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Executives

Shayn Carlson – Director, IR

Doug Milroy – CEO

Jeff Wright – SVP and CFO

Analysts

John Healy – North Coast Research

Andrea Wirth – Robert Baird

Andrew Steinerman – JPMorgan

Nate Brochmann – William Blair & Company

Chris McGinnis – Sidoti & Company

Mike Hamilton – RBC

G&K Services Inc. (GKSR) F3Q10 Earnings Call April 27, 2010 11:00 AM ET

Operator

Good morning. My name is Ashley and I will be your conference operator today. At this time, I would like to welcome everyone to the G&K Services fiscal 2010 third quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. (Operator Instructions)

Mr. Carlson, you may begin.

Shayn Carlson

Good morning. I am Shayn Carlson, Director of Investor Relations for G&K Services.

Thank you for joining our call today to discuss fiscal 2010 third quarter results. With me today is Doug Milroy, our Chief Executive Officer, and Jeff Wright, our Executive Vice President and Chief Financial Officer. After a discussion of third quarter results, we will open the call for any questions.

Before we begin, all statements made on this call concerning our intentions, expectations, or predictions about future results or events are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

These statements reflect our current expectations or beliefs and are subject to risks and uncertainties that could cause actual results or events to vary from stated expectations, which could be material and adverse. You are cautioned not to place undue reliance on these statements and we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Information concerning potential factors that could affect G&K and its future financial results and operating performance are included in our Annual Report on Form 10-K after the fiscal year ended June 27, 2009. A replay of this call will be available starting today at approximately 1 pm Central Time, continuing through May 27. You may access the replay by visiting the Investor Relations section of our Website.

At this time, I will turn the call over to Doug.

Doug Milroy

Thanks Shayn. Good morning everyone. Thanks for calling in today. We appreciate your interest in our company. As this has become my practice, today I am going to cover three things. First, I’d like to briefly recap the quarter; second, remind you of the key elements of our game plan, which is driving our company’s progress and third provide you with an update on the game plan, walk you through some examples and update on progress in a couple of specific areas.

So first the third quarter, for Q3 total revenue was $199 million versus $231 million in the prior period or down about 14%. When you adjust that number for divestiture activity which we have shared with you and foreign exchange, you see the following observations. Rental organic growth was negative 10.5% in the quarter versus negative 14% in the prior quarter. That's our first improvement in rental organic growth rate in nine quarters.

On a sequential basis, it’s the least decline in rental revenue since our employment levels began their significant slide, down just over 1% sequentially. If you look at the earnings side, we reported $0.38 a share which you need to adjust to $0.28 a share to net out the gain on divestiture activity. $0.28 reflects an operating margin of 5.8%.

So when you look at those numbers, I would argue in short the business continues to strengthen. It’s our third consecutive quarter of stabilizing revenue, which is clearly positive progress. Equally clearly it’s not good enough and remains as you would expect an absolute focus for us.

OI margin continues to develop its positive trend line. We are seeing the impact of the overhead reductions that we have taken. We are seeing the impact of other cost reductions we are taking. We are seeing the improvements in our underperforming locations, which I will share in a little more detail in a minute.

So in other words, we are continuing to see improvements that are entirely consistent with our stated focus, earning our right to grow, focusing first and foremost on improved profitability, our profitable growth not just growth. As a result of all that, our cash flow remains strong. We have paid down nearly $80 million of debt in the last 12 months.

Jeff will take you through the financial details in a few minutes as he usually does.

Second I would like to recap our game plan. I am guessing most of the people who follow our company have our new game plan memorized. Frankly, we think that's good. I would ensure you know where we are taking the company and put you in a position to track our progress against that. Nonetheless I would like to recap it very briefly today, as a reminder for those who follow us regularly but also for new investors and new potential investors calling in today.

So let me recap actually two things. I want to recap what the game plan is but again, why does it make sense for us, how did we come to it? Late last summer, as most of you know, we launched a new game plan for our company, it’s got four key elements to it. One, redoubling our focus on customer satisfaction. Now clearly with a 170,000 customers, we already have a very high level of customer satisfaction, redoubling it is ensuring that every single employee’s actions in our activities are aligned with our customer’s needs.

The second element of the game plan is driving a relentless focus on day-to-day execution better basic locking and tackling in the way we run the business every day. Third is our focus on cost management, looking to strip out every cost that we possibly can. However making sure we always remain consistent with our number one focus of continuously improving customer’s satisfaction. And then the last element of the game plan is addressing our underperforming locations where we are relentlessly focused on the business at the bottom end of our spectrum and I will share a positive progress with you there in a minute.

So those are the four key elements of the game plan. As I said last summer, we stepped back and looked at how we wanted to run the business and we came to one very positive conclusion that there was significant opportunity in front of us for profitable growth in our core business and that frankly, we weren’t focused enough on the basic elements of running the business well to capitalize on that. We needed a clear game plan for how we were going to get at it, which is what we have developed, it’s what we have executed against and it’s what I just shared with you.

