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CFA Institute Research Challenge
Hosted by
CFA Society Minneapolis, Minnesota Bethel University
CFA INSTITUTE RESEARCH CHALLENGE 12/21/14
2
Bethel University Student Research This report is published for educational purposes only by students competing in the CFA Institute Research Challenge. Date: 12/21/2014 Ticker: GGG:NYSE
Coverage We initiate coverage on Graco, Inc. (GGG) with a 12-month price target of $81.50 and a HOLD recommendation. This is a 3.2% return on the current stock price as of December 21, 2014. Our price target was based on a Discounted Cash Flow Model in addition to various per share valuation methods and qualitative assessment about the macroeconomy and industry growth in the future. Solid but conservative business model. Although GGG is a strong company from many angles, management’s current approach tends to be more conservative. This increases the likelihood of a potential missed opportunity that could have driven overall growth at a higher rate. We see this as being an incredibly important potential miss, specifically in our current slow growth macroeconomic environment. Impressive share of the market not yielding significant growth. GGG has incredible margins from serving a niche market and essentially having the advantage of being able to charge a high price for their high quality products. The company does not however show signs of further grabbing significant market share, or significantly increasing their bottom line despite insignificant threats of new entrance to their market, low threat of substitute products, low bargaining power of customers and suppliers and low competition in the industry. A detailed Porter’s Five Forces analysis can be seen in Appendix 7 At 20.71x NTM EPS of $3.95 combined with DCF Analysis, GGG appears fully valued with little upside. At this valuation level GGG’s premium over its industry IME is at a historical high as well as right at it’s 52 week high. We do not see the company growing at a pace over projected estimates and do not see the market granting a higher multiple for GGG.
Company Overview Graco, Inc. designs and manufactures equipment to move highly viscous, difficult-to-handle fluids and coatings. The company operates in three operating segments, Industrial, Contractor, and Lubrication within the Diversified Machinery Industry.
Business Model/Strategic Focus. Graco has an enduring business model that has continually helped the company navigate the ever-changing global economy. This model includes four strategies for long-term growth: new product development, targeting new markets for existing technologies, geographic expansion, and key acquisitions. The CFO Jim Graner recently commented on November 6, 2014 at the CFA analyst day, “The strategies are the same today as they were ten years ago. We believe in our strategies. They have served us well and we believe will continue to serve us well.”
Industry: Diversified Machinery
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Sales and Margin
Source: FactSet, Team Estimates
Source: Yahoo! Finance
CFA INSTITUTE RESEARCH CHALLENGE 12/21/14
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Graco’s strong focus on the key business components of operational excellence, customer intimacy, and product leadership give the company a strong current and future position within the global market. Management. Graco has a strong management team with broad experience in the industry. Their consistent adherence to long-term strategies paired with their talented team has been one of the major components to which Graco can attribute its success. Graco has a culture intently focused on innovation and product quality that has been set by the management team. On our site visit, we were able to see that employee retention was strong, backed by a comment, “You are new here if you haven’t been around for ten years or more.” Detailed management overview is in Appendix 16. Patrick J. McHale, 52. President and Chief Executive Officer, a position he has held since June 2007. James A. Graner, 69. Chief Financial Officer, a position he has held in conjunction with Treasurer from September 2005 to June 2011. Christian E. Rothe, 40. Vice President and Treasurer, a position he has held since June 2011. Prior to Graco, held various positions in business development and accounting and finance. Jim Graner, CFO, will be retiring in the fall of 2015. We are confident that the hiring decisions made by the company, whether external or internal, will be consistent with the strategies employed throughout the company’s history.
Industry Overview and Competitive Positioning As part of the Diversified Machinery Industry, we used ratios and models comparing four main competitors with Graco’s performance: Colfax (CFX), Nordson (NDSN), Idex (IEX), and FlowServe (FLS). The company’s relatively strong financial ratios, when compared to competitors, stems from the high ROI provided to customers and the premium that Graco charges for its products. Although finding a list of trading competitors in the Diversified Machinery Industry is not difficult, comparing these companies to Graco poses a significant challenge. The diversified nature of the industry eliminates the plausibility of comparing most companies in the industry side-by-side. Graco currently offers over 60,000 SKU’s, most of which have different competitors entirely. Therefore, a ratio analysis between competitors primarily provides guidance in our projections and target price models, rather than a direct comparison. Operational Excellence. Graco has centralized manufacturing operations that have allowed the company to effectively leverage their overhead, driving their cost savings, reliability, and quality in their products. This is well exemplified by the highest profit margins of any of their competitors (see Exhibit A). They emphasize return on investment and believe in both manufacturing and engineering excellence by investing heavily in their factories as well as their R&D programs. They have a relentless focus on quality and efficiency in their factories. Their operational excellence, specifically within manufacturing, has allowed Graco the flexibility to be a rare company that has a high product mix with a low volume of sales. Even with such high quantities of units, their flexible manufacturing infrastructure, including shared components within products, allows them to quickly and efficiently transition to create a wide array of products, depending upon sales demand (Exhibit B).
Source: FactSet, Team Estimates
Exhibit B: Source: Graco Numbers
Exhibit A. Source: FactSet
CFA INSTITUTE RESEARCH CHALLENGE 12/21/14
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Customer, Distributor, and Supplier Intimacy. Graco has strong relationships with material suppliers, end users, and channel partners. Their central attention is niche markets in which they can charge a premium price for their high-quality and specific products that are cost-effectively manufactured. In serving niche markets, they have a determined customer-centered approach they use in developing new products to solve new problems and continually improve existing product lines. Despite selling heavily through distribution, Graco has made sure to stay close to the end users to ensure that their products are not only the quality that they expected, but also to seek out new opportunities for future innovation. They have a distinguished sales staff that are highly trained and focused on showing their customers the high ROI they receive from investing in Graco products. For example, in their contractor segment, the sales people will travel to demonstrate products to potential customers. They allow the contractors to use the products for a period of time to prove the quality and ROI inherent in the high-quality equipment. Close relationships, such as these, allow Graco to maintain their position as a product leader in these niche markets. Product Leadership. Spending three times the amount of research and development as their competitors, Graco ensures that their products are of the highest quality and innovation (see Exhibit C, D). Their quality standards prove to be much higher as well, as the company has committed to rigorous testing 10x the regulatory standards, compared with competitors’ equipment that might break down at 2x or 3x regulatory standards.
