Graco: Mastering The Flow - [Business Breakdowns, EP.178]

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1:08This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from, and we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

1:50This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. I'm Jesse Pugge, and today we're breaking down Graco, a leading manufacturer of fluid handling equipment and industrial products. Graco was founded in 1926 and has become a leader in the design and manufacture of systems used to move, measure, control, dispense, and spray a wide variety of fluids and powders. You might be familiar with Graco's products if you've ever used a paint sprayer, but Graco's equipment is used for much more than that. Their fluid handling systems are used on things such as gluing the soles onto shoes, pumping ink onto bills, lubricating heavy machinery, and even coating Doritos with flavored powders.

2:30To break down this $13 billion market cap company, I'm joined by Aaron Wasserman, managing member of Third Period Capital. We cover Graco's market position, its huge range of SKUs, and what the future might hold. Please enjoy this business breakdown of Graco. So today we're talking about a company that's a super interesting business. I think people are going to find it fascinating, but it's not incredibly well known. Graco, Graco Industries. Why don't we just jump in? What is Graco? What do they do? What do they sell? Help us understand it at a high level. So Graco is a company I have to admit, I know a little bit better than most because I'm from Minnesota originally.

3:07And so Graco is headquartered in Minneapolis. It was started almost 100 years ago as a great company. And essentially, fast forward to today, they make fluid handling equipment. And so if you think about valuable fluids or corrosive materials, things that need to be moved or monitored, their products would help with that. So that could be in a manufacturing setting where they are dispensing or monitoring the fluid movement throughout a production line. Or it could be the movement of the fruit filling that goes into a Pop -Tart that would be administered with a Graco pump. Or it could be a painting contractor would use a spray painter to spray your home or to align on a road.

3:53So there are several thousands of different SKUs, but essentially it's all about moving liquid or monitoring liquid that is either valuable or hard to handle. Who are their example customers? I mean, I could guess from what you just said, but who are some example customers? So a contractor would go into Home Depot or Sherwin -Williams and say, I need a new paint sprayer. I could use a paint roller to paint a home. It would take me two, three days, or I could use a paint sprayer and do one to two homes a day. So that's a productivity solution that that professional would go into Shore Williams.

4:23There would be two different options to choose from. There would be the Graco higher -end paint sprayer that costs $2 ,500, $3 ,000. It tends to be more reliable. There's higher user loyalty around it. It breaks down less. It's easily serviceable from the field, et cetera. Or you could go with a Titan sprayer, which is made by their chief competitor in that segment, a company called Wagner. The paint contractor would be a typical example. But Pepsi or whoever, I think Pepsi makes Doritos, they would, in the production of the Doritos chip business, use an oil sprayer to spray oil onto a chip that the ingredients of the Dorito would adhere to the chip.

5:04And so that's deep in a production line in a manufacturing facility. That would be a Graco customer as well. So they have contractor customers, they have industrial customers, and they sort of run the gamut, really. So it's almost like there's a B2B and a B2C division. How is it organized? Are those the two big divisions or are there other divisions? Essentially, you can think of it as for more B2C, which you could be a DIY or going into a Home Depot, you want to buy a paint sprayer. You're not necessarily paying for uptime. You're spray painting, you're finishing your lawn furniture for the season.

5:39You don't want to spend $2 ,500 for a paint sprayer. You'll go with the Wagner sprayer that's $1 ,000. But that's a pretty small part of their business. Home Depot is about 8 % of their revenue. There's more competition in that end. But at the higher end, where the systems are more complex, and the product could cost tens of thousands of dollars, which goes into an industrial system like we were talking about with Doritos or Pop -Tarts, that's a real business -to - business sale. There's very little competition there for Graco. It tends to be a more customized solution, harder to manufacture, harder to mass produce.

6:13So that's sort of the trade -off. They will sell into Home Depot. Price points are a little bit more competitive, but the manufacturing process is more automated. So that's where they can get their returns. Whereas more of the business really is industrial customers that have unique solutions where the Graco expertise is very important and therefore it's a high margin sale. And how big overall in revenue and any other numbers or stats that gives someone listening a sense for the scale of the business and the reach? It's very interesting. So they sell 70 ,000 SKUs. A lot of these products are in the field.

6:50These technicians have been using these products for decades. And so if you think about it, the technician buys the system, it could be a paint sprayer, it could be a greaser, lubricator, whatever. And over the lifetime of use of that product, there are aftermarket products because again, the liquid going through these systems is very corrosive. You can think of paint as liquid sandpaper, and it really wears down the system. And so you need these aftermarket parts and the stream of that revenue, that aftermarket streams about five to six times what the system costs. And so service is very important.

