11. Projected 2 – 3% GDP growth serves as GGG
baseline
0
2000
4000
6000
8000
10000
12000
14000
16000
18000
-
200
400
600
800
1,000
1,200
01 02 03 04 05 06 07 08 09 10 11 12 13 14
Sales($Millions)
GGG Sales to GDP
GGG Sales Real GDP
GDP($Billions)
.92 Correlation
12. 40%
15%
13%
8%
6%
5%
4%
4%
3% 2%
Industry Factors
Residential and Non-
Residential Construction - 40%
Automotive - 15%
Industrial & Machinery - 13%
Other - 8%
Mining, Oil and Gas - 6%
Public Works - 5%
Vehicle Services - 4%
Wood - 4%
White Goods 3%
Chemical - 2%
13. Segment Outlook
59%
31%
10%
Segment as % of Total Sales
Industrial
Contractor
Lubrication
32.3%
22.5%
20.6%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
Industrial Contractor Lubrication
Segment Margins
14. Diverse End Markets in Manufacturing/Construction
Industrials projected to increase with U.S. GDP
Economies of China and Europe may stall growth
Projected to hold margins around 33%
Industrial
42%
32%
26%
Sales % by Region
Americas
EMEA
Asia-
Pacific
0
20
40
60
80
100
120
0
200
400
600
800
1000
1200
04 05 06 07 08 09 10 11 12 13
Ind Segment Sales vs. Ind.
Indices
Total Sales IPI Materials
IPI- Bus EquipSales($Millions)
IndustrialIndices(07=100)
.80 Correlation
16. Lubrication
Majority US Sales
Fluid product-line in industrial machinery
Margins steady at around 22%
-
500,000
1,000,000
1,500,000
2,000,000
2,500,000
3,000,000
0
20
40
60
80
100
120
01 02 03 04 05 06 07 08 09 10 11 12 13 14
Sales($Millions)
Sales to Oil Production
Lubrication Oil Production
Barrels(inthousands)
.60 Correlation
17. Threat of New Entrants.
Insignificant
Bargaining Power of Suppliers.
Low
Competition in the Industry.
Low
Bargaining Power of
Customers. Low
Threat of Substitute Products.
Low
Porter’s 5
Forces
18. Currency
At current rates:
• Sales for 2015 would decreased by 4%
• Earnings 10% from currency exchange.
Euro/GBP/CHF
22%
Asian 8%
8%
CAD
4%
USD
66%
Sales by Currency 2014
CHF
22%
GBP
12%
EUR
66%
Sales in European Currencies 2014
20. Long-Term Cash Deployment
Priorities
> International Footprint
> Product Development
> Production Capacity and Capabilities
> Supplement to Organic Growth
> Leverage Our Strengths
> Dividend Payout Ratio – 30%
> Three Million Shares Remaining on Authorization
Organic
Growth
Acquisitions
Shareholder
Return
21. Graco Reported Q4 Results
$ in millions except EPS Fourth Quarter
2014 2013 Change
Sales $306.0 $271.9 13%
Gross Profit 164.8 145.2 12%
% of Sales 53.8% 54.10% (0.3) pts
Operating Earnings 69.5 63.3 10%
% of Sales 22.70% 23.30% (0.6) pts
Net Earnings 49 44.7 10%
% of Sales 16% 16.50% (0.5) pts
Diluted Earnings
Per Share 0.8 0.71 13%
Diluted Shares in Millions 61 62.9
Includes dividends (post-tax) from Liquid Finishing Business held separate:
Divdiends $4.00 $4.00
EPS Impact $0.07 $0.06
27. EPS/PE
GGG Premium over IME - 5 Year Analysis
5 Year Numbers NTM - PE NTM - PE
GGG 5-Year Average 19.06 Current IME 17.4
IME 5-Year Average 15.90 Estimated 16.5
Correlation 0.90 Est. GGG 19.94
% Spread Average 20.8%
Recent Month Spread 19.1%
Current PE Premium is 19.1%, which we conclude shows that Graco is undervalued compared
to the industry.
I would like to start by thanking everyone for being here today, we are the Bethel University CFA team. My name is Seth, and my colleagues here with me are Grady, Harrison, Donovan, and Roman. W e are going to be informing you why we see Graco’s Incorporated as a investment that still has room to grow.
Undeniably Graco is the market leader in nearly all of the niche markets within which it operates. That being said, while their market dominance has lead to them being able to charge a premium, from our analysis this is not indicative of significant future growth. To the contrary, we believe that Graco will continue to perform about the same as it has been over the last several years based off an analysis that has data ending on December 31, 2014.
