Cintas Corporation (NASDAQ:CTAS) Q2 2017 Earnings Conference Call December 22, 2016 5:00 PM ET
Mike Hansen - CFO
Paul Adler - VP & Treasurer
Minaz Putnik - Barclays Capital
Toni Kaplan - Morgan Stanley
Nate Brochmann - William Blair
Andrew Steinerman - JP Morgan
Hamzah Mazari - Macquarie Capital
Andy Whitman - Robert W. Baird
George Tong - Piper Jaffray
Joe Box - KeyBanc
Scott Schneeberger - Oppenheimer
John Healy - Northcoast Research
Gary Bissey - RBC Capital Markets
Dan Dolev - Instinet
Good day, everyone, and welcome to the Cintas Quarterly Earnings Results Conference Call. Today's call is being recorded.
At this time, I would like to turn the call over to Mr. Mike Hansen, Vice President of Finance and Chief Financial Officer. Please go ahead, sir.
Good evening and thank you for joining us tonight. With me is Paul Adler, Cintas' Vice President and Treasurer. We will discuss our second quarter results for fiscal 2017. After our commentary, we will be happy to answer any questions.
The Private Securities Litigation Reform Act of 1995 provides a Safe Harbor from civil litigation for forward-looking statements. This conference call contains forward-looking statements that reflect the company's current views as to future events and financial performance. These forward-looking statements are subject to risks and uncertainties which could cause actual results to differ materially from those we may discuss. I refer you to the discussion on these points contained in our most recent filings with the SEC.
We are pleased to report that revenue for the second quarter which ended November 30 was $1.297 billion, an increase of 6.4% over last year's second quarter. The organic growth rate which adjusts for the impacts of acquisitions and foreign currency exchange rate fluctuations was 5.7%. Organic growth for the Uniform Rental and Facility Services segment accelerated to a rate of 6.5% from 5.9% in our first quarter.
Second quarter gross margin improved to 44.1% from 43.3% last year. Scott Farmer, Cintas' Chairman and Chief Executive Officer stated in today's press release that this is our 13th consecutive quarter of year-over-year gross margin improvement. As Scott mentioned this accomplishment plus our industry leading organic sales growth is a great reflection of the significant opportunities we have ahead of us and of the great execution of our employees whom we call partners. Gross margin of the Uniform Rental and Facility Services segment improved to 44.7%, an increase of 80 basis points compared to last year's second quarter.
The First Aid and Safety segment gross margin improved to 46.1% representing both the year-over-year and the sequential increase of 290 and 30 basis points respectively, due to the realization of synergies from the acquisition of ZEE Medical in fiscal 2016.
Operating income for the second quarter of fiscal 2017 of $203 million increased 1.3% from last year's second quarter. Operating income margin was 15.6% compared to 16.4% in last year's second quarter. Second quarter operating income included $3.3 million or 0.3% of second quarter revenue of transaction expenses related to the previously announced agreement to acquire G&K Services.
Net income from continuing operations for the second quarter was $123 million compared to $115 million in last year's second quarter. Earnings per diluted share or EPS from continuing operations for the second quarter were $1.13 which included a negative $0.02 impact from G&K transaction expenses, compared to $1.03 in last year's second quarter.
Second quarter net income and EPS from continuing operations increased 6.9% and 9.7% respectively compared to last year's second quarter. Excluding the negative impact of the G&K acquisition expenses net income and EPS from continuing operations increased 8.8% and 11.7% respectively compared to last year's second quarter, and net income margin from continuing operations improved to 9.7% compared to 9.5% in last year's second quarter.
We're updating our annual guidance, we expect fiscal 2017 revenue to be in the range of $5.180 billion to $5.225 billion, and fiscal 2017 EPS from continuing operations to be in the range of $4.57 to $4.65. This guidance includes the benefit from our adoption of accounting standards update 2016-09 entitled improvements to employees share based payment accounting, and the impact of one less workday in fiscal 2017 compared to fiscal 2016.
This guidance also includes second quarter year-to-date G&K transaction Expenses, but does not include any future G&K transaction expenses. Please refer to the table in today's press release for more information.
As Scott Farmer was recorded [ph] in today's press release, we are pleased with our second quarter results. They've put us in a solid position to again achieve record revenue and to grow our EPS double digits for the seventh consecutive year. We thank our partners for striving to exceed expectations and in doing so delivering best in class results.
Before I turn the call over to Paul, I'd like to provide a brief update on our acquisition of G&K. We are excited about this opportunity and the long-term value creation for Cintas, its employee partners and its shareholders. When we announced the transaction in August, we indicated that the merger was subject to approval by G&K shareholders, regulatory clearances in both the U.S. and Canada and other customary closing conditions. The merger was approved by G&K shareholders in November.
We continue to work toward obtaining regulatory clearance and completing the other closing conditions. We remain optimistic that the deal will close no later than the end of the second calendar quarter of 2017. In order to avoid creating speculation, we will not be providing any additional commentary on this process. We will update the market going forward as appropriate.
