February 08, 2011 - 2:53pm EST by
2011 2012
Price: 14.70 EPS $0.33 $0.35
Shares Out. (in M): 14 P/E NA NA
Market Cap (in $M): 202 P/FCF 8.0x 8.0x
Net Debt (in $M): 220 EBIT 45 45
TEV ($): 425 TEV/EBIT 9.4x 9.0x

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Mac-Gray presents investors with a stable and highly visible revenue and cashflow stream, improving economics on an attractive capital base & market, improving corporate governance and a reformed capital-allocation strategy focused on returning cash to shareholders through deleveraging and increasing dividends - all at a very attractive 12% FCF yield.  With steady state FCF of ~$2.00 / share, a potential dividend hike and a re-rating of the stock to a 5% dividend yield, could easily make the stock double to $30 / share in the not-to-distant future.  Even without multiple-expansion improving operating performance will, at the very least, provide high mid-double digit returns for the next two years.

Business Description

Mac-Gray Corporation (TUC) is a leading laundry facilities management contractor in the United States.  It has two lines of business 1) Facilities Management (95% of sales), and 2) Commercial Laundry Equipment Sales (5% of Sales).  The facilities management business provides self-service coin & card operated laundry services to residents of multiunit housing, such as apartment buildings, condominiums, colleges and university residence halls, and hotels and motels.  85% of the facilities management business caters to the apartment and condo market while 13% to the academic market.  The commercial laundry equipment business sells, services, and leases to retail laundromats, restaurants, hotels, health clubs, and others who operate their own on-premise laundry facilities.

The self-service coin & card industry is fragmented with 2/3 of the market consisting of self-operated facilities and independent regional owner/managers with a handful of locations.  Mac-Gray is the second largest operator with around 15% of the market (competing with privately held Coinmatch who has a slightly higher share of the national market).  Competition is pretty rational as the big players generally respect each other's turf, while overall capacity remaining relatively stable (maintaining steady returns).

EOS are achieved through better source-pricing and through market density / operational efficiencies, which has prompted larger players to pursue a roll-up strategy.  Larger operators, like TUC, provide property managers with a clear value-proposition to outsource non-core business to an operator who can guarantee uptime and efficiency.  Property managers can instantly increase the NOI on their properties while avoiding the headache and complexity of a laundry business.

Business Model

TUC's main business model relies on long-term contracts that average 7 - 10 years.  The terms of these contracts vary, but generally TUC is in charge of providing and maintaining the capital equipment (i.e. washing machines) while sharing, on average, 50% of the revenues.  Volume and price are the main business drivers in terms of unit & facility economics; and while the broad economic-health of the markets they operate in (employment and occupancy rates) does indeed influence the utilization of their assets, in general, the impact of economic cycles has been quite manageable - translating into a quasi-recession-resistant business.  2009 and 2010 were particularly though years as the national housing market crash caused apartment vacancy level to peak to abnormal historical highs across most markets, however, even in such extreme circumstances, Mac-Gray was able to cut capital spending and keep free-cashflow steady and actually reduce debt by almost 25% in two years (reducing leverage ratios from 4.15x in 2009 to 3.1x in 3Q of '10).

A slide in the company's most recent presentation does a good job of describing the revenue and cost drivers, copied here:

Revenue = (# of Machines) x (# of Cycles) x (Vend Price)

- Less: Rent = ranges from 38% -60% of revenue (a fixed, or variable, percentage of revenue)

- Less: Op's & Sales Exp. = ranges from 14% -32% of revenue (Warehousing + Delivery + Service + Collection+ Processing)

= 16% to 38% EBITDA margins (before allocation of G&A) (Company avg: 29%)

A tainted history of overpriced acquisitions

Mac-Gray's stock has traded sideways ever since its IPO.  Stewart MacDonald, part of the company's founding family and current CEO, has pursued an ostensibly flawed acquisition strategy that has clearly destroyed shareholder value.  However, after some activism on the part of an investor / shareholder (Fairview Capital), the board seems to have restructured its capital budgeting strategy with a renewed focus on reducing debt and returning cash to shareholders.  While acquisitions will likely continue to be part of the company's corporate strategy, there is evidence to suggest they will be more disciplined in price by focusing on profitable organic growth and immediately accretive tuck-in acquisitions.

FCF > Net Income

GAAP net income is an insignificant metric for valuing Mac-Gray mainly due to amortization of intangibles and excess D&A from accelerated depreciation schedules associated with 4 large acquisitions made during 2004 - 2008.  Management estimates that true maintenance capex for its existing equipment is between 20 - 25 MM per annum.  Backing out these non-cash expenses leads to approximately $50 MM in cash earnings and an estimate of ~$25 MM of levered FCF.  Normalized EBITDA minus capex is approximately $45 MM which translates into an EV/EBIT of ~ 9.0.

We are optimistic that returns on growth capex will improve as a soft market for independent operators, some of whom are in distress, will continue to offer better pricing.  As smaller players exit certain markets, organic growth opportunities have become increasingly attractive.  

Some sources of better performance

2011 should mark a turning point for top-line growth, margin expansion and cashflow generation.  A few things to look out for are:

-       Lower apartment vacancies improving utilization

-       Price increases in most markets

-       Rollover of contracts with better terms & IRR's

However, it is important to note that with or without growth, the stock is too cheap to ignore. 



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