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Cintas Corporation (NASDAQ:CTAS)

F3Q10 (Qtr End 02/28/10) Earnings Call Transcript

March 18, 2010, 5:00 pm ET

Executives

Bill Gale – SVP and CFO

Mike Thompson – VP and Treasurer

Mike Hansen – Corporate Controller

Analysts

Ashwin Shirvaikar – Citi

Justin Haki [ph] – Robert W. Baird

John Healy – Northcoast Research

Nate Brochman – William Blair

Scott Schneeberger – Oppenheimer

Gary Bisbee – Barclays Capital

Greg Halter – Great Lakes Review

Andrew Steinerman – JP Morgan

Operator

Good day, everyone, and welcome to the Cintas quarterly earnings results conference call. Today’s call is being recorded. At this time, I’d like to turn the call over to Mr. Bill Gale, Senior Vice President of Finance and Chief Financial Officer. Please go ahead, sir.

Bill Gale

Good day and thank you for joining us for our discussion of our third quarter fiscal 2010 results. For the quarter ending February 28, 2010, total revenue was $862 million, a 3.7% decrease from the third quarter revenue of fiscal 2009 when adjusting for the one less work day in this year’s third quarter versus last year. Earnings per share were $0.32 versus $0.47 a year ago. This is $0.01 higher than the upper end of our previously issued guidance.

We are pleased to see the stabilization in the economy and the significant reduction in job losses. In fact, our total revenues have been relatively comparable over the last four quarters when adjusting for work day differentials. We find this development encouraging, but at the same time, we expect job recovery to be sluggish.

We have updated our internal estimates with our third quarter actual results and continue to believe that our previously released fourth quarter guidance is appropriate. Therefore we are reiterating our guidance for the fourth quarter of revenue between $870 million to $890 million and earnings per diluted share of $0.30 to $0.34.

Our businesses have been greatly impacted by the large number of job losses and facility closures that have occurred since early in calendar 2008. During this time, we continue to focus on taking care of our customers, but working also to reduce our cost structure and conserve cash. The price environment remains extremely competitive.

Despite the most significant recession since the 1930s, we are pleased to report that our financial condition has strengthened, leaving us with over $550 million in cash and marketable securities and with no short-term debt. Our ratio of net debt to capitalization improved to 9%, down from over 21% a year ago.

Reflecting the strong cash flow and confidence in our business, last week we paid an annual dividend of $0.48 per share, continuing our practice of raising the dividend every year since going public in 1983. We continue to be very disciplined in making acquisitions, but continue to search for great opportunities at good values.

During this quarter, in addition to some small US-based document management and fire service acquisitions, Cintas expanded its presence in the Document Management business in Europe by purchasing a company in Belgium. Combined with our prior European acquisitions in the Netherlands and Germany, we continue to see great opportunities with this business in Northern Europe.

We wish to express again our sincere appreciation to all of our employees who we call partners. They are to be complimented for their unwavering focus on taking care of the customer and making Cintas the strong company it is and will continue to be.

With me today is Mike Thompson, Cintas’s Vice President and Treasurer, and Mike Hansen, Cintas’s Corporate Controller. After some comments from Mike Thompson and Mike Hansen, we will open the call to questions.

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.

Mike Thompson

Thanks, Bill. I will talk about our income statement. Our third quarter had 64 workdays, one less than last year’s third quarter as well as this year’s second quarter, both of which had 65 workdays. Total revenue for the third quarter of fiscal ’10 was $862 million and represented a 3.7% decrease from the third quarter of last year on an adjusted workday basis. As compared to this year’s second quarter, revenue declined 1% on an adjusted workday basis.

While US job losses and revenue pressures continue, new business sold to prospects and to existing customers has generally offset these losses, allowing total revenue to be stable over the last four quarters on an adjusted workday basis.

Total company internal growth was negative 3.6%, an improvement from second quarter internal growth of negative 10%. As a reminder, there are 66 workdays in this year’s fourth quarter. Note that in fiscal 2011, workdays will actually be the same as fiscal 2010. That means there will be 66 workdays in Q1, 65 in Q2, 64 in Q3, and 66 in Q4.

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. Uniform Direct Sales; First Aid, Safety and Fire Protection services; and Document Management services are combined and presented as other services on the face of the income statement.

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 72% of company revenue in the third quarter.

Rental revenue was $622.5 million for the quarter, a 6.3% decrease as compared to last year’s third quarter on an adjusted workday basis and down 1.8% as compared to last quarter on an equivalent workday basis. The sequential decrease of 1.8% is largely due to the impact of holiday closures and weather related issues. Internal growth was negative 6%, an improvement from second quarter internal growth of negative 9.5%.

While still declining, US job losses have moderated. This moderation of job losses as well as of our efforts to maintain our existing customer base as a result of an improvement on a loss business metric and the stops within our ad stop metric as compared to both last year’s third quarter and this year’s second quarter. However, achieving new business and traditional customer adds continues to be difficult in an economy where jobs have not yet been added.

Competitive pricing in the marketplace for both customer retention and new business continues to be aggressive. However, as long as it makes economic sense, we will continue to vigorously fight our competition in the marketplace. We are protecting our market share, and our customer satisfaction level remains high.

