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Executives

Glenn Stolt - VP and Treasurer

Rick Marcantonio - Chairman and CEO

Jeff Wright - SVP and CFO

Analysts

Michel Morin - Merrill Lynch

Mike Hamilton - RBC

Scott Schneeberger - CIBC World Markets

Ted Kundtz - Needham & Company

David Long - William Blair

Mike Schneider - Robert W. Baird

G&K Services Inc. (GKSR) F1Q08 (Qtr End 9/29/07) Earnings Call October 30, 2007 11:00 AM ET

Operator

Good day, ladies and gentlemen. And welcome to G&K Services Fiscal 2008 First Quarter Earnings Call. At this time all participants are in the listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host today, Mr. Glenn Stolt Vice President and Treasurer. Please begin sir.

Glenn Stolt

Thank you, Sean. Good morning everyone. Thank you for joining us to discuss G&K's fiscal 2008 first quarter results. As always we will complete our prepared remarks and follow it with the Q&A session.

Joining me on the call today is Rick Marcantonio, Chairman and Chief Executive Officer, and Jeff Wright, Senior Vice President and Chief Financial Officer.

Before I turn the call over to Rick, I'd like to remind everyone that this call may contain forward-looking statements within the meaning of the Federal Securities Laws, including statements concerning business strategies and their intended results, and similar statements concerning anticipated future events and expectations that are not historical facts. These forward-looking statements are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. The forward-looking statements in the press release distributed this morning reflect Management's best judgment at this time.

But all such statements are subject to numerous risks and uncertainties, which could cause actual results to differ materially from those expressed in or implied by the statement provided. Additional information concerning potential factors that could affect future financial results is included in the Company's Annual Report, and from time to time in the Company's filings with the SEC.

As always a replay of this call will be available starting today at approximately 1:00 PM Central Time through November 29th. You may access the replay by visiting the Investor Relations Section of our website.

At this time I'll turn the call over to Rick Marcantonio.

Rick Marcantonio

Good morning and thank you for joining us. This morning we're pleased to report strong first quarter results. For the first quarter, revenue exceeded expectations and totaled a record $243.8 million, up 9.3% over a year ago. We also draw very strong earnings that exceeded both our expectations and consensus estimates.

Earnings per diluted share were a record $0.58, up almost 35% from first quarter a year ago, clearly strong top and bottom-line performance. In addition, we delivered a significant improvement in operating margin. Our first quarter operating margin was 9.8%. The highest level in 19 quarters and the highest level of operating income since we initiated our new strategic business. We believe an impressive result and further evidence of the success we're having in executing our new strategic visions.

It’s important to note that it’s not just one thing that is working or a single initiative that we are excited about at G&K. Our results are be driven by a number of key initiative. In fact, we have been investing in several key growth and productivity programs tied to our long-term strategic vision. The result, we continue to gain momentum driving revenue growth, expanding margin, exceeding customer expectations and creating competitive advantage.

To start this morning, let me provide an update in a few key areas. After that Jeff will take you through a detailed review of our financial results.

First, I would like to start out by talking about our sales organization. As you may recall, recently, we’ve been very focused on increasing the productivity of our sales force. As a reminder, we made significant investments in expanding our sales force a little over a year ago. Last quarter, we reported that we’ve begun to see early signs of improvements in sales productivity.

Today, I am very pleased to report outstanding results in this area. First, sales productivity as measured in average weekly new sales written is up approximately 20% from a year ago. This increase in productivity ultimately drove an all-time quarterly new account sales record for G&K, eclipsing the high watermark set during fiscal 2006, an outstanding accomplishment by our sales organization. While this outcome had very little impact on our first quarter revenue, it will help drive revenue growth in the coming quarters. We’re also testing a new sales automation tool, which we plan on rolling out in the second half of this fiscal year.

Staying with our sales organization for a moment, we also continue to generate significant momentum in national accounts. As you may recall we have multiple national account wins last year. And I am happy to report they’ve rocked to a great start again this year.

During the first quarter, we signed Honda Canada, RR Donnelly, Gulf Oil and Labella’s Food Distributors to name just a few new national accounts. We also expanded our existing business with Home Foods by beginning to serve an additional region for them.

In addition, we renewed our national account relationships with the United Rental, Sun Media and Swift among many others. More than ever, these national account wins continue to demonstrate that across North America, customers are increasingly looking to G&K to help solve their critical image and safety needs.

Turning to our direct sale business for a minute, for the quarter direct sales revenue grew approximately 12% driven almost entirely by organic growth. We’re pleased to report strong gains from our Lion Uniform Group and our field direct sales business.

During the quarter, Lion began new uniform programs with [Ecolab] and SHOW NASCAR just to name a couple. In addition, I wanted to provide an update on our exclusive strategic agreement with Dockers, San Francisco. As we’ve noted before the introduction of Dockers apparel to our customer base, it will be done in a phased approach.

As discussed, it is a key component in extending our presence in the direct sales category. We are focused on building a direct sales business model to meet the needs of our customers and to capture a larger share of this important market segment. Today, we have started to introduce Dockers apparel through our Lion Uniform Group to their customer base.

As we complete the investments needed to support on much larger direct purchase business, we will faith in the offering Dockers apparel to our direct sale catalog customers, who are serviced primarily by our rental organization. This phase will likely happen later this fiscal year.

We believe that our exclusive access to this market-leading brand strengthens our capabilities and enhances our competitive position in the direct sale market. Overtime, I also see us introducing the Dockers brand in the rental segment.

As a side note, our relationship with Dockers San Francisco was profiled in the September issue of Industrial Launderer, a monthly magazine for the uniform and textile service industry. The articles focuses on our Dockers relationship as well as the number of other strategic initiatives we've been pursuing to realize our vision to be the market leader enhancing image and safety in the workplace through innovation.

