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Cintas Corporation (NASDAQ:CTAS)

F3Q07 Earnings Call

March 20, 2007 5:00 pm ET

Executives

Bill Gale - VP of Finance and CFO

Scott Farmer - CEO

Mike Thompson - VP and Treasurer

Analysts

Scott Schneeberger - CIBC

Michael Schneider - Robert W. Baird

Kartik Mehta - FTN Midwest

Chris Gutek - Morgan Stanley

Gary Bisbee - Lehman Brothers

Pete Carrillo - Citigroup

Bruce Simpson - William Blair & Company

Greg Halter - Great Lakes Review

Presentation

Operator

Good day everyone and welcome to the Cintas Quarterly Earnings Results Conference Call. Today's call is being recorded. At this time, I would like to turn the call over to Mr. Bill Gale, Vice President of Finance and Chief Financial Officer. Please go ahead, sir.

Bill Gale

Good evening and thank you for joining us to hear the results for our third quarter of fiscal 2007. We are pleased to announce increased sales and profits for the quarter ending February 28, 2007. Revenue grew at a rate of 8.2% to $905 million. Earnings per share were $0.48 versus $0.45 a year ago, a 6.7% increase.

During the quarter, the company purchased 1.4 million shares of Cintas stock under the authorized share repurchase program. Our financial condition continues to remain strong.

At February 28, debt-to-capitalization was 30.1%, despite the expenditures of over $135 million for acquisitions this year and the repurchase of approximately $200 million of our stock so far in fiscal '07.

Last week, the company also paid its annual dividend of $0.39 per share, an 11.4% increase over the dividend paid last year.

Due to the lower rental revenues in the third quarter from what we had previously expected, as well as the recent trends in the growth components, we are adjusting our guidance for the year.

For the entire year, we expect revenues to be in the range of $3.675 billion to $3.725 billion and earnings per share to be between $2.03 and $2.08.

With me today is Scott Farmer, our Chief Executive Officer and Mike Thompson, our Vice President and Treasurer. After some comments from both Mike and Scott, we will open the call to questions.

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

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

I would now like to turn the call over to Mike Thompson.

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Mike Thompson

Thanks, Bill. As Bill mentioned, total revenues were $905.4 million for the quarter, an 8.2% increase over that reported in the prior year. Our third quarter had 64 workdays, the same number of workdays as the third quarter of fiscal 2006.

As a reminder, the workday breakdown for each quarter of fiscal 2007 is the same as the quarterly breakdown in fiscal 2006, which means that our fourth quarter which will end at May 31, 2007 will have 66 workdays.

Internal growth for the company was 4.5% as compared to 6.1% in the second quarter. Rental revenues for the third quarter were $665.6 million compared to $631.3 million last year. This was an increase of 5.4%. Factoring out acquisitions made over the last 12 months, our rental organic growth rate was 3% for the quarter.

As mentioned in our earnings release, our revenue growth has been impacted by a few factors. First, we experienced a mild winter season into early February. Our third quarter is traditionally a slower growth quarter when looked at on a sequential basis. This is due to the fewer amount of workdays caused by customer closings around the holidays and the short month of February.

Typically, increased volume from the seasonal injection of jackets and mats helps offset these items. This year's delayed winter weather did not allow this to occur.

We also continued to experience external economic pressures, especially in our uniform rental business. Many traditional uniform wearing industries continued to show declines in domestic employment due to off-shoring and improving technologies.

Employment levels within our customer base continue to be negatively impacted, not only through the direct reductions in the number of people wearing uniforms in such businesses, but also via the ripple effect this reduction has on numerous ancillary businesses that depend on those businesses for a portion of their livelihood.

These ancillary businesses include all types of companies, ranging from part suppliers to distribution centers, to electricians and plumbers servicing these facilities, to local restaurants and bars surrounding these facilities.

Unemployment levels in the overall economy have remained relatively low with offsetting growth occurring mainly in the healthcare, financial services, government, and until recently housing sectors. These sectors have not been a large part of our traditional uniform rental base.

We continue to grow in all of our lines of business, but the leakage from lost business and staffs continues to be higher than traditional levels.

There has also been a disruption in our new business from the continued implementation of our new sales organization. Scott Farmer will provide an update on the current status of this initiative in a moment.

Other services revenue of $239.8 million increased approximately 16.9% from last year's third quarter revenue of $205.1 million. On an organic basis, this segment of our business grew 9.3% in the third quarter as compared to 8.9% in the second quarter.

As a reminder, the other services segment includes: The direct sale of uniforms to national account customers. The sale of uniforms through our catalog to local customers, primarily customers who rent products from us. Our First Aid and Safety Division including Fire Protection Services. And our Document Management Division, which is primarily document shredding.

Our uniform direct sale business, which includes both our National Account Sales Division and our Rental Division catalog sales, in total increased approximately 5.3% on an organic basis for the quarter. As a reminder, this business does experience more volatility in its revenue base, due to the timing of new account rollouts.

We continue to see strength in healthcare, hospitality and gaming, which are the key sectors for our National Account Sales Division.

The First Aid and Safety Division, which includes the Fire Protection business, continues to expand at a rapid rate with 25% growth during the quarter and 11.4% on an organic basis. Our First Aid and Safety business and our Fire Protection Services business each achieved double-digit internal growth rates again this quarter.

We are very encouraged by the value proposition that we offer to our customers and our expanding line of first aid, safety, and fire protection services. And we continue to expand our products, services, and geographic coverage of this business.

Our Document Management business is expanding at a rapid rate with total third quarter revenues growing 56% over the second quarter of fiscal 2006. After entering this space approximately four years ago, we have now grown to a business with an annual run-rate of over $110 million in revenue.

We are servicing approximately 115 markets in United States and Canada, including approximately 80 of the top 100 markets. Given our size and scope in this business, we now consider ourselves to have a national coverage.

We will continue to fill in the remaining footprint with strategic acquisitions or greenfield startups, as opportunities arise.

Our Document Management Division continues to deliver strong organic growth rates, achieving 27% organic growth in the third quarter.

