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Executives

Shayn Carlson – Director of Investor Relations

Richard L. Marcantonio – Chairman of the Board & Chief Executive Officer

Jeffrey L. Wright – Chief Financial Officer & Senior Vice President

Analysts

John Healy - FTN Midwest Securities Corp.

Michel Morin - Merrill Lynch

[Andy Aaron] – Needham & Company

Andrea Wirth – Robert W. Baird & Co.

Ashwin Shirvaikar – Citigroup

G&K Services Inc. (GKSR) F1Q09 Earnings Call October 28, 2008 11:00 AM ET

Operator

Good day ladies and gentlemen and welcome to the G&K Services Fiscal 2009 first quarter earnings conference call. (Operator Instructions) I would now like to introduce your host for today’s program, Mr. Shayn Carlson, Director of Investor Relations.

Shayn Carlson

Good morning. Thank you for joining us to discuss G&K’s fiscal 2009 first quarter results. Once we’ve completed our prepared remarks we’ll open the call for questions. Joining me on the call today is Rick Marcantonio, Chairman and Chief Executive Officer and Jeff Wright, Senior Vice President and Chief Financial Officer.

Before I turn the call over to Rick, I’d like to remind everyone that this call may contain forward-looking statements within the meaning federal securities laws including statements concerning business strategies and their intended results and similar statements concerning anticipated future events and expectations that are not historical facts. These forward-looking statements are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. The forward-looking statements in the press release distributed this morning reflect management’s best judgment at this time but all such statements are subject to numerous risks and uncertainties which could cause actual results to differ materially from those expressed in or implied by statements provided. Additional information concerning potential factors that could affect future financial results is included in the company’s annual report and from time to time in the company’s filings with the SEC.

A replay of this call will be available starting today at approximately 1:00 pm Central Time through November 27th. You may access the replay by visiting the Investor Relations section of our website. At this time I’ll turn the call over to Rick Marcantonio.

Richard Marcantonio

Good morning and welcome to our first quarter conference call. Before I begin I’d like to mention that our prepared remarks will be more concise than normal because we’re working on a very specific list of actions to drive our short-term results and we want to allow ample time to take your questions.

To start then, as a brief reminder on October 6th we announced expense reduction actions taken to manage the continued difficult economic environment and certain reserves increased or established to address recent changes in events. As a result of the expense associated with these items and the difficult economic conditions we revised our first quarter guidance. We estimated revenue to be in the range of $245 to $246 million and earnings to be in the range of $.07 to $.09 per diluted share. This morning we reported results that met this revised guidance.

It’s important to know that we’re not satisfied with our current performance. While G&K is a strong company, in light of the difficult economic environment we’re taking actions to improve our short-term results. I’d like to expand on this point for a minute.

As we announced about three weeks ago, we’ve taken aggressive actions to reduce our cost structure to manage the difficult economic environment. Specifically we closed or are in the process of closing three plant locations. We also closed or are in the process of closing two branch facilities. We reduced selected headcount at our U.S. and Canadian corporate offices and we also moved to outsource our fleet maintenance function. In all when you count the five location closures, select corporate reductions, and the outsourcing of our fleet maintenance function we have taken a total of approximately 200 positions out of the company.

These actions will reduce our cost structure and improve our capacity utilization while enhancing customer service and maintaining our market coverage. Importantly, once complete, these actions will provide anticipated annual savings of between $3.5 and $4.5 million.

In addition to these significant cost structure actions we’re taking additional spending reductions to further improve our short-term performance. We will not just stand by and wait for the economy to rebound. Again I’d like to give you a few examples of these new initiatives.

First we are aggressively attacking our cost structure and reducing non-revenue generating discretionary spending in areas such as travel, training, and entertainment. Next we’ve delayed spending on a selected long-term business – on selected long-term business involvement projects. Also we previously communicated that we were considering building two new plants later this fiscal year. We have now decided to delay the construction of one proposed plant.

The second proposed plant is still under review because of capacity constraints. However, with that said we are in the process of identifying alternative solutions to optimize all available capacity and drive additional efficiencies in this business prior to moving forward with construction of the proposed plant. In addition we further reduced our plant capital expenditures this year by redeploying production equipment from plants we’ve closed to replace capital investments previously required.

Again given the tough economic environment we’re looking to aggressively drive down spending and we will remain vigorous in our cost and capital reduction effort. However, we will not stop all spending. Our investments in this tough economy will be focused on generating revenue growth.

For example we will continue to add selectively to our sales force and marketing program. In addition we will continue to support the rollout of Dockers apparel to our 175,000 customers, an important growth initiative for G&K.