I will now turn the call over to Paul for additional information.
Thank you, Mike. First, please note that our fiscal year 2017 contains one less workday than in fiscal year 2016. It is the third quarter of fiscal 2017 that has one less day than the prior year quarter. We estimate that this will negatively impact fiscal 2017 total revenue growth by about 40 to 50 basis points and operating margin by approximately 10 to 15 basis points in comparison to fiscal 2016.
For those of you modeling our results by quarter please keep this in mind. Our third quarter is generally not as strong as the fourth quarter due to reasons including the resetting of payroll taxes, and this year it will also be negatively impacted by one less day of revenue. In addition energy comps will be very difficult in our third quarter as gasoline and diesel prices were at their lowest levels in last year's third quarter. And finally we will spend more on the branding campaign in the third quarter than in the fourth quarter.
As Mike stated, total revenue increased organically by 5.7% in the second quarter. Driven largely by new business wins, penetration of existing customers with more products and services, and strong customer retention. Total company gross margin was 44.1% for the second quarter of this fiscal year, compared to 43.3% last year, an improvement of 80 basis points.
We have two reportable operating segments, Uniform Rental and Facility Services, and First Aid and Safety Services. The remainder of our business is included in All Other. All Other consists primarily of Fire Protection Services and our Direct Sale business. First Aid and Safety Services and All Other are combined and presented as Other Services on the income statement.
Uniform Rental and Facility Services operating segment included the rental and servicing of uniforms, mats and towels, and the provision of restroom supplies and other facility products and services. The segment also includes the sale of items from our catalogs to our customers on route.
Uniform Rental and Facility Services revenue was a little over $1 billion, an increase of 7.2% compared to last year's second quarter. Excluding the impact of foreign currency exchange rate changes and acquisitions. The organic growth rate was 6.5%. We continue to see the impacts of weakness in the oil, gas and coal industries, however, we believe that we have hit the bottom. We estimate that the resulting decrease in revenue from affected customers lowered our organic growth rate by about 75 basis points in the second quarter. This compares to about 110 basis point impact in the previous quarter.
Our Uniform Rental and Facilities Services segment gross margin was 44.7% for the second quarter, an increase of 80 basis points from 43.9% in last year’s second quarter. Energy related costs were 10 basis points lower than in last year's second quarter. However, job losses previously mentioned in oil, gas and coal negatively impacted this segment's current year second quarter operating margin by about 40 basis points. So, on a net basis, the low price of oil had a negative impact on our Uniform Rental and Facility Services operating margin of 30 basis points because the benefit of lower prices at the pump for our fleet of trucks was more than offset by the negative impact to operating margin resulting from weakness in our oil, gas and coal customers.
Our First Aid and Safety Services operating segment includes revenue from the sale and servicing of First Aid products, Safety Products, and Training. This segment's revenue for the second quarter was $125 million, which was about 4% higher than last year's second quarter. On an organic basis, the growth rate for the segment was 3.3%. The reduction in overall segment organic growth is due to the continued assimilation of the ZEE Medical business. Route consolidation and optimization continued in the second quarter as expected. However, in examining the monthly organic growth rates of the second quarter, we believe that we saw the bottom followed by an upswing in the growth rates in the final months of the quarter.
We previously disclosed that we added sales reps in our first quarter. ZEE Medical did not have a dedicated sales force as the business previously relayed only upon SSRs to grow the business. The added sales reps were help us grow the acquired customer base by penetrating with our broad range of products and services. As a result of this investments in addition to a bottoming of growth rates in the second quarter, we expect improving organic growth rates through the remainder of this fiscal year. This segment's gross margin was 46.1% in the second quarter compared to 43.2% in last year's second quarter, an increase of 290 basis points. Also, we are pleased to note that gross margin improved again on a sequential basis, this time by 30 basis points. Our margins are benefiting from the realization of acquisition synergies, including improved sourcing and the leveraging of existing warehouses.
We have about 16 months of results since the ZEE acquisition. There is more work to be done and exciting opportunities ahead. However, we are very pleased with progress and performance to date. Large acquisitions have a short term impact to growth rates as we on board and good will the acquired customers and train the SSRs on our products, services and processes. This is typical, and we know that growth rates will soon improve. In the interim we have made significant strides in expanding gross margin. Our year-to-date gross margin dollars are up 53% over two years ago and up 22% over last year. Our year-to-date gross margin percentage is almost back to pre-ZEE levels and our revenue of course is significantly greater.
Our Fire Protection Services and Direct Sale businesses are reported in the All Other category. All Other revenue was $167 million, an increase of 3.5% compared to last year's second quarter. Organic growth rate was 2.8%. All Other gross margin was 38.5% for the second quarter of this fiscal year compared to 39.6% for last year's second quarter. As we have mentioned previously the Direct Sale business by its nature is not the recurring revenue stream that our other businesses are, such as Uniform Rental and Facilities Services and First Aid. Therefore the growth rates are generally low and are subject to volatility, such as when we install a multi-million dollar account. Our Fire business however continues to grow at a rapid pace, the Fire business organic growth rate was a little over 10% and operating margin expanded.