Their product development is customer-centered and “enables customers to reduce their use of labor, material and energy, improve quality and achieve environmental compliance.” They invest heavily to help cut costs for their end-users and those customers are willing to pay a premium for these solutions that help achieve a higher ROI on their own work. In addition, Graco performs quality and accuracy testing at each important juncture within the manufacturing process in order to achieve 100% product quality certification. Environmental Compliance. Graco maintains a strong commitment to environmentally friendly machinery. In their recent acquisition of QED Environmental Systems, the company has taken steps towards “environmental monitoring and remediation”. EcoQuip, another recent acquisition, “offers an eco-friendly abrasive blasting technology”. Graco also launched Diesel Exhaust Fluid dispensing solutions to facilitate clean and hygienic disposal of these fluids in garages and heavy equipment maintenance facilities. The ability for Graco to enter into and capitalize on environmentally friendly equipment will strongly facilitate growth for the company’s top-line objectives. Shareholder Value. Graco’s management maintains a strong initiative to provide maximum shareholder value. This can be seen through two avenues: Dividends and Share Buybacks. Graco strives to continuously provide a dividend at 30% of EPS (Exhibit E). This per share valuation was recently raised to $1.20 on an annual basis, matching our team’s projections. Graco has also announced aggressive commitment to reducing diluted shares outstanding under 60M with a target by the end of FY2015, done at an average rate of 10,000 shares per day. To reflect this commitment, we have employed a target common shares level of 59.9 for FY2015 valuation.
Macroeconomic Outlook The domestic macroeconomy shows slow, but steady growth in the post-recession environment. We expect U.S. GDP to grow between 2-3% in 2015 (see Appendix 14-15). Graco’s annual sales performance is fairly correlated with GDP, and thus we expected to see sales figures to grow minimally at 2%. After collecting and analyzing various economic indicators and indices, we have determined a correlation with Graco’s sales and stock price on a few key arenas: Oil and Mining Industries, Housing and Construction, and Industrial Indices. End Market breakdown can be seen in Exhibit F.
Exhibit C: Source: Graco Numbers
Exhibit D. Source: FactSet, Team Estimates
Exhibit E Source: FactSet
Dividend Payout Ratio
Exhibit F: Source: Graco Numbers
Exhibit E Source: FactSet
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The success of Graco’s Lubrication segment, and the company as a whole, is loosely tied to the success of various mining, oil, and gas indices (See Exhibit G). Paired with the company’s recent acquisition of UK-based Alco Valves Group and a potential improvement in mining and the recent boom in the oil industries, we see strong growth prospects for proportionate sales stemming from these markets. See Appendix 14-15 for complete analysis. The success of Graco’s Contractor segment is strongly tied to the success of various housing market health indicators (See Exhibit H). We forecast slow, but steady growth in the housing market based on low interest rates and relatively relaxing credit. See Appendix 14-15 for complete analysis. Our main comparison index is an industrial production index. We have used comparison trends and correlations between Graco’s valuation and the valuation of the index as guidance for our target price models. See Appendix 14-15 for complete analysis.
Operating Segment Overview Graco, Inc. operates with three operating segments, Industrial, Contractor, and Lubrication. These three segments are tied to economic indicators that correlate with sales production on the segment level. Industrial. Per management comment, Graco considers the Industrial segment to be the “rockstar”, boasting roughly 59% of the company’s sales with a margin of 32.3% in FY2013. Through this segment, Graco provides products that spray protective coatings, fast-set foam insulation, sealants and adhesives, and other sanitation based fluids. Opportunity for expansion and acquisition exists primarily in the Industrial segment due to the wide array of end markets. Performance. Industrial will continue posting the strongest margin, ranging between 32-33%. However, Industrial share of total sales will slowly taper off to about 58% of sales as the other segments gain market share, characteristic of pre-recession levels. Contractor. Contractor directs its sales toward three broad areas: paints, texture, and pavement maintenance. A primary catalyst for growth exists with the conversion of manual brush and roller techniques to spray applicators. This is the second largest segment by sales, representing 28-30% of overall sales and a margin between 20-23%. Performance. We estimate that contractor will represent 32% of sales in 2015 and will rise to 33-34% in the years following. Contractor performance is tied to movements in the industrial and construction industries and, with slow post-recession growth, we expect room for growth in the upcoming years. Margin will rest at 22.0% for 2015, as contractor performance continues to strengthen. Lubrication. Lubrication derives its sales around two main areas: industrial machinery lubrication and vehicle services. Therefore, the segment is reliant on success in the Auto
and O&NG Industries. The company produces equipment that allows customers to manually and automatically apply lubrication fluids to machinery and equipment. In
2013, Lubrication represented 10% of overall sales, with a strong margin of 20.6%. Performance. Lubrication revenues will grow very slowly, due to depressed commodities prices in the mining and oil industries. Margin will remain at or above 21%, with share of sales remaining at 9.0%, reflecting little to no growth in O&NG industry.
