Cintas' Fiery Valuation Overshadows Growth Expectations

Summary

• CTAS enjoys multiple EPS tailwinds manifested in the hospitality sector rebound, introduction of new services, and M&A.
• Dividend growth trends are likely to persist.
• Price multiples remain high, narrowing potential returns for long-term investors.

Hispanolistic/E+ via Getty Images

Investment Thesis

Cintas (NASDAQ:CTAS) is one of these companies you buy in the hopes their revenue grows enough that your investment would make sense. Here are the returns based on the current share price:

• EPS/Price: 2.9% FCF/Price: 3.0%

Would you buy a company yielding these returns if it wasn't on the stock market? I don't think so. Interest rates are rising, and soon you'll get better yields buying treasury bonds.

Some cite revenue growth as a factor in buying CTAS. Every investor has their own required rate of return on investments they buy, and I know people in the private-equity space who wouldn't touch a business if it doesn't yield at least a 20% return each year. The national average of cap rates on a two-bedroom apartment is 5%, mirroring a more temperate investor base. Let's assume you're comfortable with an 8% annual yield on your cash and bought all CTAS shares for the current price of $390 per share. To get your required 8% Return on Invested Capital ROIC, which in this case is $41 billion, CTAS needs to triple its net income from current levels. Only then you'll start receiving your 8% ROIC rate. Until then, it is just disappointing low to mid single-digit returns.

One can't ignore the company's growth record, but I believe that investors are paying too much for that. In the past four years, average EPS annual growth stood at 10%, supported by organic growth, share buybacks, price increases, and M&A. Applying this growth rate to the current earnings level means that an investor needs to wait eleven years to start earning the 8% ROIC discussed above.

Our hold rating mirrors CTAS's strong market position, growth record, and solid balance sheet, supported by long-term contracts and management expertise, weighed against high price multiples.

Revenue Trends

From a strictly financial point of view, in some cases, it makes sense for a business to lease nondurable goods throughout its lifespan if the price is right. CTAS has been in operation for decades, verifying the sustainability of its business model, and it is clear that its customers find value in outsourcing non-core operations, from uniform and towel cleaning to hand soap restocking.

CTAS scale allows it to offer low prices, creating a competitive moat against market entrants. The company is profitable and is finding new ways to increase revenue. Last quarter, organic growth was 10%, supported by several factors.

1. Price increases from CPI escalators in its lease contracts
2. Market share expansion
3. Introduction of new products

Merger and acquisition "M&A" contributed 0.3% to revenue growth.

The company's historical growth figures offer a source of optimism. It recently adopted a new Customer Relationship Management "CRM" system from SAP (SAP), equipping its sales force with a state-of-the-art digital arsenal to enhance sales. A rebound in the hospitality sector as governments ease social distancing rules offers another growth tailwind.

I believe that CTAS will continue to grow in the coming quarters. My main concern is about valuation. As mentioned above, CTAS needs to triple its net income to start making sense as an investment at current prices. The question is, are these growth factors enough to bring us to this level, and if yes, how much do we need to wait?

Valuation

At the time of this writing, CTAS is trading at $390 per share, down 3.7% in the past five days. I believe there is still more downside potential, given its high valuation.

The stock trades at 37x PE, almost double the industrial sector's median, and its EV/Sales is more than triple the industry average. These ratios are mirrored in Seeking Alpha's Quant Scores, rating CTAS an F on valuation.

Seeking Alpha

For CTAS to trade in line with peer average, the price should decline 50% to $200 per share. Even if CTAS maintained a 10% revenue growth, it would require seven years to reach its peers' average.

CTAS shares snowballed in the past five years, outpacing the index. However, this comes at the expense of higher price multiples more than earnings growth. Below is a chart showing the PE ratio across the years.

Data by YCharts

Financial Position

I mentioned M&A as one of the potential drivers of revenue growth. CTAS's solid financial position gives it this option. Total interest-bearing debt stands at $2.8 billion, compared to $8 billion in assets. The annual interest rate is $90 million, weighed against a $1.4 billion EBIT.

Financially-stable companies often hold some debt, leveraging return on equity "ROI." Last week, CTAS issued $1.2 billion in new notes to refinance recently matured $1.2 notes. The company found itself borrowing at slightly higher interest rates. Below is the company's debt schedule.

Value millions	Coupon	Maturity	Price	Effective Yield
$300.00	3.25%	22-Jun	$99.41	9.46%
$400.00	3.45%	25-May	$99.54	3.47%
$1,000.00	3.70%	27-Apr	$98.95	3.94%
$800.00	4.00%	May-32	$98.44	4.06%
$250.00	6.15%	Aug-36	$120.59	4.22%

Click to enlarge

Source: Morningstar

Have you noticed the 9.46% effective yield on the $300 million, 3.25% notes maturing next month (June 2022)? This has more to do with the recent market disruptions and illiquidity of the note's market than it does for CTAS's credit fundamentals.

Dividend

CTAS enjoys a stable dividend distribution policy, supported by a low payout ratio and robust FCF. The company has been growing its dividend for more than thirty-six years, earning it a position among dividend aristocrats. However, its yield, which currently stands at 0.96%, is sub-par.

Seeking Alpha

I expect incremental but steady increases in the dividend, despite market disruptions.

Summary

The stock market is pricey these days and I believe that the market selloff will continue as the Fed raises interest rates. Soon, it will become more economically feasible to invest in bonds rather than inflated equity. There are still some bargains, but CTAS is not one of them.

Even if CTAS grew 10% annually, it would take years until its earnings are big enough to justify its current price. The implied Required Rate of Returns is minimal at current levels. Our hold rating mirrors the company's growth record, growing dividend, scalable operations, and competitive moat, weighted against high valuation.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of CTAS either through stock ownership, options, or other derivatives. 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.