G&K Services F2Q08 (Qtr End 12/31/07) Earnings Call Transcript

| About: G&K Services, (GK)

G&K Services (GKSR) F2Q08 Earnings Call January 29, 2008 11:00 AM ET

Executives

Glenn L. Stolt - Vice President and Treasurer

Rick Marcantonio - Chairman and Chief Executive Officer

Jeff Wright - Senior Vice President and Chief Financial Officer

Analysts

Kartik Mehta - FTN Midwest

Ashwin Shirvaikar - Citigroup

Mike Schneider - Robert W. Baird

Scott Schneeberger - Oppenheimer

Michel Morin - Merrill Lynch

Theodor Kundtz – Needham

Mike Hamilton - RBC

Operator

Good day, ladies and gentlemen, and welcome to the G&K Services second quarter fiscal 2008 earnings conference call. At this time, all participants are in a listen only mode.

Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] And as a reminder, this conference is being recorded. Now, ladies and gentlemen, your host for today’s conference, Glenn Stolt, Vice President and Treasurer.

Glenn L. Stolt

Thank you, Tyrone. Thank you and good morning, everyone. Thanks for joining us to discuss G&K’s fiscal 2008 second quarter results. As always, once we’ve completed our prepared remarks, we’ll open the call for questions.

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 that 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.

A replay of this call will be available starting today at about 1 PM Central Time through February 28. You may access the replay by visiting our Investor Relations’ section of our website.

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

Richard Marcantonio

Good morning. Earlier this morning, we reported another strong quarter. For the second quarter, revenue exceeded expectation and totaled a record $255.3 million, up 10.6% over the prior year. This record quarterly top line result marks an annual run rate that exceeds $1 billion. With $1 billion in revenue squarely in our sights, we are now focused on driving to the next billion dollars.

We also drove very strong earnings that exceeded consensus estimates. Earnings per diluted share were a record $0.60, up over 33% from the second quarter a year ago. Clearly solid top line results and strong bottom line performance.

In addition, we delivered higher operating margins. Our second quarter operating margin was 9.3%, an increase of 100 basis points compared to the prior year period; a significant improvement and I believe a testament to the benefit we’re driving from the revenue growth and productivity initiatives we have in place. Overall, a strong second quarter performance.

Performance in the first half of the fiscal year was equally as strong. For the half, total revenue was up almost 10%; operating margins were up 130 basis points; earnings were up 34%; and we generated more than three times the level of free cash flow that we produced in the prior year period. Clearly, we’re pleased to report very strong first half results.

I’d like to take the next couple of minutes and update you on a few areas that helped drive our strong performance. After that, Jeff will take you through a detailed review of our financial results.

To start, I’m pleased to report continued success in our sales organization. Importantly, we continue to drive year-over-year improvement in sales productivity. During the first half, sales productivity was up over 10% from last year, a very solid achievement. As you would expect, this increase in productivity drove a significant year-over-year increase in first half new account sales.

For the first half, new account sales increased by more than 20% versus the prior year. Our sales organization has done a great job of ramping up the productivity of our sales force, and they are focused on driving even higher levels of sales productivity going forward. That is why we continue to gradually expand our sales team. Today our sales force head count is up at a mid-single digit rate compared to a year ago.

Shifting to the service side of the business for a minute, we had a tremendous quarter generating higher route productivity. For the quarter, we achieved record route sales. In fact, for the first half of fiscal 2008, route sales are up over 25% compared to the prior year period. Again, a significant accomplishment and it’s worth noting that we achieved this improvement while also driving our annual outerwear promotion.

I’m also happy to report that our National Account team has delivered another outstanding quarter. During the second quarter, we signed a number of new National Accounts including a large power transmission company, a major glass manufacturing enterprise, and a well-known retail food chain.

In Canada, we also added the retail store business of a major tire manufacturer as a new National Account. These very large, well recognized companies, among others, helped generate record new business written as measured in average weekly revenue for our National Account business.

In addition to these successes, we also continued to drive momentum with National Accounts in the transportation, security and retail convenience store markets − key segments for our Lion Uniform Group.

During the quarter, Lion secured a new uniform program with the Geo Group, a leader in privatized correctional and detention management. This program will start next month and when completed will place 5,000 guards in uniform.

In addition, we expanded our relationship with Continental Airlines. Beginning in July, we will outfit their pilots in a new uniform program. Overall, strong execution from both our professional and our route sales teams.

More importantly, these are great examples of driving positive organic growth through specific growth initiatives that we can control, despite the impact we are seeing from employment levels and economic softness.

Now let me take a minute to update you on the results of our investments in segmented marketing. First you may recall that our unique ProSura Food Safety program has helped food customers, from processors to grocery stores to restaurants, mitigate cross contamination issues in the food environment.

As a result of our targeted marketing efforts in this sector, our revenue in the food industry is up almost 10% for the first half of the fiscal year, with even higher growth in the food retail segment.

Importantly, our exclusive offering of BioSmart textile technology by Milliken, as you remember a new line of antimicrobial garments and towels, is helping us generate a significant amount of sales leads, which are being converted into new account wins.

In just the last eight weeks, we’ve generated a tremendous amount of qualified leads, strengthening our pipeline of food account prospects. In fact, the customer interest and account momentum around BioSmart is so positive that we’re expanding the product offering to include additional garments like chef coats, aprons, and wraps for the retail food market.

In addition, our first half revenue from ProTect Safety Solutions, which provides customers with flame resistant apparel, is up over 25% compared to last year. Clearly, our success in offering customers unique solutions is driving overall revenue in share growth.

Turning to the acquisition front, we continue to be very active in seeking strategic acquisitions that will leverage our existing operations, enhance our capabilities, or expand our overall presence.

Just last month we announced the acquisition of Nanoclean Limited, a small clean room business located in Ireland. The addition of Nanoclean strengthens our relationships with key multinational customers and I believe it’s a great example of how we provide specialized garments and process control services to meet the unique needs of customers in the microelectronic, pharmaceutical and medical technology industries.

