Description

I suspect this could be an interesting short on complacency. 

To be clear, CTAS is a beast. CTAS is a uniform and other service/supply company.  The key to the business is building route-density to leverage the efficiency of truck drivers.  CTAS offers the best service with unique brand offerings (Carhardt).  Its employees aren't unionized, allowing CTAS to provide attractive incentives and make route/other adjustments.  The uniform industry experienced peak demand post-Covid as employers couldn't source uniforms consistently due to a lack of truck drivers and low-skill labor.  This drove a period of substantial pricing power amplified by material labor market expansion.  today, the circumstances have reversed.  Uniform/other supply is abundant and demand is rolling.  Demand is dropping as the labor force peaked 11/23 (see below).  Further, all corporations are looking to squeeze cost.  To offset this impact, it appears that CTAS has barged into the competitive process and stolen a fair bit of share from VSTS which had to cut guidance.  Then UNF reported on 6/24 that each contract rolling had a far more vigorous competitive response.  This makes sense.  VSTS and UNF realize that CTAS is coming after them for share.  Given the massive incremental/decremental of the business, if they expect to see more competition, they need to engage more aggressively to protect their turf.  CTAS may have struck the first blow while VSTS/Others were sleeping, but now the market is more competitive.  Meanwhile, CTAS takes annual price increases.  I suspect that these calls aren't going to go as well this year.  in fact, my suspicion is that customers are going to refuse and threaten to move their business if they get a price increase.  The uniform industry is akin to your cable bill.  if you don't call to threaten to quit, your bill goes up and up - but perhaps not as aggressively as cable.  after a long period of retention, CTAS customers may decide its time to stop taking price and threaten to evaluate alternatives or bid out contracts up for adoption.  Despite moving into more challenging market conditions, the stock seems to have rallied straight into stormy waters.  the company reports tomorrow and will guide for FY 6/25.  We suspect that it will be "OK" and we believe the key metric is revenue growth of 7%.  there is elevated risk that they can't guide this high.  at this valuation, the market could become aware of the risks to this guidance in coming quarters and compress the multiple which has expanded to a record of 30x ebitda and nearly 50x eps.

CTAS's growth algo is roughly the following:

We see risk to job growth as employment peaked 11/23 and pricing assumptions due to the presence of more competitive market.  This will force CTAS to take more share to generate 7% in FY6/25.  If it does this, its competitors will get more desperate to retain their contracts and to steal other renewals, bringing down price for the industry.  the stock fails to acknowledge the reality of these risks at its highest valuation ever.  If the company musters the courage to guide to 7%, we suspect there is amplified risk that at some point in the coming 4 quarters that it will miss, especially if the labor force contracts.  this isn't going to be a multi-bagger but could be nice risk-reward.  at this point, I am just derivatives to play tomorrow's earnings where I suspect there is 50-75% where management guides to 75%. however, if they are being realistic, I suspect mgmt needs to guide to a much lower growth forecast.  I will re-evaluate further after they report.  

More info:

They have built the most dense route which provides a cost curve advantage.  They have become highly efficient route operators and cross-sellers of goods.  CTAS has demonstrably higher margins as a result of this efficiency.  This allows them to compete on price effectively to take share.  CTAS employment force is not union – allowing them to provide alignment.  VSTS is union which may limit ability to provide incentives on cross selling.  The crux of the short is that CTAS market and growth is on the cusp of decelerating and could go negative.  Conditions have gone from acutely short during the pandemic when uniforms were hard to source – to abundantly available.  The stock has blindly rallied with QQQ and ignored some high frequency trouble signs when UNF reported on 6/24/24.  There is a real chance that CTAS has to guide below the street which expects 7%+ today.  Given the peak valuation and the torque to volumes (with high incremental/decremental), this could create a significant hiccup.  Should the market sense the US labor force is set to decline by 1-2%, the multiple compression here could be substantial.  What is great about the short is that management has to provide a guide next week on FY6/25…  Do they address reality or do try to fake till they make it?  Stock appears to have no clue that a looming correction in employment could occur and drive results to LSD or negative?  It is worth mentioning that post-Covid the uniform suppliers struggled with consistent supply of uniforms – driving pricing for suppliers and zero competitive bidding provided service was satisfactory.  Today, that impulse is reversing 180 degrees as employers are desperate to cut costs.  Our base case is mgmt. guides in line and stock is ok.  However, we sense there is real probability they have to guide to something more conservative which could shake the stock.  We like 7/19/24 puts which don’t price in much vol.