And I think I feel the need to step back and address that because I recognize that the game plan as we stated may seem very simple, almost simplistic. But in my experience, that's how you make money. Get a very clear simple understanding of where we are going, rounded first and foremost in customer needs, then pull it down in a way that every employee can understand it, can own it and stick with it religiously, avoiding flavor of the month and that's exactly what we are doing.

So with that as a recap of the game plan, let me go to the last part, which is I would like to give you some examples that highlight our progress. The first area, if I talk about redoubling our efforts around customer satisfaction, it is clearly the cornerstone of profitable growth and we have done three very specific things in that area. One is better define it. As I have said, we have spend a lot of time with customers, I have spent a lot of time with customers personally, we have done a great deal of market research and the net of that, I think is the ability to very clearly and very simply state precisely what our customer requirements are. Then the second thing we have done is make sure that all our efforts are aligned with that.

In short I can tell there is not a function in our company that’s untouched in our effort to better align with what we understand the customer needs to be. And it’s not just lining up the team, it’s also ensuring that the investments we make are entirely consistent with those defined needs. So for example, we have done a fairly significant realignment of our IT priorities. So that's one example that puts us in a better position to deliver the capabilities for our front line team to meet those customer needs. And then the third is once you have defined it, once you have aligned the company with it, you have got to measure and track it religiously. And you do those three things and you ensure customer satisfaction is not just some platitude but it’s become a precisely defined way that we are running our business day in and day out. So I thought that example might be helpful.

Let me move on to the next element of the game plan, better execution and I will give you a couple of examples there. We talked last time about our focus on execution in particular with our sales organization. So I would like to give you two examples there. If you think about what we just described, if you sharpen your definition of what your customer needs, I think you may extend to sharpen the training associated with that. So we have made enhancements to our basic sales training. That positions our sales team to come in and get up to speed a lot more quickly.

We better educate our reps on the business, on the industry, on our core products, our services and the net of that is positioning them to walk in much more quickly and understand specific customer needs. Because if they understand needs, we can translate that into value and that's what our focus is and that ultimately will lead to increasing sales productivity.

I will walk you through another sales example, it would be leveraging our sales automation system. In fact this is a good example of execution and cost management, which I think illustrates although we always talk about these as four consistent elements of the game plan. In fact for the most part, they are interwoven. But if we look at our sales automation system, we made a modest seven figure investment in sales automation a few years back and when we examined, we conclude we are not getting the full return from it that we should be.

Instead of making it our core system, we built up other tracking systems around it, you can imagine excel, spreadsheets, and all kinds of various tracking and complexity around it. And so, what we have done is said that that was unnecessary and we have stripped it back to the core system that was there. We have made some improvements to the system and said that we will have one clear system as the foundation of improving our sales effort. So it enhances our execution but it also leverages investments we have already got in place.

If I go to the next area of the game plan, increasing our cost management focus, over the last few quarters we have discussed a lot of changes in this area. Clearly it is not about events, it’s become in a central way that we run the business and we have continued to aggressively manage our overhead. If you look at our corporate spending, we are down $2 million in the third quarter on a run rate basis versus the prior year’s quarter. And with that comes a lot of related cost, healthcare, worker’s comp, all of those kinds of things are also down significantly on a year-over-year basis. But I think whenever we talk about cost management, it’s really important to recognize it’s not just about headcount and the related cost to headcount, it’s about every line item in the entire business.

So for another example, just continuing a very high focus on how we manage our stock rooms, giving us much better day to day utilization of the current merchandise that's in service. So again, this is a good example of cost focus but also better execution at the same time, again illustrating how some of these are interwoven. And the net of that is our third quarter merchandise amort has improved by 70 basis points versus the prior year period. And I could go on. We have challenged every other non personnel expense from telephones, to rent, to professional fees, to whatever you might think of and you can see reflected in our earnings numbers, we are making good progress and our challenge remains just as we continue our diligence in that area to make sure we need no stone unturned and that as a team, we recognize when it comes to cost management, there is no silver bullet. The imperative is that it becomes a way of life for the organization.

If you look at the last element of our game plan, we talked about improving our underperforming locations. And for the third consecutive quarter, we are very pleased with our progress in this area. So, again, we have driven a very consistent plan here, looking at an underperforming operation, step one is continue to improve it just simply with better day to day management of what we have, can we improve it. (Bailing) that are the structural changes that makes sense, hence bailing that is a candidate for divestiture. So that's the three steps we have stuck.

And in the group of businesses we have defined as needing more targeted attention and focus, our third quarter operating income was up $2.7 million on a quarterly run rate since we launched our new game plan. You may recall that number was cited as $2 million on a run rate basis last quarter. On an annualized basis, that's 130 basis points of OI margin improvement. And I think the most positive part is that we remain confident that there is more to come.

So I must say I would like to step back and acknowledge the teams working with those businesses, the teams working in those businesses have done just a super job for us.

I guess the last part there, just to remind you last quarter, in fact on this call we said we expected to complete one additional divestiture during the quarter. We did that, it was another linen operation as we have shared at the time. And when you take that together with the other linen divestitures we have made the clean-room divestiture we talked about last time, it really has accomplished its goal of allowing us to focus more of our time, effort and attention on our core uniform business. And I think it's important to remind you, obviously, there is the revenue impact. We expect that total revenue impact from the divestitures we have made to be above $35 million.

So in summary, I suspect it’s no surprise to you that our game plan remains unchanged. We are absolutely staying the course for the direction in the company that we have laid out. It’s been very well received and embedded with our team mates across the company. It’s been well received with customers and prospects. And as I have said, while we will clearly continue one a quarterly basis to have some ups and downs, there is no question in our minds that the results – that the progress is showing up in our results and we are as confident as we have ever been at the trend line that we are on.

So now I will ask Jeff to take you through those financials in a little more detail and then he and I would be happy to take any questions you have.

Jeff Wright

Thanks, Doug, and good morning to everyone. This morning I will also cover three areas in a bit more detail. First, I will review our third quarter financial performance. Next, I will also provide some more detail around specific results that are coming from executing our new game plan. And then finally, I will provide some directional insight for the fiscal 2010 fourth quarter, which by the way includes the 14th week this year.

So, to start, I would like to provide an overview of our third quarter performance, and so working down the income statement. For the quarter, revenue totaled $198.9 million. That compares to revenue of $231 million in the prior year period. As we have noted before, lost customers from economic difficulties, lower customer employment levels and difficult pricing all continue to pressure revenue.

Third quarter revenue from rental operations was $185.6 million, down from $209.9 million in the prior year period. On a sequential basis, after adjusting for foreign currency translation and divestitures, rental revenue was almost flat, down just 1% from the second quarter of fiscal 2010 and marks the third consecutive quarter of improved sequential results. This compares to a sequential decline in rental of approximately 1.5% last quarter, 3% in our first quarter and about 5% in our fiscal 2009 fourth quarter.

Within our core rental business, customer employment levels continue to stabilize for the fourth consecutive quarter although we are still seeing a net reduction of wears. For the quarter, our rental organic growth rate improved to negative 10.5% compared to negative 14% in the company’s second quarter. And again, the sequential decline of rental revenue is moderating, which is encouraging.

Turning to direct sales, third quarter direct sale revenue was $13.3 million compared to $21.1 million in the prior year period and that prior year period included the successful launch of a new uniform program to a major customer. While direct sale volume continues to be impacted by a weak overall economic conditions, we have recently added several new customers in this business, which is also encouraging.

Shifting to profitability, third quarter net earnings were $0.38 per diluted share. This compares to a prior year period net loss of $4.74 per diluted share. The company’s current year third quarter included the net gain from divestiture activity and asset sales, which totaled $0.10 per diluted share. The prior year period included a $5.18 per diluted share loss from goodwill impairment, fixed asset write-downs and other non-cash charges. So on an adjusted basis, third quarter earnings totaled $0.28 per diluted share compared to $0.44 in the prior year period.

Current year third quarter earnings benefited from lower merchandise expenses, reduced benefit costs and gains from location profit improvement actions. These benefits were offset by the reduction in fixed cost absorption due to lower revenue and also a higher effective tax rate in the current year.

Third quarter operating margin was 7.0% compared to negative 48.6% in the prior year period. The current year third quarter adjusted operating margin was 5.8% and that excludes that net gains from divestiture activity and asset sales. And the prior year period adjusted operating margin was 6.3% when excluding the loss from goodwill and other impairment charges. The current year adjusted operating margin benefited from the efficient utilization of merchandise, lower staffing and related benefit costs and the continued profit improvement in the company’s underperforming locations. These benefits again were offset by the reduction in fixed cost absorption due to lower revenue.

On a sequential basis, the third quarter adjusted operating margin was down 10 basis points compared to the second quarter. We incurred extra payroll tax in the third quarter due to the annual reset of the payroll taxes and also pay increases are delivered at the beginning of the calendar year for most of our employees. In addition, we incurred cost related to the divestiture activities and other improvement initiatives. Offsetting these expenses were improvements in health insurance costs, workers’ compensation costs, bad debt expense and a number of other items. We continue to have many moving parts impacting our results but we are confident that our third quarter results reflect the continued positive trend line in operating margin that we have achieved in the last three quarters.

Despite the economic pressure on revenue and earnings, we continue to generate strong cash flow. For the nine months ended March 27, 2010, cash flow from operations was $54.2 million and free cash flow was $42 million. With the continued focus on improving profitability, strong working capital management and targeted capital spending, we expect to continue generating solid free cash flow in the fourth quarter. We continue to utilize our strong cash flow to pay down debt and fund our quarterly dividend. As Doug mentioned earlier, debt net of cash was down $77.9 million over the last 12 months and is actually down $114 million over the last six quarters. As such our financial stability and flexibility remain strong.

Given our strong cash flow, modest leverage, and available capacity under our revolving credit facility, we clearly have significant acquisition capacity. However evaluations remain quite high and we have raised our hurdle rates even higher. With that said, we continue to look acquisitions that would strengthen our existing businesses.

