Mac-Gray Corporation (TUC) – Laundering Money

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Mac-Gray (TUC) is an operator of laundry rooms in multi-unit housing facilities such as apartment buildings and colleges. They are the second largest company in the space with 86,000 rooms in 43 states.

Business Model

TUC contracts with facilities owners for the rights to manage the laundry room in their buildings. TUC supplies the coin or smart-card operated laundry machines and services the laundry room. In return, TUC pays a portion of revenues (ranging from 38%-60%) from the laundry services to the facility owner, and sometimes pays an upfront fee as well. The management contracts average seven years, after which time the parties can renegotiate the deal and typically new equipment is installed upon contract renewal. They also have a small segment (5% of revenues) that distributes laundry equipment to commercial buyers.

The business has some attractive features:

  • Stable recurring revenue- people will always need to do laundry
  • Somewhat captive target market- it is easiest to do laundry where one lives
  • Long term contracts
  • Ability to deploy capital into an easily scalable business model

Recent History and Earnings Power

In the 05-08 period, TUC pursued an aggressive acquisition strategy with the typical end result of overpaying and overleveraging the company. In the last 4 years the business has been slightly down to flat during which time management (prodded by activist shareholders) cut back on capital spending and deleveraged the balance sheet: TUC has done $66 million a year in EBITDA for the last two years. That appears to be a stable run rate for now. Where things get tricky is depreciation and amortization versus capex. TUC is showing $47.5 million in D&A, while cash maintenance capex on the current portfolio of facilities is around $25 million. About $13 million of the difference relates to the amortization of contracts acquired in acquisitions of competitors. The rest of the difference is caused by the accelerated depreciation on machine assets acquired in the acquisitions of 06-08, which are being depreciated over five years instead of the typical ten.

The business is still capital intensive due to the fact that equipment is typically replaced upon renewal every seven years. Capex from 08-10 was all maintenance capex, which includes equipment in renewal locations as well as in new locations to replace unrenewed contracts. Capex over that period averaged $24 million so that is probably a good proxy for maintenance capex, and is in line with management estimates of $20-25 million. (The upfront incentive fees paid to facility owners are capitalized in a separate account and amortized to cost of sales and not D&A and are thus not included in capex. The amortized amount has roughly matched the cash expense for the last few years.) So on an unlevered basis we get about $42 million in normalized pre-tax earnings (EBITDA-maintenance capex).

Cash interest is about $13 million a year at current debt levels. The normalized tax rate is 41%, and the currently high D&A serves as a nice tax shield. That gives us $26.7 million in normalized free cash flow:

As the company puts it in their investor presentation the three drivers of revenue are: number of laundry machines in the portfolio, cycles run per machine, and price of a load. All of these metrics have taken a hit over the past few years. The company has shrunk its laundry room portfolio 1-2% in an effort to conserve capital and not renew contracts on unattractive terms. Machine utilization also declined due to increased apartment vacancies during the recession. Management estimates that has been a $15 million a year hit to revenue from normalized vacancy levels. And lastly, the company has not increased laundry prices in two years even as their operating expenses have risen. Management feels the business environment is improving and they have announced a range of initiatives to grow earnings:

  • Investing capital in incremental facilities (not just replacing unrenewed ones) as well as acquisitions of competitors
  • Bringing on additional sales staff to target national accounts and expand geographic reach into states where they do not operate
  • Expanding into two new lines of business (to be named later)
  • Implementing price increases
  • Rolling out the “Change Point” electronic payment system (where the customer can pay by credit or debit card) in new or renewed accounts

Capital Allocation

The core questions for an investment in TUC are A. is this is still a good business that is worth reinvesting capital in? and B. if not, will management and the board return free cash flow to shareholders accordingly? From their history and recent comments, the answer to B is most likely no. That leaves us with the first question- will TUC be able to earn a decent return on reinvested capital?  This is a mature industry with lots of competition including large national players like Coinmach and many smaller regional players. And while on the face of it TUC should have meaningful competitive advantages due to economies of scale their ROIC numbers do not reflect that:

(Assumes constant maintenance capex of $24 million. Invested capital defined as shareholder’s equity+debt-cash. Tax rate assumed at constant 41% in line with historical average). While the numbers could certainly be worse, TUC is probably not earning its cost of capital. And while one might argue that invested capital is overstated due to the overpriced acquisitions that might prove the point- the only growth TUC has been able to manage in years is overpaying to buy out competitors at a poor ROIC. That leaves the “blame it on the economy” argument for the muted recent returns. While there might be something to that argument, for investors it doesn’t really matter unless one is very bullish on the economy rebounding in the near future.

