G&K Services CEO Discusses F4Q2010 Results - Earnings Call Transcript

| About: G&K Services, (GK)

G&K Services, Inc. (GKSR) F4Q2010 Earnings Call Transcript August 17, 2010 11:00 AM ET

Executives

Shayn Carlson – Director, IR

Doug Milroy – CEO

Jeff Wright – EVP and CFO

Analysts

John Healy – Northcoast Research

Andrew Steinerman – J.P. Morgan

Chris McGinnis – Sidoti & Company

Mike Hamilton – RBC Wealth Management

Operator

Good morning. My name is May and I will be your conference operator today. At this time, I would like to welcome everyone to the G&K Services fiscal 2010 fourth quarter earnings 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) Thank you. I would now turn the conference over to Mr. Shayn Carlson, Director of Investor Relations. Sir, you may begin.

Shayn Carlson

Good morning. Thank you for joining our call today to discuss fiscal 2010 fourth 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 fourth 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 for 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 September 17. 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, and thank you very much for calling in today. As I always like to note, we appreciate your interest in our company and your taking the time to call in.

Today I’d like to cover three things. First, I’d like to briefly recap the fourth quarter. Then I’d like to take a look back at FY ’10, in part obviously because this is the end of our fiscal year. So it’s appropriate to look back at a full year. But also it’s a full year since we introduced our new game plan. So there too I think it makes sense to step back a little bit. And then third, I’d like to look ahead a little, obviously, to FY ’11, but we would actually like to speak today to longer term goals for the company as well. So I’ll cover those three points in order.

If I turn to the fourth quarter first, for Q4, we reported revenue of $220 million versus $218 million in the prior year’s same period. We reported earnings of $0.61 versus $0.16 in the prior year same period. But I’ve got to tell you there is a lot of moving pieces, as you’ve no doubt picked up from the press release already. To get an accurate picture of the underlying trends in the business, which is what I’m to do formals, I think you need to make a number of adjustments to both revenue and earnings.

Without an accounting change, we need to detail for you a little more. We’ve had some truing up not any new divestiture activity, but some truing up of some of our previous divestiture activity. We obviously had a 53rd week in the year, which fell in this quarter. And then as always, foreign exchange and tax rates. So frankly, this quarter, in particular, I think it’s best to let Jeff detail all those changes for you at once in a few minutes. That way, we only go through it once.

So what I’m going to attempt to do is move past that for the moment and speak to what we see as the underlying trends in the business. First, if you look at the revenues side, when you net all that out, rental organic growth was 6.25% negative for the quarter versus 10.5% in the prior quarter sequentially and versus a negative 11.5% in the prior year’s same quarter. So that’s our second consecutive quarter of improvement in our organic growth rate after eight quarters of decline.

Or if you look at it on a sequential basis, it again is the least sequential decline we’ve seen since North America began shutting jobs sometime ago. We are down about 1% sequentially. So that’s the fourth consecutive quarter of what we describe as stabilizing revenue. So from our vantage point, the quarter clearly feels like progress.

If you look at the earnings side, as I said, we reported $0.61 a share. Jeff is going to take you through the adjustments in a few minutes. But if I jump to – on an adjusted basis, the earnings were $0.36 for the 14-week quarter, which I know because that’s the way we talked about it last quarter when we gave some directional guidance on what we expected. So again, that standard we’d be looking at a year-over-year increase of 33% in EPS.

If to try and get a little more apples-and-apples, you take out the extra week and you try to do a comparison on a 13-week quarter, you would back out $0.03 earnings, it would still be $0.33, which would be a year-over-year improvement of 22%. That’s reflected in an adjusted operating margin of 6.7% or 200 basis points up from prior year when we first initiated our new game plan. So in our mind, the fourth quarter clearly continues to establish a positive OI trend line.

Again, as we’ve said, Jeff will take you through the adjustments. Clearly we’ve got a little bit of lift from the 53rd week. But even without that, you are looking at a 20% year-over-year. And I think the part I feel more strongly about is the numbers are fundamentally consistent with what we’ve said our focus in the business would be, which is focusing first and foremost on profitability or, what we call, earning our right to grow.

So when we step back, it’s a quarter we feel good about. Next, as I said, I’d like to step back and look at the year, and not just in the classic we’ve closed a year, let’s go through all the numbers, but more a reflection of this has been the first year with our new game plan. You will recall it was actually on this phone call last summer that we introduced it.

I’m willing to bet, frankly, my last dollar that everybody on this call can recite all four elements of the game plan by heart. But I’m going to go through them anyways. You will recall it’s made of redoubling our focus on customer satisfaction, driving a relentless focus on day-to-day execution, increasing our cost management focus, and addressing our underperforming locations. So when we look back at the year, I would argue we’ve made good progress on all four fronts.

Clearly we’ve redoubled our focus on customer satisfaction. It shows up in improved customer retention. It shows up in increased customer satisfaction. Last quarter we talked about having developed a new and more targeted measure for customer satisfaction early in the year. And we finished the year at a high for that measure.