I will now turn the call over to Scott for some additional comments.

Scott Farmer

Thanks, Mike and good evening, everyone. Before Mike takes us through the rest of our third quarter results, I felt it important to provide everyone with an update of our ongoing sales reorganization which we call Project One Team.

At Cintas, we have always prided ourselves on having a top-tier selling organization. In fact, Selling Power Magazine recently identified Cintas as one of the top 50 companies to sell for. This award is presented to companies with large sales forces based on various factors including compensation, training, and career mobility.

We believe that our new Project One Team initiative will make a great sales organization and make it even better.

As you may recall, historically, our sales process was managed on a local level with individual sales reps and sales managers reporting through local general managers within a specific line of business.

The Project One Team structure provides for a separate professional sales organization that reports through the organization directly to me. The new structure is designed to improve revenues, to increase sales rep productivity, and to improve cross-selling opportunities and reduced sales rep turnover.

Another benefit of the new sales organization is the additional time our local general managers now have to devote to the operational side of their business. By having the sales teams now report to a separate organization, we freed up approximately 20% to 25% of our general managers' time. Time they can now use to address their service and production areas of the business as well as take better care of their customers.

Many projects are underway in these areas, which are designed to reduce lost business and to become more efficient in our processing and delivering techniques.

While we are still in the early stages of this process, one encouraging sign is that our Rental Division customer satisfaction index has risen to its highest level in many years.

As we mentioned in our second quarter earnings call, the Project One Team organization was rolled out to all of our groups as of the end of December. The new organization is now in place across the company.

We are very encouraged by the early results of this new organization. The transition of this new organization, as expected, has led to some disruption in the amount of new business being sold.

During the process, we promoted many high-performing sales representatives to managerial positions. And then, we hired or backfilled a significant number of partners into the open sales territories. These new sales representatives are not producing at levels comparable to those sales representatives who were promoted.

We expect the full benefit of the new sales organization to occur once the new sales managers and sales representatives have been properly trained in their new areas of responsibility and gain experience in their new positions. For example, a new uniform sales rep typically takes 9 to 12 months to become fully productive.

Even though it's still early in the transition process, we are already seeing positive signs from the new organization. Our sales rep turnover is improving. In fact, our sales rep turnover is now lower than it has been in many years. We are also seeing some very positive results of our sales retraining efforts.

The new training programs have been established in order to provide our sales force with the tools necessary to properly identify and execute on cross-selling opportunities. These new programs also are providing a more consistent approach to the fundamentals of the sales process along all lines of our business.

In the short-term, this training has pulled our sales reps and our sales managers from the field, thereby reducing the amount of time they have to sell new business. However, these new training programs are providing a solid foundation for future growth.

For example, while we are still very early in the process, preliminary results have shown that we are now achieving better pricing on new uniform rental business being sold. And our cross-selling results are improving.

Cross-selling improvement is currently being seen through the improved growth within our other services segment. This is mainly due to the size of these divisions and the amount of customers, versus the size of the rental division.

As mentioned earlier, our internal growth for our other services segment was 9.3% for the quarter. While we are experiencing some economic headwind, we are excited about our future growth prospects in all lines of our business. We believe that we are now better organized today to take advantage of these opportunities.

In fact, after seeing our preliminary results under Project One Team and the positive impact we believe it will have once it is fully in place, we wish we would have implemented this structure two or three years ago.

I will now turn the call back over to Mike for some additional financial information.

Mike Thompson

Thanks, Scott. I will now discuss our margins for the quarter. Total company margins for the quarter were 42.6%, a 20-basis point increase over 42.4% in the second quarter of fiscal 2007 and a 40-basis point increase over 42.2% in the third quarter of last year.

From a historical perspective, energy costs remained high. Energy costs for the third quarter were approximately 3.3% of sales versus 3.1% in the second quarter and 3.8% in the third quarter last year.

The 20-basis point increase in energy costs from the second quarter was mainly due to increased fuel costs or natural gas used primarily to run our rental plants. Delivery, gas and electricity were comparable with the second quarter.

We traditionally experience an increase in energy costs from the second to the third quarter due to colder weather. This year's quarterly increase in energy costs was not as significant as prior years mainly due to milder weather.

The 50-basis point margin improvement in energy costs, when compared to last year's third quarter, was due to a decrease in fuel costs mainly to run our rental plants. This was due to a combination of the milder weather this year and a reduction in the price of fuel.

Delivery, gas and electric were comparable to the prior year. We have not seen a sustained reduction in the price of gasoline or diesel.

Our rental margins for the third quarter were 44.2% of revenue versus 44.5% for the second quarter of fiscal 2007 and 44.5% in the third quarter of fiscal 2006. The decrease in rental gross margin of 30 basis points from the second quarter was due to the increase in energy costs, as well as an increase in service labor.

When comparing rental gross margin to the third quarter of fiscal 2006, the favorable energy benefit of 50 basis points was offset by increased delivery costs.

The additional reduction in rental gross margin was due to a combination of factors, including increased depreciation on Ultra-Clean trucks and some additional equipment maintenance.

As we have mentioned on previous calls, we are experiencing increased delivery labor costs due to the introduction of our Sanis Ultra-Clean service. This is a more labor-intensive service and our current route volumes and densities are low.

We expect labor costs to come more into line as we further penetrate our geographic markets and increase route volumes.

The gross margin in our other services segment continues to strengthen, reaching 38.1% for the third quarter versus 35.3% for the third quarter of fiscal 2006 and 36.3% of revenue for the second quarter of 2007.

Our First Aid and Safety and Document Management divisions continue to gain scale and become more profitable businesses. Their high growth rates and related margin improvement are driving the overall margin improvement in the other services operating segment.

Our selling and administrative expenses were 28.0% of revenue as compared to 26.9% in the second quarter of fiscal 2007 and 26.8% in the third quarter of the prior year.

As a reminder, all employee benefit costs for the entire company, other than wages and bonuses, are included in our administrative expenses. This includes medical and retirement costs, as well as payroll taxes and workers' compensation.