Regarding selling and general and administrative expenses, total company SG&A was 28.2% as a percentage of second quarter revenue compared to a total company SG&A in last year's second quarter of 26.8%. The increase was the result of strategic investments, as well as the 70 basis point increase in employee medical expenses. The strategic investments include a new enterprise resource planning system, the national branding campaign ready for the work day and sales resources to grow recently acquired customers and our First Aid and Safety segments.
Regarding the increase in medical expenses, note that we’re self-insured and we had a handful of atypical very expensive claims in the quarter. I mentioned that SG&A was impacted by our investments in an enterprise resource planning system, namely SAP. SAP amounted to about 20 basis points of expenses related to the piloted operations. We continue to be pleased with the conversion efforts and the capabilities of the new system. Since last quarter’s earnings call, more locations have been included in the pilots, also with the upcoming acquisition of G&K we’re planning and adjusting our SAP implementation plan as necessary.
Our internal SAP resources are involved in this effort, as a result we expect SAP expenses in fiscal 2017 to be less and estimate a range of $20 million to $25 million. As of November 30, short term debt was comprised of commercial paper in the amount of $66 million. We expect this amount to be temporally higher as of the end of the third quarter due to payment of our regular dividend. On December 2, we paid an annual dividend of $1.33 per share, an increase of 26.7% over last year’s annual dividend.
We’ve increased this dividend for 33 consecutive years, which is every year since we went public in 1983. The annual dividend is an important part of our capital allocation strategy and illustrates our enduring commitment to effectively deploying cash to increase shareholder value. During the third quarter of fiscal 2016, we entered into an interest rate lock agreement with a notational value of $550 million for our forecasted debt issuance, in anticipation of debt issuance for the closing of the G&K acquisition and to protect same cost from rising interest rates. We recent entered into interest rate lock agreements with a notional value of $950 million.
Our effective tax rate on continuing operations for the second quarter was 34.9% compared to 37.4% for last year's second quarter. The decrease in the effective tax rate year-over-year is attributable to both the favorable settlement of a prior year federal tax audit and the adoption of ASU 2016-09 on stock compensation. We expect the annual effective tax rate for continuing operations for fiscal 2017 to be about 34.7%.
Our cash balance as of November 30 was $143 million and we had no marketable securities as of quarter end. Cash and marketable securities decreased about $20 million from the balances of August 31st. Cash flow from operating activities as of November 30 year-to-date increased 14% from the prior year period. Uses of cash in the second quarter included CapEx and repayments of debt. Capital expenditures for the second quarter were about $76 million our CapEx by operating segment was as follows, $66 million in Uniform Rental and Facility Services, $6 million in First Aid and Safety and $4 million in All Other.
We expect CapEx for fiscal 2017 to be in the range of $290 million to $310 million. This range includes about $40 million of CapEx related to our SAP implementation. Finally, in the second quarter we received a payment from the buyer of our investment in Shredit, proceeds were about $26 million and recorded in the investing section of the cash flow statement.
That concludes our prepared remark. We are happy to answer your questions.
[Operator Instructions] We do have our first question from Minaz Putnik with Barclays Capital.
Good evening gentlemen, thanks for the call, first question is just around the acceleration in the Uniform Rentals business, maybe just a little bit more color related -- was it broad based, was it a couple of -- was it selling more mat and towels, anything there, how sustainable do you think that is?
Well we saw our organic growth from the first quarter this second quarter accelerated about 60 basis points as Paul said about 35 basis points was because of the lessening oil and gas customer impact and so I guess I would say you know we've seen quite steady performance except for that vertical for some time now and I would say that that is sustainable as we move forward in this economic type of environment, if we see the economy change one way or the other we may see some change, but we feel very good about our execution and that's kind of where we've been, that's where our results have been for a number of quarters except for that one vertical.
And I think Paul has said that you think oil and gas is at the bottom, 75 base impact in 2Q, how should we think of that impact in the quarter lessening going forward like is 35 basis points the right number like you saw this quarter?
Yes Minaz, this is Paul. We estimate that that headwind that went from 110 to 75 will continue to step down in Q3 and Q4 such that you know for the full year the headwind would probably be in the 75 to 85 basis point range for the full year.
And then just on First Aid and Safety, your comments on improving growth rate for the remainder fiscal year, again just some color on -- from 3.3 how do we step it up? I know you talked about monthly it was better, I was wondering if you could maybe put some numbers on those monthly rates, or any color on how we should model that?
Paul mentioned that we saw some acceleration through the quarter, in the last month of the quarter we were about 4.5 and I would expect to see step up from there in the third and then little bit more step up in the fourth. We're not ready to give particular guidance, but we expect that to return to that high single-digit low double-digits overtime, and we certainly expect to make progress on that in the back half of the year.
