Description

UNF: Transformational oligopoly market structure emerging, new CEO, ~20%+ upside to Consensus FY 2019E EBITDA, 36-58% 1-year share price upside, 54-78% 2-year share price upside, ~100%+ 2-year upside in the event of tax reform and/or deployment of unlevered balance sheet, very low existing hedge fund ownership

Unifirst Corp (“UNF”) is currently the third largest player in the uniform rental industry with over 275,000 customers in 45 States, Canada, and Europe.  UNF operates 225 customer service, distribution, and manufacturing facilities and has leading market positions in 368 of the top 382 MSA in the US and all major markets in Canada.

The uniform rental industry is characterized by “hub and spoke” businesses that reap significant synergies from acquiring adjacent competitor locations through route consolidation.  While for decades the uniform industry has included a number of high quality businesses, three weeks ago, the industry officially became an oligopoly, transforming the industry’s remaining players into truly special, “Buffet-esque” businesses.  

• August 16, 2016: Cintas Corp (“CTAS”) announces acquisition of G&K Services (“GK”) for $2,201MM (deal closed March 21, 2017).

• September 19, 2016: UNF announces acquisition Arrow Uniform for $122MM (deal closed same day as announcement).

• October 16, 2017: Aramark (“ARMK”) announce acquisition of AmeriPride for $1,000MM (deal close expected before end of calendar year 2017).

Source: UNF Investor Relations Presentation supplemented with Management commentary and our estimates

Pro Forma for ARMK’s announced acquisition of Ameripride, the top 3 players will now control an estimated 90% of the market.  The closet analogy we can find in the public markets today of this favorable market structure is in the processed potato industry, where the top 3 players (Lamb Weston [“LW”], McCain, and Simplot) control a similar industry share to CTAS, ARMK, and UNF pro forma for these recent deals.  However, we believe that the top 3 uniform rental companies are actually higher quality businesses than LW, Simplot, and McCain today since (1) no uniform rental customer represents >1% of revenue for UNF, while LW has large French fry customers like McDonald’s (11% of LW total sales) that exert significant market power, and (2) uniform rental companies enjoy 5-year customer contracts, whereas processed potato customer contracts are generally only 1-3 years in duration.

The sellside appears to understand the oligopolistic pricing power and strong market positions of both CTAS and LW, forecasting continually expanding margins for each company through 2020 and assigning high EBITDA multiple based valuations to each business. Meanwhile, for UNF, not only does the sellside expect no margin expansion, but also analysts have not even bothered to project out to 2020 (fiscal year ending August 31). Of the 6 analysts that cover UNF, only 1 has a buy rating on the name, even though UNF trades at a 3.5-4.5 turn EBITDA multiple discount to both CTAS and LW on FY 2018 numbers.

Compared to other uniform rental companies, UNF’s organic revenue growth and margin profile have both been temporarily depressed since FY2016 due to overexposure to the oil and gas sector.  In the last two quarters, UNF’s oil and gas focused business has rebounded.  UNF is now taking price and improving volume, and therefore organic growth has positively inflected.

UNF’s former Chairman and CEO Ronald Croatti tragically passed away in May 2017.  The business’s long-time CFO, Steve Sintros, was elected by the board to be the new CEO.  Mr. Sintros is a steady hand, and we were encouraged to see his election to the CEO position.  Mr. Sintros is also very conservative in terms of investor communications and has a tendency to sandbag UNF’s annual guidance, historically leading to large beats vs. Consensus EPS expectations.

Per the table above, UNF has come in well ahead of the top end of its Initial EPS guide every year since FY 2009 except for FY 2016, when the steep drop off in the rig count lead to a sharp and unexpected decline in oil field rig worker uniform wearers that not even Mr. Sintros’s conservatism could account for.  Per a June 2016 UNF IR presentation, we know that 5.5-7.0% of revenue comes directly from the energy sector, with UNF’s largest industrial laundry facility residing in the Permian Basin in Odessa, TX. According to management, another few percentage points of revenues is derived from service industries surrounding the oil fields (e.g. restaurants and hotels around Odessa, TX) for a total UNF indirect + direct energy exposure estimated at ~8-10% of total UNF revenue.  This 8-10% of revenue is high margin work that was effectively cut in half in FY 2016.  However, the good news is that this headwind has turned into a tailwind going forward with the Permian rig count now up to 380 rigs, or up 188% since the trough that occurred on April 29, 2016.