Now let me –- with that as a review our financial results, let me provide a bit more detail on a few of the positive results that we are driving from executing our new game plan. By focusing on increasing cost management and better execution, we continue to lower our cost structure. As Doug highlighted, our third quarter corporate spending was down approximately $2 million on a year-over-year basis and our company headcount is down 14% from last year. In fact, total labor, which is our single largest cost component improved by 60 basis points as compared to the prior year third quarter. In addition, our employee benefit costs including healthcare, workers’ compensation, and stock-based compensation were all significantly lower as compared to the prior year period as a result of lower staffing and changes we have made to certain management incentive programs.

In our field operations, the team has done a great job in managing our merchandise. Third quarter merchandise amortization was down 70 basis points from the prior year period. Our direct sale business has also done a nice job of scaling in the cost structure to help partially offset the decline in volume. We will continue to drive cost side of the business while investing in sales and service teams to support our redoubled focus on customer satisfaction.

In addition to increasing our cost management focus, we have been very active in also addressing our underperforming businesses. As you may recall, we have completed five divestitures and made operating changes in other locations since initiating the new game plan less than a year ago. As highlighted earlier, we are pleased to report that for the third consecutive quarter, our bottom performing locations improved operating income. On a sequential basis, operating income from these locations improved by approximately $700,000 after posting a $1 million sequential improvement in both the first and second quarters. This has been an area of outstanding progress. While still early, we continue to execute again location specific game plan in multiple locations to drive improving profitability.

Turning to our divestiture activity, last quarter we mentioned that we were in the final stages of divesting another linen operation. During the quarter, we finalized this divestiture and have now completed five divestitures in the past nine months. These operations were not part of our core uniform and facility services business. As reported last quarter, the five divested operations accounted for approximately $35 million in annual revenue. While we can't guarantee that there won’t be some additional divestitures at some point in the future, we have completed the divestitures that we are on in our near term radar.

Now as we have done throughout this fiscal, we will provide some directional input to help the investment community. As started in our press this morning, we expect fourth quarter revenue to be generally consistent with third quarter after adjusting for divestitures in the 53rd week of fiscal 2010. Sequentially, we expect rental revenue to be slightly lower and direct sales revenue to be somewhat higher. Divestitures will decrease revenues sequentially by approximately $1.5 million, in the 53rd week, will add approximately $15 million when comparing the fourth quarter to the third quarter.

While we are encouraged that we have seen a continued moderation in the decline of our rental revenue, economic and employment conditions remain challenging.

From a profitability standpoint, we expect fourth quarter operating margin to improve slightly compared to the third quarter adjusted operating margin. The extra week of revenue will contribute margin at a rate consistent with our recent performance as most expenses are full incurred on weekly basis. In addition, we expect our fourth quarter effective tax rate to be higher than the third quarter and to be a more normalized rate of approximately 40%.

As Doug described, we continue to execute against our new game plan, a game plan that is producing improved results. We are confident, we are on track and moving the company forward to improve our performance. We look forward to reporting our progress in the quarters ahead.

So that concludes our prepared remarks and we would be glad to take your questions at this time.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of John Healy with North Coast Research.

John Healy – North Coast Research

Doug, I wanted to ask you kind of a big picture question. If my calendar works right, you have been there about a year now in terms of running the company. I wanted to get your perspective on what the biggest wins you guys have had, where you have made the most progress with your plan and then also get a little bit of perspective on what part of the plans have been most challenging and present the most opportunities for you guys as you head into fiscal 2011?

Doug Milroy

First of all you are right. I was hoping John you would give me another week. But you are right, it’s been almost a year. What do I think have been the big wins? I would say that when we step back and looked at what we regarded as our underperformance and we spent 60, 90 days last year on a real deep dive last summer, a lot of time out with customers with the team in the field and so forth, trying to assess what elements of how we were running the business needed to change. I would say we got that a lot more right than not. And as a result, our game plan or what we articulate as our new game plan is a very solid one for the company. And you stand up and you launch a new game plan like that and you just hope that in six months, nine months, a year later you are going to look back and think you took the company in the right direction. And we are as convinced as ever that the game plan the way we articulated it and the key elements that are in it is in fact the direction to be taking our company in. So I would put at the top of the list as the biggest wins.

The next one that I would put right alongside of that is, as Jeff and I just shared with you, we think are making progress with that game plan. It’s one thing to say, here is our new game plan, it’s another to begin to turn it into reality and begin to have it show up in your numbers, so the progress that we have made with the game plan.

We labeled it in – and I am not sure we have used to term here today, but in each of our previously calls, we have talked about the notion of earning your right to grow and that the focus needed be foremost on profitability and that’s consistent with the results we are churning in.

When I think about the last part of your question, the challenge the opportunity, I guess kind of two things come to mind. One is you don’t put a new game plan out there and snap your fingers, and everything marches according to it the very next day. It just takes time. And I wish it had got down the week we would have launched it. So that kind of impatience is tough. But the team really is grabbing and making their own and the results will continue to follow.

