Geoff Gannon July 17, 2015

UniFirst (UNF): Maybe Too Expensive; Maybe Just Right

Here’s a stock trading for 1.4 times sales. We’re sure of that. What we can’t be sure of is whether it’s trading at 10 times normal pre-tax profits or 14 times normal pre-tax profits.

That word “normal” is the problem.

UniFirst provides uniforms and protective clothing to American and Canadian businesses of all sizes. These businesses typically sign a 3 to 5 year contract. UniFirst then personalizes, cleans, and delivers whatever uniforms the business needs. The ongoing task is basically showing up at a customer location once a week to deliver fresh uniforms and collect the dirty ones.

Quan and I have probably talked about most publicly traded uniform and textile rental companies in the U.S., U.K., and E.U. at some point. Sadly, they haven’t been cheap enough for us to buy. We like the industry.

If capital allocation is good and the stock is not clearly selling at a premium price – we’d be willing to consider buying almost any of them.

At the right price.

We’ve decided that “right price” is 10 times pre-tax profits.

Luckily, UniFirst does trade for about 10 times pre-tax profit. However, the price is closer to 14 times pre-tax profit if normalized a certain way. I’ll explain that “certain way” in a second – but first an aside.

When we investigate a business in depth we come up with a unique way of normalizing earnings that is appropriate to that company. For example, Hunter Douglas made $200 million last year but we think it can make $300 million in a normal year and $350 million in a good year for housing. That’s not surprising because its sales are lower in both the U.S. and Europe than they were in 2006 and 2007. Its market share isn’t. The U.S. market for blinds and shades should in a cyclically normal year – assuming the same real prices per window covering and the same demand for window covering per person – be more than 25% higher now than it was 10 years ago. That’s because of population growth and inflation. It’s an easy estimate to calculate. And I’m confident in it. America isn’t going to have a lot fewer windows per person. And blinds and shades aren’t going to cost a lot less in real terms. So, in the case of Hunter Douglas we were aggressive in saying that future earnings will be much, much higher than any year from 2008-2014. That’s a no brainer.

UniFirst’s earnings are not as simple to normalize.

Our standard way of normalizing the earnings of a company we know nothing about is to simply take the most recent year’s sales and multiply that by the median EBIT margin over as many years of history as we have for the company. This is far from perfect. But, it’s also very good at eliminating cyclically overearning stocks from our list. In recent years, UniFirst has had a 13% return on sales. Today, it’s up to a 14% EBIT margin. However, if you study the company’s long-term past (for about the last 20 years) you’ll find that the median return on sales for those years is just 10%. So, current earnings might overstate normal earning power by up to 40%.

That’s a big mistake for an investor to make.

In this case, it’s basically the difference between paying a P/E of 15 or a P/E of almost 22. We like the industry. But, uniform rental isn’t the ad agency business or something. You don’t want to pay 20 times earnings for one of these companies.

To be fair to UniFirst, the S&P 500 shows a pretty similar spike in return on sales. Starting in 2009, UniFirst’s operating margin jumped from around 10% to about 13%. Gross margin moved – but not as decisively or consistently. This is exactly what has happened at a lot of big public companies in the U.S. Taking the S&P 500 as a whole – there has been a reduction in selling, general, and administrative expenses. Gross costs are not lower than in the past. It’s entirely possible that companies got bloated during the 1990s and 2000s. When the crisis hit, these public companies were most concerned with growing EPS and shareholder value and therefore slashed operating expenses – like employees working at corporate – to the bone. That’s a theory. There could be other explanations. But, stopping cap-ex can reduce depreciation a little. Firing people reduces SG&A. And not increasing salaries as quickly as your sales increase, also reduces SG&A. So, lower cap-ex and lower employment and lower salaries than are normal can all reduce SG&A relative to sales. These could all be reactions to low demand.

Since 2010, UniFirst’s operating expenses have grown much slower than sales.

To give you some idea of what I mean, UniFirst’s SG&A as a percent of sales was 24.6% last year. Ten years earlier, it had been 27.1%. So, we have an improvement in return on sales of 2.5% due to a reduction in SG&A. That may sound small. But, consider that UniFirst has $1.44 billion in sales now. So, we are talking about $36 million of cost savings. If the stock normally trades for 10 times pre-tax profits (about a P/E of 15), that is $360 million of value created through getting lean. That’s $18 per share of added value. Again, this isn’t unique to UniFirst. You can find a lot of public companies in America with this same pattern of reducing operating – not gross – expenses faster than sales since the financial crisis hit.