I invite you to read this article. To obtain a copy, you can either visit our website under Investor Relations, the featured report section or access the Industrial Launderer website at www.ilmagonline.com under archive.

Shifting gears, it's important to remember that through our segment at marketing program, we continue to lead the industry in providing customers with innovative images safety solutions. I would like to be a bit more specific.

First, as a result of ProSura Food Safety Solutions for both food processors and the retail food segment, we continue to generate robust revenue growth in the food segment. Our first quarter revenue with food processors grew organically by well over 10% versus a year ago.

In addition, we're getting strong interest in BioSmart, our exclusive line of antimicrobial garments and towels for the food industry. This innovative and proprietary product offering resulted in signing several new accounts in the quarter, most of them in the retail food segment. And we grew our grocery and casual dining revenue by over 5%, driven in-part by ProSura retail and BioSmart.

In addition, our revenue from ProTect Safety Solutions, which provide customers with flame resistant apparel is up well over 20% compared to last year. Clearly, our success in offering customers unique solutions is driving overall growth and expanding the market we serve.

Finally, let me spend the moment on acquisitions. As you know, acquisitions remain a key strategic growth initiative for G&K. We continue to be very active on the acquisitions front having completed three deals over the last nine months. In fact, I'm pleased to report that the addition of GRANTEX, ALTEX and Leef has gone as expected and our integration plans are on schedule.

All three of these quality businesses are providing strong revenue contribution. As a reminder, we'll continue to pursue strategic acquisitions to enhance our overall growth and increase our capacity utilization. We will also continue to look for segment specific direct purchase uniform businesses.

Before I turn the call over to Jeff, I would like to repeat that I am very pleased with our strong first quarter performance. We continue to execute against several key growth and productivity initiatives. Initiatives that have been identified as, important steps in our strategic plan, differentiating us on the competition, enhancing our overall results.

Our focus remains unchanged, lead the industry in providing customers exceptional service and innovative emergent safety solutions. By executing against this vision, we expect to generate even greater financial performance and shareholder returns over the long term.

I would now like to turn the call over to Jeff. Jeff.

Jeff Wright

Thank you Rick. As Rick highlighted earlier, we’re very pleased with our first quarter performance. Total revenue exceeded expectations and totaled $243.8 million for the quarter, an increase of 9.3% over the last year.

Organic rental growth, revenue from acquisitions and strong direct sale growth drove the increase over the prior year. As expected, our rental organic growth rate was 3.5% in the first quarter.

New account sales, strong route sales, and solid customer retention drove organic rental revenue growth. This was some what offset by the change in employment levels of certain traditional uniform wearing industries, which continues to put modest pressure on organic growth.

With that said, we continue to focus on the multiple avenues of growth to expand our top line, on both on organic and acquired basis

Earnings per diluted share also exceeded expectations, and increased to $0.58, an increase of 35% from $0.43 per diluted share during the prior year period.

Earnings were above expectations due to significantly higher operating income. Driven by solid revenue growth, lower merchandise, production and administrative cost and partially offset by increased selling and interest expense.

Importantly operating margin for the first quarter increased significantly to 9.8% of consolidated revenue up from 8.2% in the prior year period. This 160 basis point improvement in operating margin was the result of the incremental income and fixed cost leverage realized from revenue growth, lower merchandise cost, and productivity benefits achieve from operational initiatives. Partially offset by higher selling expenses and ongoing acquisition integration cost.

Rental revenue in the first quarter was $226.1 million, a 9.1% increase over the prior year of $207.3 million. This increase was driven by rental organic growth, additional revenue from acquisitions, and a more favorable Canadian exchange rate.

Direct sale revenue increased to $17.7 million from $15.8 million last year. This 11.9% increase was driven primarily by organic growth.

Rental gross margins for the quarter increased to 36.8% from 36.5% in the prior year period. Our production costs positively impacted gross margins due to the fixed cost leverage from revenue growth, and cost reductions from productivity initiatives.

As expected, margins also benefited from lower merchandise expense as we anniversaried higher merchandise costs associated with the strong new account growth over the past 12 to 18 months. Direct sales gross margin increased to 28.1% from 23.9% in the prior-year period. This increase in gross margin was due primarily to efficiencies gained from strong revenue growth.

Selling and Administrative expenses were 21.4% of consolidated revenue for the quarter, down from 22.4% in the same period last year. Selling and Administrative expenses decreased compared to the prior year due to lower administrative expenses, offset partially by higher selling expenses.

During the quarter, we also recorded a number of unusual less frequent items that had an offsetting impact on our income statement. These included an expected gain from the sale of property, offset by plant expenses associated with severance cost related to the move of an additional 130 U.S. manufacturing jobs to our Dominican Republic location, severance cost related to a few corporate personnel moves, and cost for inventory obsolescence in our direct sale business as a result of adding Dockers, San Francisco to our product offering, which in some cases, will replace existing product. Again, these items are planned and had an offsetting impact in our income statement.

Depreciation and amortization of intangibles was 4.9% of revenue this quarter, compared to 5.0% in the prior-year period. For those of you who track these two items independently, depreciation expense was $9.2 million for the first quarter and amortization expense was $2.8 million.

Again, we are pleased to report both a sequential and a year-over-year improvement in operating margin.

Let me take a minute to detail a few of the specific investments we made during fiscal 2007 to positively impact our operating margins. First, we are now enjoying the full run rate of office savings from deploying handheld technology across our organization. As you may recall, utilizing handhelds allowed us to reduce our workforce by over 100 positions. In addition, we continue to look for additional opportunities to drive higher levels of customer satisfaction and further productivity benefits from our handheld platform.