So I think what I am trying to say is deeply embedding that game plan in every fiber of how we run the company continuing to do that is the challenge that’s in front of us. And your other word you used with opportunity. The biggest opportunity is the top line revenue growth, profitable revenue growth will ultimately come around.

We are very pleased to see the moderation, but I don’t get too excited about a moderation in the decline. We want to see growth, but we only want to see profitable growth. And we remain absolutely convinced that that will come. But as we sit here today, that in fact I would put in the bucket of the biggest opportunity going forward.

John Healy – North Coast Research

Okay, great. And Doug, I was wondering if you could talk a little bit about maybe the trends throughout the quarter, how you saw them? And maybe if you saw more improving trends exiting the corridor or if there was any sort of sequential off fluctuations in the business?

Doug Milroy

No, I wouldn’t say there was anything noteworthy within the quarter. Anything that happened within the quarter is consistent with the broad trends that are you seeing as we described the business.

John Healy – North Coast Research

Okay, helpful. And then a question for you Jeff, I wanted to talk a little bit about – you mentioned uniform amortization expense being a little bit of a tail end. If you could kind of provide us with a little bit more color there in terms of maybe as a percentage of the overall cost structure of the company and maybe if you are starting to enter an environment where revenues are maybe flat on a year-over-year basis, what the margin potential benefit could be as you kind of anniversary some of those uniforms rolling off the P&L?

Jeffrey Wright

Sure. Well, John, in terms of the kind of the overall benefit to the company and I think we tried to articulate that on the script, but it drove about 70 basis points of improvement on the operating margin line. And it’s really – it’s kind of this day-to-day blocking and tackling, day-to-day execution that we are trying to drive into the business.

And we have I think as you know used stock rooms, used merchandize in all of our facilities. And then in times of a downward economy, those used stock rooms grow, because there has been layoffs and we take the uniforms back into our stock rooms.

The challenge and the opportunity in front of us is as our revenue growth moderates and then starts to improve, if we can put those uniforms back to use, their assets that have either been partially amortized or fully amortized, and we can put an asset to better use, than having it sit in our stock room. So we got a nice 70 basis point less here this quarter.

And going forward, it all kind of depends on number one, how effectively we can utilize that. And then, of course, if we start to be more successfully on ramping up our new account sales and so forth, that can obviously add some merchandize cost. So a lot of that will go into the mixture as we consider the benefits going forward. But I guess that’s the color I would give you.

John Healy – North Coast Research

Okay, great. And just last question, can you update us on where you are from a sales force standpoint, if you guys have begun to kind of invest in the sales force in growing head count yet or if you guys are not yet doing that?

Doug Milroy

John, it’s the latter. We are not yet doing that. Our focus with our sales force is on productivity foremost. And looking to the local team to be assessing the market opportunity there, the business opportunity there, the management scope and capability to bring on new sales people and so forth. And we shared with you last time we were down somewhat say over prior year and we remain at roughly those levels.

John Healy – North Coast Research

Okay, thank you both so much.

Jeffrey Wright

Thank you.

Doug Milroy

Thanks John.

Operator

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

Andrea Wirth – Robert Baird

Good morning, guys.

Doug Milroy

Good morning.

Andrea Wirth – Robert Baird

Nice quarter.

Doug Milroy

Thanks.

Andrea Wirth – Robert Baird

Wonder if you could first clarify something on your execution for 4Q. Jeff, I think you had made a comment that rental revenues will be lower, but direct sales will be higher. Is that on a sequential basis? Do you still think rental revenues will continue to be lower, even adjusted – even including the extra week?

Jeffrey Wright

No Andrea, that would not be including the extra week. It would be more on a comparable 13 weeks to 13 weeks. I was trying to give a little bit of additional color that we said, revenues will be flattish when you exclude the extra week and exclude the additional divestiture activity. But then when you look then at what’s left, we are forecasting, projecting that rental revenue will be down just a little bit more and direct sale likely to be up when you kind of parse that flattish picture apart into the two buckets.

Andrea Wirth – Robert Baird

Okay, got it. And then, I guess could you maybe kind of comment a little bit then what the add stops are looking like? I am assuming they are still continuing to decline at this point, maybe just a little bit more color there on those.

Jeffrey Wright

Sure. We continued to see that the add stops are continuing to moderate, but still have not yet reached that kind of inflection point where you are flat and/or net addition of jobs. So we still had a net loss of jobs in the third quarter. And so, again, we see glass half full or glass half empty, we see that as the continued moderation picture, it’s a smaller loss of jobs, but haven’t quite hit the inflection point in our book of business yet.

Andrea Wirth – Robert Baird

Got it. And how about no programmer interest, is that – has started to improve yet or is that still a little bit challenging?

Jeffrey Wright

The no programmer interest is still in that kind of 50% range. I think I don’t have the numbers right in front of me, but I think it was actually a little bit better than the quarter before. And so that is the kind of small ray of hope that has – we get more new business startups and as the economy starts to improve. Hopefully, we will see more and more no program opportunities out there for us as well.