Besides our sharp focus on cost and non-revenue generating spending reduction we’re also concentrating on generating higher returns from past investments and taking further actions to stabilize and improve our organic growth.

To step back for just a moment you may recall that during the last economic downturn in the 2001 to 2002 timeframe G&K bottomed at a -4.5% rental organic growth rate. At that time there had been little investment in the sales force, marketing programs were limited, and our presence in serving national accounts was minimal. We were also in the early stages of deploying sales tools, technology, and accountability metrics.

Today we believe G&K is in a much stronger position to weather tough economic conditions and produce organic growth. For example our proprietary segment and marketing programs are supported sales results.

From a sales force perspective we’re also much stronger than during the last downturn. Our sales force has expanded by over 60% since 2002 and they are trained and armed with proprietary programs and the new sales automation system we rolled out over the past year. This new sales automation system has gained wide acceptance and is driving activity, visibility, and accountability within our sales force.

Staying with sales for just a moment we’ve also grown our national account business. Today national accounts make up approximately 15% of our total rental revenue compared to just over 10% six years ago. This provides more financial stability in our customer base. Recently we added a recognized world leader in pizza delivery as a new national account. We also renewed significant relationships with a leading energy utility, a well-known pharmaceutical company, a nationwide transportation business, and a large oil services company to name just a few.

In summary we believe that we’re better positioned to sustain organic rental growth in this economic downturn as compared to the early 2000s.

To shift gears I’d like to provide an update on our direct sales business. As we communicated over the last couple of quarters we continue to roll out the Dockers brand as a complimentary offering to our over 175,000 customers. Through our face approach we’re now offering Dockers apparel through approve and process and fulfillment system in 50% of our U.S. region.

While this effort is still in the initial stages the customer response has been outstanding, especially from women who often find Dockers apparel to be a superior in addressing their fit needs. We will continue to report our progress on this important long-term growth initiative as we go forward.

In addition we recently kicked off our annual outerwear promotion which occurs primarily in our second quarter. Early results are in and we’re off to a terrific start with this program as well.

Staying with our direct purchase business for just another moment, as many of you are probably aware, share holders of both Delta and Northwest Airlines recently approved the merger of the two companies. While this merger is pending regulatory approval from the Department of Justice, we’re already working closely to integrate the Northwest customer service and flight attendants into the Delta uniform program which we rolled out to Delta in early 2006.

In fact, throughout November we’ll be hosting fit clinics for the Northwest employees. Pending regulatory approval we will see upside in direct purchase volume this spring.

Before I turn the call over to Jeff I’d like to reiterate that we’re committed to taking actions necessary to address the tough economic conditions and improve our short-term performance. We’ve reduced our cost structure, decreased headcount, and significantly reduced discretionary spending and delayed selected business involvement in capital expenditure plans. We have also focused our remaining spending on initiatives that will generate revenue growth.

With that said I’d now like to turn the call over to Jeff Wright

Jeffrey L. Wright

Thank you Rick. I’ll begin with a brief financial overview of our first quarter results. For the quarter, revenue totaled $245.2 million, an increase over the prior year period driven by contribution from acquisitions. Revenue growth continues to be challenging due to an economy that is driving companies to go out of business, to consolidate operations, to eliminate headcount, and to reduce expense items. I’ll provide more specifics on economic pressures we’re facing in a couple of minutes.

For the first quarter earnings totaled $.08 per diluted share which met our revised guidance. This level of earnings was impacted by a number of items. As you may recall the cost of our recent expense reduction actions to close locations, reduce headcount, and outsource certain plant functions totaled $2.6 million. Importantly once complete, these actions alone will result in $3.5 to $4.5 million in anticipated annual savings.

First quarter earnings were also impacted by increased reserves for environmental matters of $4.5 million and by establishing a reserve for compensation related changes of approximately $3.3 million. In all these, expense reduction actions and reserves totaled $10.4 million or approximately $.42 per diluted share.

Earnings were also pressured by lower than expected revenue from tough economic conditions, higher energy costs, increased pricing for product inputs, and the impact of recent hurricanes. In addition our effective tax rate was higher than we had previously anticipated which also impacted earnings.

Despite the cost associated with the expense reduction actions, continued economic and cost pressures, and a higher effective tax rate we generated $11.7 million of operating cash flow.

With these comments as a financial overview let me provide some commentary on the economy and then discuss how economic driven pressures are impacting our rental organic growth.

As we all know we’re facing unprecedented economic times. Whether you engage economic activity by industrial output, new construction starts, consumer confidence, or employment levels, by any measure the economy is suffering. For example US Industrial Output posted its biggest drop since 1974 in September. In addition US Consumer Confidence suffered its deepest monthly drop on record in October.

