Earnings Call Transcript - CTAS Q3 2022

Operator, Operator

Good day, everyone. And welcome to the Cintas Third Quarter and Full Year 2022 Earnings Release Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Paul Adler, Vice President and Treasurer, Investor Relations. Please go ahead, sir.

Paul F. Adler, Vice President and Treasurer, Investor Relations

Thank you, Sergei. And thank you for joining us. With me is Todd Schneider, President and Chief Executive Officer; and Mike Hansen, Executive Vice President and Chief Financial Officer. We will discuss our fiscal 2022 third quarter results. After our commentary, we will open the call to questions from analysts. The Private Securities Litigation Reform Act of 1995 provides a Safe Harbor from civil litigation for forward-looking statements. This conference call contains forward-looking statements that reflect the company's current views as to future events and financial performance. These forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those we may discuss. I refer you to the discussion on these points contained in our most recent filings with the Securities and Exchange Commission. I'll now turn the call over to Todd.

Todd M. Schneider, President and Chief Executive Officer

Thank you, Paul. Our third quarter financial results are led by a strong revenue increase of 10.3%. The benefits of our strong top line growth flowed through to our bottom line. Excluding the one-time gain recorded in this year’s third quarter of selling and administrative expenses, operating income margin increased 90 basis points from 18.4% to 19.3% and EPS grew 13.5% from $2.37 to $2.69. Our financial results are indicative of our compelling value proposition. Businesses prioritize all we provide including image, cleanliness, safety, and compliance. And with challenges like labor scarcity and rising costs, businesses increasingly turn to Cintas to help them get ready for the workday. I'm especially pleased with our financial results because they were achieved in a period in which U.S. inflation hit a 40-year high. Inflation is broad, and one need not look any further than the corner gas station to see it. We've been able to navigate this challenging time and deliver increased operating margins and EPS by productively starting new business, penetrating existing customers with more products and services, providing excellent service while driving operational efficiencies, and obtaining incremental price increases from our customer base. As we grow via new business, we achieve operating leverage, better negotiating leverage with suppliers, denser routes, and more volume on our plants. As we penetrate existing customers, we realize even stronger incremental operating margins. I thank our employees, whom we call partners, for their continued focus on our customers, our shareholders, and each other. Turning now to our business units, the uniform rental and facility services operating segment revenue for the third quarter of fiscal 2022 was $1.55 billion compared to $1.42 billion last year. Organic revenue growth was 8.9%. Our new vertical strategies of healthcare, education, and state and local government continue to post leading revenue growth rates. However, there are opportunities for us in all verticals. Businesses in all sectors are struggling to fill open positions. There are about 11 million job openings in the U.S. alone. Businesses remain concerned with their ability to properly sanitize even as COVID infections decreased. Additionally, businesses are shedding non-core competencies to reduce costs and minimize the impacts of inflation. For these reasons and others, businesses are increasingly outsourcing to Cintas. Our First Aid and Safety Services operating segment revenue for the third quarter was $213.0 million compared to $198.5 million last year. Organic revenue growth was 6.2%, which is a nice improvement from last quarter's 3.2%. This improvement reflects the growing momentum of our First Aid cabinet business, which grew 22% in the third quarter. We welcome this mixed shift because it is a more consistent revenue stream and has higher profit margins. Third quarter revenue growth improved despite a difficult comparison. Last year's third quarter saw a high response to the COVID-19 pandemic, with sales of personal protective equipment (PPE) being very high and the business grew organic revenue of 17.7%. The amount of PPE has declined year-over-year as expected; however, COVID infections are still prevalent. In fact, we sold about $15 million in a new product, which is COVID test kits, in this year’s third quarter. PPE remains a larger percentage of the revenue mix than it was pre-COVID. Our Fire Protection Services and Uniform Direct Sale businesses are reported in the All Other segment. All Other revenue was $194.3 million compared to $160.7 million last year. The fire business organic revenue growth rate was 15.3%, and Uniform Direct Sale business organic growth rate was 48.7%. Both businesses have bounced back as expected. I'd like to comment on another one of our strengths, namely cash flow. Third quarter operating cash flow increased 18.5% from last year. In this year's third quarter, $105 million was used for acquisitions. On March 15th, we paid shareholders $99 million in quarterly dividends. During the quarter, and through March 22, 2022, Cintas purchased $584.2 million of Cintas common stock under our buyback program. We continue to allocate capital in many ways to improve shareholder return. Our strong balance sheet and cash flow enable us to do so consistently. Finally, I want to share some great news on our technology front. Our ERP provider SAP extended membership in their Strategic Customer Program to Cintas. This is an exclusive program; only 1% of SAP's customers have membership in it. Inclusion in the program enables us to engage directly with top management at SAP and gain access to its developers and new technologies to realize valuable outcomes for our customers, suppliers, and employees. This program will speed the pace of our transformation into a more data-driven and process-efficient business. I'll now turn the call over to Mike.