Our Uniform Direct Sales operating segment includes the direct sale of uniforms, branded promotional 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 catalog.

Uniform Direct Sales revenue accounted for 11% of company revenue in the third quarter. Revenue levels in this segment continue to be soft, as customers are maintaining uniform programs, but few are upgrading or refreshing them. Last year’s third quarter marked the most dramatic sequential revenue decline in this business during the current downturn. We are now 12 months out from that decline.

Internal growth was negative 1% in the current third quarter. While growth has not returned, we have seen stabilization in this business. The third quarter internal growth rate of negative 1% marks a sizable improvement from the 17% decline last quarter. Looking forward, we continue to believe further economic stabilization needs to occur before customer spending under these more discretionary types of programs returns 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 revenue accounted for 9% of company revenue in the third quarter.

During the quarter, revenues within our First Aid, Safety and Fire Protection services operating segment decreased 8% versus last year’s third quarter. Internal growth was negative 6%, an improvement from negative 17% last quarter. As with Uniform Direct Sales, last year’s third quarter marked the most dramatic sequential decline in First Aid, Safety and Fire Protection revenue throughout this economic downturn. Going forward, we expect to see better year-over-year revenue comparisons.

The first aid and safety revenue in this segment decreased 5% from last year’s third quarter and was down slightly compared to the second quarter, excluding the normal holiday impact. Fire protection services revenue was down 12% from the third quarter of last year. However, fire services revenue increased 7% over the second quarter as we continued to focus on test, inspection and repair service.

Our Document Management services operating segment includes document destruction, storage, and imaging services. Document Management increased 8% of third quarter total company revenue, up from 7% in the second quarter. Revenue increased 29% over the third quarter of fiscal 2009 and 10% over the second quarter of this year. Internal growth was 27%.

Recycled paper prices strengthened significantly during the third quarter and accounted for the significant lift in the internal growth rate from 9% in the second quarter to 27% in the third quarter. When excluding the impact of recycled paper revenue, internal growth for document destruction service and purge business was a robust 15%.

We continue to expand our geographic presence. And as Bill mentioned earlier, we have expanded into Belgium. While small relative to the company in total, our European businesses are performing to expectations. We continue to look for additional document management acquisition opportunities, both domestically and abroad.

Turning to margins, we continue to actively manage our cost structure in order to maximize results during this challenging environment. Total company gross margin for the third quarter was 41.7% a 30 basis point improvement from the third quarter of last year. This improvement came in spite of a 20 basis point increase in energy cost from last year’s third quarter.

Third quarter total company gross margin decreased 10 basis points from the second quarter. However, total energy cost increased 40 basis points from the second quarter to the third quarter. Rental gross margin of 42.7% was down 110 basis points from last year’s third quarter. Lower revenue levels and one fewer workday this year compared to last year’s third quarter pressured rental gross margins. In addition, energy costs increased by 20 basis points. However, as compared to last year’s third quarter, expenses were reduced by $23 million on a dollar basis.

Rental gross margin declined 80 basis points compared to the second quarter. Energy cost increased 50 basis points in the third quarter compared to second quarter. The one fewer workday in the third quarter also contributed to the lower margin. Other services gross margin was 39.2% for the quarter as compared to 34.7% in last year’s third quarter and 37.3% last quarter. All operating segments within other services had gross margin improvements compared to last year’s third quarter and compared to the second quarter.

Uniform Direct Sales gross margin improved significantly from last year due to our cost savings initiatives of the past year and the right-sizing of the organization. Gross margin improved slightly from last quarter. However, gross margins continue to be stressed relative to historical levels due to lower fixed cost absorption from lower revenue levels and fewer new program redesigns and rollouts.

Third quarter First Aid, Safety and Fire Protection margins improved primarily due to the elimination of the lower margin fire installation business over the past year. Document Management gross margin improved primarily as a result of recycled paper prices. Gross margins also benefited [ph] from revenue gains, allowing local operations to cover larger portion of their fixed costs.

Selling and administrative expenses were 32% of revenue, an increase from 28.3% for the third quarter last year. In addition to the impact of lower revenues and one less workday, selling expenses increased by 120 basis points compared to last year’s third quarter. Sales commissions paid on ads where the sales force was involved have increased.

Traditionally, as it occurred, when our existing customers hire additional workers and/or add additional services for growth reasons. Unfortunately, this is still not the case today. Rather, the primary adds, which we are achieving by selling new and different products and services to our existing customers and in many cases using our sales force to obtain this further customer penetration. We also continued our planned increase in sales force headcount. As the economy stabilizes, we have positioned ourselves to take advantage of opportunities, as they begin to arise.

In addition, medical expenses increased 80 basis points compared to last year due to higher employee utilization of the medical plans. Sequentially SG&A increased from the second quarter mainly due to a combination of the reset of payroll taxes on January 1st, the increased planned investment in selling, and an increase in medical costs.

Our effective tax rate was 32.8% 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 decreased during the third quarter due to the timing of reserve requirements, but then returned to higher 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 37.3%.

And now Mike Hansen will discuss our balance sheet and cash flow.

