Mac-Gray (TUC) is a company that will do okay in a deflationary environment, and even better in an inflationary one. It is the nation’s second largest laundry facilities management company, second to Coinmach, a private company. The business is predictable and easily understandable. A typical laundry facilities lease runs for seven to eight years, and begins with Mac-Gray installing new washing machines and dryers in the laundry room. The company takes charge of maintaining the machines and collecting laundry room revenues, forwards a fixed portion of the revenues to the landlord, and keeps the rest as profit. TUC derives 95% of its revenue from facilities management (the remaining 5% comes from selling laundry machines to laundromats), and about 14% of its revenue derives from universities and colleges, hence the revenue is somewhat seasonal.
Laundry facilities management is a mature and highly fragmented industry. Most landlords have established relationships with tiny companies who install, service and collect revenue from their laundry machines, and are hesitant to change companies. This is despite the fact that large companies like TUC offer economies of scale and modern technology. Mac-Gray purchases all of its machines from Whirlpool in return for discounts. It also installs refillable card systems in its laundry rooms, saving on the costs of transporting coins, and because the number one reason why tenants go to outside laundromats is because they ran out of coins. Card technology also allows Mac-Gray to adjust their prices more frequently and in smaller amounts to keep up with inflation. Still, the company has to acquire smaller companies in the business in order to increase density within its service areas. As a result, growth in business is expected to be muted.
The income statement of Mac-Gray looks terrible, due to large depreciation charges and high interest expenses stemming from a large debt load from past acquisitions. Net income does not accurately reflect the true earnings of the company. This is because with technological improvements and the outsourcing of Whirlpool’s factories to other countries, the cost of new laundry machines have been dropping, and true capital expenditures run below that suggested by depreciation. The cash flow statement reveals that the company spends only half of depreciation on new machines. I estimate the company has true earnings of 20-25M annually on a cash basis.
Paradoxically, debt is a good source of growth for this company. Mac-Gray has about 235M of debt, and simply paying down that debt by 10% a year would yield earnings growth of around 5% for the next 10 years. Unlike most companies, Mac-Gray has a predictable cash flow from a captive customer base, which is governed by long-term leases. Capital expenditure is largely associated with lease renewals, and is predictable and controllable. About 8-10% of the company’s leases come up in a year, and the company has the option of not renewing the lease if the return on investment is not sufficient to cover the cost of capital. To a company with predictable earnings and expenses, debt is not toxic.
The company is sensitive to two main economic variables, interest rate risk and apartment vacancy rates. About half of Mac-Gray’s long-term debt is variable rate, and half is fixed. In the unlikely event of a sudden and large hike in interest rates, Mac-Gray may not be able to fully pass on the cost increases to their customers. In addition, the company is also sensitive to apartment vacancy rates. A slight rise in apartment vacancy rates in some markets in 2009, perhaps as a result of the one-time housing tax subsidy by the federal government, resulted in a 1% drop in revenues in that year. However, in this economic climate, I do not anticipate that large numbers of people will start buying houses and moving out of apartments. In fact, the housing rate in the US is currently dropping, with less people owning houses.
Management is competent and conservative, with a long history in the industry. CEO MacDonald owns more than 30% of the company (when stock from various trusts and family members are aggregated), and hence is a true owner-manager with interests aligned with shareholders. I am generally happy with management performance. Their current major use of cash flow is to pay down debt. I am, however, less thrilled about the recent decision to begin paying a dividend.
What is the proper valuation for a company with $20-25M annual earnings growing 5% annually? TUC is in an unglamorous but steady industry, and its pricing power with its captive customer base makes it more resistant to inflation than most other businesses. The business is sticky; landlords hate having to change management companies, and is anyway locked down by long-term leases. Furthermore, moderate inflation might even be helpful in lowering the real cost of its debt. I think that valuing TUC at a PE of more than 10 is appropriate. In fact, a valuation with a PE of 12-15 is not outrageous. Applying a PE of 12 gives a market cap of $240M. With outstanding shares of 13.8M, that is a price target of $17.40, suggesting a 30% undervaluation at the current price.
I am in the midst of acquiring a position in TUC.
{ 5 comments… read them below or add one }
As a former employee of Mac-Gray I agree with most of what you have said and am impressed with your research.
Let me add a few things:
1. The outsourced laundry business is fragmented: MacGray and Coinmach combined have have 33% of the market share; the small (and most are tiny) regional companies have another 33%; and the final 33% are apartments/condos and schools who own their own equipment.
2. The Industry is highly competitive; its not unusual for property owners and universities to get 5-8 bids.
3. There is some economy to size but equipment is available to most of the companies for about the same price.
4. Equipment prices are not going down; they are going up. Especially when you factor in card systems and electronic versions of the machines. (Adding card readers to machines and value added card machines which take the credit card or currency and convert them to card value are very expensive.)
5. Neither MacGray or CoinMach have been increasing market share unless they purchase small companies (hence the heavy indebtedness). Statistics are measured by machine cycles and cycles are down. Revenue might be flat or up slightly based on vend price increases.
6. The stock price for MacGray was very flat until they declared a dividend and there’s nothing else in their financials that would make one run to their stock broker to purchase this stock. One analyst I talked to said that his firm might invest only as a “Flight to safety” when the rest of the market is tanking.
7. Its safety is in its ability to employ a fair number of people to provide a livelihood. As an investment I would not risk it and as a former employee I have not placed a nickle into their stock.
To Formerly MacGray,
Thank you for your very insightful comments. It is to attract the readership of people like yourself that I started this blog.