Our next question comes from Toni Kaplan with Morgan Stanley.
SG&A was a little bit higher than we had expected in the quarter even adjusting for the transaction expenses and you called out SAP in the national branding campaign and medical expenses as been big drivers there, SAP you're going to keep investing in this year, but just when we think about the other two would you expect those to come down at all, or would you expect sort of double-digit SG&A expense growth for the rest of '17 as well?
I would say this, first of all Paul called out medical and certainly medical was a spike of 70 basis points this quarter, again as he said, we had some -- we had a combination of a handful of high dollar claims that hit us this quarter. We don't see that as a trend going forward. As it relates to the other items that Paul pointed out in terms of -- let me speak to SAP for a second, we certainly have guided for more SAP expense in the back half of the year, as we kind of move out of the pilot and into the full implementation.
The spend that we have talked about tonight $20 million to $25 million, you can imagine the bulk of that is in the second half of the year. But it is lower because we're starting to combine a little bit the SAP and the G&K system conversion and so we're going to make sure that we've a coordinated effort to move forward in the right way with both of those projects. If you kind of think about the first half of the year, the first quarter we were up about 70 basis points over last year. Second quarter without that medical spike we're up 70 basis points and we will continue to invest in SAP in preparation for the G&K closing. And we'll have some of that ready for the workday.
So, yes, Toni, we will see some heightened SG&A as we continue to prepare for these two large projects. We want to make sure that we are providing the right resources for each of them.
Can you talk about how you're anticipating the impact from the new administration will be, whether it's on taxes, labor growth, wages or anything else that you think will be especially impactful to your business.
Certainly we've seen a lot of positive sentiment and at this point in time it's just sentiment and so we've got ways to go before we see anything impactful, but having said that, look if we see lower corporate income tax rates that will be certainly beneficial for us because we're mostly a U.S. based company. If we see a repatriation opportunity certainly that's not significant for us, but if we see a lot of cash coming back and flowing into the economy that's going to be good for our customers and ultimately good for us.
And then if we see some infrastructure spend that's going to be good for construction, for equipment and certainly that's going to benefit our customers and eventually benefit us. But I would say again Toni, we are a ways away from seeing anything yet and I -- as we think about our year, we are not including any benefits from changes from the new administration, we absolutely like how our year is going so far, we've got a very good organic growth rate, we've seen Rental continue to be strong First Aid is going to continue to be strong in the second half of the year. We've seen some really nice gross margins and gross margin improvements, so we feel like we've got a very healthy business that's executing very well and boy if we get some help in the back half of the year from changes from the new administration that will be even better.
Okay, thanks for the answers, and happy holidays.
Our next question comes from Nate Brochmann with William Blair.
So I wanted to ask a couple of things. One, obviously over the last five years you've really kind of changed the direction of the company in terms of developing new end markets and new services and what not. Could you talk a little bit about how the culture has evolved along with that in terms of supporting those new entrepreneurial efforts? And also two, just kind of looking forward, where do you think the next milestones are over the next three to five years post integration at G&K and the SAP in terms of some of the ongoing efforts to continue those various growth drivers.
Well you're right Nate. I think today and over the last five years, we've been a more innovative company than maybe 10 and 15 years ago. I think, if you go back kind of prior to the last cycle. We were kind of building the footprints still, we we're adding sales reps and we were getting a lot of growth in that manner. And as we fully build out that footprint, and as we got into the great recession, we started certainly to recognize that we can't wait for employment to come back and we have to be more innovative and we have to create products and services that our customers really value and want to use, we've got to create garments that our customers want to wear, not just have to wear. I think we've done a great job of that. And we’ve got some active channels of feedback from our customers, from our service sales reps, we’ve got an active R&D program, we are looking for vendors to partner with like Carhartt.
And so we -- there is no doubt we kind of changed from a company 10 and 15 years ago where we were building a footprint to a company that really looking for more and unique ways of serving businesses. So as we move forward then, we’ve got some exciting thing ahead obviously and that is the SAP and the G&K integrations. And as we move forward from there, I think there still are many opportunities to create products and services that pull even more types of customers into our customer base and to provide them with broader products and services. So we’re going to continue to look for those kinds of opportunities.
And Nate, I would say one of the biggest assets that we’ve got certainly the biggest assets are our people and our culture, but really when you think about it, one of the biggest assets we have got is a great infrastructure to provide services close to a million businesses and we’ve got that infrastructure that can reach many more businesses as well. And so we are a nice avenue for many vendors to provide products and services. And I think that’s something that we can continue to take advantage of as we move forward.
Thanks, that’s very helpful for the insight. And just one little bit of quick clarification, last question but, talking about the encouraging sentiment, I mean clearly we feel that throughout the market in terms of the economy and some of the larger corporations out there, when you say positive sentiment, are you referring to just kind of that nuance, are you hearing that out of your customers as well in terms of kind of maybe some of that individual positive sentiment percolating up a little bit from your sales force?