Exhibit G: Source: Bloomberg
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Ind. Prod.Mining
GGG MonthlyPrice
Exhibit H: Source: Bloomberg
Source: FactSet, Team Estimates
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53% 25%
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Geographic Sales Blue: Americas
Red: EMEA
Green: Asia-Pacific
2012 2013
2014E 2015E
Employee Efficiency Sales Per Employee. An important analysis to keep tabs on, we compared Graco’s employee/sales ratio for a nine year period, tracking efficiency pre- and post-recession. The results were extremely conservative, with the company clearly not gaining any material efficiencies or synergies through their employee head-count. This supports our analysis that the company has reached a maturity stage and will struggle to continue its high historical growth rates.
Geographic Breakdown
Graco has diversified its presence in many regions, which proves effective in avoiding economic downturns in any one country. Per management comment, the company employs local and regional sales personnel that live where they sell, promoting efficiency. In northern Africa, the market is served by salespeople from France and in certain areas of Saudi Arabia, the company serves the market with salespeople from the UK, both common practices in the industry. As the company is currently in the process of adding on-the-ground salespeople in the denoted regions, we expect growth from these markets.
Americas. Graco’s production in the Americas comprises roughly 55% of overall company sales. Two-thirds of overall sales. Sales production from this region is largely tied to housing, and general economic health indicators. Growth opportunity exists with potential expansion into South America, noted by the company’s recent commitment to boosting the sales force on the continent. However, as the developed market in the United States is difficult to foster significant expansion, we see this number staying flat for the near-term. Europe, Middle East, Africa. EMEA comprises the next largest segment for Graco’s sales, at roughly 25% of sales. Europe presents opportunity in emerging markets, while Graco’s presence in the Middle East
and Africa is minimal, presenting strong opportunity for expansion. We see EMEA’s share of sales increasing in FY2014 and FY2015 backed by expansion opportunity and increased volume from the Alco-Valves acquisition. Asia-Pacific. The Asia-Pacific segment is comprised mainly of China, Japan, and Australia, with surrounding islands included. This geographic segment comprises roughly 20% of Graco’s sales. The Asia-Pacific region presents the greatest room for development and future expansion. Much of the success of this region stems from productivity in China, and given the macroeconomic outlook in the country, we have taken a conservative stance on growth of sales from this region, keeping sales at 20% for FY2014 and FY2015.
Source: Company Data, Team Estimates
Source: The Conference Board
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China GDP Growth Outlook. China, one of the world’s largest economies, is a significant piece of Graco’s Asia-Pacific sales. The International Monetary Fund suggested, in 2014, that China projected GDP growth is between 6.5-7.0%, down from current estimates of 7.5% for 2015. Chinese economists suggest that the economy needs growth above 7.0% in order to foster job creation to support the growing population. China’s economic data can be seen in the Appendix 14.
Valuation Our valuation are based on a discounted cash model, the details of which can be seen in Appendix 8. Our estimated sales CAGR from 2014 through 2018E is 6.3% paired with Net Income CAGR of 6.45%, as the company exhibits signs of a mature company – shrinking sales growth opportunity with increased margin efficiency. It must be noted that these growth rates will factor in the 2008-2009 financial crisis, representing growth rates that fall far below historical sales growth of 9%. Graco management strives for top-line sales growth of 10%, with two-thirds from organic and one-third from acquisitions. Our models estimates are more conservative, due to Graco’s current size and shaky global economic conditions in the post-financial crisis environment.
Conservative Estimates. Though Graco’s management team targets top-line sales growth of 10%, our analysis suggests the company will not be able to reach these historical goals, especially given Graco’s maturity and current established markets. Sales Assumptions. In order to more accurately project sales revenues in the next five years, we have broken down
sales by operating segment. Macroeconomic trends were used to draw estimated trend lines between sales growth within each segment and the level of economic activity. Industries and indicators covered include Housing, O&NG, and Mining Industries on a domestic and global basis. Details can be seen in Appendix 8. Discounted Cash Flow Analysis – $81.71. Our DCF valuation projects a 12-month target price of $81.71 based on an 8% top-line growth scenario for FY2015E. This valuation stems from an average comparing the Perpetuity Growth Method and the Exit Multiple Method to converge on a target price (Exhibit I). Our detailed model can be seen in Appendix 8. Our models are based around top-line sales growth as analyzed by forecasting revenue for the Industrial, Construction and Lubrication segments. Growth calculations for each segment were based primarily on a percentage of sales or assets. From here we projected revenue forward at a flat growth rate due primarily to a similar projected capital structure as stated by management.
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Exhibit I. Source: Team Estimates
Exhibit J. Source: Team Estimates.
Exhibit K. Source: St Louis Fed
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Weighted Average Cost of Capital. WACC is based on industry competitors and market conditions in combination with Graco’s historical capital structure (Exhibit J). WACC is 5.94% based on a continual capital structure of 50% equity (9.39% cost) and 50% debt (2.49% cost). Cost of Common Equity was calculated by a peer comparison of quarterly equity return compared to a weighted average of the S&P500 Index and the Dow Jones Industrial Average. Levered Beta (2.70) was calculated by deriving the unlevered beta of three competitors, IDEX, Colfax, and Nordson, and determining an average consensus. The risk free rate of 1.59% is set as the 5-Year T-Bond as of 12/2/2014. Long-term growth, g, is set at 2.71%, an average of the Real Potential GDP Growth Rate factoring in 145 quarters of domestic economic data (Exhibit K). We feel this is an accurate representation due to Graco’s strong ties to economic strength. Detailed WACC components can be seen in the Appendix 8. Further Valuation Methods. Price to Earnings per Share – $80.27. Our PE analysis is a blend of two parts, as seen in Exhibit L. We believe shares warrant a premium multiple given a currently strong financial position, strong long-term growth stemming from both organic and strategic acquisitions, and the company’s ability to provide a high ROI to its end users. Using the 12/26/14 NTM-PE multiple of 20.71, we arrive at a projected target price of 81.80 for FY2015. Graco, Inc. also carries a historical P/E premium over the industry IME of about 20.8% on a 5-year timeline (Exhibit M). This number is currently below historical trends, so we believe the P/E of the company will outperform relative to the industry over the next few months to in line with historical levels. We believe the business cycle has peaked, generating an Industrial Machinery P/E at our team’s estimate of 16.50. We Graco’s P/E at 19.93, as it typically trades at a 20.8% premium above the IME P/E. This P/E of 19.93 leads to an estimated 2015 stock price of $78.73. A blend of the two target prices reaches $80.27.