Mike Hansen

Thanks, Mike. Our balance sheet continues to get stronger, primarily due to robust cash flow. Our cash and marketable securities increased almost $72 million from November 30th. Over the last 12 months, we have increased our cash and marketable securities on hand by over $390 million and paid an annual dividend of $74 million.

DSOs on accounts receivable were 39, an improvement from November’s DSOs of 41. We continue to aggressively manage our accounts receivable in order to lessen any impact from current economic conditions. New goods inventory levels at February 28th were consistent with the levels at the end of the last quarter. We believe current levels are appropriate based on our current revenue level and mix. Net property, plant and equipment balances increased slightly from November 30th to $895 million.

CapEx through the first nine months of this year was $79 million, including $31 million in the third quarter. This is about 60% of the amount we spent through nine months of last year when CapEx was $133 million. Accrued liabilities increased as of February 28 due to the $74 million accrual of the annual dividend, which was paid on March 10. The dividend of $0.48 continued the company’s track record of increasing the annual dividend every year since going public in 1983.

Long-term debt at February 28 remained at $786 million, as all outstanding debt is now fixed rate. Any early retirement of this debt will require a prepayment penalty and is not currently attractive. Our average rate on the outstanding debt is approximately 6%. Total debt as a percentage of total book capitalization remained at 24%, while net debt or long-term debt less cash and marketable securities as a percentage of total capitalization improved to 9%.

As mentioned earlier, our cash flow continues to be strong. Through nine months we have generated over $275 million in cash and cash equivalents. Acquisition activity has picked up to some degree, as we spent $35 million during the quarter with acquisitions primarily in document management and fire, repair and inspection services.

Our combined cash flow, current cash balances, and access to additional capital had provided us the ability to weather the economic difficulties of the last 18 months and are allowing us to now begin to act on acquisition opportunities that become available at attractive valuations.

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

Question-and-Answer Session

Operator

Thank you. (Operator instructions) And we’ll take our first question from Ashwin Shirvaikar with Citi.

Ashwin Shirvaikar – Citi

Thanks. Hi, Bill, Mike and Mike.

Bill Gale

Hi.

Mike Thompson

Hi, Ashwin.

Ashwin Shirvaikar – Citi

My first question is, is it possible for you guys to talk a little bit more quantitatively about the things such as pricing and ad stops [ph] in ballpark? I know you don’t give exact numbers, but in ballpark.

Bill Gale

Well, generally speaking, I would tell you that ads have improved over the last couple of quarters to basically equate to the stops. So we are very close to having a neutral impact on that for several weeks over the last couple quarters. So that’s a positive sign. Now, keep in mind, some of those ads -- or a lot of those ads are not necessarily new wares, but rather our additional products and services at existing customers. As far as pricing is concerned, I think as we mentioned in our comments, it continues to be very, very competitive. And we are finding it probably one of the most aggressive price environments that we have seen for quite some time. Meaning that many of our competitors are in our customers at the end of a contract and offering very low prices.

We are finding some difficulty in obtaining price increases during the contracts themselves. And as we get new business, we are often meeting very competitive environment and having to basically get business with lower prices than what we would have seen several years ago. We think a lot of this is due to the desire on the part of our competitors to keep volume in their facilities and cover their fixed costs. So we expect this to continue for some time, but hopefully we will resume to more traditional pricing in the not too distant future.

Ashwin Shirvaikar – Citi

And on the pricing, is that fairly widespread across small and large competitors or is it more of a smaller -- more the larger national competitors?

Bill Gale

Well, I would tell you, some of the larger national players are really the ones who are most aggressive. But in order to keep business, we are finding local and regional players are having to meet much of this price competition also.

Ashwin Shirvaikar – Citi

Okay. And then one question on Document Management. Can you maybe break out -- as you grow the storage piece, break out the destruction versus storage?

Bill Gale

Ashwin, we will intend to break that into further segments as they get larger. At this time, we’re just going to report on the Document Management business in total since it’s just about 8% of our revenue. But given its growth and its growth potential, I would say that at some point in the future we will be giving more detail there.

Ashwin Shirvaikar – Citi

So what I was leading with that was what kind of incremental CapEx investment do you need on the storage side?

Bill Gale

Well, we are really not very aggressive on the storage side. Our growth is primarily coming from shredding side. So our capital spending is mostly with trucks and with plant-based shredding and bailing systems.

Mike Thompson

The revenue is still predominantly from the destruction side of the business.

Ashwin Shirvaikar – Citi

Right, right. And last question, any update on (inaudible)?

Mike Thompson

On Suda [ph], certainly it’s across the board we’ve seen increases, but it varies widely. So we’ve certainly seen an increase not only with the reset of payroll taxes, but certainly some of the preliminary hits we’ve seen coming through on the state have been significantly higher. We don’t have a good quantification efficacy. We are still seeing the impact of those. From the healthcare side, certainly we don’t know what’s going to happen with the healthcare legislation coming up this weekend. But we’ve certainly seen some increased usage in this quarter by our employees again. It tends to ebb and flows. There is no real reason other than we have a medical plan our employees are using it.