Medical costs increased by 10 basis points from the second quarter, but we are 50 basis points higher than last year's third quarter. The decrease from the second quarter was a combination of a lower, more normalized high-cost claimant figure than we saw in the second quarter. This was offset partially by an increase in the number of participants in our plan.

Our medical plan is especially self-insured. We did switch administrators on January 1st. At that time, we also had our annual open enrollment. With a move to the new provider and plan, we experienced an increase in the number of partners that are on our medical plan. When compared to the third quarter of last year, the 50-basis point increase in medical costs is a combination of rising medical costs and the increase in number of participants.

Payroll taxes were flat when comparing the third quarter of fiscal 2007's percent of sale to the third quarter of 2006. However, there was a 60-basis point increase in these costs from the second quarter of 2006. This is an annual occurrence as the calendar tax year ends during our fiscal third quarter and payroll taxes reset.

Selling expense increased 30 basis points over the second quarter and 70 basis points over the third quarter of fiscal 2006. This investment is being made in the new sales structure in order to benefit growth in the long-term.

G&A labor was flat as compared to the second quarter and down 10 basis points versus last year. Income before net interest and taxes increased 3.2% over the third quarter of fiscal 2006 and is a healthy 14.7% of revenue.

Income before income taxes for the rentals operating segment was $105.2 million or 15.8% of revenue. And income before income taxes for the other services segment was $27.5 million or 11.5% of revenue.

Net interest costs increased 1.1% of sales from 0.6% of sales in the prior year third quarter. This increase is due to additional debt taken on to fund acquisitions and the funding of our share buyback program.

We continue to hold approximately $157.5 million in cash and marketable securities rather than prematurely liquidating investments and taking a loss. As investments reach maturity, our intention is to use the proceeds to pay down remaining commercial paper borrowings, contingent on cash needs and acquisition opportunities.

As of February 28th, we had approximately $170 million of commercial paper outstanding, an increase of approximately $93 million from the second quarter.

Our third quarter effective tax rate was 37.3% for the quarter, which is consistent with the second quarter. We expect the effective tax rate to remain at 37.3% for the remainder of this fiscal year.

For the quarter, net income of $76.7 million increased 0.2% over the third quarter of fiscal 2006 and earnings per share increased 6.7% to $0.48 per diluted share, reflecting operational results and the impact of the share buyback program.

The balance sheet continues to be very strong. Our current ratio stands at 1.7 to 1. This ratio includes $225 million of debt currently included in current liabilities, as this debt becomes due in June 2007.

As previously disclosed, we entered into a forward starting swap, which we intend to exercise in conjunction with an anticipated $200 million debt issuance in 2007, in order to offset the majority of the debt coming due in June. Additional information regarding this swap is included in our most recently filed 10-K.

Cash and marketable securities stood at approximately $157.5 million. As marketable securities mature, we anticipate using these funds to pay down debt depending on operating and acquisition needs.

DSOs on accounts receivable were 40 days, which represents a slight increase over the prior year. We have noted our customers on average taking longer to pay their bills, which is indicative of a more difficult economic environment. We have not experienced a change in our level of write-offs, but rather in the timing of collections.

Inventories have increased $29 million from May 31, 2006. This increase reflects the build-back to normalized levels after a significant reduction at May 31, 2006, as well as the introduction of new products and the result of the revenue growth.

Our Rental and National Account Sales divisions had strong revenues in the fourth quarter of fiscal 2006, especially in May.

Inventory levels have subsequently been replenished to more appropriate levels in order to properly support customer service.

Accrued liabilities increased approximately $46 million from May of 2006. This increase was due to the dividend payable to shareholders of approximately $62 million.

Our total outstanding debt stood at $884 million at the end of February, which includes the long-term debt due within one year. Total debt as a percentage of capitalization was approximately 30.1% and net debt-to-cap was 26.1%.

As mentioned in our earnings release, we've purchased 1.4 million shares of outstanding common stock during the quarter at a cost of $57 million. This increases the total number of shares purchased since the inception of our share buyback program to 14.2 million shares at a total cost of $580 million. We have an additional $420 million of additional authorization to purchase our common stock under parameters established by our Board.

Since the inception of the buyback program, we have purchased approximately 8% of our outstanding shares.

Operating cash flow for the nine months ended February 28 was $322 million, an increase of $11 million as compared to the $311 million generated during the first nine months of fiscal 2006. This increase was mainly generated from an increase in net income.

Capital expenditures were approximately $129 million for the first nine months of the year. We expect capital expenditures for fiscal 2007 to be approximately $160 million to $170 million.

During the third quarter, we spent approximately $140 million on a combination of acquisitions and share buybacks. In addition, we accrued approximately $60 million for our annual dividend payment. The $0.39 dividend was paid to our shareholders in March.

This concludes our formal remarks, and I would now like to open the call to any questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And we'll hear first from Scott Schneeberger of CIBC.

Scott Schneeberger - CIBC

Hey, good afternoon. A Project One question to start off, on an absolute level, how has headcount changed throughout the process? And where do you see that going from here?

Scott Farmer

Well, we don't typically report on the number of sales people that we have in our sales organization. I think that what the benefits of this will be is that it will be a more consistent sales force as a result of lower turnover. So that we'll have more people in their sales positions longer and therefore see sales productivity go up.

Our sales headcount is going to be based on the opportunities that we see within the certain geographic markets and things like that. So, the ideal headcount will be designed around the number of prospects and the number of opportunities that we have in that market. But the One Team organization is more designed to improve rep productivity, reduce turnover and improve our opportunities to cross-sell our various businesses.

Scott Schneeberger - CIBC

Thanks. You had indicated in the press release that six months to a year is what it takes for new reps to fill the shoes of the reps that were promoted. Where are we in that process? Do we have to wait another couple of quarters? When do we see a turn there, would you say?

Scott Farmer

Well, the full organization went live by the end of the calendar year on the new organization. So, in the third quarter we had a lot of training time. A lot of those people were promoted into their jobs at the beginning of that quarter. So, as every month goes by, we'll see their tenure and their expected productivity continue to improve.