UNF’s margins are still temporarily depressed by IT spend due to an over budget IBM contract that has now been written off as of September 21, 2017.  UNF is currently employing an incremental ~50 FTEs versus prior period as the company determines its path forward without IBM.  However, even if this ~50 IT person team is retained permanently in house, at $100k per FTE, this is only $5MM of incremental expense, or a ~30 basis point headwind to margins that can be overcome through positive operating leverage as the business continues to return to strong topline growth.  While UNF has also highlighted healthcare costs, energy input prices, and minimum wage creep as incremental headwinds to EPS, we do not believe these are material year-over-year incremental expenses that cannot be more than offset by continued mid-single digit organic growth.  We believe these are ordinary inflationary costs and should be no different than similar costs borne by CTAS, which has considerably higher margins than UNF today.

We see no material impediments that would prevent UNF from reaching its previous EBITDA margin profile of ~19% and EBIT margin profile that of ~14% that was achieved from FY2013-FY2016.  

We believe that UNF’s new mid-cycle margin profile should actually be higher than the margins achieved in FY2013-2016 due to the uniform industry’s newfound oligopoly status.  Uniform company management teams have frequently cited the rule of thumb that when they acquire a company, they will typically lose 5-10% of the target’s revenues to competitors due to business disruption.  For instance, in CTAS’s acquisition of Omni in 2002, CTAS cited losing 10% of Omni revenue due to attrition just three quarters after closing the deal.

UNF has the opportunity to take market share from both recently acquired AmeriPride (~$600MM of total revenue) and GK (~$1,000MM of revenue) as ARMK and CTAS integrate their respective targets.  Furthermore, as these businesses are integrated, UNF will further enjoy superior pricing power due to reduced competitive intensity as the industry goes from five to only three major players. Steve Sintros addressed these issues on the FQ4 2017 UNF earnings calls:

• “And then we'd expect the same with the Aramark and AmeriPride deal. I think the consolidation goes without saying that it'll leave less options particularly for the larger national and regional players. And I think we're well positioned to take advantage of that. In terms of the pricing environment, I think the pricing environment may be impacted by these transactions and probably has been to some extent.”

• Furthermore, we believe that AmeriPride and GK were considered to be low price, “ankle biter” competitors, so having these companies integrated into large, disciplined players like CTAS and ARMK should be positive to the overall industry pricing environment.  GK, for instance, was one of the largest uniform rental providers to WMT.

Due to UNF’s highly cash generative business model, the company has now built up an excess of net cash:

Previous CEO Ronald Croatti had a stellar long-term track record of shareholder value creation; over his 27-year tenure as CEO, UNF’s stock price rose nearly 1,600%.  However, Mr. Croatti was viewed as being quite stubborn when it came to deploying UNF’s under-levered balance sheet.  We see potential for a positive change in capital allocation policies going forward with Steve Sintros at the helm.  In addition to share buybacks, we believe that UNF has the opportunity to (1) roll up the remaining ~10% of the uniform rental market and (2) acquire businesses in the adjacent ancillary services and linen industries, which are more than twice the dollar size of the uniform rental market.  CTAS has historically enjoyed success cross-selling services like first aid and fire safety on its existing uniform driver routes, and new UNF management has expressed more of a desire to expand into these markets than previous CEO Croatti.

While we expect a continued acceleration in organic growth over the next several quarters thanks to (1) the oil and gas rebound and (2) reduced competitive intensity coupled with share gains from AmeriPride and GK, simply assuming 5% organic growth and margins returning to FY 2013-2016 levels results in 20% upside to Consensus EBITDA on FY 2019.  Note that there is currently no 2020 Consensus EBITDA estimate, so below we simply grow the 2019 consensus figure by 6% to estimate 2020E Consensus EBITDA.  We believe that by FY 2020, UNF margins will exceed FY2013-2016 margins thanks to pricing power; however, for conservatism, we assume margins still remain nearly 300 basis points below CTAS in FY 2020.