We welcome Nanoclean’s customers and employees to G&K, and we continue to pursue additional quality businesses and I am happy to report our pipeline of acquisition candidates is quite full.

Shifting away from the top line performance for a minute, I’d like to reiterate that we’re pleased to report that our first half operating margin increased 130 basis points compared to prior year. While Jeff will cover our margin expansion in more detail, I want to highlight a couple of areas that drove increased productivity to drive margin expansion.

First, we focus on productivity as measured by total revenue per employee, which is up over 9% for the first half of fiscal 2008 compared to a year ago. This helps demonstrate the leverage we are achieving from our focus on both accelerating revenue growth and driving efficiencies throughout our organization.

In addition, we’re achieving higher levels of productivity as a result of planned actions we’ve taken and specific investments we’ve made. For example, we’re achieving benefits from our execution on investments in automation, like Autoserv Plus, and from capacity adjustment decisions like the shift of additional selling operations to the Dominican Republic.

Our first half selling and administrative costs are down 60 basis points compared to the prior year period, again in part due to the leverage benefit from overall revenue growth and the result of the office savings we’ve achieved from the implementation of handhelds across our entire route organization.

Importantly, we continue to look at technology, automation and best practice cost controls to improve our overall productivity and generate higher margins.

Finally, as a service business, our success depends on our greatest asset, our people. I’d like to take a moment to recognize our Canadian team led by Bob Wood. Just recently we were honored to be recognized as one of the best 50 employers in Canada for the fourth consecutive year.

We take great pride in providing a safe and positive work place for our people to build a rewarding career. This focus of making G&K a great place to work is the key competitive differentiator and strengthens our ability to fulfill the image and safety needs of our customers and drive increasing returns for our shareholders.

I’d like to repeat that I’m very pleased with our strong second quarter and first half performance. We continue to focus on executing the initiatives we identified as part of our long-term strategic plan; initiatives that are in our control to execute again, initiatives that focus on growth and productivity, and initiatives that are clearly working.

I’d now like to turn the call over to Jeff.

Jeffrey Wright

Thank you, Rick. As Rick highlighted earlier, we’re pleased with our second quarter and first half performance. Total revenue exceeded expectations and totaled $255.3 million for the quarter, an increase of 10.6% over last year.

This record quarterly revenue was driven by rental revenue growth and solid gains in direct sale revenue. Strong revenue contribution from acquisitions and the benefit of foreign currency translation also added to the increase in revenue over the prior year.

During the quarter, our organic rental growth rate improved to 3.75%, up from 3.5% last quarter. This increase was driven in part by the increase in new account sales and the route sales productivity.

While we’re encouraged to show improvement, the organic rental growth rate was slightly below our internal plan in part due to the lost revenue from the fire in one of our production facilities.

More importantly, we continue to see an impact from softness in traditional uniform wearing industries and more recently the affect of slowness in the overall economy.

In addition to continued employment declines in the industrial manufacturing and automotive industries, we’ve recently been impacted by declining employment levels in other industries. For example, employment in the specialty trade, general building contractors, lumber and wood products, and wholesale trade of durable goods industries as reported by the Department of Labor is down almost 400,000 jobs in just the last year.

Clearly, declines related to softness in the housing sector and slowness in overall economic conditions is offsetting some of our sales gains. I would, however, like to make one additional point in how economic trends impact our business. I think sometimes our industry is characterized as economically sensitive. We actually believe our industry is fairly resistant to an economic downturn.

Recall that our uniform programs are vital aspects to how our customers conduct business. Uniform programs are rarely a program that is cut. So while companies in a downturn will tighten their belt and take actions like reducing travel, eliminating consultants, reducing overtime, and controlling discretionary spending, they generally do not cut their uniform program.

So while we can see a modest impact to our revenue growth when there is a reduction in employees wearing uniforms and the associated usage items, we do not see drastic declines in our programs. I believe this is important to keep in mind as we potentially enter an economic slowdown.

With that said, we continue to focus on driving the avenues of growth we control like new account sales and route sales. As Rick highlighted earlier, we continue to gain traction in these areas.

In addition to driving greater sales productivity and route sales, we continue to invest in marketing programs to address unique customer needs; expand our direct sale capabilities to better serve the total image and safety needs of our customers; and implement technology, automation and training to improve our customer service levels.

Again, these are just a few examples of the internal growth drivers that we control and focus on to drive accelerating revenue growth.

Earnings per diluted share exceeded expectations and rose to $0.60, an increase of 33.3% from the $0.45 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 and production cost, and savings achieved from ongoing productivity initiatives.

The improvement in earnings was partially offset by higher fuel costs, investments in growth and productivity initiatives, and onetime costs of approximately $0.03 per diluted share related to the fire at one of our company production facilities.

Of course, excluding the onetime cost from the fire, second quarter earnings per share increased 40%. Importantly operating margin for the second quarter increased significantly to 9.3% of consolidated revenue up from 8.3% in the prior year period.

This 100 basis point improvement in operating margin was a result of increased rental and direct sales, gross margin, and the leverage realized on selling and administrative expenses from overall revenue growth.

The increase in operating margin was partially offset by higher energy costs, one-time expenses related to the production facility fire, expenses associated with the systems implementation, and ongoing acquisition integration costs.

We’ve mentioned systems implementation costs a couple of times. Let me provide a quick update on this topic. During the second quarter, we implemented a new information system for the Lion Uniform Group. This new system handles all aspects of this business including e-commerce, order entry, customer service, and distribution.

As with any major systems installation, we have moved into the process of stabilizing this new system to return the business to normal productivity levels. We expect this process to continue to negatively impact Lion’s financial results and overall business in the third quarter as we improve system performance.

Rental revenue in the second quarter was $232.2 million, an 11% increase over the prior year of $209.1 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 $23.1 million from $21.6 million last year. This 6.6% increase was driven by organic growth and acquisitions. Rental gross margins for the quarter increased to 36.2% from 35.5% in the prior year period.

