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SUMMARY

Cintas (NASDAQ:CTAS) is an extremely well-run company, with a fantastic culture cultivated over many decades, that dominates its core market while maintaining moderate growth opportunities. Because of its culture and scale advantages, CTAS realizes superior returns in its core business relative to its peers. CTAS generates a tremendous amount of cash and maintains a very strong balance sheet. The company is clearly focused on maximizing shareholder return and does so by returning to shareholders via dividends and stock buybacks any cash it cannot more profitably invest, in their view.

Unfortunately, the company is available for only an 8% discount from its fair value despite near-term uncertainty on input costs and on how quickly the economy will recover to pre-recession levels. My valuation does not take into account the dividend, which currently yields 1.5%, or the fact that the company has a solid and active stock buyback program that its board just re-approved. However, the dividend yield is not enticing enough and the stock buybacks are not reliable enough to overcome the small discount from fair value. As a result, I recommend HOLD.

DETAIL

Profile

CTAS has four reportable operating segments that all center on servicing small-to-medium sized businesses reliably and efficiently.

1. Rental Uniform and Ancillary Products - Includes the rental/servicing of uniforms, mats, towels and related items, as well as restroom supplies and other facility products and services. This segment is CTAS’s core business and represents ~71% of revenue. They dominate this market with about a 30% share, according to Morningstar. They are able to accomplish this with their culture, state-of-the-art technology, efficiency, innovation, infrastructure and customer service. The number two company in this business, Aramark (RMK), has a much larger focus on its own primary business (food and support services), which CTAS does not directly compete against. This segment realizes the largest operating margins (15.9% in 2008, which is obviously pre-recession and 13.1% in 2010) relative to the other reportable segments and is essentially the company’s cash cow (a necessity for a company in a very mature business). The cash generated from this business is used to fund its own capital expenditure needs, any cash shortfalls in the remaining segments, and then dividends, stock buybacks and debt payments. Margins may fluctuate due to the economy and temporary increases in input costs (namely fuel costs) as we have seen over the past few years, but will remain relatively consistent over time. Even at the depressed operating margins seen in 2010, this segment still generates a lot of cash, a fact the market seems to not fully appreciate. Over time, growth in revenues and operating margins should track inflation on average in this segment at the very least.

2. Uniform Direct Sales - Includes the direct sale of uniforms, branded promotional products and other related products to national and regional customers, as well as catalog sales to local rental customers. This segment represents ~11% of revenue and had operating margins of 12.6% in 2008 and 10.4% in 2010. While I have no doubt this represented a solid opportunity for revenue and profits when they first initiated it, as it still does today, I see this segment more as a necessity. Not every business wants to rent its uniforms, but may still want to rent everything else. This segment provides a wonderful opportunity to not exclude from CTAS’s other offerings any businesses that want to buy their uniforms instead of rent. I do not see this is as a growth business over time, but I do see it as being self-sustaining. As long as it is cash flow positive and continues to realize reasonable operating margins of over 10%, then this segment serves its purpose as supporting the Rental Uniforms and Ancillary Products segment.

3. First Aid, Safety and Fire Protection - Consists of first aid, safety and fire protection products and services. This segment represents ~10% of revenue and is the least profitable segment with operating margins of 8.9% in 2008 and 3.8% in 2010. This segment is relatively new to CTAS, so they see it as a growth area and have purchased a few companies in this segment in recent years. They see this as another way to easily profit from existing customers. There is some concern in this segment that the company may be throwing good money after bad as the other segments are more profitable. However, I do not think that is the case for reasons I will address in a discussion on the deployment of capital later in this article.