Bill Gale

And keep in mind, most of the costs that we are seeing in the third quarter tends to be late in calendar ’09. And as you get near the end of a calendar year, employees often will use more medical expenses than they otherwise like. But I will remind you that our medical expenses in the first quarter were about 4.4% of our revenue, dropped in the second, but then kind of came back up to this level of 4% here in the third quarter. So it is something that we are continuing to monitor, and we had some plan changes go into effect January 1 that we believe will help us control costs as we move through 2010, but they really haven’t get yet.

Ashwin Shirvaikar – Citi

Okay. Thank you, guys. Very useful.

Operator

And we’ll take our next question from Justin Haki [ph] with Robert W. Baird.

Justin Haki -- Robert W. Baird

Good evening, guys.

Mike Thompson

Hi, Justin.

Bill Gale

Hello.

Justin Haki – Robert W. Baird

Hi. My question really is on the rental operating margin. I mean, it fell 400 basis points sequentially. I know a lot of that was on the SG&A side just from the added headcount that you have. But I was hoping that you could give a little more color on what your expectations are kind of for 4Q and really for the first half of ’11. I mean, do we -- is it wrong for us to assume that things get better from here or do they kind of hover at this level?

Bill Gale

Well, I think a lot of it depends on what happens with the top line. If we continue to see stabilization in the business, I think you will see improvement in those margins, assuming that there is no big energy spike -- energy cost spike. So our expectations are that we will begin to see some leverage on those margins as we go forward. And we are hopeful that that will take place.

Mike Thompson

Additionally, you also have the third quarter is a little different because of the workdays. So again, depending on what happens with the economy going forward, we would hope to get some benefit Offsetting that, obviously we will have some selling costs because we are keeping the sales force if you’re looking at operating versus gross margins pretty active.

Justin Haki – Robert W. Baird

I guess, I mean, just to push on a little bit more though. I mean, with your commentary that pricing is so aggressive and you are having to kind of take a haircut on some of your new business that you’re bringing in, I mean, even if we do see some employment growth, I mean, are we talking about maybe margins improve 100 basis points over the next couple quarters or is that too aggressive?

Bill Gale

We are not prepared to quantify the amount at this time.

Justin Haki – Robert W. Baird

Okay. And then another question, just on RFID, I know you guys have talked about that in the past, any update on just your thinking on that? Is that an investment you still consider pursuing?

Bill Gale

Yes, we are still very interested, and we are continuing to evaluate various chips and various processes within our R&D group. I can tell you that right now we do not have a viable economic solution, but we still think the potential exists and we are continuing to invest in looking for that.

Justin Haki – Robert W. Baird

Great. Thank you very much.

Operator

We will take our next question from John Healy with Northcoast Research.

John Healy – Northcoast Research

Hi, good evening, guys.

Bill Gale

Hi, John.

John Healy – Northcoast Research

I wanted to talk a little bit about the balance sheet and the cash flow. You guys continue to generate a lot of cash and make the balance sheet even more pristine than it has been in the past. I wanted to talk a little bit about what you feel like your access to credit is right now in terms of the cost and the flexibility to take a commercial paper and maybe what your (inaudible) of debt, what do you think the credit markets would -- what that would cost you, and kind of how you feel about taking leverage of this company in the future and maybe kind of your thoughts on capital allocation kind of going forward from here?

Mike Thompson

Sure. I’ll start and then Bill will also jump in if he can. Certainly we believe our access to capital has never been better. The market has stabilized. We have $600 million CP line out there being untapped really because there is no reason to tap and put on the balance sheet. We continue to look at acquisition opportunities, but certainly we have plenty of cash in our balance sheet to use. Historically, we’ve gone as high as a 35% to 40% debt-to-capital, and we’re comfortable with that. Right now, our net debt-to-capital is less than 10. So it gives us a lot of space to move.

And looking at the current markets, we are certainly in constant communication with our banking group, and we believe we could easily float quite a bit of debt, easily $500 million to -- even up to $1 billion that would do the CP line, not that we hate it today, but you’re talking rates in the 5.5 to 6.0 range depending on the term. Our name in the market has been very good. Whenever we floated CP, it’s never been an issue to put it out to the marketplace and get favorable rates. It’s just funding the opportunity for the need for that cash, and we believe there will be an opportunity in the future.

Bill Gale

As far as capital allocation, our current thought continues to be to invest for growth in the company, both for internal growth as well as for acquisitions. You notice that we did ramp up the acquisitions a bit in the third quarter, as opportunities presented themselves that had been not really there earlier in the 2009. And we expect that to continue. So if we cannot make good acquisitions and utilize this cash that would be in the best long-term interest of our shareholders, then the Board is committed to look at other ways to get return back to our shareholders. That means by our stock, increasing the dividend, whatever it will take to make sure that we generate an adequate return for the shareholders. But right now, we believe that acquisitions will become more and more available at reasonable prices in the not too distant future, and we hope to take advantage of that.

John Healy – Northcoast Research

It’s very helpful. And then I want to ask you guys a little bit about the gross margin potential for kind of the current uniform business. I was wondering if you could kind of put some thoughts around when we should begin to kind of see some more (inaudible) we are going to see some improvement on the rental gross margins. And I thought being at some point in time, when you begin to anniversary some of the larger losses of customers in your business and some of those (inaudible) that have been in merchandising service become fully amortized that maybe aren’t being put in place right now. You should have some gross margin recovery, even if revenues remain pretty -- revenue growth remains pretty muted. Are we thinking about that right, and maybe your thought process on when that should begin to be seen in the results?