J. Michael Hansen, Executive Vice President and Chief Financial Officer

Thanks, Todd. Our fiscal 2022 third quarter revenue was $1.96 billion compared to $1.78 billion last year. The organic revenue growth rate adjusted for acquisitions, divestitures, and foreign currency exchange rate fluctuations was 10%. Gross margin for the third quarter of fiscal 2022 was $898.2 million, compared to $809.5 million last year. Gross margin as a percent of revenue was 45.8% for the third quarter of fiscal 2022, compared to 45.6% last year, an increase of 20 basis points. Energy expenses, comprised of gasoline, natural gas, and electricity, were a headwind, increasing 45 basis points from last year. Gross margin percentage by business was 46.3% for Uniform Rental and Facility Services, 44.2% for First Aid and Safety Services, 46.6% for Fire Protection Services, and 37.7% for Uniform Direct Sale. Operating income was $407.6 million compared to $326.5 million last year. Operating income margin was 20.8% compared to 18.4% reported last year. Fiscal 2022 third quarter operating income included a $30.2 million gain on the acquisition of an equity method investment. The gain was recorded in the Uniform Rental and Facility Services segment's selling and administrative expenses. Excluding this gain, fiscal 2022 third quarter operating income, as a percentage of revenue, was 19.3%, an increase of 90 basis points from last year's third quarter. Our effective tax rate for the third quarter was 18.2% compared to 14.4% last year. The tax rate can move from period to period based on discrete events, including the amount of stock compensation expense. This year's third quarter equity method investment transaction included a significant tax benefit. Excluding the transaction, the effective tax rate for the third quarter of fiscal 2022 was 19.6%. Net income for the third quarter was $315.4 million compared to $258.4 million last year. Diluted EPS was $2.97 compared to $2.37 last year. Fiscal 2022 third quarter diluted EPS contained $0.28 from the gain on the equity method investment transaction, which included a related $0.07 tax rate benefit. Excluding this gain and the related tax impact, fiscal 2022 third quarter diluted EPS was $2.69 compared to $2.37 in last year's third quarter, a 13.5% increase. We're increasing our financial guidance. We expect our fourth quarter revenue to be in the range of $1.96 billion to $2.02 billion and diluted EPS to be in the range of $2.54 to $2.74. Our fourth quarter fiscal 2022 effective tax rate is expected to be approximately 23.2% compared to a rate of 19.4% for last year's fourth quarter. The expected higher effective tax rate is anticipated to negatively impact fiscal 2022 fourth quarter diluted EPS guidance by approximately $0.14 and diluted EPS growth by approximately 560 basis points. Our financial guidance includes share buybacks through March 22nd, but does not include the impact of any future share buybacks. Finally, I wanted to provide an update on our debt and liquidity. We have $650 million of senior notes maturing April 1st, 2022, and $300 million of senior notes maturing June 1st, 2022. We expect to refinance these amounts with funds received via the issuance of new senior debt. Also, we closed today on a new credit facility, increasing it to $2 billion and extending it to 2027. We have a strong balance sheet and ample liquidity. I'll turn it over to Paul now.

Paul F. Adler, Vice President and Treasurer, Investor Relations

That concludes our prepared remarks. Now, we are happy to answer questions from analysts. Please ask just one question and a single follow-up if needed. Thank you.

Operator, Operator

Thank you. Our first question comes from Andrew Steinerman from J.P. Morgan. Please go ahead.

Alexander Hess, Analyst

Hi, this is Alex Hess on for Andrew Steinerman today. I wanted to touch briefly on what you guys are seeing at the vertical level, maybe with respect to a rebound and a potential rebound in hospitality, or is that still being dragged in your last quarter from Omicron? Also, any comments on progress in driving adoption in healthcare? Thanks, guys.

Todd M. Schneider, President and Chief Executive Officer

Sure, Alex. Thanks for the question. Our vertical strategy is working quite well. You mentioned the hospitality sector; it is certainly bouncing back. If you read in the news, bookings are up in the airlines and the hospitality sector. So yes, that is bouncing back. I think the results in our direct sales business, which is largely tied to the hospitality sector, have been outstanding. In our other verticals, we're having very good success as well. In healthcare specifically, we see that we're very much in the early innings, but we have products and services that are compelling for that customer base, and we're continuing to evolve and create new products and new technologies that we're integrating there. As a result, we're very bullish on our strategy in that area, and I think the results are reflective.

Operator, Operator

Hamzah Mazari from Jefferies. Please go ahead.

Hamzah Mazari, Analyst

Hey, good morning. You had referenced penetrating more customers as part of strong incrementals. Specifically, do you have a sense of how many customers today are buying more than one service from you? Has that changed at all due to having SAP? What was that same number pre-pandemic, just so we can get a sense of that initiative?

Todd M. Schneider, President and Chief Executive Officer

Yes. Hamzah, certainly being virtually on one system now is helping our transparency into cross-selling. What I'll tell you is we're in the early innings of cross-sell. Our ability to add products has a long runway in that area. Just to reach even a reasonable level of penetration, where we feel excited about it, there is a long, long runway to penetrate our customers with our existing products separate from what we're bringing into the marketplace in the future, which we’re always working on. So we feel good about that. It's certainly improving, but we’re still very much in the early innings.

Hamzah Mazari, Analyst

Got it. Just my follow-up question, I'll turn it over. It is just around M&A, any updated thoughts on the pipeline there, or have valuations come in at all? I know you've talked about historically that M&A doesn't necessarily mean it has to be route-based, just walk us through that as well, the rationale there? Thank you.

Todd M. Schneider, President and Chief Executive Officer

Sure, Hamzah. As we noted, M&A was good in the third quarter; the investment we've made in acquiring businesses. We're highly acquisitive. The pipeline looks attractive. It takes different reasons for different companies to transact. You can't always predict that timing, but we are very much a willing buyer and interested in making deals of all shapes and sizes. We're ready, willing, and able to continue to move forward in that area.

J. Michael Hansen, Executive Vice President and Chief Financial Officer

Yes. Hamzah, as you heard Todd mention, our third quarter included an overall acquisition number of $105 million, which is certainly a step-up from where we've been. Included in that is the purchase of the remaining shares of the equity method investment, which was about $48 million within that number. However, the rest of the M&A of $57 million is still a step-up from where we've been. So there has been some good movement this entire fiscal year, and we like the messaging that we're getting. We like the pipeline, and as you can see so far this year, we've acted on many of those.

Operator, Operator

George Tong, Goldman Sachs. Please go ahead.

George Tong, Analyst

Hi, thanks, good morning. Can you discuss how the business is being impacted by rising input costs, including wage inflation and higher energy costs? How effectively are pricing trends offsetting this?