It shows up in revenue stabilization and improved margins. And it will clearly be the key to our long-term success. It runs through the whole game plan. It’s by having a high level of customer satisfaction, customers stay with us, they buy more from us, and their instrumental in helping us acquire new accounts. So that’s a look-back at the first bucket.

The second, improved our day-to-day execution. Again, across the business, got sharper at the systems and the processes that are critical to our success. We made improvements to them, and in many cases, at lower cost. And again, it shows up in revenue and margin.

We increased our cost management focus. You will recall all the way back, I guess it was Q1 last year we had some fairly material changes, which obviously had a major impact. But I think more importantly, it’s been the ongoing ethos that we are driving deep into the company about how you manage cost. And you consistent ask yourself two questions, is what we are thinking about spending on of value to our customer? Is it in some other respect absolutely necessary? And if it’s not, then don’t spend it. And just driving that into a fabric of our company, I think you see again in margin expansion.

And then last is among our most significant success stories for the year, addressing our underperforming locations. You will recall this time last year we used, in fact, a pretty harsh word on ourselves that we had been too accepting of underperformance and that we had to shift that as a major element of our game plan. As such, if you look at the Q4-to-Q4 run rate on the businesses that we’ve been focused on, year-over-year we’ve expanded our profits by $3 million on a quarterly run rate basis or $12 million on an annualized basis.

So in the end, having gone through and highlighted a little bit those four key points, we would assert our game plan has fundamentally taken us in the right direction. We have reversed our trend of the recent years. We’ve done it in the phase of a very difficult economy. And in the end, we’ve taken what was already a strong balance sheet and made it even stronger, paying down nearly $70 million in debt in the last 12 months.

But when we think about setting ourselves up for future success, frankly I think the most important part of all of that is that the results were entirely consistent with what we said we would do. And we feel that’s particularly important, both externally and internally. So in a moment, I’d like to go on and talk a little about FY ’11, but before we do that, I want to hit one more important point on FY ’10.

I’d like the opportunity to step back and publicly acknowledge our team. As you’ve listened to and participated in these calls over the quarter, as you’ve tracked our progress, you’ve no doubt noted, we have been through a lot of change this year. And we’ve managed through that change in a very tough environment. And I think some kudos are due to the team that has stepped up and made all this good stuff happen. It’s a team that’s very excited about what we’ve done and more excited about where we are going and one that we can all continue to count on. And I just want the opportunity to step back and publicly say thank you.

Now if we look ahead to FY ’11 and beyond, let me start with next year. So if you start with next year, you would say, what’s the game plan for next year. And I guess the question I’ve put out is, how could we even think about doing other than sticking with the game plan that got us through the last year.

Our customers consistently endorse it. They endorse it with their words when you talk to them about what we are doing. And even more importantly, they endorse it with our pocket books. Our team is very much behind where we are taking the company. And as the leader in the company, I’ve spoke before about the personal priority that I put on constancy of purpose and what a critical success factor that is in running a business well for the long-term. So all of those reasons would suggest why would you even think about changing it.

And then last, I think most importantly, the progress, the game plan, the validity of it is showing up in our results. On an absolute basis, which I just reviewed with you, or if you look at it on a relative basis, I mean, a year ago we were very candor in highlighting our shortfall, either to the financial standards we had achieved years ago or frankly highlighting our shortfall relative to our competitors. So again, that candor from a year ago, I think it’s appropriate for us to point out we are closing both of those gaps.

So at the end of that assessment, what’s our game plan for FY ’11? Well, you no doubt have guessed, you already know the four elements in it; redoubling our focus on customer satisfaction, driving a relentless focus on day-to-day execution, increasing our cost management focus, and addressing our underperforming locations. It has taken us a long way this year, and we have every reason to believe it will in the coming year.

So the only color commentary I want to add to that game plan is to make sure that we highlight that fundamentally customers are at the heart of it. It is customer satisfaction that ultimately drives profitable growth. So with that as our game plan, I think the question then is, how far can that singular focus take us? And it’s hard to put an exact number to that question, but I guess I’m compelled to quote my friend, Buzz Lightyear, when I think about how far that can take us. I’d like to think, to infinity and beyond is where that game plan will take our company.

Now, having said that, I realize that infinity is a little hard to model on a go-forward basis and that a specific number would actually be helpful. So a year into our game plan, I think that’s appropriate. I think we do need to talk about more specific goals. The investment community often asks us about our specific long-term goals and I think rightly so. But every bit as importantly, we need specific long-term goals for our team as well. Clear goals create focus. They create motivation. They give you a sense of accomplishment. There is something very human about wanting specific goals to shoot for and to measure our progress against.

So having said all that, today we are announcing what we call our 10-10 goals. 10% return on invested capital and 10% operating margin. So let me talk about those goals in a little more detail. On the first one, return on invested capital, I’ve made a couple observations over the last year as what I label a relative newcomer to our industry. And another one is a robust discussion of return on invested capital is largely absent.

When I look at calls or reports or speeches, they tend to focus on revenue growth and operating margin. And that includes ourselves. But when we think about long-term goals, my experience has been that the ultimate measure is return on invested capital, not just revenue growth or operating margin expansion. So clearly, it’s not an entirely new and novel concept. Returns have been a focus here in our business and they will continue to be. I just want to see us give it a little more external visibility with the top-line measure around return on invested capital.

