G&K Services' (GK) CEO Doug Milroy on Q2 2016 Results - Earnings Call Transcript

| About: G&K Services, (GK)

G&K Services, Inc. (NASDAQ:GK)

Q2 2016 Earnings Conference Call

January 26, 2016 11:00 am ET

Executives

Jeff Huebschen - Director, IR

Doug Milroy - Chairman, CEO

Tracy Jokinen - CFO

Analysts

Andrew Wittmann - JPMorgan

Sean Egan - KeyBanc Capital Markets

Kevin Steinke - Barrington Research

Chris McGinnis - William Blair & Company

Judah Sokel - JPMorgan

Operator

Good morning. My name is Hope. And I will be your conference operator today. At this time, I would like to welcome everyone to the Second Quarter Fiscal Year 2016 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be question-and-answer session. [Operator Instructions] Thank you.

Mr. Jeff Huebschen, you may begin your conference.

Jeff Huebschen

Thanks. Good morning and thank you for joining us to discuss G&K Services Second Quarter Fiscal 2016 Results. With me today are Doug Milroy, G&K's Chairman and Chief Executive Officer; and Tracy Jokinen, Chief Financial Officer.

Before we begin the call, I'd like to remind everyone that statements made today concerning our intentions, expectations or predictions about future results or events are considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements reflect our current expectations and are subject to risks and uncertainties that could cause actual results or events to vary from stated expectations. 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 our future financial results is included in our most recent annual report on Form 10-K and in subsequent SEC filings.

During this call, we will reference certain non-GAAP financial measures, a reconciliation of these non-GAAP measures to the nearest GAAP measures is provided in the earnings release we issued this morning and is available on our Web site. A replay of this call will be available later today and will be available through February 26. You may access the replay by visiting the Investor Relations section of our Web site.

And with that said, I'd like to turn the call over to you, Doug.

Doug Milroy

Thanks Jeff. Good morning. Thank you everyone for calling in.

As you've seen our team continues to do a really terrific job executing on our game plan. And that led to another quarter of record financial results. So we are obviously, really glad to have the chance to walk you through those. Today, I would like to hit a few highlights on the quarter. Talk about a couple of details of our game plan give you a little of the color behind the execution. And then, as always Tracy will provide the financial details.

So with that, when you look at Q2, there is a lot to like in the quarter. We made really good progress in the quarter on our 15/5 goals. We continued the solid mid-single digit organic growth, and again, posted strong margins and strong ROIC gains. We have an operating margin of 13%, return on invested capital nearly 13%, 12.7%. So both of those are high watermarks going all the way back to the late 90s. And I think notably well above our last set of goals and nice steps toward our next set of goals.

In fact that's our 15th -- now, our 15th consecutive quarter that we have had year-over-year gains in margins and ROIC. So not surprisingly that led to record earnings per share posting number 11% over last year and again, not surprisingly that let to strong cash flow, which we -- we continued to steward in a very disciplined way gives us the opportunity to invest in our business and it gives the opportunity to increase our cash return to shareholders.

So a lot to like in the quarter, I think it's particularly noteworthy when you look at the environment that that we are playing in. The challenge as we saw in Q2 persisted -- Q1 rather persisted into Q2. Weaker Canadian exchange rate remains a significant headwind for us, in fact, got a little worse. And wear losses continue in some important sectors of our customer base. Again, this quarter we saw our overall add-quit metric has a negative number. Let not surprisingly by meaningful job losses with our energy-related customers.

So when you look at that environment, I think the results this quarter especially demonstrate the strength of our business model and the strength of our team. We couldn't be more proud of what our team has done this quarter. It's what you've seen. It's what you've become accustomed to. We work through whatever is thrown at us and I think it's foundationally above our fundamental approach to this business. It's about our game plan driving those results.