Well, I think -- I would say more of it is coming from just kind of the general economic discussions, the rally in the stock market, the rise in the interest rate environment. I would say more of it is coming from that. When we think about the business, our specific business, in the second quarter, I would say if you kind of push aside a lot of this sentiment and noise, the economic environment for us in the second quarter didn’t feel a whole lot different than its felt in last few quarters with the exception of that oil and gas vertical, not deteriorating anymore and maybe stabilizing a little bit. But generally speaking I would say the economic environment doesn’t feel a whole lot different today than it has over the last few quarters.
Fair enough. Thank you very much for the time. Appreciated.
Our next question comes from Andrew Steinerman with JP Morgan.
You presented the way you have your fiscal year 2017 EPS guide little bit differently in the second quarter press release and the first quarter press release, I just wanted to make sure, I was getting the math correct here, I believe that Cintas lowered the range of the 2017 EPS -- range of EPS before the accounting benefit and before the G&K transaction cost by $0.03, I could calculate, why I think it’s $0.03, but I was just wondering is that the way you see the difference between the range before today and the range after today, when looking at EPS before counting benefit and before G&K costs?
And just to make sure, did you say lowered by $0.03?
EPS, yes I think you lowered the range by $0.03.
That’s not the way I see it. So when we think about the -- and by the way we added the table because it is a little bit -- there are some moving parts and we wanted to make sure that we were as clear as we could be about it. So when I think about the first quarter, our range overall was 455 to 463, and that included a negative $0.02 from G&K in the first quarter and at that time, we had told you, we thought that ASU impact was $0.07, would be $0.07 for the year. That kind of gets us to 450 to 458, compared to tonight’s range or today’s range of 451 to 459. So I would see it as, I mean it’s really about the same but a penny higher.
Our next question comes from Hamzah Mazari with Macquarie Capital.
Mike just wondering, on your next financing cost, you spoke about locking in financing and interest rate, certain interest rate. Could you give us a sense of how we should think about pro forma and that financing cost and would that be an offset to your 130 million to 140 million synergy number you’ve put out there for G&K?
So back at August, when we announced the transaction, we had talked about a, roughly a 4% rate and I would expect that we’ll be a little bit better than that. We have locked some of the rates, but not all of them. So there will still be some movement, but I would expect that we may be a little bit better than that.
Okay and just last question, with the newer administration if there is a higher tariff on overseas sourcing, does that impact you guys at all or is that not material, and any color there would be great? Thank you.
Well, we certainly have an active global supply chain and we source from all over the world and we do our best to take advantage of existing trade agreements. I would say if the new administration pulled back on existing trade agreements or made changes to existing trade agreements, there could be some impact and we’ll do our best to work around that.
So for example we have production in Haiti and we take advantage of the trade agreements with Haiti, we have some NAFTA benefits and if those go away then we’ll certainly have to determine how to adjust. Having said that, when you think about the cost of materials for us, in specifically garments, let’s keep in mind rental revenue is about 50% of the Uniform Rental and Facility Services segment. When you think about the cost of rentals we have the material cost, the production cost and the service cost, and so the material cost is certainly not the majority of that. When you think about then the material cost, the biggest cost in there is labor and so we'll work to see how can we manage that labor input as best we can.
And so I guess what I am telling you is, it's a large part of our cost structure but it's not, it’s not significant and it happens over a long period of time. So for example we have to go source it, then we bring it into our distribution center where is stays for a turn, then it gets shipped to our rental locations where we put it into service and we amortize it over 18 months. So it takes quite a while to see the full impact of changes to our sourcing, and while we're going through that long supply chain timeframe we would be working towards improving our sourcing capability. So we're keeping our eyes on it, no question about it, and we'll react appropriately.
Next question comes from Andy Whitman with Robert W. Baird.
Great so, hi guys I wanted to just -- a little bit more on the guidance question, I agree with you it’s a I guess a penny raise, if you go a step further I guess you cut the SAP investment this year by about $5 million, that's $0.03 the other way, but then Healthcare looks like a surprise that was about a $0.04 hit in the positive direction if you add it back. So I guess those if you just assume SAP and Healthcare then you kind of, you’re still back to the kind of flat to maybe a penny pick up, would you agree with that Mike.
Yes, I would say its right around there Andy. You know when we think about our guidance for the second half of the year we think about, look we feel very good about the revenue, we feel very-very good about the gross margin, we have a healthy business and its executing well. We also have two very large and important projects ahead in SAP and in G&K, and we're going to make sure that we are investing in the right way to make sure that we implement those in the best way that we can. And so as I mentioned to Tony a little bit ago, we will continue to see some elevated SG&A because we're going to make sure we're ready for both of those projects and all of that's incorporated into that guidance.