The guidance that we want to give is through the end of this fiscal year. And we don’t want to be overly optimistic about what's going to happen beyond that. So, although we are very excited about what the impact will be, I can tell you that I would like to get a couple more months under our belt to watch what the real activity is. And we'll provide guidance for next fiscal year based on what we see.

That said, every month that goes by and that these sales reps and sales managers are in their new position, it is going to generate improvement in their ability to accomplish their jobs.

Scott Schneeberger - CIBC

Thanks. Just on the core rental business. You noted some verticals where you've been seeing decent performance overall, but I think with decelerating growth. What are you doing within some of those verticals, healthcare, financial services, government, etcetera, to continue to drive business?

Bill Gale

Well, we are looking at some additional products that will be more conducive to a couple of those segments. But I would tell you that as far as uniform rental is concerned, we are not going to be seeing much activity in the segments of financial services or government.

But we are seeing some great opportunities with some of our other businesses, especially in financial services. And we are seeing a lot of great opportunities in the uniform business in the healthcare market. So, as we continue to develop products and delivery techniques in those segments, I think that will help to fund the growth as that area of the economy continues to improve.

Scott Schneeberger - CIBC

One more quick one and then I will hop out. You had foreshadowed that you were thinking of going international. And it wouldn't be a matter of a year or two, but multiple years. Does the slowing that you are seeing now will speed-up that initiative? Thanks very much.

Scott Farmer

Well, I guess the best way to answer that is that we are analyzing where our opportunities would be in our different business segments, relative to opportunities internationally. I think you all know we are in Canada, in Mexico, in the Caribbean, and with the hotel industry and the cruise line industry and things like that. But really offshore into Europe or Asia or something like that, we are looking at our opportunities that make sense.

While we have said in the past that we would look out into the future and it might be a few years out, I would say that if the right opportunity presented itself sooner than that, we would certainly take a look at it. And so, we are in that process right now of evaluating what would make sense for us.

Bill Gale

I think on top of that also. The other part of the question was because of our slowing growth rate. We would not look to international because of a slowing growth rate. Here we see a lot of opportunity. We see a lot of benefit from this new sales organization. So, we don't feel compelled to look for that growth. Elsewhere at this point in time although if opportunities arise, as Scott indicated we would look at that.

Scott Schneeberger - CIBC

Thanks.

Operator

Next, we will hear from Michael Schneider of Robert W. Baird.

Michael Schneider - Robert W. Baird

Good evening guys.

Bill Gale

Hi, Mike

Scott Farmer

Hi, Mike

Michael Schneider - Robert W. Baird

Maybe first we can start just with Project One. Scott and all of you are very optimistic about the ultimate returns from this. Can you give us a sense and it sounds like you have got some data from the early field deployments to back this up? Can you give us a sense of what new business growth is in some of the first territories to adopt Project One? And who are presumably beyond the 6- to 9-month period versus some of the newest ones that are just being impacted by the disruption to give us some confidence? And give us the basis for which you are confident?

Scott Farmer

Well, I guess that I can give you some generalities in this regard. We have seen improvement in sales rep productivity. We have seen a reduction in sales rep turnover to the level of sales rep turnover that we haven't seen in several years. So that's a big positive. The cross-sell activity continues to improve in these markets, more so than the markets that we just rolled this out to. So, the experience and the tenure of these folks in these areas help to drive that.

And I would say one of the big things from an overall company standpoint is the opportunity that our general managers now have to spend significantly more time in their business is definitely showing an overall improvement in our customer satisfaction scores. And I think that obviously bodes well for our ability to continue to cross-sell. It's more likely for a happy customer that wants to add one of our new products or services. The likelihood of renewing those customers and reducing lost business is a benefit as well.

So, I would say that those are the type of indicators that we have seen that we would expect to continue throughout the rest of the organization.

The biggest disruption and the biggest issue that Project One Team has had for us at this point is the time to take the reps out of the field to do the training. And the fact, we are putting rookies in behind our most experienced and really some of our most productive and active sales reps who just got promoted.

So you are replacing one of our more productive people with somebody who has really no production at the beginning of his tenure.

Michael Schneider - Robert W. Baird

And the first territory to be rolled out was in what quarter, was that Q1?

Scott Farmer

No, we actually tested the program through the end of last fiscal year, the later part of fiscal 2006.

Michael Schneider - Robert W. Baird

Okay. So when you look at the organic growth in that so called territory one, is organic growth today higher than it was a year ago?

Scott Farmer

Yes.

Michael Schneider - Robert W. Baird

So, you have actually seen an improvement in the organic growth rate in that territory despite the economic deterioration?

Scott Farmer

Yes, an improvement over where the organic growth rate was for comparing that group prior to Project One Team or to after Project One Team.

Michael Schneider - Robert W. Baird

Okay. That's great news. And then just switching gears to acquisitions during the quarter. It looks like you spent by my quick numbers, I think some $80 million in the quarter. Can you tell us how that breaks down between the two divisions? And what type of revenue you've actually purchased, so we can model those acquisitions going forward?

Bill Gale

Michael, I can't give you the exact details, but it was primarily in the Document Management and the First Aid and Safety divisions. There was very little in the uniform and rental.

Michael Schneider - Robert W. Baird

Okay. And a similar question, how much was contributed in each segment by acquisitions this quarter?

Bill Gale

We are not going to be disclosing that detail at this time.

Michael Schneider - Robert W. Baird

Okay. And then final question, just on the earnings guidance for Q4, it is actually at the mid point, at least down year-over-year. And it is the first quarter in a long time or frankly, I can remember that it's actually going to be a negative comparison. Is that something you would expect to spill over into fiscal '08 at least in the first half?

Bill Gale

Well, a lot of it is dependent upon what happens, obviously, with the top line growth, as well as what happens with interest expense. A part of what you are seeing there in the fourth quarter is the impact of the additional interest expense also. It's too early for me to give you a prediction on next fiscal year. We will have to wait and do that in July when we talk about the call, because we are just in the beginning of our budgeting cycle right now.