We also continue to gain incremental income from the fixed cost leverage created by additional revenue growth and the execution of operational initiatives to lower our cost structure and drive margin expansion. Let me give you a couple of noteworthy examples.

During the past few quarters, we enhanced our garment sorting capabilities. This initiative, which is internally called AutoSort Plus took the advanced sorting system we utilized in our modern fully automated plants, and implemented portions of this system into our older, less automated plants. In the end, we reduced our production workforce by approximately 50 positions as a result of this initiative.

As previously mentioned, we also recently transitioned the remainder of our US selling operations from Mississippi to our Dominican Republic operation. This initiative shifted approximately 130 jobs to the Dominican Republic. We encourage severance and shutdown expenses in the first quarter related to this project, but we'll capture annual savings of approximately $2 million moving forward.

These are just a couple of examples of how we continue to look at increasing productivity and improving margins. Importantly, this specific investment for plan steps is part of our overall strategic plan to deliver improved financial performance.

Continuing down the income statement, interest expense for the quarter was $4.0 million, up 0.5 million over the same period last year. The increase is driven by higher average outstanding borrowings as compared to the prior-year period.

Our higher debt balance is a result of the acquisitions we’ve completed during the last nine months and also our share repurchase program.

For the first quarter our effective tax-rate was 37.8%, compared to 38.5% last year. We did adopt the new income tax accounting standard called FIN 48 in the first quarter. The adoption of the standard had virtually no impact on our effective tax rate. The adoption did impact our balance sheet with income tax reserves move from short-term to long-term and the reserves growth stop as they are no longer presented net of federal benefit.

Now, let me turn to our capital structure and cash flow, which remained extremely strong. Total debt of $246.1 million was up approximately $25 million compared to this period last year. Debt as a percent of total capitalization was 29%.

Total shareholder equity increased to $603.2 million, compared to $555.5 million a year ago. Clearly, our balance sheet provides the capacity to pursue further strategic acquisitions, fund organic growth opportunities, and repurchase our shares.

Cash flow from operations increased to $14.3 million for the first quarter compared to $6.9 million in the prior year. Cash from operations increased compare to the prior year period due primarily to stronger earnings, higher depreciation and amortization levels, and lower net working capital investment needed to support the growth from the business.

Capital expenditures were just $2.4 million for the quarter, compared to 9.8 million in the prior year. We expect capital expenditures to be in the range of $30 million to $33 million for fiscal 2008.

Free cash flow defined as cash flow from operations less capital expenditure, increased to $12.0 million compare to negative $2.9 million in the prior fiscal year. We expect to continue to generate strong free cash flow in fiscal 2008.

Cash flow use for business acquisitions during the quarter totaled $40.3 million. As previously disclosed, we completed the acquisition of Leef Services during the first quarter. And we also recorded the number of adjustments to previously executed acquisitions, again, this acquisitions strengthens our market position and leverages our existing operations in the Upper Midwest.

As previously disclosed, we initiate the share repurchase program to purchase up to $100 million of the Company’s common stock. During the first quarter, we purchase 257,300 shares. Since inception through the end of the first quarter the Company has bought back 489,000 shares or approximately 2.3% of shares outstanding at a cost of a approximately $19.1 million.

We planned to continue to repurchase shares from time-to-time. The timing and the amount of the repurchases will be determined by the Company’s management based on its evaluation of market conditions, share price and other factors.

In addition the company has paid a dividend for 38 consecutive years, since going public in 1969. We recently announced the 25% increase in our quarterly dividend, which marked the second consecutive year of significantly increasing our dividend. We expect to increase our dividend periodically, subject to future financial performance and capital requirements.

The execution against our share repurchase program and our increasing dividend continue to demonstrate our confidence in our strategic plan, the strength of our business model, and our commitment to delivering increasing shareholder value.

Looking forward we expect revenue in the second quarter of fiscal 2008 to be in the range of $252 million to $255 million. This revenue guidance represents a sequential improvement in our rental organic growth rate and a year-over-year increase in direct sale revenue. It also reflects the initial revenue from the strong new account growth both Rick and I highlighted earlier.

As for earnings, we are expecting diluted earnings per share to be in the range of $0.53 to $0.57 for the second quarter. Our second quarter earnings reflect continued efficiencies gained from revenue growth, and productivity savings from ongoing operational initiatives.

In addition the earnings guidance includes higher anticipated merchandise cost from record new account sales in the first quarter. We anticipate that higher merchandise expense, especially as we continue to generate new account growth going forward will impact earnings during the second quarter and in the back half of the year.

During the second quarter we also plan to install our significant new information system at our Lion uniform business. We anticipate that we will incur fairly significant training, travel and other implementation cost during the second quarter.

Our earnings guidance also reflects our ongoing integration efforts for the three acquisitions we completed during the past year.

And finally, our guidance includes gradual additional selling investments, as we continue to expand our sales organization to capture additional growth opportunity.

It's important to recognize that this guidance represent the sizeable improvement in our operating margin from the second quarter of fiscal 2007, and represents earnings per share growth of 22% at the mid-point of our range. Furthermore, our guidance reflects a more normalized effective tax rate for the second quarter between 38% and 39%.

That concludes our prepared remarks, and we would be glad to take your questions at this time. I'll turn it back to the operator.

Question-and-Answer Session

Operator

Thank you, ladies and gentlemen. (Operator Instructions) Our first question comes from Michel Morin with Merrill Lynch.

Michel Morin - Merrill Lynch

Good morning.

Jeff Wright

Good morning.

Michel Morin - Merrill Lynch

I was just looking at your guidance, it seems like the revenue guidance looks a bit conservative, and we're trying to square that with the expectation that organic growth should tick up sequentially. And if I'm correct, the Leef acquisition was not a full contributor this quarter. So, is there something in particular that would be holding you back a little bit here or you're just being cautious because of the employment outlook?