One example where the impact of competition might go unnoticed is the new Change Point system. TUC is touting this a game changer for the industry. This technology enables customers to pay for laundry machine use by credit or debit card. It also electronically monitors the laundry room so that customers can be alerted by email or text when laundry is done and property managers can get real-time reports on laundry room status. While still in the very early stages (in 750 rooms at the end of 2011) this technology has increased same facility revenues 10% over previously coin-operated rooms (which still make up 70% of the units for TUC). This system will also enable TUC to more effectively adjust pricing as it can now be changed in any increment versus only 25 cent changes in coin operated machines. Certainly, this sounds attractive. But aside from the fact that this will take a while to roll out (it can only be implemented upon renewal when machines are changed out), their larger competitor, Coinmach, has the same technology. So over time any incremental profits from the new system will probably be competed away and given back to the facility owners in the form of a larger cut of revenues.

While management has not given detailed guidance, the capital allocation is clearly shifting from the deleveraging mode of the past few years to investing more capital in the business. Part of that emphasis might stem from the TUC board’s recent rebuttal of a $17.50 a share buyout offer from a shareholder. That valued TUC equity at $250 million, or a 10.6% FCF yield (assuming the above $26.7 million in FCF). That is probably pretty close to fair value for this business if there is no growth left in it. The buyout offer prompted management to update their business plan to include more growth initiatives.

In 09 and 10, TUC reduced debt by $75 million, and they have payed down another $13 million through three quarters in 11. Management has said there will be further deleveraging, but they have not revealed a target leverage level and it sounds like they think something close to the current level of debt is sustainable if they find suitable acquisition targets. The company put in a small dividend in 2010 and recently raised it to 24 cents a share, or $3.4 million, annually. They also recently announced a token $2 million stock buyback. So it sounds like most of the free cash flow in the near future will be going back into the business via the various announced growth initiatives.

Valuation

TUC trades at 9.3X EV/EBITDA-maintenance capex. On an unlevered basis TUC does not appear very cheap for a business with minimal growth prospects. It is cheaper on a levered basis at  a 13.3%  normalized FCF yield. It is probably fair to look at TUC on a levered basis given the stable nature of their business and their long term contracts. A 13% FCF yield could be attractive for what looks like a stable recession resistant business without risk of technological obsolescence. And there might be some embedded upside to run rate earnings with price increases, a possible rise in utilization as vacancy rates decline, and the roll out of Change Point. If the company were to commit to more aggressive return of capital to shareholders it might be an interesting opportunity. But I don’t think either the somewhat cheap valuation or the potential drivers of increased earnings are compelling enough to justify an investment in a minimal growth business without confidence in profitable capital allocation.

Disclosure: No position

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19 Responses to Mac-Gray Corporation (TUC) – Laundering Money
  1. Daniel
    January 19, 2012 | 2:21 pm

    Very good analysis. Great and sensible conclusion. The company and business model sound very enticing, with the type of continuity that should be sought out in any investment.

    Profitable capital allocation, as you explain, is the key factor to watch here. If we start to see some improvements in this area I think the investment would have little risk.

    Great analysis!

    Reply
    • Elie Rosenberg
      January 19, 2012 | 8:25 pm

      Thanks Daniel!

      Reply
  2. Luis
    January 19, 2012 | 6:02 pm

    I agree, excellent writeup and analysis. A few observations:

    There is no arguing that Stewart McDonald, the CEO, has engaged in some outrageously expensive and value-destroying acquisitions.

    However, there is evidence to suggest they’ve reformed their capital budgeting strategy and will be more disciplined going forward. Shareholder activism and proxy fights in recent years, have put significant pressure on the board to reform corporate governance and oversee the co’s strategic growth plans.

    The deleveraging, dividend and share-buybacks, while seemingly immaterial, signal they are paying attention to capital allocation. On their growth plans, I’ve talked to the CFO and they have a very clear hurdle stating they will only participate in small to medium sized tuck-in acquisitions with minimum IRRs between 15% to 20% (renewal IRRs average higher). Is this credible or achievable? I believe it is, here are a couple reasons why:

    First, I can’t help give them the benefit of the doubt and believe they’ve learned a hard lesson from their costly acquisition binge as McDonald nearly lost his job as CEO, and he and other family members, all large shareholders, suffered the consequences as the stock got pummeled in 2008/09. In my mind, worst case, marginal returns on capital will meet or slightly exceed WACC.

    More importantly, while the industry indeed is mature and fragmented, I disagree that it is intensely competitive to the degree that all excess returns get competed away. Roll-up and scale economies do exist, but ROICs have been distorted by a handful of very expensive acquisitions that created hundreds of millions of intangibles and goodwill on the B/S. Going forward, these also get renewed with more attractive terms, relatively speaking.

    The incremental economics of a new facility that increases density in a particular market are also more attractive (which isn’t seen in historical numbers).