The increase in rental gross margin resulted from lower production costs as a result of the cost reductions achieved from productivity initiatives and overall leverage from revenue growth. As expected, margins also benefited from lower merchandise cost as we controlled replacement garments and non-garment related merchandise.

Direct sale gross margin increased 28.5% from 27.8% in the prior year period. This increase in gross margin was primarily due to efficiencies gained from revenue growth.

Selling and administrative costs were 21.4% of consolidated revenue for the quarter, down from 21.7% in the same period last year. Selling and administrative expenses decreased compared to the prior year due to leverage from revenue growth and office savings generated from our hand held technology platform.

As mentioned previously, we also experienced a fire in one of our production facilities. The expenses related to this temporary business disruption impacted our earnings by approximately $0.03 per diluted share during the quarter. These expenses impacted operating margin by approximately 40 basis points in the quarter. Moving forward, we don’t expect this issue to significantly impact our third quarter results.

Depreciation and amortization of intangibles was 4.8% of revenue this quarter, consistent with the prior year period. For those of you who track these two items independently, depreciation expense was $9.6 million for the second quarter and amortization expense was $2.8 million.

Continuing down the income statement, interest expense for the quarter was $4.0 million, up a half a million dollars 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 have completed during the last 10 months; and our continued investment in buying back stock under our share repurchase program.

For the second quarter, our effective tax rate was 37.0% compared to 38.0% last year. The lower effective tax rate was primarily due to the enactment of a federal tax rate reduction in Canada.

Now, let me turn to our capital structure and cash flow, which remain extremely strong. Total debt of $264.7 million was up approximately $66.4 million compared to the prior year period. Debt as a percent of total capitalization was 31.2%.

Total shareholders’ equity increased to $583.4 million, up from $561.1 million in the prior year period. Clearly, our balance sheet provides the capacity to pursue further strategic acquisitions, fund organic growth opportunities, and repurchase our shares.

Cash flow from operations for the six months ended December 2007 increased significantly to $43.5 million, up 55% compared to the prior year period. This strong cash flow production was driven by a 27.3% increase in operating income, and our continued focus on controlling working capital investments needed to support the growth of the business.

Capital expenditures were $8.5 million for the six-month period compared to $18.4 million in the prior year. This decrease in year-to-date capital expenditures is partly due to the sale of assets of approximately $3.9 million in the first quarter of this fiscal year.

We now expect capital expenditures to be in the range of $25 to $27 million for fiscal 2008 compared to our original expectation of $30 to $32 million.

During the first half of fiscal 2008, free cash flow, defined as cash flow from operations less capital expenditures, increased to $35.0 million, up 260% from the prior year period. Free cash flow per diluted share increased to $1.66 per diluted share, up from $0.45 per diluted share in the prior year period.

This significant level of free cash flow also outpaced our earnings per share of $1.18, which I believe is a sign of a strong company. We expect to continue to generate strong free cash flow in the second half of fiscal 2008.

Cash flow used for business acquisitions during the first six months of fiscal 2008 totaled $45.2 million. As previously disclosed, we completed the acquisition of Nanoclean Limited in the second quarter, Leef Services during the first quarter, and we also recorded a number of adjustments to previously executed acquisitions.

As previously disclosed in the fourth quarter of fiscal 2007, we initiated a share repurchase program to purchase up to $100 million of the company’s common stock. During the first half of fiscal 2008, we purchased approximately 1.2 million shares.

We also bought back approximately 0.5 million shares since the end of the second quarter. Since inception of the share repurchase program, the company has bought back about 1.9 million shares or approximately 9.0% of shares outstanding at a cost of approximately $75.2 million.

We plan 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.

Looking forward, we expect revenue in the third quarter of fiscal 2008 to be in the range of $252 to $255 million. This revenue guidance represents a rental organic growth rate that is roughly consistent with the second quarter, driven in part by strong new account and route sales achieved in the first half of fiscal 2008, offset by continued softness in employment, and overall economic conditions.

Third quarter revenue guidance also includes lower year-over-year direct sale revenue due to a large uniform shipment to a Fortune 100 customer in the prior year period, and the impact of stabilizing our new information system at Lion Uniform Group.

As for earnings, we’re expecting diluted earnings per share to be in the range of $0.52 to $0.56 for the third quarter. Our third quarter earnings reflect continued efficiencies gained from revenue growth and productivity savings from ongoing operational initiatives.

In addition, the earnings guidance includes higher energy cost and higher anticipated merchandise cost from record new account sales.

During the third quarter, we also expect to continue incurring expenses to optimize and stabilize the new information system that was installed at our Lion Uniform business in the second quarter. Our earnings guidance also reflects our ongoing integration efforts for the four acquisitions we completed during the past year.

In addition, our guidance includes a gradual increase in sales staffing as we continue to expand our sales organization and increase sales productivity to capture growth by generating higher levels of new business.

Furthermore, our guidance reflects an effective tax rate for the third quarter of 39% to 40%. It’s important to note that our prior year third quarter earnings results reflected 25.4% effective tax rate. If the prior year result were to reflect an effective tax rate of 39.5%, earnings per diluted share would have been approximately $0.46 per diluted share.

The earnings guidance for the fiscal 2008 third quarter implies a 13% to 22% increase over the prior year results when adjusted for a comparable effective tax rate.

Now given that there is a fair number, of moving parts to understand, we thought we would provide you a more detailed road map of our third quarter guidance. So I’ll try to read slow here, but here is what the reconciliation looks like when comparing third quarter guidance to the prior year.

So begin with the prior year third quarter actual earnings per diluted share, of $0.57. As noted in the press release, adjust this result down by $0.11 to factor for a comparable income tax rate.

Next, adjust down by approximately $0.05 per share for the cost of stabilizing our systems investment at Lion and also ongoing acquisition integration costs, net of the income from acquisitions and debt service costs, then add back approximately $0.13 per share for leverage from growth, our productivity improvements and all other factors. This should bring you to the mid point of our range of $0.54 per share for the third quarter.

