Q3 2013 Earnings Call Company Participants: Operator

Company Name: Cintas Corp.
Company Ticker: CTAS US Date: 2013-03-19 Event Description: Q3 2013 Earnings Call
Market Cap: 5,662.54 Current PX: 45.93 YTD Change($): +5.03 YTD Change(%): +12.298
Bloomberg Estimates - EPS Current Quarter: 0.710 Current Year: 2.541 Bloomberg Estimates - Sales Current Quarter: 1118.400 Current Year: 4291.727
Q3 2013 Earnings Call Company Participants

William Clifton Gale J. Michael Hansen
Other Participants
Sara Rebecca Gubins Nate Brochmann Joe G. Box Andrew J. Wittmann James Samford Andrew C. Steinerman Daniel Hultberg Shlomo H. Rosenbaum Gary E. Bisbee Jason Rogers
MANAGEMENT DISCUSSION SECTION

Operator
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. Bill Gale, Senior Vice President of Finance and Chief Financial Officer. Please go ahead, sir.
William Clifton Gale

Thank you for joining us this evening. With me is, Mike Hansen, Cintas' Vice President and Treasurer. After some commentary on the results, we will be happy to answer 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 third quarter revenue of $1.76 billion, which represents record quarterly revenue for Cintas and growth of 6.3% from last year's third quarter. Organic growth, which adjusts for the impact of acquisitions and the impact of one less workday compared to last year's third quarter, was 6.9%. As we noted in the press release, the organic growth in each of our four operating segments improved from second quarter levels. We indicated in last quarter's call that we expected our Uniform Direct Sales segment to have a good second half of the fiscal year and that was certainly true in our third quarter. The execution of our global accounts and
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Company Name: Cintas Corp. Company Ticker: CTAS US Date: 2013-03-19 Event Description: Q3 2013 Earnings Call
strategic markets and our global supply chain teams during the third quarter was outstanding as we rolled out several large new programs on our way to over 15% growth in the Uniform Direct Sales operating segment. Third quarter net income decreased by 1.7% to $75 million and there were a number of factors that contributed to this decrease. Our third quarter had 64 workdays, which is one less than last year's third quarter. Keep in mind that a number of our large expenses; including rental material cost, depreciation and amortization, are determined on a monthly basis instead of a workday basis and one less workday results in one less day of revenue to cover those expenses. In addition, we have discussed on our last few calls that strong new business sales and the absence of meaningful customer hiring over the past few years have resulted in increasing rental material cost and capacity pressure on our routes. As a result, Rental segment material cost exceeded last year's third quarter material cost, just as it also did in this year's second quarter. We also continued to add route capacity during this quarter to ensure that we have the ability to continue providing excellent service to our customers. In our selling and administrative expenses, our costs associated with employee-related medical benefits, increased by roughly 60 basis points compared to last year's third quarter. Keeping in mind that we are self-insured, this increase was due to new claims experienced during the quarter. Medical costs have historically been in the range of 3% to 4% of revenue and this third quarter expense continued to be in that range. In addition to the higher medical costs, our expenses associated with auto and other liability claims increased roughly 50 basis points compared to last year's third quarter. Despite these added costs during the quarter, our earnings per diluted share for the third quarter did increase over last year's third quarter. This year's earnings per diluted share were $0.60, a 3.4% increase over last year's third quarter of $0.58. This was due to the positive impact of our share buyback program. During the third quarter, we repurchased roughly $28 million of our stock, bringing our total purchases during the last 12 months to $309 million of Cintas stock. As of February 28, we have $191 million available under the current Board authorization for future shares repurchases. As we enter our fourth fiscal quarter, we are updating our fiscal 2013 guidance based on our third quarter performance. We expect revenue to be in the range of $4.3 billion to $4.325 billion and earnings per diluted share to be in a range of $2.50 to $2.54. The guidance assumes the current U.S. economic environment continues and does not worsen going forward. It also assumes no impact for additional share repurchases. Now, I would like to turn the call over to Mike Hansen for more details on the third quarter.
J. Michael Hansen
Good evening. As Bill mentioned, total revenue increased 6.3% from the third quarter of last year, with total company organic growth being 6.9%. Total company gross margin for the third quarter was 41.1%, which is down from last year's third quarter gross margin of 42.1%, but slightly better than this year's second quarter gross margin of 40.7%. I will discuss these items in more detail by segment. Before doing so, let me remind you that there were 64 workdays in our third quarter, which is one less than last year. Our fourth quarter will have 66 workdays, which is the same as last year's fourth quarter. As a planning note for fiscal 2014, we will have 65 workdays in each quarter for a total of 260 workdays, this creates year-over-year workday differences in each quarter except the second and results in one less workday for the entire fiscal year.
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We have four reportable operating segments: Rental uniforms and Ancillary Products; Uniform Direct Sales; First Aid, Safety and Fire Protection Services; and Document Management Services. Uniform Direct Sales; First Aid, Safety and Fire Protection Services and Document Management Services are combined and presented as Other Services on the face of the income statement. The Rental Uniforms and Ancillary Products operating segment consists of the rental and servicing of uniforms, mats, towels and other related items. This segment also includes restroom supplies and other facility products and services. Rental Uniforms and Ancillary Products revenue accounted for 70% of company revenue in the third quarter and totaled $748.9 million, which is up 3.9% compared to last year's third quarter. Organic growth was 5.5%, which is a nice up tick from the 4.5% organic growth rate in the second quarter. Sales rep productivity continued to be strong and we did see a slight pickup near the end of the quarter in our net adds-stops metric. Our Rentals segment gross margin was 41.9% for the third quarter, a 120 basis point decrease from last year's third quarter gross margin of 43.1%. Energy-related costs were down 10 basis points from last year's third quarter. Bill touched on the primary reasons for the decreased gross margin: the impact of one less workday; the higher material costs and service costs associated with added route capacity. The third quarter gross margin of 41.9% was the same as the second quarter. The negative impact of one less workday in the third quarter was offset by the impact of the processing system write-off in the second quarter. Our Uniform Direct Sales operating segment includes the direct sale of uniforms, branded promotional products and other related products to national and regional customers. Uniforms and other related products are also sold to local customers including products sold to rental customers through our direct sale catalog. Uniform Direct Sales revenue accounted for 12% of company revenue in the third quarter and totaled $126.1 million, which represented sales growth of 15.6% compared to last year's third quarter. As Bill mentioned, we had several rollouts in the third quarter in our Fortune 1000 business, including the largest single customer rollout in Cintas' history. Uniform Direct Sales gross margin was 29.2% for the third quarter, down from last year's third quarter gross margin of 30.5%. This segment's gross margin can move from quarter-to-quarter due to changes in mix of product and timing of program rollouts. And this year's third quarter revenue included a much higher mix of Fortune 1000 national account sales, which tend to have slightly lower gross margins than our hospitality and gaming business. Our First Aid, Safety and Fire Protection Services operating segment includes revenue from the sale and servicing of first aid products, safety products and training and fire protection products. First Aid, Safety and Fire Protection revenue accounted for 10% of company revenue in the third quarter. Revenue was $112.9 million, which is up 11.3% over last year's third quarter revenue. Organic growth was 6.9%, which is a nice improvement over the 4.8% organic growth rate in the second quarter. This segment's gross margin was 44% in the third quarter, which is up 80 basis points from the 43.2% in last year's second quarter and the 42.4% in this year's second quarter. Our First Aid and Safety gross margins were very strong due to continued efficiencies gained by the good performance in this business. Our Document Management Services operating segment; includes document destruction, storage and imaging services and it accounted for 8% of third quarter total company revenue. Document Management revenue totaled $87.8 million, which is 8.9% higher than last year's third quarter. Revenue increased organically by 5.8% compared to last year. We have lapped last year's steep drop in recycled paper prices and now have better year-over-year comps. This year's third quarter average recycled paper price remained relatively low at $140 per ton, but this is slightly higher than last year's third quarter average of $135 per ton. This $140 average price also remained lower than our expected third
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quarter paper price of $160 per ton. Our updated guidance for the fourth quarter assumes that recycled paper prices will stay roughly at the $140 level. The third quarter gross margin of 47.1% is comparable to last year's third quarter of 47%. Switching to selling and administrative expenses; SG&A was 28.7% as a percentage of revenue in the third quarter, which is up slightly from the 28.5% in last year's third quarter. As Bill mentioned, medical and auto and other liability claims were up a combined 110 basis points. Offsetting these increases were better leveraging of our G&A functions and constant challenging of our cost structure. Our effective tax rate was 36.1% for the quarter compared to 37% last year. The effective tax rate can fluctuate from quarter-to-quarter based on tax reserve builds and releases relating to specific discrete items. For the full fiscal 2013 year, we expect our effective tax rate to be approximately 37%, which is slightly higher than last year's 36.8%. Last year's rate was impacted favorably by the resolution of federal audits. Turning now to the balance sheet; our cash and marketable securities were $246 million at February 28, down $30 million from the $276 million at November 30. This decrease was due to the $80 million payment of our annual dividend in December, offset by cash generated from operations. Included in the $246 million at February 28 was $54 million of cash located outside of the U.S. Accounts receivable increased by $16 million, since November 30, due to the higher sales level in the third quarter compared to the second quarter. DSOs were roughly 40, which is the same as at last year's third quarter. New goods inventory at February 28, was $247 million, up $11 million from November 30, due mainly to inventory associated with several large Uniform Direct Sales customers. Despite higher sales this year, the inventory level of $247 million is down $29 million since last year at February 29, due to improved inventory management. Accrued liabilities decreased $87 million compared to November 30, primarily due to the $80 million December payment of our annual dividend. Long-term debt at February 28, was $1.3 billion. As of February 28, our total debt to EBITDA remains slightly below two times. Moving on to cash flow; cash provided by operating activities in the third quarter was $141 million, which is up from last year's third quarter amount of $132 million. CapEx for the third quarter was $52.7 million. Our CapEx by operating segment was as follows: $38.3 million in Rental; $1.4 million in Uniform Direct Sales; $2.5 million in First Aid, Safety and Fire Protection; and $10.5 million in Document Management. We expect CapEx for fiscal 2013 to be in the range of $190 million to $210 million. This concludes our prepared remarks and we will now take any of your questions.
Q&A
Operator
Thank you. [Operator Instructions] We'll take our first question from Sara Gubins with Bank of America Merrill Lynch. <Q - Sara Rebecca Gubins>: Hi. Thanks. Good afternoon. <A - William Clifton Gale>: Good afternoon, Sara. <Q - Sara Rebecca Gubins>: You saw a nice pickup in the organic growth trends. I'm wondering if you could talk about the tone of your clients? And any details on types of clients, maybe by industry that are adding programs or expanding their programs?