4. Document Management - Consists of document destruction, document imaging and document retention services. This segment represents ~8% of revenue and realized operating margins of 14.3% in 2008 and 9.5% in 2010. This is the newest segment of the company and they have built it to this point mostly through acquisitions. Again, they saw an opportunity to leverage their existing customer base for more revenue. While organic growth in this segment has been impressive, growth the past year was heavily influenced by recycled paper prices. The company sells as recycled paper some of the paper they shred, and market recycled paper prices spiked in 2009 and have not yet come back down materially. For example, growth in 2010 was 18.8% overall, but would have been around 10% if recycled paper prices had remained the same year-over-year. Despite having lower revenue than the First Aid segment, this segment has actually contributed more to operating income each of the past two fiscal years. Understanding that recycled market prices will fluctuate over time, I believe this segment represents the largest growth opportunity for the company. Obviously, they are competing against much bigger and more established companies in this arena, such as Iron Mountain (IRM), and the chances of CTAS ever becoming the number one player in this market are slim. However, they should still be able to maintain the market share they have already acquired, continue to make smart acquisitions and grow with the overall industry.

Just to provide some basic facts, they have 7,700 local delivery routes, 418 operations centers and eight distributions centers. They have 30,000 employees, only 225 of which are unionized. They also currently have six manufacturing facilities, although they also rely on external suppliers for a significant amount of the products they rent/sell. They currently serve over 800,000 customers, no one representing more than 1% of revenue.

Throughout every segment, they have focused heavily on cost cutting since fiscal year 2009 when they saw the writing on the wall regarding the economy. As a result, operating profits have declined less across the board than revenue has. I expect these efforts to continue for at least another year or two and for these cost savings to be more permanent than temporary in the long term.

Also, their primary focus has been the U.S. since inception. They still see opportunity to continue to garner new customers and to further penetrate their existing customers in the U.S. They also have operations abroad that seem fairly small at this point. While they have the expertise and culture to be successful abroad, the scale advantages in the U.S. do not transfer. It would take some time to build this up, so I do not see this has a near-term catalyst.

As I have said before, the company's primary advantage is its culture, which leaps off of every page I read from them. I will briefly describe their history, provide some detail on their culture, discuss their primary competition, explain my thoughts on their deployment of capital, and then discuss any specific risks and the valuation.

History

According to CTAS’s website, the company began in 1929 when Richard Farmer started a small business to reclaim and clean rags for local factories. His son, Herschell Farmer, took over in 1952 when Richard Farmer retired. The company entered the uniform rental business in 1965, and Herschell, after 23 years as CEO, turned the reigns over to his son, Richard Farmer, in 1975. Richard was CEO until 1995, which is when he appointed Robert Kohlhepp as CEO while retaining his title as chairman. In 2003, Robert Kohlhepp became vice chairman of the board and Scott Farmer, Richard's son, became CEO. Richard eventually retired to chairman emeritus, Robert became chairman, and Scott is still CEO.

I am personally a fan of multi-generational companies like this one, especially when the next generation starts at the company young and has to work his or her way up the ladder. Maybe it is my appreciation of the Taggert’s (Dagny, not her brother) and d’Anconia’s in one of my favorite books of all time, "Atlas Shrugged." I like the fact that Scott did not become CEO when his father stepped down in 1995 as he was likely not ready yet. He did not become COO until 1997 and was subsequently promoted to CEO six years later. In many companies that promote from within, there is a natural progression of filling the role of COO for a few years before becoming CEO. That fact tells me that the next generation in the family has to earn their place, something all too often not seen in multi-generational companies.

Culture

I am a firm believer that an appropriate culture that permeates the organization and drives the employees towards the company’s vision and mission can be one of the most indomitable, enduring assets a company can have. The problem with culture is that it takes a long time to develop and instill throughout the organization and requires complete buy-in from every single person from top to bottom, especially the board and the top executives. Even worse, it is really hard for an outsider (i.e., investors like you and me) to determine what kind of culture exits, to determine how strongly it exists and to truly measure its effectiveness.