Now just spinning the numbers and analyzing them in a different way, here is what the reconciliation looks like when comparing our third quarter guidance sequentially against the second quarter results which were reported today.

So begin with the second quarter earnings per share of $0.60, add back the impact of the plant fire, offset by the residual impact in the third quarter of approximately $0.02. Adjust down for the impact of our second quarter outerwear promotion, Lion systems cost, and the reset of government payroll taxes for approximately $0.10.

Also adjust down for a higher income tax rate of about $0.02 per share. And finally add back approximately $0.04 per share due to the leverage from growth and productivity benefits and again all other factors. This reconciliation also arrives back at the midpoint of our third quarter earnings range of $0.54 per share.

We normally wouldn’t go into this level of detail but given the number of moving parts we thought this might be helpful for everyone to understand our third quarter outlook. Again, the midpoint of our third quarter guidance implies a 13% to 22% increase over the prior year result when adjusting for a comparable effective tax rate.

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

Question-and-Answer Session

Operator

Our first question is from Kartik Mehta - FTN Midwest.

Kartik Mehta - FTN Midwest

Wanted to get a little bit better understanding of your comment about the economy, Rick. I understand there’s some softening in some other industries this time around than there were in the past. Is that something that started happening later in the quarter, or was that something you started evidencing throughout the quarter, and as a result you just became a little bit more cautious?

Rick Marcantonio

I’m not sure it happened late. I don’t think I can peg when it happened within the quarter. We’ve been watching the economy for some time. We talked a quarter or two ago about the impact from the automotive industry, for example, and we’ve seen some continued softness. And our projection did take that into consideration.

But I’d still say that we have a pretty strong forecast in place. If you take the midpoint of our range, we’re looking at a roughly 7% increase in revenue during the third quarter. And as Jeff indicated to you − we didn’t break it out in detail − we’re expecting some downside or some negative growth in our direct purchase business because of the roll out of a program with a large customer a year ago. So that would tell you that the rental side of the business is up even greater than that, or our forecast is for that.

Kartik Mehta - FTN Midwest

So in this environment, what has your experience been and ability at price increases? Obviously, energy costs are going up, which you indicated that it’s probably having somewhat of a negative impact on the cost side. So I’m wondering how your customers have reacted to price increases and if you’ve been able to achieve those?

Rick Marcantonio

That’s a very good question. When I joined the company 5 1/2 years ago, we were in a really bad economic downturn at that time and it was very difficult to price during that time period. I think that we’re not seeing that. First of all, I don’t see the economic downturn today that we’re in anywhere near like it was back then, that’s number one.

Number two, we’ve continued to be able to price in this environment. And I think that partly speaks to the strength of the programs that we’re bringing forward that gives us a chance to differentiate. So, we’re still able to price. Doesn’t mean it’s incredibly easy all the time, but it’s not like it’s impossible either.

Kartik Mehta - FTN Midwest

And then one last question, Jeff. Could you talk about the percentage, the impacts from the energy costs to get an idea?

Jeffrey Wright

I’m speaking for second quarter, our second quarter energy cost compared to the prior year was up, rough numbers, about $1.5 million this quarter compared to last quarter. So, you can run that out and see what kind of impact that had on the margins.

Kartik Mehta - FTN Midwest

$1.5 million compared to 2Q ‘08, right?

Rick Marcantonio

He wants to know the comparable.

Jeffrey Wright

Yes.

Kartik Mehta - FTN Midwest

$1.5 million, is that a sequential comparison, not year-over-year, right?

Jeffrey Wright

No, that’s year-over-year, Q2 of this year to Q2 of last year, our energy costs were up $1.5 million.

Operator

Our next question is from Ashwin Shirvaikar - Citigroup.

Ashwin Shirvaikar - Citigroup

The question I have is, you did a pretty good job with the cash flow. With regards to use of cash, you mentioned full M&A pipeline. What are valuations like there? What are you ready to do in terms of M&A for growth?

And second, given the stock pretty much is in the same place as when you announced your buyback, any chances you might accelerate the pace of the buyback, or any thoughts there?

Rick Marcantonio

I’ll start with the acquisitions side, and Jeff can add to that and also talk about the share repurchase if you like. We’re seeing similar kinds of valuations on business. As I mentioned in my prepared remarks, the acquisition pipeline is quite full for us and we’re investing heavily to make sure we can take advantage of the acquisitions that make sense for us.

Again, there are a number of acquisitions out there, not all of which we have gone after for a wide variety of reasons. But as you can see by our performance, we’re getting leverage out of the revenue we’re bringing in, both organically as well as through acquisition.

And we’re pretty excited about continuing down the path. It’s proven to do exactly what we want it to do, which was to leverage some of the investments we’ve already made. So you will see us continue to invest in acquisitions, and as I mentioned the pipeline’s full.

Jeffrey Wright

Maybe adding on, you had asked about the stock repurchase program which we announced last spring, a $100 million program. We’ve been reasonably aggressive in repurchasing shares, it’s been 7 or 8 months now. And as the numbers lay out in the press release, we repurchased about $75 million so far program to date.

So future repurchases are going to be contingent upon how management sizes things up in terms of the market and so forth. But we obviously view it as a successful program, and then we’ll see what the future brings in terms of doing more.

Ashwin Shirvaikar - Citigroup

A question on the operational front. To what extent can you continue to push the productivity improvements? How much more is possibly there to come? Would you characterize it as a lot of the low hanging fruit are gone, or would you say that you’re still in the second or third inning of a game?

Rick Marcantonio

I’m sure Jeff would want to add to this. We still see significant opportunity to leverage the business. Just look at the one dynamic I reported. I think I reported that our revenue per employee was up almost 9% for the first half of the year. We have the ability to bring more revenue through this without adding significant amounts of people or capacity in our business.

You never can predict where our revenue will occur. We have a lot still, even though we’ve increased our capacity utilization quite a bit at a plant level, we still have tremendous capacity there to add on.