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<A - William Clifton Gale>: Sara, what we saw was we saw a weak beginning of our quarter. December was relatively weak. January, first couple of weeks started out and then things got a little bit better. And as we got into February, I would say, the latter part of February began to show a little bit of life in the add-stop metric among existing customers. I would say the general tone that I'm hearing from our operating and sales management is kind of a little bit of relief that we got through some of these big issues that the year-end fiscal cliff and some of the other things that were going on, and while I don't think there's a robust attitude that things are going to be really great, I think that there's just kind of a relief and maybe a little bit more optimism in the marketplace. <Q - Sara Rebecca Gubins>: Okay. Thank you. <A - J. Michael Hansen>: And Sara, I would say that, that we did not see any significant one segment has significant improved performance over another. It was generally pretty broad. <Q - Sara Rebecca Gubins>: Okay. And then it's a little hard to compare because of the year-over-year days not matching. But if I look at the guidance for the fourth quarter, it looks like you could be expecting a slowdown in the organic growth rate. So, first, is that correct? And, second, if so, could you talk about why? <A - William Clifton Gale>: I'm not sure that's totally correct. The low-end of our guidance which show growth of about 5.6% and the top-end about 8%, but there I would say, within that guidance we're looking at kind of a quarter relatively similar to what we saw this quarter. <Q - Sara Rebecca Gubins>: Okay. And then just last question, any update on the pricing environment? Is it getting any marginally easier now that there's some incremental optimism? Thank you. <A - William Clifton Gale>: I would say the answer to that question is no, it's no different. The pricing environment appears to be no different than what we've seen for the last several quarters, which is a pretty competitive environment. <Q - Sara Rebecca Gubins>: Okay. Thanks a lot.
Operator
We'll take our next question from Nate Brochmann with William Blair. Please go ahead. <Q - Nate Brochmann>: Good evening, gentlemen. <A - William Clifton Gale>: Hi, Nate. <Q - Nate Brochmann>: I wanted to attack two things. I mean, one, kind of, following on that question, I mean, I'm definitely encouraged to see kind of the organic growth picking up. And I would assume that's in spite of probably a little bit of a weather impact too, I would assume some of your regions seeing a couple of lost days because of weather, compared to last year where we didn't really have much weather. Would that be fair to say that that was kind of a little bit of a headwind during the quarter? <A - William Clifton Gale>: I'm not sure, I could really say that, there were couple of those winter storms, but I didn't hear a lot of problems among our locations with deliveries and that sort of thing. So, there's always a little bit of that in the third quarter in different parts of the country, but nothing out of the ordinary. <Q - Nate Brochmann>: Okay. That's great. And then in terms of adding some of the route capacity back to handle the new business, would it I mean how do you feel about where you are with that right now? Do you have more to go based on the level of business that you have right now? And then also, would it be fair that if we did see some pick up in the economy and the employment rate and that add-stop metric kind of shoot up a little bit at hopefully some point, that we could see even a little bit greater route density than we normally would see in a rising environment like that?
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<A - William Clifton Gale>: Well Nate, that's certainly our hope. What we have seen, we've had just some really nice new business over the last year or so. And as we spoke in the last couple of quarters, we've had to add some routes because we have more stops and we just needed to have the capacity in order to handle that new business. And there is no doubt that when we see adds consistently taking place at our existing customers, that is going to be very beneficial to route density and thus it's going to have a nice marginal impact positively on our results because not only will we get more revenue from a stop but we'll be able to utilize with adds more of our existing Stockroom inventory as customers do add employees to their head count. Now, is that going to necessarily happen in the fourth quarter? I don't know. I hope that we'll begin to see some of that but it's still been a pretty sluggish employment growth especially in the Uniform Rental wearing sectors but with the little bit of uptick we saw at the end of the February maybe that will continue. I know there's been a few analysts who have put out some reports of their surveys with private customers that indicate there might be some trends of that. So we'll have to wait and see but we're certainly going to have the capacity on our routes to handle those adds if they do occur. <Q - Nate Brochmann>: Okay, great. Thanks and definitely optimistic for that to hopefully start trickling through, so.