The first step is figuring out if an appropriate and consistent culture even exists. Not every company comes out and says the magic words, such as “Our culture is the reason for our success because …” You would think more CEO’s would at least pay lip-service to it, but I simply do not see it discussed very often. CTAS is unique in this regard. They seem to want to tell the investor every chance they get about their culture. Of course, as many people have said, notably Ronald Reagan among them, “Trust, but verify.” But first let’s see what management has said about their culture.

Upon reading the company’s website the culture appears to have truly taken shape with the most recent Richard Farmer, the one who took over as CEO in 1975 and only just retired as chairman. Here is the company's press release last year upon Richard's retirement (emphasis added):

"Through his experiences growing up in his father’s business and the decades that followed, Farmer established Cintas' rich corporate culture, founded on honesty and integrity. He taught his associates about the value of teamwork, appreciating people, and respecting the opinions of the people who do the job.

"There is no one who can surpass the standard of ethical and intellectual brilliance that Bob [Robert Koelhepp, new Chairman] has brought to every position he has held in the Company," said [Richard] Farmer. "I am confident that he, along with my son, chief executive officer Scott Farmer, will see our company to continued success, with our rich culture serving as the foundation of that success," he added."

As indicated, the heart of the culture is how they treat their employees. They call their employees "partners" and all are eligible to participate in the Partners' Plan, which includes profit-sharing, employee-stock ownership and matching 401(k) contributions. The benefits sound fairly standard, but just the simple act of calling employees "partners" creates a different mindset. And the constant emphasis placed on the culture is key evidence, including a "risk" in the 10-K that they will not be able to find sufficient people who fit in with their culture.

One final thought from the company on their culture, which is from their website:

"Cintas is a unique company with a unique culture. For more than 74 years, we have built a successful model and corporate culture based upon a spirit of cooperation among all our partners in every part of our company.

Over the years, we have established strong feedback mechanisms that enable all our partners to express their ideas and grievances. This is particularly evident in the "Hot Line" program, in which every employee-partner has the ability to voice concerns directly to the President, if issues cannot be resolved at the facility level. In this program, all concerns are addressed personally and in the strictest confidence."

So they have referred to their culture in a number of different places in glowing terms. How do we measure the truthfulness of their words and how effective the culture is? Obviously, there is no direct way to assess culture, so we have to use context clues and anecdotal evidence.

First, as I mentioned, the current CEO is the fourth generation of his family to be CEO and upper management has a very long tenure with the company. The current chairman (not a member of the Farmer family) has been with the company since 1967. The CEO, being the son of the former CEO, grandson of the one before that, and great-grandson of the original, has been with the company since 1981. He was COO from 1997 to 2003 and then took over as CEO in 2003. That is one of the first things I look for when assessing culture. If the CEO was brought from outside the company to be CEO, then any talk of culture can most likely be disregarded. Similarly, if upper management does not have a long tenure with the company, on average, then the culture might not be as strong as advertised. In my experience, companies with strong cultures promote from within and keep talented people for a very long time. That is the best way to ensure that culture is sustained and promulgated to the next generation.

Second, we can look to the makeup of their employees. Historically, companies with a very strong culture tend not to be unionized while companies that are unionized tend to not have a very strong culture. This dynamic is primarily due to whom the employees feel has their best interest in mind. In a union, whether through personal experience or through information distributed by the union leaders, unionized employees tend to have an “us against management” mentality. Conversely, non-unionized employees will resist joining a union if they feel that management has their best interest in mind. CTAS employees ~30,000 people, most of home drive a truck and deliver and pick supplies. That sort of job is ripe for a union. In fact, union organizers have targeted CTAS and its competitors many times. Yet of those roughly 30,000 employees, a mere 225 are unionized. That is not a typo. Less than 1% of all employees in this business are unionized. That is pretty glaring evidence in my opinion, especially compared to some of CTAS’s competitors.

