Earnings Call Transcript - CTAS Q3 2020

Operator, Operator

Good day, everyone, and welcome to the Cintas Quarterly Earnings Results Conference Call. Today's call is being recorded. And at this time, I would like to turn the call over to Mr. Mike Hansen, Executive Vice President and Chief Financial Officer. Sir, please begin.

Mike Hansen, CFO

Thank you and good evening, and thanks for joining us tonight. With me is Paul Adler, Cintas' Vice President and Treasurer. We will discuss our third quarter results for fiscal 2020. 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 SEC. Before discussing the financials, I want to say that our thoughts go out to all of those impacted by the COVID-19 Coronavirus. This is a challenging time for all of us, and we can't thank our partners—our employees, whom we call partners—for doing all that they can to keep our customers' places of business clean, safe, and ready for the workday. We currently find ourselves at the peak of uncertainty as it relates to the pandemic's impact on the economy. The response of our country and each state is evolving daily. A week ago, we hadn’t seen much impact on our business, and we were expecting today to increase revenue and EPS guidance based on our year-to-date results and fourth-quarter outlook. However, much has changed in a matter of days, and more changes are likely to come. Due to this uncertainty, including the severity and duration of the pandemic, we're not providing guidance for the fourth quarter of fiscal 2020 at this time. We certainly remain focused, though, on the safety and well-being of our employee partners and the care of our customers. So let’s move to providing our third quarter results, and then we will open it up for questions. Our fiscal 2020 third quarter revenue was $1.81 billion, an increase of 7.6% over last year's third quarter. Earnings per diluted share or EPS from continuing operations were $2.16, an increase of 17.4% over last year's third quarter adjusted for G&K integration expenses. Free cash flow for this year's third quarter was $300 million, an increase of 17.2%. The organic growth rate, which adjusts for the impact of acquisitions, foreign currency exchange rate fluctuations, and differences in the number of workdays, was 5.7% for the third quarter of fiscal '20. The organic growth rate for the uniform rental and facility services operating segment was 4.8%, and the organic growth rate for the first aid and safety services operating segment was 12.5%. Gross margin for the third quarter of fiscal '20 of $824.4 million increased by 9.2%. Gross margin as a percentage of revenue was 45.5% for the third quarter of fiscal '20 compared to 44.9% in the third quarter of fiscal '19. Operating income for the third quarter of fiscal '20 of $314.7 million increased by 13.1%. Operating margin was 17.4% in the third quarter of fiscal '20 compared to 16.5% in fiscal '19. Net income from continuing operations for the third quarter of fiscal '20 was $234.5 million and reported earnings per diluted share were $2.16. Excluding the G&K acquisition integration expenses in fiscal '19, EPS increased by 17.4%. In addition to the solid financial performance, we continue to generate strong cash flow and commit to effectively deploying cash to increase shareholder value. Third quarter free cash flow was $300 million, an increase of 17.2% compared to last year. In the third quarter of fiscal '20, we paid an annual dividend totaling $268 million. The dividend of $2.55 per share was an increase of 24.4% over last year's annual dividend. In addition to the annual dividend, we purchased $393.1 million of Cintas' stock in fiscal '20 to date, including $200 million in March. The amount remaining under our buyback authorization is $1.1 billion. We ended our third quarter with fiscal year to date revenue growth of 7.2% and an organic growth rate of 7.1%. Operating income, excluding last year's G&K integration expenses increased by 14.7%. EPS adjusted for last year's special items increased by 22.2%. And finally, free cash flow for the third quarter year-to-date increased by 61%. Our employee partners have really done a great job this year. With that, I will turn the call over to Paul for additional details for our third quarter results.