    This is a business with very predictable and rational competitors (Coinmach). While they do co-exist and compete directly in many markets, more often than not, they respect each others turfs. Also, the recession did eliminate some excess capacity from independent owners.

    I believe you’ll be surprised to see SSS improve due to higher utilization & prices. Plus, technology is also helping reduce costs as washing machines become cheaper, more efficient, and last longer.

    But primarily, as you correctly stated, it is the levered FCF that makes this interesting.

    Reply
    • Elie Rosenberg
      January 19, 2012 | 8:55 pm

      Luis,

      Thanks for the comments, you make a lot of good points.

      I agree management has probably been scared straight to some extent by all the shareholder activism the past few years. That combined with the leverage remaining on the company makes it doubtful they would do another large value destroying deal. But I think they should at least present to shareholders a credible strategic plan in light of a buyout offer that was at least within striking distance of fair market value as the business stands today. Given the company’s size relative to their addressable market the onus should be on them to justify not running this business for cash and only investing incremental capital on very opportunistic deals. Instead they presented a series of vague initiatives (including going into two new business lines?!) and got very defensive when asked to present the long term vision for the company that justified turning down a reasonable buyout offer.

      On the competition factor- It is interesting that TUC is choosing not to renew ~30% of the deals that come up a year because they don’t like the economics- they say 8 to 10% of contracts come up for renewal annually and they don’t renew 3% (granted that number includes a small % of cases where the facility decides to in source laundry). That is a pretty high churn rate where presumably a competitor is undercutting them.

      If TUC had economies of scale it seems like they would steadily gain market share organically due to a lower cost structure (i.e. through outbidding competitors on new facilities instead of acquiring competitors), which does not seem to have happened over the years. I agree in theory they should have economies of scale, but they just don’t seem to be reflected in their numbers.

      I totally agree the opportunity for organic growth in FCF through better pricing and utilization is very interesting. I just wish management would be content with that as the upside and return the rest of the FCF to shareholders!

      Reply
      • Eric
        February 6, 2012 | 4:30 pm

        The fourth scariest thing about this company (after the unbelievable failure of the management team to generate a return on capital that warrants reinvestment in a business that a child could run; the board’s arguably criminal inability to do what’s right for the company’s shareholders; and the shareholders’ apparent unwillingness to hold the board and mgmt team accountable despite having the opportunity for change served to them on a plate multiple times), is the fact that the company’s underlying market should actually be expanding since 2009. If you ignore the bogus REIS data (that the company references liberally but doesn’t even own a subscription to, btw) and look at free US census numbers both nationally and by region that Mac-Gray serves, the number of renter-occupied apartments in this country has actually increased every year since 2004, and the rental vacancy rate has been decreasing since 2009…. yet the company is selling less laundry at lower margins, while investing more capex. This suggests that a lot of the capex they have been investing recently is at even shittier returns on capital than they’ve generated historically, and that results will continue to decline.

        Hopefully Moab follows up on their proxy from late last year and carries the torch for shareholders at the ’12 annual meeting. This company is a shareholder friendly board and a returns-oriented CEO away from being worth $20+/share (doesn’t matter whether we get that in the public markets or split the difference with a PE group willing to put in the heavy lifting), but activists are going to have to keep trying to crack it open at the board level before things get fixed.

        Reply
        • Elie Rosenberg
          February 6, 2012 | 5:06 pm

          Great point…it was interesting that management tried to spin out of this on the last conference call by saying even though vacancy rates are down but rental rates are up so people spend less on laundry. I am going to guess laundry isn’t the first thing to go when rent gets raised. They seem to be missing the bigger picture.

          Do you think activists can get anywhere with given the CEO ownership and antagonism towards change? It seems like there hasn’t been a lack of trying over the years.

          Reply
          • Eric
            February 6, 2012 | 5:16 pm

            Activist investors own marginally more shares than the MacDonald family. If Moab runs a proxy and wins the third party proxy advisors (ISS, glass lewis), then it will come down to a couple of large owners that still control their own proxy voting — most notably Bernie Horn of Polaris. Bernie’s support of the incumbency is unfathomable to me, but he came out swinging in the board/mgmt’s defense on the last conference call (despite revealing in the same call that he didn’t know how many laundry rooms the Company manages), so hopefully he takes some time to familiarize himself with the business and the actions of the board before voting his considerable block this year. I think the fact that yet another member of the board was recently “appointed” is likely to increase some folks’ openness to change, but time shall tell. It’ll be a close race if Moab runs a good proxy.

  3. Luis
    January 19, 2012 | 9:56 pm

    Likewise, you make some excellent thought provoking points.