Third, we can look to anecdotal evidence, although that is not always reliable. I have had the opportunity to speak to some CTAS employees who are low-level management. They have verified that they can go directly to the president of the company with a complaint, that they are happy with their benefits, and that the company’s culture is indeed discussed and encouraged by all levels of the organization, at least as far as they have encountered.

Fourth, we can look to margins. Happy employees are more productive employees, and happy customers are better paying customers. Even in the down year of fiscal year 2010, the company realized an operating income margin of 13.3% on its core business, uniform rentals and ancillary products. Their closest competitors realized the following operating income margins on their uniform rental businesses in their most recent fiscal years:

  • Unifirst (NYSE:UNF) realized 12.5%.
  • Aramark (RMK) realized 6.8%.
  • G & K Services (GKSR) realized 7.2% on uniform rental and direct sales combined (not broken out separately) and realized a mere 23.6% gross margin on uniform rentals, which is not even close to CTAS’s 43.6% realized in 2010.

Some of the reason for the higher margins realized by CTAS is due to the scale advantages resulting from their vast infrastructure. But that can be traced back to CTAS’s culture because they had to grow to that size. Some of those companies, such as G & K Services, have been around as long or longer than CTAS but have nowhere near the success. CTAS’s culture has helped CTAS to simply outpace the competition over the decades.

Fifth, we could look to external recognition. The company has won numerous awards regarding the workplace, including making Fortune's 100 greatest places to work for about 10 years running. There are simply too many awards to list. While not always evidence in and of itself (the companies that make those lists could just have really good PR people), it helps support the case when coupled with the other evidence.

Finally, we can look to some of the actions undertaken by the company. Clearly, their culture is centered on treating people correctly. Naturally, one would expect that mindset to extend to how they treat their customers. Upon reviewing the evidence, it is clear that the company does not just stop at making sure their employees are reliable and friendly towards customers, but they go out of their way to create best practices to help their customers succeed. Their press releases include titles such as:

  • “Dirty Dishware, Restrooms and Odor Are Top Three Reasons Why U.S. Adults Would Never Return to a Restaurant.”
  • “Cintas Announces Top Tips for Keeping Restaurants Clean to Drive Repeat Business.”
  • “Cintas Shares Critical Fire Safety Tips to Prepare Businesses during Fire Prevention Week.”
  • “Poll Reveals 85 Percent of Americans Would Never Rebook at a Hotel with Dirty Floors.”
  • “Cintas Releases Infection Preventionist Survey Results.”

Obviously, much of that is to drive demand for their business, but not everything relates directly to them. At the core is a mindset of wanting to treat people right, whether they are employees or customers.

The evidence, in my opinion, is fairly strong that CTAS does have a strong culture that helps drive results. The company's true competitive advantage, what allows it to maintain a dominant market share and realize outsize returns in such a commodity business, is its culture.

Competition

I have touched on three major competitors a few times up to this point. Here I will delve a little more into those competitors and explain how they measure up against CTAS. First, before reading this article, could anyone tell me a single uniform company other than CTAS? I know I could not before doing the research. That brand recognition goes a very long way.

1. Aramark – Aramark is the next closest competitor to CTAS with revenue in the uniform apparel business at $1.5B. Aramark was taken private in 2007 but still provides annual reports. The primary roadblock to Aramark competing effectively against CTAS is Aramark’s other much larger business segment, Food and Support Services. That segment realized revenue of over $11 billion in 2010 and is clearly a much larger focus of management and the company’s resources. In addition, Aramark has not been as successful in avoiding unions as CTAS has been. Aramark employees 171,000 employees (only about 14,000 of which are in the uniform business) and 23% of those employees are unionized versus less than 1% for CTAS. This level of unionization takes a toll on profits and the balance sheet. Aramark carries a defined benefit pension plan, a staple of a unionized workforce. CTAS, despite being around since the 1920’s, has a defined contribution plan instead, which is generally cheaper and poses much less risk to the balance sheet.