Paul Adler, Vice President and Treasurer

Thanks Mike. We have two reportable operating segments: uniform rental and facility services and first aid and safety services. The remainder of our business is included in all other. All other consists of fire protection services and our uniform direct sale business. First aid and safety services and all other are combined and presented as other services on the income statement. The uniform rental and facility services operating segment includes the rental and servicing of uniforms, mats and towels, and the provision of restroom supplies and other facility products and services. This segment also includes the sale of items from our catalogs to our customers on route. Uniform rental and facility services revenue was $1.45 billion, an increase of 6.6%. Excluding the impact of acquisitions, foreign currency exchange rate changes, and the difference in the number of workdays, the organic growth rate was 4.8%. Our uniform rental and facility services segment gross margin was 45.8% for the third quarter compared to 44.9% in last year's third quarter, an improvement of 90 basis points. Gross margins have strengthened for many reasons, including strong revenue growth and realization of cost synergies from the acquisition of G&K. Our first aid and safety services operating segment includes revenue from the sale and servicing of first aid products, safety products, and training. This segment's revenue for the third quarter was $170.5 million. The organic growth rate for this segment was 12.5%. The first aid segment gross margin was 48.0% in the third quarter compared to 48.2% in last year's third quarter. The difference in gross margin was due to revenue mix in the quarter, which consists of service, product sales, and training. The strong organic revenue growth benefited from more safety and personal protective equipment product sales, which generally have lower margins than the other revenue categories. Our fire protection services and uniform direct sales businesses are reported in the all other category. Our fire business continues to grow each year at a strong pace. The uniform direct sales business growth rates are generally low single digits and are subject to volatility such as when we install a multi-million-dollar account. Uniform direct sales, however, is a key business for us, and its customers are often significant opportunities to cross-sell and provide products and services from our other business units. All other revenue was $192.1 million, an increase of 9.9%. The organic growth rate was 7.1%. The fire business organic growth rate was 4.1%. Fire revenue was weighed down by the loss of a struggling national account in the retail sector that recently disclosed the closing of over 100 stores due to mild winter weather that resulted in less sprinkler repair services revenue from freezing and bursting water pipes and by a decline in sales rep productivity through the Christmas and New Year's holidays. The uniform direct sales business organic growth rate was 11.1% and benefited from additional sales from a rollout last quarter of Carhartt branded garments to a Fortune 100 customer. All other gross margin was 41.3% for the third quarter of this fiscal year compared to 42.3% last year. Selling and administrative expenses as a percentage of revenue were 28.2% in the third quarter of fiscal '20 and 28.3% in the third quarter of fiscal '19. G&A labor expense as a percent of revenue improved year-over-year. Our effective tax rate on continuing operations for the third quarter of fiscal '20 was 18.9% compared to 20.1% last year. The tax rate can move from period to period based on discrete events, including the amount of stock compensation expense. Our cash and equivalents balance as of February 29 was $234.4 million. Of that amount, $144.7 million was in the United States and unrestricted. Capital expenditures in the third quarter were $63.2 million. Our CapEx by operating segment was as follows: $50.2 million in uniform rental and facility services, $10.1 million in first aid and safety, and $2.9 million in all other. Year-to-date free cash flow was $745.2 million, an increase of 61% compared to the prior year period. Free cash flow increased because of strong earnings growth and improvements in working capital, particularly accounts receivable, inventories, uniforms and other rental items in service, and accounts payable. As of February 29, our balance sheet remains strong. Our leverage was 1.7 times debt to EBITDA. We have an untapped credit facility of $1 billion, no debt maturities in the next 12 months, and no material debt maturities in the next two years. That concludes our prepared remarks. We are happy to answer your questions.

Operator, Operator

And first we have Manav Patnaik with Barclays Capital.

Manav Patnaik, Analyst

Good evening, gentlemen. Just, maybe in light of all the stuff going on, perhaps you could help us with a little bit more detail in terms of where your exposures lie; whether that's restaurants, lodging, and so forth, just we at least know the magnitude of what percentage of revenues are really at risk versus those that could go like 50-50 or whatever it is. I was hoping you could help us with a little bit more color there.