Todd M. Schneider, President and Chief Executive Officer

Good morning, George. Thanks for the question. Certainly, expected that inflation and input costs would be something that we would want to discuss. I have a few examples I'd like to share regarding steps we are taking to mitigate input costs. Inflation is certainly challenging. It's very much there. As I mentioned in my prepared remarks, whether it's fuel or other areas, input costs are real. But we actively take steps to make sure that we mitigate that type of exposure. You mentioned pricing; it's certainly a component of our strategy, but it is by no means the only strategy to combat inflation. So we’re taking other steps, almost all of which involve technology. These were all initiatives we have been working on, but due to the inflation subject, we decided to pull them forward and expedite them. Individually, they are not massive movers, but collectively, they certainly add up. I'll go through a few examples that I think might help provide a little color. First off, I mentioned in our last call that we've invested in proprietary routing technology that fits our business well. We've tried about every routing software out there, and we finally decided to build it ourselves. We're executing on it, and this has been an important investment during the past couple of years. We recognize that we only generate revenue when the truck stops. When it stops at our customers' place of business, that's when we can generate revenue. So we must be more efficient. I'm very pleased with our investment. Certainly, it takes time, and we're conscious of customer disruption. We're trying to accelerate on this subject. Additionally, we've invested in automation and have three different processes for how to implement it into our uniform processing facilities. This provides us with flexibility we didn't have in the past. We're working faster due to rising labor costs. We're also using technology through SAP, enabling us to analyze inventory and reducing costs significantly.

George Tong, Analyst

That's very helpful. Thank you. And then just as a follow-up, could you provide a brief update on how your customer base is being affected by supply chain disruptions and the flow-through impact on demand for Cintas' services?

Todd M. Schneider, President and Chief Executive Officer

Certainly, George. Our customers are experiencing supply chain disruptions, slowing them somewhat, but we care passionately about how our customers are doing, as it impacts us directly. While I mentioned earlier that the primary challenges our customers are facing are staffing and labor costs, they're looking for ways to outsource, and we benefit from that. We're excited about supply chain issues abating, and our customers being able to accelerate, but to date, that's a bit of a headwind; however, we have the tailwind of outsourcing benefitting us.

Operator, Operator

Ashish Sabadra, RBC. Please go ahead.

Ashish Sabadra, Analyst

Thanks for taking my question and providing that detailed color on the technology front. I was wondering if you could also talk about how technology is helping you with dynamic pricing and local pricing. Can you elaborate on the pricing trends, what normalized pricing has been historically, and how are we thinking about pricing here, particularly in the inflationary environment and the response from your customers to potentially higher prices?

Todd M. Schneider, President and Chief Executive Officer

Thanks, Ashish, for the question. Certainly, being on one technology platform enables us to use large amounts of data for analysis. Pricing is a local subject, customer-by-customer, industry by industry. The technology allows us to make good long-term decisions, targeting our approach. We've been implementing this strategy over the past couple of years and will continue. Historically, we've seen pricing growth of around 0% to 2%, and currently, we're above that, given all the inflation in the news; customers are more receptive to these discussions.

J. Michael Hansen, Executive Vice President and Chief Financial Officer

Certainly, with all of the inflation in the news, the conversation on pricing is a bit easier now than in the past. Our customers have generally been receptive, resulting in a higher pricing impact than before. We've talked about 0% to 2% in the past, and we're a bit above that today. However, the primary source of our growth is coming from volume, not pricing, due to the value that we're adding to customers by penetrating our customer base.

Todd M. Schneider, President and Chief Executive Officer

To conclude, the majority of our growth comes from volume, not pricing, derived from the value we offer customers and the new business we are selling.

Ashish Sabadra, Analyst

That's very helpful color. If I can just ask, I'm not sure if you have quantified how big energy is as a percentage of overall expenses, but also, my question is more about how you are thinking about improving the energy efficiency of the business, both on the truck side and on the laundry facilities front?

J. Michael Hansen, Executive Vice President and Chief Financial Officer

Sure, Ashish. The third quarter's total energy expense for the business was 2.3% of sales. In our guidance side, given the rising gas prices, we anticipate seeing this increase to 2.6% to 2.8% in our fourth quarter. However, we've made significant progress in improving our energy efficiency. Back in calendar 2014, total energy was 3% of revenue. We've reduced that to 2.3% today through various initiatives, including routing efficiency. We're planning to increase our use of electric vehicles to work toward a net-zero goal by 2050.