Now where does the 10% come from? When you think about return on invested capital, the target clearly has to be meeting or exceeding your cost of capital. There is no room to set arbitrary targets on what we think we might want to go after. And obviously, your weighted average cost of capital is dependent on a lot of factors, how rates move around and leverage and others. And all of those things can change over time. But our cost of capital now is right around 10%. And so we thought it made sense to just set that as our goal rather than keep referring to a number that shifts a little bit from time to time. So that’s how we landed on 10%.

On the margin side, let me speak to that next. At the same time, we frequently get the question not just about long-term goals, but very specifically, can you get back to double-digit operating margins? And both Jeff and I have consistently said through the last year, we don’t see any reason why we can’t. And as we sit here today, we still don’t see any reason why we can’t. And therefore we thought it made sense to establish that as well as a clear goal.

Now, let me speak to what I think will be a couple of logical questions about our goals. I’m sure there may be several. But two that come top of mind would be, what your revenue goal associated with this? And I would share with you that importantly, we are not establishing a revenue goal today. We are not saying we won’t ever, but at least not right now.

I think profitable revenue growth will be in fact an essential element of achieving these goals. But if we state explicitly a revenue goal, we would be again placing the emphasis on the wrong place. The focus has to be, first and foremost, on earning our cost of capital as the surest way to increase value for our shareholders. And when you make an explicit revenue goal, you run the risk of detracting and having some of your focus on the wrong measure.

The second question I would expect to get is, okay, I get your goals, when? When are you going to achieve these goals? So my answer there would be, it’s clearly not measured in quarters. It’s not even measured in the coming year. And obviously, it depends on a lot of factors. As you’ve seen this quarter, we still have a lot of moving pieces in our game plan. And I assure you that’s going to continue. There is going to be some ups and downs on a go-forward basis.

And regardless of what quarter tough decisions fall in, we are going to make the right decisions for the long-term. So we are going to have some ups and downs. You read the same papers I do. We clearly still face an uncertain economy. And the last thing I’d capture is, I think it’s way too early to tell how the competitive dynamics going to evolve as we move out of this recession. So obviously, the when depends on a number of factors. But having said all that, we still expect to achieve our 10-10 goals within the next two to four years.

So in summary, if I wrap up, I’d leave you with four thoughts. One, our quarter continued to establish a positive trend line in our business. Two, I think when you look back at the full year, it legitimates our game plan. So that brings me to point three, we would be silly to do others than stick with the game plan that’s working for us. And four, as a result of that, we are convinced that game plan will be foundational to delivering our 10-10 goals.

So as I alluded to earlier, now I’ll ask Jeff to take you through the financials in some detail. And then he and I would be happy to answer any questions you may have. Jeff?

Jeff Wright

Thanks, Doug. And good morning to everyone. This morning I’d like to cover two areas in more detail. First, I will review our fourth quarter financial performance with you and talk you through all the various moving parts. And then I’ll provide – secondly, I’ll provide some directional insight for the fiscal 2011 first quarter.

So to start, let me provide you an overview of the fourth quarter performance. For the quarter, revenue totaled $220.2 million that compares to revenue of $218.0 million in the prior year period. This higher level of revenue resulted from the extra week in our fourth quarter, an accounting change related to certain in-service merchandise items, and a stronger Canadian dollar. The extra week accounted for revenue of approximately $15 million, and the accounting change was approximately $6.7 million.

These gains in revenue were partially offset by the loss of revenue from the impact of a difficult economic environment on our customers and their employment levels and also our divestiture activity over the last 12 months. As you may recall, during this fiscal year, we have divested non-core businesses that generated approximately $9 million on a quarterly run rate basis.

Fourth quarter revenue from rental operations was $203.5 million, up from $200.7 million in the prior year period. After adjusting for the extra week and the accounting change, fourth quarter revenue from rental operations was $182.8 million. On a sequential basis, after adjusting for foreign currency translation, divestitures, the extra week and the accounting change, rental revenue was down, as Doug mentioned earlier, about 1% and marks the fourth consecutive quarter of stabilizing revenue results.

Within our core rental business, customer employment levels continued to stabilize for the fifth consecutive quarter and were essentially flat in the fourth quarter. So while our add-quit metric has continued to improve slightly, we are not yet seeing robust hiring within our customer base. For the quarter, our rental organic growth rate improved to negative 6.25%, and that compares to negative 11.5% in the prior year period. We are encouraged by our continued progress in improving the rental organic growth.

Turning to direct sales, fourth quarter direct sale revenue was $16.6 million. That compares to $17.3 million in the prior year period. And direct sale volume continues to be impacted by weak overall economic conditions.

So let me shift to profitability and let me walk you through this because, as Doug mentioned earlier, there are a lot of moving pieces. Fourth quarter net earnings were $0.61 per diluted share. This compares to a prior year period of $0.16 per diluted share. Our fourth quarter included a benefit of $0.23 per diluted share due to an accounting change to certain in-service inventory items and a gain of $0.02 per diluted share from divestitures and asset sales.