Price to Sales per Share – $81.04. Price to Sales per Share was calculated using assumptions about the company’s historical sales per share and price to sales per share ratios. Graco clearly carries a premium over competitors in the Sales per Share ratio, as seen in Exhibit N. Details can be seen in Appendix 10. Price to Cash Flow per Share - $81.73. Price to Cash Flow per Share was calculated using assumptions about the company’s historical Cash Flow per Share and Price to Cash Flow per Share trends. The premium on Price to Sales per Share and Price to Cash Flow per Share is due to its higher margin stemming from high operational efficiencies compared to competitors. Details can be seen in the Appendix 11.
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35 Daily NTM PE - GGG/IME With Spread Spread
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Exhibit M. Source: FactSet
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Exhibit N. Source: FactSet
Exhibit L. Source: FactSet, Excel
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Industry EV/Sales (Source:Factset, Team Estimates)
Exhibit O. Source: FactSet.
CFA INSTITUTE RESEARCH CHALLENGE 12/21/14
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EV/Sales. Historically, Graco shows a premium over our four trading competitors in this ratio. We recognize Graco’s valuation correlation with our chosen trading comps, by employing our DCF template to determine NDSN, CFX, and IEX as the closest valuation competitors in our calculation of WACC (see correlations in Exhibit O). We also recognize Graco’s valuation as the leader in the industry, confirming our PE premium of 20.8% over the industry. EV to Sales historically indicates the cost of purchasing a company’s sales. Graco’s higher EV to Sales compared to trading comps demonstrates its leadership and maturity in its industry class.
Conclusion. Graco’s valuation performance is closely tied with industry competitors, noted by the tickers in Exhibits N and O. Using industry comps as guidance, we are able
to place Graco in a premium position in a variety of metrics. We conclude that Graco’s current P/E premium over the Industry of 19.1% will expand to the historical level of 20.8%. However, with our negative outlook on the Industrial Machinery Index, we expect the Industry P/E to shrink from its current level of 17.4 to about 16.5 by FY2015 (Exhibit P). Graco will remain the leader in the industry, but will experience P/E tightening with the industry.
Investment Summary We are initiating coverage of Graco, Inc. (GGG) with a HOLD rating and a target price of $81.50 for FY2015. This offers a 3.2% return over the current stock price as of December 21, 2014. Our valuation is derived from a blending of our target price models, and weighting our target price evenly with our Discounted Cash Flow Model. Graco, Inc. will continue to outperform the industry and peers due to its competitive positioning, long-term growth tactics, and product excellence. The company’s management effectively employs a long-term strategy, which centers on steady growth. Through both organic and inorganic growth we expect Graco to grow at a top-line CAGR of 6.3% for the period ’14-’18E based on conservative estimates and historic top-line sales growth forecasts. Although the company is highly profitable with an effective leadership team, we see Graco as a mature company that will require a riskier change in strategy to achieve maximum potential upside. A tangible example of this can be seen in the allocation of dollars from the sale of the Liquid Finishing business in 2015. The company has publically stated they will repay debt with these proceeds. This will ultimately decrease their leverage, which affirms our conservative estimates. In support of our target price and hold recommendation, we see Graco, Inc. as a financially strong, mature company that will outperform peers for years to come. In both the short and long run, the company will need to increase their tolerance of risk to drive higher levels of growth in order to maintain their goals of top-line growth at 10%.
Financial Analysis In this section, we will outline the assumptions made in our analysis. Full financial statements can be seen in the Appendix 1- 5 and we determine sales CAGR from 2010-2018 to be 9.13%, with EBIT CAGR at 12.89%. Our assumptions are fairly consistent when compared to Graco’s management expectations of 10% top-line growth and 12% bottom line growth
5-Year GGG Price w/ Daily Volume
Exhibit P. Source: FactSet, Team Estimates
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Top-Line Sales Approach Criticism. Our valuation models are heavily based on top-line sales growth estimates. Therefore, with our models contingent on accurate projections, we determined that a sensitivity analysis was appropriate to stress test our sales growth assumptions. This analysis can be seen below. We converged on a historical sales growth rate of 8% for FY15, reflecting moderate economic growth in global markets. Scenarios in which sales growth falls above and below 8% were rejected due to our team’s consensus opinions on global economic health. We feel that 10% growth is unobtainable for Graco based on two reasons: 1) Their capital structure is too conservative, and 2) Economic markets have not fully recovered, post-Recession.
