UniFirst Investing To Compete With Cintas
- UniFirst had a good quarter, but the stock corrected because it was overheated. This is a good entry point since the economy is reopening. Energy & hospitality should improve.
- 2022 EPS estimates are likely too low given the speed of the economic recovery. 2021 guidance is probably too cautious.
- UniFirst is investing in a new CRM system and opening a new service center in NYC. They should help improve speed, reliability, and lower costs.
- UniFirst needs to invest in technology and scale the business to catch up to Cintas. Then, it can turn this industry into a duopoly.
- Some of the market share the top uniform companies don't have isn't worth acquiring. Restaurants and hotels are less sticky and less profitable to serve.
In this article I will discuss UniFirst's (NYSE:UNF) latest earnings report and its attempt to catch up to Cintas (CTAS) through investing in a CRM system. I will use an interview with the former NY market sales manager for UniFirst as my guide to study the completive landscape in the uniform industry. These anonymous interviews with former managers are great because they tell us details companies won't. No company will give specific details on its flaws and the competitive market landscape. I still hold a position in UniFirst; it's a core part of my portfolio.
UniFirst Had A Good Quarter, But The Stock Was Too Hot
UniFirst reported EPS of $1.71 in Q2 2021 which beat estimates by 4 cents. It reported sales of $449.76 million which beat estimates by $2.46 million. That was a 3.2% decline from the prior year. UniFirst is still being hurt by the pandemic. In this quarter specifically, it was hurt by the winter storms in Texas. The topline was hurt by $2 million and the bottom line was hurt by $2.6 million or 10 cents per share.
This was a pretty solid quarter when you add back the impact of the winter storm. Obviously, it's tougher to control for the pandemic. Undoubtedly, results would have been much better if the pandemic was over. The company stated it had stable results in the quarter and there wasn't a large step up in March. The ability to give guidance was based on the expectation that the pandemic won't cause further shutdowns. I'm expecting further improvement as the economy fully reopens. I think UniFirst is being cautious.
UniFirst stock is down 13.03% from its peak in early March 2021. The initial decline occurred because of a downgrade (buy to hold). The solid earnings report didn't turn the stock around though. I think that's because the stock was overheated in early March. As you can see from the chart above, the EV to EBIT ratio go to the mid-20s which is near Cintas' valuation.
At its peak, UniFirst stock was 22% above where it was before the pandemic. Conversely, the company reported a 6% decline in income this quarter. It's more reasonably valued now especially with the cyclical expansion coming this spring/summer due to the stimulus and economic reopening. Personally, I don't sell any holdings that I think might fall 15%. It requires extreme precision to time it right. It also costs a lot in taxes (capital gains).
To be clear, UniFirst rents uniforms out to businesses on 3-5 year contracts (average contract length is 4.5 years). Its main function after delivering the uniforms is cleaning them. This core laundry business had sales of $398.2 million which fell 3.4% yearly. Its margins fell 40 basis points to 8.9%.
The specialty garments business had $35.2 million in sales which fell 2.1%. This business involves cleaning items such as nuclear garments. It's a lumpy due to the timing of outages and projects. This is a higher margin business which makes sense since it's a greater value add service. Businesses especially don't want those garments to be contaminated or get crossed up. This business line had 14.9% margins which were up 200 basis points.
Finally, first aid had sales of $16.3 million which were down 0.7%. Margins fell 640 basis points to 0.6%. Margins were hurt by the decline in the higher margin wholesale business along with the investment in its van business to expand it to new geographies. Overall company margins fell 50 basis points to 9%.
Full Year Guidance Was Conservative
UniFirst finally was confident enough to give full year guidance now that the pandemic looks to be nearly under control in America (the vaccination process has been slower in Canada). 2021 sales guidance calls for sales of $1.793 billion to $1.803 billion. This implies 3.5% organic core laundry sales growth and 10.4% core laundry operating margins. Full year diluted EPS is expected to be from $7.3 to $7.65 which compares to $7.13 in 2020 and $8.52 in 2019. The pandemic set the company back a couple years. However, there is hope the company beats these 2021 estimates. The CEO, Steven Sintros, seemed to suggest on the call that guidance is fairly conservative. He stated,
"we have this population of customers which we sort of talked about before that we're staying in close contact with that are either shut down or significantly reduced services because of the environment. And those are the ones that we feel like we could see some pull forward for the second half of the year. I will say we haven't built a tremendous amount of it in."
The company was especially conservative due to uncertainty about how quickly the vaccine rollout will help the economy. We are seeing with recent economic reports that the economy is almost instantaneously improving. Firstly, the March BLS jobs report showed 916,000 jobs were added. The March ISM manufacturing PMI was the highest since 1983. The ISM non-manufacturing PMI hit a 24 year high (record high). Employment is very important to UniFirst. You need to be an employee to wear a uniform!