I agree with your point that economy of scale is modest with TUC. There are only modest savings with equipment purchases, and servicing costs flatten out once you pass a critical equipment density in a given area. I think that the main benefit of scale for TUC is actually increased access to bank loans.
I agree that at this time, cost of equipment is now going up. TUC is in a capital intensive industry. This would be a problem if capital is scarce, but it is not now. The Fed is pumping unprecedented amounts of liquidity into the system, and capital is cheap. The nice part of TUC’s business is that it enters into long-term leases with its clients, the duration of which nicely matches the duration of most commercial bonds/loans. As long as the anticipated return from the laundry lease exceeds the interest required to service the loan, TUC enjoys positive carry, and can carry debt with little risk. As long as large numbers of people do not move out of apartment complexes and impair TUC’s laundry earnings, debt is a valid way to finance a company like TUC. The investment opportunity arises only because investors were indiscriminately fleeing high debt companies without thinking about what the debt funds, and whether it is stable.
I also agree with you that TUC is a defensive safety stock. It is not going to triple under any reasonable set of circumstances. Growth is going to be debt financed. But a nice steady return in excess of inflation is a valuable thing for investors with lots of capital to deploy. Many investors buy up boring stocks like railroads and utilities for this very reason.
My only real worry and uncertainty with TUC now is inflation. In my research, I find that TUC has considerable pricing power and can up its fees almost arbitrarily, and hence it is reasonably insulated against inflation. But… not being in the industry, I am not 100% sure on this, and will appreciate input from you. In your opinion, can TUC raise its fees in line with or in excess of inflation?
TUC or their competitors usually cannot arbitrarily raise the laundry vend fees. These are done two ways: 1. prior agreement with the landlord and terms placed in the contract or 2. outside the contract with mutual consent of the landlord.
Card operated machines can handle small incremental annual increases (let’s say 5% on year, 6% the next or can handle different vend rates at different times of the day) yielding minimal impact on the number of vend cycles. Coin operated machines are upgraded $0.25 at a time which can be a much larger percentage increase ($1.25 to $1.50 without any vend price flexibility) and usually accompanies a short term reduction in vend cycles due to the higher percentage.
Historically landlords have been reluctant to increase vend prices but need to be reminded that over the past 15 years that the laundry vend prices have not kept pace with the rapid increase in water/sewer/electric/gas rates.
Therefore, its not the overall rate of inflation that the vend prices should be tied to but the rate of utility costs that the landlord wants/needs to offset.
Thanks for the tip, Formerly MacGray.
What I understand from your comments is this: The landlord bears the cost of utilities required to run the laundry room, and offsets this expense from the laundry fees that TUC gives to the landlord. In other words, the landlord bears the cost of utilities inflation, whereas TUC bears the cost of capital equipment inflation. The landlord is actually motivated to seek laundry vend price increases, and would presumably do so in an inflationary environment, limited only by the possibility that his tenants would revolt and move out. Utilities inflation does not hurt TUC; it actually helps TUC. If TUC revenue is based on a fixed percentage of laundry vend fees, and vend fees increase while debt rates stay fixed, TUC margins go up (the classic inflation helps debtors situation). Of course, the next time the lease is up and new equipment has to be purchased to renew the least for another 5-8 years, that equipment would be more expensive. In an inflationary environment, the business will get increasingly capital intensive, but as long as credit is available, that should not be a dire issue.
This is the situation as I understand it. I was afraid that it was TUC which actually bears the cost of utilities. If that is the case, inflation will increasingly erode TUC’s margins, since the landlord has no incentive to raise laundry fees, and TUC is contractually bound and unable to unilaterally raise fees. If the latter situation applies, I would appreciate it if you would advise me on this.
As a digression, I am wondering why you have not personally invested in this industry. As an insider, you have great insight into the critical financial parameters (such as percentage of costs that are allocated to utilities vs equipment), and should be able to call the ups and downs in the industry quite accurately and take long/short positions as appropriate. Is it because you are still employed by the industry and don’t want to put all your eggs in one basket, or because you think that the industry is mature and have limited growth prospects? Or perhaps because the laundry industry is limited to basically one significant publicly traded stock?
Permission to raise vend prices is a 50-50 proposition…..50% of the time the landlord will grant the increase; 50% of the time rejecting the concept fearing tenant push-back especially of there have been recent rent increases. The percentage or fixed rate commission (legally its is rent since the contracts are almost always leases for space) that the landlord gets may or may not be tied to the vend price increase.
These contracts are highly negotiable and rarely are any two alike juggling 1. upfront money (sometimes called a signing bonus), 2. monthly commission (rent) which can be fixed or a percentage, 3. types of equipment to be installed, and 4. facility renovation.
My status as my icon implies is as a former Mac-Gray employee.
If you look at the financials it shows a mature company in a mature business with no way to grow by leaps and bounds except by using debt to purchase pricey competitors (notice that even in an economic downturn with low interest rates that no major acquisitions were made). The company is steady enough that it can provide jobs for a number of people with minimal or little layoffs; although I’m sure that hiring freezes may have been in effect. Its OK for the employees who want a steady, non-advancement job. Its great for a handful of corporate staff who get paid a decent wage with options. But, I have been successful investing my money in a variety of other ways and see no real growth potential via stock appreciation and/or by dividends
The business tends to be steady enough that predicting long and short positions would be a serious waste of time.
Even if Coinmach were to go public again I would not invest in either company; and none of the other regional organizations are large enough to do so.
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