The Shares Of Graco Are Still Overpriced – Seeking Alpha

Shares of Graco Inc. (GGG) are down about 15%, and this has put this dividend aristocrat on my radar. I thought Id look in on the shares to see if theyre worth buying at the moment. Ill answer this question by reviewing the financial history here, and by looking at the stock itself. For those who have missed the title of this article, and have skipped the bullet points above, Ill jump to the point: this is a great company, and the dividend is safe in my view, but the shares are overpriced. Just because I dont think theres value at current prices doesnt mean that I think theres no value here, obviously. Thankfully, the options market presents investors with the opportunity to generate cash by agreeing to buy this great company at a great price.

The financial performance over the past few years has been impressive in some ways. For instance, sales have grown at a CAGR of about 5% since 2015. In spite of that, though, net income was basically the same in 2019 as it was in 2015. On the other hand, cash from operations has exploded, having grown at a CAGR of ~17%. For their part, management has spent about $484 million on share buybacks over the past five years. In addition, theyve returned just over $418.6 million to owners in the form of ever-growing dividend payments. This has caused those dividends per share to grow at a CAGR of about 10% over the past five years. In my view, the future of the dividend here is of critical importance, and Ill spend the rest of my words trying to work out how sustainable (or not) the dividend actually is.

After looking at it, I think the dividend is sustainable here for a number of reasons. First, the companys traditional payout ratio (i.e. dividends divided by EPS) is quite low, and dividends relative to cash from operations per share is even lower. Second, the company has cash on hand of ~$220.9 million, which is greater than the estimated outflows over the next three years, per the table below. In addition, the company generated ~$418 million from operations over the past year.

Finally, as of December 27, 2019, the company had unused credit lines of ~$546 million. Investors who are either interested in reading more about the debt picture here, or are suffering insomnia, are advised to check out pages 44-45 of the latest 10-K for a more full discussion of debt here. Ive done that work and have concluded that debt will not crowd out dividend payments. In sum, comparing the sources of cash to the obligations laid out in the table below suggests to me that the dividend is reasonably safe here.

Source: Latest 10-K, author compilation

Source: Company filings

Nothing Ive ever written or said will be as well known or impactful as something like the (alarmingly authoritarian sounding) phrase ask not what your country can do for you, ask what you can do for your country or Mr. Gorbachev, tear down this wall brought to the world by Raegans great speechwriter, Peter Robinson. Ill never match those or countless other famous turns of phrase that offer interesting insights into the human condition or the politics of a particular time period. What I lack in insight, though, I make up for in repetitiveness. My small circle of friends and associates know me for repeating one phrase: The more you pay for something, the lower will be your subsequent returns.

Although my phrase lacks the depth and timeliness of something like we have nothing to fear but fear itself, it does stick with people because I bludgeon the listener with near-constant repetition. The result is that whenever I pull out this truism in conversation, phrases like drone on and yeah, we know and shut up about it, already soon follow. Its an almost liturgic call and response between my friends and I. Id like to take the opportunity to welcome you, dear reader, to this now virtual community.

In case its not obvious, the point of the phrase is that price paid is the single largest determinant of the returns the investor will enjoy over time. If a company can produce a stream of future cash flows discounted to a value of X, paying more than X will lead to terrible returns, and paying less than X will lead to great returns. For that reason, I think investors need to obsess about not overpaying for a given companys future cash flows.

I judge the risk of overpayment in a few ways. Most simply, I look at the ratio of price to some measure of economic value. If the company is trading at a low price relative to its own history and to the overall market, thats a good sign in my view. On that basis, Graco is hardly cheap, per the following chart.

Interestingly, the valuation has held up relatively well here. In fact, the shares are priced at approximately the same level as they were over the past three years. This is troublesome in my estimation. In addition, I think a PE of 23 times is objectively too expensive for most companies. For that reason, I cant recommend the shares at current levels.