Jeff Wright

Michel, this is Jeff, I will answer the question and Rick can add to it. I don’t think the guidance is cautious. I think it’s our estimate of where we think things will be. It does reflect our sequential improvement in our rental organic growth rate. Actually, as soon as it is moving up to 4%, and it includes the impact of all of our acquisitions, including Leef. Leef had, while it wasn’t a full quarter in Q1, it was almost a full quarter. And it obviously includes continued drug sales growth as well, but I think our guidance is realistic and not overly conservative.

Michel Morin - Merrill Lynch

Okay. That’s very helpful. And then, I may have missed this because I jumped on a bit late but, on in terms of pricing, how has that been trending, both for the industry and yourself?

Rick Marcantonio

Well, we don’t report specific results on pricing. I would tell you that the pricing environment feels fairly normal above consistent over the last year or so. Those are big words that I think I feel comfortable communicating about the pricing environment right now.

Michel Morin - Merrill Lynch

Okay. That’s very helpful. And then just finally, I think in the press release or in the prepared remarks rather, you talked about the written sales, weekly sales, growing about 20%, can you remind us how the math works on that, if you were to sustain that over the next twelve months, where that might take your organic growth rate to, if everything else were to stay equal?

Jeff Wright

Sure. Again, we mentioned our new account sales were at record levels, up about 20% over the prior year. And, of course, if we are to sustain that, which I think is, that’s a -- that’s an assumption because this is an all-time record for G&K for a quarter, but if were to sustain that, it would be, that component of your organic growth would drive up 20%. Now again, that’s just one component of overall organic growth. But, I think if you work through the math that would probably represent a 2 to 3 point increase in your organic growth rate, again, if you flex through all those assumptions.

Michel Morin - Merrill Lynch

Great. That’s very helpful. Thanks very much.

Operator

Our next question comes from Mike Hamilton with RBC.

Mike Hamilton - RBC

Good morning, everyone.

Rick Marcantonio

How are you? Good morning.

Mike Hamilton - RBC

I was wondering, Rick that you didn’t commented at all on activity on the direct side. Are we seeing anything in new customer wins there, any project rollouts?

Rick Marcantonio

I am sorry -- I did comment just briefly in the prepared remarks, but I would just kind of go through it in detail. The direct sales business opportunity is one that we are quite excited about. It’s important to understand that there is component of it. So the Lion business, which, had a very good quarter, picked up some major new account wins, I have reported, two for example were Ecolab and [Saab] and Shell NASCAR. While we have been servicing Shell, we’ve serviced an additional piece of Shell.

So those are just two wins in that particular business. Our direct sale business that comes out of our field organization also had a recently good quarter, and the combination of both of those drove growth in our direct purchase business that was double-digit and I think it was around 12%, and all of it was organic. So, that, you know, in our mind it was a good -- it was a very good quarter.

One might wonder where we are at in the Dockers rollout, which is what we announced last quarter, and I will just remind everybody the way we are going up against the Dockers’ opportunity is we are trying to do it in a phased approach because there are investments that need to be made in order to capitalize on it over the long-term. And so, if you think about it, sort of, in maybe three phases, we are in phase one right now. We have introduced Dockers at part of our Lion Uniform product offering for our uniform direct purchase business.

We are building more infrastructure and making more investments to be able to roll Dockers in addition to other products into a catalog, a much more enhanced catalog offering, which will be sold by primarily by our rental organization and that should happen sometime in the second half this fiscal year. And then, over the longer-term, I’d expect Dockers to be part of our rental operations. We might have a Dockers product in our rental product line as well.

And then, I guess the only other part about direct purchases as, you know, this is a big quarter for us in terms of our outerwear promotion. And our revenue, I mean in the second quarter -- excuse me -- and our revenue projections for the second quarter include a nice increase in our outerwear promotion, which is a big promotion.

Mike Hamilton - RBC

On the new account wins, is there any particular quarterly bulge when delivery comes or is it slower than some of the big projects we have seen in past?

Rick Marcantonio

No, I think we had a number of wins not only in direct purchase but rental that we are managing through the execution. The only time that it becomes a time period where it’s difficult to execute it’s breakeven in the hauling time period, pretty much the month of December, it’s a very difficult time to do a lot of new product installation. But other than that we pretty much see it as a regular ongoing kind of thing. If we had an introduction like we had a years ago with Delta, where I had report that separately and tell you that, but everything else is kind of an even flow.

Mike Hamilton - RBC

Thanks. I was wondering if you had a feel for foreign currency impact on the operating income line in the quarter?

Rick Marcantonio

Yeah, I think Jeff would like to comment on that.

Jeff Wright

Sure. And maybe I can comment both on revenue and NOI. But I'll comment, I guess from a kind of an EPS perspective. On a year-over-year basis the Canadian dollar has clearly strengthened against the US dollar. From a EPS perspective, it's probably a little just shy at $0.02 over earnings per share. So, and are kind of moving from 43 last year to 58 this year, again, my calculations suggested $1.07 and $1.08 was the impact from that positive Canadian exchange rate.

On the revenue side as you know, we factor out foreign exchange out of our organic growth rate. So, our organic growth rate is a, kind of, transparent peer number on a kind of a same-store basis. But it would have had about a 1.3% impact due to the FX, so, in other words if didn’t exclude FX our organic growth rate would be close to 5%. And I know that, I'm not sure everybody in the industry excludes that from their organic growth rate, but we do. So that’s the impact on revenue.

Rick Marcantonio

Thanks. If we could come over to CapEx, where you guys have just done a great job. Your implication on four years suggests you're going up to above as higher run rate as we have seen in recent years. So, are there any particular projects worth noting there?