Regarding employment as reported last month, the U.S. economy has shed 760,000 jobs so far in 2008 and the unemployment rate is at a five year high. Clearly companies both large and small are being pressured to curtail costs, forgo spending, reduce employment, consolidate operations, and in some cases seek bankruptcy protection or simply close their doors. In summary our revenue growth is being significantly impacted by this economic backdrop.

Now specific to G&K during the quarter, organic rental revenue was consistent with the prior year period. Rental growth continues to reflect solid route sales and pricing offset by an increase in customer attrition, reduced usage items, reduced customer employment levels, and lower new account sales during this difficult economy.

Let me give you just a couple of specific example. During the quarter we lost revenue as a result of a large regional auto dealer that went out of business shutting its doors on approximately 20 locations in the southeast and Gulf Coast region. Of course G&K is well diversified from an industry and customer standpoint but this is just one example of a customer that is now gone that represented approximately $400,000 in annual revenue.

We also continue to be impacted by employment reductions within our customer base. For example, in a couple of Canadian markets our revenue with large automotive manufacturing customers is down 30% due to a decline in wearers as a result of workforce reductions.

As another example of economic driven lost revenue, a large printing company customer in the upper Midwest recently consolidated operations. And as a result we now serve only one location instead of previously serving two locations and are generating about 75% less revenue from this account than previously.

The economy continues to cause customers to go out of business, cut back on items, delay their uniform decision, and reduce their employee base. Clearly slowness in overall economic conditions is offsetting some of the areas like route sales and pricing which we control and which are generating positive momentums.

Clearly as Rick highlighted, we’re focused on the things that we can control, driving increased productivity from the investments we’ve made, and taking additional actions to stabilize and improve our organic growth.

Let me give you some more detail in the actions we’re rapidly implementing. We have been scrutinizing our expenses across the organization. We’ve significantly reduced discretionary spending in multiple areas and have employed stringent administrative controls to monitor and limit future spending. We have also delayed spending on a couple of significant business development projects. While these are important projects for driving future competitive advantage, we’ll put these on hold and reinvest when appropriate. They’re simply not affordable in this environment.

As Rick also mentioned we have decided to forgo the building of one plant location indefinitely. In addition we continue to evaluate a second proposed new plant due to current capacity constraints. However we’re now evaluating alternative structures to allow us to drive more efficiency and address the capacity needed for continued growth.

Again we’re looking at every line items of expense and all capital budget dollars as opportunity for spending reductions. That being said we will continue to support revenue growth. This includes adding selectively to our sales force, making incremental investments in marketing programs, and continuing to roll out Dockers to our large customer base. These investments are core to our strategic vision and will generate future revenue growth.

Now let me highlight a few details from our first quarter margins, our balance sheet and cash flow. First, rental growth margins for the quarter were 29.4% compared to 32.9% in the prior year period. The change in growth margin was the result of the expense reduction actions and reserves for certain matters described previously which totaled approximately 1.9% of rental revenue. The compensation related reserve along with some of the charges associated with the expense reduction actions were recorded to costs of rental operations on the income statement. In addition, energy costs also impacted rental growth margins by approximately 100 basis points. It’s important to know that the benefits of our gasoline hedging program helped us set the pressure of higher energy costs by approximately 20 basis points, so energy costs went up 100 basis points after the benefit of hedging.

Direct sale gross margin was 25.0% compared to 28.1% in the prior year period as a result of the impact of fixed cost absorption from lower direct sale volume. As Rick mentioned earlier, we are off to a good start with our annual outerwear promotion and optimistic about future revenue growth and supporting the Delta Northwest merger.

Selling and administrative expenses in the quarter were 25.2% of consolidated revenue, up from 22.8% in the prior year period. First quarter charges associated with expense reduction initiatives and reserves established or increased for environmental matters accounted for approximately 2.5% of consolidated revenue.

First quarter operating margins were negatively impacted by the expense reduction and reserve items noted earlier. When adjusting to exclude these items which total $10.4 million, operating margins would have been 8.1%. The change in adjusted operating margin as compared to the prior year period was the result of lower gross margins due to higher energy costs, costs associated with environmental compliance, lower direct sale contribution, depreciation expense related to our new line uniform information system, and investments to expand our direct sale business.