Short thesis:

• Material multiple expansion to 30x ebitda from low 20s
• Weaker market
• US labor force peaked in November, 2023.  2H24 will be negative if we don’t see more growth
• Uniform industry supplies restaurants and industrials – two segments with substantial pullback of late
• Supply of uniforms went from short post-pandemic to abundant
• Small business and corporations are sharpening pencil on expenses – bidding out more
• UNF reported 6/24 and pointed to lower growth and more competition
• Inflation pricing has run thru system
• Growth algo of +6-8% could be challenging

We have four main questions:

• Does CTAS benefit from lag on contractual pricing and is likely to benefit still from inflation if FY6/2025?  New contracts won’t … but is there a tailwind within existing contracts still?
• What drove CTAS +7.7% organic growth in March 31, 2024 with 0.4% US labor growth?  How much was lagging price vs share gain vs cross-selling?  Is it possible they can hit 6% with a slight decline in labor force?  Or was this peak outperformance of the market with comps getting much tougher?
• How much is recurring revenue and comes up for bid?  We believe 20% of contracts renew each year but that points to 5-year contracts which seems long.  Need to confirm.
• Management reportedly is decidedly conservative on guidance and provides beatable estimates.  However, they also know that a guide of 3-5% guide vs 7% expectation could cause a substantial decline in the stock.  Do they guide 6-8% to start and pray?  Or are they honest at the get-go?
• Is CTAS so much lower cost that it can clean up in this new market where most contracts rolls trigger a competitive bidding process?  Or does this just trigger a huge price war?  If roughly 20% of contracts come up a year, if they took more than their fair share of the competitive renewals – this could drive 4-5% volume grwth.  However, it would likely trigger a massive price war?  Incumbents have an enormous advantage and incentive to match on price and customers prob prefer to keep existing supplier.

CTAS as a growth darling and QQQ component has ripped

• Multiple has expanded to 30x EBITDA vs very low 20s in past
• Up 20%+ YTD

Fundamentals have materially decelerated or declined.

• US total labor force participants peaked in November of 2023 and is modestly lower since then.
• YTD labor force is +0.4% Y-o-Y.  we could go negative in 2H24 if employment picture doesn’t improve
• Small business sentiment on lows and every employer searching for savings.
• Competitors stating that more and more contract renewals are put out to competitive bid as employers sharpen pencils on expense control (akin to ALIT)
• Competitors stating that pricing moving to historical norms (LSD)

US total labor force (flat y-o-y)

Margins have expanded materially and dwarf peers.  A component of this is clearly their expansion of route density via cross-selling and share gains.

UNF margins have been in decline

VSTS – modest improvement

If volumes were to drop due to decline in the market, decremental pain most acute at highest margin operator.

Management was highly confident on last call. 

Management reportedly always presents beatable estimates

High degree of recurring revenue and medium term contracts

How do they miss?

• Estimates assume 7% growth for 6/2025
• Number of uniformed employees goes negative
• Limited pricing on legacy and new contracts
• Enormous pressure on cross-sell and market share gains in a market where competitors are desperate to hold existing and win new customers… while customers are highly price conscious
• Big question:  what (if any) price improvement do they get to rolling old contracts or embedded pricing on a lag?
• Last quarter CTAS had 7.7% organic growth with job gwth of LSD Y-o-Y

Given the potential deceleration in market conditions and premium valuation, CTAS would be really smart to do a big deal with material synergies.  Would they buy VSTS despite its union work force?

Bulls seem to think that CTAS can exploit VSTS service issues to drive 7% growth.  It's worth mentioning that we believe VSTS has ~$2.8bn of revenue with perhaps $560mm up for renewal.  If CTAS completely owned VSTS and took 50% of that contract renewal… it would be $280mm or ~3% growth vs their growth algo of share driving 1% normally.  This type of aggressive pricing action would likely cause compression on CTAS renewals too. 

Barclays Note:  6/24 after UNF whiff…

Lastly, CTAS expectations are high, just like the multiple - but we think it

will continue to deliver

We think the challenges facing CTAS's competitors are company specific - or at least due to their

subscale and culture vs. CTAS. All of UNF's talk of increased new national account bid activity

and challenging pricing environment is a constructive read-through for CTAS, in our view. We

also don't read too much on the 'pricing normalization' comments, since CTAS has never

needed to use its pricing muscle to deliver solid numbers (and it has talked about it being in the

+/- 3% range already). And while yes, the industrial world is weakening, UNF did also say that

there is not much change on a consistent but cautious macro - nor is it seeing any significant

headwinds in any of its end markets, not even in manufacturing (~ 43% of UNF revenues, similar

exposure for VSTS vs. ~28% for CTAS). And recall, CTAS has 1M customers with an estimated

average weekly spend in the $100's - so there needs to be a lot of dislocation for any significant

impact, in our view.

