Mac-Gray (TUC) – Cheap stocks live in the strangest places
As I generally adopt a bottom-up investing policy, and go into investing without any preconceived notion of what sector my stocks are going to be in. As a result, I am often surprised at the odd niches where attractive stocks hide. However, Mac-Gray Inc. (TUC) is one of the more unusual ones. They operate laundry facilities in any buildings large enough to require them, including apartment complexes, college dorms hospitals, and hotels and motels. They are the biggest single provider of services in college residences. Generally they lease the space and provide it with laundry equipment, while the property owner is responsible with cleaning, maintaining, and security.
As their leases run for multiple years, they tend to have a captive audience of users, and as a result they display fairly decent earnings resilience, although they claim that a decline in apartment occupancy owing to the financial crisis has affected their recent results. On the whole they claim to have generally no difficulty in renewing their leases, and that usually they are the ones who decline to renew based on a lack of profitability. They are also in a position to somewhat pass higher costs on to consumers.
Yesterday morning they reported earnings that were consistent with their previous performance, and the market did not greet this with approval, sending them down more than 6%. The day was generally bad for the markets, but they may have been reacting to slightly higher administrative expenses and a spike in capital expenditures in the company itself. On the whole, I am sort of pleased with this outcome of earnings; I’ve had this article being planned for days, but I didn’t want to recommend it before a disruptive event like earnings, so I held off on it. This exposes me to the risk that the company gets a good response from earnings, forcing me to abandon it as a value proposition. It’s one of the reasons I hate earnings season, and this one particularly has seen my stocks being punished by the market even if they produce respectable and estimate-beating earnings. I take it as a sign that there is perhaps too much optimism in the market right now.
Mac-Gray’s reported earnings are not so impressive, but recently their depreciation has been running higher than capital expenditures for the last few years, partly owing to recent large acquisitions and partly because they have been bleeding off some unprofitable contracts. They also lease equipment to customers who do not want to become full clients. The company is continuing in its efforts to pay down their debts incurred for the acquisitions.
Turning to the figures, in 2007 operating earnings were $17.1 million, depreciation was $38.7 million and capital expenditures were $26.7 million, producing $29 million in operating cash flows. They paid $13 million in interest, producing $17 million in pretax free cash flow. Owing to the fact that much of their free cash flow was depreciation, they only paid $0.7 million in taxes that year, producing free cash flow of $16.3 million.
In 2008, operating earnings were $20.5 million, depreciation was $48.8 million owing to a large acquisition, capital expenditures not counting the acquisition were $24.3 million, giving operating cash flow of $44.9 million, which is more like it. Interest incurred that year was $20.6 million, leaving $24.2 million in pretax cash flow. That year they actually received a tax refund of $0.8 million, producing $25 million in free cash flow.
In 2009, operating earnings of were $21.1 million, depreciation was $49.9 million, and capital expenditures were $21.3 million, giving us operating cash flow of $49.6 million. Interest was $19.7 million, and final operating cash flow was $30 million. Taxes paid that year were $1.3 million, leaving $28.7 million in free cash flow.
For 2010, based on their earnings announcement, operating income was $18.4 million owing to lower margins and a small decrease in sales, depreciation was $47.5 million and capital expenditures came to $28.6 million, producing operating cash flow of $41.3 million. Interest paid in 2010 was $13.4 million, owing partly to some favorable interest rate swap movements, producing pretax free cash flow of $28.9 million. Â Taxes paid that year $2.2 million, producing free cash flow of $27.7 million. The company now has a market cap of $204 million, which represents a free cash flow yield of 13.6%, with interest covered 3.08 times.
I am aware that I often calculate cash flow arising from excess depreciation as though it were taxable, as it gives a better clue as to long term earnings power, but here the excess depreciation is so large relative to earnings that I prefer to give the figures as they are because it seems that there will be a long time before earnings and depreciation will converge, so the firm will have significant tax-free income for some time. If the free cash flow is entirely subject to tax, the company would produce free cash flow of roughly $17.4 million.
In the latest conference call, TUC mentioned two interesting facts. First, they anticipate that sales for 2011 will be more or less identical to 2010’s sales, and that they anticipate capital expenditures to rise to the area of $33 million, which will no doubt cut into free cash flow. They also, and very helpfully, announced a useful tidbit that they estimate $28 million to be their “maintenance†level of expenditures, meaning that counting unrenewed contracts that must be replaced, $28 million per year is roughly what they need to maintain earnings power. This would suggest that the bleed-off of contracts as shown by capital expenditures being below $28 million in 2008 and 2009 has apparently come to an end and they anticipate actual expansion in 2011. As a result, the company may show some long-term growth in future years. I am of course hesitant to rely on such growth, but even without it, it would appear that company’s earnings from the same level of operations next year will be on par with those from this year and as a result the investment stands without it.
On the whole, then, the stability in operations that Mac-Gray has demonstrated, the slow improvement in occupancy rates that they see, the continued paying down of debt incurred to make acquisitions, places this company within the increasingly rare set of value propositions in this market, and I can recommend it for portfolio inclusion.
Assuming that the average contract is 8 years this means that 12.5% of their contracts should be renewed annually just to “march in place”. Their renewal rate is much lower than they imply and you have to be careful on their spin of their renewal rate.
I wonder why they don’t report same branch/store sales like retailers. What this would reveal is that for the past few years any increases have come as a result of price increases and not from an increase of customer base.
Once they acquire another company their percentage loss (of those new customers)is very high.
The competition in the out-sourced laundry business is brutal. Their gain/loss of contracts when vying against Coin-Mach is negligible meaning that neither has gained or lost enough to yield a significant statistical pattern.
IMHO the only reason to invest here would be as a flight to safety when the rest of the market turns south Mac-Gray does provide some stability.