Doug Milroy

And this is Doug, I continue to look at that as a testimonial to the value of what we offer or customer base that even in these tough times, people see the uniform program as an opportunity in their business.

Andrea Wirth – Robert Baird

Got it. In terms of the margin performance, I think last quarter you had been guiding to more of a potential for a roughly 100 basis points decline sequentially and obviously things looked a lot better. Where did that come from? Was that primarily driven by the better merchandise cost?

Jeffrey Wright

Andrea, this is Jeff. I would say that it was driven by a number of things. We have got a number of things that are working positively for the company. As we have mentioned, we have really tightened our cost management in a number of areas both personnel and non-personnel related.

We continued to get nice improvement in our underperforming businesses, our bad debt expense was down and probably down further than what we anticipated, but that’s again a sign of an improving economy. A number of our benefit areas healthcare cost, workers’ comp cost, et cetera, were showing nice positive improvements.

So I would – I will just say that it was across the board a little bit and to your point that helped to offset the increase in payroll taxes, some of our annual wage increases that we do at the beginning of the calendar year.

And then some of the extra expenses around divestitures and other restructuring activities that we have in place. But when you put all that together, it drove margins a little ahead what it was for the quarter.

Andrea Wirth – Robert Baird

Got it. And just on merchandize cost, do you think you can see a similar type of benefit next quarter already, in terms of merchandize costing 70 basis points impact or is that a little bit too high?

Jeffrey Wright

Well, I guess it depends on where a new account sales come in, it depends on again the effectiveness of our teams in the field that continue to utilize the used stock that we have. But I would think that we would continue to see a positive benefit at least in the near-term there.

Andrea Wirth – Robert Baird

Okay. And then just final question on pricing, are we starting to see any improvement there yet in the industry or is it still extremely competitive?

Doug Milroy

Are we starting to see – if you – the first part of your question, the answer is yes. Prices have firmed over the last quarter or two versus the prior year comparable quarters. When you say very competitive, I am going to back away from the word very just a little bit. Pricing in my mind remains competitive, but it’s been that way in any industry I have ever been in. And historically, it’s going to get more difficult in a tough economy. But I think the imperative is to turn the conversation back to value. And that’s what we are doing in every corner of our business.

In my experience you focus on your customers and customer satisfaction and then price becomes much less of it in the conversation. I guess I would offer frankly of the – as a relative newcomer to the industry. I am really struck by the persistent noise, I will call it the persistent noise I see around pricing.

And when I look at what we do, when I look at the image that we help our customers with, the safety needs in their facilities, and protecting their employees, when I think about the personal aspects of what we do, people are aware of what we do. It makes it very personal. I think all that translates to significant value.

And I think that would be a better focus for our industry is to turn the attention more to that value message. It is absolutely what we are driving here at our company, focus on the customers is your number one priority. That creates value and that will absolutely be where our focus will remain.

Andrea Wirth – Robert Baird

Got it, thank you.

Operator

Your next question comes from the line of Andrew Steinerman with JPMorgan.

Andrew Steinerman – JPMorgan

Hi Doug.

Doug Milroy

Hi Andrew.

Andrew Steinerman – JPMorgan

This might be a – hi. This might be difficult. You said that it might be able to – to a more specific question. You said that the company has gotten so much better at measuring customer satisfaction. Do you have actually kind of an index of customer satisfaction? Are you able to tell us how much customer satisfaction has improved since last year? Do you have sort of a goal for kind of a level of customer satisfaction? Because as you realize, there's probably some level of customer satisfaction that's too high.

Doug Milroy

The last part of your question intrigues me. If – Andrew, if you want to expand on it a little bit, because I am not saying that’s any of our team that there is such a thing as customer satisfaction too high.

Andrew Steinerman – JPMorgan

Right. So my point would be you only want customer satisfaction to be as high as you could get value for, to get paid for.

Doug Milroy

Well, back to the value message. So let me answer your question a couple of different ways. Back to the value message, intellectually I agree with what you said. You got to make sure you got paid for ethos as the following: go satisfy the customer, create all the value you possibly can, then we find ourselves in a second – importantly a secondary and a lesser conversation about how that value is going to get split and that’s called price. But if we create a ton of value in the first place, it’s a much lesser question in the second place.

And as far as measures, yes, we absolutely have measures in place, we have goals established, we track toward them. And I think what I would describe to you the biggest shift is organizations can easily mix up two different words, customer research and customer satisfaction. And I think we have and we will continue historically to spend our money and our focus on customer research.

But where we have shifted some dollars and some emphasis is on customer satisfaction. One is helping you understand your industry and its dynamics and all those kinds of things. The other is helping you understand where you are at with any given customer. And so that’s with our measures and goals and metrics, that’s where we have shifted our focus.

Andrew Steinerman – JPMorgan

Thanks. And Jeff, could you tell us where energy as a percentage of revenues is this quarter versus last quarter?

Jeffrey Wright

Sure. Let me look at that up for you real quick. Did you want the year-over-year or the sequential?

Andrew Steinerman – JPMorgan

Whatever is convenient for you.

