Cintas: Strength In Core Operations Offsets Weakness In Ancillary Divisions

Feb.18.13 | About: Cintas Corporation (CTAS)

We entered into a long position in Cintas (NASDAQ:CTAS) in March. Despite the market volatility having an impact on the company's share price, we are pleased that the company has been able to meet our expectations. We have been interested in Cintas for the longest time as it is the industry leader in the uniform rental business and we also like that the founding family (the Farmers) has transitioned its management and ownership interests to the third generation of family leadership (Scott Farmer). We are attracted to Cintas because not only does the company dominate its next two peer competitors (Unifirst (NYSE:UNF) and G&K Services (NASDAQ:GK)), we find that there are operational execution barriers (economies of scale) to entry that will enable Cintas to maintain its lead and expand its business.

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Source: Morningstar Direct

We remembered back in 2007 that Cintas was the subject of a failed $8B buyout bid. Based on the company's allocation of free cash flows over the last 10 quarters, we believe that the Farmer family is effectively creating a "homemade-leveraged buyout" as the company has repurchased ~$1B in stock during this time period. The company has been able to reduce its outstanding shares from 152.8M as of FY 2010 to 123.2M as of H1 2013. The company has financed this through $345M of its free cash flows from business operations and $525M in newly issued debt. Cintas's board authorized a $500M share buyback program in October 2011 and repurchased $281M in the last 12 months, leaving $219M remaining on the program's authorization.

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Source: Morningstar Direct

Cintas's continues to generate steady performance and the Q2 2013 period was no exception. Despite facing a challenging macroeconomic environment, the company still registered 3.4% organic revenue growth on a year-over-year basis. Its core Rental Uniform and Ancillary Products Business segment represents the lion's share of revenue for the company and it generated 4.6% revenue growth. Pre-tax segment income grew by 11.1% on the strength of revenue growth and positive operating leverage resulting in a nearly 3.45% decline in SG&A expenses, even taking into account higher cotton prices providing headwinds to the gross margin. This segment accounted for 71% of Cintas's revenue during the quarter though its gross margin eased downward by 130bp. The segment's gross margin declined due to the following factors:

  1. The write-off of a $1.6M garment processing system that failed to provide the expected operational improvements.
  2. Increased materials costs due to garment injections associated with new business
  3. Weak customer hiring demand constraining its ability to utilize existing inventory
  4. Expansions of its route capacity in order to serve new customers

Cintas's fastest growing segment is the First Aid, Safety and Fire Protection segment. This segment enjoyed the fastest revenue and profit growth of all of Cintas's business segments for the last two quarters and for the 2012 fiscal year. Q2 2013 segment revenue grew by 9.66% however a narrower gross margin resulted in only 7.7% segment profit growth. Organic growth for this segment was 4.8% but its gross margin decreased by 70bp year-over-year. This decrease is primarily due to a heavier mix of National Account fire business in the second quarter compared to the other quarters, as well as the impact of some acquisition-related costs incurred during the quarter. The segment accounted for 10.5% of CTAS's revenue during the quarter and its steadily increasing its share of the company's revenue each quarter.

Cintas also has a Uniform Direct Sales segment. This segment had flat sales performance during Q1 2013 and Q2 2013 and soft profit performance during this time period. Q2 2013 profit declined by 21.4% and revenue edged downward by 1.5%. We agree with the cautious tone for this segment articulated by Cintas management but were displeased to see its soft gross margin performance. We are pleased that management is planning several large rollouts in the second half of the year in order to restore growth in this business. This segment generated just over 10% of the company's revenue and is its 3rd largest business segment in terms of revenues and profits. The business segment's gross margin decreased by 220bp due to the change of the segment's product mix as well as due to the timing of new product rollouts.

Cintas's last business segment is the Document Management segment. This business segment continues to see weak performance, with Q2 2013 profits sagging by 51.5% versus prior year levels. The primary cause of revenue and profit weakness in this business was due to a 32% reduction in recycled paper prices realized by the business. Recycled paper prices were $150 per ton in Q2 2013 and this was worse than the $170 in Q1 2013 and the $220 per ton in Q2 2012. This negatively impacted segment revenue by $5.5M, which falls directly to the bottom line of the division. The bad news is that the division would have seen a 40% increase in its operating income if it didn't have to deal with this headwind. We expected the second quarter recycled paper price to be $170 per ton, so the actual average second quarter price created a $1.5 million negative variance for the quarter versus our expectations. The good news is that recycled paper prices reached a nadir in Q3 2012 and can't decline much further. At least this drop accounted for only 50bp of revenue and 4% of company profits.

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Source: Cintas's last six earnings calls

Cintas focuses on the shredding side of the document management industry. We are expecting to see growth in the service side of this business, which will be offset by the headwinds from reduced recycled paper prices. Excluding the decline in recycled paper prices, this division at least generated 6.8% revenue growth for the quarter. This segment is also exposed to Europe; however its total European exposure to the company only represents 1% of total company revenue. Because recycled paper prices began collapsing in Q2 2012 and bottomed out in Q3 2012, we believe that the worst is over for this segment with regards to year-over-year quarterly results comparisons.

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Source: Cintas's last six earnings calls

We shared a similar cautious outlook as management for FY2013. Management projected that the company will generate annual revenue in the range of $4.25-$4.35B (3-6% growth) at the beginning of FY2013 and it narrowed this guidance to $4.275B-$4.325B after the Q2 2013 earnings call. Management raised EPS guidance from the range of $2.47-$2.55 (9-12.3% growth) to $2.50-$2.58 (10%-13.7%) after Q1 2013 and it reiterated this guidance in Q2 2013. We are also glad to see that management's guidance for FY 2013 assumes that the company will not be making additional share repurchases during the rest of the year, which in our opinion is very conservative and provides us with a small margin of safety. We believe that despite the weak economy, the company can easily increase its dividend and or repurchase additional shares. Management projected $190M-$210M in capital expenditures, which is only $23.4M more than what was spend in FY 2012 for CapEx and acquisitions. The company generated $285M in free cash flows from operations in FY 2012 and $75M in H1 2013 versus $81.6M in H1 2012.

We expect the company to generate at least $285M in free cash flow for FY 2013 since that it was the company generated in FY 2012 and the company has been making investments to rationalize its working capital needs. The company has $276.5M in cash offsetting $1.31B in long-term debt. However Cintas can certainly service it with its strong level of free cash flows as its Interest Coverage Ratio for FY2012 was 7.67 Times Interest Earned and 8.46X in H1 2013. Considering Cintas's low debt costs and the dearth of high-grade credit opportunities for lenders, we believe that Cintas will certainly be able to refinance its debt when it matures and based on its solid ROE of 14.49% and 46.9% return on tangible equity, we believe it would be foolhardy for the company to try to pay down its low cost, tax-deductible debt financing.

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Source: Cintas Q2 2013 Press Release

In conclusion, we are not only maintaining our holding in Cintas, but we believe that investors should take advantage of dips in the market to accumulate a position in the company. Cintas possesses industry-leading dominance in the uniform services and related products industry and we believe that the document management business can either be turned around or sold. We are glad to see that Cintas management has a prudent outlook for the company and in addition to generating higher levels of revenue than its immediate competitors, but also has significantly stronger economies of scale which enable Cintas to convert its net income into free cash flows and enjoy above average Returns on Shareholders Equity versus its peers.

Disclosure: I am long CTAS. 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: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this article. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.