Graco Maintains 2024 Outlook Despite Slow First Quarter

Equity Analyst

Krzysztof Smalec

Graco is a wide-moat industrial firm that has consistently delivered returns on invested capital above 20%. The company differentiates itself by manufacturing specialized products that handle difficult-to-move liquids, often used for niche applications where competition is limited. The firm offers a wide array of products, including pumps used to move peanut butter or caramel, automotive paint spray systems, and injection pumps for the oil and gas industry.

Graco generates half of its sales from nearly 63,000 products of which it sells no more than one per day on average. Graco’s relentless cost control and commitment to lean manufacturing allow it to leverage shared components across different product lines to operate its plants efficiently and lower the overall cost of its products. The high-mix, low-volume nature of the business and the relatively small size of many niche end markets act as a barrier to entry, as rivals would struggle to establish the scale needed to challenge Graco’s competitive position.

While Graco is a high-quality business protected by a wide economic moat, the main challenge we see is generating growth, as the firm mostly competes in mature end markets growing at low-single-digit rates. Historically, Graco’s organic growth rate has outpaced GDP growth thanks to its commitment to research and development, which has allowed the company to generate additional sales by developing new products, penetrating adjacent markets, and capturing market share from competitors. We think that Graco can continue to increase sales 100-200 basis points faster than GDP growth thanks to its strategic initiatives, and we project mid-single-digit average organic sales growth over the next five years.

To achieve its long-term 9%-10% annual revenue growth target, management will have to rely on mergers and acquisitions. So far, Graco has largely avoided overpaying for M&A and managed to use a steady stream of tuck-in acquisitions to boost growth without diluting ROICs, which gives us comfort that management will remain prudent. But the strategy carries execution risk if the firm struggles to find targets at attractive prices.

Business Strategy & Outlook

We award Graco a wide economic moat rating primarily due to customer switching costs and secondarily due to intangible assets. Graco is a leading manufacturer of equipment used for managing fluids, and its portfolio includes a wide array of niche products with little direct competition. The firm specializes in moving materials that are abrasive, viscous, or corrosive, which inherently create more wear and tear on pumps and other equipment. Graco’s engineering capabilities, reputation for quality, and experience with handling difficult-to-move liquids are key differentiators that have allowed it to establish a strong competitive position across all the markets it competes in.

Graco has a large installed base of equipment that is protected by customer switching costs. Many of its products perform mission-critical functions and are integrated as part of a customer’s production process. As such, a strong record of reliability is crucial to win business, considering the risk of product failures leading to unplanned outages or wasted material. Furthermore, since Graco’s equipment often accounts for a relatively small portion of a customer’s total production costs (for instance, a paint system at an auto assembly plant), the potential cost of unscheduled downtime could far outweigh any cost savings from switching to a cheaper but less proven alternative.

Graco also benefits from a relatively high level of recurring revenue. The company generates roughly 40% of its sales from aftermarket parts and accessories tied to its installed base. Abrasive fluids create constant wear and tear on equipment, creating a steady demand for replacement parts (for example, spray gun tips). This creates a steady stream of recurring revenue that generates relatively high margins and helps smooth out demand in cyclical end markets. Graco holds high levels of inventory to ensure that replacement parts are readily available and offers same-day shipping on most products, which helps retain customers.

Graco’s wide moat is also protected by intangible assets, including its strong brand name, patent portfolio, and reputation for quality, which allow the company to command premium pricing. Moreover, the firm has established itself as a leader in innovation, spending roughly 4.5% of sales on research and development, nearly 3 times as much as its competitors. Not only does Graco’s continuous investment in innovation fend off competitors, it has allowed the company to gain ground on its rivals. For example, while many peers cut R&D spending during the Great Recession, Graco increased it from $30 million in 2007 to roughly $38 million in 2008 and 2009, which allowed the company to capture market share during the recovery. Given its healthy balance sheet and strong cash flows, Graco has ample liquidity to continue funding its R&D even during an economic downturn, and we believe that its commitment to innovation will make it difficult for rivals to undermine Graco’s competitive position.

A unique aspect of Graco’s business is the breadth of its portfolio. The firm derives roughly half of its revenue from nearly 60,000 different stock-keeping units it sells on average no more than once a day. The high-mix low-volume nature of the business makes the company’s moat difficult to assail, as it would be challenging for a new entrant to replicate Graco’s long-standing customer relationships, distributor network, and wide array of products to establish sufficient scale to compete effectively.

Graco’s wide moat has allowed it to generate lucrative returns on invested capital, which have averaged around 25%, or nearly 3 times its cost of capital, over the last decade. The company operates in niche industries with high barriers to entry, and we believe that its reputation for quality, manufacturing excellence, and continuous innovation will make it challenging for rivals to breach its moat. As such, we believe that Graco’s wide moat will help the firm continue outearning its cost of capital for many years to come.

Wide

Economic Moat

Graco

Graco, Inc. is a manufacturing company, which designs, manufactures and markets systems and equipment used to move, measure, control, dispense and spray fluid and powder materials. It operates through the following segments: Industrial, Contractor and Process. The Industrial segment includes the Applied Fluid Technologies and Industrial Products divisions. It markets equipment and pre-engineered packages for moving and applying paints, coatings, sealants, adhesives, and other fluids. The Process segment markets pumps, valves, meters, and accessories to move and dispense chemicals, oil and natural gas, water, wastewater, petroleum, food, lubricants, and other fluids. The Contractor segment equipment includes sprayers that apply texture to walls and ceilings, highly viscous coatings to roofs and markings on roads, parking lots, athletic fields and floors. The company was founded by Russell Gray and Leil Gray in April 1926 and is headquartered in Minneapolis, MN.

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Graco, Inc. is a manufacturing company, which engages in the design, manufacture, and sale of systems and equipment used to move, measure, control, dispense, and spray fluid and powder materials. It operates through the following segments: Industrial, Process, and Contractor. The Industrial segment markets equipment and pre-engineered packages for moving and applying paints, coatings, sealants, adhesives, and other fluids. The Process segment includes pumps, valves, meters, and accessories to move and dispense chemicals, oil and natural gas, water, wastewater, petroleum, food, lubricants, and other fluids. The Contractor segment offers sprayers that apply texture to walls and ceilings, and highly viscous coatings to roofs and markings on roads, parking lots, athletic fields, and floors. The company was founded by Russell Gray and Leil Gray in April 1926 and is headquartered in Minneapolis, MN.

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