Workplace uniform giant Cintas (CTAS 1.21%) completed its $2.2 billion acquisition of competitor G&K Services in March 2017, and integrating the two companies and realizing merger benefits has proved to be a multiyear project, as management had originally projected. But efforts to wring more value from the tie-up finally seem to be coming to fruition.
In Cintas' fiscal second-quarter 2020 earnings conference call on Dec. 17, executives discussed examples of recent progress in the integration effort. Let's briefly review three of management's comments to gauge how the process is affecting Cintas' results and long-term investment prospects for its shares.
1. Tangible synergy realization
[In] our uniform rental and facility services segment, gross margin was 46.6% for the second quarter, compared to 45.3% in last year's second quarter, an improvement of 130 basis points. Operating-income margin was a record 19.5% for the second quarter, and it was 19% year to date. Profit margins have strengthened for many reasons, including strong revenue growth and realization of cost synergies from the acquisition of G&K.
-- Paul Adler, treasurer
Cintas' uniform rental and facilities services business makes up roughly 80% of the company's total top line. During the earnings call, executives detailed how gross margin and operating margin are improving as major integration efforts are wrapping up.
For example, as Cintas has incorporated G&K manufacturing volume into its existing plants, and closed some G&K plants, it's achieved production efficiencies that are beginning to turn up in higher profitability. This impact is speeding up as the company has now completed most of its plant integrations and closings.
Over a longer time period, Cintas will continue to find opportunities to boost the yield from combined operations. Management cited a specific example on the call, explaining that the company often converts G&K workwear rental customers to Cintas uniforms when inventory in legacy G&K products gets depleted. Cintas' products carry slightly higher margins, and management believes that switching customers over to Cintas workwear provides them, in many cases, with a higher-quality uniform.
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2. SAP software conversion progress
[W]e're about 85% of the way through our SAP journey at this point in time. So we've made some good progress in the quarter, and we're still on track to complete the project by the end of the fiscal year. As far as benefits are concerned, I think the benefits from SAP are going to be kind of [found] throughout the [profit and loss statement].
-- Adler
Cintas' conversion to German software giant SAP AG's namesake enterprise software was one of management's most prominent business themes in calendar year 2019. Implementing a single accounting, finance, and data analysis framework across the organization will be especially helpful to Cintas. It has grown through acquisitions of numerous smaller uniform companies, and as a result, management's information for decision making and reporting has been gathered (until now) from a host of disparate accounting and finance systems.
On the call, Adler discussed the benefits to invoicing and pricing that the SAP system will bring. He also mentioned that having the company's uniform rental and first-aid segments under a single system will foster opportunities for collaboration within its sales team and help with product cross-selling to customers.
Though the enterprise software's rollout is 85% complete, the company has so far realized only a fraction of the ultimate benefit to the profit and loss statement; this will happen over a period of years. Analyzing data provided by SAP should also help Cintas get a firmer grasp on the profitability of G&K's manufacturing operations and service routes, and assist in making better-informed decisions.
3. Improved working capital management
[From a] working capital standpoint, we certainly have been in a period of disruption over the last couple of years, as it relates to our accounts receivable, converting two systems as it relates to our inventory, and shutting down [distribution centers], opening new DCs, converting a lot of volume. And we're starting to get some of those inefficiencies and disruptions behind us. And so for example, in accounts receivable, we've seen a nice improvement year over year. And that's part because we've gotten a little bit of that disruption behind us.
-- CEO Michael Hansen
Hansen's point above relates to disruptions from both the G&K Services integration and the SAP implementation. It also illuminates how improving an organization's handling of its current assets, from physical inventory to accounts receivable, helps liquidity and cash flow, and ultimately widens profits.
As the SAP conversion nears completion, management has much more visibility into the accounts receivable of its various operating subsidiaries, which helps to facilitate collections while pinpointing delinquent accounts more quickly. And the integration of G&K inventory into Cintas' distributions system is speeding inventory turnover, while helping the buildup of additional inventory for future sales.
The fine-tuning of the components of working capital (i.e., current assets less current liabilities) shows up most prominently in Cintas' cash flow. Hansen said that Cintas has enjoyed a cash conversion ratio of over 100% in fiscal 2020. This ratio, calculated by dividing operating cash flow by net income, measures the amount of net profit a company converts into cash in a given period.
By my calculation, cash conversion reached 115% in the first six months of fiscal 2020. Free cash flow more than doubled during the same period against the first two quarters of fiscal 2019, to $445 million. These are perhaps the two clearest pieces of evidence that Cintas has indeed reached a tipping point in its gradual effort to extract value from the G&K acquisition.