This doesn't just happen. This is a strong team executing a really sound strategy. And we've talked about that a lot. I thought it might be useful to actually provide a couple more examples that give you the color behind what we are doing. So if you look at the first element of our game plan, keep our customer promised. That clearly continues as our number one focus. It's absolutely core to everything we do. But I want to talk about it today from a slightly different angle. And that is, the opportunity that it provides to sell more to existing customers when you've already very highly satisfied customers. And we think that is beginning to and will continue to create a real growth opportunity for us. I think its best understood in a little bit of historical context.

So let me go back to -- when we initiated our game plan, our whole focus was on, how do we strengthen our customer service approach? How do we improve, redouble our efforts and improve on our ability to retain the customers? And we made really good progress with that. Then you recall a few years ago, we shifted our focus more to rebuilding our sales team and you've seen the kind of results we posted there.

So it's more recently that we started building a team of customer solution experts focused on this opportunity to identify and solve the problems for existing customers and as a result sell them more. I would tell you that it's early in that game but the results are very promising and I think most importantly in the context of this call to see it as the third leg in the stool, if you will, and adding another very concrete leg to our growth story. So we feel very good about our actions and activities there.

Second element of our game plan improved how we target customers; I just spoke about a moment ago about the multiyear efforts to rebuild our sales team. The next step, we've taken there is deployment across the company of mobile technology that puts everything a seller could need in one place, in the palm and their hand whether that's smartphone, tablet, they have it all there in one place. And that's what is most important. It's not the phone or the tablet per se that I mean that's cool but that's not the end to itself. It's the fact that they now have all of the tools a seller could use in one place focused on the right set of prospects consistent with that element of our game plan, improve how we target customers focused on the right set of prospects that we've selected. We think that really sets our team up for continuing strong new business wins.

So just a couple of examples, you couple that with a third element of our game plan driving operational excellence and continuing to really embed a culture of continuous improvement. You couple that with the fourth element of our game plan; strengthen our already high performing team. In fact, it’s that one that allows the others to happen. Without that you've got nothing. Taken together, it continues to be a really winning approach for us. And you see it in our numbers. It's allowed us to post consistently the kind of results that you see here in Q2.

So I guess, my summary would be, I think you know I'm awfully proud of our team here. We've a great team executing very well in a tough environment. The examples I took you through and frankly countless others, I could take you through illustrate, why we've got so much confidence in our game plan and our approach, why we've got so much confidence in our team and perhaps most importantly why we've got unequivocal confidence that we will achieve our 15/5 goals noting that this quarter is a nice step in that direction.

So with that, I will turn it over to Tracy and she will take you through the details.

Tracy Jokinen

Okay. Thanks Doug.

This morning, I will provide more detail on our second quarter results and give you an update on our outlook for the rest of the year. So first let's look at the results for the quarter.

Revenue grew 2.4% to $243 million; organic growth remained in the mid-single digit range coming in at 4.7%. This strong organic growth was partially offset by foreign currency exchange, which reduced revenue growth by 2.5%. This was a bigger negative impact than we previously expected as the Canadian dollar continued to decline throughout the quarter.

Organic growth was driven primarily by new account sales and pricing gains. Year-to-date, new account sales continue to track above last year's record level. Organic growth also benefited from the timing of deliveries around the Christmas holiday, which added about 30 basis points to revenue growth for the quarter.

On the negative side, direct sales were slightly lower than last year. And also our add-quit metric which measures changes in uniform wears in our existing customer base was negative this quarter with meaningful job losses at our energy customers. We are also clearly seeing spill over into energy related industries and geographies and the add-quit metric was also slightly negative outside the energy sector. Despite all of this, we still had nice organic growth in the quarter, so we are very proud of what our team accomplished.

Second quarter operating income grew 10% to $31 million driven by a revenue growth and strong margin expansion. Operating margin improved by 90 basis points to 13% driven primarily by a leverage from our revenue growth, lower selling in administrative expenses and lower energy cost. These gains were partially offset by higher rental merchandise expense and increased health insurance cost.