7:24And the reason I'm saying all of this is because their catalog of products is very, very large, but it all rolls up into about 2 .2 billion of revenue, which isn't that much. So these are really niche applications. They don't have a lot of competition in these niches. Gross margin for the business has been very stable historically at 51 % to 55%. We can talk about why. The pre -tax margin in the business is about 30%. And there's very little capex in the business. And so returns on invested capital are about that 30 % range, returns on equity 35 to 40%. It's honestly a very beautiful business.

8:04There's very little financial leverage in the business. So they've been generating those returns really just on the robustness of their flywheel. I want to come and talk in much more detail about the P &L in a second. Before we do that, you mentioned it was started 100 years ago. What have been a handful of the most important milestones and flexion points in the company's history? So it started with two brothers, Lyle and Russell Gray, who created essentially a better way to lubricate a car. In a cold winter in Minnesota, the grease guns would malfunction, they would become safety hazards, and they found a way to cut, I think it was 20 or 30 % of the technician's time and the material out of the lubrication of cars.

8:49As the depression kicked in, as the war occurred, they expanded their products at that core pump technology. They found uses for it in airplanes, combines, excavators, you name it. So they really expanded their products then. I think it was about the 60s or 70s where they really decided to expand geographically and really invest in their distribution. They now sell from third -party distribution in 100 countries. And that is just an incredibly powerful competitive advantage. There are a few CEOs that have really left their mark. George Aristides, I think in the 90s, he really pioneered a very deep ROI mindset at this company.

9:38So measuring not just the return characteristics of an acquisition or a capital expenditure program, but really hiring decisions, new product development spend, it was very measured, and he was very concerned that it hit a hurdle rate. And that ROI mindset is very deep in the company even to this day. Dave Roberts was the second CEO in the early 2000s. He came from the Marmon Group, which is owned by Berkshire Hathaway. And he did a wonderful job. He expanded margins. He took that ROI mindset to the next level. He left Graco in, I think it was 2007. In what I think is a little bit of a surprise, he left the CEO role to become CEO and chairman of Carlisle Companies.

10:25And he has an interesting role a few years later in the Graco story, which we'll come to. But then taking over from Dave was Pat McHale, who storied CEO, shop rat, started as an entry -level technician, worked his way up to become CEO, a number of roles in the company, a tremendous amount of humility, and honestly, evidence of some psychological safety around owning your mistakes. He made some acquisitions in the oil and gas sector that ended up not working out so well. They were small, but he was very vocal and public about owning them. And I think that that getting better mindset, continuous improvement, and just the willingness to make and own your mistakes is a big part of the culture today.

11:13And finding ways to suggest how to make manufacturing processes better and more robust, which is a key element to the culture today, it stems from the mindset and the personality that Pat had. And so I think those are the three characters that really left their mark with the company. And what's interesting is over the last 30, 40 years, the strategy of the business hasn't really changed. Talk about the competitive landscape or market they exist in. Sounds like in some places more competitive than others? And then what are some of their high -level differentiators? Sounds like culture is one of them, but what are some of the other big differentiators?

11:53At the low end, I keep coming back to paint sprayers. The competitor there is a company called Wagner. We don't know much about the financial profile of Wagner. It's a private German company. What's interesting about Wagner though, is the price points are lower. If you talk to the distributors, if you talk to people at Sherwin -Williams, I was just in a store the other day in Reseda, California. The store manager is wearing a Graco shirt, which is like, okay. But if you talk to him, he'll say, yeah, the Graco product is priced at a significant premium, but the loyalty of the users is much higher.

12:30The quality is better. It breaks down less. So the end users see a real value. The ROI to the customer is higher, even at that higher initial price point. But you'll also hear him say often that Graco holds more inventory. So it doesn't push as much inventory to Sherwin -Williams, which is a real benefit for them. And they can clear the inventory faster. So the turns on the Graco product are higher. And you can even see this at Home Depot. You'll see the sales technician from Graco leaving his business card or her business card right in the product display window. If you have any concerns, any questions, give me a call.

13:09So they just do a better job of canvassing distribution. They invest in their distribution. They do that more so than Wagner. I would say Graco spends about 4 % of revenue on new product development. Its competitors spend closer to 2%, which doesn't sound like a big deal, but consistently over decades, that really does add up. I don't know much about the manufacturing process of Wagner, but Graco designs and manufactures its product in Minneapolis for 90 -ish percent of their product suite. And so that co -location and that kind of mindshare between the two parts of the business, it creates more rapid innovation.