Mike Hansen, CFO

Sure Manav. As I mentioned earlier, we’re currently facing a high level of uncertainty. As of last week, we didn't observe significant impacts on our revenue, and we are working to better understand this situation as we move through the weekend and into the future. It’s important to note that we have a very diverse customer base, with about 30% of our revenues coming from industrial sectors and 70% from service-oriented businesses, including healthcare, retail, distribution centers, food service, and hospitality, all of which are being affected in various ways. For instance, healthcare really needs us right now—they require our scrubs, microfiber wipes, cleaning chemicals, and fire protection products. In the restaurant sector, some locations are closed while others operate solely on a carryout basis, and we are learning about their needs as we visit them this week. They may still require chef works, hygiene products, first aid, and safety supplies, but understanding those needs will take some time. Office environments are prioritizing cleanliness more than ever, so we are noticing an increase in demand for our first aid and safety products as well as personal protective equipment like gloves. However, hotels, casinos, and arenas are currently experiencing very minimal business activity, and we are still in the process of comprehending the overall impact on the business. It’s challenging to provide a detailed breakdown because no single category accounts for more than 10% of our revenue, and the situation varies significantly by geography. Businesses on the coasts may experience more severe impacts compared to similar businesses in the Midwest. It will take time for us to gain clarity on the overall effect on our business, and we are not there yet.

Operator, Operator

Thank you. Next, we have a question from Andrew Wittmann with RW Baird.

Andrew Wittmann, Analyst

Great. Thanks. A question that we've gotten a lot this week is how customer closures work and how they affect you and what the contract says when such things happen. I know there are probably different ways to treat different categories of customers; small customers, large customers, maybe even by end market. But for those customers that are shutting down, we know are shutting down, how does that get treated by Cintas and what is the impact on your financials?

Mike Hansen, CFO

That’s a great question, Andy, and as I said, we're still working on gaining clarity there, but it's going to be all over the board, right. This is not a normal environment; in a normal environment, we may have a business shut down for a week, and we still may be charging the rental of garments and other products. That means holiday manufacturing shutdowns are good examples of that, semester breaks at school are good examples as well. What we're talking about right now is quite different. We have to understand from our customers how long do they think they will be closed and many of them right now don't know. But how long do you think they're going to be closed, and what are the needs of the business today versus maybe where they were a couple of weeks ago? It's going to be all over the board, Andy, from small businesses to large businesses and different kinds of verticals in different geographies, and as I said, we're working through that to gain clarity.

Operator, Operator

Thank you. Our next question will come from Andrew Steinerman with JPMorgan Securities.

Andrew Steinerman, Analyst

Hi Mike. Let me give it a try. So, my sense is that the uniform rental business really is kind of cyclical on a delay. When you look at your fiscal 2008, it was actually up. It wasn't until 2009 and 2010 fiscals you did have kind of moderate declines about 5% organic per year for those two years. So, my question really is, do you think that the impact that you’ve experienced now will be more immediate or do you think it's going to be delayed like I described from the last recession?

Mike Hansen, CFO

Yeah Andrew, this is not a normal recession or even like the great recession. I think there's going to be—there is going to be a more immediate impact simply because we have so many businesses that have been ordered to close. We have 40 states that have closed their schools. I think over 20 states have closed their restaurants. That's unprecedented, and it's not like our customers are going out of business over time or even had the chance to reduce their workforce. They are closing, many of them on orders from municipalities. There will certainly be a more immediate impact. What is that impact? One of the reasons that we did not provide guidance is that it's really hard to tell. We've never been through a pandemic, and in this pandemic, we're seeing things that we really haven't seen in the 90 years of Cintas operating this business. We need a little bit of time for clarity. As I said, we haven't seen much of an impact up until a week ago, but there is going to be an impact coming, and that's why we did not provide guidance because it's just too hard to tell right now.

Operator, Operator

Thank you. Our next question will come from Seth Weber with RBC Capital Markets.

Seth Weber, Analyst

I guess just following up on that line of questioning, I think in 2010 your decrement margins were sort of mid-30%. I guess Mike, just trying to read what you're saying, it seems like the impact could be rather shocking. So from a detrimental margin framework, should we think about levels above kind of where you were in the last time that organic growth was down? Is that kind of what you're messaging? Thanks.