Mike Thompson

You are saying about that right. Remember, we’ve had to adjust our cost structure dramatically over the last 18 months and done a decent job of doing that given the revenue declines. Certainly, when you rotate that fixed cost we have in place, we remain such that when the revenues grow or stabilize, we will see some other benefits of what we’ve been doing internally. Right now, job losses continue; revenues are still declining to some degree although lessened as far as existing business. So there is still that churn effect going on within Cintas of profitable business of 15 men uniform going to 13 men, while I’m adding in new services, so I’ve got a kind of a double hit and I’m losing profitable business and adding in the first share of an agreement where it’s pretty expensive.

As you move forward depending on how much new business you sell with that material cost impact is in the sale cost. You should see gross margins improve especially because of selling below the gross margin line. So we expected to improve again depending on what goes on the marketplace. We need the job loss to be stable at zero versus continuing to drag down. Let’s see if we are getting closer to that. But every time we think the next month is going to be the zero month; it’s still a little bit down. So hopefully we will get there.

Bill Gale

We’ve got excess capacity in our plants and in our routes and obviously within our stock rooms, meaning that we have a lot of garments that are continuing to be amortized that could -- that aren’t generating any revenue. So if -- as Mike just said, if we just get stabilization with an existing customer, you are going to see an improvement in gross margins just from that because we will not have to keep shuffling around trying to advantage the capacity as much as we are having to do. So I think that’s the first sign of really an improvement. And then as we can obtain other new customers and begin to make those customers profitable by growing with them, start seeing some churn in the work force, which generate additional revenues for us, people leave jobs and go to other jobs, I think that you will see an improvement going forward.

Mike Thompson

And the other piece behind that obviously is with that capacity that we have begun utilizing a little better. There is -- we don’t believe there needs to be a significant increase in CapEx or cash flows to just continue to be very positive.

John Healy – Northcoast Research

When I think about kind of free cash flow maybe going out maybe a year -- or maybe a year or two, is it realistic to think that the capacity that’s still in the business that CapEx should remain at lower levels and maybe historic levels for the intermediate timeframe?

Bill Gale

It should as long as couple things. Again, we have a very localized service model. So if one market or geographic area would spike, there could be some additional capital required or we were to expand with quicker document management or something or we need to access or obviously not free cash flow, but from acquisitions you could use some cash. But I’d agree to your statement.

John Healy – Northcoast Research

Okay. Thank you, guys.

Bill Gale

Thank you.

Operator

And we’ll take our next question from Nate Brochman with William Blair.

Nate Brochman – William Blair

Good evening, gentlemen. Nice quarter.

Bill Gale

Thank you, Nate.

Nate Brochman – William Blair

Hey, why don’t you expand a little bit more on some of the additional services that you are able to sell into your existing customer base? Obviously, that’s probably a nice trend in terms of over the last couple of years building out some of those service categories. And I was just wondering why it seems like right now in terms of that’s gaining a little bit of added traction.

Bill Gale

Well, I think it’s gaining traction. A couple perspectives. One is our traditional focus on our part to do it. As Mike mentioned in the commentary, we are now utilizing our professional sales force in addition to our service group to sell into existing customers. So I think that’s helping. I think the second thing is that there is a broader offering of products and services than we’ve ever had in the past. So we have more appeal to customers of doing other things for them. And I think the third thing is that I believe there is a better feeling of what the future holds on the part of our customers and what things look like a year ago or so. So people are beginning to gain some confidence. They are still being conservative, but they are willing to take on some additional offerings now, but maybe a year ago they absolutely were not.

Nate Brochman – William Blair

Okay. That’s very helpful. And then kind of a follow-on question to that would be, if indeed the customers are starting to feel a little bit better, are you starting to get that sense from maybe some of the non-programmers out there in terms of warming up to investing again back in the uniform program, at least in terms of like the sales cycle there?

Bill Gale

Nate, in hearing from our sales force, we are hearing there is a lot of interest, and more interest now than there was a year ago or even six months ago. I haven’t really seen it in the numbers yet. But at least as far as interest in verbals, there seems to be some momentum moving forward.

Mike Thompson

Attitudes seem to be much better. I wouldn’t say they are extremely positive, but they are not negative anymore. So they are certainly moving in that direction.

Nate Brochman – William Blair

That’s great. Well, it sounds like everything is moving in the right direction, and nice job.

Mike Thompson

Thank you.

Operator

We will take our next question from Scott Schneeberger with Oppenheimer.

Scott Schneeberger – Oppenheimer

Thanks. Good afternoon.

Bill Gale

Hi, Scott.

Scott Schneeberger – Oppenheimer

Could you guys address what type of weather impact you incurred in the quarter and how you think that may impact the fourth quarter?

Bill Gale

We actually were pleasantly surprised that the weather had a relatively minor impact on our businesses, especially in the Northeast during the quarter. If you recall, when we put out the guidance in mid-February, we’ve put in an additional caveat that we were concerned what was happening with the weather and how that could impact our businesses. But I have to give it to our operating people and our drivers, they did a phenomenal job of servicing customers. And the impact was less than was thought it could have been when we kept cheering about the horrible snowstorms and closures throughout the Northeast.