Stable Growth in Earnings. For Graco, FY2014 looks to be another year of standard top- and bottom-line growth. Continuation of steady growth in earnings through FY2015 and beyond rests on the heels of two primary drivers. First, we must remain bullish on the market through 2015, especially given Graco’s correlation with overall market movements as a major member of the Industrial Machinery industry. Second, as stated by the company directly, “we will continue to do what we always do, slow and steady growth.” However, in the dynamic, post-recession market, these long-term tactics may not be enough for Graco to continue to post its historical 10% growth rate goals. Margin Analysis. Graco has historically exhibited higher margins when compared to
peers, specifically profit and operating margins over the past 5 years, by 15%. This stems from the premium charged for the company’s products. We feel that these margins may receive pressure from shrinking top-line growth and the general state of maturity reached by the company, but will continue to remain relatively high when compared to peers. Ratio and margin analysis can be seen in Exhibit Q. Allocation of Cash Proceeds. Graco is in a unique position in which the company will have access to roughly $800M in debt-based capital to expend on the company through credit lines, uncharacteristic of the cash-light company. Per management guidance, we see a few potential avenues for cash expenditure: 1. Continued, or expanded share buyback program through FY2015 and potentially FY2016 2. Increased dividend payout – Note the increase to $1.20/share in 2014, an average growth rate of ~8.5% 3. Strategic Acquisitions of a medium to smaller magnitude (<$250M) due to FTC regulation 4. Further increase R&D expenditure dominance, potentially 5+% of sales 5. Further exploration into the recovering O&NG market, boosting sales share to 10% from current 6% Profitability – DuPont Analysis. Graco exhibits a high five-year average return on equity of 39% coming from a high quantity, low volume mix which yields relatively high net income margins and asset turnover (1.12 5yr avg). Our forecasts indicates an estimated a drop in ROE to 35-36% primarily due to a lower net income margin and asset turnover caused by the maturation of the company. Details can be seen in Exhibit R below.
Conclusion. Our analysis aligns with our investment summary; Graco is a highly stable and profitable company with an enduring business model that will enable the company to succeed for years to come. We do not see overwhelming indications in our analysis that push us to see Graco outperforming conservative profitability or growth estimates.
Exhibit Q. Source: FactSet, Team Estimates
Exhibit R: FactSet, Team Estimates
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Investment Risks and Opportunities Divesture of Liquid Finishing Business. In Accordance with FTC regulations, Graco has agreed to divest its interest in the Liquid Finishing business of a 2012 acquisition from Illinois Tool Works. The announced sale of this business to Carlisle Company will realize an estimated $570M in cash. Speculation and uncertainty exists as to Graco’s use of this cash in the upcoming business year. Graco management has announced a commitment to paying down roughly $300M of their current repayable debt from a revolving credit line. We believe the company will reissue this debt at a cheaper rate, keeping their capital structure at 50% equity, 50% debt, a structure consistent with historical trends. Future Acquisition Strategy. Uncertainty arises in Graco’s acquisition strategy for the future. With the recent FTC order to divest the Liquid Finishing business, we conclude that Graco will have an inability to pursue acquisitions of high magnitude in the future. We believe the company will keep acquisitions at middle levels, between $100-250M. We believe these acquisitions will generally represent new expansionary industries, or industries in which Graco’s current presence is non-dominant. However, Graco’s maturity and size will limit growth opportunity in the future, both organically and inorganically. Growth Opportunities
Expansion into South America and Africa. Graco management has labeled expansion as a key to growth. Graco has the opportunity to capture new markets, especially within developing and emerging economies. Oil and Natural Gas Industry. With its recent acquisition of UK-based Alco Valves Group, Graco is positioned to strengthen its presence in the O&NG Industry. O&NG currently accounts for 6% of the company’s business, and we see this expanding as the industry recovers on the back of rising commodity prices in the future. End-User Conversion. Graco continues to pursue opportunities through the conversion of manual brush and roller paint techniques to spray applicators. Results have been disappointing, but strong upside exists if Graco can capture the development in emerging economies and smaller cities. Product Development and Research. Graco maintains a commitment to product excellence backed by consistently keeping R&D expense at 4.5-5.0% of sales. In addition, through the hiring of top employees with new ideas in the engineering and development areas, Graco can continue to produce the best products in the industry. Margins are reliant on continued adherence to these guidelines.
Threats to Growth
Sluggish housing market in the United States. Contractor sales, through home center stores, are tied with the US housing market. Strict home-mortgage requirements in the post-recession environment places pressure on sustained growth. See Appendix 15 for details. Acquisition opportunity. Graco needs to continuously acquire new companies and segments in order to stay viable atop the industry as the quality product leader. Their recent acquisition and dissolution of ITW’s Liquid Finishing Business projects uncertainties in the company’s ability to acquire reasonably viable businesses in the future. Geopolitical tension in China. With direct business in China and Hong Kong, Graco is susceptible to the political turmoil that has been developing. Slow growth and potential recession in Europe. While our models are based on the assumption that Europe avoids recession, we have factored in sensitivity analyses to show what the company’s business could look like in an economic downturn. Discontinuation of the R&D Tax Credit. A potential discontinuation would adversely affect the company’s R&D expenditure. This would force a business model revamp as Graco’s competitive advantage is centered around new, high quality products.
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Appendix 1. Income Statement
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Appendix 2. Balance Sheet
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Appendix 3. Statement of Cash Flows
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Appendix 4. Common-‐Size Income Statement
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Appendix 5. Common Size Balance Sheet
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Appendix 6. Selected Graco-‐Constructed Charts. Source: 2013 Presentation
CFA INSTITUTE RESEARCH CHALLENGE 12/23/14
Appendix 7. Porter’s Five Forces
Threat of New Entrants. Insignificant. Graco, and its competitors, have a dominant presence in the market. The products provided are expensive to produce, industry customer relationships are strong, and business models have long-‐term focus. Smaller companies will be absorbed by larger companies.
Threat of Substitute Products. Low. Graco maintains commitment to providing the most expensive product that provides the highest ROI for end-‐users. Graco has strong customer relationships, but until the customer switches to a Graco product, they will remain with the cheaper products.