You know we have an operation in the Dominican Republic that can make more garments if we need them, and that’s another example of the ability to leverage. And we continue to drive. We still have productivity improvements that we’re going for in our sales organization, so we wanted to deliver more new sales per employee.

So it’s not anything even close, in our mind, of tapping out. Actually we still think we have significant upside on that.

Ashwin Shirvaikar - Citigroup

One clarification I had is on the systems cost for Lion. Is that drag going to continue beyond the March quarter, or is it pretty much done then?

Jeffrey Wright

That’s a good question. We’re anticipating, and hopeful I would say, that most of the cost will be incurred here in Q3. We don’t expect at this time that there’d be a lot or much drag into Q4. But it’s a pretty significant effort.

This is a business with upwards closing in on a couple of hundred employees, and it was a top to bottom replacement of their information system. And so you have a lot of training, a lot of people are getting familiar with the new system, and so forth.

The real good news is the system is working. But getting the level of productivity back up to where it was just takes a bit of time, optimizing and stabilizing that system. So we expect that, we had some of the cost here in Q2, probably be even a bit more cost here in Q3, and should subside by Q4.

Ashwin Shirvaikar - Citigroup

Okay, and obviously you’re putting it in, it should be a fairly scalable system that gets you your next $100 million from this business?

Jeffrey Wright

That’s absolutely; we’ve installed a system that we hope is scalable as we grow it in the future, that’s absolutely right.

Operator

Our next question is from Mike Schneider - Robert W. Baird.

Mike Schneider - Robert W. Baird

Jeff, maybe just continue on the Lion questioning. The Q3 costs you expect to be sequentially greater than what they were in Q2?

Jeffrey Wright

That’s correct for a couple of different reasons. But one, again, is that when you’re ramping up the productivity, we’re having to put more people on all fronts whether it’s customer service or distribution or other areas to make sure that we’re servicing this business correctly.

And secondly, up until you go live, as you know, most costs get capitalized and put on the balance sheet. And now as we went live, that all starts to be amortized plus any residual programming efforts and fixes and so forth is also hitting the P&L. So the costs, yes, will be greater in Q3, but again as the previous caller asked, we expect will subside as we move into the back half of this fiscal year here.

Mike Schneider - Robert W. Baird

And can you just put some ranges around what the sequential increase is, is it as much as $1 million or $0.03 a share?

Jeffrey Wright

It’s probably not quite that much, but I’d put it in the range of a couple of cents a share.

Mike Schneider - Robert W. Baird

Okay. So with that in mind, then I’m taking a step back to the guidance and I appreciate the clarity and going through the sequential change in the earnings. The thing I’m struggling with is, if you look above the operating income line, and you scrub the fire from this quarter, it looks like you did about 9.7% operating margin. And the midpoint of the guidance assumes just 9% operating margin. And it sounds like maybe 20 basis points of that would be higher Lion savings.

So I’m curious why the operating margin would presumably, for the guidance, be down 50 basis points sequentially when historically I would say the third quarter is usually stronger, although there certainly has been a lot of variability. Is this just a significant dose of conservatism you put in there, or what am I missing?

Jeffrey Wright

Michael, no, I wouldn’t say it’s a significant dose of conservatism. There’s ongoing investments, and I’ll speak to a couple and then I’ll talk about one other issue as well, but we’ve done four acquisitions the past year and the third quarter will happen to be a fairly big quarter from an acquisition integration standpoint.

A couple of these deals we had some fairly significant overlapping operations, particularly the deal that we did in the Midwest here, and there’s a lot of fairly heavy lifting to integrate these businesses. So a lot of that’s happening in Q3.

We are continuing to add to our sales and marketing effort, so our sales head count will continue to move up at this mid-single digit kind of pace.

And then finally, and we haven’t talked about this in great detail in the past but, one issue that hits us in Q3 is there’s a reset of all your government payroll taxes. And so when you compare sequentially from Q2 to Q3, the FICA and Medicare and Medicaid, those types of things, go way up comparing again Q2 to Q3.

And just before I stop and listen to any other comments you’ve got, I know one question then would be, why didn’t we see that same impact last year between Q2 and Q3? And of every year’s a bit different, but one of the things going on last year was that we were getting through a lot of the heavy investment with handheld, starting to realize the benefit from our handheld investment in Q3 last year, and so we were able to offset some of that payroll tax impact.

So I guess in responding to your question, I’d say it’s a couple of things, one is some investments that happened to be hitting in Q3 should subside in Q4, and then secondly this reset of your payroll taxes as you begin a new calendar year.

Mike Schneider - Robert W. Baird

Thank you for the color. And then during the quarter, two questions on the specific second quarter, the merchandise cost you cited is lower and favorable during the quarter. Again, I’m curious how that’s flowing through when you’ve got such strong new account sales for the last three quarters.

It would seem to me that merchandise costs are rising. You mentioned something about replacement garments. Could you just address those two topics, new sales and then replacement garments?

Jeffrey Wright

Sure. I’m glad you asked the question because if you peel back the onion a bit, our overall merchandise costs are down, but in fact merchandise related to new accounts, as you pointed, is moving up. Now, we’ve been able to actually offset that through a couple of methods.

One is our, what we call, replacement garments. That’s of course the garments that you’re putting in an ongoing basis to existing customers. And one of the things that we haven’t spoken about there a whole lot is that historically our business, we’ve had a used stock room of garments at each individual plant, and we put a process in place this last year or so that we’re now starting to share some of those used garment stock rooms between plants. And it’s allowing us to better utilize our used stock room inventory, not have to buy as many new garments. So, that’s one factor.

Another factor of course is we continue to move jobs offshore from the U.S. to the Dominican Republic, again driving our cost structure down, resulting in lower merchandise costs.

And then finally, the other piece of merchandise is your non-garment related merchandise, the towels and mats, and so forth, and continue there with a number of programs to keep our investments and productivity in the best spot possible. Again, glad you brought it up, we’ve done a nice job of offsetting the increased merchandise from the record new account sales, and actually drove a reduction in overall merchandise.

