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Cintas Corporation (NASDAQ:CTAS)

Q2 2010 Earnings Call

December 22, 2009 5:00 pm ET

Executives

Michael Thompson – VP & Treasurer

William Gale - CFO

Analysts

John Healy – Northcoast Research

Scott Schneeberger - Oppenheimer

Ashwin Shirvaikar - Citigroup

Andrew Steinerman - JPMorgan

Vance Edelson - Morgan Stanley

Vishnu Lekraj - Morningstar

Andrea Wirth - Robert W. Baird

Gary Bisbee - Barclays Capital

Nate Brochman - William Blair

Operator

Good day everyone and welcome to the Cintas quarterly earnings results conference call. At this time I’d like to turn the call over to Mr. William Gale, Senior Vice President of Finance and Chief Financial Officer.

William Gale

Good evening and thank you for joining us. With me today is Michael Thompson, Cintas’ Vice President and Treasurer. After some comments we will be opening the call to questions.

For the quarter ending November 30, 2009 total revenue was $884.5 million, a slight increase over the first quarter of this when adjusted for this quarter’s one fewer work day. While job losses appear to be moderating, the industries in which the majority of our customers operate in, continued to lose jobs. So there still is a negative drag on our revenue.

While we are hopeful that a recovery may be near, we are still uncertain as to when that will occur. We continue to see revenues being below the comparable period in the prior year for the next several quarters.

As a result our key focus will be to continue to take care of our customers, ensuring they value our service offerings. We also recognize the need to continue to right size our organization structure to adapt to the new revenue environment.

We have substantially reduced costs in all areas of the company as Michael will explain shortly. Net income was $57.2 million, down from last year’s $71.8 million, but higher than our first quarter income of $54 million. Please note both our first and second quarters of this fiscal year contained legal settlements that are reported separately on the income statement.

These settlements were made in order to avoid the potential cost and distraction that these cases would have had on the organization for the next few years. During the quarter the company continued to aggressively manage capital spending and acquisitions. We currently have almost $0.50 billion of cash and marketable securities and no commercial paper outstanding.

We are well positioned to aggressively pursue acquisitions when the right opportunities present themselves. We are continuing with our practice adopted last year at this time of providing no guidance. We caution everyone that in our view the recovery in the job market will be slow in coming and will take some time to return to what we saw in the late 90’s or even in the middle of this decade.

We will continue to focus on providing our customers with exceptional service and manage our cost structure efficiently. Because of our view of the sluggish recovery we believe the current analyst estimates are overly optimistic for the remainder of this fiscal year and into 2011.

The Private Securities Litigation Reform Act of 1995 provides a Safe Harbor from civil litigation for forward-looking statements. This conference call contains forward-looking statements that reflect the company's current views as to future events and financial performance.

These forward-looking statements are subject to risks and uncertainties which could cause actual results to differ materially from those we may discuss. I refer you to the discussion on these points contained in our most recent filings with the SEC.

I would like to turn the call over to Michael Thompson who will give you more color on the quarter.

Michael Thompson

Thank you William and good evening everyone. Total revenues for the second quarter of fiscal 2010 were $884.5 million, a 10% decrease from the second quarter of last year. The decrease was mainly due to the significant job loss experienced during this economic downturn. When compared to the first quarter of this fiscal year, revenue decreased 1%.

This year’s second quarter had 65 work days, the same as the second quarter fiscal 2009, but one less work day than the 66 in the first quarter of this fiscal year. When adjusted for the one less work day revenue for the second quarter increased by 1% over the first quarter.

Company internal growth was negative 10%, an improvement from first quarter internal growth of negative 12.5%. Work days for the remainder of this fiscal year are 64 for the third quarter and 66 for the fourth quarter. Our third quarter is traditionally our most challenging quarter due to the lower work days and customer holiday closures.

We anticipate customer holiday closures will be longer and more widespread this year than they have been in better economic climates. Any revenue and earnings estimates for the remainder of this fiscal year should take these factors into account.

We have four reportable operating segments; rental uniforms and ancillary products, uniform direct sales, first aid safety and fire protection services, and document management services. As a reminder on the face of the income statement, uniform direct sales, first aid, safety and fire protection services and document management services are combined and presented as other services.

The rental uniforms and ancillary products operating segment consists of the rental and servicing of uniforms, mats, towels, and other related items. The segment also includes restroom supplies and other facility products and services. Rental uniforms and ancillary products revenue accounted for 73% of company revenue in the second quarter.

Rental revenues were $643.6 million for the quarter, a 9.5% decrease in revenues as compared to the second quarter of last year but flat as compared to the first quarter on an equivalent work day basis. While the US economy continued to shed jobs especially within our customers’ industries, we were able to somewhat offset that revenue impact over the last six months and rental revenue has been flat the last three quarters on an adjusted work day basis.

Our lost business metric while slightly higher than the first quarter of this year has improved from fiscal 2009 levels. Our add/stop metric which includes both uniform wearers and facility service products was a positive add metric for the second consecutive quarter. And our second quarter adds were stronger than the first quarter.

The improvement was due to a combination of the moderation in job loss and our continued focus on further penetration into our existing customer base. While these adds have helped maintain our top line revenue, they’ve also increased our selling costs.

Offsetting these positives were reduced new business and a difficult pricing environment. New business was down from the first quarter as new customer prospects appear to be hesitant at adding new services in this time of economic uncertainty.

In addition competitive pricing in the marketplace has become more aggressive. Pricing for both customer retention and new business has been challenging. However as long as it makes economic sense we will continue to aggressively fight our competition in the marketplace. We continue to protect our market share and our customer satisfaction level remains high.