Data by YCharts

Source: YCharts

In addition to looking at the simple ratio of price to economic value, I want to understand what the market is assuming about the long-term growth rate of the underlying company. The more optimistic the market, the more risky the stock. In order to work out what price is telling us about future expectations, I turn to the methodology outlined by Professor Stephen Penman in his book Accounting for Value. In this book, Penman walks an investor through how they can isolate the g (growth) variable in a standard finance formula to work out what the market must be assuming about long-term growth. Applying this methodology to Graco suggests that the market is assuming a growth rate of about 7% for this company. Thats massively optimistic in my view, and is another reason I cant recommend buying the shares at these levels.

Because I dont think theres value at current prices doesnt mean I think theres no value here. I think shares of Graco Inc. are trading above the rate of their discounted future cash flows. That said, I would be willing to buy if shares traded in the mid-30s. This presents me with what I consider to be a fairly easy choice. I can wait for shares to drop in price from here. The problem with this approach is that its deadly dull and the shares may never actually drop to a level that I consider appropriate. Alternatively, I can sell put options, on which I make money by selling to people the right to sell me this company at a price I want to pay for it.

Given that Id be comfortable buying in the mid-30s, my preferred options at the moment are the November puts with a strike price of $35. These are currently bid-asked at $1.40-$3.50. If the investor takes the bid on these puts, and is subsequently exercised, theyll be obliged to buy at a net price about 27% below the current level. Holding all else constant, this corresponds to a PE of about 20, and a dividend yield of about 2%. For my part, Id be happy to own these shares at this level.

Investing, like life in general, involves making choices among a host of imperfect trade-offs. Not to name drop, but when I was interviewing him in his Kitchen, Jordan Peterson reminded me that theres no risk-free option. Theres risk a, and theres risk b. We do our best to navigate the world by exchanging one pair of risk-reward trade-offs for another. For example, holding cash presents the risk of erosion of purchasing power via inflation and the reward of preserving capital at times of extreme volatility. The risk-reward trade-off of buying shares should be pretty self-evident in early 2020. For those who are just emerging from their hibernation, I'd suggest the risk-reward trade-off for stock ownership involves the potential for capital loss weighed against the potential for capital gain.

Put options are no different in this regard. I've described the reward potential of these often, so I'll spend the rest of this section talking about their risks. I think the risks of put options are very similar to those associated with a long stock position. If the shares drop in price, the stockholder loses money and the short put writer may be obliged to buy the stock. Thus, both long stock and short put investors typically want to see higher stock prices.

Puts are distinct from stocks in that some put writers don't want to actually buy the stock; they simply want to collect premia. Such investors care more about maximizing their income, and will therefore be less discriminating about which stock they sell puts on. These people don't want to own the underlying security. For my part, I'll only ever write puts on companies that I'd be happy to own, at strike prices that represent good entry points for me. For that reason, being exercised isn't the trauma for me that is for many other put writers.

In my view, put writers take on risk, but they take on less risk (sometimes significantly less risk) than stock buyers in a critical way. Short put writers generate income simply for taking on the obligation to buy a business that they like at a price that they find attractive. This circumstance is objectively better than simply taking the prevailing market price. This is why I consider the risks of selling puts on a given day to be far lower than the risks associated with simply buying the stock on that day.

Since I've never passed up the opportunity to belabour a point, allow me to drill this into your head even further using Graco as an example. The investor can choose to buy the shares today at a price of ~$45.00. Alternatively, they can generate a credit for their accounts by selling put options that oblige them - under the worst possible circumstance - to buy the shares at a net price 27% below today's level. In my view, that is the definition of lower risk.

Although I think Graco Inc. is a fine company with a great dividend history. More importantly, I think that dividend is safe at the moment, and I think that will go a long way toward supporting share price. The problem is that most of that good news is already priced in. I dont have a problem with the company, and would be happy to own it at the right price. In my view, the problem is that the price is not right at the moment, and investors who buy at current levels face more downside than upside. Thankfully, its possible to generate some money by selling put options at the moment. If the shares remain overpriced, the investor simply pockets the premia, and thats never a hardship. If the shares fall in price, the investor will be obliged to buy a great company at a very good price.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I will be selling 10 of the puts mentioned in this article.

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The Shares Of Graco Are Still Overpriced - Seeking Alpha