Mike Hansen, CFO

Sure. If you think about the fixed versus variable and how we will manage the business through this disruption, there is a fair amount of uncertainty, as I've mentioned a number of times, and we need more clarity on what's the depth of this, what's the breadth of this, how long will it last, and what's the severity and duration? If we start to believe that, for example, the severity is pretty high but we don't expect the duration to last very long, then we may not be as aggressive because we don't want to harm the long-term opportunities and the performance of the business as we move into the next fiscal year. As we go into this, if we feel like the duration is going to be longer, then we may take different steps to reduce some of those variable expenses. We're going to need a little bit of time to understand our best expectations for severity and duration, and we'll manage accordingly. I can tell you, as we sit here today, we are generally in a mode of growing the business and adding routes and adding laundry capacity. As we sit here today, we have not, or we've slowed CapEx, for example, to only those things that are essential. In other words, we are not looking to add routes right now; that will reduce CapEx. We're not looking to expand capacity in our wash alleys, add extra processing facilities—that's going to reduce CapEx. Along those lines, that means we likely won't be hiring people to staff those new routes or to staff the added capacity. So there are certainly steps we can take to manage through this disruption.

Operator, Operator

Thank you, Sir. Our next question will come from George Tong with Goldman Sachs.

George Tong, Analyst

Oil prices have contracted sharply in recent weeks. What are your expectations for your industrial and manufacturing verticals, and what factors could potentially cause Cintas to perform differently during this energy downturn compared to the prior 2014 to 2016 downturn?

Mike Hansen, CFO

Well, I think, George, if we were looking at this only through the lens of the oil and gas vertical, then I'd say a couple things. One, it's a smaller piece of our business than it was at the beginning of that last downturn, and so that will not have as big of an impact on us this time. The lower gas prices will certainly help us. If we're just looking at the lens of that particular vertical, I think we will fare well during this, as we did several years ago. But this situation is broader, and it’s going to be really hard to tell exactly how we think we will perform in that one vertical compared to what's going on in the rest of the United States.

Operator, Operator

Thank you. Our next question comes from Gary Bisbee with Bank of America, Merrill Lynch.

Gary Bisbee, Analyst

Hey. Good afternoon. In the earlier question about cost actions, you referenced variable versus fixed but actually didn’t give us the mix of the two. Can you take a shot at that and maybe just at a high level if you do decide that this could be of longer duration, what are the kinds of actions you would take? Is it just headcount or are there other actions you would take to reduce costs? Thank you.

Mike Hansen, CFO

Well, Gary, if you think about our business, there are many variable costs involved. The question is, are they variable to the point where we can turn them off immediately, and do we want to turn them off immediately? That's the biggest question we’re dealing with, and it’s really—I think it's responsible as me to give you a percentage of total variable costs because we have to manage the business for the long term. I don’t want to throw out some variable number that makes you think we will cut our business to the bone. So let me give you some examples. When you think about the material cost of the business, we've got a lot of costs related to disposable products like paper soaps. We have direct sales like our catalog business; those are highly variable, and if we're not selling them, we don't incur those costs. We also have the gas, water, and energy costs—gas for our trucks, energy for running facilities. There certainly is a variable component of that, but there's also a fixed element, and it just depends on how much of that capacity we may decide not to pull back on. Considering laundry capacity, numerous components go into that including labor, and when you think about our route capacity, we have the costs of our drivers. There are many variable costs. Our goal is to ensure that our business remains strong for the long term and if we start to see longer duration, we will certainly consider some measures like pulling even harder on capital expenditures and other growth aspects of what we do. We may do some things through attrition, and we'll need to ensure we understand capacity utilization knowing we want to manage through this. If you go back to '09 and '10, we did close facilities, but that was a bit different scenario; it was a longer recession. This is potentially deep, but we just don't know the duration, and we do not want to impact the business long-term until we really have to.

Operator, Operator

Thank you, Sir. Our next question comes from Hamzah Mazari with Jefferies.

Hamzah Mazari, Analyst

Mike, if you could just provide just a little more detail on your contract structure. What I mean by that is, if a customer goes bankrupt, clearly you see that right away; if it's a closure, how quickly do your contracts adjust to permanent headcount changes? Just any sense as to how defensive your portfolio is, and specifically what's the lead-lag to headcount changes that may be permanent. I realize absences don't impact your business.

