three years.

Valuation

When I started writing this Graco was trading north of $45, but today the stock is offered up at under $38. Someone said it best; recently, this is no market to be a hero. So, I plan to let the sellers get finished and then swoop in and claim my prize (the best laid plans . . . . .).

Given Mr. Market's tendency to overreact, I want a nice conservative valuation in my back pocket to help me judge when to start adding shares, slowly. I've approached the matter from several different angles, some of which I've not seen posted before, so would appreciate any comments you might have on them.

Looking at the customary valuation ratios:
                                        Stock  Industry  S&P 500  Stock's 5Yr Average*
Price/Earnings 19.9 21.7 20 20.6
Price/Book 8.4 3 3.9 8.8
Price/Sales 3.5 1.5 2.7 3.4
Price/Cash Flow 16.4 14 13.9 18.4
Dividend Yield % 1.5 1.5 1.9 ---
* Price/Cash Flow uses 3-year average.

Well, it's obvious this isn't Ben Graham's idea of a value play, to say the least. But, I think it's safe to say the current price is consistent with the company's 5-year average. Graco trades at a premium to the Industry and S&P and its rate of returns and historic growth suggest that it probably should.

A historical comparison of P/E with the S&P:
P/E            1997   1998   1999   2000   2001   2002   2003   2004   2005
Stock's 14.6 14.7 12.6 12.2 18.9 18.3 21.7 24.1 20.3
S&P 500 23.8 26.9 32.9 36.6 23.8 20.1 21.1 19 17.3
Relative P/E 0.61 0.55 0.38 0.33 0.79 0.91 1.03 1.27 1.17

Considering relative P/E, a rock bottom price for Graco might be for it to trade at a P/E of about 1/3 that of the market, or 1/3 * 20 = 7 say. With ttm EPS of $1.93, that puts a minimum value of about $13.50.

More realistically, a reasonable range of relative P/E might span between 0.75 and 1.0 times the S&P P/E. Then, one might expect the shares to trade between $29 and $39.

So, perhaps, an attractive buy in price, based on relative P/E, would fall within the bottom 1/3rd of this range, say below $32.50.

Until joining IV, my preferred method of valuing a stock was to treat it like a bond and calculate the internal rate of return considering earnings growth, dividends paid, and assuming a P/E at the time of sale. So, if I assume an earnings growth rate of 12%, a dividend of $0.58, EPS of $1.93, and a P/E of 18 at the time the shares are sold (in 5-years):
Year         Start                 1         2           3            4            5
EPS $ 1.93 $ 2.16 $ 2.42 $ 2.71 $ 3.04 $ 3.40
DPS $ 0.58 $ 0.65 $ 0.73 $ 0.81 $ 0.91 $ 1.02
Cash Flows: $ 33.00 $ (0.65) $(0.73) $ (0.81) $ (0.91) $ (62.25)
Price Paid $ 33.00
Sale Price $ 61.22 = 18.0 X $ 3.40
IRR 15.1%

This calculation says one could expect a 15% compound annual return on investment if the price paid was $33 per share. (Incidentally, $37.50 corresponds to a 12% internal rate of return).

As my final method, I'll use a Dividend Discount Model with the following inputs:

I assume a high growth period extending 10 years, with the shares growing at 12% and discounted at the rate of 12% and current EPS of $1.93. To be consistent with fundamentals, I will adjust the payout ratio to about 49% (up from 30%) to account for the lower growth used in the valuation – my justification for this is that Graco recently announced a share buyback and the value of the buyback could be added to the dividend to get a higher return to shareholders then calculated considering just the dividend, alone.

Following the high growth period, I assumed a 5 year transition period to stable growth. The stable growth rate used was 4%. An 18% ROE (corresponding to industry average) was used in the stable growth phase, resulting in a payout ratio from fundamentals of about 78%. I used a discount rate of 10.5% for the stable growth period.

Based on those inputs I calculate an IV of $35.35 broken out as follows:
Estimated Intrinsic Value:       $        35.35  100.0%
Extraordinary Growth Value $ 11.33 32.1%
Stable Dividend Growth Value: $ 15.03 42.5%
No Growth Dividend Value: $ 8.99 25.4%

If I demand a minimum 15% margin of safety then I have a buy below price of $30. So after all that, I'll be looking to add shares below $30. If recent market action is any indication, the stock price should be at $30 some time next week. :)

Thanks for reading.

Rich
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