Todd M. Schneider, President and Chief Executive Officer

In addition to the energy efficiency initiatives, we invested in converting all of our locations to LED lighting for cost savings and to support our ESG goals. We're actively looking into other ways to reduce energy consumption in our production facilities.

Ashish Sabadra, Analyst

That's very helpful color. Congratulations on the solid results.

Operator, Operator

Andy Wittmann, R.W. Baird. Please go ahead.

Andrew Wittmann, Analyst

Hey, thanks. Let's just keep going on this path, I guess. Mike, just using your EPS and revenue guidance, I'm backing into fourth quarter margin guidance, which is at the midpoint about flat year-over-year. I think that's probably right, and you can comment on that, I suppose. But you just mentioned that energy prices are expected to sequentially add about 40 basis points. I was wondering if the third quarter margin was plus 90 basis points adjusted for margin improvements. Given the energy headwinds, what are the other factors affecting implied margin guidance?

J. Michael Hansen, Executive Vice President and Chief Financial Officer

Yes. Let's start with the implied margin guidance. The range we see is something like 18.5% at the bottom to 20% at the top. Last year's fourth quarter was 19.4%. So you're correct that at the midpoint, it's somewhat flattish against a 60 to 80 basis point energy headwind from a year ago. At the top of that range, it's margin expansion, even in this difficult environment. Our goal is to drive towards margin expansion over the next period. Growth means we will continue investing in capacity and routes, which comes with some costs. However, in this environment, looking at a 60 to 80 basis point energy headwind while guiding towards margin expansion, we feel confident.

Andrew Wittmann, Analyst

Yes, I wasn't trying to imply otherwise. Could you comment specifically on the labor market? Are your positions filled today? Are you having enough people to do what you need them to do? Can you talk about the overall pricing trends in that category?

Todd M. Schneider, President and Chief Executive Officer

Andy, we always have job postings and openings because we're growing. As I mentioned earlier, we're growing our volume very attractively. There is more work, and we're pleased with that. The labor market is challenging at the levels we require. We're managing at higher RPMs to reach our goals—I'm referring to our management team working harder to achieve this. We like our staffing levels and plan to continue investing in that area. Our productivity rates are strong, largely due to the culture of our partners working diligently. However, we're conscious of needing to add roles and are doing it successfully.

Operator, Operator

Tim Mulrooney, William Blair. Please go ahead.

Timothy Mulrooney, Analyst

Yeah, good morning. I wanted to revisit pricing for a second. If your uniform contracts are typically several years in length, can you talk about how you adjust for pricing? Are there annual pricing conversations stipulated within the contract, or do you just reach out to customers as needed when you hit certain inflationary thresholds? Are there inflation pass-through provisions in these contracts? Thank you.

Todd M. Schneider, President and Chief Executive Officer

Tim, thanks for the question. We have a million customers, and the variations are significant. Generally speaking, our agreements allow us to raise prices as appropriate. Typically, we have a structured approach of having a conversation once a year with the customer about the pricing adjustment, which they appreciate. In these inflationary times, as Mike mentioned earlier, these discussions have been more favorable than usual, given the current economic climate. However, some customers do have contract limits on pricing increases, but generally, we are quite flexible and aim to make good long-term decisions that help us retain customers.

Operator, Operator

Manav Patnaik, Barclays. Please go ahead.

Manav Patnaik, Analyst

Thank you. I just wanted to follow up on the labor environment broadly. You seem to be managing your own labor well, but I'm curious about the challenges, struggles, openings, turnover that your customers are facing and how that's looking today.

Todd M. Schneider, President and Chief Executive Officer

Manav, we are seeing a high level of churn within our customer base, meaning that employees are moving between employers at a higher rate than before. However, we like the trend we're seeing with ad stops from our customer base; this is a positive sign. Overall, although it’s harder for businesses right now, we are still witnessing increased activity from our customer base, which is promising.

