The Going Will Get Tougher, But Graco Will Keep Going

 

The last six months or so have seen a rerating process among industrial stocks. Whether that’s being driven by expectations of higher rates, slowing end-markets, other factors, or “all of the above”, valuations for some frequent high-flyers are getting more reasonable. Of course, “more reasonable” doesn’t mean conventionally cheap, and investors have to weigh that opportunity against the risk that companies will start coming up short as comps get tougher and short-cycle momentum starts to weaken.

Graco (GGG) shares are down a bit from my last update, slightly underperforming the broader industrial space. I don’t think there’s anything wrong here other than the aforementioned concerns about slowing end-market growth, but I think the company should have another year of high single-digit revenue growth in it, and still above-market growth in 2023 as well. Add in a history of demonstrated excellence and some M&A optionality (as well as capital returns), and although these shares aren’t conventionally cheap (trading nearly 27x forward earnings), I think this is an increasingly tempting name.

 

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The Going Will Get Tougher, But Graco Will Keep Going

Graco: More Vulnerable To Sector Rotation And Slowing Comps Than End-Market Conditions

 

Every once in a while even great companies can go on sale, so with a definite shift in sentiment away from shorter-cycle industrials I thought it was time to take another look at Graco (GGG) in the hope that maybe the Street had moved on and left a better valuation in play. Yeah … no.

Graco has underperformed the broader industrial space since my last update (by about 10%) despite two very strong quarters, but that’s not enough to put the stock into value range. The business is performing very well and there could be more upside to my raised 2021 and 2022 revenue estimates (where I’m looking for growth of about 19% and 6.5%, respectively), but that doesn’t exactly put Graco into bargain territory. Should this short-cycle fade continue, though, it may be possible to get in with a decent long-term expected total return, so I’d suggest at least keeping this name on a watchlist.

 

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Graco: More Vulnerable To Sector Rotation And Slowing Comps Than End-Market Conditions

Graco Leveraged To Ongoing Economic Improvement, But The Valuation Is Already There

There is basically nothing to find fault with at Graco (GGG) from an operational or strategic perspective. Graco is a phenomenally well-run company with both strong operational efficiency (manufacturing, etc.) and strong product development and market share in its core markets. With exposure to a range of industrial markets, including autos, and leverage to growth trends like electric vehicles, I have no concerns about Graco’s ability to continue to outgrow its markets and compound its cash flows.

My concerns are solely on the valuation side. Graco has typically traded at a fairly robust premium to the industrial space (about 15% to 40% on forward PE), and that’s fair given the superior margins, returns, and growth. Still, I do believe the industrial space is expensive and already anticipates a lot of the recovery growth that is on the way.

If I had to buy an expensive industrial stock, I could certainly argue that Graco is one where I’ll sleep better at night and where there is a better-than-average chance of the company outperforming. Still, I don’t have to buy an expensive industrial stock, and I’d rather take the risk of missing out than buying into substandard future returns.

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Graco Leveraged To Ongoing Economic Improvement, But The Valuation Is Already There

Graco Is A Top-Tier Industrial Name, But The Price Is Not So Compelling

As I said in my prior piece on Graco (GGG), investors don’t often get a chance to buy into this top-notch industrial company at a traditionally attractive (or even reasonable) valuation. When that happens, as it did in March and April of this year, it’s usually because there’s abundant fear, if not outright panic, about the industrial sector. Since the spring, though, investors have returned to industrials with enthusiasm, with valuations pushed up by low rates and a fear of missing out ahead of what should be some good recovery numbers in 2021.

Graco is not only once again trading at a robust valuation, it’s trading at a pretty rich multiple on a historical basis. Then again, it’s not so out of line with other top-quality industrials, so I suppose investors more comfortable with relative valuation (or just less sensitive to valuation in general) may still find something to like here. While I can’t fault the quality of this name, and I’ve long advocated for the notion that valuation is not itself an impediment to further rerating, investing in high-multiple stocks like Graco really isn’t within my comfort zone or core focus.

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Graco Is A Top-Tier Industrial Name, But The Price Is Not So Compelling

Graco Pulls A Strong Quarter Out Of A Tough Macro

Graco (GGG) is a pretty special company for a lot of reasons, not the least of which is its ability to outgrow sometimes challenging industrial markets through price realizations and innovative product development. While nothing so far in this reporting season suggests underlying conditions were easier than expected (the opposite, if anything), Graco managed a stronger-than-expected quarter by once again executing to its strengths.

While they're very different businesses, stocks like Graco, Illinois Tool Works (ITW), and IDEX (IEX) put me in a bind when it comes to valuation. Graco is hands down an excellent company and clearly deserves a premium, but with the shares already above 18x forward EBITDA, it's difficult to construct a positive bull case other than "just think of the leverage when the economy turns back up".