Recall, as well, the prior year period included a charge of $0.11 per diluted share related to the company’s leadership transition. So, on an adjusted basis, fourth quarter earnings increased to $0.36 per diluted share or up 33% as compared to $0.27 in the prior year period. Recall that when we provided our outlook last quarter, we included the impact of the extra week. And therefore the $0.36 is consistent with the guidance we’ve provided.

If, however, you remove the $0.03 per diluted share due to the extra week, earnings were $0.33 per diluted share or up 22% compared to the prior year. The increase in adjusted earnings was due to lower merchandise expense, production cost efficiencies, reduced administrative spending, and increased earnings from specific location profit improvement actions.

I think it’s also important to note that the prior year had a much lower tax rate, which impacted the year-over-year comparison by about $0.06 per share. So while adjusted earnings per share moved from $0.27 per share in the prior year to $0.36 per share in the current year, or an increase of $0.09 per share, our operations drove $0.15 increase while the tax rate caused the $0.06 decline in earnings per share.

Let me step back for a moment and talk briefly about the accounting change. During the fourth quarter, we changed the accounting for customer billings related to the towel and linen replacement revenue to reflect revisions to our business practices. In accordance with applicable accounting rules, these changes are accounted for on a prospective basis, and as mentioned, resulted in an increase to revenue of $6.7 million and earnings per share of $0.23 per share in the fourth quarter.

In addition, we modified the estimated useful lives of certain towel and linen merchandise to more accurately reflect their useful life. This change is also accounted for on a prospective basis. It’s important to note that these accounting changes will only affect our fiscal 2010 fourth quarter and the first and second quarters of fiscal 2011, which I’ll outline in a minute. There is no ongoing impact to our operating performance. Additionally, these changes only impact accounting and do not impact our cash flow.

As mentioned earlier, our fourth quarter earnings also benefited from divestitures and asset sales. This benefit was a result of true-up and post-closing adjustments from divestitures and asset sales that occurred during the fiscal year. There were no specific business divestitures or asset sales during the fourth quarter. As we stated last quarter, while we can’t guarantee that there won’t be some divestitures at some point in the future, we have completed the divestitures that were on our near-term radar.

Now let me shift to operating margins. Fourth quarter operating margin was 9.8% compared to 3.3% in the prior year period. The fourth quarter adjusted operating margin was 6.7% after excluding the benefit from the accounting change and the gains from divestiture activity and asset sales. The prior year period adjusted operating margin was 4.7% when excluding the charges related to the leadership transition. All of this resulted in a 200 basis point expansion in our adjusted operating margin. This improvement was driven by reduced merchandise expense, lower production costs, reduced administrative expenses, and a continued specific location profit improvement actions.

I’m sure some of you will have a question regarding the impact of the 53rd week on our margins. Almost all of our expenses are recorded weekly. This includes all payroll and benefits, as well as all costs such as merchandise, depreciation, utilities costs, etc. So the extra week does not impact our operating margins to any significant degree.

On a sequential basis, the fourth quarter adjusted operating margin was up 90 basis points compared to the third quarter. Sequentially, we drove a lower level of administrative expenses, benefited from lower payroll taxes, and continue to drive increased profitability from our underperforming locations. In addition, overall energy costs were also lower than the third quarter.

Our fourth quarter results reflect the continued positive trend line in operating margin that we’ve achieved since initiating our new game plan. Despite the economic pressure, we continued to generate strong cash flow. For the fiscal year ended July 3, 2010, cash flow from operations was $72.7 million and free cash flow was $56 million. With our continued focus on improving profitability, solid working capital management, and targeted capital spending, we expect to continue to generate strong free cash flow in fiscal 2011.

We continued to utilize our strong cash flow to pay down debt and fund our quarterly dividend. Debt net of cash was down $66.7 million over the last 12 months and down over $123 million since the end of fiscal 2008. As such, our financial stability and flexibility remains strong. So our strong cash flow clearly provides the financial flexibility to complete acquisitions. However, valuations still remain quite high, and we’ve raised our hurdle rates.

With that said, we continue to look at acquisitions that would strengthen our existing businesses. In addition to potential acquisitions, we will continue to look at other means of deploying capital, including returning capital to shareholders in the form of increased dividends.

Now, as we have done throughout this last fiscal year, we will provide some directional input to help the investment community moving forward. While we are encouraged that we’ve seen a continued moderation in the decline of our rental revenue, economic and employment conditions remain sluggish, especially given recent economic reports that we’ve all heard.

As stated in our press release this morning, we expect first quarter revenue to be down slightly from the prior year first quarter after adjusting for divestiture activity. We anticipate that the rental organic growth rate will continue its trend of improvement we’ve seen the last few quarters. We expect first quarter revenue from the company’s direct sale business to increase slightly as compared to the prior year period.

From a profitability standpoint, we expect first quarter adjusted operating margin to increase modestly as compared to the adjusted operating margin in the prior year first quarter and to be slightly lower than the fourth quarter we just reported. The first quarter effective tax rate is expected to increase to approximately 42% as a result of the expiration of stock options.

