(ABM) ABM Industries Upgraded to Neutral

ABM Industries Inc. (ABM) reported fiscal second-quarter EPS of 28 cents, up 22% year over year and net sales of $1.06 billion that grew 24% over the prior year. This marked the reversal of eight straight quarters of negative organic growth. The encouraging results buttressed with the Linc Group acquisition prompted us to revisit our recommendation, upgrading ABM Industry Inc. from Underperform to Neutral. The stock currently retains a Zacks #3 Rank (short-term Hold recommendation).

ABM Industries was hit hard by the recession and the company had been suffering from negative organic growth for eight quarters in a row. Organic revenue finally inched up 1% year over year in the second quarter of 2011, up from breakeven in the first quarter. Management anticipates mid single-digit organic revenue growth in the second half of fiscal 2011.

During the recession, ABM Industries experienced losses of client contracts, reductions in the level and scope of client services, contract price compression and declines in the level of tag (extra service) work, primarily in the Janitorial segment. With the economy and business hiring beginning to pick up, ABM should begin to see better trends. Tag revenue, which is much more profitable than a typical contract, should start to come back with the economy.

Healthy cash flow generation enabled ABM Industries to increase its quarterly dividend payout on a regular basis over the past several years. The company’s current quarterly dividend of 13.5 cents per share is 4% higher than last year. ABM Industries’ balance sheet is supportive of further dividend increases. Moreover, the company uses its cash flows for debt repayment and business expansion.

ABM Industries ramped up its acquisition activity in December 2010 by acquiring The Linc Group, a global provider of technical building services, comprehensive green solutions, and other training and support services for $300 million. The combination of the two entities – ABM Industries’ Engineering Division and The Linc Group – both of which boast double-digit growth in sales and earnings will generate a cumulative $1 billion in revenues. With Linc’s operating margins of 6%–7%, which is almost double the company average, it should provide ABM Industries with a better growth profile.

Management noted that it is looking at a number of further acquisition targets, largely in the Janitorial segment. The company currently has the capacity to fund deals up to $150 million.

On the flipside, a significant portion of Linc’s revenue is generated from government contracts that could be negatively impacted by reduced government spending on outsourced services as well as payment delays. In the second quarter of fiscal 2011, federal government budget delays held up the start of some projects, which had an adverse $5 million to $10 million impact on Linc revenues. For fiscal 2011, the impact could be as much as $50 million.

Furthermore, ABM Industries’ dependence on acquisitions for growth has its inherent risks. The company’s failure to engage in new acquisitions on a regular basis will hamper its growth rate. A slowdown in acquisition activity may not only lead to lower revenues, but also lower margins, as revenues associated with acquired operations generally have higher margins than new revenues through internal growth.

The company’s business services include Janitorial Services, ABM Facility Services, ABM Engineering Services, Ampco System Parking and ABM Security Services. It competes with privately held ARAMARK Corporation, Central Parking Corporation and UNICCO Service Company.

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