Bargaining Power of Customers. Low. Similar to substitutes, Graco has the highest quality product on the market, but also charges the highest price. Customers are willing to pay the premium as long as Graco’s products continue to provide environmentally friendly solutions to specific manufacturing challenges.
Competition in the Industry. Low. Graco’s entire business model relies on providing the best product with the highest ROI to its customers. Competition is fierce and diverse, as Graco has a number of competitors for each product. As long as Graco continues commitment to product development, they will continue to remain at the top of the industry.
Bargaining Power of Suppliers. Low. Graco is a company that produces equipment that is subject to fluctuations within the commodities market. Graco is a major buyer from suppliers, so has weight in negotiations. Competition in the industry keeps Graco’s power limited when buying from suppliers.
CFA INSTITUTE RESEARCH CHALLENGE 12/23/14
Appendix 8. Discounted Cash Flow Model and Calculations
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MRP. Market Risk Premium, as depicted in the chart to the left, is a blend of the average Quarter over Quarter returns of Graco (and competitors) over the S&P500 and DJIA. Our final number, 5.89%, is very comparable to Aswath Damodaran and KPMG’s numbers of 5.21% and 6%, but our calculation provides a more accurate representation of the industrial machinery industry.
CFA INSTITUTE RESEARCH CHALLENGE 12/23/14
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Growth Calculations. Most growth calculations were based around % of sales, historical growth rates, and % of cost of sales. Our models are based around top-‐line sales growth. Diluted Shares Outstanding is placed at 59.9, per management commitment to a share buyback program. Tax rates and cap-‐ex are placed on guidance by management statements. We have assumed a conservative stance with sales growth at 10%, 8%, 4.5%, 4.5%, 4.5%.
CFA INSTITUTE RESEARCH CHALLENGE 12/23/14
Appendix 9. PE and EPS Target Price Model
Model 2. Our model revolves around positioning Graco’s PE against the Industrial Machinery and Equipment Industry P/E. Data was gathered from FactSet. We obtained daily NTM-‐P/E ratios for Graco, the S&P500, and the Industry. As seen in the above charts, we originally pitted Graco’s PE against the S&P500’s PE, but the results were inconclusive as correlation was only .445. Transitioning over to the Industry comparison, we saw a higher correlation, showing .726 for daily NTM-‐P/E numbers on a 10-‐year basis. We decided to check to see if the correlation was stronger on a 5-‐year basis, and we obtained a correlation of .90. On a 5-‐year basis of daily NTM-‐P/E values, Graco holds a 20.8% premium P/E to the Industry P/E. Currently, the spread between Graco’s P/E and the Industry P/E is at 19.1%, an average for the most recent month’s data. This leads us to conclude that Graco will return to 20.8% by FYE2015. Now, we need to obtain an accurate estimate of where we place the IME P/E for FYE2015. Current NTM-‐P/E is 17.4 as shown by the chart to the left. Our team estimated that the business cycle projects a P/E of 16.5 for the industry by FYE2015, a decrease from today’s value.
Model 1. Taking the NTM-‐PE Ratio as of 12/26/14 and our team’s projected 2015 EPS of 3.95, we come up with a target price of $81.80.
0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0% 100.0% 110.0% 120.0% 130.0% 140.0% 150.0%
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GGG
IME
CFA INSTITUTE RESEARCH CHALLENGE 12/23/14 By applying Graco’s 20.8% premium to our projected industry value of 16.5, we come out with a target price of 78.73. When combined with our first model, we blend a target price at $80.27. Appendix 10. Price to Sales per Share Model. Model Methodology. Our Price to Sales per Share Model was based primarily on historical trends on Graco’s Sales per Share numbers and Price to Sales per Share values in comparison to industry trading competitors Trading competitors used were Nordson, Colfax, Idex, and FlowServe. To determine sales per share, our team employed our projected shares outstanding of 59.9M for FY2015 and our estimated sales for the year at 1312.0M. A simple division projects a Sales per Share value of 21.90 for FY2015, which is an estimate that fits historical trends. Data was gathered from FactSet. After obtaining our Sales per Share value, the next step was to determine the Price to Sales per Share ratio. We opted to use FactSet consensus estimates of 4.00 for 2014E and 3.70 for 2015E. Now, after multiplying our Sales per Share value of 21.90 by the Price to Sales per Share value of 3.70, we arrive at a target price of $81.04 for FY2015. Appendix 11. Price to Cash Flow per Share Model Model Methodology. Following a similar method as our Sales per Share model, we determined historical Cash Flow per share values for Graco and industry trading competitors. Trading competitors used were Nordson, Colfax, Idex, and FlowServe. We then determined the Price to Cash Flow per Share value for 2015E and a simple multiplication led us to a target price. Data was gathered from FactSet. After projecting our financial statements, we determined Cash Flow per Share to be 4.02 for FY2014 and 4.24 for FY2015. We feel that these are accurate estimates, especially when checked against FactSet consensus values of 4.08 and 3.98, respectively. Our Price to Cash Flow per Share value for 2015E was determined based on historical industry averages and Graco’s historical averages. We determined a Price to Cash Flow per Share value of 19.14, which is an average of Graco’s Price to Cash Flow per Share values for 2010-‐2013 using the industry as guidance. We feel that this is an accurate representation of Graco’s valuation. After multiplying 4.24 (Cash Flow per Share, Bethel Estimate) by 19.14 (Price to Cash Flow per Share, Bethel Estimate), we arrive at a target price for FY2015E of $81.16, which we feel is a reasonable target price. Appendix 12. Price to Book Value per Share Model While this model was performed in a similar manner as Price to Sales and Price to Cash Flow, we opted to reject this model’s target price. Price to Book Value per Share is best used for financial institutions, and we determined that this model does not fit Graco’s business model as an accurate valuation method.