Jeff Wright

We were very low, maybe as you are pointing out our CapEx was low in Q1. And part of that was this, I mentioned in some of the prepared comments, there is one unusual item, we sold some property that tended to soften that CapEx number, gets netted in there. But, we do have in the out quarters, we got this implementation of this new system at Lion Uniform Group, there is some spending there.

And we do have one plant that’s scheduled to kind of start up near the end of the fiscal year. So, at this point that’s in our forecast as well, we have not made a firm commitment on that, but it's in our forecast. So, the CapEx will probably be a little bit greater in the out quarters here.

Rick Marcantonio

But. I would call those tweaks, rather than major shifts in terms of a change in our behavior.

Mike Hamilton - RBC

Right, thanks. Last one, can you comment on fuel and energy, both in quarter and your feelings as you look into the year?

Jeff Wright

Sure, the energy kind of seems to have abetted to a degree, when you compare Q1 to last year's Q1, it actually is slightly positive on a percent of revenue basis. We’re obviously a bit concerned about gasoline, oil is up significantly, and you can kind of see a little bit of it in the forward curves here. We've built that into our Q2 guidance, so we don’t a have a lot of concern about Q2, but maybe a little bit more concern about Q3 and Q4. Again we hedged a decent portion or close to 50% of our gasoline usage, so we’re protected to some degree but the gasoline price levels are a bit concerning.

Mike Hamilton - RBC

Well, great execution. Thanks for the insights.

Jeff Wright

Thank you.

Operator

Our next question comes from Scott Schneeberger with CIBC World Markets.

Scott Schneeberger - CIBC World Markets

Hey, thanks and nice work on the quarter.

Rick Marcantonio

Thanks, Scott.

Scott Schneeberger - CIBC World Markets

I guess jumping back to direct sales, Rick, you mentioned you will have the outerwear promotion in fiscal second quarter. What type of the gross margin impact will that have, you’ve been running in the high 20s, will it move it significantly one way the other?

Rick Marcantonio

It might goose it up just a little bit.

Scott Schneeberger - CIBC World Markets

Okay.

Rick Marcantonio

I wouldn’t look for a significant increase in that margin.

Scott Schneeberger - CIBC World Markets

Alright. Thanks on that. And could we just go back over, I guess the one time items in the quarter, Jeff, I believe you said that they were a near exact offsets. But, is there any more quantification you can put on the gain on sale offset by I guess each of the severance cost items?

Jeff Wright

Yeah. I'd rather not get in to specific quantification of each item, but just again to reiterate, there was a gain on sale of a piece of property we owned that no longer fit into our long-term plans. And that did generate a gain. And then we incurred a number of one time expense items as well. And I'll just go through them again quickly, but the movement of 130 jobs from Mississippi to the Dominican Republic, there was pretty significant severance cost associated with that. There is also some severance cost here, corporate for a couple of corporate personnel moves that we made.

And then, finally, with the introduction of the Dockers San Francisco product line that, that’s obsoleted or replaced a little bit of our existing product and so we took our inventory reserve against that. And those three items really offset against that gain. Actually the one thing that will pop-out for you when you see the 10-Q is that the gain actually was in our Canadian operation and all of the expenses where in our US operations.

So, there is an impact on our US and Canadian margins that you will see when you see the Q, we don’t disclose those yet when we do our press release here, but when the Q is filed you will see that impact.

Scott Schneeberger

I think -- and we were just talking purely on the P&L just now as far as the assets?

Jeff Wright

Yeah, that’s right.

Scott Schneeberger

Okay.

Jeff Wright

All of the P&L.

Scott Schneeberger

And then, just moving into this next quarter, I am sure you’ve obviously grabbed it in your guidance, but are there any more unusual or one-time item trickling into that?

Jeff Wright

No, in terms of Q2, I don’t think that there is anything significant as in the Q2 guidance. I guess, I was just getting a high sign from my cohorts here that in with this we talked about in the guidance a bit, but we do have this fairly big systems implementations outlined. There will be some extra cost there, and so that may be one item that pops out a bit.

Scott Schneeberger

I agree. Thanks. Thanks for the -- all those (inaudible) I guess just Rick, you know you said I think over the last, may be couple of quarters, you’ve been taking your foot off of the gas pedal on as far as new sale tires, just waiting for the productivity come through. It sounds like you are very pleased with the quarter, you shot the press release and in your prepared remarks, indicated that you might go back in that direction again, I guess, can you just take us a little deeper on that for a sec?

Rick Marcantonio

Yeah, I think that you framed it correctly. The foot is back on the gas pedal. I think it’s the right way to, you know -- we will do it gradually, I mean, as I mentioned to you over the last couple of quarter, I think we added in one or two other quarters a year or so ago, we had it too many, and we had some difficulty digesting that, and so you’re going to see a continued investments in our sales and marketing organizations and I would look at it as more gradual just to make sure we can digest or similarly add those personnel into our organization. But, we are going to -- we are and will continue to invest in that organization, and our national accounting.

Scott Schneeberger

Thanks very much.

Rick Marcantonio

You're welcome.

Operator

Our next question comes from Ted Kundtz with Needham & Company.

Ted Kundtz - Needham & Company

Hello, Rick and Jeff.

Rick Marcantonio

How are you?

Jeff Wright

How are you?

Ted Kundtz - Needham & Company

Couple of questions.

Jeff Wright

How are you?

Ted Kundtz - Needham & Company

Very good doing fine. Thanks. Our national account, could you tell us what percent of revenue national accounts now constitutes?

Rick Marcantonio

I think, I (inaudible) confirmed, I think it's about 12%, they'll be doing on one hand.

Ted Kundtz - Needham & Company

Okay. Yeah, it was around 14% earlier, I didn't know if that's an increasing number or a decreasing number of your revenue?

Rick Marcantonio

Hold out one second, let me just calculate. It's about 15% of our revenue.