Speaking of earnings estimates, the 2022 consensus EPS estimate is $8.13 which is 39 cents below 2019 EPS. That would make for 3 lost years for the company versus the 2 lost years following the 2008 financial crisis. I think 2022 EPS estimates will eventually be raised once we see the economic recovery accelerate. This recovery is set to be quicker than the last one. The economy will get back to trend job growth by June 2022 if it continues at the March rate. Goldman Sachs is projecting 8% GDP growth in 2021 and the unemployment rate to end the year at 4%. If that occurs, 2022 EPS should easily surpass its 2019 level.
Specific Segments Of The Business
The table below shows UniFirst's customer base in 2019. Clearly, energy and restaurants are the industries of most concern. The good part of having an energy business is it acts as a natural hedge. Since the uninforms are picked up and delivered, gas is a large expense. At least we know that if this expense is picking up, demand for energy uniforms will also pick up. Hospitality and restaurant uniform demand will pick up as the economy reopens.
Hotels and restaurants aren't great businesses to service in general because they are volatile and use linens. Specifically, if a restaurant receives uniforms and goes out of business after 1 year (as is often the case with restaurants), there isn't much of a profit. The first year of rentals covers initial expenses to produce the uniforms. Most of the profits come in the next couple years when they are only cleaned. Then around the 4th year, they are replaced. Linens are destroyed easily which means they need to be replaced often. They also have less customer stickiness because employees don't need to be refitted when a restaurant changes uniform providers.
UniFirst mentioned automotive and manufacturing were stable which is weird because I just mentioned the manufacturing PMI was the highest since 1983. Plus, in March lightweight vehicle sales were up from 15.763 million to 17.747 million which was the highest reading since October 2017. Let's see how UniFirst does next quarter to tell if the company was being too conservative.
CRM System Implementation
UniFirst is investing in a new CRM system which will be fully implemented over the next 18 months or so (done in early fiscal year 2023). The firm completed the pilot phase and is onto the deployment phase of the initiative.
They called it,
"a foundational change to our infrastructure that will allow for service improvements and efficiencies moving forward."
The 3 most important aspects of the uniform rental business are price, speed, and reliability. The uniforms need to be delivered on time. The right unfirms need to come back. Imagine going to a laundromat and picking up someone else's clothes (it would be a disaster).
Delivery drivers will be getting handheld devices which I think will help with route planning (speed & lower costs) and accuracy (deliver the right uniforms). A new CRM system could also help UniFirst get customers to renew their contracts at a higher rate. If UniFirst supplies new uniforms in the 4th year of a contract, renewals help profitability substantially. That first year of the renewed contract would be reusing the refreshed uniforms.
I was frustrated with the analysts' questions on the conference call. They were only focused on the accounting aspect of this CRM expense for their models (capitalized $27.7 million as of Q2). Long term investors want to know how this helps with speed and reliability.
UniFirst also spent $14.1 million on a location in NYC in Q1 2020 which will serve as a future service center. This will increase speed in this key market. The goal is to provide as much speed and reliability as Cintas does (the largest uniform company). UniFirst's $509.6 million cash hoard gives it flexibility to increase capex when needed.
Dividend Hike Coming In October
Even after spending money on a new CRM system and a service center, UniFirst still generated more cash than it started with. I expect a dividend hike within the next 6 months. The last hike was in 2019 when it doubled the dividend. Management is probably too stubborn to look at the dividend more than once per year even though they skipped a hike last year. However, this is the type of conservatism that got the company this much cash in the first place. I'd rather the company be too cautious than take out too much debt. The next hike should be announced in late October which would be 2 years after the last one.
UniFirst NY Sales Manager: Uniform Moat
I will be delving into some of the comments made by a former NY sales manager of UniFirst who was in that position for 2-3 years. This person has expertise in NY so it might not be fully applicable to the rest of the company.
The former sales manager described the entrenched moats in the industry that the big players have when he discussed customer stickiness. There are high switching costs. He said,
"It's a very, very gruesome and difficult process to change a uniform provider, especially on a bigger scale. I mean, you're talking about even a medium-sized company with 300 to 500 employees. I mean, you're looking at hours of fitting. There's no technology. I mean, I'm sure there is, but it's not being used where someone can scan all uniforms. Every company, the sizing is a little different, so it's always encouraged to sort of have the customer try the uniform on first, so the whole trying period, and delivery. And the pickup of all uniforms is a very -- it's a difficult process for any company, so they really have to have a reason to leave. But the truth is that a lot of them do leave, so the service is not great at the industry overall."
Companies don't have many options if they want to use a provider with scale. The 3 major companies are UniFirst, Cintas, and Aramark (ARMK). Aramark focuses on the restaurant industry. Hopefully, the investment in the NYC facility and the rollout of the CRM system lowers costs and increases retention for UniFirst. It's good news that the industry has room to improve service because it means UniFirst can gain share from weaker competitors. He specifically called out Aramark as having incomplete service, meaning it doesn't always return all the rentals.