We believe that this is dictated by both market factors, as well as their consistent, but persistently conservative business model over the last several decades. we think that much of the growth that Graco will experience in the next several years will come from overseas expansion due to near market saturation in the domestic US markets, as well as their superior product quality as Donovan will now inform us about.
We believe Graco has a unique, yet strong business model.
Graco focuses on three essential components of an enduring company:
[Slide 2]
First is Operational excellence
Graco has dependable human capital(skills, roles, people) with a high retention
rate. The company operates like a well-oiled machine.
Additionally, Graco has centralized manufacturing operations that allow
them to effectively leverage their overhead. This is well exemplified by
their high profit margins that exceed their competitors by 3 times. [Slide 3]
Further proving Operational Excellence – Graco’s Net Income Per
Employee is double or more than their competitors. [Slide 4]
Second in the enduring company model is Customer Intimacy
Graco has strong relationships with their end users, material suppliers,
and channel partners.
The talented sales teams stay close to the end users to ensure the
feedback loop is well established– fostering continued innovation and
thousands of new products. The teams demo in person to show the
product’s high ROI that reduces the customer’s use of labor, material and
energy. [Slide 5]
Lastly, Graco has Product Leadership
Their product development is customer-centered. They are unique in that
they have over 66,000 SKUs and with lean manufacturing they are able to
sustain this business model of low volume sales and high mix of products.
[Slide 6]
They spend 3 times the amount of R&D as their competitors to ensure
quality and high specialization. [Slide 7]
We analyzed net income per employee analyze the Graco’s efficiency. In
this slide notice the # of employees (the orange bars) to net income gap
tightening in pre-recession 2007, then in 2013 the gap has further
tightened. We believe this indicates the company reaching maturation and
max efficiency further supporting our hold recommendation.
Harrison will now take us through the Macroeconomy and how Graco fits in.
[Slide 8]
In terms of macro indicators, U.S. GDP has a strong relationship with GGG stock price
and sales.
The annual U.S. GDP growth rate correlates well with top-line sales. So, GDP
projections of 2-3% going forward will create a slow, steady growth environment for
GGG.
Considering end users, key industry indicators for GGG segments performance include
construction, automotive, and industrials.
Here’s GGG’s operation segments breakout and respective margins.
Industrial’s key drivers are U.S. industrial production in addition to European and
Chinese GDP. On the domestic side, this segment has favorable outlook as GDP growth
motivates capital expenditures for industrials. However, deflationary economies of
Europe and China may stagnant segment sales and margins.
Contractor is geographically less diverse, also driven by U.S. industrial indices as well as
construction spending. Construction still lags below pre-recession levels presenting long-
term opportunity. Current construction conditions suggest steady sales and margins.
Lubrication also is geographically less diverse, loosely tied to U.S. oil production. This
segment has longer-term growth opportunity as oil production continues to increase.
However, segment margins will hold in short-term, as GGG has only recently entered oil
and natural gas. In summation, forward economic and industry conditions will allow
segment margins to steadily hold, supporting our hold recommendation.
Now I’d like to talk about a number of pertinent risks and opportunities associated with Graco. Our porter’s five forces analyses revels a probable high growth scenario within the company however this has not been the case over the last couple of years which continues support of HOLD recommendation.
One current risk, which is hitting the company as we speak, are currency headwinds. If currencies stay where they are now there will be a 4% hit to the top line and a potential 10% hit on the bottom line. Although these are projections, we see this analysis as strongly supporting our hold recommendation as the company is highly conservative in their handlings of foreign currency through not hedging.
Another current risk for the company is the R&D Tax credit, which the company receives from the government. If this were to go away their effective tax rate decrease from 32-33% to 31-32%, a relatively inconsequential drop but still important to watch as R&D is a key differentiator from their peers.
Further supporting our HOLD recommendation is the company’s capital deployment strategy surrounding the sale of the Liquid Finishing business. With their additional $570mm in cash they will repay and restructure debt, ultimately deleveraging. We see this as unnecessarily conservative and would like to see the company leverage itself to grow at a higher clip.
Another thing to point out is the loss of the dividends from the liquid finishing business. The impact to the bottom line from the loss of dividends is around $.07 in the forth quarter and on an annual basis around $.45 per share. The company is already around 2/3’s of the way to recovering the $.45 per share primarily through acquisitions.
As for acquisitions we forecasted $100-250mm deal sizes, within this we see the oil and natural gas industry and proper geographic expansion as two key opportunities. The depressed commodity price of oil has created low priced oil assets, which we see as a prime opportunity for expansion. The company to date has only made a handful of acquisitions with exposure to the industry with almost entirely American or EMEA exposure, which does not further the company’s expansion into new markets.