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Graco Pulls A Strong Quarter Out Of A Tough Macro

Nordson And The High Cost Of Excellence

In terms of smaller industrial companies, I'm not sure that there are many that deserve the Street's esteem (and the high multiples that tend to go with it) more than Nordson (NASDAQ:NDSN). Management has taken the company's strong technology in precision dispensing and fluid management and used it to establish strong share in its core adhesives market, as well as solid long-term revenue growth, impressive margin improvement, and good returns on capital and free cash flow. I'd also note that management has shown itself adept at M&A but is willing to return capital to shareholders (with a 50-year-plus record of raising the dividend).

The problem with good companies, particularly when their end markets are turning up, is the valuation, and that's the case here. Using a DCF model, Nordson needs to generate very high single-digit to low double-digit revenue growth (with some FCF margin improvement) to generate a high-single-digit total return. That's a high, albeit not impossible, bar to reach, and some investors may be willing to accept a lower return (and lower implied/required growth) given the company's solid prospects and above-average quality.

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Nordson And The High Cost Of Excellence

Carlisle Companies Taking A Familiar Road To Growth

With over $3 billion in revenue and $7 billion in market cap, I'm surprised Carlisle Companies (NYSE:CSL) isn't a little better-followed than it is. While this conglomerate is heavily weighted toward construction, Carlisle's target markets are looking pretty healthy going into 2017 and management has done a good job of meeting and raising long-term growth and margin targets.

Following in the footsteps of companies like Danaher (NYSE:DHR), Illinois Tool Works (NYSE:ITW), and Parker-Hannifin (NYSE:PH) and with a clean balance sheet, I think Carlisle has a lot of options to add businesses through M&A in the coming years and improve them by applying its Carlisle Operating System. Although the stock looks rich now, that's a common issue in the market today and investors may want to run through due diligence with an eye toward adding shares if/when the market cools.

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Carlisle Companies Taking A Familiar Road To Growth

Seeking Alpha: Investors Have Bought Ingersoll Rand's Sizzle, Can They Deliver The Steak?

I'll give credit where it's due - the involvement of Nelson Peltz and his Trian Fund Management, and the willingness of Ingersoll Rand's (IR) management to embrace that involvement, has definitely delivered substantial near-term benefits to shareholders. These shares are up more than 40% over the past year as management has committed itself to a greater return of capital, improved operating efficiency, and the spin-off of its security business.

Things may even get better from here. There are actual signs of progress in margins, even though the company remains heavily exposed to end-markets (residential and commercial construction) that are not yet out of their trough. Even so, it looks like investors have already given management ample benefit of the doubt and fiddling with the balance sheet really doesn't seem likely to produce long-term value.

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Investors Have Bought Ingersoll Rand's Sizzle, Can They Deliver The Steak?

Seeking Alpha: EnPro: Another Strong Small Industrial With Questionable Value

Small-cap industrials can be a great source of alpha-generating investment ideas. In many cases, investors would rather spend their time on the latest hot tech idea than dive into the nitty-gritty of pumps, bearings, hydraulics and the like. That said, while EnPro (NPO) is hardly a household name, it's not immediately obvious that this small industrial components company is significantly undervalued at today's prices.

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EnPro: Another Strong Small Industrial With Questionable Value

Investopedia: Colfax Makes A Bold Bid

For some companies, M&A is in their DNA. Although most investors have likely never heard of fluid-handling specialist Colfax (NYSE:CFX), the company's major shareholders are the founders of Danaher (NYSE:DHR) and investors familiar with that conglomerate's long acquisitive history will see a similar story here. What is most remarkable about this most recent proposal, though, is its sheer audacity - if Colfax succeeds in acquiring Charter International (Nasdaq:CHITY), it will dramatically increase the company's debt load, revenue base and market exposure.


The Deal That May Be
It should be noted immediately that while Charter's board supports Colfax's bid, it is not a sure thing yet by any means. Nevertheless, Colfax has offered $2.4 billion in cash and stock for Charter International - a remarkably large bid given Colfax's present market capitalization of about $900 million.

Colfax is proposing to acquire Charter for 910 pence (about $14.45) per share, a 7% premium to the standing offer from Melrose to acquire Charter. That 7% premium may not sound remarkable, but Colfax is offering a package that includes about 80% cash, while Melrose's bid was only 35% cash. Based on current expectations, Colfax is offering about 0.75 times estimated 2011 sales, 8 times estimated 2011 EBITDA, and a little less than 14 times estimated 2011 earnings per share. (For related reading, see A Clear Look At EBITDA.)



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