Mike Hansen, CFO

Our contracts are generally five-year contracts and they provide for a steady stream of revenue and generally there is some minimum level of revenue that we require. But Hamzah, we're in a little bit of a different time today, and so there will be a customer-by-customer conversation about what makes sense and that's going to take a little bit of time to get through. This is not a normal kind of ramping down or trending down of the business. This is a kind of abrupt closure of a lot of different customers, but let's remember something else about our business. There are many businesses that really need our products and services. I don’t want that to be lost. A few municipalities in areas within the country, particularly on the coasts, have identified us as an essential provider. So even though other businesses may be shutting down, we are operating because our customers need us, and we will understand the collective impact over the next few weeks. Some of our customers will be negatively impacted, but others really need us, and we are going to do everything we can to take care of them. It’s a mix, and we're going to take time to understand that and provide clarity.

Operator, Operator

Thank you, Sir. Our next question comes from Tim Mulrooney with William Blair.

Tim Mulrooney, Analyst

I understand the environment is very different, Mike, but if you go back to the last recession, and I can't remember if you broke this out or not, but how did customer retention look through that period? I'm trying to figure out how much of that mid-single-digit organic decline in '09 and '10 was due to a deterioration in retention rates versus new customer sales that we're pricing, for example?

Mike Hansen, CFO

The retention was not negatively impacted that much. It was more about customers reducing their headcount. We certainly did have more customers than normal periods do a lot of business, which contributed to a little bit of a higher loss business number, but generally speaking, our retention was really good. I think our retention, outside of possible businesses that have to go out of business, will be very good here, too. There's going to be a period of disruption that we need to work through. We have to be careful about comparing this to prior recessions; this is a pandemic that's quite different, and the destruction will be a little more abrupt and immediate. The question is how long this will last, and boy, if we can get through this as a country in the next 60-90 days, we look forward to getting back to normal operations, but we must see what that looks like first.

Operator, Operator

Next, we have a question from Shlomo Rosenbaum with Stifel Nicolaus Investments.

Shlomo Rosenbaum, Analyst

Can you talk about how many of your contracts, let's say percentage-wise, in first aid and safety are primarily consumption-based contracts, or are they contracts that are a kind of recurring revenue where you charge for them per month? Can you go into that a little bit more? Because first aid and safety has been a very good growth portion of the business; just wondering how those contracts work?

Mike Hansen, CFO

Generally, those are based on—there are some recurring revenue streams. I would tell you the bulk of that is consumption-based, and the business is performing very, very well right now, as you can imagine, with the need for sanitization and personal protective equipment. That's a business that is performing very well; it has for the whole year, and we're getting a lot of customer requests for more ways to help. When you think about the needs of many businesses today, the cleanliness and safety aspects have really risen, and we have a lot of products and services that can help in those areas. Those have been requested quite a bit over the last couple of weeks, and I expect that those will perform well.

Operator, Operator

Our next question comes from Kevin McVeigh with Credit Suisse.

Kevin McVeigh, Analyst

Can you give us a sense of not only the client mix but what were the revenue trends the last week or so? Just to get a sense of how much the business came off, and then just is there any way to think about it geographically because it sounds like California, New York, Washington maybe that's been a little bit weaker than the interior. Just any thoughts on trends the last week or so, and is there any way to bring that out within a little more context geographically?

Mike Hansen, CFO

Unfortunately, Kevin, through last week we didn't see much disruption to the revenue. In our direct sale—uniform direct sales business, we did start to see incoming orders begin to decline, so that was probably an early sign. But through last week, there wasn't much impact. There have certainly been some impacts on the coasts. For example, all of our customers in New Rochelle are hard to get to, as you can imagine, with the National Guard patrolling the streets there. That's been difficult. There are other challenges on the West Coast as well, but collectively, it wasn't that big of an impact. I expect that we will start to see some impact as we go through the rest of this week and certainly next week. That’s when we'll start to be able to provide a little clarity on our customers' initial responses and what their needs may be as we move through this. There will be some customers where their needs have really increased, and there will be others who have closed, leading to different conversations. We need to get through all those discussions, though.