Scott Schneeberger – Oppenheimer

Thanks, that’s helpful. And then obviously reiterating fourth quarter guidance, but any feel for the high enrolling of the range on the health [ph] of those comments?

Bill Gale

Not at this point. I think we have to continue to keep the relatively broad amount of guidance that we gave you the range, because some many things going to happen in the next 10 to 12 weeks. So I would say that the only comfort area we are in right now is the guidance we just provided.

Mike Thompson

We keep getting mixed signals on our KPIs, and we would like to see some trend developing. We just haven’t seen the trend change enough to change -- either tighten that range or change the range. So we feel appropriate to deploy [ph] where it is at this time.

Scott Schneeberger – Oppenheimer

Okay, thanks. And then I noticed you guys did do the acquisition in the quarter, and I think the most you spent in two years in a quarter. A, how is the pipeline? B, is this predominantly going to be in the document category and maybe a little in fire service that actually surprise me a bit? Or is there a strong work rate now at uniform rental? And I think you’ve been talking about how you’re waiting for valuations to come down in that category of supply. Four questions in there, but if you could (inaudible). Thanks

Bill Gale

The pipeline is certainly fuller than it was last quarter, which was fuller than it was six months ago. So there is a lot of discussions beginning to take place. We are seeing the predominant amount of activity -- or let’s say, activity that where action can be taken on in the document management and in the fire service business. But when I say fire service, I do not include installation. We are looking at strictly the service business itself of the inspection of fire distinguishers, emergency exit lights, et cetera -- kitchen fire suppression system. So that’s where we are focusing on, and there is a lot of acquisition candidates out there albeit most of them are relatively small, but we are targeting them and document management to expand our footprint throughout the US, and then we are now beginning to look at tuck-ins in existing operations. The uniform rental business is still very attractive to us.

As we’ve mentioned in several of these calls recently, there was a big disconnect between the sellers and the buyers as to what the business was really doing and what the future held in the short-term, what kind of volume we are buying and how much of it was going to be there six months later or a year later. If stabilization does continue, then I think that the attractiveness of uniform rental will start to increase because we know we will have a better idea of what we are getting. So we are still interested in it. There is tremendous synergies we can get from them. There are some very nice acquisition opportunities, both big and small in the industry. And we will certainly pursue them if they make sense.

Scott Schneeberger – Oppenheimer

Thanks. And just one more quick follow-up on that. More of a bias internationally or domestically, and how much of the cash is held on to the border? Thanks.

Bill Gale

The predominant amount of interest is domestic. International is still relatively small. We have a small team also looking at it. But you’re going to see the majority of the acquisitions I think in the domestic side. As far as what’s held north of the border, it’s a little over $100 million. I think it’s about $140 million.

Scott Schneeberger – Oppenheimer

Okay. Thanks, guys.

Operator

And we’ll take our next question from Gary Bisbee with Barclays Capital.

Gary Bisbee – Barclays Capital

Hey, guys, good afternoon.

Mike Thompson

Hi, Gary.

Gary Bisbee – Barclays Capital

Can you give us a sense -- you said you are remaining very disciplined on acquisitions. What do you mean by that? Is there a certain hurdle rate? How do you guys define discipline?

Bill Gale

Hurdle rates and expectations, when we put together the economics of an acquisition, what our expectations are for growth versus perhaps what others may think, so we take I would say a conservative view of what we believe that business will bring to us, and then obviously that drives the IRR. So that’s where I think the discipline comes in.

Mike Thompson

Also making sure in a more difficult environment that we look at earn-outs or hold-backs to help us, because again while things are getting less cloudy, they are still cloudy. So we will make sure that we are not the one putting on all the risk on the acquisition many times.

Gary Bisbee – Barclays Capital

Would -- does valuation relative to where your stock is trading play any part or is it all building in IRR? I guess what I’m getting at is if you use cash, which is obviously low cost -- and it’s pretty low cost debt, would you consider paying much higher EBITDA multiple than you trade at if that would get you an attractive growing business, say, in document or one of the areas that -- one of the non-uniform areas?

Mike Thompson

That’s strong. Maybe it depends on the circumstance. But certainly if we felt the long-term it was really going to drive future growth and opportunity, we may do that, but for the most part, we understand there is a buy ourselves or buy other potential there. So we’re always looking at both. But again, you can’t look at in a vacuum on a straight financial decision. You’ve got to look out and look at what it’s going to do versus the competition, access to markets that we’re not in today, and also locking up markets that we are in today.

Gary Bisbee – Barclays Capital

I guess the reason I ask -- I’m not trying to harp on this, I’m just trying to understand the thought process. You’ve done a terrific job generating cash. The balance sheet is better than it looked in an awfully long time by many valuation metrics. Over the past year, your stock has been cheap. And yet you haven’t brought back any stock in seven quarters, and the acquisitions while maybe picking up a little bit, there are really small mom-and-pop deals that don’t seem like -- unless you did an awful lot of them, they would have a real significant impact. But I guess I’m trying to understand maybe what you are waiting for or if there is some reason you haven’t been a little more aggressive given the strong shape of your cash flow and balance sheet.

