This Niche Industrial Company Avoids the Big Boys to Its Advantage

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Many investors love companies operating in large markets with huge potential for growth. For me, size is a magnet for competition, and I like leaders operating in niche markets that are too small to be economically efficient for the big boys to compete in. Graco (NYSE: GGG), a manufacturer of equipment used in the pumping, metering and dispensing of various types of fluids and coatings, is a perfect example of that.

Gross margin stability reflective of market leadership in niche market

Graco exhibited strong margin stability historically, having achieved gross margins with a narrow range of 52% to 56% for 10 years from 2003 through 2012. Two key factors are responsible for Graco’s consistent profitability.

Firstly, Graco benefits from high customer switching costs. Graco’s customers weigh the pros and cons of switching and decide that the costs of switching pertaining to tarnished reputations outweigh the benefits of switching in terms of lower prices. Graco produces equipment used in the application of paint and other coatings to different products, such as automobiles and furniture. An automobile that does not look as good as it should because of inferior equipment and lousy paint jobs will be detrimental to the brand equity of Graco’s customers.

Secondly, premium industrial pumps are part of a niche market efficiently served by Graco. which enjoys out-sized economic profits. The barrier to entry for the market is that the pie is simply too small to be shared, and new entrants will make it uneconomic for all the market players. The biggest threat in niche markets comes from irrational competitors introducing cut-throat price competition. However this is not an issue here, as Graco’s customers value quality, suggesting that price wars would be a viable strategy.

Spending for the future bears fruit

Graco spent an average of 4% to 5% of its sales on product development for the past three years, which is much higher than the average of 1% to 2% of sales devoted to R&D for its industrial peers. The key to assessing research and development spending is to focus on the direct sales contribution of such investments instead of just examining the costs as a percentage of historical sales. Graco generated 17% and 20% of its fiscal 2012 and 2011 revenue, respectively, from new products introduced in the past three years. This bears testimony to the success of Graco’s product development pipeline, as it shows that Graco is reliant on old legacy products to stay afloat.

Growth drivers

Graco registered record quarterly revenue and earnings for the first quarter of 2013, partly driven by a better showing for its industrial segment in the Asia Pacific region. Gross margins remained high at 56%, which are reflective of Graco’s pricing power.

Graco derived slightly more than half of its fiscal 2012 revenue from North America, with Asia Pacific and Europe accounting for 25% and 22% of its top line, respectively. Management has guided for year-on-year sales growth in all of Graco’s geographic regions in fiscal 2013, with a stable U.S. market offsetting challenging economic environments in Western Europe and Asia Pacific. Despite this, Graco is targeting new areas of growth in the Asia Pacific region, such as sanitary pumps and external wall sprays for construction purposes in China.

As mentioned earlier, new products are a key driver of growth for Graco. New products in 2013 include the dual control electric piston pump, which delivers higher energy efficiency; electrostatic applicators that improve spray performance; and other new sprayers.

Peer comparison

Graco’s peers include IDEX (NYSE: IEX), and Dresser-Rand (NYSE: DRC).

IDEX operates in four business segments: fluid and metering technologies, health and science technologies, fire and safety and diversified products. The fluid and metering technologies division is IDEX’s biggest revenue driver, accounting for more than 40% of its top line. For the first quarter of fiscal 2013, IDEX grew quarterly earnings per share by 12% year-on-year, despite a modest 1% increase in revenue. This was the result of IDEX’s favorable cost structure benefiting from its restructuring activities in 2012. IDEX’s strong free cash flow also suggests potential catalysts in the form of accretive acquisitions or share buybacks.

Despite this, I am negative on IDEX’s analytical-instrument and fuel-transfer equipment segments, which are vulnerable to decreases in health spending and fuel prices.

Volatility and competition

Dresser-Rand is one of the world’s largest suppliers of custom-engineered rotating equipment solutions, such as centrifugal and reciprocating gas compressors, for its oil and gas clients. Although its quarterly revenue and earnings were up, total bookings fell by about 20% compared with a year ago. This should not be a major issues, as Dresser-Rand’s earnings tend to be back loaded with the fourth quarter contributing a significant proportion of full-year earnings.

But I still have two major concerns with Dresser-Rand. One of them is that its sales of oil-field equipment are affected by the volatility of oil and gas prices. Another concern is that of keen competition from larger players like Siemens in its area of operations. This is in contrast with Graco, where large competitors are deterred from competing in its niche markets because they are too small.

Conclusion

Graco is on my watch list because of its gross-margin stability and success with past R&D investments. However, it does not look too attractive on valuations, given a forward P/E of 19.6 and a forward dividend yield of 1.5%. If the stock price corrects to give a yield above 2%, I will be much more interested in taking another look.

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