- Manufacturing business that seems globally-diversified, deeply-embedded in economic supply chain, and in a market niche, but manufacturing is not typically a high ROIC industry, partly because pricing is very tangible.
- ROIC calculation using NOPLAT rather than EBITDA less Capex due to recent acquisitions. Also excluded excess cash and goodwill and came up with a very impressive after-tax LTM 22.1% ROIC.
- Stock does not seem obviously discounted. Based on ROIC, growth and dividend, shares would be very attractive under 15x NOPLAT and FCF, but trade at 23-24x.
- Shares don't seem obviously expensive either though. If there is good execution and sustained 20%+ ROIC over the next 5-10 years, 23-24x is fine now, but those are big IFs.
- Avoiding the stock for now due to the above and other miscellaneous factors.
Recently, I've been attempting to become a more efficient investor through 1 hour general research of a variety of companies that show up on my screener or that I intuitively like from a glance. In these sessions, I've tried to gather as much information relevant to a comprehensive thesis as possible. The process has been very effective, but I am realizing that there are just a few very important factors that really make or break my interest in a company at this point. They are as follows:
- I want to be able to develop a reasonable understanding of the business (what can be obtained from reading critical sections of 10-K in 15-30 min) and being able envision the company continuing to perform as well or better than it is now into the distant future (at least 5-10 years out).
- The business has to generate high returns on invested capital (probably 15%+) consistently over long periods. The calculation can get complicated and occasionally I have to take multi-year averages to adjust for lumpiness in capital spending and other factors, so it often takes a significant amount of time, but I want to have a calculation I am comfortable with for every business I look at.
- I want to be able to glance at growth rates, current FCF, NOPLAT, EPS, revenue, etc. in conjunction with the company's ROIC calculated above and develop a strong hunch that the stock is discounted.
- I want to identify any obvious risks, headwinds, or other issues and reasons not to invest.
I will not necessarily stop using my other approach to preliminary research, but I would like to implement this method as well. As before, I will approach the preliminary research with an emphasis on finding reasons not to invest. A healthy dose of skepticism can be a wonderful quality in investing and I feel I've benefited from this in the recent past. I run a very concentrated portfolio of 2-3 positions which enables me to be highly skeptical of ideas as well.
Introducing Graco (GGG)
Graco is a mid-cap US industrials company with a market cap of $4.7B and $1.12B LTM revenue that I'd never heard of whatsoever until it showed up on my screener tonight.
The company is an industrial manufacturer with a very specific focus on 'systems and equipment to pump, meter, mix and dispense a wide variety of fluids and coatings.' Despite the specific focus (which is great and opens the company up to a niche market position), the company actually seems to have a highly diversified revenue stream and the pumps, sprays, etc. that it produces are used in the manufacturing of a great variety of finished goods globally. US Sales only made up 45% of the company's total in 2013:
Source: Graco 2013 10-K
59% of sales is in the Industrial segment where the company sells its products as a supply to another manufacturer that makes a larger product. In that sense, Graco's products seem deeply embedded in the supply chain and safely distant from consumer preferences, which is good.
Despite all of this, I have not known many manufacturers that generate high ROIC over long periods of time. The only I can think of right now is Polaris Industries (NYSE:PII), and that is very much a consumer discretionary products company as much as a manufacturer. Manufacturing product value is very visible and tangible- pricing is usually just cost plus margin rather than value-added pricing which I very much prefer.
The company boasts spending nearly 5% of revenue on product innovation or R&D. I don't know that this is a whole lot but management seems to think it is and it certainly seems discretionary based on it being a fixed percentage of revenue over the last 3 years.
The company is so diversified, has such a narrow/niche focus, is deep in economic supply chain, and spends enough on R&D that I wouldn't be surprised if it was still a high margin, high ROIC business in 10 years, but I am not all that confident in that. I don't really feel convinced.
The company made a few acquisitions this year and last, so I used EBIT rather than EBITDA less Capex in my calculation of ROIC. The company also seems to have excess cash. Cash/total assets is 35% and cash levels have not really fluctuated much from quarter to quarter in the past year. To play it safe, I assumed just half the cash to be excess and not part of working capital, but it could be higher. I also excluded goodwill as ROIC ex. Goodwill is a better indication of forward business quality and goodwill is a false asset and a sunk cost that reflects management M&A competence rather than organic business returns on capital. With all that, I calculated 22.1% after-tax LTM ROIC. That is very good. Anything more than 8-10% is above average.
Earnings have grown 11% over the past 5 years, are expected to grow 15% annually over the next 5, and the company pays a small dividend. Based on that and the company's strong ROIC, I'd think the stock to be at a very attractive price at a low to mid-teens multiple of NOPLAT. However, the stock trades for 24x LTM NOPLAT, 4.3x sales, and 23x FCF. High multiples like that can often be justified by sustained high ROIC. If the company does end up sustaining ROIC in excess of 20% for a long time, the stock is probably very reasonable even at 23-24x NOPLAT and FCF, but that sustainability is very questionable in my view and regardless of whether the company continues to execute, the stock does not seem obviously cheap at this point.
I also don't like that it is a smaller company with lumpiness in capital spending. I question why there is excess cash remaining on balance sheet while a comparable amount of LT debt remains unpaid. I also was disappointed that I didn't discover anything special about the business. I am not necessarily looking for exciting businesses that are fun to read in the news about like Twitter, Netflix, etc. What I mean is business qualities that are unique, material, and very beneficial. For example, my largest holding, Express Scripts (NASDAQ:ESRX) has leading market share that is exacerbated by the company's unrivaled focus on higher margin, more convenient mail-order prescription delivery.
Graco sports very high ROIC but there is a good chance the company will have trouble sustaining that over 5-10 years as a manufacturer. The stock also does not seem obviously cheap in my opinion. I am moving on for now.
Disclosure: The author is long ESRX. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.