Earnings per share grew to a new quarterly record of $0.92 primarily driven by our strong operating performance. There were several puts and takes in the EPS number. On the negative side, the weaker exchange for the Canadian dollar and a higher tax rate reduced earnings compared to last year. And on the positive side, we had slightly lower interest expense and a lower share count. The net impact of these was a $0.04 reduction in EPS compared to last year. We also achieved a strong improvement in ROIC, which was of 100 basis points to 12.7%, the highest level since launching our game plan.

Cash flow has been very strong through the first half of our fiscal year, with cash from operations of $56 million 16% higher than last year. We are using this cash flow to make continued investments in our business sending $23 million in capital expenditures year-to-date and we continue to expect full year CapEx of approximately $50 million.

We are also returning more cash to our shareholders. Year-to-date, we paid out $15 million in dividends and we've used another $15 million to repurchase shares. In total, cash returned to shareholders is up more than 50% in the first half of the fiscal year.

Our balance sheet remains strong; our debt level is essentially unchanged during the first half of the year. And our ratio of debt-to-EBITDA stands at 1.7x. We ended the quarter with $26 million of cash on our balance sheet and we have over $200 million of available borrowing capacity under our existing credit facility. This strong financial position provides significant flexibility to continue to pursue our capital deployment plan.

I would also like to update you on our multi-employer pension plan liability. We negotiated a final settlement with another pension plan this quarter. So we now have only $3 million of unpaid liabilities remaining on our books. Withdrawing from these multi-employer plan has been a big win for G&K, our employees and our shareholders. We eliminated significant risk by exiting these severely under-funded plans.

So let me wrap up with some comments on our outlook. Through the first half of the fiscal year there were a lot of moving pieces but we are basically on track with our plan with one notable exception, the continued erosion of the Canadian dollar. The exchange rate moved lower than we expected in the second quarter and has continued decline. We previously forecast that the negative FX impact would have base in the second half of the year but we now expect that the impact in the third and fourth quarters will be similar to that in the first half of the year reducing revenue by approximately 2.5%.

So for the full year, we now expect FX will reduce revenue by more than $20 million and will reduce earnings per share by approximately $0.16 compared to last year. Based on this change, we are narrowing our guidance. As the move in the exchange rate makes it unlikely that we will hit the upper end of our previous range.

We now expect full year revenue of $975 million to $999 million and earnings between $3.50 and $3.60 per share.

As we think our third quarter keep in mind that the annual reset of payroll taxes typically impact operating margins by 80 to 100 basis points compared to the second quarter.

And also the timing of holiday delivery that added 30 basis points to the second quarter revenue will reduce third quarter revenue by a comparable amount. So sequentially, Q3 will be slightly lower than Q2.

Finally, I would like to remind everyone that fiscal 2016 will have 53 weeks of operations compared to 52 weeks in fiscal 2015. For the full year, the extra week will increase both revenue and earnings per share by approximately 2% over fiscal 2015, which is included in our guidance. The extra week will be in the fourth quarter which will have 14 weeks compared to 13 weeks in our normal quarter. Looking ahead to fiscal 2017, we will return to a normal 52-week year, so the 2% benefit and revenue in EPS will not repeat.

So to wrap up, we had a strong quarter with progress toward our 15/5 goals, our cash flow and financial position remain strong and we are on track to deliver further top and bottom line growth in the second half of the year.

And with that, we are ready to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Andrew Wittmann [JPMorgan].

Andrew Wittmann

Hi, good morning. I wanted to start out with just some; I guess technical questions here Tracy. On the margin movements, you mentioned a couple of factors here. First, can you quantify the benefit from energy and the negatives from merchandise and health insurance?

Tracy Jokinen

Yes, sure. So our gross margin improved by 40 basis points and it was driven by operating leverage and efficiency gains. As you mentioned, energy cost gave us about a 70 basis points improvement and that was offset by higher merchandise cost around 60 basis points and higher health insurance which was around 50 basis points.