Bill Gale

Yes. I think that the -- let's don’t have a short memory here. It wasn’t more than 12 months ago I think many people felt we were dropping into a depression, and there was tremendous concern about the viability of the financial industry in the whole US economy, the world economy for that matter. So, to say that we may be missed an opportunity to buy our stock, I think we were looking at making sure the company could continue to survive and withstand anything that it met. And so it’s really just been very recently that things are starting to look a little bit better, and we are not out of the woods yet.

And acquisitions, you don’t just decide day one you are going to start buying companies up and then you will start seeing them happening within a couple months. It takes a while to do the coding and to do the analysis and et cetera. So I think you need to be a little patient and just recognize that we are not going to just rush into something (inaudible) we have confidence in the future and then we know what we are getting makes a lot of sense. And I think hopefully you will begin to see some of that happen, but as I said earlier, to me, if it doesn’t then we will have to deploy the cash somehow than either through buying our stock back or doing some other way of returning -- getting better returns for our shareholders.

Gary Bisbee – Barclays Capital

Okay. I didn’t mean to insinuate that you had missed an opportunity. I’m just trying to probe sort of how you think about it going forward. I guess just one more question on that -- on that line of thinking, and I’m certainly not asking for mains or anything, but do you see, as you look at the landscape of the business that you are in, any potential targets out there that could have more than just a token impact in the short-term on the mix of your businesses? In other words, are there some mid-sized assets out there that could be attractive in document or fire? Or is it much more likely to be, as you’ve historically more often than not, in a bunch of small mom-and-pop?

Bill Gale

Gary, we have a list. I mean, we have a very extensive list of knowing our competitors in all of the businesses we are in. And we have interest in companies, both large and small in all of our businesses. I would tell you in the fire service business, there really isn’t another big competitor outside of Cintas and Tyco. And I don’t think Tyco is going to be interested in selling their division, and it’s much larger than ours is anyway. But in document management, there are several good sized companies that would be attractive. There are a lot of good regional players that would be attractive. And in uniform rental, I don’t need to tell you that there are some very good sized players. There are some great regional players, and there are still a lot of local players. We know all of -- who they are, and we will certainly pursue those that look like that they could be doable at the right price.

Gary Bisbee – Barclays Capital

Okay. And then just one last one, can you give us a sense what type of offerings customers are adding on? You said you’re getting ads, but a lot of it is from the ability to up-sell the more stuff. You got --

Bill Gale

It covers the gamut of our different service groups and what they can offer. For example, in the uniform, I’d say, the rental business, we’ve expanded our facility services line now to include a lot of hygiene services, a lot of floor care, chemical dispensing, the restroom cleaning services. Those have provided our customers with a lot of different opportunities to outsource some of the services that they need to have done at a price cheaper than what they can indeed do it themselves. So that’s one example.

In the first aid and safety and fire service, we are doing a lot of training. Our safety supply sales are growing very nicely. Our -- the external defibrillators continue to do very well. Document Management, we have expanded into doing some imaging work for some of our larger customers. And we do have storage capability in certain markets. So each business has something that can broaden the offerings to the customers that they have or appeal to customers that we have in some of the other businesses.

Gary Bisbee – Barclays Capital

Great. Thanks a lot.

Operator

We’ll take our next question from Greg Halter with Great Lakes Review.

Greg Halter – Great Lakes Review

Yes, good afternoon.

Mike Thompson

Yes, Greg.

Greg Halter – Great Lakes Review

Just wondering if you could provide a status of the SAP initiative and what your costs so far have been on that in this fiscal year.

Bill Gale

We are fully converted in the financial system under SAP, and it’s gone reasonable well. As far as where we stand, we are looking -- we are working right now on converting our supply chain. And that is still in process, and hopefully we will be converting that sometime this fall. We are looking at other -- some of our business units and how they can be integrated into SAP. And so there is some, what they call, blueprinting going on with a couple of those businesses right now. As far as the costs are concerned, I’m not prepared to tell you exactly what we’ve spent right now. But the bulk of the spending was done last fiscal year. However, we continue to spend at a lower rate this fiscal year and going into the -- I would say probably at 40% to 50% of what we spent in the last year. And this will be a multi-year effort because we have -- each of the businesses will be looked at, and if make sense, will be converted into SAP also.

Greg Halter – Great Lakes Review

Okay. And relative to capital spending, what is your budget for 2010 -- fiscal ’10?

Bill Gale

We are looking at a $100 million to $120 million of CapEx for fiscal 2010. So I think we’ve spent, what, $78 million year-to-date. So somewhere between $30 million to $40 million in the fourth quarter is probably what’s going to happen.

Greg Halter – Great Lakes Review

And would you expect that to ramp up in fiscal ’11?

Bill Gale

Somewhat, not substantially. But it could have some marginal increase, given the improvement in the economy.

Greg Halter – Great Lakes Review

Okay. And one final one for you. Relative to the first aid segment, the income before tax there has been down year-over-year for quite a while. I think you are at $2 million now on a pretax basis. And it seems like it’s been on a steady decline. And just wondering what the management team is doing relative to stemming that -- reversing it?