In addition, the change in accounting will have a positive impact to revenue and operating income of approximately $4 million in the first quarter and approximately $2 million in the second quarter. As I mentioned earlier, there will be no meaningful ongoing impact after the fiscal 2011 second quarter. We continue to be confident in the path we are on and our ability to further improve our performance. We look forward to reporting our progress in the quarters ahead.

So that concludes our prepared remarks. And I’ll turn it back to the operator and we’ll be glad to take your questions at this time.

Question-and-Answer Session

Operator

(Operator instructions) And your first question comes from the line of John Healy.

John Healy – Northcoast Research

Wanted to ask you, Doug, about just how you feel about the economy out there. Continue to feel like there is a lot of different cross currents going on out there, and wanted to get your thoughts on maybe the conversations you are having with your customer base regarding how they feel about the economy, maybe if that's changed at all since you wrapped up the quarter and just the feedback you are getting out there.

Doug Milroy

John, I would describe the conversations I’m in with customers and what I’m seeing personally when I’m out in the field as very consistent with what you’re reading in the newspapers, which is – maybe with the exception of the recent – there is so much recently about double-dip. What I see when I travel or when I’m with customers is more what we’ve seen in the months preceding the last one or two where people say, you know what, this is strengthening. Some of it is pipeline filling, but some of it is I believe that the economy genuinely is strengthening. And yet, real reservations about hiring people. And what I see it is even people talking about reluctance to hire part-time. And the part time or temporary worker tends to come first followed by the full-time. And so that’s what you are reading in the papers and that’s what I’m seeing firsthand. So my view is, we did have a feeling of the pipeline, so to speak. And if we can maintain even a moderate level of economic growth, we will work that back off and then see more genuine activity.

John Healy – Northcoast Research

Okay, helpful. And Doug, I wanted to get your thoughts about the growth potential in the industry. Not so much for what you guys are doing at G&K, but when I think about the growth drivers to your business, obviously new sales, headcount increases, selling more of your existing product line and product introduction, I was hoping to get your thoughts on those four areas. Which one do you think will be the most meaningful to this industry's growth rate over the next year or two going forward?

Doug Milroy

My quick reaction, John, is probably you have them pretty close to the right order. The new sales, I mean, even in the – I think you’ve heard me say before, even in these tough times, we continued to convert people to uniform programs that have never had them before as they see the value of what we do. And the image it conveys for that company, the safety, the security that it provides in their place of business and for their workplace I think in the recent quarter were still at roughly of 50/50 split in terms of business that is coming from customers that have never had a uniform program in the past. And so I think – that's why I end up using goofy phrases, John, like infinity and beyond because there is just so much of the GDP out there that isn’t touched by uniform program yet. So I would say your first one is the biggest one. The second is headcount. Clearly across North America, we’ve lost a lot. That will recover. The question is when. But that will recover over time. And that will be a ready and quick addition back to revenue for us and the industry.

Product line is the eternal opportunity and challenge of full customer penetration. When you look at the offering we have and the breadth of it, that continues to create an opportunity as well is to fully penetrate every customer with the breadth of solutions that we offer. And then the last one, product introduction. The one I’d point to most recently is, of course, a more significant, a more concerted focus on our part for direct purchase, recognizing that customers in fact almost universally buy both. The question is, what’s the right balance for any given customer? And you see that reflected in the continued growth in our direct purchase business. So in summary, I think there is growth potential across all four categories you mentioned. And whether it reflects your own analysis or just coincidental, I think you’ve put them in about the order where I would see the industry growth in the coming, say, two, three, four years.

John Healy – Northcoast Research

Coincidental is probably how I put them in that order.

Doug Milroy

Okay.

John Healy – Northcoast Research

And I wanted to get your thoughts on a comment you made there. Talking about the direct sales business, is there some sort of change in the industry where companies are looking more towards direct sales, maybe towards rental? Is there any sort of like factor that's maybe driving that and maybe how do you – how you are thinking about that going forward?

Doug Milroy

You know, I don’t see anything of the nature that you are alluding to, that it’s a fundamental change in customers, for example. I think it maybe more reflects the change in the industry that the industry has viewed itself as we rent garments and we clean them for you. And a recognition, as the industry looks for continuing opportunities to expand that – well, wait a minute. While a customer might appreciate that, a customer would appreciate even more a robust full offering that meets their needs. So I think it’s more a shift in the industry’s psyche than it is one in that of the customer base.

John Healy – Northcoast Research

Okay. And then just a final question. Jeff, I thought you mentioned kind of benefiting from some uniform amortization rolling off. How big – how meaningful of an opportunity is there over the next 12, 16 months or so, for kind of unlocking some margin potential in the company with just some of the extra uniforms that you haven't been able to generate revenue on, kind of rolling off your cost structure as you anniversary some of the losses of uniform wearers in your customer base?

Jeff Wright

Sure, John. We view that there is a significant ongoing opportunity to manage our merchandise inventory very well. And I think, as you know and as many of the listeners know, we maintain used stock rooms of uniforms at all of our facilities. And those stock rooms are more full than normal right now because of all of the jobs lost in the economy. And so to the extent that we can put those uniforms back to use with our customers, that’s a huge benefit because we’ve already taken the expense on the uniforms and it’s just an asset waiting to be used and to generate revenue and margin for us. So I think there is ongoing significant opportunity. It’s one of the areas that our entire company and field focuses on everyday is managing our merchandise very well with our customers each and every day.