Mike Schneider - Robert W. Baird

And then on the sales force, the new accounts being up 20%, it sounds like head count is up, call it, 5% to 7%. Can you give us some, again, more color on exactly what productivity initiatives you’re seeing drive the most improvement in the professional sales force?

Rick Marcantonio

It’s not any one thing; it’s accumulation of a number of things. This is not something that we just started a year ago. This is something that we’ve been working on for the better part of three years.

We upticked the first line management, in terms of quality and training, and that’s helped us control our turnover, which once you put stability into your work force, you get higher productivity from that.

We’ve introduced tools from a training standpoint to train all levels or most levels of our sales organization. That allows them to be better prepared and more effective.

I think when you look at the marketing programs, we’re bringing forth programs that provide a competitive advantage to our people which allows them to have a more effective call when they make the call, things like BioSmart, for example. The lead generation that BioSmart has driven in our business is phenomenal. We’re just handling leads that have been generated as a result of it.

I’m not avoiding the question, but it isn’t one thing and it usually shouldn’t be one thing. I think the encouraging thing is there’s a number of things that we have in place or have been putting in place that continue to benefit for us. And I’m very pleased with our progress in the sales organization.

My prepared remarks went well forward to tell you how pleased I was in that, because I cut that a couple different ways so you could see how comfortable I was with that performance.

Mike Schneider - Robert W. Baird

And just, again, a sense in the quarter, when you look at the guidance range you’d put out back a couple of months ago and where you actually came out, was it the lower merchandise cost that drove most of the upside because organic growth was actually, by your prepared comments, actually slightly below where your plan was. So was it principally merchandise cost that drove the upside?

Jeffrey Wright

Michael, no, I think it was probably not one thing. And again I think we provided guidance of 53 to 57 as I recall last quarter. The consensus was 56. We reported 60. And again we might argue that if you took out the Calgary fire, it’s 63. So it’s quite a bit over.

It’s a number of things in the operations and that variance is really led by operations; it’s merchandise costs; it’s production costs, and then on the SG&A line as well.

And then our tax rate, we were probably expecting more like 38%, it was 37%. That might have added a penny. Our share repurchase really, for the current quarter impact, really didn’t have a bearing on our results versus our guidance.

So that hopefully gives you a little bit more color.

Mike Schneider - Robert W. Baird

Okay. And then final question. Just more conceptual as to the industry. You went through some prepared remarks just about the cyclicality of the business. Just to push you a bit, I’ve been following this industry for a decade now, and if you look at the past recessions, organic growth for all the companies has come down and, indeed, you’re even cautioning about organic growth in Q3 as a result of the economy.

What’s different this cycle? Have you done any analysis of your business mix versus prior cycles? I presume the amount of manufacturing has come down dramatically within your business mix versus 1998 and 2001.

But then again, I presume your retail exposure has increased, which is the softest area of the economy right now. Just some more color on what gives you confidence to say this business is recession resistant given what the history has shown, and your business mix.

Rick Marcantonio

I won’t speak for the industry; I’ll speak for G&K. I was here in the midst of the last economic downturn. I know the position the company was in then 5 1/2 years ago versus where we’re at today. And we’re in a much different position as a company.

We’re much stronger. Our business base is more diverse in terms of geography and in terms of breadth of offering and in terms of the quality of the organization that we put together. The ability of the team to be trained. It’s in a much better position.

So while there is clearly some softness in the economy, what we attempted to signal and now eagerly communicate today is we’re focused on the things we can control and introducing new programs, adding investments where we see a return that’s favorable for us, are things that we’re happy to be doing right now rather than we were much more cautious to be doing four or five years ago.

Four or five years ago, we were thinking about cutting head count not adding head count, as a matter of fact. If my memory serves me correct, we actually reduced our sales force for a while before we ended up adding to them. And we didn’t add to the sales force until we saw an economic uptick.

That’s not the position we’re at today. So we’re confident, not cocky, but confident because we see a number of initiatives that we’ve been working on for quite some time that are delivering the kind of results that we reported last quarter, this quarter, and are tied to our forecast going forward.

Jeffrey Wright

Yes, and maybe just to add, just in terms of the overall industry, we’re certainly not trying to imply that the industry is completely immune to economic softness. We are certainly impacted by employment levels, and the usage of a lot of our other ancillary products by that employee base.

But, with that said, our uniform programs are very important to our customers, and it is their face to their customer base. And so you’ll, again, rarely see the uniform program actually eliminated.

So while we are impacted, I would describe more, it’s in the lower single digit types of impacts in an economic downturn, not very significant impacts like some other industries or some other types of companies may see. That’s all we’re trying to point out.

Operator

Our next question is from Scott Schneeberger - Oppenheimer.

Scott Schneeberger - Oppenheimer

Following on Michael’s question, Rick, I think you or Jeff alluded to the fact that you might be adding sales people in the third quarter, so obviously still pushing ahead despite potential concerns on the economy. Could you just take us back a quarter or two about how you ebbed and flowed on your decision to hire more sales people?

Rick Marcantonio

We don’t report a quarter at a time how much we add. But if you think about a series of steps, that’s sort of been the way we’ve been adding sales people for the last couple of years. We add sales people and then plateau, add people then plateau.

That plateau period is really the period that I’ve talked about often where I look for the sales organization to get back to a productivity level that’s a minimum productivity level I believe we have to be at before we add more people.

My concern always is to add too many sales people and not be able to train them properly and as a result end up with either low productivity, and high turnover, or both. So we’ve been cautious about adding people only based on our own capability to digest them, properly prepare them, and make sure we set the expectation right.

So that’s the way we look at it going forward. When we introduced some of these new solutions that drive tremendous interest, we end up having to either train more people or add more people in some of those cycles as well. But I see it as a stepping, not a linear kind of thing.

Scott Schneeberger - Oppenheimer

Okay. But I infer correctly that you do see the third quarter as a hiring quarter, and I guess you’re focusing it in the higher growth areas?

