A High-Quality, High-Profit Widget Maker

02/01/2010 10:14 am EST

Focus: STOCKS

Josh Peters

Editor, Morningstar DividendInvestor

Josh Peters, editor of Morningstar DividendInvestor, and analyst Anil Daka, say Graco is a top-notch, profitable manufacturer that pays out a fat dividend.

Relentless cost control and continuous investment in research allow Graco (NYSE: GGG) to have the best of both worlds: an innovative, high-quality product line that is relatively inexpensive to manufacture. The firm produces extremely strong returns on invested capital (consistently greater than 25%), and we think it is protected by a wide economic moat.

Graco’s many products cater to the construction, automobile, and processing industries. The firm’s product line includes paint sprayers, vehicle lubrication systems, food-processing pumps, and spray foam systems. Graco’s quality stands heads above the rest. The firm inspects nearly 100% of its output, and spends less than 1% of sales on warranty costs. Such quality cognizance translates into high customer satisfaction that competition has not replicated.

In a recent survey of paint contractors by Foster & Sullivan, 71% preferred Graco, and just 11% favored the nearest competitor. We think Graco’s focus on innovation bodes well for the firm. About 4% of revenue is spent researching and introducing new products.

In fact, the firm strives to derive 30% of annual sales from products it introduced during the previous three years. These new products drive revenue growth and help extend Graco’s already substantial lead over the competition. The firm grew 12% annually between 2002 and 2007 on the strength of new product introductions.

Simultaneously, Graco streamlined its production processes to increase operating margins from the single digits in the early 1990s to their present 22%. Graco is the most profitable widget maker that we cover.

Even though Graco continues to execute well, difficult macroeconomic conditions will damp near-term earnings. To offset these forces, the firm announced an 8% reduction of its work force, and we also expect Graco to advance the introduction of some key new products to improve its revenue outlook.

Although per-share earnings declined 71% in the first nine months of 2009 and fell slightly short of the dividend, Graco’s conservative balance sheet and hefty cash flow provide ample support for the dividend. Long-run earning power should be more than sufficient to cover the current payout.

Despite the 2009 downturn, Graco announced a 5.3% dividend increase on December 4th for a tenth straight year of dividend growth. We believe this demonstrates management’s confidence in future earnings prospects, as well as a commitment to rewarding shareholders through thick and thin.

But while our current financial forecasts support a long-term dividend growth rate of 8%, driven by sales growth, acquisitions, and share repurchases, smaller hikes are likely until Graco’s earnings return to pre-recession levels.

Our fair value estimate of $28 implies limited price up side in the next year or so (it closed below $27 Friday—Editor), but a current yield of 3% plus long-term growth of 8% suggests long-term returns to current holders can still top 10%.

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