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Investment Thesis
Graco (NYSE:GGG) benefited from the strong demand in the housing and remodelling industry and other industries such as industrial lubrication, automotive, etc. in FY21. In the last few quarters, due to supply chain constraints, the backlog of orders started building up. This backlog is expected to benefit the company's revenue growth in FY22 along with the pricing actions taken in the year. However, the slowdown in the housing industry due to interest rate hikes is a major headwind for the company's revenue. On the margin front, the company should see some sequential improvement as the backlog that was priced at FY22 rates gets converted. The stock price has corrected over 25% from its all-time high of ~$81 and is currently trading at 22.61x FY22 earnings. I believe the headwinds and tailwinds facing the company are appropriately getting priced in at the current valuations, and prefer to be on the sidelines.
Business Basics
Graco is a manufacturer of systems and equipment that manages fluids and powder coating materials. The business is further classified into three reportable segments namely: Industrial, Process, and Contractor with each segment selling its products in the Americas, EMEA, and the Asia Pacific regions. The Industrial segment is the largest of all the segments and has end-users in the rail, automotive, marine, aerospace, and other industries. The segment specializes in designing and manufacturing equipment that applies paints and coatings. The Contractor segment offers sprayers that apply paint to walls with the end-users ranging from DIY homeowners to professional contractors. The Process segment manufactures pumps that move various fluids and has an end market in the Food and Equipment, pharmaceutical, wastewater, automobile, mining, and other industries.
Segment wise and Geographical revenue distribution (GS Analytics, Company data)
Mixed Revenue Outlook
Graco's revenue growth was flattish from FY18 to FY20, however, in 2021, the company saw strong demand for its products given the strength in the construction and remodelling industry, resulting in revenue growth. GGG's business is normally short-cycle and the company usually does not report any backlog. However, over the last few quarters, the longer lead times due to supply chain constraints in key materials and components such as electronics, castings, engines, and motors have led to an increase in backlog. The order backlog at the end of Q1 FY22 stood at $445 mn compared to $375 mn at the end of the last fiscal year.
Graco's revenue growth (Company data, GS Analytics Research)
In FY22, the company implemented its annual price increase, but due to the size of the year-end backlog, which was booked at last year's pricing, the company was not able to reap the benefit of this price hike in the last quarter, i.e., Q1 FY22. However, a majority of last year's backlog has been shipped; therefore, we should see the benefit of this price increase in the company's revenue from the second quarter of FY22 and throughout the fiscal year.
The headwind related to the supply chain constraints heavily impacted the sales in the EMEA region of the Contractor segment in Q1 FY22. As the availability of electronic components such as motors, chips, etc. in the EMEA region improves, the company should be able to ship its products, which should benefit the segment sales.
On the flip side, the rising interest rates and the lower housing starts in May 2022 (Y/Y and sequentially) should be a concern for the Contractor segment's growth. The Contractor segment which is ~38% of the company's revenues offers sprayers for painting walls to DIY homeowners as well as professional contractors and derives 3/4th of its revenues from Americas geography. The rising interest rate is a major cause of concern for this segment and should have a negative impact on its growth.
The Industrial segment witnessed good demand for its products in Q1 FY22 across all the major geographies, and the logistical constraints and component shortages led to a Y/Y increase in the backlog by $75 mn. The growth across both the Industrial and process segments is expected to be in double digits given the demand in the end markets and the healthy backlog across both the segments. Also, the company is expected to do a Capex of $190 mn of which $140 mn should be in facility expansion projects. Management is anticipating high single-digit growth in FY22.
While backlog conversion may support growth this year, rising interest rates and lower housing starts are a cause of concern in the medium to long term.
Pricing Action to Help Margins
After falling severely in Q2 2020 due to Covid-induced lockdowns, Graco's margins sharply recovered in 2H 2020. However, the higher input costs and the negative translation affected the company's margins from Q2 2021 onwards. In the last quarter, the gross margin dropped by 300 bps Y/Y to 51.5%. The gross margin pressure and the higher operating expenses led to a 200 bps Y/Y drop in the operating margins. The operating margin in the Contractor segment dropped 500 bps Y/Y to 25% as the component shortage led to lower sales of higher-margin products. The margins of the process segment declined 100 bps due to the cost pressures on the key components whereas the Industrial segment benefitted from volume leverage.
Graco's operating margin (Company data, GS Analytics Research)
Looking forward, the operating margin of the company is expected to benefit from the pricing actions in the first quarter of 2022. The company has almost sold its backlog booked in the previous year, so the price hikes in 2022 should start benefiting the profitability from Q2 FY22 and throughout FY22. The pricing actions in 2022 are expected to offset the input cost pressures on a dollar basis, resulting in a modest gross margin improvement in the second half. This should benefit the operating margins in FY22. Also, comparisons are easing from the second quarter as the company first started seeing the impact of input cost inflation from Q2 FY21. So, I am optimistic about the margin outlook.
Valuation & Conclusion
Graco Inc. is currently trading at a P/E of 22.61x with a consensus EPS estimate of $2.64 for FY22 and a 20.63x consensus EPS estimate of $2.89 for FY23, which is lower than its five-year average P/E non-GAAP (FWD) of 28.22x. The company's revenue is expected to benefit from the price hikes in 2022 and backlogs, however, the headwinds related to interest rate hikes and the slowdown in the housing market are major concerns for Graco. While the stock is trading at a discount to its historical levels, I believe it is justified given the mixed revenue outlook. Also, other industrial names related to housing have corrected significantly and are trading at much lower valuations (for example, our buy-rated Pentair (PNR) is trading at just 12.45x FY22 P/E). Hence, I have a neutral rating on Graco.
