Minnesota-based Graco Inc. (NYSE:GGG) designs, manufactures and markets systems and equipment to move, measure, control, dispense and spray fluid and powder materials. The lesser-known name is a recognized leader in its niche specialties that help customers worldwide in both industrial and commercial applications, including solving manufacturing problems, increasing productivity, improving quality and saving on costs.
The company possesses a vast network of outlets, with over 30,000 distributors in more than 100 countries, which is hard for competitors to replicate. As of the first three quarters of fiscal 2019, 59% of the sales come from the Americas, 24% from Europe, the Middle East and Africa and 17% from the Asia Pacific.
Graco's business is mostly exposed to cyclical end-markets such as construction, industrial, machinery and automotive. Management acknowledges the recession risk and is fully committed to shareholder value in the long run. See below some of their responses to our inquiries earlier this year:
"We have the same business model that was in place during the last recession, and I see no reason why things would be materially better or worse if we went through a similar period today. We manage the business for the long term, so there would not be any big changes in our resource commitments. Decremental margins in our business are pretty ugly when revenues decline." - Mark W. Sheahan, chief financial officer and treasurer
"Graco's model is centered on going through distribution. As a result, its structure allows our channel partners to invest in salespeople, training, and services as the business grows. If we were to hit a recession, our distributors/channel partners would have to adjust first. Graco, would see some adjustments in its variable costs but not on the fixed cost side. As a result, decremental margins would be significant. But that is okay with us. We are in a great position, given our GM to continue to invest as we move through the cycle. So, nothing significant would change in our operations or our strategies. Back in 08/09, we made some adjustments in our workforce (we had to layoff about 200 factory employees, needed to ensure or factories were still focused on productivity), and we double our investment in R&D. By the way, by the end of 2009, we rehired all but 2 of the 200 employees we had been released." - David K. Newman, Business Development and Investor Relations director
A bad time for the overall industry could be a good time for the industry's leading player from a long-term perspective. In a recession, Graco can continue to invest in widening the gap between it and its competitors. For example, during the last two recessions, the company increased its research and development spending even though it was recording declines in operating income.
During the darkest days of the Great Recession, Graco was still able to generate an 11% annual return on invested capital at minimum to support its long-term strategy. By contrast, its closest competitor, Nordson Corp. (NASDAQ:NDSN), could not break even.
In addition to the scale of distribution, Graco uses its niche market strategy to build a wide and deep moat. The company's solutions mainly deal with the difficulty of managing corrosive, viscous and hard-to-move materials. Customers are quality-conscious in this space, willing to invest in premium products built to last for years of reliable service.
Graco dominates these niche categories through its reputation it has earned over the decades and because of the high switching costs of the installed base. Furthermore, as approximately 50% of Graco's sales (or 93% of all stock keeping units) come from products sold either once or none per day, it does not make economic sense for big players to enter the market to compete.
The sustainable competitive edge also enables Graco to generate predictable recurring cash flow. Roughly 40% of total revenue comes from the aftermarket, as demanding customers keep coming back to the company for parts and accessories for the solutions they purchased in the first place.
Going forward, we see plenty of growth opportunities, mainly supported by product innovation and regional expansion at Graco. We think both initiatives could widen the moat in the meantime. The company typically invests more than 2.5 times its broader market peers like Dover (NYSE:DOV) and Illinois Tool Works (NYSE:ITW) into product development. For example, between 2014 and 2018, on average, Graco spent 4.3% of its total revenue on research and development, compared to only 1.6% among its peer group.
Disclosure: The mention of any stock in this article does not constitute an investment recommendation; investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We do not own any stocks mentioned in the article.
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