Traditionally, most of my analysis on Seeking Alpha has focused on how to avoid losses and how to profit from the price cycles of highly cyclical stocks. When dealing with highly cyclical stocks, it's usually a good idea to evaluate potential returns over a relatively short 5-year time frame because the stock prices can move dramatically over short periods of time. Investing in these types of stocks requires techniques that are different than the standard analysis most investors use to evaluate stocks.
There is another group of stocks, however, whose stock prices and earnings fluctuate far less than the classic cyclical stocks I have traditionally written about. While these stocks aren't as cyclical as a "classic cyclical," they are still usually subject to the short-term debt cycle (or business cycle) and to changes in sentiment (which can sometimes also have a cyclical quality about it). More recently, I have been adapting some of the techniques I've used with "classic cyclicals" so that I can apply them to less-cyclical stocks. And today's stock is one of those.
One of the major assumptions that I make for both approaches is that history is the most reliable guide to the future. My experience has been that 80% of the time, even if we looked at nothing else, a stock will behave in a similar manner as it did the previous cycle or two unless there is a disruption to its core business. For this reason, I don't rely much on predictions of future earnings or sentiment that aren't supported by their existence during past cycles. That doesn't mean that "this time is different" isn't true sometimes. It just means that my analysis isn't counting on this time being much different. That said, if I think a stock is currently a "buy" based on my 10-year, full cycle analysis, before I invest, I will examine the forward-looking trends and narratives more carefully to make sure there aren't major changes in the works that could affect the business.
The main difference you'll find between my analysis and others is that: 1) I focus on a clear 10-year time frame and the compound annual rate of growth (CARG) one might expect over that period of time, 2) I assume we will experience a recession during that time period, and I build that into the expected returns, 3) I try to calculate the expected returns based on a full business cycle, 4) I weight shareholder yields from dividends (and potentially from buybacks) more heavily because that is money actually being returned to shareholders, and 5) I provide an "opportunity risk/reward analysis" if a stock is not currently a "buy" so that we can get an idea of how likely it is the stock will trade low enough to become a "buy" over the next 4-5 years if we have a recession.
As part of the analysis, I calculate what I consider to be the three main drivers of future total returns: 1) Market Sentiment Returns, 2) Full-Cycle Organic Earnings Growth Returns, and 3) Shareholder Weighted Business Returns. Then, I combine all three of those CARG estimates together to get an expected 10-year, full-cycle CARG estimate. Currently, I consider an expected CARG > 15% a "buy," 12-15% an "outperform," 8-12% a "market perform," 4-8% an "underperform" and < 4% a "sell."
With that, let's get into the analysis.
How Cyclical Are Earnings?
Since I use different approaches for analyzing a stock based on how cyclical earnings are, historical earnings cyclicality is the first thing I like to examine. Let's take a look at Cintas's (CTAS) historical earnings using a F.A.S.T. Graph, which is a great tool for this sort of analysis:
I break down earnings cyclicality into five basic categories. The first category I call 'secular growth.' This category describes earnings that continue to rise every year even during economic recessions. The next three categories are 'low', 'moderate', and 'deep.' 'Low' is usually for businesses which have earnings that have a history of declining in the single digits percentage-wise during downturns but not much farther than that. 'Deep' I consider earnings that fall more than -50%, and 'moderate' somewhere in between low and deep. And last, but not least, are businesses whose earnings go negative during cyclical downturns, but recover soon after that, which I call 'highly cyclical.'
Cintas's earnings didn't fall at all during the 2001 recession, but they did fall about -31% during the great recession in 2008/9. This places Cintas in the 'moderate' category with regard to its earnings cyclicality. Stocks of moderately cyclical companies lend themselves well to 10-year time-frame estimates, so that's what I'll use for Cintas.
Market Sentiment Returns
In order to estimate what sort of returns we might expect over the next 10 years, let's begin by examining what sort of returns I could expect 10 years from now if the P/E multiple were to revert to its mean from the previous economic cycle. In order to estimate that, I'm going to shorten the time frame of the F.A.S.T. Graph so it starts in 2006.
Currently, Cintas's blended P/E ratio is 29.3, while it's normal P/E ratio over the course of the past cycle has been 20.5. If Cintas were to revert to its normal P/E ratio over the course of the next 10 years, it would produce a -3.51% CARG.
Full-Cycle Organic Earnings Growth Returns
If we begin our measurement around the same point we were last cycle, which I estimate to be about 2006, and we adjust the annually compounded EPS growth for the amount of stock that was repurchased over this time period, we can estimate how much CARG from organic earnings growth we can expect over the next 10 years if the next cycle is similar to the previous one.
Cintas has repurchased an incredible amount of shares, an amount that exceeds 1/3 of the company this past cycle. In order to estimate Cintas's organic earnings returns I'm going to back out these share repurchases and also assume that we will have a recession at some point over the next ten years (Remember how their earnings fell -31% in 2008/9? I want to take that into account as well.) When I run the numbers on that I get an expected 10-year CARG of -0.59% from organic earnings growth.