Now let me turn to our capital structure and cash flow, which remains strong. Given the status of the credit markets, let me remind everyone that G&K maintains a strong balance sheet and a strong position regarding our debt financing. Total debt of $299.7 million was up approximately $53.5 million compared to the prior year period due to acquisitions and share repurchase activity. Debt as a percent of total capitalization was 35.3%. Of note, we just renewed our receivable securitization agreement at favorable terms and our primary revolving credit facility is not set to renew until August of 2010. Again, we maintain a strong credit position.

Cash flow from operations for the first quarter was $11.7 million compared to $14.3 million in the prior year period. Capital expenditures were $6.4 million for the quarter compared to $2.4 million in the prior year period. Prior year period capital expenditures were lower than normal due to proceeds from the sale of property in our Canadian operations. These proceeds offset normal capital spending levels. For the quarter, free cash flow defined as cash flow from operations less capital expenditures was $5.3 million. Cash flow in the first quarter is typically lower than in the second, third and fourth quarter due to fiscal year incentive payments. As I’ve indicated before, given the characteristics of our business, the strong business model and our focus on reducing expenses and capital spending, we will continue to generate a strong level of cash flow.

For fiscal 2009, we had previously communicated that we expected capital expenditures to be in the range of $30 to $35 million which did not include the construction of two proposed new plants. We now expect capital expenditures to be in the range of $25 to $30 million for the fiscal year, which does not include the potential building of one new plant. As previously disclosed, the company initiated and expanded a share repurchase program to purchase up to $175 million of the company’s outstanding common stock. During the first quarter, the company purchased approximately 0.2 million shares of common stock. Since inception of the share repurchase program, the company has purchased approximately 2.9 million shares or approximately 13.5% of the total shares outstanding at the beginning of the program, at a cost of approximately $107 million. Clearly our strong balance sheet and excellent cash flow generation provides the capacity to pursue acquisitions, fund organic growth opportunities, and repurchase our shares.

The company expects fiscal 2009 second quarter revenue to range from $244 to $248 million and earnings per diluted share to range from 50 cents to 55 cents per diluted share. The revenue guidance includes continued focus on improving rental organic growth, offset by the impact of difficult economic conditions on customer retention, customer usage items, and customer employment levels. We expect rental organic growth in the second quarter to remain flat and slightly negative.

In addition, during October, the Canadian dollar weakened significantly against the U.S. dollar. The revenue range assumes that Canadian dollar to U.S. dollar exchange rate of 0.82 compared to the fiscal 2008 second quarter actual exchange rate of 1.02. Due to the weaker Canadian dollar, second quarter revenue is projected to be reduced by approximately $8 million when compared to the prior year period. The earnings guidance also reflects the weaker Canadian dollar exchange rate, which lowers earnings per diluted share by approximately four cents per diluted share when comparing to the prior year period.

In addition, the assets of our SERP pension plan include assets that are impacted by stock market fluctuations. Accordingly we anticipate that the recent decline in the stock market will impact the supplemental pension plans asset valuation. We believe that if the stock market does not rebound, the market to market adjustment on the SERP assets will negatively impact earnings by approximately two cents per diluted share. So these two external factors, the Canadian dollar exchange rate and the stock market impact on our SERP asset valuation will have a meaningful impact on our year over year comparisons in the second quarter. Neither of these items were included in previous guidance or analysts’ estimates as they are the results of market movements during October. The earnings guidance also reflects an effective tax rate of 39 to 40%.

Again, I will repeat that we are very focused on taking the aggressive actions necessary to address the economic conditions and improve our overall financial performance. That concludes our prepared remarks and we would be glad to take your questions at this time.

Question-and-Answer Session

Operator

Ladies and gentlemen, if you have a question at this time, please press the 1 key on your touch key telephone. If your question has been answered and you wish to remove yourself from the queue, please press the # key. Our first question comes from John Healy from FTN Midwest.

John Healy - FTN Midwest Securities Corp.

Good morning guys. I wanted to ask you a question about pricing. You made a point to tell us all that pricing has been positive for you guys in the quarter, I want to hear your thoughts on how long you think that can continue and if you begin to see any sort of price degradation as the quarter went on or if you saw anything take place in the first month of 2QN1?

Jeffrey L. Wright

Well, we obviously see the market still being very competitive and new business pricing seems to be as competitive as it has been for some time. Again, because a lot of these decisions are made on a decentralized local level, I don’t have total disability to all the pricing that goes on but by contract we are allowed to be able to price and pass on our increases and that is part of the benefit of having the contract in place and so we fully expect to be able to price although it won’t be easy. We would expect to be able to continue to price on our existing business and we just have to be sensible and watch how we price our new business.

John Healy - FTN Midwest Securities Corp.

