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From 1992 through 2016, facility services provider ABM Industries (ABM) provided total returns of nearly 12% annualized. Since the beginning of 2017, however, the stock has stalled out. While total returns in the S&P 500 have been 93%, including dividends, ABM investors have garnered total returns of 20.3% — and five trading sessions ago that figure was just 4.4%.

The performance of ABM stock would suggest that the ABM business has stagnated; that it’s one of many old-line companies that have struggled during the post-financial crisis period. Yet that’s not actually the case.

Between FY16 (ending October) and FY21, ABM’s adjusted earnings per share more than doubled. To be sure, two major acquisitions with a combined price over $2 billion have been a significant factor, and a focus on deleveraging (plus the impact of a global pandemic) limited dividend growth to 17.6% total over the period.

Still, all of the substantial underperformance in ABM stock has come from multiple compression. That compression, though it made some sense at points during the past five and a half years, has gone too far. ABM has a strong history: it remains a so-called “Dividend King”, one of 44 companies that have raised its dividend every year for at least 50 years. It retains a highly defensive business. And it’s at least possible that one of the key reasons that investors went from paying 20x+ forward EPS at the beginning of 2017 to a current 12.3x (based on ABM guidance) is about to reverse.

We continue to be bearish toward the broad market and macro setups. The 6%-plus rise in the S&P last week doesn’t change that outlook. And so in our long ideas of late, we’ve focused on defensive and/or counter-cyclical plays that can ride out tough conditions. ABM stock is another such opportunity: a defensive stock with an attractive valuation that may even benefit from a cooling off of the U.S. economy.

Introducing ABM Industries

ABM provides outsourced facility services to businesses, governments, event venues, educational institutions and other organizations worldwide. ABM provides janitorial services, parking lot management, mechanical and engineering expertise, and a number of offerings for airports and airlines.

94% of revenue comes from the U.S. In FY21, two-thirds of total revenue came from janitorial services; 11% from mechanical/engineering; ~10% from parking; 9% from Building & Energy Solutions (HVAC, electric, EV charging, etc.); and 4% from airline and airport services.

A little over half of revenue comes from the Business & Industry segment, which covers commercial real estate properties, entertainment venues, hospitals, along with maintenance services for rental car providers. Technology & Manufacturing (industrial and high-tech) customers account for another 15%; Education 13%; Aviation 10%-plus; and Technical Solutions (the building & energy product line) 9%.

The menu of services has been expanded by acquisitions, particularly over the past 12 years:

source: ABM Industries FY21 10-K

The biggest of the deals was the 2017 purchase of GCA for $1.15 billion in cash and stock. More recently, ABM paid $830 million in cash late last year for Able Services, which expanded the company’s engineering capabilities and exposure to potentially faster-growing markets in sustainability and energy efficiency.

Admittedly, ABM is not the best business model out there. FY22 guidance contemplates Adjusted EBITDA margins of just 6.4% to 6.8%. Obviously, the labor-intensive nature of its services are a key factor: revenue per employee this year should be a little over $50,000.1

But, again, ABM stock was a solid compounder for a quarter-century (and a decent stock before that) with this same business model. And the nature of the business model looks attractive in a difficult environment.

ABM In A Downturn

Any long position entered into at the moment needs to be considered in the context of a potential recession. To be sure, such a recession is not guaranteed; nor is further weakness in the broad market. But the risks are obvious, and, again, we remain cautious toward both the market and the U.S. economy (to put it mildly).

ABM should be able to manage a difficult macro environment. Indeed, it’s already done so. In fiscal 2008, organic revenue grew 3%; Adjusted EBITDA margins expanded nicely. In FY09, revenue did decline 3.9%, but adjusted EBITDA increased 9%. Margins rose again the following year despite minimal top-line growth (0.4%). There were acquisition-related synergies (ABM acquired OneSource in 2007) which boosted those margins, but clearly ABM made it through the worst economic environment of my lifetime. If or when the economy turns south again, history may repeat itself.

ABM remains a largely defensive business. Offices, airports, and venues have to be cleaned. Trends toward energy efficiency and sustainability aren’t going anywhere. On the margins of the business, a recession could hit demand in airports, or for parking services, or venue requirements — but as the company’s performance during the financial crisis proved, the effects are manageable.