Andrew Wittmann

Great. Thank you. And then just in terms of the SG&A line it was flat to slight -- I guess maybe slightly down here year-over-year. I was just wondering if that's a -- if there is a like an easy comp there or the sustainability or there is something unusual that you had this quarter that gave you a favorable impact there and just what that could look like as we move through the back half of the year.

Tracy Jokinen

Yes. So the improvements from the first quarter in S&A was really driven by the timing of new accounts sales and their related commission. Also in the second quarter payroll taxes are actually lower which is normal for the second quarter compared to the first quarter. But most importantly, we did have good cost management in our administrative expenses.

So looking ahead, we would expect to continue to be able to drive S&A lower as a percent of revenue and if you separate that into selling cost versus administrative cost. Selling cost will grow as we continue to invest in our sales force and that growth will largely be in line with our revenue. But we expect administrative cost will grow at a slower rate than revenue by keeping our fixed cost fixed and the continuous improvement will achieve through benefits from the projects.

And so while we are covering these details around the margin from Q1 to Q2, I do want restate our guidance range. I think I misspoke in my opening comments. Our guidance range for revenue is $975 million to $990 million. I may have said a number higher than $990 million, so I want to make sure we have that clear.

Andrew Wittmann

Okay, great. Thank you. That was a good answer. And then, I just -- on sales force in productivity it sounds like we are at increasingly high levels of net sales from your team. Is that on a per head basis, the productivity metric that you've given and what do you see it going from here, are we kind of just getting going now that you've got the tools rolled out companywide, do you see an increasing even against what's increasingly choppy macro, I just like to see what your expectation are for your sales team?

Doug Milroy

Yes. Regarding sales, the productivity is -- per person is at or above where it's been. And we still think there is runway there. And we've made some huge strides as you know over the last call it three plus years. I don't think it will continue to jump with those kind of leaps and bounds. But we do still have room to increase productivity. The choppy waters make that more difficult but longer term, the foundational things we were doing with our sales team enhanced the probability we will be able to do that. Where the real impacts come from is, having started a couple of years ago proving we could add to the size of our sales force while increasing productivity or at least maintaining a high level of productivity. And we have every expectation that we will continue to do that choppy waters or not. And that will help drive organic growth.

Andrew Wittmann

Great. One last question, I think from me at least for now. Maybe I missed it, but I didn't hear a comment on retention, I would like to get your thoughts on how retention was in the quarter. And if you are seeing any challenges creeping in to the retention rate from customers going out of business in the energy patch or surrounding areas, is the macro having effect on your retention rate?

Doug Milroy

Yes. We are having some effect from the macro. It's -- so it's not quite the headline number that has been historically. But it's -- sorry, the headline number that's been recently but a still very good retention by any historical standard.

Andrew Wittmann

Okay. Thank you.

Operator

Your next question comes from the line of Sean Egan [KeyBanc Capital Markets].

Sean Egan

Hey, good morning everyone.

Doug Milroy

Good morning, Sean.

Tracy Jokinen

Good morning.

Sean Egan

I just wanted to dig into Canada real quick, obviously, your downwardly revised guidance you citied due to foreign exchange. But, I'm curious if there is anything in addition to foreign exchange if that market has softened up a little bit maybe around the margins. You expect some further revenue decline that would be outside of a pure translational impact?

Tracy Jokinen

Yes. Actually, when you adjust for FX, our Canadian business is performing quite well. So this is really a translation issue for us. On top of the top-line challenges there, our Canadian business is -- it has nice margins and so we are also seeing some impact on our operating margin from the mixed shift just having fewer Canadian dollar revenue and gross margins.

So it's a translation issue, when we think about the transaction side, most of our cost in Canada are in Canadian dollars, so we've got a natural hedge there and there is just a small amount of our cost that are denominated in U.S. dollars.