You know and you brought up the two big programs that you're running. It sounds like, you didn't say it this way, but sounds like you're moderating some of the spend this year on SAP because there's going to be a whole lot more work next year when G&K gets done. Would you agree with that?
And then I guess the question is, is there an implication about the spending on SAP I think last quarter you said it was going to be $40 or $45 million that was cumulative not incremental to this year's number but $40 million to $45 million cumulative, do you still like that number as you look into 2018 or does that one move as well as you look at the G&K integration next year?
I would say that it's getting a little bit combined with -- those two projects are getting fairly connected, and while we're not ready to say that that 40 to 45 is going to be different, we're going to have to continue to work on these as a coordinated effort. And so we may come and say, look when you combine the Cintas legacy effort along with the G&K, we may change the amount of spend, but I'm not ready to say that we will yet.
I guess maybe one way to look at it from just a systems spend, is to say, we had originally looked at that SAP integration for ourselves as being the second half of fiscal '17 and then all of fiscal '18. And I think Paul and I have said over last couple of calls, as we insert G&K into that, it's likely going to go into fiscal '19, and we still believe that. And so there's probably going to be the same effort in fiscal '18 but just a little bit more effort in fiscal '19. That additional effort is incorporated into our thoughts on the G&K deal, and as you know we've talked about one of the longer polls in that in the synergy effort with G&K as that system conversion. And so we're going to be continuing to work on it, I'm not ready to change from the 40 to 45. But I think it will go into '19, just because we've got more locations. Does that answer your question?
Yes, I think that does, it gives it a character of how you are thinking about it and thank you for that. I guess maybe the last question that I have then is stepping back and just looking at the fundamentals of the marketplace, I would like to hear some of your commentary on the AdStop [ph] trends that you're seeing in the marketplace, as well as any comments that you can give us on the overall level of competition as it relates to the pricing trend, recognizing that they're always competitive, but maybe they’re less or more competitive today? That would helpful to give us some context of some of the drivers into that acceleration into organic growth.
The AdStops, the metric was positive this quarter, but it's typically positive. We get some benefit from seasonal items like jackets and some extra mats coming into the late fall into the early winter. The only thing noteworthy in AdStops was that the flame resistant garments FRC, that was more positive and that helps us support our conclusions that we think we have seen the bottom of that weakness in oil, gas and coal. Outside of that nothing noteworthy in AdStops, and in terms of pricing no change, it’s still very competitive but nothing significant to speak off.
Next we've George Tong with Piper Jaffray.
You indicated the bulk of your SAP spending this year will be in the back half, can you share how you're thinking about the timing of investments between 3Q and 4Q this year?
I would say that there is going to be a little bit more in the fourth quarter than in the third quarter as we really get into the ramp up and -- so, I would say if you think about that remaining, I guess it's about 15 to 20 in the back half of the year, a little bit more of it is going to come in the fourth quarter.
Got it, and then secondly, can you discuss how much additional investment you need to make in the sales force to support accelerating revenue growth in ZEE Medical?
Well we've already made that investment, we made it in -- primarily in the first quarter and so you are seeing that in those First Aid and Safety numbers that they are that investment that we made in the first quarter is now starting to become more productive and I don’t expect to see any additional investments other than kind of the routine.
Go it. And then lastly as it relates to your medical claims costs. You saw some elevated atypical medical claims in the quarter. Can you maybe elaborate on why you believe the claims are atypical and then from an actuarial perspective if you'll need to accrue claims costs at a higher rate in future quarters?
The typical claims were just simply certain claims that were very high dollar because of the specific situation of the person. Because we don’t expect a continued spike of this high dollar claims we generally don’t need to necessarily include that in our IB&R [ph] going forward.
Got it, thank you.
Next we have Joe Box with KeyBanc.
So, obviously there is lot of commentary around why the organic rate in Uniform stepped up sequentially. But I was actually hoping that maybe you could deconstruct where the 6.5% organic growth is actually coming from. Maybe just give us the sort of commentary or directional feel on how much of that might have been price, how much of that might have been volume and then just anything maybe you can tell us about the Uniform specific growth rate versus the ancillary?
Well Joe, we don’t usually get into the specific details. I can tell you, new business remains strong and we feel very good about reaching that new customer base through what we call no programmers or new customers that haven’t had a Uniform Rental program. New business remains strong penetration remains strong with things like our signature series hygiene products and services with our entrance mats and I would say that we haven’t seen much of a change in the mix of the revenue growth other than to say that oil and gas at customer base, the stops or the reduction in revenue at those types of customers has subsided a little bit.
But aside from that it is continuing to execute the way we have for quite a while now and that is no programmers being very strong, new business efforts in total being strong and continuing to find penetration opportunities.
Okay, appreciate that. And then we may or may not be coming out of the period of lower diesel costs. Have you guys given any consideration to maybe pushing through a surcharge mechanism to your customers or maybe doing hedging on that front?
