Description

Price: $32.34

Dividend yield: 1.2%

Shares: 240M

Debt: $5.3B

ARMK is an under-earnings business with a relatively straightforward long-term margin expansion and deleverage story.  We believe that a combination of margin expansion, debt pay-down and modest low single digits sales growth translates into around $3.00 per share of long-term earnings power compared to $1.57 in fiscal 2015 (fiscal year ends September).   The earnings build up is relatively simple and summarized as follows:  If ARMK is able to close the margin gap with industry leader Compass Group enabled by an excellent operations-focused ex-Pepsi executive it could add $0.75-0.80 per share.  The business enjoys stable somewhat countercyclical cash flows that can be redeployed to bring down leverage to the long-term target of 3.0x from 4.15x today, adding $0.30-0.35.  Finally, modest sales growth in the low single digits adds another $0.30-0.35.  Adding it up we arrive at around $3.00 of earnings power. At a 15-17x multiple, not unreasonable for a stable low double digits earnings growth company, stock could be worth $45-50.

Business review

ARMK has been around since 1959 and has been stitched together through a series of acquisitions by the prior CEO. The business was taken private twice and became a public company late 2013.  There is much public information available and I will avoid rehashing what is easily available.

For starters, please review the investor presentation available at:

http://phx.corporate-ir.net/phoenix.zhtml?c=130030&p=irol-calendar

There will be an updated presentation soon, with likely updated long-term targets, when management holds their Investor Day in December.

The IPO prospectus is a great source of market data and is available here:

http://phx.corporate-ir.net/phoenix.zhtml?c=130030&p=irol-sec&secCat01.1_rs=471&secCat01.1_rc=10

Some brief notes on the business:

·         ARMK is a top-3 global provider of food, facilities, and uniforms services.  More than 50% of ARMK’s sales are from the less cyclical sectors of Education, Healthcare, Sports, Leisure and Corrections. 

·         Stable counter-cyclical recurring-like free cash flow business with high 94-95% retention rates and average client relationships of 10 years. 

·         Diverse client base with no client accounting for more than 2% of sales. 

·         Capital light business with capex running at 3.25-3.50% of sales and working capital not a huge source or use of cash.

·         FCF actually increased in 2009 as lower capex and working capital more than offset a drop in earnings. 

·         This business was taken private twice and has operated at 7x leverage.

·         There are two types of contract structures:

o   75% is Profit and Loss where ARMK receives all the revenues and bears all the expenses. Obviously, greater upside from cost-savings initiatives offset by somewhat greater risk from pricing.

o   25% is client interest (“cost plus”) where the client reimburses operating costs and pays ARMK a management fee. Lower risk with not much upside.

·         Addressable market is huge at around $900 billion, with only 50% outsourced to vendors like ARMK, and fragmented with the five largest players having less than 10% market share.  The three largest players are Compass, ARMK, and Sodexo. Compass is the market leader with industry leading margins and Sodexo is the laggard.

ARMK is under-earning with blended margins of 6% which are more than 100 bps lower than industry leader Compass Group.  If you drill down deeper, ARMK has a more favorable mix than Compass with a greater mix of uniforms (2x the margins of food) and 80% from North America (where Compass’ margins are 8%) which makes a case for even higher margins, at least 200bps higher.

ARMK was built as a patchwork of acquisitions leading to a decentralized and locally driven structure with high overhead. The relatively new CEO is an ex-Pepsi executive with a strong reputation for operational excellence.  He is focused on improving margins by cutting costs and improving productivity.  At their upcoming Analyst Day management could do a deeper dive on the margins initiative.

Between food, labor, and SG&A, there is $10B of addressable costs.

Valuation math

ARMK earned $1.57 per share in fiscal year 2015, ending September. EBIT margins were 6.1% and sales were $14.3B. 

If margins were to increase by 200bps, that adds $0.80 per share in incremental earnings (assuming a 35% tax rate). 

ARMK has $5.3B of debt, $1.275B EBITDA and 4.15x debt-EBITDA ratio.  Long-term target leverage is 3.0x. At the target leverage (assuming no EBITDA growth and simply debt payment), adds $0.30-0.35 per share in incremental earnings.  This is directionally consistent with the roughly $6.00 per share of value accruing to equity from paying down $1.5B of debt.

Incorporating 3-4% sales growth per year over the next 3-4 years, adds another $0.35 per share in incremental earnings.

Adding it up, we arrive at around $3.00 per share of earnings power. 

At a 15-17x multiple, not unreasonable for a stable, counter-cyclical, stable cash flow business with a 1%+ dividend yield, we get a $30-50 stock.

Management’s long-term targets of 3-5% sales and low double digits EPS growth suggests they arrive at a $3.00 earnings somewhere around 2019-2020.  Management’s targets could be too conservative because ARMK is targeting 20-25bps per year of margin expansion whereas Compass (the industry leader) expanded margins 50 bps per year over the first three years of their profit improvement plan.   

We don’t incorporate acquisitions in our valuation math even though management targets a relatively attractive 15% IRR which could be a source of upside.

Risks

There are several to be mindful of:

·         Food and labor account for 90% of costs and 75% of contracts are profit and loss so wage inflation and commodity inflation are not insignificant risks.

·         The pricing environment needs to be monitored.  If Compass gets more aggressive on price, that’s a problem.  A related risk is contract loss. ARMK lost Live Nation on a pricing dispute.  This risk is mitigated somewhat by ARMK’s diverse client base and no client is more than 2% of sales.

·         Management and the street add back stock comp expense which boosts adjusted earnings by around $0.30 per share.  This does make us somewhat uncomfortable. 

·         The stock has had a nice move on recent earnings and is trading at 18.5x-19.5x 2016 earnings which is not cheap but not egregious for a stable, low double-digit EPS growth business (with a 1% dividend).

·         Currency exposures to be mindful of: CAD, EUR, GBP, CLP

·         Analyst Day in December is both a risk and a catalyst.  Management will likely increase their margin targets which is positive. Unfortunately, they have telegraphed their intentions increasing the “sell the news” risk.

Catalyst

Catalysts

Analyst Day in December could be a catalyst if management raises their margin targets more than street expectations.