Sean Egan

Great. And just for clarification, what exchange rate are you using within your guidance heading forward?

Tracy Jokinen

We are using the rate -- that's today's rate which is around 69.

Sean Egan

Got you. All right. Thank you very much. And I just had some questions -- previous questions alluded to some of the SG&A improvement, but do you expect incremental improvement on top of that, due to some of the investments that you discussed on prior calls yielding results as we move into the back half. Just trying to understand if there was a timing shift or we saw some of the improvements earlier than expected and we shouldn't expect the ramp in the back half as we had earlier?

Tracy Jokinen

The benefit from those projects that you referenced are more of a multiyear improvement that we expected to see. So you will see the depreciation come in ahead of the benefits and once those projects are fully deployed we certainly expect benefits across the P&L. But it's not -- it isn't something that you're going to see a big change from the first half of the year to the second half of the year so things roll in. It's more of a multi-year process.

Sean Egan

Okay, great. Thanks for that. That's all for me.

Tracy Jokinen

Thank you.

Operator

Your next question comes from the line of Kevin Steinke [Barrington Research].

Kevin Steinke

Good morning.

Doug Milroy

Good morning, Kevin.

Kevin Steinke

One is a follow-up. Good morning to you, one of the follow-up on the wear losses and how meaningful the impact was on organic growth in the quarter specifically relative to the first quarter if the drag worsened at all or if it's stabilized a little bit or how would you characterize that?

Tracy Jokinen

Well, in Q2 that's now our fourth straight quarter of wear losses in this area. And so what you are seeing happen now is the cumulative effect of that we have a rep, the beginning of the losses which happened in our -- we started to see in our Q3 of last year. So sequentially the number of wear losses from Q1 to Q2 was better. We have this cumulative effects going on.

Kevin Steinke

Okay. And that kind of -- you touched on my second question, there is -- when you start ramping or I'm sorry, lapping the more difficult comps from wear losses, I mean I guess the -- as you alluded to the comps start to become a little easier next quarter?

Tracy Jokinen

Yes. They do. And we tend to think about the impact more holistically as being a mix of positives and negatives on the revenue side. Yes, we will start to ramp those declines that started in Q3 of last year. But those wears will not be coming back in the near term. And we have the benefit today offsetting that of lower energy cost in running our fleet and so our -- the price of the motor fuel being lower. And we are also going to start to lap the big decline in energy prices as well.

So while the mix of positive and negatives to-date have been largely neutral for us. We do expect it in the back half, it will be a bit more negative as we anniversary the benefit of the energy drop but we continue to have lower wearer counts in that segment.

Kevin Steinke

Okay. And you called out the fuel benefit to margins in the quarter, I was wondering if you are able to quantify the impact of currency on the operating margin, and also the impact of lower wear levels on operating margin, just trying to separate out those pluses and minuses from external factors to kind of get a feel for what the underlying improvement is in operating margin?

Tracy Jokinen

Yes. It's a small impact. It is negative on the operating margins but its not significant, nowhere near energy cost or merchandise so the other things that we called out.

Kevin Steinke

Okay, okay. I think also in your prepared comments that you mentioned little benefit to growth from pricing. Is that correct and just can you touch on pricing and what you are seeing there in terms of any meaningful trends or your ability to get price?

Tracy Jokinen

Yes. Pricing was one of the drivers in our growth. And we don't specifically provide details on pricing but we can tell you that it has been a driver of our growth for the past eight or so quarters. So it's an important part of our business and we usually think about it in terms of focusing on great customer service and adding value to our customers that can support improved pricing.

Kevin Steinke

Okay, great. One last question for me, just in terms of Doug, you touched on with your higher customer satisfaction or are you also looking at perhaps adding some new increments?

Doug Milroy

Additional wears maybe a department we didn't have a part of the business we didn't have, a door that wasn't adequately covered by our services and so forth. And then, at the same time, we continued to work to keep our product offering fresh and as such are periodically adding thing. So for instance, you recall Ford Care [ph] offering that's just two examples and so those provide additional opportunity as well. So it's a healthy mix of the two.

