Description

“The current economic slowdown impacted all of our business segments.  We saw especially weak results in the sale of uniforms to the hospitality industry and also saw weakness in uniform rental as our customers reduced headcount or shut down facilities…Due to the uncertainties that exist in the economy we must remove the previous guidance…” (Cintas management’s opening remarks during earnings call for Q2 of FY2009 in December 2008)(note for context:  stock declined by over 16% in two days from that earnings report and by over 27% until bottoming on March 9, 2009; stock was already down by ~23% from roughly three months prior on September 16, 2008; CTAS is down by a similar magnitude at ~22% YTD with earnings being reported for Q3 FY2020 this week)

Unlike the typical research I share with the VIC community, I will try to keep this short (pun intended) with my recommendation to short Cintas (“CTAS” or the “Company”).  The Company reports this week and I therefore wanted to share this short recommendation with the VIC community in advance of this potential catalyst.  

Management’s most recent outlook as communicated by them on their earnings call in December was for earnings of $8.65-8.75 per share and consensus is $8.78.  Given the issues associated with the Coronavirus that I think could be more severe to Cintas’ business than during the financial crisis, at least until there is some confidence for people to engage in normalize activities like travel, lodging, gaming and pursuit of their education which are each relevant areas in which Cintas conducts its business, I am short CTAS as I do not believe the market has adequately discounted the severity of the business slowdown to CTAS’ financial performance this fiscal year nor the potential impact to next fiscal year.  

No one knows the longevity of the current setback to the travel, lodging, gaming, education, energy, and industrial sectors and no one customer of Cintas accounts for more than 1% of their business but as we’ve seen by the decline in business activity and the respective equities within the airline, cruise, lodging, and restaurant sectors (all of which are sectors in which Cintas has customers like Marriott, Royal Caribbean, MGM Resorts, United Airlines, Southwest Airlines, universities and numerous smaller businesses that are suffering), it would be surprising if Cintas were not to reduce or pull its recent outlook.  Some might suggest that this is already discounted by the decline YTD but I think the aforementioned description above where CTAS’ stock was down by a similar amount going into Q2 earnings of FY2009 as relevant and especially since I think this situation, at least in the near term, could be more severe to the Company’s customer base.  

The Company’s EPS declined by 31% in FY2009 and then another 5% in FY2010.  For some context, management described in their FY2010 annual report that “the U.S. economy, which lost millions of jobs in our fiscal 2009, continued to lose jobs through the first three quarters of our fiscal 2010.  These job losses directly affected our business as many of our products and services are dependent on customer employee levels.”    

I hope that the jobs being furloughed by the likes of Marriott (which noted occupancy levels of 20% or below), Disney, and MGM prove to be only a temporary setback but clearly the “customer employee levels” that Cintas serves will be reduced in the short term and I don’t think the market has yet to discount this issue at 24x the consensus EPS estimate and a 3.6% FCF yield.  It is possible that the market is simply willing to look through these issues (which are hopefully a temporary setback) but that is quite inconsistent with how many of the equities within the industries Cintas serves are being treated and this also extends to a variety of the vendors serving those industry customers as well (e.g., Sysco, Chef’s Warehouse, Performance Food, US Food, and peer Aramark).   

I do not have insight into exactly why Cintas’ peer Aramark traded down by 44% yesterday before closing down by 13% after multiple trading halts but ARMK (down 65% YTD) is now trading at 6.6x this year’s consensus EPS, more than a 70% discount to CTAS.  That said, I recognize that Aramark is more levered to challenges from closures across stadium/concert venues and universities and that UniFirst is a closer peer trading at more than a 23% discount to CTAS based on consensus EPS.  

The situation in 2008 and 2020 are different.  However, I think this situation is likely worse to CTAS (and I will again emphasize that it is hopefully just temporarily) and the longevity of the situation will ultimately determine where CTAS will trade to but for context it’s notable that CTAS traded as low as 7.2x its peak FY2008 EPS when the stock finally bottomed in March of 2009.  At that trough price, CTAS was trading at 10.4 FY2009 EPS.  If FY2020 EPS were to decline by just 10% (not the 31% from the financial crisis) to $6.84 and trade at 20x, that would result in a stock price at ~$137, not too far below the 2018 low that some machines might be focused on if the stock were to break below the December 2018 low of ~$155.  In this type of volatile environment, I don’t want to engage in spurious accuracy to pinpoint a target.  I think numbers will have to come down, I think the multiple ascribed to those numbers should be lower but admittedly in this world of being roughly a ZIRP it’s hard to be overly assertive on the multiple but I believe that CTAS, at this price and with the degree of near-term challenges (some more described below) to be a very attractive risk/reward short.  The latest data shows that only 3% of the float is short with 4 days to cover so it’s not a crowded short.  For the reasons described above and more below, I recommend Cintas as a short in meeting my objective for at least 15-20% downside in six months or less.   