Operator, Operator

Our next question comes from Scott Schneeberger with Oppenheimer & Co.

Scott Schneeberger, Analyst

I guess you’ve alluded to CapEx a few times. Just looking at it year to date, you’re trending, I think your guidance at the midpoint this year was the same as what you did last year, but you're trending about $17 million below for my numbers. So I just care if you could delve into CapEx a little bit more, and I think you had said you had already taken some action with regard to what you’ve been seeing over the last weeks or months. So just kind of delve in a little more on what you would be thinking about on a going forward basis as well, thanks.

Mike Hansen, CFO

Sure, when I mentioned that we've made some decisions to reduce CapEx, that's a very recent type of conversation. When we think about CapEx, we love to grow the business, and we have been expanding routes as necessary and expanding capacity. But we’ve also kept in mind—we’ve gained some capacity through the G&K deal, and we’ve become more efficient through projects within the facilities. Our routes' revenue per route has been growing, and we've been efficient and prudent in CapEx throughout the year. Having said that, as we look forward, we’ve been at a $50 million to $65 million quarterly rate, and that's certainly going to come down, probably by half. I don’t have a very—scientific measurement but it’s going to come down significantly as we think about the fourth quarter. Beyond the fourth quarter, it’s going to depend on our expectations for severity and duration.

Operator, Operator

Our last question in the queue comes from Toni Kaplan with Morgan Stanley.

Toni Kaplan, Analyst

Thank you to save the best for last. I am going to take the road less traveled and ask a question about the quarter. Can you talk about the organic growth deceleration within the uniform rental space? It sounds like it wasn't related to coronavirus since you hadn't really seen an impact from that yet. So I guess just what were the main drivers of the deceleration within rental? Thank you.

Mike Hansen, CFO

We've talked a little bit over the last two quarters about the choppiness that we’ve seen in industrials, and we certainly saw that pick up a little bit in our third quarter. Now whether that has to do with China in the early parts of the quarter, we're not sure, or the uncertainty surrounding that; it's really hard to pinpoint. But we certainly did see some choppiness in that segment of the business, contributing to a bit of a deceleration there. Pricing was a bit more aggressive in the quarter; we talked about that in our second quarter and that continued into the third quarter. The holidays were tough; as I mentioned in the second quarter call back in December, having two holidays on a Wednesday generally makes it difficult for our salespeople to set appointments. If you think about a two-week period where many customers, because it's on a Wednesday, take the entire week off or are in and out, it’s difficult to schedule appointments. We saw an impact on our sales rep productivity. Paul mentioned this in the fire business and also in rental, and that contributed slightly too. Collectively, those factors are what we observed in the third quarter. Setting aside the pandemic, the business has been operating at a very healthy pace, and we really like our execution here. While the disruption is coming, we believe we are poised pretty well to manage through that and get back to business once we navigate this.

Operator, Operator

Thank you, Sir. That concludes the question-and-answer session for today's call, and I would like to turn the call back to Mr. Hansen for closing remarks.

Mike Hansen, CFO

Thank you. Before ending the call, we would like to leave you with a couple of final comments. First, I want to reiterate that our thoughts remain with those impacted by the COVID-19 coronavirus as our country works to get through this difficult situation as quickly as possible. Secondly, our business has performed very well over the last 10 years, with strong revenue, income, and EPS growth. In fact, we've grown our sales and profit in 48 of the last 50 years. Although we are entering a period of disruption, all Cintas partners remain excited about the future opportunities of our business and look forward to returning to business as usual. In the meantime, we are well-positioned to enter this disruption with strong cash flow, a solid balance sheet, and an uncapped $1 billion credit facility. We feel good about our ability to manage through this and emerge on the other side with a very strong business. Thank you again for joining us tonight. We'll issue our fourth-quarter financial results in July, and we look forward to speaking with you again at that time.

Operator, Operator

Thank you, ladies and gentlemen. This concludes today's teleconference, and you may now disconnect. Please enjoy the rest of your day.