Our focus remains on taking care of our customers, enhancing our opportunities for future rental growth. Our uniform direct sales operating segment includes the direct sale of uniforms, branded promotion products, and other related products to national and regional customers. Uniforms and other related products are also sold to local customers including products sold to rental customers through our direct sale catalogue.

Uniform direct sale revenue accounted for 11% of total company revenue in the second quarter, up slightly from 10% in the first quarter. While uniform direct sale revenue increased 11% from the first quarter revenue levels continue to be soft. Internal growth was negative 17% in the second quarter a moderation from the negative 25% in the first quarter.

A large amount of this segment’s business is with the lodging, hospitality, and gaming industries. While these industries appear to be stabilizing headcount generally remains low as compared to historical levels. In addition location expansion and existing location refresh programs and/or rebranding initiatives have been isolated.

While customers have begun to plan for future expansion and improvements we expect further economic stabilization needs to occur before these discretionary types of spending return to more traditional levels.

Our first aid, safety and fire protection services operating segment includes revenue from the sale and servicing of first aid products, safety products and training, and fire protection products. First aid, safety and fire protection accounted for 9% of the company’s second quarter revenue as compared to 10% for the first quarter.

During the quarter revenues within our first aid, safety and fire protection services operating segment decreased 19% versus last year’s second quarter and were down 8% on an adjusted work day basis from the first quarter. Internal growth was negative 17% a slight improvement from negative 18% last quarter.

While the first aid, and safety revenue in this segment decreased 11% from last year’s second quarter revenue has stabilized and was relatively flat as compared to the first quarter. First aid services and training revenue were positive, as compared to the first quarter while the sale of safety items including AEDs suffered as these items are a more discretionary cost for customers.

Fire protection services revenue continued to suffer with revenue down almost 30% from the second quarter of last year and approximately 20% from the first quarter. The majority of this decline is due to the continued pressure on fire installation business. We have exiting the fire installation portion of this business over the last year and that process is now effectively complete.

We continue to focus on the test, inspection, and repair service within fire protection. Test, inspection, and repair revenue was also down but not as dramatically as the installation business. In addition to our focus on exiting the installation business, business closures, competitive pricing pressure, customer price concession requests and seasonal fluctuation all had an effect on this business during the quarter.

Similar to first aid, safety product sales, fire equipment upgrades and enhancements have been lagging as customers delay these purchases and request price concessions. Our document management services operating segment includes document destruction, storage, and imaging services.

Document management represented 7% of second quarter company revenue up from 6% in the first quarter. Revenue increased 13% over the second quarter of fiscal 2009 and 6% over the first quarter. Internal growth was 9%. When excluding the impact of recycled paper revenue and the related impact of recycled paper prices, internal growth for document destruction service and purge business was 15%.

Our document destruction services as well as our storage and imaging services continued to provide solid growth. Recycling revenue was down 12% from the second quarter of last year due to lower paper prices. However beginning in the month of November we have anniversaried the impact from recycled paper prices so moving forward full division revenue comparisons will be more meaningful provided recycled paper prices remain stable.

Turning to margins, we continue to actively manage our cost structure in order to maximize results during this difficult environment. Total company gross margin for the second quarter was 41.8% a 30 basis point decrease from the second quarter of last year. However to combat the decline in revenue cost of goods was reduced by $56 million as compared to last year’s second quarter on a dollar basis.

Total company energy costs improved 60 basis points versus last year. Second quarter total company gross margin decreased 110 basis points from the first quarter while energy costs were flat. Rental gross margin of 43.5% was down 10 basis points from last year’s second quarter. As with the company in total energy costs improved as compared to last year.

The improvement in energy was offset by margin pressure due to reduce revenue levels. However as compared to last year’s second quarter expenses decreased by $38 million on a dollar basis. When adjusted for work days and seasonality rental margins were comparable to the first quarter and as with the company in total energy costs were flat.

As we mentioned last quarter pricing has become more aggressive in the marketplace. While we are maintaining our customer base at historical retention levels, the reduced pricing levels have impacted our margins. Other services gross margin was 37.3% for the quarter as compared to 38.4% in last year’s second quarter and 38.2% last quarter.

The lower margin was due to lower fire revenue within the first aid, safety and fire segment. Within that segment first aid and safety margins were maintained as were margins for fire test and inspection business. However margins continued to be pressured in the fire installation business. As I mentioned earlier we have now essentially exited the installation business and expect fire margins to begin to recover.

Uniform direct sales margins were also lower due to reduced revenue levels from last year and a change in sales mix. Generally customers are purchasing base level and general stock garments but have been delaying purchases of more specialized higher end garments.

Document management gross margin was below the second quarter of last year due to lower recycled paper prices. However margins were up as compared to the first quarter due to a combination of higher revenue and improved recycling paper prices as compared to the first quarter. We have achieved a solid national footprint for destruction services and depending on recycled paper prices we expect margins to continue to strengthen as local operations reach scale.

We continue to actively pursue document management acquisition opportunities both domestically and abroad. Selling and administrative expenses were 29.3% of revenue an increase from 28.9% for the second quarter last year but an improvement from 29.7% last quarter. We reduced our SG&A spend by over $25 million from the second quarter of last year but the reduction in revenue over that timeframe caused SG&A to increase by 40 basis points.

G&A labor and labor related costs as a percent of sale improved from last year’s second quarter while the relatively fixed types of expenses such as insurance costs, professional fees and property taxes increased on a percent of sale basis. The 40 basis point improvement from the first quarter was due to an improvement in medical costs.

As mentioned in our first quarter earnings call medical costs spiked during our first quarter. While still high medical costs did moderate accounting for 3.7% of revenue. G&A labor also improved as a percent of sale from the first quarter. Partially offsetting these improvements was an increase in selling and bad debt expense. The increase in selling related to commissions paid on add where the sales force was involved.