Mike Thompson

There are two things in there. First, the fire installation business was certainly a drag for a couple of years and we’ve exited that business as of last quarter. And certainly the change in the external economic conditions that honestly hit first aid harder than we expected because of the tie in the headcount. So with that drop in revenue that happened very quickly was the other piece over the last 15 months or so has impacted us. So we expect going forward, again depending on what happens in the external economy, but being out of the installation business will certainly help. And then with that, a stabilization in the revenue -- the top line revenue we expected to turn. And certainly we are cognizant of it. We are watching our cost structure there. We believe they are both very good businesses to be in. And again, getting out of the installation business as of last quarter will certainly make the future comparables better.

Greg Halter – Great Lakes Review

Okay, thank you.

Operator

(Operator instructions) And we’ll go next to Andrew Steinerman, JP Morgan.

Andrew Steinerman – JP Morgan

Hi there. Mike, could you talk about what level of rental gross margins of uniforms and items (inaudible) fourth quarter guidance and maybe kind of what headwinds and tailwinds might go in that number relative to the third quarter just reported for rental gross margins?

Bill Gale

We don’t provide details on the guidance for the fourth quarter other than we certainly have indicated we believe everything to continue to be sluggish from the top line, which certainly keeps the bottom line relatively stable other than what happens with energy. Typically when we look forward to energy, we forecast based on where it is at the current time of that guideline announcement. So we have energy factored in at this point at current levels. As far as what happened in the quarter, certainly, as we indicated, the workday adjustment and also this being our third quarter, the holiday always impacts that -- the gross margin in that business

And I think certainly, as we discussed with others on the call, we expect it to improve going forward albeit we need the economy to stabilize. So we’re not continuing to chase the route structure et cetera, as jobs lessen, and you continue to lose that very profitable business. And that continues to be, to some degree, existing today. Now it’s not as bad as it was six to nine months ago, but it continues to occur. So if it’s still bad, it’s still worse than last quarter on a go-forward basis when you lose those jobs. We need that to stop and be zero so that we can start generating it on the upside. Certainly, energy did impact us this quarter. So it’s about 20 basis points sequentially. We expect hopefully that will be flattish in the fourth quarter, but that sounds out of our control. I don’t know if that answer it completely your question, but --

Andrew Steinerman – JP Morgan

Right. And are there other headwinds or tailwinds when thinking about rental gross margins fourth quarter versus third quarter? You just said the energy will be flattish --

Mike Thompson

Fuel cost --

Andrew Steinerman – JP Morgan

Are there any other headwinds or tailwinds to think about in the fourth quarter for rental gross margin?

Mike Thompson

It’s really just volume driven. I think material costs should be okay unless there is a big input [ph] new business, which we’d love to have, by the way. But the material costs should be okay. The service costs should be in line for the most part. Energy cost, I don’t know where it would -- where it’s going to go. So we feel pretty good. Production costs have been pretty consistent.

Bill Gale

It’s strictly a top line impact, I would say, in the short-term, Andrew.

Andrew Steinerman – JP Morgan

Okay. So help me with one more point here. Rental gross margins usually go up the most sequentially in a typical fourth quarter, sequentially for Cintas. Is that, in the past, premature volume driven, but it’s also usually a volume seasonal --?

Mike Thompson

It is typically almost strictly volume driven. We do a little push, because at the end of the year typically in some cases, but it’s typically volume driven because of these extra workdays traditionally.

Bill Gale

And you’ve been building up to that point throughout the year. So you incur -- you set up your organization at an operation. You start incurring the cost earlier in the year and then the volume builds in the rental business as you go. So that’s always been part of the reason why the fourth quarter has always been some of the strongest. The difficulty for us is just like last year, this year it’s a little bit different world out there and they traditionally have a slightly growing economy or positive and we are still losing jobs. So you need to then count a little bit when you look going forward. That’s why we’ve been a little cautious in those statements.

Andrew Steinerman – JP Morgan

Okay. And the medical cost is an SG&A item in that gross margin.

Mike Thompson

That is correct.

Bill Gale

Just to remind everyone, I know you know this, Andrew, but all medical cost for every employee in the G&A line, it’s not located in the production or service area, but rather it’s recorded in G&A.

Andrew Steinerman – JP Morgan

Okay. Thanks for all the questions.

Bill Gale

Thank you.

Operator

And that does conclude our question-and-answer session. At this time, I’d like to turn the call back to you, Mr. Gale, for any additional or closing remarks.

Bill Gale

Well, first off, I want to thank all of you for joining us this evening. And I would also like to announce that Mike Thompson has been asked by our Chief Executive Officer Scott Farmer and our President Phillip Holloman to work in a special operational assignment. During this assignment, which is underway, Mike Hansen will be assisting me with our Investor Relations activity. So while Mike Thompson will be helping us with this quarter’s follow-up, please direct all future requests to either myself or my assistant, Judy Girty. Either Mike Hansen or I will then get back to you as quickly as possible. Thanks again for participating, and we will be announcing our fourth quarter earnings in mid-July.

Operator

That does conclude today’s conference. Thank you for your participation.

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Source: Cintas Corporation F3Q10 (Qtr End 02/28/10) Earnings Call Transcript

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