Watch and Wait on Cintas
Steve is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Cintas (NASDAQ: CTAS), with a market capitalization of about $5.2 billion, is North America's leading supplier of corporate uniforms. The company operates almost exclusively in the United States and Canada where it serves about 900,000 customers. As the dominant player in a mature industry, Cintas has unique opportunities to create shareholder value but also faces challenges like industry revenue growth that has been sluggish and fierce competition for profits.
With market capitalizations of about $1.3 billion and about $600 million, respectively, UniFirst Corp. (NYSE: UNF) and G&K Services (NASDAQ: GK) are Cintas’ primary competitors. Superior Uniform Group is a minor, third competitor with a market capitalization of only about $71 million. Like these rivals, Cintas will look to boost its earnings and cash flow growth rates and shareholder value through superior margin expansion during the current period of weak industry growth. Historically, Cintas has bested its rivals with gross and operating margins that have averaged 42% and 13%, respectively, compared to 38% and 11% or less, respectively, for its competitors since 2007. Also, free cash flow has averaged about 8.5% of revenue since 2007 compared to less than 7% for its competitors.
Stalled revenue growth in its higher margin uniform rental business will make it difficult for Cintas to improve profit margins. Since the end of fiscal 2008, local delivery routes declined from about 8,400 to about 7,700 currently. The uniform rental business now represents only about 40% of total revenue from 70% a decade ago. Despite these unfavorable trends, the uniform supply industry remains highly fragmented with many small local players, which gives Cintas an opportunity to use its scale advantage in pursuing acquisitions. Although the number of local routes has declined, Cintas' scale is the company's main competitive advantage as the route network still towers above its competitors. This significant advantage will come into play as the company seeks to exert greater pricing power over its suppliers while limiting the impact of higher input costs like fuel, and spreading fixed costs over a broader customer base.
Going forward, Cintas' earnings are expected by analysts to grow at a rate greater than UniFirst but slower than G&K Services. Correspondingly, at its current share price of around $41, Cintas trades at a price to earnings to growth (PEG) multiple in between its competitors. Cintas is expected to grow earnings per share at 10.3% annually compared to 15.8% for G&K Services and 7.9% for UniFirst. Cintas trades at a forward PE multiple of 14.7x and a forward PEG multiple of 1.4x. This is less than the 1.8x forward PEG multiple paid for UniFirst at a recent price of about $67 per share and a forward PE multiple of 14.0x. G&K Services trades at about $32 per share, which yields a forward PEG multiple of 0.9x. Its forward PE multiple is 13.7x.
Earnings per share growth estimates for Cintas rest on estimated revenue growth of about 4.9%, which is reduced from a 7.7% rise in fiscal 2012 (ended May 2012) and a 7.4% rise in 2011. This estimated revenue growth rate is in line with the historical average revenue growth rate, which leads me to more readily accept the consensus EPS estimates. Further supporting EPS growth are the share repurchases that Cintas has made. The company’s share count is down to about 130 million from about 153 million at fiscal year end 2010 (ended May 2010). Cintas has bought back more than $800 million of stock in the last two fiscal years and has about $370 million more to repurchase under a $500 million October 2011 Board authorization.
Based on discounted free cash flows, Cintas is currently modestly overvalued even assuming that the company will return to the 6.6% free cash flow growth rate it produced for the 8-year period ending in 2010. This fair value estimate is not compelling given industry headwinds and company-specific issues like diminished route size and declining contribution of the higher margin uniform rental business.
I would not buy Cintas shares at this level but as a long-term investor I also would not sell if I was currently holding shares. Because of the company's industry leading margins and sustainable cash flows, I would look to exit shares if the PEG multiple expands closer to the 1.8x enjoyed by UniFirst either through share price appreciation or forward growth estimate reductions. On the flip side, I would consider purchasing shares if the PEG multiple shrinks due to price under performance or raised earnings expectations.
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