We have also increased the headcount of our sales force during the quarter. These new sales professionals are currently in training and it typically takes approximately one year for a new sales professional to achieve solid new business sales results. While bad debt increased from the first quarter it remains at a manageable level.

Our effective tax rate was 39.3% for the quarter which reflects the timing of specific reserve builds and releases under FIN 48. Since the adoption of FIN 48 our effective tax rate has increased during the second quarter due to the timing of reserve requirements. But then returned to lower levels for the remainder of the year.

We expect this to be the case again this year and anticipate that our effective tax rate for fiscal 2010 will be approximately 37.5%. Despite the difficult economic environment our balance sheet continues to get stronger primarily due to robust cash flow. Our cash and marketable securities increased $122 million from August 31.

Over the last 12 months, we have increased our cash and marketable securities on hand by over $350 million, reduced our outstanding debt by over $80 million and paid an annual dividend of over $70 million. So during the most difficult period in our company’s history, we increased free cash flow, improving combined cash and debt levels by over $430 million and increasing our annual dividend to shareholders.

DSOs on accounts receivable were 41, a slight improvement from August. We continue to actively manage our accounts receivable in order to lessen any impact from current economic conditions. As mentioned earlier bad debt expense increased in the first quarter but it remains at a manageable level.

New goods inventory levels continue to fall as actively manage inventory requirements given reduced demand especially in our uniform direct sale business. Inventory decreased by $19 million from August 31. Net property, plant and equipment balances continue to decline as we have significantly reduced our capital expenditures due to lower revenue levels.

CapEx for the first six months of this year were $48 million including $23 million in the second quarter. This is 50% of the amount we spent through six months of last year when CapEx was $96 million. Our capital expenditures are near maintenance CapEx levels and were consistent by segment with spending in the first quarter. We continue to inject growth capital where appropriate which is mainly in our document management business.

Included in our capital expenditures are costs related to our SAP financial system implementation. Year to date SAP related capital expenditures totaled $10 million including $4 million during the second quarter. Accrued liabilities increased as of November 30 due to increases on retirement and profit sharing, interest on debt, and legal settlement accruals.

long-term debt at November 30 remained at $786 million as all outstanding debt is now fixed rate. Our average rate on the outstanding debt is approximately 6%. Total debt as a percentage of total book capitalization improved to 24% while net debt or long-term debt less cash and marketable securities as a percentage of total capitalization decreased to 11%.

We continue to evaluate acquisition opportunities and have sufficient cash and access to capital were opportunities to become available at attractive valuations. Our strong cash flow and robust balance sheet continue to provide us the financial stability to withstand the current economic conditions while enabling us to be poised for future expansion when market conditions improve.

Thank you and we will now take any of your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of John Healy – Northcoast Research

John Healy – Northcoast Research

Quick question on the margins, as you look at the margins for the business as we go through the remainder of this year and go into 2011 could you talk a little bit about how we should see those margins move in terms of how we should begin to see those heal up and improve from here. I’m trying to understand at what point do you begin to anniversary large losses of employees within your customer base and how we should think about just the margin improvement solely from that fact as we move forward.

William Gale

First off to answer the question on when do we anniversary the large losses, that’s going to take a little longer because we were still losing uniform wearers in our customers up through and including this quarter. Now obviously the rate of loss has declined somewhat but essentially we still saw an awful lot of job losses in the first half of calendar 2009.

As for margins what we need is a, further stabilization of revenue and a stabilization in the pricing environment. We saw very aggressive pricing taking place. I think it began in our first quarter but it really seemed to accelerate in the second. We are looking at all of our customers very closely before we grant a price decrease if necessary or looking at new business aggressively to determine whether or not its profitable and has some potential down the road.

But we’re going to have to meet some of those pricing pressures in order to maintain the volume. So I really am uncertain as to when we’re going to see some margin improvement because I don’t know when I’m really start to see some increase in the revenue line and that’s what really we’re going to need to drive this thing forward.

John Healy – Northcoast Research

And could you talk a little bit about just the environment as a whole, maybe where that pricing pressure is coming from, is it competitors just trying to hold on and stay in business, is it some of your better capitalized players that are maybe pursuing different business strategy. I was also hoping to get a little bit of color on your commentary in the release that talked about plant closures or facility closures, maybe what you’re seeing there, how severe that is and kind of the timing of that.

William Gale

I think what you have to do, let’s first off make sure that everyone understands that if you just pay attention to the macro changes in the reported jobs that is not going to really tell you what the impact is on our industry. So you’ve got to cut through the reported numbers and look at it by industry and if you look at just the month of November what the government reported where there was only a net decrease of 11,000 jobs, the problem was is that the job losses were still relatively high in our traditional industries that we service.

They were offset by increases in healthcare and education services which really don’t help our revenue lines too much at all. So I think first off one needs to really judge that. But to get back to the first part of your question, there is absolutely a desire on the part of our competitors both big and small to hold onto their business and to continue to replace business that they’ve lost through client closures or through reductions in work forces and so I think they’re trying to offset some of their fixed costs and just continue to have some revenue and some cash flow to withstand this very sluggish recovery that we’re in,

I don’t think that’s going to abate in the near-term and I think that we’re going to have to continue to aggressively pursue and hold onto our customers and pursue new customers and that is going to continue to be the margin closures. As for actually facility closures, they are continuing. Customers are continuing to assess whether they want to keep their operations open or keep as many plants open and while its not nearly as bad as it was 12 months ago, or nine months ago it is still an indication that this economy is still in a very precarious state.

