The United States employment situation really hasn't gotten much better over the last year, but that hasn't hurt the shares of uniform supplier Cintas (Nasdaq:CTAS) all that much. Up more than 45% over the past year, it's worth asking whether investors have already baked in an improving job market - even if those improvements have yet to show up in the government's statistical data. Cintas remains a high-quality, well-run business with some meaningful barriers to competition, but the valuation case is a little more unclear.
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Fiscal 2013 off to a Mixed Start
Cintas didn't get this new fiscal year off to a roaring start. Although the company's performance did meet expectations, the sequential deceleration in growth is still not good news.
Revenue rose about 3% this quarter, with uniform rental revenue rising nearly 5%. Direct sales of uniforms dropped about 1%, first aid rose nearly 7% and document management revenue dropped about 8% as lower prices for recycled paper weigh on results.
Profitability was likewise mixed. Gross margin fell nearly a point, with a 60 basis point drop in rental gross margins. Operating income rose 8%, though, as the company showed good expense control once again.
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Sluggish Numbers, but QE3 and Improving Add/Stop
The macroeconomic picture for Cintas is not the best right now, as unemployment remains stubbornly high. Likewise, new business formation and job growth within uniform-wearing sectors hasn't been any better. Last and not least, Cintas' uniform rental business has tended to track the U.S. PMI (on a somewhat lagging basis), and that metric hasn't been so strong of late.
On the other hand, Cintas reported that add/stop trends improved in the first quarter (after worsening in the fiscal fourth quarter). Then there's also the ongoing growth from the energy sector (where Cintas provides fire retardant/protective clothing) and healthcare sector (where it's introducing scrubs vending machines).
Last and not least is QE3. The Federal Reserve has explicitly targeted job growth as a priority, and will back that effort with billions of additional liquidity measures. It's anybody's guess as to whether QE3 will do what the Fed wants it to do, but if it does it will be good for rivals like G&K Services (Nasdaq:GKSR) and Aramark, as well as staffing companies like Manpower (NYSE:MAN) and Robert Half (NYSE:RHI).
Good Cash Flow, but Will Margins Improve?
Cintas has an admirable record when it comes to consistent free cash flow production (as a percentage of revenue), even though operating margins tailed off in 2008 and still hasn't recovered. And management hasn't squandered or sat on that cash flow - the company pays a decent dividend and has, by my count, bought back about 20 million shares since April of 2011.
I suppose one of the important questions for Cintas is whether those mid-teens margins can be regained. The business hasn't really changed all that much, as rentals are still more than 70% of revenue, and the company still maintains a large yet efficient route-based distribution network. I wouldn't bet against this company, but I also think investors have to be prepared for a very long, very slow recovery when it comes to the job market.
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The Bottom Line
I'm a little concerned that sell-side analysts are too bullish on an employment rebound. Cintas grew its revenue about 5% a year for the decade that ended in May of 2012, but consensus expectations call for a 6% annual revenue growth out to 2016-2017. I certainly acknowledge that the Great Recession weighed down that trailing revenue growth number, but I also think this recovery could be a slow one.
In any case, and even with a slightly lower revenue growth estimate, I do believe that Cintas can grow free cash flow by a 5 to 7% clip through the next decade. As such, I think fair value sits in the mid-$30s. That suggests that the stock is maybe 15 to 20% undervalued today (even though it's near a 52-week high); that is less than my typical margin of safety for new buys, but it does at least establish Cintas as worthwhile hold. In the meantime, I could see staffing companies like Manpower and Robert Half showing greater near-term leverage if that employment recovery does start to show up.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.