Description

GKSR is a simple story of being early as a great management team builds the company for the future.  The company, a renter and seller of uniforms to the manufacturing and service industries, is well run by Rick Marcantonio.  Since taking over three years ago, he has systematically rebuilt the management team and invested heavily in the infrastructure – after years of neglect by previous mgmt.  Current returns on capital and margins are depressed but investors should start to see real value accrete to their investment in the next year.  Further, there is much discussion that there will be another round of consolidation and GKSR may very well not be independent in the next year.

Market:

The market for G&K’s services is highly competitive – some would say cut-throat as the business is incredibly sticky.  Retention rates are about 93-95% and that is after customer shut-down.  In other words, G&K loses customers to other suppliers or because the customer’s business changes or shuts down.  About half of that 5-7% decline is due to each reason.  In addition to the potential consolidation of the four big players, the market is still filled with moms and pops so there is plenty of room for smaller consolidation efforts.  For example, in Southern California (San Diego area), which is the 2^nd biggest market for G&K, there are 72 competitors. 

The big players have distinct advantages:

1. Significantly lower cost of product
2. Lower cost of operations – particularly after the installation of hand-held computers for the route salesmen
3. G&A leverage

Growth should continue as the service industry in this country expands and managers better understand the need for consistency in marketing.  Manufacturing industry declines are mostly over at this point.  Even in a weakening economy, further competitive efforts by service companies – i.e. efforts to distinguish themselves – should lead to continued growth.  This industry does not shrink – though growth would most likely slow in a weak economy.

Competition:

There are four major players.  Cintas is the biggest followed by Aramark’s uniform division.  Unifirst and GKSR are the next step down in size.  There have been rumors for some time that Cintas would take out one and Aramark would take out the other.  To date, nothing concrete has happened, but it remains a distinct option.  And as discussed above, there are many moms and pops and mid-sized companies that can be consolidated.  An example is that in Southern California, there are 72 firms – so almost 70 moms and pops that don’t have the economies of scale and pricing power of a GKSR or Cintas.

Marketing

There are two types of marketers within each company: (1) dedicated marketers – who bring in new contracts, and (2) route drivers – who manage the weekly pick up and delivery of uniforms.  Their job is to up-sell additional products or services – i.e. bathroom supplies and mats among other things.  The company is now focused on hiring more mature salesmen – 28 or older with some sales experience vs. typical 22-23 year olds that are raw.  They are also investing heavily in training them and getting them to the point where they make good enough money to stay in the business.  At the salesman level, it is a notoriously high turnover business. 

There are two keys to this business: Growing the top line and margin expansion:

1. Simple top line growth – they must open new venues, take share and invest in newer more innovative products.  Which the company has done.  One example is the ProSura line that provides bacteria-resistant uniforms for the meat packing and supermarket businesses.  Future efforts in healthcare, etc. are forthcoming.  These also much higher margin products
2. Margin expansion
1. G&A leverage due to higher sales
2. Better sales mix
3. Further G&A cuts
4. Sales leverage by having more efficient and longer term salesmen – the longer they stay on, the lower the training costs for new salesmen
5. Cost cutting due through the implementation of technology – such as hand held computers on routes – this does away with reams of paperwork – i.e. hours spent by drivers where they could be selling more.  It also enables them to up-sell products more efficiently
6. Oil and natural gas prices directly impact margins.  They have moved from 3% of operating costs to 5% in the past three years.  A decline will clearly benefit them.

Sensitivity Analysis for earnings potential

The company is on target to do north of $950mm in revenue this year.  This implies only a 5-6% growth level.  Over time, the company should be able to get the organic growth rate to 6-8%.  In the past two years, it has gone from negative 3% to positive 4-5%.  Trends are clearly good.  Margins have been depressed for multiple reasons.  Direct comps with Cintas and others are not easy as some lease delivery trucks while others buy them, etc.  GKSR leases them; thus their margins should be a bit lower.  However, with the current top line growth as well as cost cutting efforts, the company can achieve low double digit margins in the next few years.  If revenue grows to north of $1B, which it is on trend to do, then a 10% EBIT margin yields about $65mm in after-tax earnings.  There is also about $10-20mm of excess depreciation – the range is due to how each investor may calculate maintenance vs. growth capex.  Let’s take the mid point and we can easily see $80mm of free cash flow.  Further, over time, the company could reach 12%+ margins.

In Two Years

So, what does this look like in two years: you have a company pumping out more than $80mm in free cash flow and $50-100mm in net debt (currently at $200mm) after factoring in the next two years free cash.  This sector has historically traded above 20x but multiples have come down.  Nonetheless, due to the recurring nature of the business, a 15-17 multiple is warranted.  The current market cap is $820mm.  16X $80mm in free cash is $1.28B for 56% upside.  Each 1x multiple expansion yields another 10% in upside.

Balance Sheet

Due to the nature of the business, this balance sheet is under-levered.  This could easily change.  Especially should a private equity firm get involved.  You can do your own sensitivity analysis but a buyout price now is north of $50.  Considering the interest in Aramark and service businesses in general, this is clearly a buyout candidate – though the CEO has told us he has no interest at this point.

Catalyst