And, indeed, a recession augurs a potential tailwind here: a much-needed loosening of the labor market. Again, ABM is a low-margin, labor-intensive business. It also retains significant financial leverage at the moment (net debt after Q2 was ~2.6x EBITDA). And so there are few publicly traded companies with greater financial exposure to rising wages.

The tight labor market didn’t just show up after the pandemic, but before. Wage inflation was a good part of the reason why ABM stock stalled out in the years before 2020. In the Q2 2018 release, the company cut its full-year guidance, with margin pressures offsetting the boost from the GCA acquisition. Into and out of that report, ABM fell some 40% in about twelve months (with the late 2018 broad market sell-off a factor as well).

This market is a bit different, however. Wage inflation is an issue, but one mitigated by a number of factors. As chief executive officer Scott Salmirs detailed on the Q1 call in March, about two-thirds of ABM’s direct labor is covered under collective bargaining agreements; the majority of that workforce is unionized. Those employees operate under contracts that already contain annual wage increases “generally in the range of 3% to 4%.”

For the other one-third, ABM can benefit from cost-plus contracts or, in some cases, renegotiate business. Indeed, FY18 and FY19 margins turned out to be not quite as bad as feared; ABM stock would gain ~50% before turning south with the market in March 2020.

Still, given thin margins, substantial wage pressure on even a portion of the workforce is material to the bottom line. And, as management has noted, the issue has not been so much labor inflation as labor availability. Salmirs noted this issue after Q2 in pointing to the slow-and-steady return to the office as a positive, as it’s kept ABM from (so far) requiring substantial overtime costs paid to current employees.

A recession, or even some version of a “soft landing”, ostensibly would ease some of the labor market pressure, in terms of both wages and employee count. ABM management has said on recent calls that even non-labor inflation could help, as higher prices themselves may bring Americans back into the workforce to cover an increased cost of living. Indeed, ABM has made some progress already: its number of open positions peaked last summer, and perhaps not coincidentally the midpoint of its FY22 Adjusted EBITDA margin guidance was raised 20 bps after Q1.

ABM Stock Looks Too Cheap

And yet, over the last two months ABM stock has sold off with the market: shares are down 18% from late April highs. That includes a nearly 12% decline after the fiscal Q2 report for reasons that are not at all clear beyond the fact that the broad market was selling off at the same time.

A rally last week has reversed that decline and then some, admittedly, but even after the bounce ABM stock still looks exceptionally cheap. Based on the midpoint of FY22 guidance, shares trade at just 12.3x earnings.

But even that understates the case. ABM doesn’t exclude amortization of intangibles from adjusted earnings, and the figure is significant: about $70 million annualized pre-tax, ~$50 million after-tax — about $0.75 per share. Add that back and the stock is now at ~10x earnings.

Owing to the balance sheet, EV/EBITDA perhaps isn’t quite as impressive, but ABM still is below 9x on that basis. Looking to 2023, Aramark (ARMK) is above 10x EBITDA and 15x earnings2; EMCOR Group (EME) is at ~10x EBITDA and ~14x earnings. Neither peer is perfect, but both companies are more cyclical (EMCOR in particular) than ABM.

And so there seems to be a simple story here. A nervous market is selling stocks off indiscriminately, and in its panic has dumped a defensive business, pushing it to levels that simply don’t make any sense.

Unsurprisingly, the story isn’t quite that simple.

A Strange Pandemic Winner

There is a catch here. Bizarrely enough for a company whose core business is cleaning offices, venues, and airports, ABM was a pandemic winner.

Between FY19 and FY21, Adjusted EBITDA margins expanded 210 bps. More importantly, they increased by more than 40%. According to the Investor Day presentation late last year, ABM generated $600 million in cumulative “COVID-related” revenue as well.

Management has cited three core reasons for the pandemic-driven boost. First, the company simply got more work orders; there was more work to do in terms of maintenance and (of course) cleaning, and in some cases more outsourcing of that work.

Second, ABM benefited from what it calls “labor arbitrage.” The contract for, say, cleaning an office building remained intact; the actual labor cost involved in cleaning a building with 5% or 10% occupancy was substantially lower.