John Healy – Northcoast Research

Okay. Thank you.

Operator

Your next question comes from the line of Andrew Steinerman.

Andrew Steinerman – J.P. Morgan

Hi, Doug. Hi, Jeff. My question is, as we go into the second year of the game plan, we said we are redoubling our customer satisfaction initiatives. My question is, do you measure this? But do you know what your firm's net promoter score is? And my question is, when do we feel like we've gotten to the right level of customer satisfaction? And of course the next thing that will follow is, when do we think we could extract value from the customer based on their satisfaction?

Doug Milroy

I’m just capturing your different parts. As we talked about last quarter, absolutely we do measure it. We had – almost with the inception of the game plan, we did some homework on how we wanted to measure it, established for ourselves a different measure that we think was more precisely targeted to what customers want. And we’ve had that in place. We at least described it. We haven’t detailed it, but we at least described its existence in the last call. And I mentioned earlier in this call that we finished the quarter with that number at a high for the prior year. I feel compelled because I’m so proud of it. I feel compelled. You sometimes ask about trends as you are starting the New Year or coming out of the last quarter. I feel compelled to share with you that that number has moved up even yet again in August. So we are – yes, absolutely we measure it.

As far as have we gotten to the limits of where it can go, I would say, not even close yet. And I understand based on some prior conversations, behind your question is, in part you spend on some things you do to satisfy your customer and is that a good return for you? And there can come a point where new and novel or whatever doesn’t pay back. We are nowhere near that, Andrew. We’re moving through just the – focused on the basic elements of delivery for our customer and making sure that that’s at the highest standard in the industry. And that’s about other elements of our game plan. A better day-to-day execution and so forth as opposed to material investments that may or may not pay back. So I think you could get to that point where you start saying, hey, this might be of value to our customer, but what would the return be? And we will look at those kinds of things in the months and years ahead, but we’re not there yet.

To your third point about how do you share the value between us and our customers and is it making a difference in those conversations, I would say, absolutely it is. I know from my personal involvement with our customers of enough situations where people look at us and say to us, hey, in this particular situation, you’re not the lowest price, but I’m going to go with you anyways and here is why. And they generally play back some element of exactly the requirements we’re trying to fulfill. And so in other words, I think some of that value is already coming our way and contributes to the margin expansion that you’ve seen.

Andrew Steinerman – J.P. Morgan

Excellent. And Jeff, we were talking about adjusted margins before, especially because of the accounting change. When you look at rental gross margins in the quarter, what would be the underlying rental gross margins without any gains or the accounting change?

Jeff Wright

Well, we focused the discussion primarily on operating margins because we – there is so much interplay between the two different line items. May I can give you a sense for some of the bigger moving parts as we’ve picked up the 200 basis points. But clearly, the work that we’ve done on improving the specific locations profitability has had a real nice impact on driving operating margins. So that’s been one big driver. The overhead reductions, both at our corporate and our regional locations, have really helped impact operating margins. It was asked about earlier, but our merchandise expense is down nicely on a year-over-year basis, as we put to use some of those used uniforms.

And finally, I would highlight that Doug mentioned in his comments, employee productivity is improving, but our labor – total labor as a percent of revenue is also down nicely and adding to margins. So we’ve got a number of areas that are working and having an impact on improving operating margins. And of course, all of that is offset I guess a bit by continued negative organic growth here that’s slowly stabilizing for us. But we’ve been able to offset all that growth and then provide some incremental operating margin.

Andrew Steinerman – J.P. Morgan

Right. Right. And then could you talk a little bit about your guidance on operating margins going into the first quarter being down sequentially? When I look at the history of your company, operating margins are not typically down in the September quarter versus the June quarter.

Jeff Wright

Sure. As we have mentioned before, maybe I can just give a little bit of color around our guidance just to make sure things are clarified. And I’ll start with revenue. We made a comment – last year’s revenue was I think about $208 million, and if you would adjust for divestitures, which will have an impact year-over-year of around $8 million or $9 million, so that would bring you down to about $199 million. And we said we will be a little short of that. So, something in that kind of mid-190s range is kind of where we think revenue will come in at. And that will reflect a continued trend of improving the rental organic growth rate again next quarter. On the margin side, again, the guidance said that – we think we’ll be a little bit above – modestly above last year’s Q1.

Recall that last year’s Q1 was 5.3%, and we also said that we think we will be – our projections indicate a little bit underneath the 6.7% that we just reported. So that kind of puts you into a fairly tight range, 5.3% to 6.7%. And as we’ve tried to articulate many times, there is a lot of moving parts at this point in terms of both inside the company and of course externally with the economy. One particular thing that happens here each quarter as we move Q4 to Q1 is we actually put pay raises in place for all of our salary personnel in Q1. And that’s one thing that impacts us. And I can’t speak, there might be a little bit off trend lines from prior year Q4 to Q1, but as we are sizing up the business right now, we think that that’s going to be the margin range that we will be in for Q1. But we are very confident, as we articulated earlier, that we are confident that the overall trend is an upward trend for the operating income margin. And we’re going to see little blips here and there as we work through things, but we’re confident in the overall trend of the operating margin.

