CTAS - Cintas Corporation: I Am Still Positive

2024-01-13 05:11:30 ET

Summary

• Despite lower-than-expected revenue growth in 2Q24, I still expect CTAS to experience growth acceleration and margin expansion in the future.
• The company's strong balance sheet allows for potential M&A deals to further scale the business.
• The attention to hygiene post-COVID and expansion in high-growth verticals provide additional revenue opportunities for CTAS.

Investment action

I recommended a buy rating for Cintas Corporation (CTAS) when I wrote about it the last time , as I expected the business to continue its strong growth momentum, supported by strategies that have improved operational efficiencies and profit margins. Based on my current outlook and analysis of CTAS, I recommend a buy rating. While 2Q24 performance has tracked lower than my expectations, I think the set-up ahead for CTAS is favorable in both growth acceleration and margin expansion. Furthermore, CTAS has a pretty strong balance sheet that allows it to conduct more M&A deals to scale the business.

Review

While the stock price has exceeded my target price, CTAS 2Q24 results were tracking below my expectations for FY24. In 2Q24, revenue came in at ~$2.4 billion, a 9.3% growth. On an organic basis, revenue grew 9% y/y. By segment, uniform rental and facility services revenue grew by 7.9% organically; first aid and safety services revenue grew by 12.7% organically; and all other revenue rose by 13.7% organically. That said, margins came in much better than expected, with EBIT margin expanding by 50bps to 21%, driven by lower energy costs, pricing flow-through, operating leverage, and efficiency gains. Hence, while revenue was slightly disappointing, because of margin expansion, EPS did better than what consensus expected. CTAS reported EPS of $3.61 vs. consensus of $3.49.

Despite revenue growth tracking lower than my expectations, I believe the underlying business momentum remains strong, and I continue to see a possibility for growth to accelerate in FY25. There are multiple reasons for me saying this:

1. Growth in the quarter was mainly due to volume growth from new customers and increased cross-selling among existing customers. This indicates that the operating environment has turned for the better ever since the macroeconomy went into turmoil. Given that the Feds are likely going to cut rates in CY2024, I believe this will lead to a more positive operating environment for CTAS.
2. COVID might have structurally improved CTAS business as there is more attention paid to hygiene today than before. According to CTAS's financials, this is evident in the healthcare vertical's structurally higher revenue growth rate compared to the rest of the business, which I believe is a result of hygiene and cost considerations post-COVID. I believe this attention to hygiene is here to stay and has opened up additional revenue opportunities for CTAS. For example, in response to increased demand from the pharmaceutical and biotech industries, the firm has constructed two new cleanroom facilities. I believe there will be more such deals and achievements to come, especially in verticals like hospitality, education, and government, which management terms as high-growth verticals.
3. There are indications of growth acceleration when we delve further into the CTAS segmental results. Specifically, the first aid and safety segment witnessed a significant acceleration in organic revenue growth from 11% year-on-year in 1Q24 to 12.7% in 2Q24, fueled by robust cross-selling efforts and sales to the government.

Unlike my expectation for growth to accelerate, I assumed margins to be flat in FY24 and FY25 previously, which seems like that is not going to be the case after reviewing CTAS latest performance. I now expect margins to inflect higher to hit management's long-term EBIT margin target of 20 to 30%, as follows:

1. By implementing Six Sigma and collaborating with engineering teams, CTAS has enhanced plant efficiencies, allowing for the most efficient utilization of energy, labor, and equipment.
2. The company's Smart Truck technology has enhanced route density and reduced routing inefficiencies.
3. Its move to the Google Cloud has improved data security, reduced costs, and given it access to Google's AI platform.

Indeed, if we look at CTAS 2Q24 EBIT margin performance and do the incremental margin math, incremental EBIT margin has sustained 27% for the past 2 quarters, which suggests that consolidated EBIT margin can continue to increase so long as topline continues to grow.

One other thing I would like to touch on is the CTAS capital allocation policy. Based on my understanding of management's comments in the call, it sure seems like they are open to conducting more M&As, which I see as a catalyst to drive growth acceleration. I support the management decision to use M&A to grow the business, as the TAM (total addressable market) is huge for CTAS. Citing management data in the call, CTAS is currently servicing 7% of the TAM in the US (1 out of 16 million businesses). Sure, CTAS can continue to grow organically at a high single-digit percentage and slowly capture share, but remember that scale is important. The bigger CTAS can get, the better its route density gets, the better deals it gets from scaled procurement, and the better its breadth of offerings can get. The bigger CTAS can get, the faster it can grow. Hence, the question is whether CTAS has the balance sheet to support this strategy. As of 2Q24, CTAS has net debt of ~$2.8 billion, or a little over 1x net debt to EBITDA leverage ratio. This leverage ratio is one of the lowest CTAS has ever reached in the past few years. Suppose CTAS re-leverages its balance sheet to its previous high of 3x; they will have an additional ~$4+ billion of cash to deploy. The last major acquisition done, with financial disclosure, was the CTAS acquisition of G&K Services for $2.1 billion back in 2017. That acquisition was done at a 2.2x LTM revenue valuation. Suppose CTAS makes a similar acquisition using the extra cash; it could easily drive another 20+% growth based on LTM revenue.

Valuation

There are a couple of changes to my model. Firstly, looking at how 2Q24 has performed, it is unlikely to meet my 13% growth assumption previously. I have toned down my expectations to reflect reality. I now expect FY24 to grow at 9%, tracking the past two quarters performance. However, I still believe CTAS can see growth acceleration in FY25 and FY26, supported by more M&A deals, a more favorable macro backdrop, and further success in cross-selling its products. The other major update is my margin assumption. Looking at how CTAS has sustained its incremental margin performance and all the internal initiatives that have been implemented, I expect margins to improve as CTAS continues to grow. What has stayed largely the same vs. my previous model is my assumption that CTAS should trade at ~21.5x forward EBITDA, which is its historical (3-year average) trading multiple.

Risk and final thoughts

Although I am supportive of the M&A strategy, I must say that it comes with additional risk as well. Every M&A carries integration risk, and if integration is not carried out properly, it could disrupt operations, which will have an impact on growth and margins as more resources need to be redeployed from profit-making functions to fix any issues.

I reiterate my buy rating for CTAS. I am still positive that the growth drivers, including increased cross-selling, attention to hygiene post-COVID, and expansion in high-growth verticals, and willingness to conduct more M&A position CTAS for potential acceleration in FY25 and beyond. Furthermore, profit margin should continue to expand given the incremental EBIT margin performance.

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