- Simplicity is the name of the game.
- The Valuentum Buying Index is not necessarily a trading program, but the equivalent of what others might have as a star-rating system. The higher the rating, the better.
- Cintas is the largest company in the uniform industry, and its top line and earnings per share have expanded at a nice mid-single-digit annual clip during the past 10.
Simplicity is the name of the game. We were reminded recently of how Warren Buffett allocated a total of $100 million in roughly 20-25 Korean companies in 2004 by simply leafing through a reference book that dedicated a single page to each listed company -- a book much like those that Valuentum makes available to financial advisors. Mr. Buffett understands simplicity -- knowing which metrics matter and which metrics don't. He picked those companies in roughly 6 hours. In this article, let's talk about what metrics matter at Cintas (NASDAQ:CTAS).
For those that don't know Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors.
If a company is undervalued both on a discounted cash-flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores highly on our scale. Cintas posts a Valuentum Buying Index score of 4 on our scale, reflecting our "overvalued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. Obviously, Cintas doesn't fit the bill of a company like Daehan Flour Mills, which held 25% market share in wheat flour in South Korea, had a book value of 206,000 won, with 201,000 won in marketable securities and trading at just 2 times earnings (according to Buffett when he picked up shares). Cintas is not a no-brainer in this regard (even though it does have a solid market share position in uniform rentals). The company's valuation is not all that attractive, which is why Cintas doesn't score that highly on our process.
For relative value purposes, we compare Cintas to commercial services industry constituents Iron Mountain (NYSE:IRM), Pitney Bowes (NYSE:PBI), R. R. Donnelley (NASDAQ:RRD), and Xerox (NYSE:XRX). We know relative value metrics aren't perfect because no two companies are ever perfectly comparable. We rely mostly on our discounted cash-flow process to determine a firm's intrinsic worth and apply the relative value assessment to reinforce the process or uncover areas where their could be valuation upside or downside. In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score. The Valuentum Buying Index is not necessarily a trading program, but the equivalent of what others might have as a star-rating system. The higher the rating, the better.
Our Report on Cintas
Cintas Corp's Investment Considerations
Cintas Corp's Investment Highlights
• Cintas Corp's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
• Cintas primarily provides uniform rental services, but it also has first aid, safety, fire protection and document management service operations. He company serves 900,000 businesses of all types, boasting significant customer diversity.
• Cintas Corp has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 8.6% in coming years. Total debt-to-EBITDA was 1.8 last year, while debt-to-book capitalization stood at 37.5%.
• Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.
• Cintas is the largest company in the uniform industry, and its top line and diluted earnings per share have expanded at a nice mid-single-digit annual clip during the past 10 years.
Cintas Corp's Business Quality
Cintas Corp's Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital - ROIC - with its weighted average cost of capital - WACC. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Cintas Corp's 3-year historical return on invested capital (without goodwill) is 18.6%, which is above the estimate of its cost of capital of 9.9%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Cintas Corp's free cash flow margin has averaged about 8.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Cintas Corp, cash flow from operations decreased about 16% from levels registered two years ago, while capital expenditures expanded about 45% over the same time period.
Cintas Corp's Valuation Analysis
Our discounted cash flow model indicates that Cintas Corp's shares are worth between $40.00 - $60.00 each. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $50 per share represents a price-to-earnings (P/E) ratio of about 21.8 times last year's earnings and an implied EV/EBITDA multiple of about 10.2 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 5.9% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 2.8%. Our model reflects a 5-year projected average operating margin of 14.6%, which is above Cintas Corp's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 4% for the next 15 years and 3% in perpetuity. For Cintas Corp, we use a 9.9% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $50 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Cintas Corp. We think the firm is attractive below $40 per share (the green line), but quite expensive above $60 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Cintas Corp's fair value at this point in time to be about $50 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Cintas Corp's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $66 per share in Year 3 represents our existing fair value per share of $50 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements