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Executives

Shayn Carlson – Director of IR

Rick Marcantonio – Chairman and CEO

Jeff Wright – SVP and CFO

Analysts

Ashwin Shirvaikar – Citigroup

Kartik Mehta – FTN Midwest

Michel Morin – Merrill Lynch

Ondray Edward [ph] – Robert Clark [ph]

Mike Hamilton – RBC

Scott Schneeberger – Oppenheimer

Andy Aranda – Needham & Co.

G&K Services Inc. (GKSR) Q1 2008 Earnings Call Transcript April 29, 2008 11:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the G&K Services third 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) As a reminder, this conference is being recorded. I would now like to turn the conference over to your host today, Mr. Shayn Carlson, Director of Investor Relations. Please begin sir.

Shayn Carlson

Thank you. Good morning everyone. Thank you for joining us to discuss G&K's fiscal 2008 third quarter results. Once we have completed our prepared remarks, we will 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 would like remind everyone that this call that may contain forward-looking statements within the meaning of 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-statements are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. 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 statements 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 approximately 1 pm Central Standard Time through May 28. You may access the replay by visiting the Investor Relations section of our web site. At this time, I will turn the call over to Rick Marcantonio.

Rick Marcantonio

Good morning and thank you for joining us. This morning, we reported solid third quarter results. For the quarter, revenue total $251.1 million, up 6.8% over the prior year, driven by rental organic growth, revenue contribution from acquisitions and the benefit of foreign currency translation. Importantly, we continue to achieve solid year-over-year gains in new accounts sales and route sales. However, we are experiencing a fairly challenging economic environment, which is offsetting some of the progress we have achieved in growing the business. I will provide further insight on all of these factors in just a few minutes.

From an earnings perspective, we drove earnings per diluted share of $0.54. This result met our expectation and compares to the prior year period of $0.57 per diluted share, which reflected an unusually low effective tax rate. Earnings per diluted share increased to strong 17.4% over the prior year, when adjusted for a comparable tax rate. Importantly, operating income increased 8.1% driven by leverage from revenue growth, improved productivity and lower merchandize costs.

This improvement in operating performance was achieved despite a few items that were not anticipated in our third quarter outlook. For example, during the quarter, we were impacted by a significant increase in bad debt expense related to certain customer insolvencies. Higher energy costs also pressured earnings as energy prices increase significantly throughout the quarter and exceeded our original estimates. In addition, we incurred more expense that we anticipated in the quarter associated with the implementation of systems initiatives.

Earnings would have been significantly higher, if you exclude the impact of these unanticipated items. Nevertheless, we are very pleased to deliver earnings that we are inline with our expectations and up17.4% on a comparable tax rate basis.

So, on a year-to-date perspective, we have achieved solid revenue growth of 8.9%, driven by rental organic growth, strong contribution from acquisitions and the benefit of currency translation. We also drove improvements in operating margins, earning and cash flow. For the nine-month period, operating margins have expanded 90 basis points, operating income is up 20.6%, earnings are up 27.4% on a comparable tax rate basis and cash flow from operations was up 42.6%.

We believe solid evidence that our steadfast commitment to our long-term vision, coupled with our continued focus on growth and productivity initiatives, is generating positive momentum across our business. In fact our strong financial performance to date in conjunction with the fourth quarter guidance implies another strong fiscal year with revenue growth of between 7.5% and 8%, operating income growth of approximately 10% to 12% and earnings per share growth of 19% to 22% over the prior year period on a comparable tax rate basis.

As expected for the fiscal year, we project that we will deliver an improvement in operating margin of between 30 basis points and 40 basis points. With that as our financial overview, I will now take a few minutes to provide insight on a few growth drivers that continued to contribute to our positive momentum. After that, Jeff will take you through a detailed review of our financial results.

To start, we continue to drive organic growth through our focus on new account sales and increased productivity from our sales force. Our ability to capture an increasing level of new business is a testament to the value G&K provides in enhancing image and safety in the workplace through innovation.

For the quarter, new account sales were up at a double-digit rate. And on a year-to-date basis, we have driven an increase in new account sales of almost 20%, an outstanding accomplishments and again further evidence that our focus on investing in our sales force is working. As you may recall, over the last couple of years, we have significantly invested to enhance our sales leadership, expand our marketing programs, increase our sales force size and improve our sales training tools and coaching program. With that said, we will continue to invest to drive higher levels of sales productivity.

In fact, to further enhance our sales results, we have been working behind the scenes for a number of quarters on a new sales force automation tool that will increase productivity and accountability. With this new automated system fully deployed, our sales reps will have the technology enhancement to better identify, track and manage opportunities and our activities. This tool also provides sales management with enhanced reporting capabilities, by providing a dashboard down to the individual rep level to measure sales rep activity in pipeline.

This exciting new automated system has been installed in about half of our sales districts, has been widely accepted by our sales teams and will be fully implemented in the next few months. Importantly, this new sales automation system will also generate efficiency savings by reducing approximately 50 administrative positions throughout the organization. This new system will automate what historically has been a very paper-intensive process. I continue to be very pleased with the strong results accomplished by our sales teams and optimistic that we will drive further gains in sales productivity through this sales initiative.

We also continue to drive positive organic growth through our success in route sales. As many of you know, our route sales representative force is over 1,400 strong and are servicing the image and safety needs of our customers on a weekly basis. As you heard me say before, cross selling additional products and services to our existing customers remains a key focus area to drive higher revenue per staff [ph], leverage the delivery infrastructure and expand profitability on the route. I am pleased to report that our third quarter, route sales were up in the lower single digit and on a year-to-date basis, route sales were up almost 20% compared to the prior year. Again, great execution and focus resulting in expanding customer relationships.

I am also very pleased to report that our National Account team has delivered another outstanding quarter. During the third quarter, we signed a number of new National Accounts, including a leading poultry processor, a national airport parking service, a large HVAC manufacturer and two major restaurants chain, to highlight just a few. In addition, we renewed our National Account business with a very large and well-known restaurant chain, among many others; again, outstanding results and terrific momentum from our growing National Account business. Given this continued success in our capabilities to serve the image and safety needs of large customers across North America, we will further intensify our focus and investment in National Accounts.

Overall, we continue to execute well in driving new sales, in the field with local businesses, on the route with existing customers and across North America with large National Accounts. More importantly, new account and route sales are providing positive momentum in a challenging economic environment, in an environment where we are seeing the economy impact our business, with an increased level of customers experiencing financial difficulties, and employment reductions with customers in certain industries. We will provide more details on how the economy is impacting our customers in just a few minutes.

Shifting gears, let me take a minute to give you a few examples of our investments in marketing continue to provide positive momentum across the business. As you have heard me say it before, our marketing efforts center on bringing innovative, value-added products and services to the market that solves specific customer needs. For example, our customers in the food industry are concerned with the risk of cross contamination; to meet the need, we offer ProSura and BioSmart solutions.

Our proprietary ProSura program and our exclusive offering of BioSmart continue to generate strong interest in the food industry. In fact, since October, we have signed approximately 50 new customers as a result of BioSmart, including a large grocery change in one region and we have a very robust pipeline of prospective customers. It is our unique solutions like ProSura and BioSmart that are helping to drive growth. For example, over year-to-date revenue, year-to-date revenue in the food segment is up approximately 10% from the prior year period; again, further evidence of our strong value proposition.

In addition, we continue to drive impressive results in serving customers, who will need to protect their employees from the risk of Arc Flash. For these customers, our proprietary ProTect program offers flame-resistant garments that provide superior comfort and protection. The result, ProTect revenue is up over 20% on a year-to-date basis; again an outstanding accomplishment.

Turning to the acquisition front for a moment, in March, we announced the acquisition of Best Uniform Rental, a $7 million uniform and facility services company, serving customers in New Jersey, Pennsylvania and Delaware. Best Uniform Rental has been a strong Mid-Atlantic operator for over three decades, resulting in solid and growing customer base. We welcome Best Uniform Rental's customers and employees to G&K. We continue to be very active in the pursuing strategic acquisitions that will leverage our existing operations and enhance our capabilities or expand our presence.

Now, I would like to discuss our ongoing investments in the business. As I've shared with you in the past, we are committed to balancing the need to make ongoing investments in the business to drive increasing long-term success with the need to deliver short-term financial performance. Both of these are very important to G&K's success.

We continue to make substantial investments in this business. The investment cycles tend to increase and decrease as we run the day-to-day business. For example, our investments were a bit lower in the first and second quarters of this year. And accordingly, we drove significant short-term earnings improvement. Our investments in the third and fourth quarter and early fiscal 2009 will be somewhat higher, which will moderate our earnings growth. For competitive reasons, we don't always disclose the investments we are making until we are capturing the growth and productivity that we target. For instance, we have been working behind the scenes for a number of quarters on the new sales automation tool that I discussed earlier. We (inaudible) approximately 60% of our organization and the reception to this system has been excellent. We've also already reduced about 35 administrative positions and are looking forward to capturing improved sales productivity.

As another example, we are also in working behind the scene on our planned rollout Dockers San Francisco to our existing rental customer base. We will be working diligently on a few pilot locations in the fourth quarter and first quarter of fiscal 2009 with full rollout launching in the later part of the fiscal year. We are putting substantial resources behind this effort, because we see it as a big opportunity.

In addition, there are number of other initiatives where we are currently incurring expenses although, for competitive reasons, we are not ready to unveil the nature of these investments. Again, we believe these investments are critical to improve our long-term success. However, these investments do moderate short-term results. We will show more insight on these investments when appropriate and we will continue to be as transparent as possible.

I would like to repeat that I am pleased with our strong year-over-year increase in revenue, operating margin and earnings and cash flow. While the economic environment continues to be challenging, we are extremely focused on executing against growth and productivity initiatives within our control, to improve our financial performance, to enhance our competitive advantage, and to strengthen our leadership position in our industry. With that, I will now turn the call over to Jeff. Jeff?

Jeff Wright

Thank you, Rick. As Rick highlighted earlier, we are pleased to report solid third quarter results and strong year-to-date performance. Total revenue was $251.1 million for the quarter, an increase of 6.8% over last year. This quarterly revenue was driven by rental revenue growth, strong revenue contribution from acquisitions, and the benefit of foreign currency translation.

During the quarter, organic rental growth was 2.75%, as a result of strong gains in new account sales and increase in route sales. While we are pleased to generate strong new business and expanded relationships with existing customers, this positive sales momentum was offset by an increase in economic-driven customer attrition and a reduction in employment levels in certain industries.

For example, rental organic growth was impacted by customers experiencing financial difficulties and going bankrupt during the quarter. We are also seeing deterioration in the add-quit metric, which tracks changes in the number of employees wearing uniforms at our customers. In addition, we've seen some customers adjust their level of rental items due to reductions in their own employee base or in an attempt to reduce expenses. While we continue to experience employment declines in the industrial, manufacturing and automotive industries, we've more recently been impacted by declining employment levels in specialty trade, general building, lumber and wood products, and wholesale trade of durable goods.

These sectors, as reported by the Department of Labor, are down almost 400,000 jobs on a year-over-year basis. For G&K, we're down about 6,000 wears in these segments compared to last year. Clearly, slowness in overall economic conditions is offsetting some of our sales gains. With that said, we continue to focus on driving higher sales productivity to capture new business, enhancing customer service to improve customer retention and increasing route sales to expand customer relationships. As Rick highlighted earlier, we driven strong gains in both new account sales and route sales, which are generating momentum and organic growth. We also expect that our investment in a new sales automation system will further enhance sales productivity.

Earnings per diluted share met expectations and totaled $0.54. Prior year third quarter earnings were $0.57 per diluted share and reflected an unusually low effective tax rate. The lower effective tax rate resulted in a $0.11 per diluted share benefit in the prior year third quarter. Earnings per share increased 17.4% over the prior year when adjusted for comparable tax rate. Operating income rose 8.1% compared to the prior year. This increase is driven by strong operating performance, offset by continued economic softness, higher than anticipated gasoline prices, increased bad debt expense, lower contribution from direct sales, and expenses related the systems implementation activities.

With these comments as an overview, let me walk you through a more detailed financial review. Rental revenue in the third quarter was $233.0 million, a 10% increase over the prior year of $211.8 million. This increase is driven by rental organic growth, strong revenue contribution from acquisitions, and the benefit of foreign currency translation. Direct sale revenue was $18.1 million compared to $23.4 million last year. Direct sale volume compared to the year ago period was impacted by a strong prior year comparison, softness with certain customers in the transportation industry, and lower revenue due to systems implementation issues.

Rental gross margins for the quarter increased to 36.1%, up 70 basis points from the prior year period. The 12.3% increase in contribution from rental operations, was a result of improved leverage from overall revenue growth and lower merchandize cost. This improvement in rental gross margin was partially offset by the higher production and delivery cost associated with record energy prices. Gasoline cost alone increased 50 basis points when comparing third quarter to prior year levels. Direct sale gross margin was 20.8% compared to 27.7% in the prior year period as a result of expenses associated with systems implementation issues and the impact of fixed cost absorption from lower direct sale volume.

Selling and administrative expenses in the quarter were 21.4% of consolidated revenue, up slightly from 21.3% in the prior year period. During the quarter, we continued to gain positive leverage from overall revenue growth and productivity savings from the implementation of our handheld technology platform. These gains were offset by the increased bad debt expense driven by customer insolvencies. During the quarter, we experienced unusually higher rate of customer insolvencies, including Quebecor Printing, Leiner Health, Frontier Airlines and ATA Airlines. For the quarter the increase in bad debt expense represented approximately 0.6% of consolidated revenue. In addition, administrative expenses increased over the prior year period due to the on-going investment in systems implementation activities. Let me give you a quick update on our investment in a new information system at Lion Uniform Group.

As you may recall, this new system handles all aspects of this business including e-commerce, order entry, customer service and distribution. Last quarter, we'd reported that we had installed this system late in the second quarter. And we would be investing to stabilize the system in the third quarter. As I mentioned, expenses and lost revenue related to the systems implementation activity were higher than we anticipated, as Lion incurred significant overtime wages to run the distribution center, and we continue to incur systems development cost to address problem areas. The stabilization effort has been more difficult than we anticipated. While system performance is improving and Lion employees are becoming familiar with the system, we anticipate there we will continue to be some added costs and lower productivity in the fourth quarter.

Now moving back to the detailed financial review. Depreciation and amortization of intangibles was 5.0% of revenue for the quarter compared to 4.8% in the prior year period. For those of you who track these two items independently, depreciation expense was $9.8 million for the third quarter and amortization expense was $2.8 million. Importantly, operating income increased 8.1% compared to the prior year period. Operating margin for the third quarter increased to 8.6% of consolidated revenue compared to 8.5% in the prior year period. This increase in operating margin was a result of higher rental gross margins offset by increased bad debt expense, record energy costs, and the expenses related to systems implementation activities. Excluding the increase in bad debt expense and gasoline costs, operating margins would have been approximately 9.7%. It's important to know that the benefit of our gasoline hedging program helped to offset this pressure on operating margins by approximately 15 basis points. Our hedging program helped us offset this extremely volatile cost.

Continuing down the income statement, interest expense for the quarter was $3.8 million, up $0.2 million over the same period last year. The increase was driven by higher average in borrowings as compared to the prior year period, our higher debt balance as a result of the acquisitions we've completed over the last year and our investment to-date in buying back stock under our share repurchase program. With that said, we have been fairly aggressive in moving more debt from floating to fixed rates to lock in the benefit of lower interest rates.

For the third quarter, our effective tax rate was 39.9%, compared to an unusually low rate of 25.4% last year. The prior year third quarter rate was lower than normal due to reductions in tax reserves that were no longer required.

Now let me turn to our capital structure and cash flow, which remain extremely strong. Total debt of $289.3 million was up approximately $67.4 million compared to the prior year period. Total shareholders' equity stands at $563.9 million and debt as a percent of total capitalization was 33.9%. Cash flow from operations for the nine months ended March 29, 2008 increased significantly to $73.0 million, up 42.6% compared to the prior year period. This strong cash flow production was driven by a 20.6% increase in operating income and our continued focus on controlling working capital investments needed to support the growth in the business. Capital expenditures were $16.6 million for the nine-month period compared to $23.2 million in the prior year. We expect capital expenditures to be in the range of $25 million to $27 million for fiscal 2008 compared to our original expectation of $30 million to $32 million.

During the first nine months of fiscal 2008 free cash flow, which is defined as cash flow from operations less capital expenditures, increased significantly to $56.4 million, up 101% from the prior year period. Free cash flow per diluted share increased to $2.74 per diluted share, up from $1.31 per diluted share in the prior year period. This significant level of free cash flow also outpaced our book earnings per share of $1.72 per share. We expect to continue to generate strong free cash flow in the fourth quarter of fiscal 2008. Cash flow used for business acquisitions during the first nine months of fiscal 2008 totaled $63.7 million. As previously disclosed on a fiscal year-to-date basis, we have completed the acquisition of Leef Services, Nanoclean Limited and Best Uniform Rental. In addition, 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 outstanding common stock. During the first nine months of fiscal 2008, we purchased approximately 1.8 million shares. Since inception of the share repurchase program, the company has bought back about 2.0 million shares or approximately 9.4% of total shares outstanding at a cost of approximately $78.6 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.

Clearly, our strong balance sheet and excellent cash flow generation provides the capacity to pursue further strategic acquisitions, fund organic growth opportunities and repurchase our shares.

Looking forward, we expect revenue in the fourth quarter of fiscal 2008 to be in the range of $250 million to $253 million. This revenue guidance includes strong new account and route sales, offset by the impact of economic conditions on customer retention and employment levels. Fourth quarter revenue guidance also includes lower year-over-year direct sale revenue, due to a strong prior year comparison, continued softness in the transportation industry and the impact of stabilizing our new information system at Lion Uniform Group.

As for earnings, we are expecting diluted earning per share to be in the range of $0.50 to $0.54 for the fourth quarter. Our fourth quarter earnings reflect continued efficiencies gained from revenue growth, productivity savings from ongoing operational initiatives, and the impact of our share repurchase program. In addition, the earnings guidance includes ongoing investments that Rick described earlier, higher energy cost, expenses associated with systems implementation activities and ongoing acquisition integration costs. Our guidance also reflects an effective tax rate for the fourth quarter of 39% to 40%. Again, I will repeat that we are pleased with our strong year-to-date increase in revenue, operating margins, earnings, and cash flow. That concludes our prepared remarks and we would be glad to take your questions at this time.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Our first question comes from Ashwin Shirvaikar from Citigroup.

Ashwin Shirvaikar – Citigroup

Hi, it Ashwin Shirvaikar. The question is on whether you can take your comments about the June quarter forward into the following year and taking into consideration what you said about margin improvement initiatives, and new client signings and so on at this qualitatively try to build a picture for fiscal '09?

Rick Marcantonio

This is Rick Marcantonio. We don't know, we may give guidance obviously going past one quarter. But, I think it's fair to say that, we continue to invest in our sales organization, and our route sales effort and then our acquisition activity both all three of which are major drivers to sales growth. So we are investing in the drivers that drive sales growth, more committed to margin improvement. We are less focused, and we are much more focused on the long-term improvement in margins trends than we are day-to-day or quarter-to-quarter change of margin improvements because of the some of the investments we are making, but again we will be committed next year likely or are this year to improving our margins going forward.

Ashwin Shirvaikar – Citigroup

In terms of the sales productivity initiatives that you have maybe you could quantify the near-term of investment impacting - how much of an investment is it?

Rick Marcantonio

Well, I could tell you we're not going to get into the specifics of how many dollars. But and maybe Jeff can take you through just overall increase in SG&A or SG&A impact, but we are investing in a couple of those – we are investing in, I am sorry, we're investing in additional headcount in our organization to put more people on the street and that's local kinds of sales management, we call those positions GSR positions. We also continue to invest on our National Account team. National Account were extremely pleased with the progress we made in National Accounts over the last the number of years and we know that the product that we're bring forward is very interesting to National Account companies, we are the footprint to service that kind of business and we'll continue to invest in that and then we look for ways to make our people more productive, now that productivity improvement can come a couple of ways. We can train our people, make them better trained, which will make them more effective in gaining the new account, and also people that are successful have a talent to stay longer, retention improves our ability to try productivity and then we look for the non-value added components in our business that drive expense, but don't bring the kind of value forward, that's exact what we saw with the sales automation tool that we were rolling out. Historically we had our people involved in non-productive activity that took away from face-to-face selling with our customer, plus we had people tied up administratively to do work for them. The new tool that we're putting in place reduces the burden in both of those areas. So that's, kind of it, what I would tell you we are making investments and we will continue to...

Ashwin Shirvaikar – Citigroup

The system implementation cost is that system implementation processes, is that going to be done by the first quarter of '09 or is that…

Rick Marcantonio

Yes, we should be done, I think we might even finish this quarter, or we can finish the end of this quarter early next quarter.

Ashwin Shirvaikar – Citigroup

Okay and the benefits that already in the systems that what you might…

Rick Marcantonio

Oh no we are – the only benefits that I spoke up outwardly there is more than this, but that that I would like to – when we make investments, I would like to have tangible benefits that we track to make sure, we get a at least a part of our return from them and so, we knew there were a number of administrative positions that, we could reduce in fact, we put the system in place. As a mater of fact in our prepared remarks, we have identified approximately 50 positions we were willing to take out. Till-date we have 35 out, and I think in the next couple of weeks, we have another five coming out, and we fully expect to get close to 50 people out of our organization and these are not sellers these are really administrator people better supporting our sales organization and that would be one of the productivity investments that would be outward one will report. You will also see it in productivity per sales ramp. But just in the day-to-day activities, we get a substantial improvement as well.

Jeff Wright

Yes, Ashwin this is Jeff, just maybe to add on to that a little bit its the sales automation tool, I like in a little bit to our handheld system for routes in that there was a real early tangible benefit that we achieved by virtue of taking a very paper intensive process and automating it and on handheld you will recall we took about 100 position out of the organization by eliminating paper work and keying into the system. The sales automation tool, we are doing the same thing, it will be about 50 position by eliminating paper work and taking a keying away from what was previously done, and then but the bigger benefit on both is also is yet to be captured yet to comment that's improved route parts to be in the routes and improved sales productivity of our sales force and we even more excited about those.

Ashwin Shirvaikar – Citigroup

All right. Okay, and I don't want to talk too much time but the last question I want to ask is you had a good cash flow one more time and in terms of it just the investments you need to make I mean in plans and your capacity utilization, how is that going and running, sort of if you can give a longer term picture of that?

Rick Marcantonio

Sure, we have achieved some excellent cash flow and this year as you can see from the numbers. Our capital expenditures this year are going to be in that kind of mid $20 million, $25 million to $27 million range. That they may go to at that a fairly low level, they may go up a little bit over the next if you want call it kind of 2 years to 3 years, but I would say a kind of a run rate for us at this point is may be in the $30 million range would be kind of a typical annual run rate for us. That is feeding in appropriate amount of capital into the business.

Ashwin Shirvaikar – Citigroup

Okay. Thanks

Jeff Wright

You're welcome.

Operator

Our next question comes from Kartik Mehta from FTN Midwest.

Kartik Mehta – FTN Midwest

Hi, good morning Rick. I want to ask for these the current fundamentals stayed to where they are and based on the investments you are making in the sales force and I think either you have talked about, can you maintain this type of organic growth or could you believe that organic growth would accelerate if you're seeing that the work stays kind of the way that's…

Rick Marcantonio

That's a difficult to answer right I – I joined the company right at the bottom of the last economic downturn and we're in a much better position today. The things that we're controlling, we are doing a very good job out and I see that's continued to improve, we stored up a lot of room to go after in terms of route sales. I continue to want to add to our sales force, our new sales force because that pay back is there. So, we will continue to make major investments there, and I – when I say major these are not the kind investments that tank or P&L they are – we are able to handle those kinds of investments on an ongoing basis. With those kinds of things in place I continue to see an up tick opportunity for us in organic growth. What I – and actually we were demonstrating that over the last number of months. The problem is the – a part impacted by the economy specifically we were heard fairly – we were heard quite a bit from financial quits this quarter. The number of reduction in warehouse in certain industries that we were involved, and some add-quit items and selected items that were quit out of because of our tougher economic type. It's a little difficult to predict, what those are doing, but, obviously we are still able to stay very positive in our organic growth, even though those kinds of things happened and we aren't anticipated to happen quite to degree, they happened during the third quarter.

Kartik Mehta – FTN Midwest

Okay, but can you talk about newly exposure G&K has in the industries which all lagging, I think, Jeff in his prepared remarks talked about a few industries where it seems like there is an up tick and attrition, then will you be quantify your exposure to those industries.

Jeff Wright

Hi, Kartik, this is Jeff, I don't know if I can quantify it for you, but we as – as probably with us and may be with our competition, we are exposed to some of the, the sectors that we mentioned, lot of the home building sectors, lot of the construction sectors, industrial types of sectors that we do have exposure, those automotive sectors, we see a little bit of, for instance we've got very large business in the Canadian, Ontario region and those some of the industrial sectors there are down fairly significantly from an employment perspective. On the direct sales side of our business, I think we mentioned in our prepared comments that Lion has some exposure to the airlines industry and so we have seen some downturn there, as there is something softness in the airline industry. So, that helps, for you maybe gives you a little bit of color on some of the softness within various sectors.

Kartik Mehta – FTN Midwest

Yes, that's helpful, Jeff. I just, I'll go back to kind of my first question, I guess, what I was trying to get through my first question, are you able to sustain this 2.5% to 3% organic growth in this type of environment, based on the investments you're making, and that's what I am trying to understand if this is a sustainable growth level or there is a potential for the reason is even in the (inaudible)?

Rick Marcantonio

Well Kartik, this is Rick again. We think so as far as the economic environment doesn't get much worse as we think we are comfortable saying we can stay in that range and we've got a lot of new stuff coming forward too, that I think will help us and maybe over the longer term those up kick that number from there, but right now we are comfortable and in the range as long as the economy doesn't get much worse.

Kartik Mehta – FTN Midwest

And my last question for you Jeff, can you talk about the FX benefit for you this quarter?

Jeff Wright

Sure. The FX and again we are speaking primarily of just Canadian, U.S. dollar exchange rate, we've got a big Canadian business and in the third quarter the Canadian dollar was up, I think, a little over 10% strengthening versus the U.S. dollar on a year-over-year basis and I want to say helped our revenue by about $6 million roughly.

Kartik Mehta – FTN Midwest

And the bottom line, EPS wise?

Jeff Wright

And EPS wise, we'd probably say was in that $0.02 to $0.03 of earnings per share.

Kartik Mehta – FTN Midwest

Thanks Jeff, I appreciate it.

Jeff Wright

Okay.

Operator

Our next question comes from Michel Morin with Merrill Lynch.

Michel Morin – Merrill Lynch

Hi, good morning, guys.

Rick Marcantonio

Hi, Good morning.

Jeff Wright

Good morning, Michel.

Michel Morin – Merrill Lynch

Just I was hopping to drill down a little bit more on your organic growth in rentals. First of all are you still getting good pricing? I mean has the pricing environment changed it all?

Jeff Wright

Michel, this is Jeff. I think the pricing environments maintained a fairly consistently over the past few quarters, larger accounts are continue to be fairly competitively priced. Specifically around energy cost, we have seen a big run up in the energy cost, and we have moved to try to price more aggressively to recapture some of those increasing cost. So, those are maybe few other dynamics that I would point out.

Michel Morin – Merrill Lynch

But your – your contribution from pricing is not up though right is that a fair – a fair assumption relative to lets say year ago or even last quarter?

Jeff Wright

That's a fair assumption, that's probably a fairly consistent.

Michel Morin – Merrill Lynch

Okay and then if the comments you made earlier about the add staff metric worsening because of the economy, and can you put that in a historical context for us. How is that compared to, where the business was going into the life down for in short tangible?

Rick Marcantonio

Well, I wasn't here when we have started so I just want to make sure that it's clear what we were referring to when I – when I made that comment I was referring to things like if we are selling someone hand offs there might a work to try to trim their cost they will not buy the hand-cuffs for almost during this tougher economic time. That might be an example of it. I don't know if I can you give you perspective. Jeff, do you have anything you could?

Jeff Wright

I don't have any of the numbers right in front of me, but as I recall the last kind of employment downturn if you want to call that was 2001 and 2002, it pretty well kind of moves through all of 2001 and that a lot of 2002 service probably, as I recall 6 to 8 quarter real downturn in employment levels and now here I think, we are I don't know people have maybe say we are at least to couple of two or three quarters into some serious employment downturn. So, I think otherwise Rick said before our organic growth rate is in a much stronger position. Now than what we where when we downturn last time as you recall our downturn last time, we went in the negative territory. But…

Michel Morin – Merrill Lynch

Right.

Jeff Wright

We had a smaller sales force and then we had marketing programs that were now or near as robust as they are today.

Rick Marcantonio

And I will just add one other thing. We had a very strong third quarter as compared to a year ago and professional sales and that I think that's in another encouraging sign as I see then our new sales were up within right – we are almost 20% for the year, okay, and there were up double-digit for the third quarter, which was even stronger growth in the second quarter. So, I mean annual sales are very strong and we believe that that speaks to the sales proposition there is and it's a controllable. That is a controllable of us, some of this economic downturn, especially tight to financial credits which we saw spike up quite a bit in the third quarter. There is something we didn't anticipate it happened, we would live that and we will watch it a little closer obviously, but the fundamentals the part that's driving the growth in the business still look like.

Michel Morin – Merrill Lynch

And when if within the rental segment if you would have break out uniforms versus ancillary services you give the example of the hand soap, is you – is the uniform business itself still in positive territory if we were to look out at that way?

Rick Marcantonio

Yes, we haven't we don't look at that way everyday but I don't think that there is any significant differences in the growth rates of the various product lines.

Michel Morin – Merrill Lynch

Okay. All right great. Thanks very much.

Operator

Our next question comes from Ondray Edward with Robert Clark [ph].

Ondray Edward – Robert Clark

Good morning.

Rick Marcantonio

Good morning.

Ondray Edward – Robert Clark

I was wondering if you could just address the margins for a bit in rental obviously some very nice year-over-year improvements there, but you just made the comment Rick that actually your New Account sales are even stronger – stronger growth in the third quarter than the second quarter. I just wonder if you could take a little bit more and kind of explain really where that growth is coming from, especially given, the higher cost of New Accounts, you are probably making some more productivity improvements on the merchandise cost side, but I just want to kind of understand the sustainability of that margin improvement?

Rick Marcantonio

Sure. That is a great question. Thank you for pointing out the 70 basis point increase in gross margins despite the increased energy cost that we have seen the as you – as I think as our cost of rental areas split into kind of three major buckets and that would be merchandise cost, production cost and delivery cost and we have seen improvements in all of those, but in particular we have seen good improvements in our merchandise cost area and across the number of funds and I think we have mentioned that's just a little bit on our last call, but we are doing a much better job of utilizing our used stocks for our customer base and its lowering our cost and lowering the cost that we are passing on to our customers and sharing that inventory amongst locations of which we have never done before controlling our inputs from the level of new merchandise that were putting into our customers of course we – years so ago we drove more of our jobs that were used to be in the U.S. after our Dominican Republic. Offshore manufacturing facility and our self drive costs so I would tell you that and the merchandise volume those are in fact sustainable cost reductions and then in the delivery in the - in the production areas I would say its probably a little bit more just driven by overall growth in the leverage that we get from that growth and leveraging the fixed cost that we have in our plant in routes and again that would be a sustainable type of costs as long as we can keep our growth rate moving along through our strong professional sales and route sales efforts.

Ondray Edward – Robert Clark

Sure, sure and then I guess just – just looking at, what you have been seeing on an - on an organic basis. I am wondering if you could talk a little about what you saw kind of throughout the quarter January to February to March I am just wondering if you saw, as fairly meaningful decline throughout the quarter just - just in terms of, maybe customer attrition rates and metrics overall and what have you been seeing in April because it does looks like if the growth rates are expected to be sequentially I guess a low weaker again in the fourth quarter and I am just wondering if that's more kind of a function of contracts that's you actually – some non-renewals just kind of coming through next quarter or is really just things are continue to deteriorate further?

Rick Marcantonio

I guess I wouldn't and we usually don't breakdown kind of as things happen during the quarter, but we saw – we clearly saw a higher level of customer insolvencies during the quarter than we have experienced in the past and if you look at the add-put metrics, which is the employment metrics clearly the level that we saw in Q3 was a much higher than Q2 and Q1. So, we are staring to hit that a little bit more but in terms of your organic growth comment we are at 2.75% here in Q3. As we look forward to Q4 we continue to see momentum on our professional sales and route sales. I think as we have mentioned before a lot of it's just depends on how difficult this economy is going to be, but plus or minus to that a little bit, we don't see it

wildly different in that 2.75 as we move forward.

Ondray Edward – Robert Clark

Okay. and then just looking on the cost side, I think Rick you had made the comments in your opening comments that the – your systems spending impact was actually fairly significant, earnings would have been meaningfully better in the quarter versus what your return expectations are going to be or is this as much as a penny or two or how should we kind of frame that comment?

Rick Marcantonio

Well, let me tell where the investment was, okay and then Jeff will kind of just give you a sort of top of mind, what that might have been. We made investments in systems and our sales force although that was – we are going to tell you the name of the company, but it was an outsource solution for us which was a good solution for us in that regard, but, we did make system investments to make that work. We are making some systems and we are making a pretty sizable systems investment in our IT platform outlined for example and then we've got additionally some additional technology investment which are not willing to articulate today, that we believe will help us reduce our cost structure going forward, as well as improve our service to our customer base and those will be – that's one of those investment areas that I highlighted that we are not going to get into detail, so we are ready to roll it out and Jeff may be you can maybe give them a little idea of the financial impact.

Jeff Wright

Sure and I will just speak to the one that was – pops out most of the investment that we made in our Lion Uniform Group system and I will give you a couple numbers that the total cost that hit to the P&L related to that were in the rang of $0.04 of earning per share. However, obviously we are anticipating part of that, but we were probably anticipating about half of that and we got hit with added cost and part of that hit the cost of direct sale line, because they were distribution related as we incurred overtime and some extra costs to keep up with customer shipments and part of those on the SG&A line as we may fix it to the system and incurred travel cost and other things associated with stabilizing that system.

Ondray Edward – Robert Clark

Okay great and then just one final question on just the spending investments in generally. You mentioned that this a little bit more cyclical first quarter, second quarter spending with a little bit less and now you have increase debt here in the third quarter and fourth quarter, have we probably reached a peak at this point and just kind of the overall dollar spend here or do you think we still accelerate as we get into fiscal '09?

Rick Marcantonio

I don't have the exact number, but it's probably kind of similar to where it is right now. We really got – I will call it five major areas we are investing in and have been in – some of which we have been investing in for sometime. So, its not – I don't want to position it as all new investments, okay. You heard about the sales automation tool; that one will be finished end of this fourth quarter or early first quarter. We are making a pretty size investment in bringing Dockers into our rental organization, in other words lowering our rental routes to sell Dockers as a direct purchase item. That will be an investment we'll make pretty much to route the remainder of this year and into next year, all right and then we have an ongoing investment we are making in marketing programs. That's really doesn't change substantially quarter in, quarter out to that pretty much flat and then this quarter actually we are making the pretty big investment right now and identifying ways to drive improvement in our service organizations result which will ultimately benefit the customer. We are taking a pretty big charge in the fourth quarter because of that. We don't expect that kind of cost to be built-in throughout FY '09. It might be a quarter or two as we rollout the results of the work we are doing during the fourth quarter and then we are making some behind the scenes, but that's the fourth area and the fifth area as we make – and we are making a pretty regular investment in technology plays that help us either reduce our cost structure, things like lower merchandising costs and things like that or improved, our customer service. So that's more of an ongoing investment, much like the investment we are making in marketing. The three that are more incremental is the sales force and that will almost go away probably by the end of the first quarter. Dockers, which will be with us for much of 2009 and the service initiative, which will probably be fourth quarter of this year and first quarter maybe into the second quarter next year.

Jeff Wright

So, maybe – this is Jeff. Just add on to the – so, our investment levels will be at higher levels here in Q4 and probably into Q1, but some of that will tend to follow-up, we won't see that higher investment levels as we move throughout fiscal 2009.

Rick Marcantonio

Right.

Ondray Edward – Robert Clark

Great. That's very helpful. Thank you.

Operator

Our next question comes from Mike Hamilton, from RBC.

Mike Hamilton – RBC

Good morning.

Rick Marcantonio

Hi Mike, how are you?

Jeff Wright

Good morning.

Mike Hamilton – RBC

A few detailed questions if I may?

Rick Marcantonio

Sure.

Mike Hamilton – RBC

First I was wondering in dollars, what we are looking at from acquisitions in rental year-over-year third quarter?

Rick Marcantonio

Jeff will give you that.

Jeff Wright

Yes, the total acquisition impact in dollars of revenue was about $8 million.

Mike Hamilton – RBC

Thanks. I was wondering if you're able to quantify what the foregone revenue impact inline was tied to system implementation?

Jeff Wright

That's a good question Mike and it's hard to quantify to be honest with you, because it's – we built backlogs as we worked through distribution center issues and got better at serving our customers and shipping goods out, but we certainly know that there is probably some lost revenue from shipments that we didn't serve on a timely basis, but we are still trying to work those backlogs down and are hopeful of recapturing some of that revenue, but they are certainly was some level of lost opportunity there in Q3.

Mike Hamilton – RBC

Is it at the first quarter outlooks sequentially to the third look relatively stabilized?

Jeff Wright

Yes.

Mike Hamilton – RBC

Is there anything worth calling out in the quarter in terms of cost associated with employee reduction or with healthcare workers comp and maybe other side issues there?

Jeff Wright

No, the only thing I would note there as I think the – our health and our workers comp cost were lower on a year-over-year basis we continue to have good experience there. We continue to reduce the number of workers comp claims within our organization company wide and with that said fact gone a long way towards this quarter, towards offsetting some of the added expenses that we weren't anticipating in with bad debt and spiking gasoline during the quarter et cetera.

Mike Hamilton – RBC

Good. Tax rate outlook on '09?

Jeff Wright

A normalized tax rate I think it's going to be in that 38% to 39%, it tends to jump around a little bit here, but I would say in that kind of range is a pretty good outlook.

Mike Hamilton – RBC

Thanks. Then one bigger picture question for Rick, anything worth commenting on in the current environment in terms of competitive actions, anything you were seeing in out there was noting?

Rick Marcantonio

Not really. I guess I'd probably say that it has been fairly very quite and it's been fairly quite for quite sometime. I think the – probably the last big news in our industry is when AeroMark went private, a while back, but there really – it is been fairly quite.

Mike Hamilton – RBC

Thanks for the help.

Jeff Wright

Yep. Thanks. Have a great day.

Operator

Our next question comes from Scott Schneeberger from Oppenheimer.

Scott Schneeberger – Oppenheimer

Thanks. Just on the cost line, the fuel hedging is something you have done in the past. I think our energy hedging – could you just update us on that and obviously with the sustained elevated prices. Are you going to increase that, decrease that and then in discussing this could you touch on surcharges too please?

Jeff Wright

Sure. With respect to fuel hedging we have of that a program in of trying to hedge at least a portion of our exposure to gasoline and then we are also effectively hedging a portion of our exposure of natural gas, but doing that through fixed cost contracts with natural gas suppliers, so it's not technically a hedge but it's a way of locking and pricing and we've focused on about a third to half of our exposure is kind of what we have targeted and we tend to lookout 12 to 24 months. With respect to gasoline this quarter it did while we took about a 50 basis point increase in gasoline cost, the hedging program provided the benefit of about 15 basis points, otherwise there would have been 65. So it did provide a nice benefit here this quarter and we are going to continue to try to do that and that the sole purposes is not that is going to magically get us to a different place eventually. Eventually, we will all pay, where the market go to, but it can take some of the volatility out of large ups and downs in the market then in fact we saw that this quarter that it help to offset at least a little bit of the gasoline increase.

Scott Schneeberger – Oppenheimer

And where you doing any surcharges specifically or do you include that was general pricing actions?

Jeff Wright

We – maybe it's just safe to say that we haven't commented specifically on different types of pricing strategies, but we have moved aggressively to try to offset the increased energy costs that we are seeing with our customer base as I think many of the competitors have done also.

Scott Schneeberger – Oppenheimer

Okay, thanks and just kind along the lines of cost, safety has become a big issue in the industry and it looks like there could be step ups in the regulatory environment for what has to be done there? Are you – how is your safety record? Are you incurring added cost in doing proactive things? And then – well I will stop there now.

Rick Marcantonio

Well I will start it and this is Rick. Safety is not new to us. I mean, we are not just starting in the safety initiative. It doesn't mean we are not trying to do more and more, but this is not a complete start up from ground zero. We believe that it's important to make our work environment safe. We've had a good track record and we want to continue to enjoy a good track record. Frankly, I want to make the work environment as safe as we possibly can make it for all of our employees. If the employees satisfied with where they work, and comfortable where they work goes a long way to building a strong business, so.

Jeff Wright

Yes and we've and maybe just specifically, the – I think we've seen either seven or eight straight years of reduced workers comp claims in our businesses, and that's despite the growth that we've seen the business. So there are a lot of number of claims have comedown for that many years that in a row. It's been a great outcome now. We still view that there is a significant opportunity, and we continue to improve our safety programs and the benefit to the company obviously is reduce cost and so forth, but the real reason to do it as Rick pointed out is, you don't want anybody to get hurt there and so, we are going to continue to focus on that, I can tell you that the industry has received some publicity around safety initiatives, its unfortunate because I think that the industry actually is pretty conscious around safety, are up and have a little bit about it in the chair of the Uniform And Textile Service Association, the industry trade association right now, the association is actually working on an industry wide initiative to continue to improve our already good safety programs. But, G&K has been honored for quite sometime, we still have opportunities to be better and I will tell you – and tell you really stop any injures from happening, there is always opportunities there.

Scott Schneeberger – Oppenheimer

Okay. Thanks very much

Operator

Our final question comes from Andy Aranda from Needham & Co.

Andy Aranda – Needham & Co.

Hi, good afternoon.

Rick Marcantonio

Good afternoon

Andy Aranda – Needham & Co.

Touching on the fuel surcharge question, can you talk about your pricing power in general?

Rick Marcantonio

Sure. The – and I think as we mentioned before our pricing in terms of the level of pricing that we are getting in our customer base haven't changed a whole lot in total, we are still in that range of 1% to 2% pricing power with our customer base on a, year-over-year basis. We have moved more aggressively, as I mentioned before to pass along some of the increased energy costs in the form of increased pricing through our customer base. But, we are – we are in that range of kind of low single-digit pricing power.

Andy Aranda – Needham & Co.

Okay. What was your fuel, I guess energy cost as a percentage of revenues in the quarter, if you have that?

Rick Marcantonio

Well, as we mentioned before we don't - we don't disclosed to that level of detail. But, just remind people that our energy costs are made up of gasoline on the trucks,, natural gas in the plants, and electricity in the plants and they have moved up, they historically we were more in the 3% range in the last number of years. We have moved up towards today they were in the 4.5% to 5% range as a percent of revenue.

Andy Aranda – Needham & Co.

Great and looking at the bad debt expense, can you talk about that were you see that going forward. Give any referring to that?

Rick Marcantonio

Sure. On bad debt expense as I mentioned earlier we saw some really unusual level of insolvencies in the third quarter and our bad debt expense for that quarter was as higher as I seeing it for actually for a number of years. I think it was at a level where we are not going to see, I'm hopeful that we are not going to see that level moving forward. We just got hit with the maybe that the perfect storm, but the storm nevertheless and bad debt expense I don't think going forward it's going to be at the level that we saw it in Q3.

Andy Aranda – Needham & Co.

Great thank you.

Operator

I'm not seeing any other question sir.

Rick Marcantonio

Okay. This is Rick Marcantonio again. Thanks for joining us this afternoon, as I indicated we are pleased with the reporting of solid quarter and significant year-to-date growth and revenue operating margin, earnings and cash flow. We look forward to reporting our fourth quarter and full-year results in August. In the meantime, have a great day. Thanks.

Operator

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

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Source: G&K Services Inc. Q1 2008 Earnings Call Transcript
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