Michael Schneider - Robert W. Baird

Thank you again.

Operator

Now we will hear from Kartik Mehta.

Kartik Mehta - FTN Midwest

Scott, I wanted to ask your opinion about the uniform business. As you look at the business, notwithstanding maybe the economy, but some of the stuff you have talked about in the past, the offshoring. Do you think the growth rate for this business has changed as we look out two to three years or do you think the growth rate is still the same, and it's a matter of getting Project One completed and executing on that?

Scott Farmer

Well, first of all let me say that I think we will be much better positioned to take advantage of whatever opportunities we have in these businesses as a result of Project One Team. So, I think we will perform better as a sales organization under Project One Team than we have been able to in the past relative to whatever opportunities are out there.

As I look at the uniform business, I would say that one of the biggest problem areas that I see in that business is that when we take two steps forward by selling a number of new accounts and we take a step back with one of our existing accounts, eliminating a shift or moving an operation or a job offshore or something like that. That causes the headwind. If that bottoms out, if it levels off then I think that part of that headwind goes away. And we can improve our internal growth rate in that business as a result of that.

We faced this issue for many quarters in a row now. It's nothing new that this has been going on. I think that it's a matter of severity from time to time. The automotive plants make a big announcement and the timing of those things could impact our growth rate one quarter more than another. But, we also face the economies of our size in that business as well.

But, I think, we can grow in that business, and I think we will grow better as a result of our new sales organization than we could without it. We'll have to see what the economic conditions bring.

Kartik Mehta - FTN Midwest

Then from an entire company standpoint, Scott, do you feel that the way the businesses that you have now can still help you deliver double-digit organic growth as you move forward? Are there changes you would need to make to get to that point?

Scott Farmer

I think that the new businesses that we have are contributing very nicely. They are growing double-digits. And as they continue to get bigger and become a bigger part of the company, they are going to help the overall growth rate to continue to improve.

In addition to that, I think that we will continue to be able to make acquisitions in a number of these different businesses. We will continue to look at opportunities for us to develop new products and services, even within our core businesses and the rental business as an example. The Sanis Ultra-Clean is a great example of that which should give us continued opportunities to generate a future growth within our existing customer base and to prospects. So, I would say that those things being part of our arsenal of opportunities, we should be able to continue to grow the company.

I don't know in the short-term that double-digit internal growth, as a result of the disruption that Project One Team has had, is going to be there. But I would expect to see, as it takes hold an increasing rate of internal growth as Project One Team evolves and matures and becomes part of our way of doing business.

Kartik Mehta - FTN Midwest

And one last question for you Bill. If you look at the divergence between net income and free cash flow over the next one to three years, would you expect that to be similar to what it has been in the past? Or is there any reason for that to change either way?

Bill Gale

Based on limited thought of what you just said, I don't expect there to be any significant change. I would anticipate the relationship between net income and cash flow to be relatively constant. There is going to be a little bit of difference with regard to how CapEx is spent, because of the nature of some of the businesses that are growing faster. For example, a document management business requires trucks that are more expensive than uniform trucks, but doesn't require the processing of a rental plant.

Working capital requirements are less in the First Aid and Safety and the document management business than they are in the uniform rental business, because of the lack of in-service inventory. But just thinking through, Kartik, I would think that it shouldn't change dramatically.

Kartik Mehta - FTN Midwest

Thank you very much.

Operator

Moving on, we will hear from Chris Gutek.

Chris Gutek - Morgan Stanley

Not to beat a dead horse here with the growth outlook. I know you don't want to give guidance, I won't ask for it. But could you talk generally about the organic growth rate outlook for the core rental division over the next couple of quarters. Specifically what I am getting at is, do you think that the growth rates have bottomed, net of all of these moving parts?

And based on the year-over-year growth you have seen in the last couple of months and maybe even in the first couple of weeks of the fiscal fourth quarter, are you seeing signs of stabilization? Or are we not even necessarily close to stabilization yet?

Scott Farmer

I don't want to give internal growth guidance looking out too far into the future. But if you look at the guidance that we have for the fourth quarter, it would assume at the low-end of the range we had about flat growth and at the high end of the range [one to six] internal growth. So that's about where we are and I would say that would therefore predict that we're at least close to the trough and if not, working our way through that.

Chris Gutek - Morgan Stanley

Given that the growth rates have decelerated though, and taking a longer term view. And in the context of the company not needing access to capital, in fact aggressively buying back stock and also potentially in the context of having some valuable real estate, is there any reason or advantage to the company being public?

Scott Farmer

I think that's a very speculative thing to talk about. We are not really at liberty to discuss that, Chris.

Chris Gutek - Morgan Stanley

Okay. Let me try a completely different question if I could then. There was apparently an unfortunate death at a Tulsa plant recently. And I am curious if that was in your view sort of a freak one-off accident or if in fact the company is behind some mandated safety upgrades at some of the facilities?

Bill Gale

Well this event that happened in Tulsa was first and foremost a very tragic accident and we are personally saddened by the death of one of our fellow partners. Now the investigation of this accident is continuing. We have determined based on the preliminary results that the machinery was operating properly, and that the partner did not follow established safety rules, which would have prevented the accident.

But at this point, because it's under investigation by OSHA, we don't believe it's appropriate to make any further comments. But I will tell you that we have been using this equipment. It's standard industrial equipment. It's used by companies throughout the world. And it has approximately been in existence for 15 to 20 years. And we've never had an accident in the past anywhere near to this extent.

Chris Gutek - Morgan Stanley

Okay. I am curious, given ARAMARK's recent going-private transaction, if you have seen any change in their competitive behavior in particular, may be less focused on growth and potentially more focused on profitability? Have you seen any change from your perspective out in the field?

Scott Farmer

Chris, we haven't seen any change yet. But I think it's important that everyone understands that transaction was just completed not too long ago. So I think to see any dramatic change this early in the process would have been unlikely. So it's really too early to tell.