J. Michael Hansen, Executive Vice President and Chief Financial Officer

For the fourth quarter, while rental and fire sides will face tough comparisons, we maintain confidence in organic growth trends. We're projecting rental growth to continue robustly in the upper single-digit range, First Aid and Safety to rebound nicely, and uniform direct sales will normalize to low to mid-single digits.

Operator, Operator

Heather Balsky, Bank of America. Please go ahead.

Heather Balsky, Analyst

Hi, good morning. I wanted to clarify some information regarding the PPE side. Where are you now relative to 2019 levels? Are you still above them, or have you returned to a more normalized trend? Also, you mentioned sales of COVID tests during the quarter. How are you thinking about that business going forward, and is there an inventory investment around it as well?

J. Michael Hansen, Executive Vice President and Chief Financial Officer

Yes. Our personal protective equipment (PPE) sales are still above pre-pandemic levels. We've seen our customers recognize the value in continued safety and cleanliness. It's difficult to predict the trajectory of that business going forward, but it's certainly maintaining its value proposition more than before. Regarding test kit sales, we were able to fulfill about $15 million worth this quarter, but we do not anticipate that volume continuing at that level in the future.

Heather Balsky, Analyst

Thank you. Just a follow-up on the PPE side; I recall it being a lower-margin business. Is that declining? Do you see this as a tailwind for your margins as it levels off entering next quarter and the next year?

J. Michael Hansen, Executive Vice President and Chief Financial Officer

Yes, Heather, as the mix shifts back towards First Aid business, which carries better margins, we expect overall operating margins to approach pre-pandemic levels. The First Aid and Safety business has experienced great momentum, and with improved operating margins, we're very optimistic the momentum will continue.

Operator, Operator

Scott Schneeberger, Oppenheimer. Please go ahead.

Scott Schneeberger, Analyst

Thanks very much. Good morning. Just one more follow-up on inflation and price. You mentioned majority of growth is coming from volume. What percent of your customer base have you affected with price increases so far? Will we see a higher percentage of growth coming from pricing as that kicks in from who you've already priced?

Todd M. Schneider, President and Chief Executive Officer

Thanks for the question, Scott. Our approach to price increases is based on individual customer conditions, and we conduct annual conversations with customers about pricing adjustments. As time goes on, we hope to have more consistency. However, for now, the majority of our growth stems from volume, not pricing, as our customer demand remains strong. We're very proud of our relationship with SAP, which has flourished over the years. Being in their Strategic Customer Program is an honor granted to us due to our success using their technology. It allows us access to high-level management and developers at SAP, providing us a competitive edge, and we're excited about the advantages this brings.

Operator, Operator

Shlomo Rosenbaum, Stifel. Please go ahead.

Shlomo Rosenbaum, Analyst

Hi, good morning. Thank you for taking my questions. Hey Todd, how do your current volumes compare to pre-COVID levels in terms of recovery? How much more room is there for growth as the economy opens up?

Todd M. Schneider, President and Chief Executive Officer

Shlomo, great question. Most of our customers are open now. While some have not survived the pandemic, the majority are operational. They aren't all consuming at the same levels they used to, but we see significant opportunity as the economy fully opens up. We believe there's room for increased spending from our customers which will ultimately benefit us going forward.

J. Michael Hansen, Executive Vice President and Chief Financial Officer

The equity method investment was focused on product innovation within our Facility Services business. Although it hasn’t been a significant revenue producer, it has supported our rental division in creating offerings over time. Our decision to bring it fully under our ownership aligns with our strategy.

Paul F. Adler, Vice President and Treasurer, Investor Relations

Alright. Thanks, Sergei, and thank you all for joining us this morning. We will issue our fourth quarter fiscal 2022 financial results in July. We look forward to speaking with you again at that time. Thank you.

Operator, Operator

Thank you. This concludes today's conference call. Thank you for your participation. You may now disconnect.