Airing your dirty laundry usually has a negative connotation but around here we always trying to look at things in a new way.
K-Bro has lots of dirty laundry to talk about, being Canada’s largest publicly listed linen cleaning company. The company’s origins go back to the 1950s where they laundered cloth baby diapers. Now, however, they have turned the company into a nice business where they are a provider of linen cleaning services for 1) the healthcare industry (2/3rds of revenue) and 2) the hospitality industry (1/3rd) with 2014 revenues of $136MM.
What makes them interesting is:
1) The majority of their business is supported by long-term contracts with healthcare contracts typically being ten years.
2) They have good steady margins – Operating margins of 12-13%, NI margin at 8-9%, and a steady dividend payout of ~40%.
3) Capital costs are up front with minimal maintenance capex required (currently $1-2MM/year compared to operating cash flows of $22-25MM).
4) Big new contract with Saskatchewan’s 3sHealth for the provinces healthcare linen needs. The Company built a new plant in Saskatoon to serve the needs of the province. The exact expected impact of this is unclear (the Company and province have been very quiet about the terms, just that it will save the province “$100 million dollars” over the course of the contract.
What happens when these large contracts run out? We can look to 2008. When K-Bro renewed their Calgary Health Region contract the existing facility lease was up for expiry and could not be renewed. K-Bro ultimately built a new facility (~$15MM). This does remind us that, even though its reported balance sheet is unlevered, it does have $6MM of annual operating lease expenses, for which over $40MM should be added to the balance sheet as debt.
Reported maintenance capex levels: One thing that stood out to use is the Company's stated level of maintenance capital (defined as "costs required to maintain or replace assets which do not have a discrete return on investment"), which management states is $1-2MM annually. This seems at odds with D&A of $7MM; though we have never run an industrial-scale laundry plant, and despise doing our own laundry for that matter, we think their depreciation assumptions seem reasonable. Perhaps free cash flow after maintenance capital may not be as high as it seems, and earnings are a better way to assess profitability. If you are doing some sort of DCF analysis you would have to either 1) Assume the plants are completely rebuilt at some point (as capital is usually all up front) or 2) Assume the contracts do not get renewed.
What do we think? It’s a decent, possibly great, business but it’s just too expensive. Unfortunately K-Bro is trading at an almost 30x P/E ratio (2.5% dividend). Assuming a 30% increase in corporate earnings (probably a fair estimate) that still reflects a ~25x P/E multiple, which is a high price for a company that has steady but slow and lumpy growth (never mind the risk that major contracts do not get renewed). It appears that this new contract is already baked in and new growth would mean another new contract with another province that would take several years to bring to fruition. One thing we would note is the Saskatchewan union has been actively trying to make the recent 3sHealth contract public - if they are successful, this would be a good time to revisit when the economics of a major contract become public.
We’ll keep an eye open for a (large) dip and remain on the sidelines.