A summary description about Cintas’ business follows below:

·       Two reportable operating segments:  i. Uniform Rental and Facility Services, and ii.  First Aid and Safety Services

·       The segment Uniform Rental and Facility Services (~81% of revenue, ~86% of EBITDA) consists of the rental and servicing of uniforms and other garments, mats, mops, and shop towels.  In addition, this segment includes restroom cleaning services and supplies, carpet and tile cleaning services and the sale of items from the Company’s catalog

·       The segment First Aid and Safety Services (~9% of revenue, ~8% of EBITDA) consists of first aid and safety products 

·       The remainder of the Company’s business is included in “Other” (~10% of revenue, ~6% of EBITDA) and consists of Fire Protection Services (~6% of revenue) and Uniform Direct Sales (~4% of revenue)

·       Cintas services over 1M businesses across a variety of industries including food service, hospitality, gaming, education, healthcare, automotive, and government

·       Cintas provides its services to customers via local delivery routes originating from rental processing plants and branches; in total, the Company has over 11,000 local delivery routes, 470 operational facilities, and eleven distribution centers 

The core tenets of my short thesis follow below:

1.     Cintas benefits from higher levels of employment and the historically low unemployment rate experienced recently has been a tailwind to the Company.  During the past two fiscal years as the trajectory of employment levels increased and especially across the numerous service sectors that comprise the Company’s customer base, Cintas grew organically by 6.5% and 7.1%.  Although I hope the current issues ascribed to the Coronavirus are contained as quickly as possible, it is obvious that the magnitude of those working daily with a need for their uniform to be laundered will be significantly reduced.  Estimates have not yet been reduced to reflect this likelihood and although the stock has declined substantially YTD, I do not believe the price adequately discounts the near-term challenges to CTAS’ business.

2.     Although the key set of challenges I envision will be ascribed to the Coronavirus as framed above, it’s also relevant to highlight that the Company was already experiencing a sequential deceleration in its organic growth rate.  Although management has noted that energy is not a big part of its revenue mix, they did call out energy in the last two earnings calls for notable softness and this is before the Saudis decided to engage in a price war to further decimate the U.S. energy industry.  During the past earnings call, management highlighted that “we had one fairly good-sized customer in the space go bankrupt.”  Management also noted that “industrials are a bit choppy.”  Furthermore, management noted that “pricing maybe wasn’t quite as incrementally positive” as witnessed during the previous two quarters.

3.     Industry research suggests that Cintas was “desperate” to acquire G&K and therefore paid a big premium to consolidate the competitive landscape.  In theory, the rationalization was good for Cintas and the industry at large but expanded CTAS’ exposure to the increasingly difficult energy sector and there is some evidence of some questionable accounting that the Company has demonstrated pursuant to the acquisition.

4.     Allowance for bad debt and DSOs rose last fiscal year and with the looming Coronavirus, these working capital issues are likely to escalate significantly.

5.     The Company’s fastest growing business has recently been its fire inspection services but some primary research evidences a questionable reputation and there is risk to growth moderating significantly based on the Company’s reputation in this segment compounded by intensifying competition.

6.     Primary research evidences increased promotional activity by Cintas to win share and this was prior to the likely slowdown in business activity as a result of the Coronavirus.

7.     Even in the absence of the Coronavirus-related business challenges, CTAS is confronting a tough set of organic growth comps at 6% and 7.6%, respectively, from last year’s fiscal year for quarters ending February and May.

There are of course numerous risks for being short Cintas and perhaps the primary risk consideration is that this is a strong business model that generates an attractive ROIC.  There is much operating leverage in the business model and management has been effective at growing its business.  The balance sheet is not stretched and the business model is not capital intensive.  However, in the current environment we confront and as evidenced by other strong businesses serving similar customers and the context described during the financial crisis, Cintas is not immune to further downside.

Catalyst

Catalysts

Realization by the market that lower employment activity levels across Cintas’ customer base will cause results to soften more significantly than is currently being discounted