A lot of people email me saying that corporate profits don’t have to “mean revert”. Companies can have higher operating margins than they did in past decades. It’s possible. But, I think we should remember that American workers don’t really make much more money than they used to. And yet they do output quite a bit more than they used to. That obviously benefits employers. In industries that were historically unionized or closed to foreign competition – I don’t disagree with the idea that employers can be in a permanently stronger position when bargaining with employees than they used to be. But a great many companies Quan and I look at were never unionized and don’t really compete much with companies using labor outside the U.S.

There is one other very good reason for why SG&A could be permanently lower. Companies could use information technology to lower the amount of people they need in staff type functions. This invests in capital and economizes on labor. Certainly, a lot of tasks performed by humans in past decades can be performed by computers now.

However, I think it’s difficult to separate cyclical cost savings due to cutting fat from your organization during a crisis from permanent cost savings due to technology. I would caution that in the U.S. you have businesses making unusually good profits while workers are not. Since businesses are the ones who pay workers – I think it’s really important to stress the cake cutting between employers and employees is part of what determines profit margins.

This is why we need to be especially careful when looking at companies that have higher EBIT margins now than they did before 2008. UniFirst is one such company. And whether it is overearning or not is the key to deciding whether or not the stock is worth buying at anywhere near today’s price.

UniFirst is not a stock you want to pay more than 10 times normal pre-tax profits for. The right multiple for a business is determined by the cash profitability of that business. Companies that can both grow and pay out a lot of cash are worth a lot. Companies that can’t are not worth more than the average business.

As a long-term buy and hold, UniFirst has two things going against it. One, it needs to invest in working capital as it grows. Two, it makes acquisitions. As a result, UniFirst does not pay out much in dividends or buy back any stock. The company has a wonderfully stable EBIT margin from year to year. Sales are also stable. So, EBIT is predictable.

UniFirst is a very consistent business – as are most companies in this industry. It has the kind of consistency in profits that you see at John Wiley (JW.A) or Omnicom (OMC). What it doesn’t have is the free cash flow generating ability of those businesses. John Wiley and Omnicom can have P/Es of 20 and yet their annual returns can match an index fund with a P/E of 15 – because they can grow organically while also paying dividends and buying back stock. Since the early 1990s, Omnicom grew sales per share by 11% a year. It didn’t grow its net tangible assets at all. In fact, they shrank from a deficit of $200 million to a deficit of $2 billion.

As an ad agency, Omnicom can get its customers to finance its growth. As a uniform rental company, UniFirst can’t.

And so while UniFirst is a very consistent and adequate performer – it doesn’t have especially desirable cash flow dynamics. It can provide a 10% type return on equity year after year which can lead to 10% type returns in the stock for the long-run. It’s outperformed the S&P 500 over the last 30 years. So, I can’t say it’s not an above average business. But, I am going to say it’s not worth an above average price.

Imagine we can’t settle the question of whether the normal EBIT margin for UniFirst is 10% or 14%. If that’s true, then we can’t be entirely sure if we’re paying something like 10 times pre-tax profits (a P/E of 15) or something like 14 times pre-tax profits (a P/E of 22). And it’s very important in this case not to pay a premium to 10 times pre-tax earnings.

Also, UniFirst does some uniform business in areas with oil drilling. It’s possible drilling activity in North America over the last 5 years has skewed UniFirst’s results in a way we can’t appreciate.

In defense of the stock, it is unleveraged and this is the kind of business you can leverage up. Based on the stability of UniFirst’s EBIT, it can support a lot of debt. Cash flow is not very stable versus reported results. However, peers with less stable earnings have a bit more debt.

UniFirst is definitely a stock worth keeping an eye on. But, I’m not sure it’s possible to have confidence the stock is cheap enough to provide anywhere near the 11% a year annual returns it delivered over the last three decades. With stock prices so high right now, it might make sense to settle for buying a maybe 40% overvalued UniFirst or maybe not overvalued at all UniFirst. Even if you are overpaying by 40%, I would expect long-term holders of UniFirst to do better than the overall stock market.

Quan and I will consider UniFirst if it gets cheaper. We’d love to buy the stock at one times sales. Today, it sells for 1.4 times sales.

At today’s price, we’re not interested.