For the last few decades, ABM Industries (ABM) has been a sleepy stock - but one that provided attractive returns. The provider of outsourced facility solutions - notably janitorial services, which drove 60% of first-half fiscal 2019 revenue - historically has grown revenue at a low- to mid-single-digit rate. The company's Vision 2020 plan, released back in 2015, targeted 5% EBITDA margins, a ~100 bps expansion from levels at the time. This is not a spectacular growth business by any means.
Yet, for investors, it's been a successful one. Even with some recent share price volatility, ABM including dividends has returned over 10% a year for the last quarter-century. It's a Dividend King, even though its yield currently sits below 2%. This has been the type of undercovered gem that savvy investors are supposed to choose.
But that long-term success ran into short-term trouble last year. A steadily tightening labor market started pressuring ABM margins - a problem given how thin those margins were to begin with. Investors initially liked the 2017 acquisition of GCA Services - but the debt incurred amplified that margin pressure. ABM shares tumbled nearly 40% from mid-2017 highs as the market was mostly going the other way:
But ABM shares, save for a dip during the market sell-off in December, have rallied - and with good reason. Labor market pressure hasn't gone anywhere - but ABM is managing well. Margins are holding up, and revenue growth was impressive in fiscal 2018 and decent in the first half of fiscal 2019 (ending October). The fears seem to have been overblown - as was the sharp sell-off in the stock.
And ABM may well have more upside from here. The fact that the labor market hasn't improved probably is a good thing, as it suggests some help for ABM at some point in the future. Technology initiatives should contribute in the second half of this year and beyond. Valuation doesn't look hugely attractive, but ABM is cheaper than a ~20x multiple to the midpoint of EPS guidance suggests - and cheap enough to keep moving higher.
To be sure, the easy money probably has been made to at least some extent. But the case for ABM now is that, as a company, it's basically back on track. That in turn would suggest that ABM stock can get back to its historical role of driving above-market returns while few investors notice.
ABM Gets By
From a headline standpoint, YTD results actually look somewhat disappointing. ABM drove organic growth of 4% in fiscal 2018, and a 73 bps expansion in Adjusted EBITDA margins to 5.07%. Progress on both fronts has slowed. Per figures from the 10-Q, revenue has risen 1.8% in the first six months excluding the impact of an accounting change (1.1% as reported). Margins have expanded just 8.5 bps similarly excluding that impact, and just 2 bps y/y in the second quarter.
But both FY18 and FY19 performance have to be considered in context. EBITDA margins last year benefited from the addition of GCA in Q4 FY17; legacy margins actually appear to have compressed. Revenue in fiscal 2018 also benefited from a major win with TfL (Transport for London), which was fully lapped in this year's second quarter. Both tailwinds boosted last year's results - and provide tougher comparisons for this year.
This year, meanwhile, labor market headwinds, first felt in Q2 of last year, are in full force, which wasn't the case for full-year 2018. And that's a factor not just for margins, but for revenue. Retention is down 1-2 points from historical levels, per CEO Scott Salmirs on the Q2 conference call. That's not a surprise, and it's not even necessarily a problem. Rather, ABM is walking away from business that isn't profitable enough - or just isn't profitable - in the "new normal" labor environment.
And the results so far support the company's strategy, even if they are not particularly impressive on their face. (Adjusted EPS, for instance, was flat year-over-year in the second quarter.) Any growth and any margin expansion in this environment has to be considered a win. Investors clearly see it that way: ABM is up nearly 40% from where it traded before last year's fiscal Q2 release, when signs of the tightening labor market were becoming clear.
The question now is whether there's more upside ahead - or whether the company's ability to manage the tight labor market largely is priced in at this point. I did question valuation at similar levels back in early 2017, noting that P/E and EV/EBITDA multiples historically had topped out at ~21x and ~11x. ABM isn't far off, at 19.7x the midpoint of FY19 EPS guidance and likely a high 10x multiple to this year's EBITDA.
But I'd note that ABM since has acquired GCA and seen corporate tax rates down come down sharply. And, looking forward, there are some reasons to see near- to mid-term growth potentially accelerating. ABM has invested heavily in technology of late, but hasn't seen much of the benefits. In May, a new ERP system in the UK went live, and the company launched its HRIS (human resources information system) and a new cloud-based time and attendance system domestically in Q1. A unified ERP between the legacy GCA and ABM businesses is on the way later this year. All three systems should offer some benefit - while the costs related to those implementations and integrations should fade in 2020.