13:54It creates a tighter overlap between how do we solve the customer's problem and how do we implement this into the device. And my sense is their competitors don't have that. And the other thing that that creates is a much larger spectrum of products to offer the customer. So my guess is Graco's product catalog is much wider than that of Wagner. But look, Wagner is one. There are a few other small pump companies that are owned by large conglomerates. We don't have a lot of financial detail. Back to Berkshire Hathaway for a second. They bought a business called Scott and Fetzer. And that business owns a small pump company called Campbell Hossfield.

14:36And Campbell, Warren talked about it in his letters, is generating returns on equity close to 100%. So these tend to be small niche industrial businesses that are very well managed, very well run. You tend not to see moat attacks. Although interestingly, Interestingly, in 2011, Graco tried to buy the liquid finishing and powder cloning's business of ITW. ITW at that time was their largest competitor. And the FTC actually shut down the deal. So a few years later, they had to sell the liquid finishing piece of that business, which is the majority of the business, to Carlyle companies. So back to Dave Roberts, the old CEO of Graco.

15:19And at the outset, you could say, okay, this is fascinating. Here, Carlisle has the ability to replicate a mini Graco. They have this high quality asset. It was a high quality asset. Dave Roberts, plus a few other Graco employees had left Graco to come to Carlisle. So you have sort of the masterminds behind the business and you have the capital to do it. And it took them a decade. I think they tried for a decade. And then last year, they sold the business at a loss actually to private equity. And it's so fascinating because, gosh, you think, hey, here's a wonderful business. We know it really well.

15:57Let's replicate Graco. And they were not able to do that. Why? What are your theories? Is it product? Is it people? It sounds like they do everything well. They have high standards for everything. It's wild. I would love to learn more about this. But off the bat, the business that Carlisle acquired, this liquid finishing business, started to lose market share. And so that's odd. We don't exactly know what happened. But very quickly, Carlisle began making small acquisitions, add -ons to this business. And that probably wasn't the right time to be making acquisitions. Concurrently, there were some management changes.

16:39There were at least two management changes. So they didn't really have their feet under them. It is possible that they lost goodwill with their distribution. It is possible that their new product development program wasn't as effective as it should have been. It seems very clear they shouldn't have been making acquisitions. I don't know that they did a bad job, but they definitely didn't do the kind of job that Graco was doing in that business. Meanwhile, Graco took the piece of the business they could keep, which is the powder coatings business, and they've done very well with it. One, they have taken market share in that part of the business from some other industrial competitors, namely Nordson and Wagner, actually.

17:30And two, they are now expanding capacity for that business. So not only did Carlisle really stumble with this, but Graco seems to have been doing quite well. And actually, they sold their liquid finishing business at a gain. So Pat calls this a mistake. And I don't exactly know what he means by that because perhaps it was a distraction, but it wasn't a meaningful distraction. They actually made money on it. And by the way, to show you what a mensch Pat McHale is, he even donated part of the proceeds of that gain to the Graco Foundation and to the employees. So just a really high quality person.

18:09Earlier, you talked about the P &L. I want to try to wrap my head around it a little bit. So you said 50%, 51 % gross margins, pretty stable in time, 38 % operating pre -tax margins. Let's talk about revenue first. It's 2 .2 billion. How has it grown? and when you're sitting there thinking about how it has grown and will grow, what are the drivers of growth for a business like this? Yeah. If you look historically, the organic growth profile of the business is around 6 % a year. And that's really composed of 3 % industrial production growth, 2 % pricing growth, and 1 % new products and new initiatives.

18:49And that's really been an organic number. I would say that partly that's been a function of new product development. 20, 30 years ago, the vitality index of the company used to be 30 or more percent, meaning 30 % of the revenue comes from products introduced in the prior three years. That has fallen. So it is fair to say that return on new product spend perhaps has gone down over time. But nonetheless, in that 2 % to 3 % range, pricing growth has been about 2 % historically, and that should stick around. And I think a big reason for that is they are really adding value to their distribution customers.

19:33This is not a stocking channel for Graco. They are a real -time, you put in the order by noon, it's out the door by the end of the day. Often, about 40 % to 50 % of the time, it's an aftermarket part that their end user really needs. And so they're delivering a lot of value. So their compensation is through that 2 % pricing. In the past, acquisitions have moved the needle more than they have over the last five to 10 years. I think that that's an opportunity for Graco, hopefully not with large and levered acquisitions. But I know that Mark, the current CEO, has beefed up the corporate development rank, and hopefully that can be an opportunity of value creation.