Jeffrey Wright

It ran – energy ran about 4.6% of revenue. It was up from about 4% of revenue sequentially and roughly flat with the prior year.

Andrew Steinerman – JPMorgan

Okay, thank you very much.

Jeffrey Wright

You bet.

Operator

Your next question comes from the line of Nate Brochmann with William Blair & Company.

Nate Brochmann – William Blair & Company

Good morning, gentlemen.

Jeffrey Wright

Hi Nate.

Doug Milroy

Good morning.

Nate Brochmann – William Blair & Company

I wanted to kind of follow up on that question Doug, you mentioned earlier one of the things you have done is better define some of these parameters, particularly customer satisfaction. And I was wondering if you could share with us what that definition is? And also, as you have done a lot of the work over the year, in terms of talking with your customer, what were some of the biggest sticking points, and how have those been fixed?

Doug Milroy

As far as the – hang on just a second. Just jotting down your – as far as the first part, I – what I share the definition I think in these calls, you have seen me hold our pricing detailing for example pretty close to the best. I would rather layout all of our pricing for you then share publicly our definition of what we have come to understand customer’s need.

Nate Brochmann – William Blair & Company

Okay, fair enough.

Doug Milroy

And it really is going to be the cornerstone, it is and it’s continuing to be the cornerstone of how we are going to shape up direction for our customers. So we are pretty excited about it. As far as sticking points, I think to embellish them too much takes me right back to the definition.

Nate Brochmann – William Blair & Company

That’s fair.

Doug Milroy

But what I would share with you as I still think that the industry is not fully meeting the needs of our customers. That if you do broader research, you find relatively few instances where customers say, the whole industry is perfect, there is nothing else I want, I have no unmet needs from this industry. And so identifying those gaps and plug in those gaps is what we are all about.

And it’s the elements of a game plan – to your last part exactly how are we doing it? It takes you right back to the game plan. You can’t do it if you don’t have a precise definition, so that’s a first element of our game plan. And then, there is no more important imperative on the blocking and tackling them and riding up the team with what we understand those requirements to be.

Nate Brochmann – William Blair & Company

And that's all fair and I appreciate that. In terms of assuming some of the measurement, have you changed any of the incentive compensation for any of the employees along, the various lines in terms of responsibility, in terms of matching up with some of those measurements statistics?

Doug Milroy

Yes. We have changed – and the way we measure it is explicitly a part of every employees including mine performance revenue.

Nate Brochmann – William Blair & Company

Great. And then just kind of last question, and this goes back to an earlier one too is that I know you haven't added any head count yet, and I would assume part of that is just making sure you get your own platform and your game plan in place to the point where you want it before you become a little bit more aggressive. What would you need to see to kind of start adding the head count back? Is it more again getting the game plan where you want it and feel really comfortable with it or is it more about the macro economy in terms of bringing some of the head count back and becoming a little bit more aggressive?

Doug Milroy

I would say it’s the net of both of those things, because when net of both of those things implies better results for the company. So in short, the headcount will – the headcount will increase out of point when we need additional people to meet the demands of the business and we are not there yet.

Nate Brochmann – William Blair & Company

Great. Okay, thanks a lot.

Doug Milroy

Thank you.

Operator

Your next question comes from the line of Chris McGinnis with Sidoti & Company.

Chris McGinnis – Sidoti & Company

Good morning.

Doug Milroy

Good morning.

Chris McGinnis – Sidoti & Company

I guess just a couple of follow-ups. I guess to the first question originally asked was about the game plan. I know it's tough in this environment, but can you maybe talk about where you think you are at with the game plan? I guess maybe if you want to use the baseball analogy of what inning, but if you could just walk through that a little bit. I know with the operating environment now it's still difficult, but I guess just where you are at with that, if you don't mind.

Doug Milroy

No, the challenge in that I think is to answer it two ways. First of all, by definition, we are in the early stages. Even though as it was mentioned earlier, I am a week from having been the CEO for a full year, we didn’t actually put in place a new game plan until the latter part of the summer. So we are not even a year out there and so that the challenge is to take it and to really embed and continue to drive it, so into very early stages of that.

And I said there is two ways to answer that. The other reason I would say, we are in the early stages of it is I can conceive of a date Chris when we may say, well if the game plan has these four elements or these five or these three and they are different than exactly what we are listing today, because we felt we progressed this particular focus far enough. But I can’t conceive of a day when the number one objective would be any different than it is today. It’s driving a very high level of customer satisfaction.

So let me take that out for you just a little bit. When you think about the future evolutions of the company and you start talking about where your growth initiatives are going to come from and do you guys want to get into this, should you be focused on that? The answers will always come right back to customers. And we will take the company where our customers take us in terms of growth opportunities.

When I have seen customers do that, that’s how they make money. When I have seen companies depart from that with their own sense of the internal diversification and so forth without a tight tide of the customer, I have seen money thrown away doing that. So we will stay in that first camp.