Michael Thompson

And to be clear also in the release we talk about holiday closures, what we’re talking about there is the third quarter typically starting about this time, businesses will close down for the Christmas and New Year’s break and during more difficult times we’ve seen customers take longer breaks and also your concern about will they open back up in this economic environment. So that’s what we talked about in the release.

John Healy – Northcoast Research

The cash flow you generated was pretty amazing for the first six months of the year and the balance sheet is very solid, you made some comments about being interested in being more active on the acquisition side could you talk a little bit about how big of an acquisition you could make in terms of what level of comfort you would be in terms of taking that on the balance sheet and maybe just remind us what your available commercial paper borrowings could be and other access to liquidity that you would have.

William Gale

We certainly have commercial paper available to us right now that would enable us to quickly pick up $500 to $600 million in a relatively quick time period. We could also sell some longer-term bonds. We’ve talked to some of our advisors and there would be a very good appetite to increase that. As for the size of acquisition it could be relatively large because I think we have a lot of capacity given the cash flow strength of our businesses, we could easily buy a company very large and put quite a bit of debt on the balance sheet and because of what might happen, or what would continue to happen with cash flow from our existing businesses as well as the acquired businesses we could pay down that debt relatively quickly.

I would just point out what we did in 2002 when we bought Omni Services, we added a lot of debt to the balance sheet but our debt to cap ratio quickly came down because we generated an awful lot of cash from that particular acquisition as well as our existing operations. So we would be very comfortable in a relatively good sized acquisition.

John Healy – Northcoast Research

Since you brought up the Omni deal if you look at the big players that are still in the space in the uniform side of things, from an industry consolidation standpoint could you see Cintas as an acquirer of still at a large property on there from a DOJ standpoint, would that be something that you think could still happen in this industry.

William Gale

I think it could but I don’t know what the current attitude on the part of the FTC and this administration would be but we would certainly expect to be able to make a very large acquisition and get it approved.

Operator

Your next question comes from the line of Scott Schneeberger - Oppenheimer

Scott Schneeberger - Oppenheimer

As you mentioned in the press release and then again in the prepared remarks some discussion of adding on products and services to customers and also an addition to the sales force in the quarter, could you just speak to (a) on the first subject what were the cross sells that you were doing and two the strategy behind the additional sale folks and what you’re looking at going forward.

William Gale

We’ve always been interested in trying to become a larger provider of services to our customers so as we have expanded our offerings within our different businesses as well as expanding the number of different businesses we offer, we’ve been very much interested in trying to get our customers where it made sense to take additional services from Cintas. In this period of economic difficulty we’ve turned our existing sales force in our service group to work with our customers to try to find areas where we could provide additional value to them by offering some other services, be it facility services, first aid and safety, document management if it made sense, etc.

So that, we’ve really kind of ratcheted that up over the last six months or so. As for increasing the size of our sales force, we also I guess are showing a little bit more confidence now in that what everybody was seeing 12 months ago, you were staring into the potential of a depression, I think we all feel that that’s not going to happen.

And we have seen stabilization that Scot Farmer mentioned in our release of for the last three quarters as far as revenues so we think its time to start training sales people to be prepared to take advantage of the opportunities as the economy really starts picking up.

Scott Schneeberger - Oppenheimer

How is utilization running at your facilities and what steps are you taking in good locations and bad.

William Gale

As you may remember back in May we shut down some facilities to improve the utilization of what we had. We haven’t shut anything further down since that time or anything that we had already planned to do. And we’re seeing basically utilization somewhere probably in the mid to upper 70’s from a capacity standpoint. So we’ve got adequate capacity available to grow back into, as the business conditions improve.

And I would think that we should be in a position where we’re going to be able to get by with very little capital expenditure in our rental business because we’ve got that capacity available. We basically have right sized the organization but have kept available to us the ability to add a lot of volume in our plants without having to build new facilities.

Now as Michael mentioned we certainly have to increase capacity in our growth industry which has been document management, that has continued to grow during this entire period and so we are spending money there and getting new trucks available, new facilities opened up so that we can service more markets and I think that we should be sitting pretty well from a capital spending standpoint for the near-term because of the available capacity we have.

Scott Schneeberger - Oppenheimer

Could you speak, you mentioned healthcare and education may see a pick up in employment but that doesn’t necessarily translate to your business, could you take us a level or two more granular on where you’re seeing the real pressure among verticals that you serve and are there any bright points.

William Gale

I don’t really have the details on that to be able to share that with you. I’d just say generally speaking manufacturing continues to be very difficult and while manufacturing isn’t that large a segment of ours it does provide an awful lot of support for a lot of distribution and other service businesses which are customers of ours.

So we’re not seeing growth there because the manufacturing base isn’t really growing. Retail continues to be very sluggish and retail has been a target of ours over the last few years.

Michael Thompson

I would say the most stable really has been automotive after market, the service stations, dealerships seem to stabilize since all of the turmoil from nine months ago, so in looking at that data that seems to be doing better from our customers standpoint. But again the manufacturing and service industries continue to be hurt.

Scott Schneeberger - Oppenheimer

You certainly are projecting that you want to be positioned for acquisitions once you deem the time is right and it doesn’t sound like we’re there just yet, but is there consideration on use of cash beyond the stock pile because you do have access to capital in other ways, is there consideration for share repurchase, any other use of cash that’s being considered or is much more just a very primary focus on the acquisitions.

William Gale

I think that’s a board level decision that the Board continues to evaluate. I would just point you to what our behavior has been over the last 18 months to tell you what the appetite really is right now for the Board with regard to the use of cash. And given that its building up on the balance sheet I would say that barring a significant reduction in the price of our stock where it might be deemed to be a time to perhaps reenter the market I think what we are looking for is the opportunities that we think will come for some very nice acquisitions.

