Cintas: Yet More Outperformance From This Overvalued Gem (NASDAQ:CTAS)

Dear readers/followers,

Cintas (NASDAQ:CTAS) has been a complicated play. I’ve been neutral on the company more or less during all of 2022, yet the company outperformed not only the market but most other companies. This is despite being what I viewed as “overvalued” – it shows you that the market, as often, can stay irrational (or rational if you like) far longer than you can feel your opinion is “valid”, at times.

Me, I still feel that my stance on Cintas is valid – but I of course acknowledge that my neutral stances were made in underestimating this company’s outperformance. It’s a lesson I will take with me.

In this article, I’m going to provide you with a fresh look on Cintas, and where we can expect this company to go from here.

Cintas – An Update going into 2023

It’s wrong, despite the company’s outperformance, to call the company a “stable” investment. It has shown volatility during the year, first bouncing up, then diving down, only to repeat this higher. It went below my article price levels, then above it, then below again.

It’s one of those complicated companies because if you look at the valuation, I can’t help but say that even double-digit outperformance doesn’t matter in the face of this premium.

The company has been as high as this before in terms of multiples, but not often.

And when you look at the company’s operating segments, it’s hard not to sit back and scratch your head, because this company doesn’t do anything that, compared to most tech or pharma firms is complicated, it does something that at face value is relatively simple.

They provide companies with their uniforms, mats, mops, cleaning and restroom supplies, and are also going in to first aid, Safety and fire safety products. Both selling and renting out products, with associated services, courses and ancillary business segments.

Cintas operations are, as of the last full fiscal, split into the following segments.

• The Uniform Rental And Facility Services segment
• First aid and Safety Services

And the activities in these are fairly clear. It’s natural that COVID-19 was a step up for this company due to what happened during the pandemic. Still, it was a bit of a mixed bag. While Cintas was designated as an essential business and was allowed to keep operating, the business closures nonetheless impacted the company’s operations. This impacted not only in terms of how the company’s sales and services were going but also in customers’ abilities to pay their bills.

But still, the company remains in a very attractive market position, with organic growth in the double digits or high single digits, and operating margins of 20-30% due to scale, in a segment that essentially consists of clothing and cleaning. With over 1 million customers, the company is by far one of the largest in the entire field and deserves your attention no matter how expensive it’s trading at the time. Cintas is a company you should know, so you can take advantage when it does turn around (and drop).

Supply chain disruptions for Cintas were surprisingly minimal, and Cintas did increase its inventory of various supplies, such as PPE, in accordance with demands.

Competition here is regionally dependent and usually highly fragmented, despite Cintas’s massive size. The company competes both with national, regional, and local providers, as well as something as simple as local retailers. Competition level varies wildly depending on specifics, and Cintas believes that services, quality, products, price, and convenience are key. Its scale ensures that Cintas is never in a poor position in relation to the overall market – it can provide services cheaper, more efficiently, and with less risk of an outage. It’s the Oxford English dictionary example of scale/economies of scale advantages here.

Today, and even with a dividend bump, the yield for the company is barely 1%, and unless the valuation goes down, you’re likely stuck at very low levels of dividends, as well as low levels of return, unless you’re willing to go to a very high premium for this business (which I am not).

3Q23 was clear though – a definite “rise and beat” quarter. Top-line revenues grew by double digits, and puts the company in a position to rise above $8B in revenues for the year, with operating margin increasing by 0.7% and diluted EPS growth of double digits, 13% here. Organically, revenue grew by 11.3% and mostly due to increased sales volume and higher demand.

New customers are still being added across the board, and cross-sell services across the existing customer base. Even out of COVID-19, companies and customers prioritize Cintas offerings, which come to cleaning, safety and in the end, compliance.

The challenges for Cintas are very similar to other businesses however. It’s all about rising costs, including labor costs, as well as the scarcity of that labor – though for now this is also what is driving customers to approach Cintas. Cintas has responded by raising prices, which is the common theme of the entire world today.

The company ended the 3Q23 by raising the FY23 targets, now coming in to above $8.5B potentially, with annual EPS up to $12.8.

I believe the main thing to point to in this earnings period was the company overcoming high inflation, interest expenses increases as well as taxes, which is why the sort of beat we saw here is impressive, and which is also likely the reason why the market reacted with such exuberance as it did.

The company even gave us our first 2023E guidance, which is as follows:

Fiscal ’23 operating income is expected to be in the range of $1.75 billion to $1.79 billion compared to $1.55 billion in fiscal ’22 after excluding the gains. Fiscal ’23 interest expense is expected to be $113 million compared to $88.8 million in fiscal ’22 due in part to higher interest rates.