Rick Marcantonio

We will add people selectively. I mean if nothing more than we add people on an ongoing basis. We might add a lot or a little, but it’s not quite as exact as two a quarter or two a week or something like that.

But at a minimum, we’ll have the full quarter impact of adding all the people we added last quarter, and we’ll continue to look at our ability to digest them. But our game plan is not to stop adding people; our game plan is just to look at our productivity measure and our ability to digest the organization.

So if in the third quarter, our productivity is not quite up to where we might be, we might not add quite as many or we might just digest during that part. But we’re not going into a long-term retraction, or any kind of plateauing of our investment in our sales organization.

Scott Schneeberger - Oppenheimer

Another business point in question, on the last call you had alluded to potentially starting a plant at the end of FY ‘08. CapEx is down. Jeff, can you talk to us if that’s getting pushed in FY ‘09 or is it down because you spent less in the first half? Just a little bit more on the CapEx.

Jeffrey Wright

Sure, it’s probably primarily that we’ve spent a little bit less in the first half. We still have on the dockets to start a plant later in the fiscal year here. The fact is that that plant will probably only have a smaller impact on this fiscal year and primarily would impact next fiscal year.

But, we’ve continued to hold pretty tight. Again we’re not restricting capital flow in any way into the business. We’re certainly funding capital that makes sense. But we’re watching it pretty close and mostly because we’ve under-spent the first six months here, we’re taking the numbers down a bit.

Scott Schneeberger - Oppenheimer

And then, could you speak a bit to what you’re doing in your hedging portfolio to work around what’s going on with energy prices?

Jeffrey Wright

Sure, on energy, we continue to hedge both gasoline and natural gas. We try to target roughly 50% of our usage and there’s not any magic pill that’s going to allow us to avoid the long-term cost increases that we see in energy, but it hopefully can soften some of the ups and downs.

And maybe just as a point, our gasoline costs were up this quarter and the costs were, for us, weren’t up as much as we thought because we did see some benefit from our hedging activity. So, it’s meant to take a little bit of the ups and downs out.

Scott Schneeberger - Oppenheimer

Sure. And do you generally lock in for 90 days or do you go a little bit farther out?

Jeffrey Wright

No, we’ll go a bit further out than that and use a ladder type of a basis. So, as we get closer within three to six months we’ll have about 50% hedged, and if you pushed out into 9 or 12 months it might only be 30% to 40%, and maybe in the 15 to 18 month period it would be 20% to 25%.

Operator

Our next question is from Michel Morin - Merrill Lynch.

Michel Morin - Merrill Lynch

I was wondering, how significant was the outerwear promotion this year?

Jeffrey Wright

The outerwear promotion, I’m not sure if we’ve ever disclosed the dollar amount, but it’s a fairly significant driver of direct sale revenue. Primarily happens in the second quarter. There’s a little bit that’ll start in Q1, almost all of it’s in Q2 ,and then a little residual will happen in Q3. But it’s a multi-million dollar direct sale effort into our existing customer base.

Michel Morin - Merrill Lynch

And was that up year-on-year?

Jeffrey Wright

I think it was more flat to year-over-year.

Michel Morin - Merrill Lynch

So taking into account the seasonality there and given also your other comments regarding Lion, I think you mentioned earlier that direct sales will be down year-on-year, but I guess we should also assume it’s going to be down sequentially versus second quarter.

Jeffrey Wright

I think that’s a fair statement. We’re thinking that direct sale revenue could be down $2 to $3 million year-over-year. And sequentially, it may be flat to slightly down sequentially.

Michel Morin - Merrill Lynch

And then on the fire, I was wondering if you could explain a little bit what was lost and the ongoing impact that I think you alluded to for the third quarter. And then finally whether or not we should assume that at some point you might get some insurance recovery from that?

Jeffrey Wright

Related to the fire, we unfortunately, we did have a fire at one of our locations. As you might expect, it’s a pretty major disruption to the business. And the cost that we alluded to, the $0.03 is maybe two or three different areas, but one is simply the deductible that we have on our insurance coverage that comes out of our pocket.

Two is some ongoing, I’ll call it, business recovery types of costs that we don’t think will be recoverable from our insurance company.

And then finally, just the cost of stabilizing the business, the overtime being incurred, all the things that you can imagine with a fairly disruptive event. And when you add those up, it’s about $0.03. And as we move into the third quarter, we’ve stabilized that business, but still not back to normal, obviously.

And we think the third quarter is still going to have some of those stabilization costs like overtime and those types of things, but at a much lower level than in the second quarter.

Rick Marcantonio

But importantly, we’re servicing our customers during this time period.

Michel Morin - Merrill Lynch

Was this a laundry facility?

Rick Marcantonio

Yes, it was.

Jeffrey Wright

Yes, it was a laundry facility, one of our plants.

Michel Morin - Merrill Lynch

And then, given the volatility in the tax rate, what should we think about for the fourth quarter and maybe even looking ahead to next year because the Canada thing presumably is something that’s permanent? Should we assume a lower tax rate going forward than what you’ve done historically?

Jeffrey Wright

Good question, Michel. I think the lower Canadian rate is permanent. It’s something that we analyze every year. It’s the ongoing state income tax rate here in the U.S. And, as you might expect, we operate in almost every state and there’s a lot of moving parts, but our early indication, at least, leads us to believe that that rate maybe on the rise a bit.

So our long-term tax rate I think in the 38.5% to 39% range, longer term is probably a tax rate that would be typical. Last year’s rate was really, I think, abnormal and probably one that you shouldn’t really be looking at. But this quarter at 37% is a little lower than normal. Next quarter is at 39% to 40%, is probably a tad higher than normal. I know it bounces around a little bit but I guess I would say 38.5%-39% would be a pretty good longer-term rate.

Michel Morin - Merrill Lynch

And then just finally, Jeff, would you be prepared to give us a number in terms of the FX benefit to the top line in the quarter? I think you said that was a positive. I was just wondering if you can quantify that.