Chris Gutek - Morgan Stanley

Okay. And then finally a quick one. Bill, what's the targeted capital structure as you guys have been aggressively buying back stock? Where do you think the optimal capital structure currently lies?

Bill Gale

Well, I think that's under review; because I think at one point in time, we've always told people that we thought a 35% to 40% debt-to-cap was a good rate to go with. But we've been listening to a lot of interested parties and shareholders. We have been to several conferences. We have had a lot of visits. There is a different set of opinion and we are evaluating all that internally to determine what we believe would be in the best interest of the shareholders. So, I would say that it's under review and we will continue to assess what make sense.

Chris Gutek - Morgan Stanley

Okay. Thank guys.

Operator

Gary Bisbee has our next question.

Gary Bisbee - Lehman Brothers

Hi guys, good afternoon. I'm wondering if you would be willing to tell us what the revenue impact approximately was year-over-year of the warmer winter?

Bill Gale

No, we don't have the details of that Gary, but it was a factor in the lower revenues quarter-to-quarter.

Gary Bisbee - Lehman Brothers

Let me ask you differently, are you willing to tell us an order of magnitude, rank those three things that you mentioned, the warmer winter versus the Project One Team disruption versus I think what you call just the general economic conditions?

Scott Farmer

I would say that the winter effect was the least significant of that, but did have a noticeable and obvious impact. And one of them is an economic issue that we have been dealing with for sometime. The other is a timing issue. So, I think they are just different categories, and I am not sure how I would try and rank those two.

Bill Gale

It would be difficult to do that Gary with any degree of accuracy, because it's hard to go through all of the components of that. But I think relatively speaking what Scott said would be something that makes sense.

Scott Farmer

The quarterly weather thing is a one-time occurrence. The organization change is a significant operating organization change. So, that's an intermediate term thing. And the economic conditions have been a longer term thing. They are just three completely different sets of circumstances. All three of them came to play in one quarter and had an impact.

Gary Bisbee - Lehman Brothers

Yes, it's a pretty dramatic sequential deceleration. And so I was trying to see if we could parse apart what really changed from quarter-to-quarter. From my viewpoint, it's the amateur's attempt of being an economist. It seems like the industrial economy has weakened somewhat, but maybe not that dramatically. So, I was trying to figure out, if there was anything else. But that's fine. That's a fine answer. Let me move onto the next question.

At what point, do you accept that some of these, what you are calling economic conditions, are likely to persist for a while and decide that you need to get more aggressive in pursuing acquisitions outside of the core uniform businesses? And are there even targets out there within the three non-uniform businesses that are of a scale that they would allow you to dramatically move that mix of the business in the next year or two?

Bill Gale

Well, I think there are acquisition opportunities in those businesses that would certainly have an impact on the company. But I don't think we are going to do anything rash at this point, because we certainly don't believe that. With the businesses that we are in today, we still believe we have the potential to provide good growth opportunities in the company.

With that said, we are also though very active in looking at acquisitions. We are still very disciplined in our approach to looking at companies, and we will continue to add business as we think is beneficial to the shareholder.

Gary Bisbee - Lehman Brothers

And so, I guess it's safe to assume you are not at a point where you think you have to be more aggressive to move the mix away from the uniforms?

Bill Gale

I think as Scott said, before he and the rest of the management team here still believe that there are great opportunities in all of our businesses, including uniforms. And we are confident that at this point the Project One Team is going to help us to take advantage of those.

Gary Bisbee - Lehman Brothers

Okay, great. Then just a couple of quick clean-up ones, if I could? I think it's a second quarter in a row that you mentioned that you had some short-term securities that you would wait till they mature to consider paying off some of that commercial paper. Over what time period is that stuff likely to mature? Are we talking 30 to 60 days or several months?

Bill Gale

We have a few months left. I would say it's a decreasing balance as we move forward, but there are still some out there that go out to about nine months.

Gary Bisbee - Lehman Brothers

Okay, all right. And then on the SG&A, it was obviously up dramatically. You did a good job of telling us about some of the components there. But I guess as we think forward to the May quarter, are there any of those that you would expect to change? And I know you are not giving '08 guidance, but is there any reason to think that the company could move towards seeing some leverage on that line over the next 6 to 12 months or is this going to keep rising?

And I guess what I am wondering is within the three non-uniform businesses, is that possible that you are seeing sort of higher gross margins, but also higher SG&A such that that's helping the gross margin, but maybe as you grow those could hurt SG&A? Or is that not accurate?

Bill Gale

Those other businesses are hurting SG&A a little bit because of the large amount of selling expense we've in there. But as those businesses continue to grow and each location is of a size that the percent of selling expense to those locations will be reduced. We buy a lot of small or open a lot of small locations, for example, in document shredding and then we go ahead and dump in three or four sales reps into these new businesses. So, it does have a significant impact. That said when you look at everything in total, it's not moving the needle dramatically, but it is moving the needle.

I'd say in the other areas of G&A, there may be a little impact, but it's not dramatic. Again, it would be more from a scope perspective and a size and scale. That it would be a long-term issue.

Looking at the different components for this quarter is what may trigger the other way up. Traditionally payroll taxes drop back down, because they are out of the first quarter. And that's something I can tell you. As far as the other piece, it's difficult to say. We wouldn't expect SG&A to continue to rise though in total. But, different components go different ways at different times. You have pieces in there, such as medical, that are hard to quantify going forward.

Scott Farmer

But, we wouldn't expect G&A to rise in percentage wise, but in dollars it will.

Bill Gale

Right.

Scott Farmer

As we grow the company, but I think if you go back in time you'll always find that the third quarter SG&A number is traditionally one of the highest of all the quarters. And you would expect there to be some benefit, as you go forward in other quarters.

Gary Bisbee - Lehman Brothers

Okay. Great. Thanks for all the color.

Operator

Now we'll hear from Pete Carrillo.

Pete Carrillo - Citigroup

This is actually for Scott. Not certainly looking for you to speculate into this LBO issue. But, I was surprised to hear Scott, not come out and you guys say absolutely not, we would not consider going private. So, given the history of the company here, is there any involvement and etcetera. Anything you can say to that at all? Would you not rule it out?