It seems like you guys are ahead of the curve this time with your actions on reducing facility and head counts, I’m trying to better understand what’s in your crystal ball there. You are making these changes and I am trying to understand in your mind how tough the environment gets, the changes you are making, what kind of organic growth are you thinking the industry or yourself are going to see maybe over the next 12 months or so?

Richard L. Marcantonio

This is Rick again, you know, I came in right in the middle, almost at the high point. There was a low point of our negative organic growth so I didn’t have much opportunity to influence ahead of plan or ahead of time what was going on four or five years ago. We basically have seen this coming for some time. We talked earlier in the previous calls about trends we saw in the automotive industry.

I mean, it was impacting our business. We saw some real softness in the Ontario area in Canada that we have been reporting on and as things deteriorated and we see this looking at the metrics within our business, our goal was to not become victims and to stay ahead of what was going on and so the announcement we made a couple of weeks ago was an indication, a clear signal externally that we took this very serious and we would do what it took to maintain the kind of going forward position that we want to have. We continued to watch the environment very closely.

I know Jeff and I have spent a lot of time together looking at the situation. We decided not to just rest on the actions we took three or four weeks ago. That’s the reason why we drove some additional spending out of our business and at the present time we believe that the actions we have taken are sufficient going forward but we are watching the situation very closely. I don’t expect, you know, I don’t know much more than anybody else does to know exactly when the market is going to turn around.

I’m not talking about the stock market. I’m just talking about the economic side of it, but I would say that we are prepared to deal with the situation for the next 6-9 months kind of thing. We don’t expect it to be something that is going to turn around in the next three or so months and if the economic situation deteriorates much more, we are prepared to do what we have to do in order to kind of maintain the right posture within our business but importantly to stay focused on driving revenue growth.

I hope you heard during our prepared remarks that while we are very eager and aggressive at cutting into our cost structure, the one area that we have continued to maintain or the remaining money we have, we have focused on revenue generating. There are still opportunities for us to grow this business and when this economic down turn ends, we don’t want to be caught flat footed. We want to be able to benefit from some of the organic growth that will be driving from new business and be in a better position to recover quicker. So, I hope that gives you some perspective.

John Healy - FTN Midwest Securities Corp.

That’s incredibly helpful. When you guys look at October so far, have you seen the conditions in October worsened since the end of 1Q or have they been fairly similar? Any color you could give there would be helpful as well.

Jeffrey L. Wright

Sure. This is Jeff. You know, sometimes it is hard to break things down into just a few weeks but maybe the things that pop out in my mind are the employment numbers, the September numbers certainly seemed to continue to get worse. I don’t know what we are going to see for sure in October but that situation doesn’t look to be improving by any means. Of course energy costs are improving and that is going to help our situation significantly here in Q2. In Q1 we took a significant hit on energy on a year over year basis. In Q2 we are thinking now at this point it might be slightly positive. We might pick up a penny or so of EPS in Q2 and then even more in Q3, again on a year over year basis, so that is good.

Maybe the third item I would comment on is on bad debt expense. We continue to see some activity around customers that are going out of business, companies that aren’t making it, and our bad debt expense is up a little bit here, again in Q1 compared to the prior year period, so we are obviously aggressively watching our receivables. We are working hard and diligently on collection efforts, but we see a little bit of softness there as well.

John Healy - FTN Midwest Securities Corp.

Great and just a last question, you mentioned the SERP assets of being about a two cent potential headwind, is that on an annual basis or is that quarterly?

Jeffrey L. Wright

That two cent headwind is basically as a result of the October market movement so that, again if the stock market doesn’t go anywhere, that is what would be the hit in Q2 and then if the stock market remained flat, then there would be no ongoing hit. It would just be kind of a onetime hit if you will because of the fact that the stock market has come down, and then in future quarters if the stock market rebounds at some point, we would gain that asset value back but of course as you know with the counting roles, it is a mark to market and so we have to mark those assets down and we will mark them down in Q2 based on where the stock market has went.

John Healy - FTN Midwest Securities Corp.

Okay great, thank you guys.

Operator

Thank you. Our next question comes from Michel Morin from Merrill Lynch.

Michel Morin - Merrill Lynch

Yes good morning, I was wondering, I just wanted to clarify, did you provide the organic growth rate for rental?

Jeffrey L. Wright

The organic growth rate for rental, again, was flat, so another way of saying it as 0% but it was flat for the quarter and again to be clear we are forecasting that for Q2 that it will be flat and maybe slightly negative so we see it in about the same spot but it could move up or down a little bit just depending on where the economy goes.

