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Mac-Gray Corporation (TUC) is the second largest laundry facilities management contractor in the United States. The company has a portfolio of card and coin operated laundry equipment in multi-unit housing complexes as well as hotels and motels, and is the market leader in providing such services to the higher education market in the United States.

I love businesses like this. Long term contracts providing services in an industry with very slow innovation translates to consistent earnings, and maintenance capital expenditures often pale in comparison to growth capital expenditures, so depreciation charges often far exceed capex which translates to free cash flow regularly exceeding net income. The opportunity to buy companies that exhibit these characteristics at a discount is often too great to pass up. Unfortunately, as we will see, TUC is one of those that should be passed.

First, TUC does exhibit the characteristics just mentioned. It is, quite simply, a free cash flow machine. Relative to a market cap of about $200 million, the company has generated $31 million of free cash flow on average for each of the last five years. Unfortunately, the company is more levered than I would like, with debt to equity of around 2x. Luckily, this is down from more than 3x just a few years ago and the company seems intent to continue aggressively paying down its debt.

Unfortunately, regardless of how much debt this company repays and how strong its free cash flows persist to be, there is something fundamentally wrong with this company: management does not behave in the interests of shareholders.

Consider this: on October 24th of last year the company put out this release (emphasis added):

Mac-Gray Corporation (NYSE: TUC), the nation's premier provider of laundry facilities management services to multi-unit housing locations, today announced that its Board of Directors unanimously rejected an unsolicited written proposal from KP Capital, LLC to acquire Mac-Gray for $17.50 in cash per share.

The Mac-Gray Board of Directors has completed the comprehensive evaluation it undertook in response to the KP Capital proposal. The Board's evaluation process included a meeting among two Board members and KP Capital, multiple Board meetings, the assistance of two independent financial advisors, and a thorough, special review of the current and updated business plan from Mac-Gray management. Based on its evaluation, the Board has unanimously determined that pursuing the transaction proposed by KP Capital, or a sale process, would not be in the best interests of the Company's shareholders at this time. The Board believes that the Company can best maximize long-term shareholder value by continuing to aggressively implement the strategic, operational and financial initiatives currently under way as well as those specific initiatives contemplated in the updated business plan.

"The Board of Directors, with the help of two top-tier outside financial advisors and counsel, carefully evaluated all relevant aspects of the KP Capital proposal and of a possible sale process, including undertaking the significant risks and uncertainties with such a process at this time," said Thomas E. Bullock, Chairman. "Among the factors the Board considered were the Company's existing strengths, growth opportunities and financial prospects, including the strategic and operational initiatives already under way."

The Managing Member of KP Capital is Benjamin Kovler. At Mac-Gray's 2010 annual meeting, Mr. Kovler's affiliated entity, Kovpak II, LLC, made a proposal for the redemption of Mac-Gray's shareholder rights plan. At Mac-Gray's 2011 annual meeting, Mr. Kovler nominated himself, Richard Drexler and Michael Soenen as directors. None of Mr. Kovler's nominees was elected and Mac-Gray's shareholders re-elected each of the Company's director nominees.

KP Capital stated that its proposal was backed by both debt and equity financing sources, but at its meeting with Mac-Gray directors would not identify those sources, absent execution of a confidentiality agreement and a commitment by Mac-Gray to pursue discussions.

This offer represented a 33% premium over the previous day's close of $13.15 and even exceeded the 52 week high. In fact, the company's shares had not reached that level since 1998, when the company was trading in the euphoria of a booming stock market. Furthermore, the company outright rejected the idea of a sale, at any price!

Making matters worse is that the the Board provides only an extraordinarily vague rationale for rejecting this offer (and the idea of a sale in general), citing its commitment to its existing initiatives and the fear of "significant risks and uncertainties" associated with a sale! Make no mistake, this was an all cash offer; there is no risk to shareholders.

To provide some context to this offer, I should point out that it came on the heels of an indirect upset for KP Capital. You see, KP Capital's managing member, Benjamin Kovler, was part of a group known as TUC Investor Value Creation Group, LLC, which had been fighting to put three people (including Kovler) on TUC's Board, but unfortunately lost the vote. It is worth pointing out that TUC IVC Group was not a fly by night operation, jumping in the deep end with a half-hearted attempt to get board representation. Nay, the company had been a shareholder of Mac Gray for more than ten years and had been agitating for change throughout the decade.

Well, as the old activist saying goes, if you can't join 'em, buy 'em. So KP Capital launched its offer and was rebuffed.

Fast Forward four months and enter stage right Moab Capital Partners, another activist fund which has acquired 8.3% of the common stock over the last few years and is now nominating two people to TUC's board (note to management: it should be a wake-up call to be forced into two proxy fights in as many years):

Moab Capital Partners, LLC ("Moab Capital") today announced that it has given notice to Mac-Gray Corporation ("Mac-Gray" or the "Company") that it will be nominating two independent candidates for election to Mac-Gray's Board of Directors at the 2012 Annual Meeting of Stockholders. Moab Capital is the investment manager of Moab Partners, L.P. ("Moab Partners"), an investment fund that beneficially owns 8.3% of Mac-Gray's outstanding shares. Moab Capital's nominees are Jonathan G. Davis and Bruce A. Percelay.

Moab Capital has been a constructive Mac-Gray stockholder for nearly two years. However, upon reading in the Company's press release of October 24, 2011 that its Board of Directors unanimously rejected a proposal from KP Capital, LLC ("KP Capital") to acquire Mac-Gray for $17.50 in cash per share, we were dumbfounded.

This news came concurrently with a decision by the Board of Directors to not explore any strategic alternatives, not commence a share buyback with the stock trading 25% below KP Capital's takeover price, and not increase the dividend being paid to stockholders. Furthermore, the Board has not shown any evidence that questions the credibility of the KP Capital proposal, nor has it provided any business plan for the Company which justifies value to all stockholders in excess of $17.50 per share. The Board's failures to disclose this and other material information to the stockholders have come despite Moab Capital's repeated written requests for such public disclosure.

Whether Moab will be successful remains to be seen. One unique point in this situation is that insiders do own a great deal of TUC shares (23.3% according to the last proxy statement). While this represents a good deal of value at the current market cap, we should put this in context of insider compensation. The top five executives earned a stunning $4.4 million last year, and the board members were paid an average of $123,300 last year ($986,400 total). $5.4 million combined for its senior executives and directors may not seem like a lot, but this represents a whopping 1/4 of the average operating income over the last three years! It is also the highest I have seen among companies of this size.

Unfortunately, the shareholder unfriendly behaviour does not end there. A review of TUC's filings reads like a list of worst practices for corporate governance policies. The board has a Shareholder Rights Plan, or Poison Pill as it is known, designed specifically to dissuade potential acquirers. Moreover, the company has a classified board, which limits the number of directors that are up for election each year, making it a multi-year process for any agitator to effect change. Finally, the company has instituted excessive change in control bonuses for its executives (also known as Golden Parachutes), which lead to a total payout of $7.53 million to its top five executives, or 170% of their already inflated annual compensation.

As I said above, it doesn't matter how well the company performs. Their much touted strategic initiatives may pay off in spades, their lenders could forgive their remaining debt balances, and they could receive sudden one-time cash awards equal to their current market cap; it is all wholly irrelevant in the hands of leadership that has proven itself to not represent shareholder interests. There is no price low enough that would entice me to invest in this company with the present leadership.

I wish Moab and KC Capital the best of luck. What do you think of TUC?

Source: Mac-Gray Corporation: Killing The Golden Goose