Scott Farmer

We don't have liberty to discuss any issues surrounding that matter.

Pete Carrillo - Citigroup

Okay. Even conceptually you can't say -- you're against the idea or not?

Mike Thompson

You are asking a hypothetical question. But, we are a public company and there are certain things that we just can't respond to and unfortunately this is an area that we just can't talk about.

Pete Carrillo - Citigroup

Okay. In terms of the SG&A line, have you guys at all considered coming back to your partners and saying we need a potential raise in healthcare co-pays or have some sort of public company partners to contribute a little bit more to some of the healthcare increases that are going on? And is that something you considered at all or is that definitely not a possibility?

Scott Farmer

We look at it every year, Pete. That is something we just feel it's appropriate for our partners to have an affordable healthcare program for them. Obviously, it's a balancing act, but we need to be fair to our partners. They are the main reason this company does well every year and we've got to be fair to them.

So, we look at it every year and you can see we are doing other things. We've just changed administrators on January 1, for the second time in three of four years, again looking for better networks but also to help reduce costs. So, it's a balancing act. I think every company has that across the country, but we intend to be fair to our employees as well.

Pete Carrillo - Citigroup

Okay. And just last quick question was in terms of the winter effect. Did it affect not only rentals, did it also affect some of your catalogue business or direct sale business as well?

Scott Farmer

Yes it did. Again more from a jacket and mat rental, but a large portion of our catalog is jackets or a good portion at that time of the year. So, it had an impact through that as well, certainly.

Pete Carrillo - Citigroup

Okay thanks a lot.

Operator

Moving on we will hear from Bruce Simpson.

Bruce Simpson - William Blair & Company

Scott, I know that you no longer break out individual line items of the four components of organic growth as you once did. But, just directionally, as you look over the last year and your organic growth has come down, may be on the magnitude of 400 to 500 basis points, what is the largest and the second largest impact there? Is it primarily what you used to call the [drop-head] metric that you are just seeing too much erosion shrinkage of the existing wearers? Or is it primarily the Project One Team impact on new business written?

Scott Farmer

I would say that all of it has an impact. But the biggest issue that boils down to us, I would say is not having as many sales reps selling weeks in the field as a result of these people going through training programs and time out of the field, as we have rolled this out. And it was completed at the end of December. But we have been working on it through this fiscal year. So, they just haven't had as many weeks in front of the prospects to sell and therefore it's impacting our new business.

It also means that we've taken an awful lot of most productive sales reps, our most experienced sales reps. Many of them were promoted into sales management positions. And the people coming in behind them, even after they get through their training program, are not nearly as productive in the first part of their sales tenure, as the person that they just replaced. And that takes some time for them to build that backup. So, that has had an impact as well. I think it's the new businesses where we had seen the biggest impact.

Bruce Simpson - William Blair & Company

What about the pricing environment overall versus a year ago for new business accounts? Is it more intense than it once was or is that pretty predictable?

Scott Farmer

Well, I would tell you that as I stated in my comments, one of the initial and early indicators of I think a more coordinated training program, and a sales management effort that is more focused is that we are seeing. For example, in our uniform rental business, new businesses are being sold at higher prices than they were before we had Project One Team in place.

Bruce Simpson - William Blair & Company

Okay, switching gears. Can you give us what the run rate is on the Ultra-Clean business now?

Bill Gale

We have not provided that previously. And at this point in time for competitive reasons we are not going to provide that.

Bruce Simpson - William Blair & Company

Okay. On margins, the last time I heard an update on margin targets for the whole firm, it was net income rather than operating margin. And this goes back a couple of years ago when, Bill, I know you used to talk about 10% to 11% is what you thought was sustainable.

Bill Gale

Right.

Bruce Simpson - William Blair & Company

Given the changes in the business, and the investments in the business and the shift in mix, is that still really realistic? Is it either a net income or an operating income that's realistic over the next couple of years given your current portfolio of businesses?

Bill Gale

Well, our net income given the change in the debt structure of the company obviously has been impacted. So the old 10% to 11% has to be adjusted for the interest factor that's in there, which means that you are looking at probably a pre-interest number, which is somewhere in the magnitude of 9% to 10%.

Bruce Simpson - William Blair & Company

Okay. So, I guess what I am trying to get at is, has there been through maturation of the business through investments in growth [in] areas as an offset to try to create a favorable mix shift? Have we entered an area of permanently lower profitability that’s sustainable or is it realistic to think you are going to get back to the 16% operating margins?

Scott Farmer

Bruce, I think, we have said that. And we know that these new businesses that we have gotten into have operating margin potential equal to our core rental business. So, we are confident that as they continue to grow and mature that they will be able to provide the same level of profitability that the rental business has.

Now, what have been the changes in the rental business? Well, the most significant change has been the impact from a cost standpoint of energy costs and it appears to me that based on what I am seeing is that energy costs may have reached a more permanent level of over 3% of sales. That was traditionally more of a 2% line.

So, while we'll continue to look for opportunities to conserve energy, use more fuel efficient vehicles, fuel efficient processes in our plants. There maybe the impact of higher energy costs, some of which might be able to be passed through to cost or price increases, but certainly at this point in time not all of it.

So, I am hedging the answer a little bit here, because I have got a couple of wildcards and I just don't know what is going to happen with it. But I would say the basic fundamentals of our businesses are that the new businesses are as profitable as the rental business.

Bruce Simpson - William Blair & Company

Okay. And then, Bill just focusing once again on the SG&A line, from a pure dollar amount, it looks like there is roughly a $4 million to $5 million sequential increase in the number of dollars in that category from the November to the February period. And just to make sure, I understand that 5-ish million increase, even though it's over a shorter period, is that largely a factor of Project One Team and the change in sales? Or is the primary factor driving that sequential increase in medical benefits or --?

Bill Gale

The big part of the sequential increase is payroll taxes, Bruce, because as you get to the third quarter, it includes the months of January and February. So the amounts have to start being accrued again, and paid out for all the payroll taxes associated with all our employees. That would be probably the most significant sequential increase in dollars from the second quarter to the third quarter.