For conservatism, our above price targets simply account for the previous year ending net cash.  We do not model future acquisitions or share buybacks, which would result in upside to the above price targets.

Note that the only pure play comp to UNF is CTAS, which trades at 14.5x 2018E EBITDA and 13.1x 2019E EBITDA.  Our other oligopoly comp, LW, trades at 13.5x 2018E EBITDA and 12.7x 2019E.  We believe that both CTAS and LW are better comps for UNF than ARMK, which itself trades at 10.7x 2018 EBITDA and 10.0x 2019E EBITDA.  ARMK’s uniform business makes up less than 1/3 of the company’s total EBIT, and ARMK’s core business, facilities management, has historically struggled to execute against strong competition.  Furthermore, note that CTAS acquired UNF’s other pure play comp, GK, for ~13x forward EBITDA last year.  In our view, the GK precedent transaction comp is a conservative private market valuation to assume should the Croatti family ever decide to sell the UNF business. We believe the GK precedent transaction multiple is conservative given the positive industry consolidation developments since that time (i.e. since the GK deal was announced, UNF acquired Arrow and ARMK announced the acquisition of AmeriPride).

UNF has a 38.5% corporate tax rate and a net cash balance sheet, which positions the company extremely well to benefit from a potential lowering of the corporate tax rate, the key goal of the GOP tax reform bill. At a 20% corporate tax rate, we project UNF would beat Consensus 2019E EPS by 70%+.    While we can certainly pencil out some attractive upside to UNF shares based on the potential tax reform, absent reform, we believe that currently EBITDA multiples represent a better valuation metric than EPS multiples.  UNF is sitting on an inefficient balance sheet ($17.30 of net cash per share), which causes EPS multiples to optically appear high.  However, in our opinion, UNF’s new CEO Steve Sintros appears to be more willing to consider returning excess cash to shareholders through a share buyback and/or levering up to complete an acquisition.  Balance sheet optionality is not reflected in the below valuation analysis.

Balance Sheet Deployment Valuation Scenarios

CTAS levered up to ~3.0x Debt / LTM EBITDA for the GK transaction, LW spun from CAG with nearly 4.0x Debt / LTM EBITDA and has a 3.5-4.0x long-term leverage target, and ARMK is levered 4.3x LTM EBITDA today (with debt rising to “mid-4x net debt in FY2018” pro forma for AmeriPride and Avendra purchases).  Below we simply assume that UNF levers up to 3.0x Debt / LTM EBITDA and also deploys future available FCF to a share repurchase.  This is a simplifying assumption, as in practice UNF will likely employs a combination of share buybacks and acquisitions.  Acquisitions will likely be even more accretive than buybacks given the strong synergy opportunities in uniform rental route consolidation (note that CTAS guided to 13-14% of GK revenue as synergies, which enables CTAS to buy-down the deal multiple from 14x LTM EBITDA / 13x Forward to ~7-8x EBITDA Pro Forma for synergies).  At 3x leverage, we project ~$1.7bn of buyback power over the next 3 years relative to UNF’s current $3.0bn market capitalization.

Risk Factors

Historically, UNF traded below our target valuation range on a forward EBITDA or EPS multiple basis.  In our view, the valuation UNF traded at several years ago is not relevant given (1) the positive industry developments in the last 12-18 months and (2) the fact that historically UNF was an underfollowed (and highly illiquid) microcap stock that was chronically undervalued.

The other push back we expect to receive on our UNF write up is illiquidity.  While liquidity has actually improved considerably over the last few years, UNF is still a fairly illiquid stock relative to its ~$3 billion market capitalization.  As UNF continues to compound, we expect liquidity to continue to gradually improve over time.  Given that we are investing behind a long-term oriented family ownership structure in a steady, high quality business, we are comfortable taking short-term liquidity risk.  

Catalyst

• Earnings beats
• Deployment of balance sheet towards share buybacks and M&A