20:17You mentioned the razor, razor blade model that they have. What's the revenue makeup of razors versus razor blades in the business? I think 60 % of revenue is new systems or products, whereas the accessories business is about 40 % of revenue. When you think of the M &A opportunities, they can sell more new stuff or more repeating stuff? And in what channel? How do they think about that strategy? I think the acquisitions that have worked the best for Graco have been around new capabilities or new application areas for some existing technology. So in the world of electric cars or semiconductor production, you need certain kinds of bonding materials or certain types of high quality adhesives.

21:10Or frankly, through a production process, there's a lot of heat that's generated in a production process. So cooling the plant requires the movement of fluid. So there are all of these niche applications that may or may not be explored by Graco's existing customer set. So buying small businesses that have a toehold into this end market have proven to be really helpful for Graco. I think in 2015, they bought a business that was very tied into semiconductor production. And I think Mark recently said that that business has grown by 10x since 2015. So I think, by the way, that was also aided by some one or two other valve acquisitions.

21:53But the point is that these niche opportunities can grow really quickly, very rapidly. And I think those are the best forms of acquisitions. I think of acquisitions as being another form of new product development, essentially. And is there a big universe or do you have a sense for the universe of these potential 10Xer acquisitions? These are small, privately held businesses. And the fact that Graco has been investing to find them at value accretive levels and hasn't really come up with that much over the last few years, I'm not discouraged by that. I think these are well -run businesses. They're not going to trade often, and that's just fine because Graco is deep in that pipeline and they are a preferred buyer.

22:40And most likely they're probably run by founders that will eventually want to turn that business over to Graco. And it seems like they have an amazing advantage in being able to absorb them and then push them through their distribution. Exactly. Pushing them through distribution, but also infusing a lot of intellectual property with respect to engineering, with respect to production, they are value -enhancing buyers. You'll probably see some competition from IDEX and some of these larger diversified industrial companies, although you really have to be canvassing these markets well. Again, they're niche opportunities.

23:17These are $20, $30, $50 million revenue opportunities. They're not massive. And so they may just not move the needle for a large buyer. I see this in other situations. Constellation Software can buy small vertical markets. Same sort of thing. If you're deep in a small vertical, you're going to know who all those wonderful operators are. And in the gross margin profile, what are the big cost buckets in the cost of goods for this business? So it's mostly metal and plastic because labor is actually a very, very small component of COGS.

23:53I And so it's really around procuring metals, plastics, moldings, that sort of thing. There's a ton of suppliers for that stuff. For sure, Graco will benefit from beneficial supply agreements. And again, because labor is such a small component here, it really does make sense to co -locate the manufacturing and the R &D. Because if you can accelerate your R &D flywheel, well, you're not missing out that much by having all of your labor in Minneapolis, for example. I'm not familiar with industrial businesses, a 7 % to 8 % best in class. Or what does that tell you about the business? I think it tells you that it's a very well -optimized company.

24:35So the other way to look at this is what's their sales per employee. And in the latest year, it was about 550 ,000 of revenue per employee. That has doubled in the last 15, 20 years. So they are incredibly efficient. And I don't know what the typical industrial company would look like, but I wouldn't be surprised if it were a third lower or more. In between gross profit and operating profit, it seems SG &A type stuff. Are there any notable cost buckets there? Same kind of question, like is sales as a percentage of revenue much lower? Are there other signals that it's that very well -run business?

25:14Yeah. So we talked earlier about new product development. So that's about 4 % to 5 % of sales. And that's been very constant for a very long time. G &A is about 7 % to 8 % of sales. There hasn't been much movement in that. I would say you've seen some leverage on the sales and distribution spend from more accessories, revenue being sold. You just don't need to invest in that much because you'd have a captive customer at that point. So they've been able to leverage that a bit. So I think 20 years ago, that sales and distribution spend was about high teens percent of revenue. Today, it's closer to low teens.

25:51So it's almost like they've kept this employee or fixed cost base, and they've just continued to get more and more out of it every single year. That's exactly right. And this is a good time to say the reason for that, and that's very intentional. Part of the culture of this company is, let's take our fixed cost base, our cost to produce. And the goal for the manufacturing team, and really for the whole company is let's keep that basket of goods, the cost to produce that flat year over year. How do we do it? What's so fascinating about this company is their culture is around what kind of suggestions, ideas can we offer to make our own internal systems more productive, more efficient?

26:32You'd say, well, of course, that's part of their culture because they are creating that in a product. Their product that they sell to customers is a productivity enhancing tool. And they prove it by instituting that as a core part of their culture. And so if you think about that, to keep your cost to produce flat year over year, that's a really challenging task, especially when the economy is doing what it's doing, metal prices are going to do what they do, and most of the time they accomplish it. And so you see that in the financial model as well. It feels like the apex for the whole company is productivity, whether it's our product, whether it's the way we show up, whether it's our relationship with our customers.