Ted Kundtz - Needham & Company

About 15%. Okay.

Rick Marcantonio

And it’s growing.

Ted Kundtz - Needham & Company

And it’s growing, right. Does that put any pressure on your margins? Is a pressure there in winning that business?

Rick Marcantonio

No. I'll speak to you in sort of general terms, and then if Jeff wants to add anything he can. We've been asked often as we change our mix to move, to add more direct, excuse me, with more national accounts I think on a negatively impact our profitability. And the answer is we don't believe so. We have done, as you would guess, we do pricing models on our business, and there are some components of a national account that are different than smaller accounts, and I'll just remind you of a couple of them. We've talked about in the past, national accounts typically don't have bad debts.

They typically stay with us much longer, and are typically much larger stocks which increases our efficiency. Those things, sort of impact positively impact the profitability of those accounts. So, while you might have to price aggressively to get some of that business that's offset by some of those positive things that don't exist with some of the smaller accounts. So, we’re now looking it as a profit change. The only thing that happens with any new business is we have to make the investment for new business. And the quarter after we introduce it and that’s typically for the new garments and the amortization and the incentive award and the stuff like that, but nothing other than that.

Ted Kundtz - Needham & Company

Okay. That kind of lead to my next question about your, kind of, target margins going forward. It looks like certainly in the next quarter margins will be down a little bit. You got increased revenues and you are giving lower guidance on EPS and you explained why? And I was just wondering, beyond that where do you see the operating margins swinging back? Do you feel like you’re going to get nicely over 10%, sometime in the latter part of this year or is that a next year goal or is it a goal at all?

Rick Marcantonio

It is a goal.

Ted Kundtz - Needham & Company

Can you assure? I need your long-term gains on margin goals?

Rick Marcantonio

Again, I am not going to peg a particular quarter and the reason, our goals are not to just get our margins back to 10% period, it’s to get our margins above 10%. But I think the reluctance we’ve always had in communicating a specific target by quarter is, as you can see, we have been making investments behind the scene. I put it down a pretty steady or I put hand-cuffs on our conversation about what those investments have been, until we make those investments.

But we’re making investments in the business that eventually will build up sort of stronger business. That’s some of the reasons why we have had improvements. But our goals to have year-over-year improvement in our gross-margin, I mean in our operating margins and in any one quarter it might take a little bit, but we are not taking our margins backwards.

Ted Kundtz - Needham & Company

Yeah. I wasn’t looking for a quarterly projections, I was looking for more of a longer term target range that you may have?

Rick Marcantonio

I think, all I would feel this is again Rick. All I feel comfortable is our goal to get this in to double-digit operating margin ranges consistently. And whether that’s 10 or 12 or 15 depends on when we’re talking about and I won’t go beyond that.

Ted Kundtz - Needham & Company

Okay, then, one last question. Just in terms of the direct sales, effort here that you’ve got, I know it’s potentially a big area of growth for you. Is there anything that you are thinking about beyond the Dockers arrangement that you could grow this business faster?

Rick Marcantonio

Yeah.

Ted Kundtz - Needham & Company

Good. Okay.

Rick Marcantonio

Again this is Rick. I don’t mean to be not responsive. But I think that what you need to think about Dockers is just part of our direct purchase strategy. It is not our direct purchase strategy in its sincerity. So there are elements to building a much stronger direct purchase business that we’re in putting together or working on buying the string.

And I’ll just, kind of, just from 40,000 feet I will tell you there is a direct purchase uniform business model, which is the business that build direct purchase offering from scratch. They design the garments, they source the garment and there is sort of a mix and match or one that requires a lot less design, which is typically being serviced out of a catalog.

And those two are two very different businesses. They are managed differently. The resources that you put into it are more much different. You can see Dockers going into both those businesses. But as it relates to the first one the uniform side, that’s where you’re likely to see us expand into new segments. You’ll see us acquire other businesses whereas on the catalog side you’ll see more like product offering extensions as we build out our catalog offering.

Ted Kundtz - Needham & Company

Okay. Great. Thank you. And just one last question, if I could?

Rick Marcantonio

Sure.

Ted Kundtz - Needham & Company

Anything worse. Are you seeing any further weakness in the either the automotive or the industrial manufacturing sector? Those are the two sectors you mentioned last quarter, who were particularly weak for you, any change going on there, it getting worse or the same?

Rick Marcantonio

I'll say we probably feel pretty the same. Instead of the continuation, what we have seen.

Ted Kundtz - Needham & Company

Okay. Thanks very much.

Rick Marcantonio

You are welcome.

Operator

Our next question comes from David Long with William Blair.

David Long - William Blair

Hey, guys good quarter. It's Dave Long for Bruce Simpson.

Rick Marcantonio

Thank you.

Jeff Wright

Thank you. Good morning.

David Long - William Blair

I know you guys no longer quantify the add staff metric, but last quarter we had talked that it was down, I think, sequentially. Can you guys just maybe quantify how that metric is trending in the current quarter or this past quarter?

Jeff Wright

Maybe just a little bit of color, this is Jeff. And it kind of tallies in the last question, that we still see little bit of softness in some other segments out there, particularly automotive, some of the industrial segments. So, it continues to be weaker than what we would like, and probably what has been historically. But we continue to really focus our efforts on those growing segments. Segments that are really valuing our value proposition around image and safety, and looking for growth in other areas.

David Long - William Blair

Okay.

Rick Marcantonio

And I want to add this, we've reported 3.5% organic growth for the quarter. I will tell you we exited the quarter at a higher rate and we've done that. And we've give you guidance that says we will do 4% organic growth. So, we are not saying, whatever is happening in the economy has a handcuff on our ability to move our organic growth up. We believe our investments are working and driving growth in the areas we need to get growth from.