2. Unifirst – I think of Unifirst as CTAS, Jr. They seem to have implemented a similar culture as CTAS, even referring to their employees as “partners,” which appears to have helped them avoid unionization for the most part and to help them maintain reasonably high margins. They have roughly 10,000 employees and only 200 are unionized, so about 2% of their workforce is unionized. Of course, CTAS has three times the number of employees with about the same number of employees unionized, but Unifirst’s success in avoiding unions is still impressive. As mentioned earlier, they also realized similar margins at 12.5% on their uniform rental business versus 13.3% for CTAS.

Unifirst’s total revenues have stayed flat at around $1.0 billion the last three years while CTAS’s has declined. The reason for this is that Unifirst has competed on price over that time period and gained some business by being the cheaper option. This is evidenced by the fact that Unifirst’s operating margins have declined materially over the past 12 months while CTAS’s remained relatively flat. The problem with competing on price is that it is not sustainable if you are not the low cost provider. CTAS’s scale advantages dictate that Unifirst is not the low-cost provider. CTAS could easily lower prices and take back any business Unifirst took and then some. Also, when the economy improves, customer satisfaction and reliability will carry more of a premium.

Another problem faced by Unifirst is brand recognition. Unless you own a business and Unifirst has directly approached you, chances are you have never heard of them. CTAS’s name carries a lot of weight, and their scale advantages are very hard to overcome. Finally, CTAS’s larger size, capital, and access to capital means that it can more easily take advantage of opportunities when they arise, spend more on advertising and research and development, and offer a wider array of products and services. Unifirst is simply destined to always be that little brother to CTAS that can never quite get out of big brother’s shadow.

3. G & K Services – G & K Services realized revenues of $834M in 2010 but is woefully inefficient. Their margins are very low compared to CTAS and not likely to improve materially any time soon. They simply do not have the infrastructure to compete effectively and have seen sales decline more than their competitors. They are only just recently venturing into direct uniform sales to augment their matured uniform rentals business, which poses operational risk as it is a new line of business and management’s attention will be split. Splitting management’s attention is not a good idea when your margins lagged industry leaders significantly when their attention was not split. Also working against them is the fact that over 25% of their 7,500 employees are unionized. As noted previously, this will add upward pressure on costs and create a higher risk on their balance sheet as a result of defined benefit pension plans. GKSR’s pension plan had an unfunded status of $27M as of the latest fiscal year end, or roughly 6% of net book value, and that number does not even include union sponsored pension plans the company has to contribute to each year. This company is included in the discussion for the size of their revenue but poses no serious threat to CTAS.

Deployment of Capital

I mentioned earlier that there is the risk that they are throwing good money after bad by buying companies in the lower margin First Aid segment. However, I think this is likely a good use of cash when considering the paucity of opportunities in other segments, the limitations of what cash can be returned to shareholders, and management’s strategy.

First, consider investment opportunities in the other three reportable segments. Uniform Rental and Ancillary Products and Uniform Direct Sales can be grouped together for this discussion. The uniform business is obviously a very mature one and CTAS already spans the entire United States. So what makes more sense from management’s perspective? Buy up other business in this segment or simply invest in the appropriate PP&E to grow the infrastructure organically? Given the importance of their culture and their already strong brand recognition, it really makes no sense to buy other companies in this segment. They are wisely making the appropriate capital expenditures to maintain and grow their business organically. Besides, what would the incremental return be for such an acquisition over what they could do organically? I am certain it would not match the returns currently being realized by the First Aid segment.

The other segment is Document Management. The fact is that they are making acquisitions in this higher margin segment as appropriate. However, it does not make sense for them to go out and buy every single business they can regardless of price. It appears as though they invest into this business first as much as they profitably can and then invest the remaining funds in the First Aid segment. That is an outsider’s point-of-view without explicit verification from the company, but I feel comfortable making that assumption.

