GKSR G&K Services - Class A (MM)

We are downgrading our recommendation on Cintas Corporation (CTAS) to Neutral as we expect that margins will remain under pressure in the fourth quarter due to an increase in energy and medical related expenses along with higher raw material costs.

The company reported third-quarter fiscal 2012 earnings of 58 cents per share, surpassing the Zacks Consensus Estimate of 52 cents. Total revenue in the reported quarter increased 7.9% year over year to $1.012 billion, beating the Zacks Consensus Estimate of $1.008 billion.

Cintas raised the earnings estimates for fiscal 2012 to a range of $2.24-$2.27 per share from the previous target of $2.16-$2.20. The Zacks Consensus Estimate is currently pegged at $2.27, at the higher end of the company’s guidance range. The company expects revenues in the band of $4.09-$4.12 billion, up from the previous range of $4.075-$4.125 billion.

Cintas continues with margin expansion through cost efficiencies despite the pressure from higher energy and material costs. During the third quarter, gross margin increased 30 basis points (bps) to 42.1% and the operating margin inflated 200 bps to 13.6%.

This marked the fifth consecutive quarter of increase in the operating margin. Cintas has scope for further margin expansion given the unutilized capacity in facilities that the company can leverage. 

Recently, Cintas has partnered with Rubbermaid Commercial Products, the leader in solutions based cleaning products, to offer its customers with hygiene solutions and custom cleaning. The synergy has proved beneficial, enabling Cintas to augment its current product portfolio.

However, energy related costs along with medical expenses are expected to create headwinds. Moreover, lower paper price remains a concern for the company. It affected revenue growth in the Document Management segment during the third quarter.

Organic growth dropped 1.3% and gross margin declined 240 bps to 47% year over year in the Document Management segment during the quarter. If paper price remains low, it may weigh on the segment as well as revenues going forward.

In addition to paper, another important raw material is cotton which is used in uniforms. Higher cotton price remains a headwind for the balance of the year, particularly in the Rental segment, which may put pressure  on margins moving forward.

Cintas faces competition from G&K Services Inc. (GKSR) and privately-held companies ARAMARK Corporation and Alsco, Inc. Our long-term recommendation is in line with the short-term Zacks #3 Rank (Hold).

 
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