We don’t, that diesel or gas surcharge is not something that we do. And we are buying gas everyday all over the country and a hedging program is very, very difficult, it's not like we’ve got large bulk buys at specific points in time and so no we don’t typically get involved in a hedging program because it's just very, very difficult to do so.
Our next question is from Scott Schneeberger with Oppenheimer.
Could you guys address the branding campaign, maybe I am watching less TV, but I haven't seen as much as that as I did initially. Just curious what's going on and a little rehash of the quantification, past and forward, and also favorable impacts you think you may have seen thus far?
Scott, you need to watch a lot more college football. But I mean, the rebranding campaign is going very well. We’re still not far enough along that, we have enough of full body of work to be able to analyze and come back to you with return on our investments. But anecdotally what we are hearing from our partners, the customers, it’s all very positive.
In fiscal '16, we spent for the year about 25 basis points on the branding campaign and we expect that to be about the same impact here in fiscal '17. And as I said in the end of prepared remarks we will have a little bit heavier spend in our third quarter than in the fourth quarter.
Thanks. And then with regard to the new sales folks at ZEE, you answered a prior question saying that the spend is done, the initial change and now I guess you have -- I guess I’m curious see how much of that is variable, might we see that pick up or will it be commiserate with production and you’re obviously only giving guides to the fiscal yearend, I believe you said something like progressive improvement in each of the next two quarters, but based on Anniversarying if we look at the full calendar '17, we should see that continue to trend up in the back half of the calendar year and ideally thereafter, is that a fair assessment?
Yes, yes, it is. We made a larger than typical investment in the first quarter, those partners are now starting to become productive. But we will continue to add selling resources just like we always do. So it's going to be more routine over the course of the next year or so, and -- but yes, to your question. Not only do we see or we expect some improvements sequentially in the back half of this year, I would suggest that’s going to continue in the first half of next fiscal year as well.
Our next question comes from John Healy with Northcoast Research.
I wanted to ask just a little bit more on explanation on the ZEE Medical business and some of the deterioration in the First Aid and Safety organic growth, could you help us understand kind of what was going on with the sales force and it is now simply that Cintas sales people were trying to go in and retain the business and weren't focused on kind of growing and selling because we’ve seen the organic growth come down for about three or four quarters in that business, I’m just trying to understand, kind of the mechanics of what happened in the field?
Sure, so we -- lets go back to, we made that deal in August of 2015 and the first thing that we needed to do was get that business on to our systems. When we’re operating on their system, it hard for us to go and hire a sales rap, and put them on to their system because that would require them to sell ZEE Legacy product. And as you can imagine one of the things that we try to do is start to work our way out of the ZEE products and start to work into the Cintas products.
This in ZEE’s case they didn’t have sales people, they have their drivers, their service sales raps or as we call them SSR’s, they had their SSR’s do the selling. And they didn’t have a dedicated sales force, so as we brought them on the first thing we needed to do was convert them on to our system. That as we’ve talked about took us really through the entire fiscal 2016 year and so as we are doing that conversation on to our system then we have to make sure that we train those SSR’s on our products and services. And then we do what we’ve talked about is a route optimization and that route optimization then takes those ZEE Legacy route, now that they’re on our system and now we look at the whole market and we reroute the market.
And that puts us in a position then to most efficiently serve the customer, and that’s when we really like to then start to see the sales people start to drive revenue. And so in this case, in the case of ZEE, we didn’t invest in sales people early on, because it would have required us to sell for some period of time, the ZEE product and that was something we were trying to work our way out of.
So it was something that we expected and now that we are through the system integration, we are through almost all of the route optimization. We’re ready to really begin aggressively selling and we should see that organic growth improve.
That’s helpful, and Mike to just kind of along the same lines, when you think about the G&K acquisition, obviously they have sales people and I guess we call it SSRs as well. Is it reasonable to think that you might see organic in the laundry business, macro conditions stable, maybe do the same thing as you go through a digestion period or do you not typically see that same thing when you do it fairly good sized Uniform deal?
With every deal that we do, we will expect to see some revenue reduction in the legacy business and that’s true for every acquisition that we’ve made and that is because a combination of things such as, there is some disruption certainly and that disruption sometimes creates the customer -- or creates the environment for the customer to look at other providers. But in addition to that, it’s hard to sell; it’s hard to come out of the gate selling a lot of new business, because we need to train the legacy people, the SSRs and the sales people how to sell Cintas' products, how to sell using our policies, our procedures and our tools. And so there is a natural reduction in new business sales shortly after the closing of the transaction, while we are doing training and integration. And as we get through that training and integration period we then start to expect that those resources, those legacy resources will become more and more productive.
So it is just natural that we will see some pressure on sales growth in our rental business post-closing of that transaction, but the really good news is as Paul mentioned in his prepared remarks going back to Z for a second. Our gross margin dollars are up 56% over pre-acquisition dollars, and so while there is some pressure on the topline we are really creating synergy opportunities and really creating cash flow because of the synergies we're able to create.