Michel Morin - Merrill Lynch

Okay and then the $10.4 million charge, I wanted to clarify I know that you walked through this and I will look at the transcript later, but just to clarify, how much was an SG&A? If I got it right, it looks like it was more than $6 million fell under SG&A, is that right?

Jeffrey L. Wright

It did and that is because we concluded that the majority of the environmental actions we concluded needed to be an SG&A as well as there was severance related to a number of corporate positions and other activities that ended up in SG&A and so roughly about $6.1 million would be an SG&A and about $4.3 million would be in cost rental and up in cost rental again is the compensation related reserves as well as a portion again of the severance related activities and that primarily was centered around the outsourcing of the fleet maintenance staff was up in that category.

Michel Morin - Merrill Lynch

Okay so when we look at things kind of on a normalized basis excluding these cost items, have you already realized your annualized cost saving projections or do you expect to see further benefit in the second quarter?

Jeffrey L. Wright

We definitely expect to see further benefits in the second quarter and even then it won’t be at quite the full run rate of the 3.5 to 4.5 that we articulated because we still, one of the plants referenced is still being closed down at this point and the switch on the fleet maintenance from internal to external is still in process and will take actually a number of months so we anticipate the savings will move up in Q2 and then move up a little bit further in Q3 and we really won’t get to a full run rate until we get into Q3.

Michel Morin - Merrill Lynch

And that would be more visible at the gross margin line, it sounds like, based on what you have just described.

Jeffrey L. Wright

Yeah. Again I think there are impacts on both the costs of rental and in the SG&A categories.

Michel Morin - Merrill Lynch

Okay and then specific to gross margin on the rental side, just normalizing for the four million or so hits, it looks like it came in at about 31.3 which is very significant erosion year on year and versus the fourth quarter, you pointed to energy costs, what else, I mean is it just that it is a fixed cost business and you are running flat on the top line or what else was a significant driver of that decline here?

Jeffrey L. Wright

Well I think that’s a good question. We mentioned this early, didn’t spend a lot of time with it, but we did have the impact of the gulf coast hurricane which cost us some extra funds in Q1 as we recovered, particularly in our Houston markets and we have also as we mentioned we have got some product input costs across a number of categories that are impacting us and those would probably be a couple of things that I would highlight to you.

Michel Morin - Merrill Lynch

Okay, great, thanks very much, Jeff.

Jeffrey L. Wright

Sure.

Operator

Thank you. Our next question comes from Andrea Wirth from Robert Baird.

Andrea Wirth – Robert W. Baird & Co.

Good morning, guys. Just a question on the energy side, do your hedges actually maybe hurt you this quarter, just given how fast the prices have dropped and would your benefit actually be a little bit better this quarter if not for the hedges?

Jeffrey L. Wright

Andrea, that is correct. As you know, we've been enjoying the benefit of the hedges the last couple of quarters. I think the benefit was in the range on $500,000 in Q1 and in Q4 I think it was in the range of $800,000 positive. At this point, based on where energy prices have went we would expect that those would turn negative and in fact they will offset some of the positive movement that we see in Q2 and when I mentioned earlier that we should see $0.1 to 0.2 of positive energy movement that was taking into account that there is an offset with our energy hedges in Q2.

Andrea Wirth – Robert W. Baird & Co.

Got it and could you remind us how your energy costs break down just in terms of is it more gasoline or natural gas or what's the mix we should be looking at?

Jeffrey L. Wright

Sure, and I'll pull out the exact numbers here for you. But our energy costs this quarter in Q1 ran about just a little over 5% of revenue and roughly about 2 1/2 of that was related to gasoline. A little bit short of 2 was related to natural gas and about 1 was related to electricity and those are the numbers that get you a little bit over 5% for the quarter.

Andrea Wirth – Robert W. Baird & Co.

Got it, got it, okay. Then just a question on the environmental side, have all of the issues there been remedied now at this point or are we still kind of working through that process and maybe we see some lingering costs just from kind of going through that process of remedying those issues?

Jeffrey L. Wright

Sure, this is Jeff again. We are in the process as we mentioned on our October 6th call, we're in the process of conducting inspections, reviews at all of our facilities facilitated with an outside firm to make sure that we are addressing all the issues. That process is not fully complete although I would tell you is substantially down the road so there's a chance that we certainly will be incurring some extra expense related to that using the consulting firm and so forth. And of course, if we're to find any further issues that certainly could impact us moving forward.

Andrea Wirth – Robert W. Baird & Co.

And the plants that have already been identified are those already remedied or we still kind of working through that as well. You said the plants have been identified with some issues.