Chris McGinnis – Sidoti & Company

Alright. In terms of you guys mentioned acquisitions in the future possibly with your balance sheet improving, you talked about your increasing your hurdle rate. Can you just expand on that a little bit, what you are looking for or how you would define that your criteria for the acquisitions?

Doug Milroy

Sure. And the – when we say that we are increasing in the hurdle rate, in a financial sense, people could hear that as the discount rate and we more mean the hurdle we get over before we are excited about doing an acquisition. And so the things that we are looking at is frankly foremost we are focused on the core business we have and how to improve it. So acquisitions that are highly complementary with that would be of interest to us.

But when we think about the hurdle we have to get over, first of all, we are only interested in something that’s in pretty good shape. We have got a lot to focus on right now and I wouldn’t want us to get into any kind of a problem through an acquisition. So we are only interested in things that are of a good shape. And then secondly, we are only interested in things at a reasonable price.

And when you look at the market, our experience recently is the seller sense of value hasn’t changed much through this recession. So I think the sellers who have stayed in the market, but remain steadfast in their belief of what their businesses are worth. And then you see another group of sellers who have said I am not going to get what I want in this market, so they have taken those businesses which I think there is a correlation will tend to be more attractive properties off the market so to speak.

Chris McGinnis – Sidoti & Company

I guess a housekeeping sort of – the bump up in the CapEx in the quarter, was that due to the – you guys mentioned last quarter the expansion, I believe in the stronger growth area, I guess geographic territory that was doing well that you invested in. Is that the bump up on the CapEx on a sequential basis?

Jeffrey Wright

This is Jeff. Good question. Not that I recall, I do remember the discussion the higher growth area that’s been a nice run business for us sand we expanded that facility. But I don’t recall if that was as the big driver of CapEx and actually I am not going to provide you a lot of insight here, but there wasn’t anything kind of unusual other than just kind of normal ebbs and flows of capital spending.

Chris McGinnis – Sidoti & Company

Okay, no problem. Well, thank you very much. I appreciate it.

Jeffrey Wright

You bet.

Operator

Your next question comes from the line of Mike Hamilton with RBC.

Mike Hamilton – RBC

Thank you. And thanks for all the detail.

Jeffrey Wright

Good morning, Mike.

Doug Milroy

Good morning, Mike.

Mike Hamilton – RBC

Good morning. First, just follow-up, any insights on fourth quarter CapEx, Jeff?

Jeffrey Wright

No, other than just kind of in this kind of normal range of CapEx that we have been having the last few quarters, $4 million to $5 million probably in that range would be the insight I would give you.

Mike Hamilton – RBC

Thanks. Could you walk through Canadian dollar impact on third quarter P&L?

Jeffrey Wright

Sure, if you – and I will just give you a kind of a year-over-year if you will look at the impact of the Canadian exchange rate on the prior year March 2009 quarter compared to the current year March 2010 quarter that the Canadian dollar strengthened quite a bit and we would calculate that probably in the range of $6.5 million of benefit if you will of increased revenue as a result of that stronger exchange rate and again just to emphasize, that’s already taken into account when we calculate our organic growth.

Mike Hamilton – RBC

Right. On the operating line?

Jeffrey Wright

Well, I would just, I guess I don’t have a specific number for you. But you just apply kind of the normal Canadian margin and you could get to – get through to the operating income impact.

Mike Hamilton – RBC

Fair enough. Thanks. I am assuming the gain on the facility and related divestiture is all in SG&A?

Jeffrey Wright

It is, yes, we actually kind of other income and expense, but that gets grouped into SG&A. You are correct.

Mike Hamilton – RBC

Alright. Anything quirky on the tax rate that gets applied there to be thinking about or –?

Jeffrey Wright

Well, the only I would tell you is that the – maybe just to emphasize that number that we gave you is a net gain. There is – we have the divestiture that happened in the quarter, we have true-up adjustments from previous divestitures. We also had a couple of other small asset sales. So there is some gain numbers, there is some loss numbers. The net gain is the number that we have articulated in the press release.

And the only quirky thing I would tell you is that if you apply tax rates, if you apply the tax rate to the gain and if you apply a tax rate to the loss, when you net it together, it gives you kind of a quirky outcome, if you look at the effective tax rate in that pro forma attachment to the press release, it looks a little out, I think it’s some 20% and it’s mostly just the math of applying to a gain and to a loss.

Mike Hamilton – RBC

Okay, thanks. That clarifies, you read my mind. I appreciate it. That's all for me.

Doug Milroy

Thanks Mike.

Jeffrey Wright

Thanks Mike.

Operator

(Operator Instructions).

Jeffrey Wright

Okay.

Operator

At this time, there are no further questions. Speakers, do you have any closing remarks?

Doug Milroy

Sure, we do, thank you. Closing remarks, I just would briefly like to repeat where I started, thank you for calling in today. We appreciate the time everybody takes to engage in these call. We appreciate your interest in our company.

We are clearly well on our way with our new game plan, it’s showing progress. And the plan and the progress together give us real confidence going forward. And we look forward to updating you in August on that progress.

Thank you, everybody.

Operator

This concludes today’s conference call. You may now disconnect.

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