Andrew Steinerman – J.P. Morgan

Jeff, I didn't catch if you agreed with me that typically in your company, let's say, in a more normal economy, operating margins are up for September versus June. And while you did note pay raises kick in at the beginning of a fiscal year, I assume also annual – just kind of annual fee raises to your clients also kick in perhaps more normally at the beginning of your fiscal year. I might be wrong on that. And I'm just asking, do you agree with that characterization that usually the September quarter versus the March quarter is a modestly up operating margin?

Jeff Wright

Andrew, no, I didn’t agree with that. I mentioned that I didn’t have a chance to go back and look at the last number of years, how Q4 might have compared to Q1 over the course of many years. But we do have the pay raises that are going into place for sure. We know that today in Q1. With respect to your comment on fees, the customers, those actually are spread out, I would describe, pretty evenly, they usually happen on the anniversary date of a customer’s contract. And therefore, there is no one time in the year where you get more or less than the other. They are generally spread fairly evenly over the year. So again, I would just make a comment that there continues to be a lot of moving parts. Our projections indicate the range that we’ve talked about. But we are very confident that the overall trend in operating margin is moving in the right direction.

Andrew Steinerman – J.P. Morgan

Thank you for that explanation. I appreciate it.

Operator

Your next question comes from the line of Chris McGinnis.

Chris McGinnis – Sidoti & Company

Just talking about the 10% operating margin, I guess what are the biggest buckets thinking about it taking out the organic growth of the business? I guess what are the major buckets of the four key buckets, if you want to call it, of your turnaround?

Doug Milroy

Chris, I guess I’d describe it this way. When we think about the 10% OI goal, clearly you’d like to think about profitable growth and the roll that that will play in a 10% margin. But speaking more directly to your point, we’ve been clear about – you can’t rely on your top-line. You’ve got to manage your income statement down the whole thing aggressively. So the way I’d answer your question is, we look very consistently at five buckets in our income statement. The first is merchandise. And that ranges from, are we buying it smart to are we using it effectively in service with our customers. The second bucket is production expenses, and that’s no different than anybody else running plant of any other kind. It is, how can you move things through your plant as quickly as possible, with as high a quality as possible, for as low a cost as possible. So, driving margin improvement in that second bucket.

Then the third bucket is, being a road-driven business. We look at our roads and road optimization, driving road density, driving customer penetration so that you’re getting the maximum gain from any one stop you choose to make and managing market through the road aggressively. And the fourth bucket is selling expense. And I prefer to flip it around and talk about sales productivity rather than selling expense. But for whatever level of investment we have decided to make in our sales effort, are you managing that investment from maximization of your profitable growth, your sales productivity.

And then the last bucket is G&A, as it pertains to certainly corporate and our regional structures. We’ve made some changes there and talked about them. But also it’s in every day, in all of our businesses kind of things where you’re working that angle of margin on a consistent basis. So when we think about getting to 10% operating income, I wouldn’t highlight any of those. I wouldn’t discard any of those in that discussion. It’s going to require aggressive management on our part across all five of those buckets to achieve our goals.

Chris McGinnis – Sidoti & Company

And what was the timeframe? Sorry, I heard it, but I just wanted to double check. What was the timeframe on the operating margin?

Doug Milroy

Two to four years.

Chris McGinnis – Sidoti & Company

Two to four years, all right. And I guess thinking about your sales force, are you still reducing or are you adding to that?

Doug Milroy

It’s been stable. Over the last couple of quarters of discussion with you, we have highlighted that our focus is driving more productivity out of the expenditures we are making. As far as the actual headcount, it’s been in a bucket, I would call, stable over the last several quarters.

Chris McGinnis – Sidoti & Company

All right, great. Thank you very much.

Doug Milroy

Sure.

Operator

Your next question comes from the line of Mike Hamilton.

Mike Hamilton – RBC Wealth Management

Good morning, everyone, and congratulations.

Doug Milroy

Hey, Mike, thanks.

Mike Hamilton – RBC Wealth Management

Jeff, was wondering, and I may have just missed it, can you break out the currency impact on the quarter?

Jeff Wright

Sure. The currency impact, when you compare Q4 last year to Q4 this year, had an impact of just shy of $5 million, I’d say about $4.8 million. And then if you took that down to the bottom line, it probably had an EPS impact of, I’d say, $0.02 a share probably.

Mike Hamilton – RBC Wealth Management

Yes, thanks. Obviously, one of the areas that's been very pleasing for the last year has been performance out of Canada. And just wondering if you can kind of give your views, you're starting to get some noise out of north of the border that the economy is beginning to show at least a few signs of sputtering. How are you looking at your business for the coming year?

Jeff Wright

I guess my comments I would make, Mike, is the – I think both the US and the Canadian economies have been in a tough sled the last couple of years here. Maybe US a little bit more difficult, but I think it’s been difficult in both. Particularly a year or so back, we’ve got, as I think people know, a pretty heavy concentration of business in that Ontario sector that’s a fairly heavier industrial sector. So those businesses were impacted pretty significantly when you dial back 12 to 18 months. But we’ve been pretty pleased, I think, across the board – not just Canada, but pretty pleased across the board that we are starting to see nice improvements.