And there are some levers to pull in the business as well. Both Aviation (16% of fiscal 2018 revenue) and Healthcare (4%+) continue to struggle. In Aviation, start-up costs related to a new catering initiative hit Q4 margins. Delta (DAL) apparently has insourced some existing contracts. And the labor shortage has been particularly acute in that industry, as ABM needs to not only find workers but get them through TSA clearance. But ABM does see better days ahead - Salmirs on the Q2 call projected improvement within 12 to 18 months - and new lines of business provide another potential benefit. The Healthcare business, meanwhile, after a leadership change is being realigned amid the existing segments, which could potentially help demand and will lead to a few million in annual cost savings as well.
But the broader argument here is that ABM's current performance isn't occurring in a particularly beneficial environment. In fact, it's the opposite. This is a defensive business, with much of its revenue coming from stable end markets like education, hospitals, and public sector facilities. The current labor market is about as big an external headwind as ABM is supposed to face. (Organic revenue growth was -3.2% in FY09 and -0.8% in FY10 - during the worst parts of a generational financial crisis. Adjusted EBITDA margins expanded in both years.)
In that historically difficult labor market, ABM is hanging in. So what happens when the market eases (as it will at some point) - particularly with help from new technology, new business lines, and a continued focus on cross-selling? It seems likely that ABM's growth will accelerate - and even near $40, ABM should have room for upside in that scenario.
Valuation and Risks
The simple bull case for ABM, even after the gains of late, is that recent quarters have only proven the resilience of the business model. Even in a tough environment, ABM has been able to drive growth. Management has been clear about the pressures (and still says it sees little near-term improvement) and wise in devising a strategy to counteract them.
That business model, again, has been successful, driving double-digit investor returns for a quarter of a century now (and beyond: the 40-year average return is 11.7%). With the rally only getting ABM in the range of historical valuation, historical returns should continue as well - and owning a defensive stock in this market, at this point in the cycle, adds another plus.
The more aggressive bull argument would include that case - while also emphasizing just how difficult the current market is. Much like a cyclical stock should see its multiples expand at the trough of the cycle, ABM valuation deserves some credit for being, in some sense, at the trough of its own cycle, if in costs instead of revenue. Labor tightness will be alleviated at some point, somehow - and that suggests potentially higher margins for ABM in a normalized environment. Meanwhile, even with the rally, the stock sits off its highs; there's certainly a 'feel' argument that even going up to $45+, another 14%+ upside, is required for the market to fully price in ABM's ability to navigate the current environment.
So what are the risks? Valuation could be one, particularly at 11x+ EBITDA on a trailing twelve-month basis. Peer comparisons are difficult - stocks like Aramark (ARMK) or TrueBlue (TBI) play in similar markets, but have different underlying models - but that figure, again, is the high end of ABM's range.
In terms of the business, one worry is that ABM, particularly post-GCA, is less defensive than it has been. Business & Industry is almost half of revenue now. Technology & Manufacturing is almost 15%. ABM probably is more vulnerable to a cyclical downturn from a revenue standpoint than it was a decade ago - though such a downturn might also give some relief on the labor cost front. Along those lines, ABM's performance hasn't been consistent in terms of end markets. The Technical Solutions business has driven 40% of the YTD revenue gain (again, excluding accounting changes) - with benefits from two 'mega-projects', as Salmirs termed them on the Q2 call.
Still, that's a far cry from where ABM sat a year ago, when there were very real worries about the company's long-term margin potential, or non-unionized competitors being able to undercut the company (34% of employees are unionized, per the 10-K). The issue now comes down more to price and return expectations than anything else.
And, again, the easy money likely has been made. But it's not as if ABM is expensive. Trailing twelve-month free cash flow is $200 million, suggesting a 13x multiple. Adjusted P/E doesn't exclude amortization of intangible assets; if it did, ABM's P/E would be above $2.50, and its adjusted P/E closer to 15x. Valuation is reasonable enough to think it can at least hold, even if the quick multiple expansion seen this year (in particular) likely is at an end.
From here, ABM seems like it should get back to what it was - and there seems a reasonable expectation that new highs above $45 should be on the way if not in the second half of FY19, then looking to FY20 results. That's mid-teen upside on a percentage basis, including the dividend. And it's enough to think that even though ABM has rallied, its gains aren't quite over yet.
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.