Jeffrey Wright

Sure, for the second quarter, if you pull our 10.5% revenue growth for the whole company for the quarter, if you pull that apart, as we mention the rental organic was 3.75%. I think acquisitions added, I want to say, 4% to 4.5%. And then I think FX added about 2.5%, so which would give you the total. Direct sale was up a little bit and added maybe half a point to our overall growth rates.

Operator

Thank you and our next question is from Theodor Kundtz - Needham.

Theodor Kundtz - Needham

Just a couple of quick questions. Lot on the finance already. Could you talk about the National Account business a little bit and what your outlook for that is in terms of the growth? And what percent of sales does that represent?

Rick Marcantonio

I’ll ask Glenn to give you the calculation of what percentage of revenue it is. Our outlook is bright. There’s a couple of things happening. It shouldn’t surprise you that centralizing of some of the decisions and purchasing of uniform programs has been occurring and in our opinion will continue to occur. So that supports a trend in National Accounts.

In addition, many of the solutions that we’re bringing forward with are of interest on a broad basis to National Accounts, things like dealing with any kind of bacteria, or any kind of contamination, are big issues. And they’re keen to deploy any kind of solution that will help them. So, many of the solutions that we’re bringing forward are right up the alley of things that our National Account customers might be looking for.

And so we see it to be bright. I don’t think we’ve ever given a projection to it, but it’s being growing at double-digit rates. It now represents about 14% of our revenue, which continues to be a larger and larger part of our business.

Remember, historically that was not an area that we had focused on partly because of our footprint. Three or four years ago when we filled out our footprint to make it sufficient, we basically have been able to accelerate growth, and we are doing a nice job. We’ve expanded that organization significantly over the last couple of years, and the tools they have available.

Theodor Kundtz - Needham

And how is the pricing environment in that business? Is that a lot more competitive than your normal business?

Rick Marcantonio

Yes, it is more competitive and it lead you to the “you don’t make as much money?” I will let Jeff describe to you what we’ve described a couple of times in terms of how we look at the profitability of that business.

Jeffrey Wright

Sure. The pricing is more competitive, there’s no doubt. These are larger companies; they’ve got big operations; they’re wanting to leverage their spend, et cetera. So the pricing is more competitive.

But the profitability characteristics are quite a bit different as well than a smaller account. And I’ll give you a couple of them, but one of the big ones that jump out is the average stop size.

One thing we measure is the amount of revenue that you gain every time you stop a vehicle, stop a truck. And the average stop size for a National Account for us is over three times as large as a non-National Account. So you gain a lot more revenue while you’ve got the truck stopped. And of course there’s a lot less driving time. So your delivery costs are much more efficient.

Of course, again these are larger accounts. It leverages your plant and your infrastructure. Usually with these very large accounts, the turnover is less because that’s a very big cost to change out and change your uniform program with thousands of employees. So you have the customer for quite a long period of time.

There tends to be not as much financial turnover. You don’t see big national companies moving in and out of bankruptcy generally. So a lot of those characteristics really help you on the expense side. And we really target a typical operating margin, that’s the same as our smaller account business. And so you’re basically offsetting that more aggressive pricing with efficiencies on the cost side.

Theodor Kundtz - Needham

Is the pricing environment changing at all for the National Accounts? Is it getting any tougher, or is it pretty stable?

Rick Marcantonio

I don’t know if we can really answer that. It’s so individual. The set of circumstances is so different. I think the pricing environment, it feels kind of the same.

Theodor Kundtz - Needham

One other question. Rick, you talked about some of the areas that were weak, some were strong. Are you seeing any changes out there in the environment? Are any areas getting marginally worse, or since we’re in this environment you’d have to say marginally worse, over the last couple, several months. I’m asking you for your prognosis for the economy here I guess, and what are you seeing out there?

Rick Marcantonio

I’m not sure that we would see or talk about any more than what we’ve already seen or we reported on. We’ve seen the weakness in the automotive industry, that’s pretty widespread in a number of different areas. And I think we’ve weathered that storm. But I’m not sure there’s any one particular industry right now that -

Jeffrey Wright

Yes, we mentioned on the call just a little bit, some of the, you might call them, the more construction related types of industries, but especially trade contractors, lumber and wood product, wholesale trade related, the durable goods, electric, gas, sanitary services; those are three or four others that we’ve seen some reductions in the number of employees in uniform in those industries within our base of business.

I would agree with Rick, nothing in the last two or three months one way or the other, just a little bit of softness.

And again, we really feel good about where our own efforts are around professional sales and route sales in a much different spot the company is than we were the last time the economy was in a tougher environment in the early 2000 range. And so, we’re really focused on what we can do to keep our organic growth where it needs to be.

Operator

Our next question is from Mike Hamilton - RBC.

Mike Hamilton - RBC

I know you don’t use weather as an excuse or a boost, but a year ago because of the lack of early winter, you were forced to call out weakness on the mat side, which obviously you got some benefit this year. Is weather playing any impact at all, as you look into third quarter?

Rick Marcantonio

Not really, not even, not at all. We haven’t thought about that as a major contributor. I think we look at the factors that we control and feel very positive about, as Jeff just mentioned, professional sales, the route sales are two just areas we feel really good about. And we can’t control the economy.

I think if you take our revenue forecast and you take the midpoint versus a year ago, we’re forecasting somewhere around 7% to 8% in total growth, with, we already told you, a downturn in our direct purchase business, which would signal to you that the other side is up greater than that.

So that’s the way we look at the business. There is going to be some continuation of economic softness. But again, we feel good about where we’re at in terms of weathering that.

Operator

Thank you, ladies and gentlemen. There are no further questions at this time. Please proceed with any further remarks.

Richard Marcantonio

I’ll just say thank you for joining us today. As I indicated, we’re very pleased with reporting another solid quarter and a significant first half year-over-year growth in revenue, operating margin and earnings. And we look forward to talking to you in three months and reporting our third quarter performance. Thank you very much. Have a great day.

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