Equity research: Does EnviroStar present a good investment? (Part 4 of 7)
EnviroStar has consistently earned highly attractive returns on tangible capital (EBIT / [Net Working Capital (ex. Cash) + Tangible Assets]), ranging from 25% to over 85% over the past ten-year period. This is indicative of the fact that this business would be difficult to replicate given sufficient capital and talent. If this were not the case, competition would drive down these abnormally high levels of return on tangible capital.
The following insights help explain why the business possesses favorable economic and growth characteristics.
The company has a meaningful customer base that creates a significant barrier to entry for new entrants.
A virtuous cycle is created as equipment distribution businesses scale. Customers prefer to work with distributors that provide sensible pricing, product quality and selection (create a one-stop-shop), and high-quality support services. The ability to deliver on each of these three items increases with scale, which thereby increases the distributor’s value proposition to both new and existing customers.
By having sufficient volumes and a reputation, a distributor is able to negotiate favorable terms (pricing and exclusivity) from manufactures. This either enhances the profitability of the company or the savings that can be passed on to customers. EnviroStar has relationships with major manufactures, including Pellerin Milnor Corporation, Chicago Dryer Company, Cleaver Brooks Inc., E-Tech Inc., Fulton Thermal Corp., and Unipress Corporation. Two of these manufacturers accounted for approximately 45% and 19%, respectively, of the company’s purchases for FY 2013 and FY 2012.
Maintenance, repair, and service support are important value-added services. When a customer has a part break, fast servicing and repair of that machine is required to minimize lost revenue. Therefore, many customers choose to work with regional distributers that have a longstanding reputation. Replacement parts and maintenance services create a meaningful recurring revenue stream, estimated to total 15% to 50% of the initial product sale value. EnviroStar stores ~$2.0 million worth of inventories, including replacement parts, in its two main distribution centers (38,000 square feet), both located in Miami, Florida.
A new market entrant faces a chicken-and-the-egg problem. In order to replicate this business, the new market entrant would have to develop relationships with multiple manufactures. It would be difficult to negotiate favorable terms given that the new market entrant does not have an existing installed customer base. Therefore, it would be difficult to deliver a sufficiently compelling value proposition to customers to get them to switch distributors because the new market entrant will likely be less competitive on its ability to deliver a pricing advantage, product selection, and maintenance services.
A larger strategic competitor would ask a buy-versus-build question. Given the stickiness of customers created through long-term relationships, the incumbent has a meaningful competitive advantage. Execution risk and initial upfront investments (that is, sales force, infrastructure, logistics systems, inventory, et cetera) are substantial.
As a result of this economic characteristic, it is most probable that EnviroStar will continue to build upon this natural competitive advantage in a similar fashion to what it has done over the last 50-plus years since its founding.
Rising water and resource costs generate demand for more efficient commercial and industrial laundry equipment.
The average American household washes 400 loads of laundry each year using thousands of gallons of water. According to a survey of 100 municipalities, water prices have risen by 75% between 2000 and 2012. Electricity prices have risen by 43%. Within Miami, water costs have increased by 37% during this same period. Customers continue to move toward equipment with improved water and energy efficiency as the result of escalating energy costs, government and consumer pressure, and a focus on containing operating costs. As an example, approximately 25% of annual gross wash and dry revenue of laundromats is consumed by utility costs, according to the Coin Laundry Association.
Regulatory catalysts will continue to drive the commercial dry cleaning equipment upgrade cycle.
The commercial dry-cleaning industry in the United States consists of approximately 36,000 shops (the low range of estimates is 25,000 shops). Approximately 85% of dry cleaning shops in the U.S. use perchloroethylene (“perc”) as their primary cleaning solvent. Most dry cleaners use about 140 gallons of perc a year.
Perc, which evaporates very easily into the air, is suspected of causing cancer in humans, is considered toxic, and can cause dizziness, nausea, and headaches when either inhaled or absorbed through the skin. Once in the body, perc can remain stored in fat tissue. Numerous studies have shown the dangers of perc. The National Institute for Occupational Safety and Health (NIOSH) has designated perc a “potential occupational carcinogen.” The National Toxicology Program has designated it as “reasonably anticipated to be a human carcinogen.” The International Agency for Research on Cancer (IARC) has designated perc as a “probable human carcinogen.” Perc that makes its way into the ground can move through the ground and enter groundwater. Plants and animals living in environments contaminated with perc can store small amounts of the chemical.
