Description

Johnson Service Group PLC is a U.K.-based company that rents uniforms to businesses and runs a chain of dry cleaning stores. This is a decent business with steady, recurring revenue and good cash flow selling at little more than 8 times earnings and yielding almost 6%.

The uniform rental business, which generates about 80% of consolidated operating profits, is the largest in the UK, with a 23% market share. Davis Service Group (another interesting stock) has 21% of the market and Rentokil has 14%. JSG’s uniform rental division serves 50,000 companies, none of which represents more than 5% of revenue. There are about 1 million wearers. Customer contracts usually run three years.

JSG provides uniforms to factory workers, mechanics, hospital workers, chefs, waiters, hotel workers, etc. The breakdown is roughly one-third industrial customers, one-third retail customers, e.g., supermarkets, garages, restaurants et al; and one-third the food processing industry customers. My impression is that the food industry customers provide excellent margins to JSG because the standards of hygiene are much higher than elsewhere and because workers change uniforms much more frequently. JSG’s customers include Safeway PLC, Coca-Cola, Cadbury Schweppes, Ford, British Aerospace, and Volkswagen.

JSG delivers uniforms to the customer’s site, usually weekly, and, after use, collects, sorts, launders, re-packages, and re-delivers the items to the workers. Each worker typically has three uniforms assigned to him. At any given moment, one uniform is worn, one is stored in a locker, and one is cleaned. JSG depreciates the uniforms over 2.5 years. On average, each garment costs JSG about $15 from the garment manufacturer. (All figures are converted to dollars at 1 pound = 1.6 U.S. dollars.) JSG charges customers about $1.50 per week for each garment rented. Pricing has been stable during 2000-2002.

For most customers, it’s cheaper to outsource uniform service to companies like JSG than to take care of it in-house. JSG’s scale gives JSG lower costs that customers can’t match. When the customer hires JSG, they replace a fixed cost with a variable cost. Moreover, when customers contemplate the hassle of cleaning and repairing garments, they conclude that owning their own uniforms doesn’t make sense. A big attraction to this business is that customers care more about the convenience factor than the cost factor, which may account for the lack of pricing pressure over the past three years.

Customers also want a uniform rental agency that has nationwide coverage and can service all of the customer’s locations. These customers are moving their business away from the regional agencies and toward the three big agencies.

Customer loyalty is high. Retention rates exceed 90%.

In 2001, the UK uniform rental business generated $39 million of operating profit on $202 million of revenue. Over the three years 1999-2001, the division’s return on assets (operating profit as a proportion of tangible assets excluding cash) has run at 20-24%. Before JSG acquired Semara Group, another uniform rental company, in February 2000, the uniform rental division’s operating margin was 25%; Semara’s margin was only 8% -- 13% if one excludes excess overhead (since eliminated). Pro forma combined for the year before acquisition, JSG + Semara’s operating margin was roughly 18%. Semara’s margin was depressed by, among other things, low-priced large accounts. JSG has been able to bring the combined margin up to 19% in 2001. There’s obviously a big opportunity to boost profits by further bringing the margin back up toward the 25% level. Management thinks they can get the margin up to 22-23%.

JSG runs a uniform rental business in Ireland that is currently losing money. This is a small part of JSG’s business, however, constituting less than 10% of JSG’s revenue.

JSG runs the biggest dry cleaning service in the UK. The unit currently operates 517 stores. The management makes major efforts to offer a high quality service. The company’s surveys show high customer satisfaction, with strong loyalty. Operating profit in 2001 was $12 million on $114 million of revenue and roughly $56 million of tangible assets at 531 stores. So, on average, each store generated $23,000 of profit on $215,000 of revenue and about $100,000 of store-level investment. Profits were off 6% in the first half of 2002, with comp-store sales up 1.8%. This is a business with high operating leverage. Fixed costs are 80% of total costs. The business throws off lots of cash and needs little in the way of capital expenditure.

I like that the management has been decisive in closing underperforming dry cleaning stores. Customer convenience is the name of the game in this business. Management is opening new stores in high traffic locations, especially in or adjacent to supermarkets, and with drive-thru windows to attract customers who don’t want to get out of their cars.

On a consolidated basis, in 2001, JSG reported net profits before special items and amortization of $34 million, or $0.60 per share, on $353 million of revenue. Profits were up 3% from a year earlier. There were 53 weeks in the 2000 reporting period; I’ll have to find out whether this makes a difference in comparability. Direct labor costs were $135 million of the $300 million in total operating costs in 2001.

The UK has been going through a more severe recession than the U.S., especially in the industrial area. JSG’s business isn’t recession-proof, as shown by results in 2002. When layoffs go up, garment rentals go down. In the first half, net profit adjusted for special items and amortization was off 9% to $14.4 million, or $0.25 per share, from $15.8 million, or $0.28 per share, a year earlier, on a 1% decline in revenue. Profits in the second half are estimated to have declined by 35%. Full year 2002 profits are estimated to have declined by about 15%.

I don’t see any reason why there shouldn’t be a full recovery of profits when there’s a recovery in the economy. JSG hasn’t lost customers to the competition.

As indicated earlier, JSG generates good cash flow. In 2001, for example, JSG generated net funds from operations before working capital changes of $87 million, while capital expenditures were $52 million. For every $100 going out for operating expenses and capital expenditures, $120 comes in, which from my experience is a strong ratio.

JSG took on a fair amount of debt to acquire Semara Group for $166 million in early 2000. The nice thing about a company with strong cash flow combined with a meaningful amount of debt is that the company can use the cash flow to make its profits grow nicely. It can pay down debt, which decreases interest expense, which increases net profits faster than operating profits, which in turn increases free cash flow further, which lets them pay down even more debt, and so forth. JSG has already reduced its net debt to $114 million at mid-year 2002 from about $170 million at mid-year 2000. The debt is manageable. Interest coverage in the first half of 2002 was 5.7x.

A new CEO, Stuart Graham, was brought in during the spring of 2002. He comes with a strong reputation. I am going to try to find out more about Graham by talking to his colleagues at his former firm, ISS/AS.

JSG's dividend is 28.2 U.S. cents per share, so the yield at a $5 stock price is 5.6%. The dividend is covered 2x by prospective earnings.

I think that the stock is worth about $600 million, or about $10 per share, based on adjusted operating profits of $57 million capitalized at 12 times, less net debt estimated at $100 million at mid-year 2003. There are 57.4 million shares outstanding. Current market cap: $287 million. Adjusted operating profit is arrived at by taking operating profit (before special items and amortization) in a recovery of $53.4 million, adding back depreciation of $51.5 million, adding the regular proceeds from reselling used uniforms/charging the customer for unrecoverable uniforms of $9 million, subtracting stepped-up pension expense (sign of the times) of $5.6 million, and subtracting capital expenditures of $51.7 million, all of which I assume are for maintenance. I consider the cash flows from resale of uniforms, which doesn’t flow through the P&L, to be a normal part of earning power, because it appears to be a steady and consistent contributor to cash flow.

As a cross-check, earning power of $0.65 per share capitalized at 17 times yields a valuation of $11.

It should be noted that the most prominent uniform rental company in the U.S., Cintas, is a glamour stock, trading at 35 times earnings. I don’t think that JSG will trade up to a multiple like that. But if it traded up to a multiple that’s even half of 35 times, the stock will produce a nice return.

Catalyst

New CEO
Debt Paydown
Economic Recovery
Likely Takeover Target