David Long - William Blair

I see. And you talked about kind of auto being little lackluster. But the food segment area Rick you've talked about being particular strength, unlike the couple of quarters has that food segments spilled over to maybe education and cafeterias any new pickups from this staph infection, and superbug that's been in the news lot lately?

Rick Marcantonio

I can't really speak to that, but I can tell you that when we introduced ProSura to the food processors a number of years ago, two or three years ago, we've seen a steadily increase. And it’s attractiveness to them and driving new business for us. We put a modified version of that program into food retail, where there is a lot of sort of food processing been done at retail. And we're just starting to get some of benefits from growth in that particular area.

It’s even been stimulated more by Biosmart which was the product that we introduced last quarter, which has the microbiological, it has the ability to kill microorganisms, in when they become in contact with bacteria and things like that. And we have a chance to rejuvenate that product when we bring it back through our wash formula.

And that sort of stimulating interest now in the food retail areas where they would use it for things like toweling systems and also aprons. And that’s kind of the area we're seeing additional interest by some of our new offerings.

But, again we're continuing to work on things behind the scenes that I think will drive both performance in the food area. The other is, we're having a lot of success with our FR garments. That area was up by, I think have reported about 20% in the first quarter. So, there are number of areas that we're seeing positive growth in.

David Long - William Blair

Okay. And one last question is just for Jeff. I noticed interest expenses was up a little bit year-over-year, and I know it depends a lot on acquisitions and the share repurchases, but how are you guys modeling that rest of the year or how should we be thinking about modeling that for the rest of the year?

Jeff Wright

Well, I think in terms of the rest of the year we had the incremental debt from the three acquisitions we have done over the last nine months was pretty well in the full quarter. So, you have got to get close to a full quarters worth of impact of interest expense from that. We also continue our share repurchase program. About half of the repurchases we made for the quarter, the interest expense was in the first quarter, but the other half was probably only in a month or so maybe in a little bit less than month.

So, there is a little bit of incremental expense coming from the share repurchases, and then, of course you’ve got the impact of ongoing cash flow that’s going to reduce your debt levels. So, I would tell you that if you modeled it out it kind of start where we were in Q1 and share repurchases somewhat offsetting the cash flow from operations but net-net interest expense slowly moving down as you move through the year.

One item that just maybe tied into that just related to our share repurchase program, but folks might have a question on what the impact of that was to our EPS. It was a positive impact to EPS, however, it was pretty modest in Q1. In fact, we would calculate maybe two-tenths of a penny in that range when you take the impact of the shares but less backing off the increased interest expense as an offset. So, we reported $0.58 of earnings per share and actually with or without the share repurchase program it would have been $0.58 anyway.

And then it’s going to have an increasing impact here in Q2 and moving forward.

David Long - William Blair

Okay. Thanks for the color.

Jeff Wright

Thank you.

Operator

Our next question comes from Mike Schneider with Robert W. Baird.

Mike Schneider - Robert W. Baird

Hey, good morning guys, and congratulations on a nice quarter.

Jeff Wright

Thank you.

Rick Marcantonio

Thanks, Mike.

Mike Schneider - Robert W. Baird

First, just I apologize if I missed it, route sales productivity, Rick you mentioned sales productivity overall was at 20% growth, was that the professional sales force or the route sales force or both?

Rick Marcantonio

It was the professional sales force. That’s the new business generated by our sales organization. While we don’t break-out the components of route sales, it basically was, I think the highest was right about one of our largest quarters ever and I think -- just give me one second enough, it was up a double-digit.

Mike Schneider - Robert W. Baird

Okay.

Rick Marcantonio

Which confirms what I’ve been saying all along, that the route sales was not a one-time or short-term opportunity. It continues to be an opportunity in our business?

Mike Schneider - Robert W. Baird

Right. So when you drill down into the organic growth and the acceleration that appears to be under way, can you give us a sense now of at least just qualitatively, is it primarily the ancillary products that are growing faster than average or indeed are some of the new markets for the uniform business? Can you drive in that business to match the average growth rate?

Rick Marcantonio

Well, our new sales are being driven both from just penetrating our customer segments that we’ve been in, but also our new solutions, alright. And our professional sales force arming them with product offerings that no one else in the industry has, has clearly contributed to our growth, I mean, you just clearly, I mean, I gave you our increase in food processing for the quarter was up over 10%, I mean, you are not doing that by just having a standard overall program.

So, our new programs are definitely helping us, as it relates to, and those programs are really what route sales are all about. Route sales are selling additional solutions whether they be restroom supplies or paper products or mats or toweling systems. And we’ve made, you know, while we haven’t spoken to them with the kind of same vigor that we’ve talked about our new segmented marketing effort like ProSura, we have introduced new restroom supplies, for example, a whole new suite of products for restroom that are hands free, that are really are quite interesting.

So, those are the two areas that come to mind. And then, you know, there are also our new sales are being driven in direct purchases, while Lion continues to pickup new customers by offering. And we’re slowly getting Lion involved with some of our customers segments where we have lots of business today. So, those are the three primary areas.

Jeff Wright

Yeah. Maybe just tack on to it, Michael, I don’t know, forget that your question or not but certainly on the route sales side where we are trying to penetrate additional products and services into existing customers that tends to be the ancillary products and services and that our new account sales tends to be driven or led by garment programs. And I think Rick was trying to articulate that many of the new programs are being led by some of the new ProSura and BioSmart and other products that we’re offering our customer base.

Rick Marcantonio

Yeah. I think that just to be very clear. New sales by our professional sales are typically more oriented towards garments and ancillary products are secondary offering like mats and restroom products and things like that. I am sorry. Hopefully, that clarifies.