Jeffrey L. Wright

Well for any issues that have been identified, of course, we've reserved for them appropriately and we are in the process of remedying any issues that have been identified.

Andrea Wirth – Robert W. Baird & Co.

Okay, so still working on that, not quite completed. Is that fair?

Jeffrey L. Wright

Yeah, I think that's fair to say. As you might imagine, it's things that aren't necessarily remedied immediately, sometimes you have to put in some fixes that take a little bit of time.

Andrea Wirth – Robert W. Baird & Co.

Okay and then just on new business wins. Were they actually down year-over-year in the quarter?

Jeffrey L. Wright

Yeah, this is Jeff. Yeah, one thing we maybe didn't mention we could have highlighted even a little bit more is that our Q1 results last year were an all time record for the company. You might remember that, in fact, I think in that quarter it was about 20% ahead of any quarter ever in the history of the company so had just stellar results in Q1 last year. And so, yes, the results were down on a year-over-year basis and actually reasonably significantly again because they were so high in the prior year.

Andrea Wirth – Robert W. Baird & Co.

Got it, got it and when you talk about your business wins do you talk about it on a net basis including any potential losses?

Jeffrey L. Wright

No, Andrea, for our new business wins it's simply new accounts that have been sold by our new accounts sales force and when we talk about that it's the new business wins and it does not include the customer attrition.

Andrea Wirth – Robert W. Baird & Co.

Got it and just in terms of lost contracts have you seen any change in that rate or has that been fairly stable?

Jeffrey L. Wright

Yeah, well, as we mentioned in the script again, with customer attrition that is up a bit and it's really led by what we would call financial quits which are quits that are happening because of companies that are having financial difficulties.

Andrea Wirth – Robert W. Baird & Co.

Got it and not necessarily in terms of switching to another provider?

Richard L. Marcantonio

That's correct.

Jeffrey L. Wright

Yes, that's correct.

Andrea Wirth – Robert W. Baird & Co.

Okay, great. Thanks, guys.

Richard L. Marcantonio

Yep.

Operator

Thank you. Our next question comes from Andy Aaron from Needham & Company.

[Andy Aaron] – Needham & Company

Hi, good morning.

Richard L. Marcantonio

Good morning.

[Andy Aaron] – Needham & Company

You had mentioned that bad debt expense would be up, well, it was up a little in Q1 versus prior periods. I was wondering if you would talk about bad debt expense and DSO trends moving forward and perhaps quantifying the impact you might see.

Jeffrey L. Wright

Yeah, sure, this is Jeff. You know, bad debt expense I think was probably if you looked on a, again, a year-over-year basis, Q1 last year to Q1 this year, bad debt probably cost us closing in on 0.2 cents of earnings per share and so that was the impact. We've built in, in terms of our projection for Q2 I would say a modest amount of increase in bad debt again on a year over year basis but not getting really worse then what it was here in Q1. And I guess I just emphasize that we recognize the current economy, we've talked to all of our office personnel and the people that do collections and we are staying very focused on our collection efforts and so I think we will be doing everything we can internally to make sure that we're managing that situation.

[Andy Aaron] – Needham & Company

Okay. You know the familiar outlook, what have you assumed in terms of the unemployment rate?

Jeffrey L. Wright

You know our forecasting doesn't get quite that detailed where it's linked specifically to the unemployment rate.

[Andy Aaron] – Needham & Company

Okay. You know, (inaudible 00:51:21) your bad debt expense if you see things kind of maintaining, not getting any worse as you said, if things do get a lot worse, if unemployment rates go up, if just your output goes down, that would materially impact your outlook.

Richard L. Marcantonio

Well, it would if we did nothing. This is Rick again. I think the point that we're clear on is we're watching this very closely as we should, frankly. If we see this situation deteriorate further to a point that's beyond the kind of actions we've already taken, we've taken actions this quarter that will not only help us this quarter but in future quarters, if we see the environment deteriorate further then we will be looking for way to try to protect our short-term results.

So I don't think you can assume that we won't do anything, it's just a question of how far it might go and what we're able to identify. But right now we feel like the actions we've taken, that we announced a couple of weeks ago plus the additional things we articulated in our prepared remarks, we feel are sufficient to weather the current situation as we see it today.

[Andy Aaron] – Needham & Company

Okay. Thank you very much.

Richard L. Marcantonio

You're welcome.

Operator

Thank you. Our next question comes from Ashwin Shirvaikar from Citigroup.

Ashwin Shirvaikar – Citigroup

Hey, guys.

Richard L. Marcantonio

Good morning.