(Source: Mike Hansen, Cintas Earnings Call 3Q23)

What sort of risks and questions does this bring? Maybe customer retention and what sort of things we should expect out of Cintas? Retention is excellent for the time being, and there is nothing out of the current customer conversation that needs to be raised as a sort of concern. Customers are paying the increased prices because challenges in finding their own solutions are simply easier to overcome for Cintas than for them to do it themselves.

With that, let’s move onto the heart of the matter.

Cintas Valuation into 2023

The valuation is the real problem we’re looking at here. Because we’re trading so expensive in terms of both historical and other perspectives, options aren’t even a “thing” here as I would consider them. Maybe if you already own Cintas, but if you did, then my stance would be to consider profit rotation at almost 37x normalized P/E.

The simple fact is that the 10-11-year normalized premium comes in around 28x – that’s almost 10x below the current level. Even if we allow for a 30-32x P/E, that’s market-inferior levels of return at 3.5-4.5% annually, at today’s forecast of double-digit EPS growth until 2025E.

Those are not good prospects, despite A- credit and less than 40% debt, even before going into the sub-par 1% yield.

Cintas is a great business with a great track record, and I don’t see anything possible that could de-rail these fundamentals. Not with the world as it is looking today. However, that does not in any way equate to a company being a safe long-term investment, when it’s trading almost 10x above normalized P/E when that normalized is already a fairly steep premium.

Cintas comes with plenty of competitors and ancillary companies (in the commercial service/supply sector), albeit none or few with the same sort of outperformance. These peers include Rollins (ROL), Tetra Tech (TTEK), Stericycle (SRCL), Casella (CWST), Brink’s (BCO), and others. The peer average here is very wild – with Casella at 65x P/E and Brink below 10x. What we can say is that quality services tend toward a 20-28x P/E in this segment, even if outperformance is possible, and Rollins, for instance, is higher than Cintas at this time. Cintas can also be compared to machinery and Textiles as well as building products, but these comparisons together with the peers found there make a lot less sense.

S&P Global targets come in as follows for 2023. 12 analysts are between $292 and $530 – an absolutely massive spread. 5 out of 12 are still at a “BUY”, coming in at an average PT of $478, which implies an 8.2% undervaluation even at today’s levels. Problematic, to say the least, is what I see there. I wouldn’t buy the company close to this level, seeing what sort of returns we can expect here.

In order for Cintas to generate double-digit returns, we would have to accept valuation premiums of over 35x P/E, which is around 7-10x P/E higher than what I would consider the non-exuberant P/E average for this sector. We’re in exuberant levels exactly because of the way the market currently is – wages, inflation, labor, etc.

That’s eventually going to normalize, and when it does, I believe that Cintas will not be far behind.

Until it does, Cintas may very well continue to go up. But this journey it has made in 2022 and may continue to do in 2023, that’s not an argument to “BUY” the stock for me.

That’s an argument to be perhaps even more careful than I was before.

So, in the end, it’s all about Valuation, and Cintas doesn’t work for me at this time.

To my mind, the 20-year average premium of 25X P/E is the most that should be paid. Including 2024, which I view as relevant based on analyst accuracy and outperformance, the highest I would go would be $300/share – and I’m increasing that target for the 2022 outperformance. This is above the S&P Global low target stock price of $292/share, though I view this particular target as actually quite valid compared to the $530/share current high.

Thesis

My current thesis for Cintas is:

• The company is fundamentally an excellent services company with a high premium – and is better bought, as proven by history, at cheap valuations.
• With cheap prices and fear, this company can easily generate triple-digit returns, even if the dividend is comparatively low.
• At current valuations, even a forward premium of 30X+ results in potential market underperformance, or a bare-bone upside close to the market. This is a no-go in terms of what you “should” invest in at this particular time.
• Given current trends, I consider Cintas a “HOLD”. It’s not as dangerous to invest in as a few months back at peak valuations, but it’s nowhere near where I’d want to buy the business. I would also say that if you hold Cintas, it is time to consider rotating.

Remember, I’m all about:

1. Buying undervalued – even if that undervaluation is slight, and not mind-numbingly massive – companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.

2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.

3. If the company doesn’t go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.

4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.

Here are my criteria and how the company fulfills them (italicized).

• This company is overall qualitative.
• This company is fundamentally safe/conservative & well-run.
• This company pays a well-covered dividend.
• This company is currently cheap.
• This company has a realistic upside based on earnings growth or multiple expansion/reversion.

It’s a great company but lacks cheapness and a realistic upside to an attractive fair valuation. For that, I give this a “HOLD”.