In 2007, California became the first state to ban perc use in dry-cleaning. Other states are contemplating such action. The EPA ordered a phase-out of perc machines at dry-cleaning shops in residential areas by 2020, but they may continue to operate if alternative technologies are used (CO2, hydrocarbon, and wet cleaning).
The dry-cleaning equipment distributed by EnviroStar includes commercial dry-cleaning machines, most of which (including the company’s proprietary Green-Jet® dry-wet cleaning machine) are environmentally friendly because they eliminate the use of perc in the dry-cleaning process.
There will be continued demand for non–perc using machines as end users are forced to comply with EPA regulations.
EnviroStar is the beneficiary of long-term population density and income growth in its core markets.
Commercial laundry and dry-cleaning services deliver high value proposition in densely populated urban areas. Multi-family residential areas increase in proportion with increased population density. It is oftentimes impossible for individual tenants to own their own washer and dryer. Furthermore, high-income earners frequently demand the value-added services of outsourcing laundry.
Therefore, the company is a beneficiary of favorable long-term demographic growth trends. Miami (a core market to EnviroStar) is estimated to increase in population, population density, and income per capita over the next five years. According to data from SNL, between 2012 through 2017, Miami’s population is expected to grow from 5.6 million to 5.8 million (0.7% CAGR), population density is expected to increase from 1,102 people per square mile to 1,141 (0.7% CAGR), and per-capita income is expected to grow from $24,920 to $27,935 (2.3% CAGR).
Laundry needs in developing markets are currently less fully developed than in North America. Continued development and growth of disposable income in these countries will cultivate an increased need and demand for laundry services and equipment. Foreign sales by the company to the Caribbean and Latin America range between $4.0 million and $5.0 million per year. For FY 1Q14, foreign sales increased by 70% versus FY 1Q13.
The company is managed by a talented family-owner/operator.
The Steiner family’s ability to build this business into what it is today from a standing start is admirable. Bill Steiner founded the company in 1960, and today, the company has grown to $38.2 million of LTM revenues. The Steiner family is a substantial owner. Michael Steiner (president, CEO, and chairman of the board) owns 57.4% of shares outstanding. His brother, Robert Steiner, owns 14.4%. Lastly, management has a track record of returning capital to shareholders through special dividends. Recent examples include a $0.40-per-share special dividend paid in December 2013 and a $0.60 special dividend paid in December 2012.
The Market Realist Take
According to the Coin Laundry Association, industry growth is based on the demographics of population density, population mix, and population income. The more concentrated the population, the greater the need for quality coin-laundry facilities. National and regional demographics indicate renters, the primary users of coin laundries, are the fastest-growing segment in the U.S. As of the 2000 U.S. Census, 31% of the nation’s 116 million households were renter-occupied. The number of coin-laundry stores built over the past 60 years has grown steadily as the population has increased and shifted to more concentrated areas. The end result has been a mature, stabilized industry with predictable rates of turnover and values of existing coin-laundries, development of new turn-key facilities, and equipment expansion and replacement.
EVI peer Alliance said in its 2012 annual report that continued population expansion in North America will continue to drive steady demand for garment and textile laundering by all customer groups. Population growth has historically supported replacement sales and modest growth in the installed base of commercial laundry equipment. According to the U.S. Census Bureau, the United States population has grown at a compound annual rate of 0.9% since 2000 and is projected to grow at approximately 0.8% per year, on average, over the next ten years.
Plus, customers are increasingly trading up to equipment with enhanced functionality at higher average selling prices. For example, the larger national and regional customers in the laundromat and multi-housing customer groups are more likely to take advantage of recently available electronic features, such as cashless payment systems and advanced electronic controls, which the company believes provide these customers with a competitive advantage. Customers continue to move toward equipment with improved water and energy efficiency as the result of escalating energy costs, government and consumer pressure, and a focus on containing operating costs.
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