Kevin Steinke

Okay, great. Thanks for taking my questions.

Doug Milroy

Thank you.

Operator

[Operator Instructions] Your next question is from the line of Chris McGinnis [William Blair & Company].

Chris McGinnis

Good morning. Thanks for taking my question. A nice quarter.

Doug Milroy

Good morning, Chris.

Chris McGinnis

I guess just a follow-up in maybe another way just -- you maybe just talk about the macro and what you are seeing around outside of energy and maybe kind of the confidence you have in, maybe why you're doing a little bit better than some competitors that recently reported.

Doug Milroy

So I guess taken in two parts the macro and then the competitive landscape. The macro I'm probably not going to give you anything you don't already know. We are experiencing what you read. Certainly, the oil and gas and we have been very specific about that regrettably there was a spillover effect in the communities where that kind of business is most concentrated. At the site of oil and gas as such that's why we referred to the add-quit negative even outside of oil and gas. That's kind of the view of the macro economy.

And then, when you talk about the competitive how -- why maybe outperforming some competitive benchmarks, I would kind of link the two together. I think it's our execution. We talk about the game plan over and over and frankly sometimes it may seem a little repetitive. But it's that nuts and bolts basic execution day in and day out focus on your customers, we are going to go, target our customers, don't think we can be everything to everybody, work really hard at continuous improvement just never let enough on that and most importantly never looking much the economy. I mean you have been with us for the journey in the last five, six years. No matter what we see from macro trends we manage to work through it. So I think it's that -- that's allowing us to post the kind of numbers you are seeing.

Chris McGinnis

Great. Thanks for taking my questions.

Operator

Your next question is a follow-up question from the line of Sean Egan.

Sean Egan

Hi, I just wanted to clarify, I apologize if you've mentioned it earlier, but energy as a percent of sales, did you mention that?

Tracy Jokinen

We mentioned that it was down 70 basis points, so we are -- today we are at 2.9%.

Sean Egan

Great. Thank you very much.

Tracy Jokinen

You're welcome.

Operator

Your next question comes from the line of Judah Sokel.

Judah Sokel

Hi, guys. This is Judah, JPMorgan filling in for Andrew.

Doug Milroy

Hey, good morning.

Tracy Jokinen

Good morning.

Judah Sokel

Good morning. I was just wondering, if you could comment on the revenue and margin expansion components of your long-term plan. My question is, how dependent is your achievement of 50% margins on sustaining the 5% constant currency revenue growth, can you have the margins even if you are not able to sustain at 5% kind of mid-single digit organic growth?

Doug Milroy

We don't know that we can't, would be the clearest way I would answer it. We clearly believe that top-line growth is important to achieving the 15s. It's the first time, this is our third set of financial goals and it's the first time we had a hard revenue goal and part of that hard revenue goal was to illustrate the focus of the company and shifting to growth and part of it was to illustrate exactly what you're asking us that is an important element in achieving the 15 OI and the 15 ROIC.

I don't want to ever say that it's essential. We've done a lot of other good work and we have a lot of runway still in some of our productivity initiatives in those kinds of things. But it's much more likely that we will need that top-line growth than not to achieve those bottom-line financial targets.

Judah Sokel

Okay, great. Thank you guys.

Operator

[Operator Instructions] There are no further questions at this time. I would now like to hand the floor back over to you, Jeff.

Doug Milroy

Hope, this is Doug. Thank you for your help today. And just quickly by way of wrap-up thank you all for calling in again this morning. We were obviously pleased to have the chance to share these results with you. And clearly, it takes us one more big step toward our goals of 15/5. We look forward to further updating you in April. Have a good day, everybody. Thanks.

Operator

Thank you. This does conclude today's conference call. You may now disconnect.

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