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Graco Inc. (GGG), IDEX Corporation (IEX): This Niche Industrial Company Avoids the Big Boys to Its Advantage

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 Inc. (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.

Graco Inc. (NYSE:GGG)

Gross margin stability reflective of market leadership in niche market

Graco Inc. (NYSE:GGG) 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 Inc. (NYSE:GGG) 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 Inc. (NYSE:GGG) 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 Inc. (NYSE:GGG)’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 Inc. (NYSE:GGG)’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 Corporation (NYSE:IEX) , and Dresser-Rand Group Inc. (NYSE:DRC) .

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