Bruce Simpson - William Blair & Company

Can you quantify what that largest piece represented?

Bill Gale

I don't have that detail in front of me, Bruce.

Bruce Simpson - William Blair & Company

Okay. And then the last question that I have. It has to do with something we haven't talked about in a while, RFID. Is that something that is still on the plate or has the company reached a conclusion that that’s not really economically viable any longer? Where do you stand with the adoption of that technology?

Scott Farmer

Well, as we have stated, we are still committed to the concept. Our problem is that the chip that we were using could not meet the criteria of readability. And therefore, we are working now with some other chip suppliers to see if we can come up with a chip that can withstand the industrial laundry process and have the reliability that we need to have in order to make this more viable than just the barcode system that we use today. We still have the software and the antennas in place in our test plant, and we will be able to test with other suppliers' chips and we have got a few suppliers that we are working with, and we hope that we can come up with something that will make sense.

Bruce Simpson - William Blair & Company

Okay. Thank you.

Operator

Greg Halter has our next question.

Greg Halter - Great Lakes Review

In the past, I think you have talked about other operating margins, other service revenue margin of 32% to 37% as a goal. And obviously you have exceeded that at 38.1% in this quarter. I am just wondering if you have given any reconsideration to where you stand in that area?

Bill Gale

We are reconsidering that, and we will be providing more guidance on that at yearend. Obviously as the document shredding and First Aid and Safety businesses get to be larger components of other services, that is ratcheting up the gross margin. And also some improvements within our National Account Sales division through sourcing activity have been a positive as well. So, we are aware of that and obviously at this point, we think we will be towards the upper end of that range. But we will give more guidance in our 10-K.

Greg Halter - Great Lakes Review

Okay. And I wondered if you had the rentals and other service revenues -- the pre-tax income figures for those two segments?

Bill Gale

I have got it here, and I can't put my finger on the page right now. I am sorry.

Greg Halter - Great Lakes Review

That's alright. I have got. Two other quick ones if you are still looking. Just wondered, in the past you had mentioned that your share repurchase was not in your guidance figures? And I wonder if there is any change in that?

Bill Gale

No, there has been no change in that concept. So, we don't have that anticipated in the guidance.

Greg Halter - Great Lakes Review

Okay.

Bill Gale

I found it Greg.

Greg Halter - Great Lakes Review

Okay, thanks.

Bill Gale

Income before income taxes for rentals' operating segment?

Greg Halter - Great Lakes Review

Right.

Bill Gale

Was $105.2 million. And other services segment was $27.5 million.

Greg Halter - Great Lakes Review

So that was up 35% year-over-year. Okay. And the last question is, what do you normally pay for the acquisitions. And again I can presume primarily in document management and First Aid in relation to EBITDA for the companies you are acquiring, is it five times or ten times?

Bill Gale

It really varies Greg. It depends on the acquisitions. I would say that we are paying today in the same range that we have been paying. But I can tell you, it really comes down to the quality of the underlying business. Uniform rental is looking at the customer contract situation and their customer relationships and the inventory that you are getting, etcetera, and whether or not you are buying a plant. And you can follow that through every business that we are acquiring.

We really have a set parameter, where we obviously have made a lot of acquisitions in the past and we think we are pretty astute at it. We follow a very rigid approach to make sure that we are not overpaying and hold to that and look for strategic opportunities. So we don't provide those ranges. But I can tell you that it's a very stringent process.

Greg Halter - Great Lakes Review

Okay. I am just wondering if it's above or below the 9.6, you are currently trading at now?

Bill Gale

Yeah.

Greg Halter - Great Lakes Review

Thanks.

Bill Gale

Sure.

Operator

And now we will hear again from Michael Schneider.

Michael Schneider - Robert W. Baird

Guys, just on the margin topic within other services again. You have been basically accelerating incremental margins within other services. You look back a year ago, you were doing this 7%, 8% incremental margins, and now you are doing over 22% pre-tax incremental margins. Is that a function again of just beginning to leverage the sales force and sales initiatives that you have got in place? I guess question one.

And then question two, does that number actually continue to accelerate, or are you at a pace now of investment, which will probably cap that incremental increase?

Bill Gale

Well, I think the answer to your question is that we expect those margins to continue to improve, because those businesses continue to become bigger. We are working on ways of picking a lot of acquisitions and bringing them into the Cintas way. We are looking at opportunities in sourcing in our direct sale business that are paying benefits. So, our expectation, Michael, is that we would hope that that will continue to improve.

Now with that said, also we keep buying other businesses and then we keep bringing those in. We wanted to establish the national footprint. So we've got that investment aspect that's going on at the same time.

But as Mike talked about before, there certainly is no question that our expectations from the contribution from those businesses is higher to-date than what it was a few years ago and we are going to maybe be updating that in our next 10-K.

Michael Schneider - Robert W. Baird

Yes, Bill, I understand that operating margins in other services are rising. I am focused on incremental margins and those have been running. Operating margins in this quarter are 11.5. Incremental margins on that increase in revenue are running at 21%. What I am asking is that number has been rising now for four or five quarters. Is that number prone to continue to rise because you are investing on the margin less? Or is the 21% incremental margin the theoretical cap for this business?

Bill Gale

The timing of that really depends, Michael. It doesn't necessarily indicate that that's going to continue to rise at a faster rate. We can say that in total it's going to continue to rise, but from a sequential basis type of approach, I can't say that it is always going to continue to rise or that we have capped out. I don’t think it's capped out completely, but I can't say if next quarter is going to be higher than this on a sequential basis.

Michael Schneider - Robert W. Baird

Okay. Thank you.

Operator

That was our last question. I will turn it back over to you for any closing remarks.

Bill Gale

Thank you all for joining us. We appreciate your interest. We will be releasing our fourth quarter results sometime in mid-June. We will be looking forward to talking to you at that time.

Operator

That does conclude today's conference. We do thank you for your participation.

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