Mike Schneider - Robert W. Baird

So, is the growth rate of the garment business matching or exceeding the growth rate in the ancillary products today? I am trying to get a sense of what’s driving the mix or which way the mix is shifting?

Rick Marcantonio

Yeah. Michael and we don’t break those out between garments and ancillary products. But, again, you know, we had a -- if your new account sales are primarily garment driven and your route sales are primarily ancillary products, and we had a really blowout, maybe, the little bit strong of a term but really strong first quarter, then, that's a big driver for us here in the first quarter.

Mike Schneider - Robert W. Baird

Okay. And then, national accounts. What were national accounts up during the quarter? And I'm sorry, I missed what percent of sales there are today?

Rick Marcantonio

We reported that national accounts about 15% of our revenue today. And they were up double-digit, strong double-digit. Strong teens double-digit, which they've been for a quite sometime, I mean, I only have this, I mean we've reported strong growth at national accounts and it continues to be strong.

Mike Schneider - Robert W. Baird

And then, the guidance for next quarter and the gross margins, it looks like you have picked an acceleration, as a result of the new account sales but there is an equal loss that I guess of sequentially lower gross margins. Is that more a function of the day-to-day garment cost being deployed on local accounts or is that, I guess, is that indicative of the national account pricing beginning to be a greater influence on the margin mix or both?

Jeff Wright

Yeah. And I'd say it’s not the ladder which is the national account pricing. It's primarily that our new account sales are very strong, and the incremental merchandize cost associated with that will began to impact our numbers here in Q2 and moving forward. So that will have an impact on our gross margins. And then, also, I think there was a comment earlier on our operating margins, obviously from Q1 to Q2, we'll be down a little bit. And the other reasons are, well, we mentioned on the call which is the implementation of the new system at Lion Uniform and also some acquisition integration costs that are happening.

Mike Schneider - Robert W. Baird

Okay. And can you quantify the acquisition integration costs you expect in Q2?

Jeff Wright

No, sorry and in fact some of the actions we need to be careful, they need to be announced to employees in the right way and so forth.

Mike Schneider - Robert W. Baird

Okay. And just all expectations are clear, Jeff you mentioned that if you sustain the 20% growth in sales productivity that would add 2 points to 3 points is that a kind of realistic expectation for us to start modeling? And I presume that’s over a 12 month period just given the way the cycles work correct?

Jeff Wright

Yeah, right Mike. That would be over a 12 months period. We had a very good quarter in Q1, it would be unrealistic, it could be probably a stretch to think that we can perform at that level consistently over a number of quarters. Our goals are to do such, but it would probably be unrealistic. So, I wouldn’t be putting that into your expectations.

Mike Schneider - Robert W. Baird

Okay. And then I guess just final question. Can I try and get some more detail on the Dockers role. Can you give us some qualitative sense as to what this is hitting the numbers in the first half of the fiscal year? And I guess when you turn that curve from expenses to probably greater contribution out of that program?

Rick Marcantonio

The Dockers contribution to volume and profits in the first half of the year is minute. Remember that none of the catalogue business will be in there. We’re basically introducing it as part of a uniform program in Lion. So, it has to be a uniform program, not just a catalogue offering. And it has to become incorporated as part of the uniform offerings, so that takes time.

The catalogue business, we have not pegged the date, we’re likely to roll out some of it some time in the second half of the fiscal year. And when we get to a point where we’re comfortable knowing when that is, we will talk to the quarter and it’s potential impact in sort of macro term, in terms of how big it is in the quarter. But our second quarter guidance really does not reflect any kind of unusual activity from it.

Mike Schneider - Robert W. Baird

Okay. Thank you again.

Rick Marcantonio

You’re welcome.

Jeff Wright

Thank you.

Operator

Our next question comes from Michel Morin from Merrill Lynch.

Michel Morin - Merrill Lynch

Yeah. Thanks for the follow-up. I just wanted to check you talked about productivity gains, is there can you quantify that a little bit for us?

Jeff Wright

Michel, this is Jeff, I guess, you know, we mentioned a few things during the conference call script, productivity gains that we’ve got out of our handheld unit, well over 100 positions that have been eliminated. Some productivity gains, that we’ve got out of our plant operations through our Auto Sort Plus initiative, about 50 positions.

And then we also talked a little bit, this is more of a gain moving forward. But the 130 positions that have been moved from our Mississippi operation to our Dominican Republic operation, but then as we mentioned that those 130 would result in a couple of million dollars roughly of savings moving forward.

Michel Morin - Merrill Lynch

Right.

Jeff Wright

So, I guess, beyond that where you looking for something else?

Michel Morin - Merrill Lynch

I was specifically interested on sales force front, you know, I did pick up on the handhelds. I was wondering if there was, when you look at sales per sales person. What are we looking at in terms of improvement there?

Rick Marcantonio

I reported in my prepared remarks that our productivity for the sales organization, and that’s the professional sales organization, not the route side of the business, was up 20%.

Michel Morin - Merrill Lynch

The 20%.

Rick Marcantonio

That’s the point.

Michel Morin - Merrill Lynch

All right. Okay.

Rick Marcantonio

Which was good.

Michel Morin - Merrill Lynch

That’s fine. Thanks very much.

Rick Marcantonio

Okay. You’re welcome.

Operator

I’m not showing any further questions at this time.

Rick Marcantonio

Okay. Then in closing, then I would just want to thank you all for joining us today. As I indicated in my prepared remarks, we are extremely pleased with our strong first quarter results. We are off to a solid start in fiscal 2008. And we look forward to reporting to you our second quarter results sometime in late January. Thank you very much. Have a great day.

Operator

Ladies and gentlemen thank you for your participation in today's teleconference. This does conclude the conference you may now disconnect. Good day.

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Source: G&K Services F1Q08 (Qtr End 9/29/07) Earnings Call Transcript
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