Thank you, and just one final question, when you look at the acquisition of G&K, I know you guys had put out the 140 -- 130 million to 140 million cost savings number, but I believe that's before any sort of revaluing of the inventory and amortization of the merchandize, is there a way to think about how much of the synergies would be leaked away because of that?
You know I'm not quite sure I understand the question and I would just say John, that I think we're still very comfortable with the 130 to 140. There is some work that remains to be done in an acquisition of this size, all that purchase price accounting is performed by an independent party and so there could be some movements there, but at this point in time I think we understand the economics well enough that we're still comfortable with that 130 to 140. So nothing related to your question that causes us pause at this point in time.
Right, but is that 130-140 before or after any purchase accounting associated with the merchandize that's been fully amortized that's still in the field that would get revalued higher and put on your balance sheet once the deal closes.
It includes our understanding our estimates based upon experience of doing deals as to what we believe that purchase price accounting to be. But as I said [multiple speakers]. Yes, we reflected it to the best of our knowledge, but as I said we don't determine that ultimately, we'll have an independent accounting firm come in and sign off on that.
And next up we have Gary Bissey with RBC Capital Markets.
Hey guys, just a couple of quick ones, I know it's getting late here. The -- what is the cost of the swaps or the interest rate activity you did between now and actually you getting the financing to closing the deal, should we think that interest expense changes because of these things you are doing how to prepare for taking on that debt or is that not going to be material?
Generally there is not a cost and there is a true up at the time that we would do the financing. So, the answer to your question briefly we won't expect any change in our interest expenses.
And then on the third quarter headwinds that you mentioned I just wanted to ask about those quickly. So the one less workday, we know the SAP have been very clear about that, the branding spend you said similar for the year, but in the second quarter, it was up year-over-year, so I guess the mix of timing within the year, it's the third quarter or is that on a year-over-year basis the branding spend likely to be more and is that something that'll be a drag on margins?
Year-over-year, I think probably the third quarter is probably similar. The fourth quarter would probably be a little bit better year-over-year. But when you're thinking about our Q3 and Q4 there is still more in that Q3 then in the Q4 of fiscal '17.
And then just last one on that, the energy comps, can you give us a sense how much do you think that changes from this quarter you just reported in terms of energy costs, fuel costs?
I think if you kind of view an annualizing of that 75 to 85 basis points for the year, I think that gets us down in the fourth quarter to probably something in the way of 40 to 50 basis points of drag.
I'm sorry, I was just asking about the fuel costs. I think you said that gasoline and diesel prices were the low was the third quarter a year ago. So, [multiple speakers] materially different sequentially, February versus the November you’ve just reported?
I don't have the data with me by quarter, but I can tell you this, because we've already given you -- our Q1 energy was about 1.9% of revenue, Q2 was 2%. We think we'll end '17 in like the 2% to 2.2% range. So, we're expecting prices at the pump to rise. That compares to about 2% for fiscal '16.
But all in the second half of the year for us was about 1.8%. So, you can see we're guiding a little bit of an increase.
And our final question comes from Dan Dolev with Instinet.
Can you just give me a sense of the incrementals on rental on the gross margin side? I feel like it was -- the second quarter kind of broke a little bit of a trend, you were running at 63%, its maybe like in the 56% range, what should we expect sort of looking at third quarter and fourth quarter in terms of gross margin incremental in rental?
I would say this Dan last -- for fiscal '16 our incremental gross margin in rental was about 58% for the year. In the second quarter it was about 56% last year. It was almost the exact same this year in the second quarter. And if you look at our incremental gross margins for the year, it's something in the way of just under 60. So I think we're continuing to have the performance that we've seen over the last year or so.
Going into the second half of this year the only thing that I would say is we will be a little bit more aggressive in making sure that open positions in our rental business are filled, so that when we are ready to close the G&K transaction we're not trying to both fill our open positions and perform integration. We want to make sure that we are fully staffed as much as possible and so that's the only think I would say, it may put a little bit of pressure on that second half of the year, but generally speaking we think they will be healthy.
That pressure versus the second quarter or pressure versus kind of the --?
Pressure versus what we saw in the second half of last year I guess or relative to this 60% -ish.
Got it, and what about the other incrementals, they was actually much healthier in First Aid, any trend to be called here?
I would say that I'm not ready to give you a specific number. We've seen some really nice improvement over the last two quarters, and we expect to get back to and exceed pre-ZEE gross margins and as we grow the revenue I think we’ll make progress on that, but I'm not ready to just call it out specifically yet.
Got it, thanks so much. Happy holidays.
And that does conclude our question-and-answer session. I'd like to turn the call back over to Mike Hansen for any closing comments.
Well, thank you for joining us tonight. And we wish you all a wonderful holiday season. We will issue our third quarter earnings in the latter half of March. And we look forward to speaking with you again at that time. Thank you.
Once again that does conclude today's call. We appreciate your participation.
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