Michael Thompson

And we think the pipeline right now as it has been for the last six months is pretty good on acquisitions. Its just valuations haven’t come back in line where we think its appropriate yet. So we continue to be actively discussing various acquisitions in the pipeline but they just haven’t come to fruition.

Operator

Your next question comes from the line of Ashwin Shirvaikar - Citigroup

Ashwin Shirvaikar - Citigroup

I wanted to take a step back and ask you about what are your underlying economic assumptions when you say that street estimates are too high because on the one hand you did mention that revenue seems to have stabilized so if you assume stable revenues for the next couple of quarters is that fair in your mind and then on the cost front, you’ve taken an awful costs, are you at a level of operating cost that you feel is optimal for the circumstances, can you talk about that a little bit.

Michael Thompson

On the first certainly you have to look at where we are year to date and if you look at a stabilized revenue environment and stabilized economy as we indicated in the release we’re not looking at future expansion at this point in time. So combining that outlook with the work day and the holiday closures that we talked about in third quarter I think gives you a feel of where we believe it will be which is a more stable environment than we’ve seen over the last excluding the current month, going back to the previous year and being consistent from there.

We just think the job recovery which does typically lag economic recovery is going to be slow and its not going to be a snap back that we’re going to see jobs being added at a tremendous rate. So that’s our issue from that end. As far as our cost structure we feel we’re in a pretty good spot right now from a cost structure that we have right sized the organization. We do not feel that we need to add a lot of costs back in.

Certainly we have looked at the sales force and seen some opportunities but it takes awhile to train reps and get them up and ready so we’ve taken some steps there. I wouldn’t say they’ve been dramatic but we’ve started to take steps there as we’re being a little cautious in that area as well.

William Gale

One of the things that I think you need to consider is that often when you’re seeing the adds coming back at your existing customer base that becomes more profitable business. And you get some more leverage there going forward with the results. But as we have seen over the last couple of quarters we’ve seen revenue stabilization but the fact is its not coming really through adds per say as much as its coming through some new business and new offerings within existing customers.

So that’s a little bit more expensive business and that’s why you’ve seen a little bit of the margin pressure, our selling expense for example as Michael indicated was up 50 basis points. So I’m afraid what’s happening is is that one there is an expectation on the part of many analysts that there is going to be a more robust job recovery which is going to add more profitable business to us in the near-term that I don’t think we necessarily hold the same view.

And then the second thing is I don’t think that there is a true understanding that while revenues may be relatively stable the problem is is that the cost of that revenue is a little bit more expensive than just adding customers or adding wearers to existing customers. So that’s the disconnect I think that happens. Also don’t underestimate the fact that this third quarter tends to be, our third quarter tends to be more difficult because of the holiday closures, the fewer number of work days, weather issues, that sort of thing so I think that some of that has got to be factored in also.

Ashwin Shirvaikar - Citigroup

One of the points you mentioned a couple of times, the costs associated with new revenues, is that anything other than normal commissions and amortization.

William Gale

Its pretty much commissions, amortization of the new garments or the product, you also will have some additional costs relatively minor with just sizing and that sort of thing that would enter into it.

Michael Thompson

And as I mentioned in my comments, with a focus on trying to add additional services within our existing customer base we have shifted some of our focus on our sales force into selling, into certain items within our existing accounts. So those adds are paying commissions to sales reps versus strictly a straight growth add on from a customer that adds an employee.

Ashwin Shirvaikar - Citigroup

And you talked about pricing and medical costs on the call, did you quantify pricing and also what’s the outlook going forward on medical costs.

William Gale

We did not talk about the pricing because that’s a very difficult thing to quantify. It just varies across the board with different, new business versus what were selling new business for, and what we’re having to do with existing customers. So I really don’t have that data to give you I can just tell you that it has certainly been more competitive.

As for medical costs, I have no way to predict what the future will be on medical costs. We were encouraged that we did see a drop from what we had experienced in that first quarter which was just higher than we’d ever seen. Our hope is that we will continue to manage that as best we can. We want to be able to provide our employees with a good medical plan that will cover them and its really what happens with the whole cost of medical from the medical providers.

This new healthcare legislation whatever it may turn out to be we don’t know what impact that’s going to have on companies such as our who are self insured for medical. And so it really is its uncertain going out into the future. We’re committed to continue to provide a good package to our employees and we recognize that we have to manage the costs accordingly. But its very difficult to predict what will take place.

Ashwin Shirvaikar - Citigroup

Eventually when you return to growth, let’s call it late next year and into 2011 maybe, will that return to growth result in maybe at least a temporary negative impact on cash flow as you, because of CapEx going up and working capital rising.

William Gale

It will certainly impact yes working capital, we’ll definitely absorb some cash. Injection of new garments you’ll have to have that take place but as I mentioned earlier from the uniform rental perspective we don’t see a need for a lot of new rental plants so I don’t think we’re going to have the same degree of spending on plants and facilities as maybe we saw in the 90’s when we had very robust growth.

Some of our other businesses the most capital intensive the other businesses is document management from the cost of the trucks and I don’t think that’s going to cause much more capital spending than what you have seen over the last few quarters because that has continued to grow.

Operator

Your next question comes from the line of Andrew Steinerman - JPMorgan

Andrew Steinerman - JPMorgan

You talked about three quarters now of a rental business being stable and you also gave your economic comments but it seems to me that perhaps the most recent quarter that the business was a little less stable, I think I heard you correctly that lost business was a little higher sequentially in this quarter versus sequentially the last quarter. And I think you made a similar comment about new business and so is there some additional headwinds happening right now or am I not asking the question correctly.