"Aramark was verily well known for picking the stuff up, but not bring it back."
Losing uniforms is bad because it irritates the customer and costs the uniform company money to replace them. Aramark might struggle because it's not exclusively a uniform company (lack of focus). If he is criticizing UniFirst for losing customers, he's being too critical because UniFirst's customer retention rate is 90% and its national account retention rate is 95%.
Cintas Has The Best Speed & Prices
I'm not sure when this former NY manager left. It seems like speed was a problem for UniFirst in his area because he stated,
"Speed, I mean because typically when a customer signs up, it takes almost eight weeks to get it installed with Aramark, UniFirst, where Cintas could turn around in two to three weeks. So given the competitive market, especially when someone's looking for a change or looking to really start a program, they really get to sort of enjoy the product pretty quickly. I feel like their distribution centers are more spread out."
It makes sense that UniFirst is adding a new service center in his former area. This should increase speed in this key market. The handheld devices might help with route planning. I don't know for sure, but I'd imagine the speed differential between Cintas and UniFirst isn't that wide throughout the country. It probably varies depending on the location of the nearest service center. There is no question Cintas has the greatest scale though. This partially explains its higher EV to EBIT multiple. I think the fact that Cintas is more leveraged and aggressive with acquisitions endears it with Wall Street. Being in the Nasdaq 100 doesn't hurt either.
He mentioned that it's illegal to have service contracts auto-renew in NY so salespeople are always calling the big companies when their contracts are nearly up. I imagine that a better CRM system would allow UniFirst to remind all clients to stick with them when their contract is almost up.
The former sales manager was very complementary to Cintas and very critical of Aramark. He mentioned Cintas competes well on price, but that service and reliability are the most important differentiating factors. He said,
"They [Cintas] do have ability to lower the prices. Typically, in the garment industry, special rental industry its price per piece. I did see that they're able to sort of undercut everybody to get the business."
Cintas has a great brand and scale. UniFirst was actually founded before Cintas. UniFirst was founded in 1936 and Cintas was founded in 1968. I don't think UniFirst will ever defeat Cintas, but it doesn't need to. The goal is to grow its scale (lower costs) to create a duopoly eventually.
Market Share Growth Potential Limited?
My long term vision for UniFirst is for it to continue to take market share from the 'mom & pop' locations and potentially from Aramark. Technology automates the laundry process to makes sure uniforms aren't damaged or lost (uniforms have barcodes). This creates a moat the small companies can't compete with. The most important aspect of the moat is having high renewal rates just like a SaaS company. Remember, renewals are very profitable because after a 5-year contract is renewed, customers already start with uniforms. Uniform companies get the recurring rental money (the upfront uniform cost has already been incurred).
The textile rental services business was $39 billion annually as of 2019. As you can see below, UniFirst has 5% share and the top 3 firms have just 26% share. The uniform rental and dust control market is $10.3 billion annually. UniFirst has 12% share and the top 3 have 65% share. The point of these two pie charts is to show the large white space for expansion.
The former sales manager made a point I never considered. He/she described how the smaller uniform servicing companies often service non-profitable/volatile industries in NYC.
"But overall, there is business that's not profitable, and it seems like the smaller companies go after that business. Like I said, the restaurants, the linens, the hotels, the inconsistent business, I would say. So, they continue to strive, and there's 12 million people in New York City, so they'll find someone to pay them. Because they [linens] destroy easily, so every time it's destroyed, you pretty much have to replace it. People don't take care of them either. I mean, you got a restaurant, if a wine falls off, you're not really concerned with that. For a cleaning company, that's a replacement. You can't take it and it's tough to get out, so it's a very difficult product in that way Yeah, I guess it's also easier to switch providers if you have linens, because you don't have to refit everybody."
That means some of the market share the 3 major uniform companies don't have, might not be worth getting. Of course, keep in mind, they all already service some hotels and restaurant businesses. Furthermore, Aramark services a fairly high percentage of restaurants. This point is just to show the limiting factor in potential market share gains. I'm not sure what percentage of the market share that the top 3 don't control is in these industries.
UniFirst is my 6th largest position. It is 6.86% of my taxable account. My last article mentioned it was my 5th largest position. I didn't sell any shares. One stock just went up much more than UniFirst, surpassing it. I plan on holding UniFirst for many years because it is one of the top companies in a business with high switching costs. I hope to see the company continue to invest in technology to grow its lead over 'mom and pop' businesses and catch up to Cintas. We are mostly through the cyclically weak period caused by the pandemic. That being said, the stock's multiple has expanded solidly. The company must grow earnings to see its share price rise.
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