    I believe the churn, new contracts and acquisitions are all characteristic of the industry, as they slowly exit markets where they are poorly positioned in, while increasing density in markets they dominate. There is a lot of strategic and tacit dynamics going on between the big players while they consolidate the rest of the smaller players. Either way, turning down renewals because they don’t meet a hurdle is exactly what I want to see, smart allocation of capital. Is it a sign of a hyper competitive market? I don’t believe that to be the case across all cities and regions.

    You are correct that this has some hair on it. And believe me, I am frustrated with lots of decisions management has made. Not least the recent fiasco with the PE buyout offer. Having said that, I am holding my contrarian view here that management isn’t clueless.

    I enjoyed your analysis and really like your blog. Btw, I noticed your writeup on PNCL. Any thoughts how that will play out?

    Reply
    • Elie Rosenberg
      January 19, 2012 | 11:38 pm

      PNCL is a really interesting situation, I wish I could figure out how it will play out. The CEO is trying to scare the unions and vendors into concessions and the market seems to believe that he is seriously thinking about taking the company into BK. On the face of it it doesn’t seem they are in any danger of being forced into bankruptcy given their balance sheet, minimal cash burn, and the payments that should be coming from Delta in 2012. Maybe they would voluntarily file or Delta wants to force them into BK to get out of the big contract reset at the end of 2012? I really don’t know. The market seems like it is usually right when it comes to failing airlines. What are your thoughts?

      Reply
      • Elie Rosenberg
        January 20, 2012 | 8:21 am

        Letter released this morning provides some clarity on PNCL-
        http://edgar.sec.gov/Archives/edgar/data/1166291/000116629112000003/exhibit99-1.htm

        Reply
    • Zambr
      February 7, 2012 | 7:28 pm

      Is there really that much hair to this story? At $14, you have a business that generates a FCF yield of +10% and management has done everything wrong! From an earnings perspective, the company should have the wind at it’s back with stronger multi-family development. I feel reasonably protected from the downside that at the very least, the company can sustain this level of earnings which supports the 5.7x EV/EBITDA valuation. With, in my opinion limited downside and potential positive catalysts, I believe this is an interesting opportunity.

      Reply
      • Luis
        February 8, 2012 | 12:11 am

        I agree. I’ve owned the stock since 09 when it reached mid single digits, and despite the capital appreciation on an EV basis it is as cheap as my entry point due to the extinguishing of debt. This is a FCF machine, so the downside is that management invests in unprofitable growth and shareholders earn somewhere close to their cost of capital. There is embedded optionality to the upside in my opinion. Besides, what more could you ask for than announced buyout offers and ongoing activism from reputable investors? Heads I win, tails I don’t lose much = attractive situation. Boring business, with limited growth? Yes, but this is also one of those rare businesses that can actually be modeled out 10 years in the future with reasonable precision. In my book that deserves a premium.

        Reply
  4. James Brenner
    January 20, 2012 | 3:17 pm

    Why did the company turn down the $17.50 cash offer? Based on your analysis, shareholders should have been very pleased to get that premium.

    Reply
    • Elie Rosenberg
      January 21, 2012 | 8:05 pm

      They didn’t really explain why they think the company is worth more than $17.50. My guess is that they think a. poor economy is depressing current earnings and b. they can still grow the company through acquisitions.

      Reply
      • Eric
        February 13, 2012 | 3:17 pm

        circled back here again. the reason they rejected the offer is because stewart and the directors are on the take and don’t want to give up their delicious compensation. there is no earthly acquirer for this business that would allow stewart to keep his job post-close. This business is not worth 17.50 with the current management team in place.

        you are somewhat accurate regarding acquisitions. There are <10 businesses left in this space that aren't total non-entities, and since the incumbent team gets comped based on total ebitda with no acq adjustment, they are incentivized to pay insane prices for those businesses. they are not however doing those acquisitions because they think there is incremental roll-up value to shareholders.

        Reply
  5. Luis
    January 20, 2012 | 10:54 pm

    Seems likely PNCL could file for Chapter 11. But given the book value, it is hard to imagine equity holders being impaired below today’s stock price. Liquidity problem, and negotiating tactic, not a solvency issue. I have been picking up some shares at these levels. Very asymmetric risk/reward.

    Reply
    • Elie Rosenberg
      January 21, 2012 | 8:08 pm

      The value is certainly there, but I am worried about what would happen to the equity in Chap. 11. It doesn’t seem like management has much incentive to work for current common equity holders vs. giving the new equity away to better set up the reorganized business (through recap and concessions to unions).

      Reply
  6. James Brenner
    April 1, 2012 | 10:29 pm

    Is there a higher bid coming? Stock acting like it.

    Reply
    • Elie Rosenberg
      April 2, 2012 | 2:47 pm

      Don’t know. I haven’t heard anything.

      Reply
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