Michael Thompson

You’re asking the question correctly, we don’t see it that way. As we mentioned on last quarter’s call we weren’t as optimistic as the numbers tend to be and the downturn that we’ve seen this quarter we think is a little bit of timing and just effort. Sometimes you get fluctuations that are a little more positive or negative but overall when you look at the final output, revenues on a same work day basis were stable and you’re going to see a little bit back and forth.

We didn’t see lost business decrease dramatically from Q1 but it was down a little bit. We didn’t see adds spike tremendously over Q1 but they did improve. So I wouldn’t look at it too much that there was a dramatic change, certainly new business has been a little more difficult but it was difficult in the first quarter as customers, as new prospects are a just a little bit hesitant to put in new programs.

We’re still selling new business but its not at the same levels.

William Gale

I would be very careful, I think Michael’s right, its kind of like minor changes in these parameters and I think sometimes people try to read too much into it. We are actually encouraged that from a rental standpoint on a comparable work day basis it was relatively flat. And I think that that’s an encouraging sign and hopefully we’ll continue to see that and then start seeing things get better as we move throughout 2010.

But I think it will be very slow.

Andrew Steinerman - JPMorgan

So maybe let me take a shot and ask you a little bit more about the February quarter and obviously you’ve given a lot of qualitative comments and we have one less business day and the factory shutdowns, seem tough, when I look at a typical February quarter historically this is your worse quarter, its down about 1%, this is rental revenues when you look at the kind of last decade. And we’re also losing a point and a half because of one less day, so my question is if we were going to quantify how much the February quarter will be down from the November quarter will it be down a lot more than normal or is it we lose the day which is one and a half percent down on rev and then we talk normal seasonality you’ll lose another point or so, but then when we try to say stepping back that’s still stable.

William Gale

You’re looking at the revenue line correctly. I would say that there tends to be in addition to what you just said a little less success on selling new business because you have the month of December and then you get into, by the time you come out of the holidays before companies really start willing to start thinking about adding new services that factors into it.

So I think that’s another issue. We’ve seen in the last year for sure, you come out of the holidays companies shut down for longer periods of time, not sure what’s going to happen here this time. I think a lot of it depends on the confidence level. And then we have some cost pressures that we experienced in our third quarter that we don’t have in the other quarters. All the payroll taxes are reset so we’ve got all that expense for all the employees in the company.

So you always see a little pick up in our SG&A spending as a result of that. Its just a number of those different things that give us reason to ask you guys to be very cautious in how you look at the third quarter.

Michael Thompson

I would agree with William, and if you look at it as you indicated, you’re correct on revenue its just we’re a little more cautious than a typical quarter and remember also when you get those shorter work day months, when you get to the margin side you have things such as material costs that’s calculated on a monthly basis or depreciation where you’re taking a full quarter hit despite one or two less work days in a quarter. So it does have an impact on the margins more extensively than just the top line.

Andrew Steinerman - JPMorgan

But are you comfortable saying that sequentially in this February quarter that revenues won’t be impacted as much as they were in February of 2009.

William Gale

No, I can’t say that. I can’t say that’s true, I can’t say its false. I don’t really know.

Operator

Your next question comes from the line of Vance Edelson - Morgan Stanley

Vance Edelson - Morgan Stanley

So one more question on your point that analyst estimates are too high, is that specifically referring to the quarterly estimates that you see out there going forward or are you thinking of that partially in terms of the 2010 fiscal year and if that’s the case how much of the rejiggering that’s needed is simply because second quarter results already feel shy.

William Gale

I think I see it in all, the answer to all your questions for the next several quarters as well as I mentioned in my opening comments even into 2011. And its not just because we missed supposedly the estimates for this quarter. I think there was just too much optimism in those numbers.

Vance Edelson - Morgan Stanley

And then you mentioned that you’re adding new customers which is helping to offset other revenue declines, and yet your competitors are cutting prices and it sounds like they’re doing what’s necessary to hold onto their customers as best as possible, so could you elaborate on the competitive dynamics that are allowing you to add customers when you do add them. Is it essentially a matter of taking market share from smaller less well capitalized players and is that becoming easier.

William Gale

Yes it is becoming easier so we are taking market share not only from them but also from some of the bigger competitors. But certainly the little guys are having more difficulty. And I think we’re also finding that there are still companies that are willing to take on the service so its not like our whole source of no programmers has totally dried up. That’s not the case. We are still selling to no programmer business, its just not nearly what it used to be.

Vance Edelson - Morgan Stanley

When you think about the pricing pressures across your business where are they most pronounced among the various business lines.

William Gale

The uniform rental and facility services rental have been probably the most impacted. We saw in the second quarter our fire service business, there was a fairly dramatic competitive increase in competitive pressure there also.

Operator

Your next question comes from the line of Vishnu Lekraj - Morningstar

Vishnu Lekraj - Morningstar

Looking at what you’ve been saying or listening to what you’ve been saying in terms of what you expect over the next half year to 12 months and the recovery in manufacturing and goods producing industries, how that’s going to impact your revenues going forward are you looking to explore moving outside or building more service type customers into your customer base to motivate growth going forward.

William Gale

Yes, absolutely. We are looking at our strategic direction to identify those industries that will provide greater opportunities for growth over the next five to 10 years. And we are going to see what we can do to develop products or service offerings that appeal to that type of customer.

Vishnu Lekraj - Morningstar

Specifically though with the uniform rental are you looking to move into more hospitality, move into healthcare which seems to be resilient in terms of jobs.

William Gale

Absolutely, we have mentioned that before that that has been one of our strategies is to identify how we can convince those types of companies that have traditionally always bought uniforms or had their employees buy their own uniforms as is the case with healthcare, what the value of perhaps a rental program could be and we’ve got some experiments going that are showing some promise. And we are hopeful that that will provide a new avenue for growth down the road.

