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On Dec 5, we reaffirmed our Neutral recommendation for business services provider Cintas Corporation (CTAS - Analyst Report). The company’s expansion through higher penetration levels and broadening of customer base to include business segments that are not historically served augur well for its growth prospects. However, an increase in raw material costs and challenging macroeconomic conditions could weigh on the margins moving forward.

Why the Reiteration?

Cintas reported an organic revenue growth of 7.1% in first quarter fiscal 2014 with a diligent execution of its operational plans. This included 6.7% organic growth from Rental Uniforms and Ancillary Products, primarily due to improvements in productivity of sales representatives and an overall increase in the number of sales workforce. Sales productivity improvements are generally the culmination of increased tenure and advanced training procedures of sales personnel, which in turn result in a higher number of products and services sold.

During recession, Cintas had taken initiatives to enhance its operations by evaluating sales force productivity, optimizing routes and streamlining labor overhead. The company returned to year-over-year rental organic revenue growth in mid 2010 and has continued the growth trajectory since then. Organic growth from the Other Services segment was also commendable, which was driven by growth in each of the operating segments and accretive acquisitions. All these measures augur well for the long-term growth perspectives.

In order to have increased market penetration, Cintas has a highly talented and diverse team of service professionals who regularly visit customers. These frequent contacts with existing customers strengthen personal relationships, which consequently provide a platform to launch additional products and services. In order to pursue the strategy of broadening the customer base, Cintas has a national sales organization that introduces its products and services to prospects in all business segments.  The company also broadens its customer base through geographic expansion, particularly in emerging businesses of first aid and safety, fire protection and document management, in addition to strategic acquisitions at an opportune time.  This focused approach for steady top-line growth is commendable.

However, a continuous increase in raw material costs such as cotton, due to global headwinds, may weigh on the margins going forward. Cintas procures raw materials from a wide variety of domestic and international suppliers, making it susceptible to market risks which are beyond its control. Cost of rental uniforms and ancillary products comprises production expenses, delivery expenses and amortization of in-service inventory, including uniforms, mats, shop towels and other ancillary items.

In fiscal first quarter 2014, gross margin from Rental Uniforms and Ancillary Products decreased to 42.6% from 43.3% in the year-earlier quarter due to higher sales volume, increase in material cost and higher service costs associated with expanded route capacity. In addition, the U.S. and foreign trade policies, tariffs and other impositions on imported goods, trade sanctions, and limitations on the imports of certain types of goods also escalate product costs and adversely affect its operations. This undermines the growth potential of Cintas to some extent.

Other Stocks to Consider

Cintas presently has a Zacks Rank #3 (Hold). Other companies in the industry that warrant a look include McGraw Hill Financial, Inc. (MHFI - Analyst Report), Global Payments Inc. (GPN - Snapshot Report) and Higher One Holdings, Inc. (ONE - Snapshot Report), each carrying a Zacks Rank #2 (Buy).

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