Second, they are limited in what they can return to shareholders. They have raised dividends every year since 1983. If they want to continue that trend, then they cannot suddenly increase dividends materially in any one year. Therefore, they are limited to increasing dividends a few pennies a year. Given the pride they clearly have in that record of annual increases, I do not see them changing their approach to dividends any time soon. So that leaves share buybacks. Again, the company is limited here, this time by what the board approves as well as by stock price (they hopefully would not want to overpay). They recently used up all of the funds they were previously authorized to use for share buybacks, and, as a result, the board had to approve another $500 million for stock buybacks. However, once again they have a limit on what they can spend, and some of that will be needed to eliminate the dilutive impact of stock options in the future. So they clearly have to be judicious about when to use these funds.

Third, the company could pay down debt, which is currently close to $800 million. However, there a few factors to consider here. Of that long-term debt, about a quarter is due over a year from now and then principal payments are relatively small until over five years from now. In addition, the interest rate on the majority of it is only around 6.0%. Meanwhile, recessions offer an opportunity to make acquisitions more cheaply than normal, sometimes substantially more cheaply. This can be due to looming high debt payments of the acquiree or just poor financial performance in the near-term. A long-term focused company such as CTAS would find this a wonderful opportunity to make acquisitions at cheap prices that will yield solid cash flows in the future. In other words, since near-term liquidity is not an issue and the recession has presented a great opportunity to buy companies with suppressed margins now that should only increase in the future, I believe paying down debt is not the better option. That does not even consider the fact that early retirement of the debt would require a prepayment penalty that the company has noted renders early retirement unattractive at this time.

Having gone through the alternatives, I believe management has clearly demonstrated a very wise, long-term focused, and shareholder-friendly deployment of capital. An appropriate and wealth maximizing allocation of capital often speaks wonders about the competence of management, though I needed no further convincing by now.

Balance Sheet Risks

There really are none in this fantastic company. Debt-to-capitalization ratio is a mere 25%, which is incredible for a company that does a material amount of its own manufacturing, has routine maintenance capex requirements, particularly for its transport infrastructure, is expanding via acquisitions, has raised dividends every year for about 28 years, and has a relatively generous stock buyback program.

They also have no defined benefit pension plan thanks to only having 225 unionized employees out of 30,000.

Their total debt was $788 million and their net debt was $503 million as of 11/30/10. Net book value is $2.4 billion. Total cash and marketable securities was $285 million, which is sufficient by itself to cover over 60% of current liabilities, including current portion of long-term debt. Overall, the balance sheet is very strong.

Other Risks

The risks I have seen are either not legitimate to me or are only temporary. They include increased competition, rising input costs, and a slowly recovering economy. These risks are minimized for a long-term focused investor because the uniform business will be around for a long time, CTAS will always dominate that business, higher input costs will eventually be reflected in higher sales prices, and the U.S. economy will eventually improve to pre-recession levels, in my opinion.

Is now a good time to buy?

I independently projected the revenue and operating income margins for each reportable segment for fiscal year 2011 before second quarter 2011 results were released and was able to get to the low-end of management’s projected range for the next fiscal year for both total revenue and earnings. Upon review of the second quarter results, my predictions have not changed. Assuming conservative growth estimates, which include revenue not reaching fiscal year 2008 levels until fiscal year 2014 as well as margins only improving modestly from their fiscal year 2010 levels, I value the company at $30.36, which represents a low 8% potential upside from the current stock price. That valuation does not include the 1.5% annual dividend yield or the expected stock buybacks, which would obviously increase the return on this investment.

Even though this is clearly a company I would be very happy owning part of for a very long time, I still must follow my investing principles and require a larger discount to value. Otherwise, my annual return is limited to my discount rate, the low dividend yield, and the boost in value resulting from any stock buybacks, which are impossible to predict with any degree of certainty. Therefore, I recommend HOLD on this stock. I will wait for a larger discount to my valuation resulting from either a drop in stock price or an increase in my valuation before buying this stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Cintas Analysis and Valuation