We’ve mentioned the improvements in the select group of what we’ve dubbed our underperforming business. But again I’d emphasize a couple things. We’re seeing our merchandise cost down, and that’s kind of across the board and a function of everyone’s hard work across both US and Canada. And we’re seeing labor cost down as we drive productivity as well. And again I’d say, that’s pretty well across Canada and the US. So the business is, again, rebounding fairly nicely as we stabilize revenue and then drive a lot of the productivity improvements.

Mike Hamilton – RBC Wealth Management

Thanks. And anything worth noting on healthcare, workers' comp and any of those variables in the fourth quarter?

Jeff Wright

No. I’d say nothing worth noting there. We actually continue to do, I think, a pretty good job on both healthcare and workers’ comp to control those expenses. They were pretty – when you look at the periods presented, if you compare it either sequentially or year-over-year, they are pretty comparable as a percent of revenue. But I think as a team, we’ve done a pretty good job in improving and driving safety in our company’s continued strong focus and driving our workplace accidents down to a goal of zero eventually. We don’t want anyone to get hurt. But that’s a big focus for the company and will eventually result in those workers’ comp costs coming down.

Mike Hamilton – RBC Wealth Management

Jeff, if you could give me some further illumination on the accounting adjustment. Is the other side of the entry basically inventory adjustment here? I mean, we're grossing up sales. What's the other side of it?

Jeff Wright

Sure. That actually is the other side of it. We had – maybe I can just provide a little bit more color on the accounting change. Our business practices have changed related to certain replacement fees for lost and damaged towels and linens. And we had previously deferred the revenue and spread it over a period of time. And it was on the balance sheet as an offset to inventory. And we’ve now changed some of our business practices, and we’ve also confirmed that our merchandise amortization period already includes a provision for lost and damaged products. So deferral of that revenue is no longer required and not appropriate. So we will recognize it immediately moving forward and the amounts that were on the balance sheet will be allowed to stream off the balance sheet basically over the next three quarters. So that’s the one item.

And again, we also looked at the useful lives of those towels and linen merchandise and reset those to more accurately reflect their useful life. And just as an example, many of the linen items have shifted from primarily cotton-based products to polyester-based products, which last a lot longer. And so the life has been extended out in some of the linen pieces. But again, this is only an accounting issue. There is no impact on our customers. There is no impact on our cash flow. And again, just to reiterate the numbers, the number in Q1 is again expected to be about $4 million coming up; and in Q2, it will be about $2 million; and after that, it will be modest to no impact after that. So hopefully that helps.

Mike Hamilton – RBC Wealth Management

Yes. No, great explanation. I just have to be careful when I knock the candle over at the restaurant now.

Jeff Wright

You’re damaging a long-lived asset.

Mike Hamilton – RBC Wealth Management

If it is petro chem based, now it will go poof on me now. One final one for you. And that's I thought even ex-ing out the additional week, the direct sale looked solid in the quarter and it sounds like you're looking for that to pull back a little bit first quarter. First of all, is that accurate? And is there anything going on with larger program activity or anything else worth noting there?

Jeff Wright

Sure. The direct sale business has been continuing to stabilize consistent with the rental business. We do expect that – we mentioned that it will be up on a year-over-year basis, Q1-to-Q1. And I’d just point out that last year it was at a fairly low level. It was – I think the number was about $12.5 million. So it’s going to be up over those levels, but it may in fact be down a little bit from Q4 levels. So the business does continue to stabilize. We are pleased with that. And we do have a nice pipeline and potential opportunities in place. So that’s the color I’d give you there.

Mike Hamilton – RBC Wealth Management

Thanks for all the great detail. I’m sorry, Doug, yes?

Doug Milroy

The only thing I would add to that is that direct purchase business is made up of predominantly two chunks. One, you alluded to, is there anything major going with programs there. And the other is just smaller incremental sales to customers on an ongoing basis that core catalog business. And over the last couple of years, as we’ve invested in and strengthened that core catalog business, you see a more stable growth in its – a more stable revenue trend in its growth pattern. And so it’s not going to happen in one or two quarters, but over time, that will provide stability to that direct purchase number and take a little of the lumpiness out of it that comes from start or stop on big programs. So over time, that trend will moderate.

Mike Hamilton – RBC Wealth Management

Thank you.

Operator

We have now reached the allotted amount of time for questions. I will now turn the conference back over to Mr. Carlson.

Doug Milroy

This is Doug. I’ll take it, Shayn. And all I wanted to do was end where I started, which is – thank you for calling in. We appreciate this time every quarter to have a chance to update you on our business. We feel that we are clearly on our way with our new game plan, which as we go into the year remains unchanged. We think we have results that validate that. And while we expect there to be some up and down around the trend line, we like the look of our trend line. And to that end, we look forward to updating you on the next set of data points on that trend line and one more quarter. We look forward to talking to you in November. Thank you, everyone.

Operator

This concludes today’s conference. You may disconnect at this time.

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