CFA INSTITUTE RESEARCH CHALLENGE 12/23/14
Appendix 13. EV to Sales, Competitor Analysis Valuation methodology. This valuation technique was used to determine how Graco compares to trading competitors in the industry. We compared Graco’s EV/Sales values with Nordson, Colfax, Idex, and FlowServe on a historical and projected basis. Projected values were taken from FactSet consensus estimates.
As seen in the supplemental chart, it is clear that Graco has a premium over the four trading competitors. Additionally, strong correlation exists between Graco and the trading competitors, with the strongest correlation existing between Nordson, Colfax, and Idex. We used this correlation to determine that Nordson, Colfax, and Idex would be our three competitors used in the Levered Beta calculation of our DCF analysis.
Appendix 14. EV to EBITDA, Competitor Analysis
Valuation methodology. This valuation technique was used to determine how Graco compares to trading competitors in the industry. We compared Graco’s EV to EBITDA values with Nordson, Colfax, Idex, and FlowServe on a historical and projected basis. Projected Values were taken from FactSet consensus estimates. As seen in the supplemental chart, Graco has a premium over the four trading competitors. Additionally, strong correlation exists between Graco and two competitors, Nordson and Idex.
-‐ 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00 EV/Sales
GGG
NDSN
CFX
IEX
FLS
-‐
5.00
10.00
15.00
20.00
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014E
2015E
EV to EBITDA GGG
NDSN
CFX
IEX
FLS
CFA INSTITUTE RESEARCH CHALLENGE 12/23/14 Appendix 14. The Conference Board Economic Growth Projections.
CFA INSTITUTE RESEARCH CHALLENGE 12/23/14
Appendix 15. Selected Economic Data with Comparison Correlations to Graco, Inc.
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CFA INSTITUTE RESEARCH CHALLENGE 12/23/14
Appendix 17. Management Profiles. Name Position Since Bio Patrick J. McHale, 52
Director, President and Chief Executive Officer
1999 Mr. McHale, 52, is President and Chief Executive Officer of Graco Inc., a position he has held since June 2007. He served as Vice President and General Manager, Lubrication Equipment Division of Graco from June 2003 until June 2007. He was Vice President, Manufacturing and Distribution Operations from April 2001 until June 2003. He served as Vice President, Contractor Equipment Division from February 2000 to March 2001. Prior to becoming Vice President, Lubrication Equipment Division in September 1999, he held various manufacturing management positions in Minneapolis, Minnesota; Plymouth, Michigan; and Sioux Falls, South Dakota. Mr. McHale joined the Company in December 1989 and has been a director since June 2007.
David M. Lowe, 58
Executive VP, Industrial Products Division
1996 David M. Lowe, 58, became Executive Vice President, Industrial Products Division in April 2012. From February 2005 to April 2012, he was Vice President and General Manager, Industrial Products Division. He was Vice President and General Manager, European Operations from September 1999 to February 2005. Prior to becoming Vice President, Lubrication Equipment Division in December 1996, he was Treasurer. Mr. Lowe joined the Company in 1995.
Charles L. Rescorla, 62
VP, Corporate Manufacturing, Distribution Operations and Corporate Development
2001 Charles L. Rescorla, 62, was elected Vice President, Corporate Manufacturing, Distribution Operations and Corporate Development on December 6, 2013. From June 2011 to December 2013, he was Vice President, Corporate Manufacturing, Information Systems and Distribution Operations. He was Vice President, Manufacturing, Information Systems and Distribution Operations from April 2009 to June 2011. He served as Vice President, Manufacturing and Distribution Operations from September 2005 to April 2009. From June 2003 to September 2005, he was Vice President, Manufacturing/Distribution Operations and Information Systems. From April 2001 until June 2003, he was Vice President and General Manager, Industrial/Automotive Equipment Division. Prior to April 2001, he held various positions in manufacturing and engineering management. Mr. Rescorla joined the Company in 1988.
James A. Graner
CFO 2005 James A. Graner, 69, became Chief Financial Officer in September 2005, a position he held in conjunction with Treasurer from September 2005 to June 2011. He served as Vice President and Controller from March 1994 to September 2005. He was Treasurer from May 1993 through February 1994. Prior to becoming Treasurer, he held various managerial positions in the treasury, accounting and information systems departments. He joined the Company in 1974. On September 19, 2014, James A. Graner announced his intention to retire from his position as the Company's Chief Financial Officer. Mr. Graner's retirement will become effective in August 2015.
Dale D. Johnson, 59
VP and GM, Contractor Division 1996 Dale D. Johnson, 59, became Vice President and General Manager, Contractor Equipment Division in April 2001. From January 2000 through March 2001, he served as President and Chief Operating Officer. From December 1996 to January 2000, he was Vice President, Contractor Equipment Division. Prior to becoming the Director of Marketing, Contractor Equipment Division in June 1996, he held various marketing and sales positions in the Contractor Equipment division and the Industrial Equipment division. He joined the Company in 1976.
Mark W. Sheahan, 49
VP and GM, Applied Fluid Technologies Division
1996 Mark W. Sheahan, 49, became Vice President and General Manager, Applied Fluid Technologies Division in February 2008. He served as Chief Administrative Officer from September 2005 until February 2008, and was Vice President and Treasurer from December 1998 to September 2005. Prior to becoming Treasurer in December 1996, he was Manager, Treasury Services. He joined the Company in 1995.
David M. Ahlers,
VP, HR and Corporate Commiunications
2008 David M. Ahlers, 55, became Vice President, Human Resources and Corporate Communications in April 2010. From September 2008 through March 2010, he served as the Company's Vice President, Human Resources. Prior to joining Graco, Mr. Ahlers held various human resources positions, including, most recently, Chief Human Resources Officer and Senior Managing Director of GMAC Residential Capital, from August 2003 to August 2008. He joined the Company in 2008.
