Cintas Corp.

    • Based on a new public FOIA and our research, we believe Cintas’ Fire Protection Services business has committed fraud and is causing a public safety hazard by having workers conduct fire and safety inspections without proper licenses or permits, and falsify inspections. We call on Cintas to conduct a review to assure stakeholders it’s not a systemic issue placing Cintas in non-compliance with its credit agreement. Fire Protection is its fastest growing segment. Our research indicates that Cintas’ has a poor reputation, and that new private equity and public money is entering the space, which will compress its growth and margins. In addition, we believe that Cintas is facing financial strain in its core uniform rental business from its 2017 levered acquisition of G&K for $2.1bn. With sell-side analysts failing to acknowledge any of these problems, or conduct a nuanced valuation of its various business segments to reflect divergent growth and risk profiles, our variant view suggests 60%-75% downside.
    • We Believe Cintas Overpaid For G&K, Is Struggling To Integrate It, And Spinning A Weak “Beat And Raise” Story to consolidate share and extract synergies, Cintas acquired G&K Services in 2017 for $2.1bn with new debt. Based on proxy statement disclosures, Cintas paid an additional $425m above its initial offer to acquire a business that was described to us as having a poor reputation. Cintas touted a “Beat and Raise” story post acquisition, but based on our forensic review, it appears that Cintas may have suppressed G&K’s sales, only to raise sales guidance by a similar amount to the sales that had been suppressed. Even worse, evidence points to Cintas over-estimating expenses, only to roll-them back and claim outperformance. In addition, Cintas said one thing, but did another by subtly changing capital priorities (cutting capex, increasing share repurchases) in an effort to artificially grow EPS. For FY 2019, we estimate Cintas had no underlying outperformance relative to initial guidance.
    • Recent changes in revenue disclosure reveal for the first time that Cintas’ fastest organically growing business is fire inspection, which has grown at a 3 year CAGR of 14%, above the historical and projected industry growth rate of 8% as illustrated by National Fire Prevention Association.
    • Based on our research, the biggest fundamental challenge in the industry is a qualified labor shortage. Cintas has used an “affiliate network” to expand its reach, but this approach brings challenges such as monitoring the quality and capability of its workforce.
    • Using a Freedom of Information Act (FOIA) request, we find that Cintas was charged with fraudulent business practices. Upon a fire outbreak in Aurora, IL, it was determined that Cintas had 8 of 12 inspectors unlicensed and unfit to carry out inspection duties for the 22 properties within Aurora’s jurisdiction. These inspectors were thus falsifying inspection records. Based on our research, we believe this may not be an isolated incident, and that Cintas may have breeched its credit agreement by incorrectly representing that it holds all the necessary licenses to conduct its business in compliance with the law.
    • Cintas must conduct an independent and formal review to assure all its stakeholders that it is in compliance with all applicable laws, and holds all necessary permits when conducting life-critical inspection operations.
    • Cintas is also being sued in a wrongful death lawsuit for inaccurate inspections in a mining accident that was documented by the Mine Safety and Health Administration. Incidents such as this, while very unfortunate, add complex tail risks to its business
    • Given lapses in judgement such as this, and based on industry conversations, it doesn’t appear to be a secret in the industry that Cintas has a poor reputation. As a result, new money is flooding into the industry to disrupt Cintas’ national market position. We find evidence that historical contracts that locked in customers for 3-5 years are being shortened to just 1 year, and that prices are compressing; both are negative outcomes for Cintas.
    • Fueled by cheap financing and the ability to leverage contractually mandated inspection revenues, private equity players are creating regional platform acquisition vehicles to seize market share from disgruntled Cintas customers. In addition, APi Group, a large national competitor was just acquired by a UK SPAC, and will be listed on the NYSE, giving it broader access to public capital to compete against Cintas.
    • Spruce Point has various concerns about the Board including a lack a separation between its Chairman and CEO, Board and family relationships that are not independent, unjust compensation practices, and the closeness of Cintas with its auditor.
    • Ernst & Young has been Cintas’ auditor since 1968. The engagement partner at Ernst & Young is Craig Andrew Marshall. Mr. Marshall is also the audit engagement partner at Papa John’s International (Nasdaq: PZZA). Papa John’s dismissed Mr. Marshall and E&Y in 2018. Since hiring KPMG in early 2019, Papa John’s disclosed a new material weaknesses of financial controls and reporting. Both Cintas’ CFO J Michael Hansen and its VP/Treasurer Paul Adler both worked at Ernst & Young. Spruce Point believes it is time Cintas shareholders appoint a new auditor and fresh eyes to look at its accounting practices.
    • Cintas’ just appointed Karen Carnahan to its Audit Committee. Cintas claims she is “independent”, yet as a 30 year former Cintas veteran and Treasurer connected to CEO Farmer, we question why is she joining now in light of our views that Cintas is experiencing financial stress? Furthermore, we find that she serves as a Trustee of another Audit Director’s company, and is likely paid; can she act independently?
    • Cintas management, with the blessing of the Board, claimed great performance for the G&K deal. Special bonuses were awarded to executives for completing the deal, despite our evidence it has weakened the overall financial profile of Cintas.
    • Cintas’ annual incentive plan is based on sales and EPS growth, along with non-financial goals. In 2019, 41.75% of CEO Farmer’s bonus was tied to EPS performance, while for most other executives, it accounted for 50% of the bonus. Cintas conveniently achieved almost the maximum EPS target within one penny, and claims its $7.60 EPS took into consideration various “one-time items”. Yet, in FY 2019, Cintas adopted a new revenue recognition method that boosted pre-tax income by $22.3m and Diluted EPS by $0.15 cents. Why wasn’t this considered a “one-time” or “extraordinary” boost to income?
    • Analysts and investors love Cintas for its consistent ability to grow earnings, while returning capital through share repurchases, and a modest dividend yield. The consensus view is that it can produce 5-6% organic sales growth and 10-11% EPS growth by using its market dominance in stable industries to satisfy customers.
    • As a result, analysts’ reward Cintas with the highest multiple among its commercial and safety publicly traded peers. The average analyst price target is $255 per share. Yet, at the current share price of $259, there’s 1% implied downside on valuation alone, and materially more downside based on increasing business pressures.
    • Our view of Cintas is markedly different from consensus and we believe: There is a uniform displeasure with Cintas’ billing practices, one-style approach to customers, and willingness to skirt the law with fraudulent business practices that place lives at risk. The G&K acquisition has worsened Cintas’ overall financial profile through greater capital intensity, bloating of receivables and bad debts, and greater exposure to cyclical industries such as oil and gas. Cintas corporate governance is substandard for its size and position as an S&P 500 company. Notably the CEO/Chairman roles are not split, it allows pledging of stock by executives, and the Board is stacked with long-time allies of the CEO with business connections between Board members. As a result, the expansion of Cintas’ valuation multiple over the past few years is unwarranted.
    • Analysts fail to critically evaluate each of Cintas’ business lines and apply a proper valuation to reflect the different growth and risk profiles.
    • Despite trading a 4x sales and 18x EBITDA, not a single one of Cintas’ business lines can be justified at this valuation by looking at recent acquisitions completed. Transaction values are closer to 1x – 2x of revenues. When summed together, the fair value of Cintas’ business is $69 – $107, or 60% – 75% downside.
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