ABM Industries (NYSE:ABM) is a facilities services firm that presents an attractive risk-reward opportunity. In the short and medium term, the company's potential as a buyout candidate creates a 25% upside as well as valuation support. Even without this catalyst however, ABM is a quality business trading at an attractive valuation of ~8% free cash flow yield and ~9x 2013E EBITDA. There is also a 2% dividend yield to reward investors while the positive catalysts materialize. In this article, we will highlight 1) defensive nature of ABM's business, 2) why traditional P/E ratio undervalues the company, 3) a hypothetical buyout scenario.
ABM Industries provides various janitorial and facility maintenance services to commercial clients. The business is extremely simple but also stable. The company typically serves its clients under 1-3 year contracts which, coupled with low needs for capital expenditure, provide a steady stream of free cash flows. ABM's business is recession proof by its nature. In an economic downturn, client companies may lower their headcounts but will still have to maintain common areas at a minimal standard, providing support for ABM's businesses. In fact, a high unemployment rate depresses staff wages and may lead to higher margins for the company. Due to its consistently strong free cash flows (~$126mm for LTM 3Q13), management was able to make a major acquisition every 2-3 years and have a track record of successful deleveraging.
Attractive valuation obscured by flawed P/E metric
After a strong run up in October to $28.45/share, some may argue that ABM appears overvalued at 2013E PE of 19.2x. However, earnings have consistently understated cash flows due to depreciation and amortization (D&A) being much greater than on-going capital expenditure needs. For example in 2012, D&A was $51mm yet capital expenditure was only $28mm. The difference was mostly due to amortization of intangibles of ~23mm which we consider non-economic. As a result, we consider EV/EBITDA and free cash flow yield to be more appropriate valuation metrics. In those terms, ABM's valuation is very reasonable at 9x 2013E EBITDA and ~8% FCF yield, respectively.
Attractiveness and feasibility as a buyout candidate
ABM industries is exactly the type of business that private equity firms love - the type that they can pile on debt to increase returns. We already mentioned ABM's recurring/contractual cash flows as well as its defensive characteristics. These traits directly translate to a debt capacity much greater than your average business. However, ABM is only leveraged at 2x EBITDA. In comparison, Blackstone bought one of ABM's competitors, GCA Services, and increased leverage to 6.4x in September 2012.
ABM can easily raise debt in the syndicated loan market. With consensus 2013E revenue of $4.8bn and EBITDA of $~209mm, the company is bigger than GCA Services as well as most leveraged loans issuers in the market. We estimate that a private equity firm can buy the company at 11x EBITDA, increase leverage to 6x and still earn a 20-30% IRR. That transaction multiple would provide a 25% premium to current shareholders. The current debt market is highly accommodative with deals regularly getting done at 6x leverage and "covenant-lite" debt deals becoming the norm. We believe financial buyers will be tempted to target ABM and take advantage of the environment before the Fed's inevitable "tapering" puts an end to easy credit.
Significant holdings by private shareholders used to be a barrier to a potential takeout. However, these insiders have gradually reduced their stakes, increasing the likelihood of a deal. Ted Rosenberg (former chairman and son of the original founder) passed away 3 years ago, and his estate has reduced its stake to only 2.1%. Lord Ashcroft owned 8% earlier in the year and has reduced his stake to ~5.3%.
The company does have significant non-debt liabilities but we do not see this as a deal breaker. As of 9/30/2013, there were ~$360mm of self-insurance obligations offset by ~98mm of insurance recoverables and deposits. The company pays about $90mm in self-insurance claims per year. However, even with this additional liability, fixed charge coverage ratio will be around ~2x (FCF / fixed charges) if the company increases leverage to 6x EBITDA to support an LBO.
The appearance of a high P/E ratio may deter some investors, but when considered using the right valuation metrics, the company is actually attractively valued. In the meantime, the defensive characteristics of the company as well as LBO upside create a great risk reward scenario.