Karen Park Gallivan, 57
VP, General Counsel and Secretary
2003 Karen Park Gallivan, 57, became Vice President, General Counsel and Secretary in September 2005. She was Vice President, Human Resources from January 2003 to September 2005. Prior to joining Graco, she was Vice President of Human Resources and Communications at Syngenta Seeds, Inc. from January 1999 to January 2003. From 1988 through January 1999, she was the general counsel of Novartis Nutrition Corporation. Prior to joining Novartis, Ms. Gallivan was an attorney with the law firm of Rider, Bennett, Egan & Arundel, L.L.P. She joined the Company in 2003
Jeffrey P. Johnson, 54
VP and GM, EMEA 2008 Jeffrey P. Johnson, 54, became Vice President and General Manager, EMEA in January 2013. From February 2008 to December 2012 he was Vice President and General Manager, Asia Pacific. He served as Director of Sales and Marketing, Applied Fluid Technologies Division, from June 2006 until February 2008. Prior to joining Graco, he held various sales and marketing positions,
CFA INSTITUTE RESEARCH CHALLENGE 12/23/14 including, most recently, President of Johnson Krumwiede Roads, a full-‐service advertising agency, and European sales manager at General Motors Corp. He joined the Company in 2006
Brian J. Zumbolo, 44
VP and BM, Lubrication Division 2007 Brian J. Zumbolo, 44, became Vice President and General Manager, Lubrication Equipment Division in August 2007. He was Director of Sales and Marketing, Lubrication Equipment and Applied Fluid Technologies, Asia Pacific, from November 2006 through July 2007. From February 2005 to November 2006, he was the Director of Sales and Marketing, High Performance Coatings and Foam, Applied Fluid Technologies Division. Mr. Zumbolo was the Director of Sales and Marketing, Finishing Equipment from May 2004 to February 2005. Prior to May 2004, he held various marketing positions in the Industrial Equipment division. Mr. Zumbolo joined the Company in 1999.
Bernard J. Moreau, 53
VP and GM South and Central America
2013 Bernard J. Moreau, 53, is Vice President and General Manager, South and Central America, a position he has held since January 2013. From November 2003 to December 2012, he was Sales and Marketing Director, EMEA, Industrial/Automotive Equipment Division. From January 1997 to October 2003, he was Sales Manager, Middle East, Africa and East Europe. Prior to 1997, he worked in various Graco sales engineering and sales management positions, mainly to support Middle East, Africa and southern Europe territories. He joined the Company in 1985.
Caroline M. Chambers
VP, Corporate Controller and Information System
2005 Caroline M. Chambers, 49, was elected Vice President, Corporate Controller and Information Systems on December 6, 2013. She has also served as the Company's principal accounting officer since September 2007. From April 2009 to December 2013, she was Vice President and Corporate Controller. She served as Vice President and Controller from December 2006 to April 2009. She was Corporate Controller from October 2005 to December 2006 and Director of Information Systems from July 2003 through September 2005. Prior to becoming Director of Information Systems, she held various management positions in the internal audit and accounting departments. Prior to joining Graco, Ms. Chambers was an auditor with Deloitte & Touche in Minneapolis, Minnesota and Paris, France. Ms. Chambers joined the Company in 1992.
Mark D. Eberlein, 53
VP and GM, Process Division 2013 Mark D. Eberlein, 53, is Vice President and General Manager, Process Division, a position he has held since January 2013. From November 2008 to December 2012, he was Director, Business Development, Industrial Products Division. He was Director, Manufacturing Operations, Industrial Products Division from January to October 2008. From 2001 to 2008, he was Manufacturing Operations Manager of a variety of Graco business divisions. Prior to joining Graco, Mr. Eberlein worked as an engineer at Honeywell and at Sheldahl. He joined the Company in 1996.
Peter O’Shea, VP and GM, Asia Pacific 2013 Peter J. O'Shea, 49, became Vice President and General Manager, Asia Pacific in January 2013. From January 2012 until December 2012, he was Director of Sales and Marketing, Industrial Products Division, and from 2008 to 2012, he was Director of Sales and Marketing, Industrial Products Division and Applied Fluid Technologies Division. He was Country Manager, Australia -‐ New Zealand from 2005 to 2008, and from 2002 to 2005 he served as Business Development Manager, Australia -‐ New Zealand. Prior to becoming Business Development Manager, Australia -‐ New Zealand, he worked in various Graco sales management positions. Mr. O'Shea joined the Company in 1995.
Christian E. Rothe, 40
VP and Treasurer 2011 Christian E. Rothe, 40, became Vice President and Treasurer in June 2011. Prior to joining Graco, he held various positions in business development, accounting and finance, including, most recently, at Gardner Denver, Inc., a manufacturer of highly engineered products, as Vice President, Treasurer from January 2011 to June 2011, Vice President -‐ Finance, Industrial Products Group from October 2008 to January 2011, and Director, Strategic Planning and Development from October 2006 to October 2008. Mr. Rothe joined the Company in 2011
Disclosures: Ownership and material conflicts of interest: The author(s), or a member of their household, of this report [does not hold] a financial interest in the securities of this company. The author(s), or a member of their household, of this report [does not know] of the existence of any conflicts of interest that might bias the content or publication of this report. Receipt of compensation: Compensation of the author(s) of this report is not based on investment banking revenue. Position as a officer or director: The author(s), or a member of their household, does not serve as an officer, director or advisory board member of the subject company. Market making: The author(s) does not act as a market maker in the subject company’s securities. Disclaimer: The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with [Bethel University], CFA Institute or the CFA Institute Research Challenge with regard to this company’s stock.