Ashwin Shirvaikar – Citigroup

Morning. I have a few modeling type questions. I apologize if you answered these earlier, I hopped on a little bit late from another call. But first, could you quantify the impact of Canadian currency on margins? I know you did it on EPS but is there an impact on margins also?

Jeffrey L. Wright

It is an impact on margins as well, Ashwin, I guess I haven't run that at the margin level. Again, we disclosed that we estimated about $.04 of EPS impact. You know, really, I think the majority of that would be up in the margin category so I think that should allow you to calculate the impact on margins.

Ashwin Shirvaikar – Citigroup

Okay, so it's not so much translation as it is margins?

Jeffrey L. Wright

Well, again, a $.04 impact to the bottom line and about an $8 million impact to revenue.

Ashwin Shirvaikar – Citigroup

Okay. Now, you know, some of the actions you've taken, do they have tax implications that affect the tax rate going forward?

Jeffrey L. Wright

Not so much going forward as you can see in the release for Q1 our tax rate looks a little strange obviously up over 70% and that's because there's a chunk of the reserves that we've established that are not tax deductible. And when you would account for those it would put you into a more reasonable tax rate so we're anticipating that our tax rate here in the second quarter again will be in that 39 to 40% range which is a pretty typical range for us.

Ashwin Shirvaikar – Citigroup

Okay and you did mention you're going to be careful with the large (inaudible 00:54:41) and so on, does that also extend to potential acquisitions that you might have or are you going to be broadly speaking careful with all kind of spending or does the acquisition pipeline look fairly active here?

Richard L. Marcantonio

This is Rick, well, we have been and will be fairly careful in any acquisition but that's been kind of our practice going forward. The acquisition pipeline continues to be full and we haven't seen a gigantic falloff there. I think what we're doing is we're trying to make sure that, as we always do, that whatever we decide to buy we can maximize the return from that investment.

Are we looking at it a little closer during this time, the answer is yes. I mean deals that might be sort of border line are ones that we will probably push aside more often than not. Not that we look at a lot of borderline deals but I think that the closer they are to an excellent return for us, the more interested we are. The closer they move to borderline in this economic environment we just will take a pass on them. And that's part of this discipline that I believe that Jeff and I have instilled in this company to manage through this situation and that put us in sort of a victim kind of mindset.

Ashwin Shirvaikar – Citigroup

So have you seen valuations come down moderate maybe a little bit?

Richard L. Marcantonio

No.

Ashwin Shirvaikar – Citigroup

You haven't.

Richard L. Marcantonio

No, this is Rick. No, we have not. We haven't seen the current economic environment impact valuations negatively.

Ashwin Shirvaikar – Citigroup

Okay, question on interest expense. You do have a variable rate, don't you?

Jeffrey L. Wright

We do have a variable rate but only on about, I'll use 50% as an average. But about 50% of our debt is locked up into fixed rates and then the other half, of course, is subject to variable rates.

Ashwin Shirvaikar – Citigroup

So that should be a little bit of a benefit in the current environment?

Jeffrey L. Wright

Correct.

Richard L. Marcantonio

Correct.

Jeffrey L. Wright

Although I know everyone has kind of been tracking our variable rate is LIBOR based and LIBOR rates have really spiked up there for awhile. Luckily I think we had all of our LIBOR contracts in place and since I think have come down a fair amount. I haven't seen it in the last few days but hopefully LIBOR rates will come back down to where they were a month or so ago.

Ashwin Shirvaikar – Citigroup

Okay and you did mention, sorry I'm jumping around a bit, but you did mention that your outerwear promotion is going fine.

Richard L. Marcantonio

Right.

Ashwin Shirvaikar – Citigroup

Due to expectations.

Richard L. Marcantonio

Right and that's a second quarter result. We thought we'd give you some visibility, now we've got roughly four or five weeks under our belt but the first four, or five weeks feel very good to us.

Ashwin Shirvaikar – Citigroup

Okay, and last question, can you quantify maybe the impact of (inaudible 00:57:54)? I know it's going to be at some point positive. But when you last did Delta, how much of a benefit was it?

Richard L. Marcantonio

This is Rick again. We obviously know those numbers but I'd prefer to wait until they get final approval. Once they get final approval, we'll communicate to you the opportunity. That opportunity, assuming everything goes as planned, would be primarily in the third and fourth quarter of our fiscal year.

Ashwin Shirvaikar – Citigroup

Okay, so it would be this fiscal year?

Richard L. Marcantonio

Yes it would. At least if they say that's their plan, again, things change and that's why I'm a little reluctant to go much deeper then we've done until—

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Source: G&K Services Inc., F1Q09 Earnings Call Transcript
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