Geographically another issue we see is the failed capitalization throughout developing countries in regards to the conversion from roll on manual application of paint to spray application. We see this as particularly pertinent throughout Asia Pacific where significant growth is needed and few acquisitions have been made. Although we do not challenge management’s knowledge of their business, we see potential to take better advantage of the current environment and grow at a faster clip, which supports our HOLD recommendation.
In summation we see the slow and conservative approach taken by the company as support for our recommendation, we see Graco as a solid company, but not currently the best stock.
Now, let’s take a look at our valuation procedure.
Our team decided to break our core valuation down into two sections– a Discounted Cash Flow model and a price to earnings analysis.
Due to its lengthy, detail-oriented nature, we decided that the Discounted Cash Flow would represent the highest weight in determining our target price. We feel that, due to Graco’s strong cash generation and steady, continued growth, these models are a great representation of the valuation of the company’s common stock.
Ultimately, our analysis is a blending of models, centering on a YE Target price of 81.50
In performing our analyses, we looked to the financial ratios and valuation metrics from four main competitors, as seen on the screen, Nordson, Colfax, Idex, and Flowserve.
In determining various metrics and industry averages, we would look to Graco’s placement amongst its peers as guidance to our projections.
To begin, we will analyze our DCF model.
One of the main components within the DCF Model is weighted average cost of capital. Our WACC was based on a capital structure of 50% equity, 50% debt, which is consistent with Graco’s average capital structure numbers from the previous three years. We see this as a conservative stance, especially given currently low interest rates and Graco’s commitment to paying down a chunk of its debt from the proceeds of its liquid finishing sale.
This drives our conservative top-line estimates for the company’s future growth as the company is unwilling to use high leverage. As discussed earlier, we outlined the importance of Graco’s consistency within their business model. While this has, in the past, promoted strong returns and increasing sales at a 9-10% clip, we don’t feel that the current marketplace (whether in regards to macroeconomics or acquisitional opportunities) continues to promote historical growth rates. Graco would need to adjust to a more aggressive capital structure to continue those growth rates.
Next, We calculated Market Risk Premium based on the average quarter over quarter returns for Graco and its five competitors. After a weighting process, this number came out to 5.89% as seen on the screen. This is comparable to KPMG’s estimate of 6% as of September 2014, but more accurately reflects the industrial machinery industry.
Our next analysis was a Price to Earnings model comparing Graco’s positioning over the Industrial Machinery Index, denoted by IME on the on-screen tables.
Data taken from FactSet are NTM PE Ratios on a daily basis. Our theory was to find a strong correlation between Graco’s PE and the IME PE. We found a strong correlation showing that Graco averages a 20.8% premium to the IME over the past 5 years.
The on-screen chart shows Graco’s PE compared to the Industry, with the shaded region denoting the spread.
Our team evaluated the current spread between Graco and the IME, showing that Graco held a 19.1% premium over the IME PE. We determined that Graco would outperform the IME over the next 12 months, returning to its 5 year average of 20.8%.
However, we also hold that the IME could be at a peak or in the middle of a decline.
Our team estimated that the IME PE would drop from its current PE of 17.4 to around 16.5 by the end of 2015. With a 20.8% premium, we place Graco at a 2015 PE of 19.94, centering on a target price just under 80.00 per share.
Graco has an enduring business model erring on the side of conservatism and consistency. While this has proved to be extremely useful in the company’s history as far as growth, expansion, and opportunity, we see these growth techniques reaching a peak.
Earlier, we discussed Graco’s shrinking acquisition opportunity. With the recent order to divest the liquid finishing business of a larger acquisition, our team has concluded that Graco will be unable to maintain its customary inorganic growth, showing signs of maturity.
Secondly, we talked about the stable, but relatively unimpressive marketconditions. With Graco’s strong correlation to various economic indicators, GDP growth, and sentiment indices, notably in the Oil and Natural Gas Market, we see a slow growth base-line for Graco’s productivity in the near future. A return to historical growth trends would be contingent on a recovering O&NG market, strong global GDP growth, and a push to expansion in underdeveloped markets.
We still hold that Graco is a strong company. We don’t believe the recent quarterly earnings miss is material evidence against the longevity of the company. Therefore, we conclude that a hold recommendation is appropriate for the company’s common stock, fulfilling a 3.2% return as of the date of our analysis.
Finally, we’d like to thank the CFA society and all the industry mentors who volunteered their time. At this time, we’d like to open the floor for questions.
