Addressing the bear argument
The following are arguments that the bears may make as well as insights associated to mitigants.
Commercial equipment distribution is a cyclical business. FY 2013 was a top-of-the-cycle year for EnviroStar. The stock price will decline as earnings come off cyclical highs.
Investors who run a numerical analysis based on sensible assumptions will find that as long as the long-term growth thesis remains intact, then a buy-and-hold strategy for this security at current valuations will result in an attractive return profile even if results for a specific year are shocked (please refer to the Appendix for a numerical example). There is precedence in the marketplace that sophisticated and long-term–oriented investors will look through business cyclicality if there is conviction regarding the long-term growth thesis because the numerical analysis demonstrates that this is a sensible action. As a great investor once said, “Why should we demand that smoothness [of earnings] accompany each orbit that the Earth makes of the Sun?” Lastly, a three-year average EBIT (a proxy for a normalized, mid-cycle operating income) results in a high single-digit earnings yield.
EnviroStar has already had a strong recent run-up and is trading at record high valuation multiples (over a five year period).
On an EV/EBITDA basis, EnviroStar generally traded between a 1x to 3x EBITDA multiple over the past five years. Currently, the company is trading at a 5.3x EBITDA multiple.
First, it is important to consider that asset price levels were depressed during the Great Recession. Cheap stocks got cheaper. Second, EBITDA in FY 2008 was $924 thousand and then it declined to $835 thousand by FY 2012. These data points were used in the bear narrativeto support the thesis that the business was in secular (versus cyclical) decline. However, results in FY 2013 as well as FY 1Q14 demonstrate that the long-term growth thesis remains intact. Furthermore, it is likely that multiples continue to expand as the market gives full credit for the long-term growth trajectory that the company has been able to demonstrate since its founding in 1960.
Lastly, current price levels are similar to the highs experienced by the company in early 2005. It has taken the company’s stock almost nine years to recover to a similar price level. During that time, the company has significantly improved its fundamentals.
EnviroStar is in an ordinary business with a track record demonstrating that it is able to execute extraordinarily well. The company’s leading market position, favorable regulatory catalysts favorable long-term demographic trends, and superb management team will allow it to grow over the next five, ten, or 20 years.
The Market Realist Take
According to industry observers, environmental concerns remain an ongoing challenge in the laundry industry, and manufacturers are striving to meet the demand for “greener” machines and processes as well as higher safety standards.
EVI peer Alliance Laundry Systems’ annual report for 2012 stated that the North American market for standalone commercial laundry equipment has grown at a compound annual rate of approximately 0.9% since 2002. Historically, North American commercial laundry equipment sales have been relatively insulated from business and economic cycles, as economic conditions tend not to affect the frequency of use or replacement of commercial laundry equipment. Alliance believed its growth would be sustained by continued population expansion and by customers increasingly “trading up” to equipment with enhanced functionality and therefore higher average selling prices.