Graco Inc - Company with High Risk to Dividend Growth

Graco Inc. (GGG) and its subsidiaries, provides fluid handling systems and components. Its products are used to move, measure, control, dispense, and spray a wide range of fluids in Industrial, Contractor and Lubrication applications. The company was founded in 1926 and has headquarters in Minneapolis, Minnesota.

GGG is part of S&P Mid-Cap 400 Index and has been increasing dividends for last 10 years (including the latest one). The most recent dividend increase of 2.7% was in December 2009. In last 10 years, the annual dividends have increased from $0.13 per share to $0.80 per share.

Trend Analysis
Here I am looking at trends for past 10 years of company’s revenue and profitability. These parameters should show consistently growth trends. The trend charts are shown in images below.

• Revenue: Growth until 2006, flat since 2006, drop in 2009. The average revenue growth for last 10 years has been approximately 3.3%. Year 2009 revenues significantly lower this growth rate.
• Cash Flows: Overall, until 2008, a growing trend of free cash flow and operating cash flow. Most of the time FCF is more than net income.
• EPS from continuing operation: In general, it had an increasing trend until 2007, and significant drop in 2009.
• Dividends per share: Growing trend.

Risk Parameter Calculation
Here, I use the corporation’s financial health to assign a risk number for measuring risk-to-dividends. The risk number for risk-to-dividends is 2.24. This is a medium risk category as per my 3-point risk scale. High payout factor, significant reduction in operating margin, and negative EPS growth makes this medium risk dividend stock. It is very close to being a high risk to dividend stock.

Quality of Dividends
This section measures the dividend growth rate, duration of growth, consistency over a period of past five years.

• Dividend growth rate: The average dividend growth of 10.5% (stdev. 23.65%) is more than average EPS growth rate of 1.9% (stdev. 14.3%).
• Duration of dividend growth: 10 years of consecutive dividends growth.
• 4 year rolling dividend growth rate for past ten years: Less than 10%.
  
• Payout factor: It has been less than 37%. But 94% for 2009.
• Dividend cash flow vs. income from MMA: Here, I analyze how the dividend cash flow stacks up against the income from FDIC insured money market account. The baseline assumption is (a) stock is yielding 2.3%; and (b) MMA yield is 1.75%. With my projected dividend growth of 9.3%, the dividend cash flow is 1.54 times the MMA income in 10 years time period. For dividend cash flow to be twice the MMA income, the pricing has to be $31.2 (i.e. yield 2.4%)

Fair Value Calculation
This section determines what price I should pay to buy a given stock

• Net present value (NPV) price based on 15 year DCF: $21.7
• Average high yield price calculated based on past 10 years: $26.4
• Pricing based on past 10 year relative price-to-earnings ratio. $31.9
• Pricing based on price-to-earnings ratio of 12: $20.9
• Graham number: $10.3 The range of fair value is calculated as $20.6 to $8.9.

Qualitative Analysis

GGG intends to focus of its core competency of solutions/components for fluid management systems. Its strategy for growth consists of expanding in emerging markets and value added acquisitions.

• Its revenue is diversified in Americas (55%), Europe (29%), and Asia/Pacific (16%). In addition, its also has diversified revenue stream from industrials (55%), contractor equipments (33%) and lubrication equipments (11%).
• It continues to have stable to growing cash flows.
• It has also taken a bit of debt. If the growth plans do not materialize, servicing debt will be challenge.
• More than half of its revenues come from industrial sector. However, its presence in growing industrial sector of emerging markets (i.e. China and India) is week. It needs to expand in these markets. This will be risk factors to its growth.

Conclusion
Graco Inc. has enjoyed a stable and slow growth for last few years. It has a well defined growth strategy around its core competency. It continues to have a positive cash flow. The present dividend payout is very high. However, a continued weakness is end market (i.e. US and Europe) can affect dividend growth in near future. The stock’s current risk-to-dividend rating is 2.24 (medium risk), which is very close to being a high risk. I would continue to watch for any changes w.r.t lower dividend risk and or falling into my fair pricing range.

Full Disclosure: No position at the time of this writing.

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