Cintas is the first company I've analyzed using this method in which organic earnings were expected to be negative. My guess is that part of that has to do with backing out such a large amount of share repurchases from the numbers, combined with a reasonably deep drop in earnings during the great recession. My estimates are probably on the conservative side because such big numbers, particularly from buybacks, could be underestimating the actual earnings growth a little bit. However, I think it does highlight how much Cintas's earnings growth is dependent on future buybacks, and also that earnings could have more volatility during a recession than current investors might think.
Shareholder-Weighted Business Returns
These return estimates are more complicated than the first two, but the idea behind this is to figure out how much the company is making in cash and/or earnings per share while taking into account debt and cash levels, how much of a dividend yield it is paying to shareholders, what percentage of shares it is buying back annually, and how much cash the company is keeping for itself, all on a per share basis. Once that is complete, I assume any money the business keeps for itself will accrue over a 10-year time period, but I don't assume that it will compound (since I estimated the earnings growth in the last section).
For buybacks, if the company is buying back shares when sentiment is below average, I will assume the value of the buybacks will compound over time. If they are buying back when sentiment is higher than average, I will assume the buybacks accrue but do not compound value over the 10-year time period. (This is just a way to weight the value of buybacks over time for the estimate, it isn't intended to be mathematically precise - which is fine for me, because we never know exactly what price the buybacks will be made over time anyway, so there's no sense in pretending we do.) I will assume that dividends paid to shareholders compound their value over time because shareholders can immediately reinvest the dividends in the best investment available.
As I noted, this process is intended to estimate how much money the business is likely to make and how much of that money will likely be returned to shareholders via dividends and buybacks. I limit the expectation of shareholder returns by how much cash is currently being generated and the company's apparent intention of investing that cash itself or returning it to shareholders. If buybacks and dividends are consistently greater than cash flows and earnings, I will assume they are unsustainable through a full cycle that includes a recession, and I limit the shareholder return expectations to actual cash flows and/or earnings estimates I think are reasonable.
First, let's revisit those buybacks and see what sort of returns we might expect from them in the future. I'll look at both 1-year and 3-year time frames.
We can see that over a 3-year time-frame Cintas hasn't bought back any shares, but I think that has to do with the fact they made an acquisition in 2016, which likely resulted in a pause of the buybacks. The buybacks appear to have resumed in late 2018, and were reduced by -1.65% since then, so I'll use that most recent number for the likely reduction going forward.
In addition to the buybacks, Cintas also has a 0.90% dividend yield, for a total shareholder yield of 2.55%.
Next, let's look at the earnings yield to see if it is currently yielding enough to support the shareholder yield estimates.
The earnings yield looks high enough to support my estimates. Now let's take into account debt, cash, and free-cash-flow levels by looking at free-cash-flow-to-equity/enterprise value yield.
The FCFE/EV yield as of the end of last quarter was +2.7%; if we adjust it for today's EV, it drops to +2.6% since the price has risen a bit. Cintas has a history of returning virtually all of its excess cash to shareholders so I'll assume that the shareholder returns over the next 10 years will be a CARG of +2.6%.
Future Return Expectations
Putting all three - market sentiment returns (-3.51%), earnings growth returns (-0.59%), and business/shareholder returns (+2.6%) - together, I estimate a full-cycle 10-year CARG return of -0.86%. That level of expected return puts Cintas in the 'sell' category for me.
In order to estimate the opportunity risk/reward, I use F.A.S.T. Graphs' forecasting tool to estimate future price appreciation, including dividends, for the next 2-3 years using analysts' estimates. Then I assume we will have a recession after that point. What I want to know is if a recession begins in 2-3 years, whether I will have a reasonable chance to buy Cintas at a significantly lower price than it trades today or if I would likely never get a chance at a lower price.
If we forecast out 2 years, including dividends, analysts estimate that Cintas's price could rise to $278.63. During the 2001 recession, Cintas price fell about -50% and during the 2008 recession, it fell about -65%. If during the next recession Cintas's price falls in the same range as the previous two recessions, we could expect it to trade from $97.52-$139.32; this entire range is far below the $216.50 it trades at today so I see little opportunity risk in selling this stock today.
Cintas has a great history of returning value to shareholders, but I think investors are currently underestimating how far Cintas's earnings could fall during a recession. When this is combined with Cintas trading much higher than its typical P/E multiple, it creates a fairly big potential downside for the stock price. Additionally, since most of Cintas's earnings growth has come in the form of buybacks this past cycle, it makes it more difficult for Cintas to prop up EPS via buybacks when the price is high. So, while there is nothing wrong with Cintas's business, investors are currently willing to pay too much for the stock, and there will almost certainly be significantly lower prices available over the next few years.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.