So for CTAS's upcoming F4Q24, we continue to expect another solid qtr., constructive and

confident commentary, plus a guide that could be in-line with the Street since CTAS is typically

conservative. However, with the stock price & multiple just off of historical highs, the bar for

CTAS is higher - meaning that the immediate reaction could be negative, but our analysis of

guides to actuals illustrates that mgmt’s initial guides end up being consistently beaten on both

the bottom & top lines. Recall, we characterized CTAS's fiscal 3Q24, commentary, and guide as

being simply summed up in 2 words - “robust" and "momentum.” Management commentary

and the raised guide indicate that momentum is expected to continue - albeit due to workdays

and comps, so there will likely be a slight sequential deceleration on a relative basis.

• Note: Our time with CTAS at CEO-led UK & EU Meetings (5/14) confirmed CTAS's competitive

differentiators (for which culture is foundational) were as strong as ever and potentially

strengthening. Stock price performance has been excellent – we think driven by CTAS’s quality &

consistency and expanding to European/ESG investors (see BIPS of ESG: ECL, CTAS & WSC -

#CircularEconomy as a driver of growth, 06/08/22). There’s also recession resiliency: ~2/3 of new

business comes from non-programmers & typically represents reallocation of existing spend vs.

asking a customer to spend new $’s. End markets are well diversified (~70% services, <30%

manufacturing) with no customer group >10% based on the 3-digit NAICS code; no single

customer is >1%. And lastly, the value proposition strengthens demand across a diverse end

market, leading to TAM expansion via skillful introduction of new products and entry into new

markets.

High frequency data point suggests market conditions are deteriorating quickly,  UNF 6/24/24:

Sure. Let me hit those one at a time. I think when we talk about the more challenging pricing environment, it's primarily

inflation -- emerging from this inflationary period, right? I think about it from how we're managing our vendors, and

after multiple years of higher costs, we're putting more programs out to bid with our vendors. And I think you're just

seeing some of that, in general, in the marketplace, and that's leading to somewhat of a more challenging pricing

environment, which probably isn't surprising.

From a new account perspective, I wouldn't say there's really been a significant change. We've talked about over the

years new account acquisition is often a competitive situation, but I wouldn't say there's any significant change in that

pricing environment over the last few quarters. And as far as the ads versus reductions, I don't want to overestimate that.

But we had been talking about, if you go back over the last couple of years, a year ago, we were getting some more pull

from ads versus reductions. In the last couple of quarters, we had been saying it's been mostly stable. And although,

again, as I said in my prepared remarks, I would still say it's mostly stable. We have seen a little bit of weakening there

during the quarter. It didn't have a significant impact but wanted to mention it just as we think it may be a precursor of a

little bit weaker hiring environment.

Separate question

We certainly continue to get the price, right? But I think when you think about price increases and you think about the

environment, we're consistently going through a cycle where we're renewing accounts and going through annual

escalators.

And so in general, as you go through those cycles, yeah, it's a balance between getting more price from your customers

appropriately based on the profile of the customer, also trying to secure renewals in the face of potentially competition.

And again, I think just customers out there looking at all costs, I mean, we've all gone through years of sort of mounting

costs in many, many areas, and I think there's just more activity out there right now. And, you know, continuing to

develop and maintain relationships with our customers and show the value of the service is really a big focus to make

sure we can secure renewals at appropriate pricing going forward, but it's really just more activity out there in the

market.

Step function down in Organic growth at UNF: 6/24

Could UNF be a substantial net share loser in this market?  It is possible.

Our updated full-year guidance, which Shane will discuss shortly, implies Core Laundry Operations' organic growth in

our fourth quarter to be approximately 3.5% at the midpoint of the range. During the last few quarters, as the market has

emerged from a period of significantly elevated inflation levels, we have discussed a more challenging pricing

environment and its impact on our sequential organic growth rates. Although it was too early to be making too many

comments about next year, we did want to communicate that based on these trends, we currently expect organic growth

in fiscal '25 to be more modest than our fourth quarter.

Catalyst

FY 2025 guidance below street or an eventual cut which causes multiple compression