Third, the company’s EnhancedClean offering — developed immediately in the wake of the pandemic — boosted both revenue and profits.

To some degree, these tailwinds are all going to fade. To some degree, they’re doing so already: even after the post-Q1 hike, EBITDA margins are guided down 60 to 80 bps this year versus FY21.

In this context, 10x earnings perhaps doesn’t seem quite as attractive. Indeed, the compression (about eight turns’ worth) from 2016 to the present makes much more sense. At the start of that period, ABM had its Vision 2020 effort, which was supposed to get EBITDA margins from under 4% to ~5% or so; the market was pricing that in. At the end, margins are potentially headed south from what looks like a peak — and, skeptics would argue, the market is pricing that in as well.

The Long Case

But that skeptical argument is one that would hold much more water were ABM trading at a higher multiple. 10x earnings (again, as adjusted for non-cash amortization) is a multiple that is pricing in a decline going forward. And it’s not at all clear that from a multi-year perspective, that is what is going to happen.

For one, while the pandemic tailwinds will fade, they won’t go away entirely. After Q4, ABM said it expected to keep about 50 to 70 bps of the pandemic-driven margin enhancements. EnhancedClean is not a time-limited offering. Labor efficiency in a hybrid return-to-work model will stay elevated; ABM still is seeing just 5% to 10% occupancy in offices on Mondays and Fridays, but obviously the buildings (aside from EnhancedClean) still need to be cleaned.

In other words, ABM still sees normalized EBITDA margins in the 5.8% range. Applying that margin to this year’s expected revenue still suggests EV/EBITDA around 10x and P/E at ~12x. Neither multiple seems unattractive for a defensive business.

But there’s another aspect to consider: 5.8% isn’t necessarily a ceiling. Again, the ~5.2% baseline from FY19 that ABM is using in estimating its residual boost is a baseline that came during a particularly tight labor market. There’s perhaps some room for mitigation on that front, through both company-specific initiatives and changes in the labor market.

More importantly, there’s what ABM calls the ELEVATE initiative. Elevate follows on the successful Vision 2020 by changing operations across the board. ABM is adding account management functions to improve retention and boost cross-selling (including so-called ‘tag revenue’, individual work orders which generally offer higher margins); investing in recruiting labor productivity to improve efficiency; and using artificial intelligence and real-time data to improve outcomes. ABM plans to acquire another ~$1 billion in revenue as well (after Able brought on a similar amount) to boost scale.

ABM plans for ELEVATE to boost organic revenue growth to the mid-single-digits while driving ~20 bps of annual margin expansion (even with the expected drop-off in COVID tailwinds). At December’s Investor Day, ABM laid out targets of $9 billion in revenue, EBITDA margins of 7%, and run-rate free cash flow of ~$400 million. Those targets, if hit, suggest three-year total returns in the range of 100% (at 10x+ EBITDA and 15x free cash flow).

Obviously, management targets alone don’t and can’t make a bull case. The case was stronger a few sessions ago; after a 15% gain last week, there is a sense that perhaps some of the potential upside has been quickly captured. (Again, we do see a reasonable chance that the market reverses, meaning ABM may revisit those lows.) Aggressive investors might see more upside elsewhere in the market, and if the market really does turn sharply to the south, ABM is not going to emerge unscathed: the stock dropped 60% from peak to trough during the 2007-09 sell-off.

Still, the risk/reward here looks attractive. The business has downside protection in the mid-term, even if that’s not necessarily true for the stock in the near-term. (Besides ABM’s own crisis-era performance, a decade ago I took a detailed look at how defensive stocks as a whole performed during that period; the short answer is not well.)

There’s room for upside from internal improvements and, potentially, a more benign external environment. Valuation is reasonable to the extent that investors can ride out some volatility, and to the extent that even if FY25 targets are missed, there’s still a path toward positive returns.

It’s not the most exciting investment opportunity to come around, certainly. But that’s precisely the point. Over the past few months, investors have had all the excitement they can handle; more may be on the way. Owning a quality business with some downside protection might be boring, but in this market it’s one way to stay invested while still avoiding trouble.

As of this writing, Vince Martin has no positions in any securities mentioned. He may initiate a position in ABM this week.

Tickers mentioned: ABM

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