Michael Thompson

We have been doing that as well [inaudible] healthcare but over the last five or six years of manufacturing jobs have left the US for abroad, we’re able to go to that environment mainly because we took our uniform programs and developed them for other industries so we’re certainly doing that and continue those efforts.

Vishnu Lekraj - Morningstar

Should we expect then maybe some higher costs associated with the selling of those newer garments to newer customers.

William Gale

Not necessarily, I think its more of a having the right type of products and convincing those type of customers the value of what a program like that can bring to them.

Michael Thompson

Its certainly a longer sales process in the beginning when you first enter a new industry or have a new product offering for an industry to educate those first few customers and them taking that product but as far as the actual cost itself it would be about the same from a sales cost perspective.

Vishnu Lekraj - Morningstar

I want to drill down a little bit on your uniform direct sales have you heard anything from your customers in terms of they expect to start spending here in the next over 2010 or is there’s just no communication between yourself or they haven’t said anything to you.

Michael Thompson

We’ve had a lot of discussion with customers and from what we have seen in the uniform direct sale market is a lot more discussion on their part of future plans. The difficulty we have is that until they actually pull the trigger, its hard to say when that’s going to be because they are more discretionary in nature and they can always push those programs back six or nine months.

But I would say the activity is certainly picked up. There is certainly a lot more discussion about new redesigned programs, not so much as openings although there has been some talk of that, but redesign of brands, upgrading of, freshening up of programs so to speak but again we’re cautious there because we want to make sure that until they see their revenues beginning to increase its going to be difficult for them to make that spend but we are encouraged somewhat at least they’re having those discussions now.

Vishnu Lekraj - Morningstar

So just to clarify that we probably could expect a little bit slower growth within that service line than we’ve seen in the past due to the nature of what’s going on with those type of customers, correct.

William Gale

I think at this point that’s probably a fair assumption because I think many of those types of industries are sitting on the sidelines talking about a lot of things but not doing it much yet.

Operator

Your next question comes from the line of Andrea Wirth - Robert W. Baird

Andrea Wirth - Robert W. Baird

I wanted to first dig a little bit more into pricing, I just want to make sure I’m thinking about this the right way, is it fair to say that most of the pricing pressure is coming in on the renewals so maybe its call it 20% of your rental business right now is seeing some of the pricing pressure or is that not necessarily the right way to think about it.

William Gale

I think you’ve got to look at it, its not just on the renewals its on the new business, its on the, even within a contract being able to convince a customer to accept a price increase is more difficult so it really runs across the whole board of business.

Andrea Wirth - Robert W. Baird

And at this point should we consider the pricing levels now to be the permanent levels going forward or is there actually the opportunity for pricing to go back up from here.

William Gale

It could go back up but I think it could also go down.

Michael Thompson

Certainly people are being more aggressive today be it competition to maintain and generate some cash flow to cover their fixed costs. Certainly customers today are being much more cost conscientious than they have been in a growth economy. We would hope that the pricing would rebound, will it come back to levels before, that’s difficult to say but once growth returns typically what does occur is at least from a customer standpoint they’re not looking strictly at cost at least not as hard as they are today.

Andrea Wirth - Robert W. Baird

And just in terms of the actual contract terms are you seeing any changes there, customers looking for shorter terms, anything going on in that front.

William Gale

We occasionally get requests on that but we are holding pretty firm on that. That’s not in the best interest of the industry to allow that to happen because the investment that one makes in all the uniforms so while there might be some inquiries, I don’t see much of that happening in reality.

Andrea Wirth - Robert W. Baird

And in terms of your sales force and then adding to the headcount there, is the headcount actually up year over year now for your sales force.

William Gale

Yes.

Andrea Wirth - Robert W. Baird

And so then in terms of just the increased costs, we should probably assume that there’s a little bit of a headwind for call it the next 12 months or so.

William Gale

At least that yes, because we also as we continue to see opportunities down the road it takes awhile to get people trained and in place and we’ve got to invest in that future. So yes, there is going to be some headwinds for a little while until we start really seeing some nice growth coming from not only new business but also existing customers.

Andrea Wirth - Robert W. Baird

And just looking at the energy costs going forward into next quarter is it probably fair to say that those are a little bit higher just given what we’ve seen on the natural gas front and a little bit higher on diesel and gasoline.

William Gale

You tell me what’s going to happen with diesel gasoline and natural gas for the next three months and I’ll tell you whether that has an effect on our quarter. It is what it is so we’ve done a lot to try to become efficient but we can’t predict what’s going to happen with energy prices. We were happy to see they were stable from the first quarter to the second quarter. And they are going to fluctuate up and down but hopefully we’re going to stay within a reasonable range.

Operator

Your next question comes from the line of Gary Bisbee - Barclays Capital

Gary Bisbee - Barclays Capital

First of all Happy Holidays, first one can you clarify for me the commentary you’ve made the last two quarters on the add/stops, are you talking that its up sequentially a bit in each of the last two or is it up year over year and is the right way with revenue being flattish ex the work day changes, is the right way to think about it that sales or new business activity is down in equal amounts to offset the improvement in add/stops.

Michael Thompson

Its kind of a mixed bag but it is sequentially that we’re talking about although because these were two straight add quarters, they are up year over year as well. But we are talking sequentially. Also when you talk about directionally what’s occurring you are right that the adds are making up more of the growth so to speak to offset the job loss.

Lost business has been pretty consistent, its better than last year sequentially it was down a little bit. New business I would say that the adds are making up more of the lower new business as well as the price increase pressures that we talked about. So price increases have taken a hit and new business as well if you go sequentially and those adds are offsetting that.

