This article is part of our Rising Star Portfolios series.
To the list of certain things in life -- death and taxes -- go ahead and add laundry. If you want to turn heaps of dirty clothes into fat stacks of filthy lucre, just open a laundromat.
Don't be fooled by their humdrum image. I've learned that effectively operated laundromats, in apartment buildings or as independent businesses, can be venerable cash machines. During my research, I stumbled upon laundromat facilities manager Mac-Gray
This company might not be squeaky clean, but a host of factors make it very compelling: Activist shareholders pushing for better governance, new shareholder-friendly management, the potential for improving profits, and a valuation so small, you'd think it got shrunk in the wash.
Turning soap suds into money
Aside from a 5% sliver of its revenue from equipment sales, Mac-Gray makes the bulk of its money from facilities management. Apartment buildings, condos, and college dorms outsource the management of their laundry rooms to Mac-Gray. The company collects the change, services machines, and makes sure that everything operates smoothly. In exchange, Mac-Gray collects revenue, 38% to 60% of which gets repaid to the complex owner as rent.
The company manages these facilities under long-term contracts, typically five to 10 years, and because there's relatively inelastic demand for laundry, it enjoys a fairly stable and recurring cash flow stream. The best laundromats are extremely profitable, posting operating margins in the vicinity of 35%, and Mac-Gray -- as the second-largest facilities-management contractor, with about 15% market share -- can actually improve upon this sweet-smelling opportunity.
Mac-Gray's market share and density of customers in large metropolitan areas confer sizable local economies of scale. Many tasks associated with managing a laundromat are costly, relatively time-consuming, and labor-intensive: collecting change, purchasing and servicing machines, and making sure each laundry room has the right balance of washers and dryers. The company can scale costs associated with mundane tasks, and in equipment purchases, negotiate better prices than its customers could as stand-alone entities. Facility owners seem pretty happy with the arrangement, too -- just witness Mac-Gray's 97% contract renewal rate in each of the past five years.
As Mac-Gray's presence in markets has grown, mostly by tuck-in (but never folded) acquisitions, it's built up a weak network effect. As with AON
Will the grime come out?
Given its fantastic business model, I didn't expect to find a business like Mac-Gray trading at a strikingly reasonable 8.5 times trailing free cash flow. As it turns out, stubborn stains in the company's fabric have unraveled its valuation, to our benefit.
Management's paid itself quite well, pursued an arguably value-destroying acquisition strategy, and suffered from the Great Recession's travails. But I think that's all poised to change, thanks to a few additional catalysts:
- Activist pressure: Recognizing a solid business with less-than-admirable management tendencies, an activist group spearheaded by Fairview Capital and River Road Asset Management, which owns roughly 17% of shares, has begun rabble-rousing. They've called out management's compensation practices (which didn't align with shareholder interests) and acquisitions' failure to improve returns on capital, and they put a representative on the board in 2009.
- Shareholder-friendly moves: From all indications, the group agitation is working. Management has eased up on acquisitions and initiated a dividend, paid from Mac-Gray's cash flow. The company's debt load sits at more than $225 million -- manageable, but a fairly large sum for a company that did $320 million in revenue last year. However, management's dutifully paid it down, and indicated that it will continue to.
- Improving profitability: Though laundry's fairly inelastic, Mac-Gray's business is not immune to the overall economy. The number of loads is contingent upon occupancy rates at the apartment buildings it manages. During the Great Recession, those rates plunged. An improving economy and declining vacancies should help put those washers and dryers back into service. Coupled with price increases -- which Mac-Gray has mostly avoided since 2008 -- that should juice the bottom line.
But there's one more kicker here: 87% of Mac-Gray's contracts have just four years left, on a weighted average basis. Recently, management's expressed a desire to keep attractive contract rates, maximizing value to shareholders. With pending expirations, I'd expect the company to extract better terms from the businesses that renew. As these numbers flow through the income statement, fatter margins -- and a higher share price -- should follow.
Valuation
The laundry market won't qualify as lusty growth fare anytime soon. Fortunately, at 8.5 times free cash flow, Mac-Gray doesn't need much growth to pay off handsomely. My baseline valuation calls for modest 3% top-line growth, mostly attributable to price increases, and EBITDA margins expanding 200 basis points over a four-year period, as vacancies decline and management renews contracts at better terms.
By this math, the shares are worth $24, for roughly 50% upside -- maybe $27, if the company really kicks things into gear. Under a less rosy scenario -- 1% top-line growth and EBITDA margins declining 300 basis points -- shares would be worth $12.50.
Risks
Current CEO Stewart McDonald owns 26.5% of shares, but that's no guarantee that he'll continue his shareholder-friendly ways. Despite activist pressure, the company could go right back to bad acquisitions, or indulge in dubiously fat executive paydays. Today's prices give us some protection against that risk, but not enough to ignore it altogether.
Facilities management also breeds intense competition. Mac-Gray's dominant position and economies of scale afford it some advantage in bidding, enabling it to earn an acceptable return at contract rates that would make smaller players bleed cash. Consistent underbidding hurts every contender in the market, so these businesses have mostly respected each other's turf. However, there's no guarantee that courtesy will endure.
The bottom line
I can't own a laundromat today, unless you're willing to extend me a super-cheap $100,000 loan. But I can own Mac-Gray, an apparently improving business with great economics and a superb valuation. That's why I'm buying in. Join me at my discussion board to chat up Mac-Gray, or comment below.
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