William Gale

Keep in mind I just want to make sure everyone understands when we talk about adds we’re not just talking about additional uniform wearers, we categorize an add as adding an entrance mat to an existing customer, adding some hygiene services so adds to us include everything from new uniform wearers to new entrance mats, new hygiene services, etc.

Gary Bisbee - Barclays Capital

And so that would explain why there could be incremental costs associated with it.

Michael Thompson

Right, especially when you take those sales reps and they go in and sell them new service but its to an existing customer. In a normal situation you may have a uniform wearing customer, they hire three people, there’s a little bit of commission there for the driver but not like it would be to send the sales rep in selling a new service.

Gary Bisbee - Barclays Capital

Let me just ask you a big picture question then, you’ve clearly proven in the past that uniform acquisitions can be nicely accretive over time but in the last couple of years you’ve been much more focused on documented first aid, safety, fire acquisitions. When you think about this great balance sheet that you’ve got right now, how do you weigh the benefits of continued diversification to the business overall versus opportunities to gain market share within the core uniform business. My take is I think investors would be more pleased to see more diversification but given that there can be good accretion from uniforms, how do you think about that and can you give us any guidance on what we might expect.

William Gale

That’s a good question and we really study that continuously and we look at all these different alternatives and I think one of the interesting things that people maybe don’t necessarily realize is that when you look at an acquisition you also take into consideration what you perceive the future environment to be. And while acquisitions in uniform rental may have looked attractive in just general terms two years ago as we began to see the weakness in the business starting to come about we didn’t want to buy a company like the uniform rental business and then find out that a year later we only had 80% of what we thought we were buying.

So you’ve got to be very careful there and I think on the part of the sellers they didn’t have that expectation and wouldn’t factor that into their expected price that they were going to see a downturn in their revenues. So I think you’ve got to look at an acquisition in light of what you expect it to perform for you over the near-term as well as down the road and what synergies you can get and we are not against buying any additional uniform rental companies.

In fact we would be interested in doing it at the right value in light of the current, at least our expectation of what the economic environment is going to be. So I think that we feel that we have the ability and the financial wherewithal to probably do both, to pick up some nice uniform rental companies to also expand offering, look for additional acquisitions in fire and first aid and document management.

And even start thinking about, okay what is the next document management service that we want to have and should we start thinking about buying a player in that and then doing a rollup like we’ve done with some of the other businesses. I think we’re big enough, we’re strong enough to be able to do all of those things and we’ve got people working on each one of those within the company.

Gary Bisbee - Barclays Capital

Help us think about currency impact going forward, can you remind me what percent of your revenue is from Canada these days.

Michael Thompson

Its under 10%, we don’t give an exact percentage but its under 10% and in this quarter the Canadian dollar really didn’t move much, there was a very minor impact so again—

William Gale

Our European business is relatively, is still very small.

Gary Bisbee - Barclays Capital

Obviously you’re spending on like increasing the inventory at uniforms has been down as the uniform business has slowed, should we have any expectation that we’re going to see amortization from big programs you may have started 18 months ago fall off and is that likely to be a benefit any time in the near-term or is that already—

Michael Thompson

You wouldn’t see a significant change quarter to quarter just because no one customer is a huge customer and but certainly unless growth picks up higher, you’re going to see either stable or down number there because the amortization will continue to roll and your injections on existing customers isn’t as great as new business injections.

So you’ll see some stabilization but it won’t drop quite as quickly because the revenues are stabilizing but again you won’t see any one time dramatic change because we don’t have any one customer that large.

Operator

Your next question comes from the line of Nate Brochman - William Blair

Nate Brochman - William Blair

Happy Holidays gentlemen, just wanted to kind of ask you a wrap up question if I could and that is combination of everyone else’s questions but what I get the sense is we’re entering the seasonally slow period, we’re being a little bit cautious, we’re adding back a little bit to the cost line, but yet overall you still feel pretty good about the overall trends, maybe not as rapid as people would have hoped in terms of imbedded in estimates but yet we’re still past the negative inflection point, moving positively and the overall thing that I take away is that you are adding the sales forces again which means that one, you can use your stronger balance sheet to become more aggressive relative to your competition not just on pricing but in terms of the sales effort, but two it really does signal that better times are ahead and we can keep the positive trajectory of trends rather than worrying about kind of going negative again, is that kind of the general way to think about all the comments.

William Gale

I would absolutely agree with what you said. I think the only thing I would caution is again I don’t want to beat a dead horse here, but I just don’t think you’re going to see this rapid addition of, into the work force in this country and therefore all of the adds that we’re going to get as a result of our customers adding on business.

I think its going to be relatively slow but on the other hand it is not the doom and gloom that many people were predicting nine months or 12 months ago. And I absolutely agree with that, that we have turned the corner. Our management here, we’re still very bullish on our business. We have demonstrated that this is great cash flow business and we’re very pleased to do what we do and we think that being the strongest company in all the businesses that we’re in that we are in the best position to really take advantage of what’s going to happen as the US economy and let’s say the North American economy continues to improve.

So I would completely agree with what you said.

Nate Brochman - William Blair

And while at the end of the day the breaking profile of economic recovery is certainly open to debate in any conversation with any customer or any company, any client right now, the fact though that you are adding more aggressively, you have a lot of different bullets in terms of whether its acquisitions or new service offerings, and the fact that you do have a fair amount of leverage in your model, again while the pace of earnings growth might not be as optimistic as we might have thought going into this call, it feels that the future is still pretty bright with all those things especially on a comparative basis.

William Gale

Yes, you are right on that, absolutely.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

William Gale

Thank you all very much for joining us this evening. We really appreciate your continued interest in our company. And we would like to wish all of you and all your family a very joyous holiday and a prosperous 2010.

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Source: Cintas Corporation F2Q10 (Qtr End 11/30/09) Earnings Call Transcript

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