Operator
We'll take our next question from Joe Box with KeyBanc. Please go ahead. <Q - Joe G. Box>: Good afternoon, guys. <A - William Clifton Gale>: Hi, Joe. <A - J. Michael Hansen>: Hi, Joe. <Q - Joe G. Box>: So, you've put up two consecutive years of solid SG&A leverage and obviously that abated this quarter and I get it that medical costs and liability were up a combined 110 basis points. I guess I'm just curious, do you see those headwinds reversing in the coming quarters or could we be looking at an ongoing drag? And then I guess more importantly, how should we think about SG&A leverage going forward? <A - William Clifton Gale>: Joe, I don't think we expect those type of spikes to continue. Of course we're self-insured for medical benefits and you are going to have quarters when you'll have some relatively expensive cases and this happened to be one of them that we had several that must have hit. But I'd say that we would expect if you look over the average cost of our medical benefits over the past year or so, it's been lower than what we saw in this most recent quarter. So I have no reason to expect that to increase at least this year. Obviously going into 2014, all companies are going to face some additional costs associated with some of the requirements of the Affordable Care Act. But that's going to be every company is going to feel that. As to these cases, again I think that's kind of an aberration. I can't say that it won't happen again but it's more likely not to happen than to happen. So with all that said, I'd say as long as we continue to see that top line growing, we're going to see some additional SG&A leverage not necessarily to the same degree we've seen over the last two years, but some marginal continued leverage improvement in the SG&A line. <Q - Joe G. Box>: Okay, great. That's helpful, Bill. And then maybe switching gears to the merchandise amortization component, can you maybe just help us understand the different moving pieces? Was there a benefit from lower cotton but yet that was more than offset by newer uniforms going out, just kind of curious for some color there. <A - J. Michael Hansen>: Sure, Joe. When we look at material cost, as we mentioned it was higher this year than last year. But what we did see is that the increase in the third quarter over last year was less than the year-over-year increase in our second quarter. And we talked numerous times in the past about how we expected cotton to peak mid fiscal 2013 and so we probably did get a bit of a relief coming off of that. But also, just saw a little bit of a decrease in the rate of the material cost increase, so it was a positive sign during the quarter.
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<Q - Joe G. Box>: And maybe can you just talk about some of the garments that you've put out into service post recession, I mean we're coming up against a couple of years of pretty good growth. Are you starting to replace some of those uniforms and products now or is that not really coming up yet? <A - J. Michael Hansen>: No, I think that certainly can come up and it just depends on the type of the customer and how they use their garments and we will always be replacing garments but I wouldn't say that we've seen a serious uptick in the amount that we're pulling from the Stockroom based on these new accounts put in service over the last couple of years. I would say that more of the impact has been we're just continuing to sell new accounts. <Q - Joe G. Box>: Okay, got you. Last question then I'll turn it over. On the Direct Sales side, clearly a standout, can you just talk to the longevity of some of these programs? I mean are they meant to last a few quarters, last a year or are they generally more seasonal in nature? <A - William Clifton Gale>: Well, I wouldn't say they're seasonal but they're more related to a specific customer requirement to do the rollout. So, our sales organization is constantly working on replenishing these types of big account rollouts, but obviously it's dependent somewhat on the customer themselves. So, what you saw this quarter is probably not repeatable in the short-term. We would expect there still to be positive growth in the Direct Sales segment in our fourth quarter but this certainly was kind of an unusual event, one that we knew was coming. And that's the nature of Direct Sales. We see this all the time where we can have these very, very high growth quarters followed by flat to somewhat down quarters and it just is the nature of the business. <Q - Joe G. Box>: Understood. Thanks, guys.
Operator
We'll take our next question from Andrew Wittmann with Robert W. Baird. Please go ahead. <Q - Andrew J. Wittmann>: Good afternoon, guys. <A - William Clifton Gale>: Hello. <A - J. Michael Hansen>: Hi, Andy. <Q - Andrew J. Wittmann>: Hi. So, you talked about the extra workday setting up for comparisons on the revenue side. It's kind of harder to peel out what the margins would be adjusted for that. Is it fair to kind of gross up the revenue from this quarter by that extra day, look at the same cost structure and then compare that to last year? Is that a fair way to look at it or if we do that, are we missing something? <A - William Clifton Gale>: That's a little too simplistic I think, Andy. I mean you can do a little bit of that but, like when you look at some of the Rental gross margins, but the problem we have is the quarter gets kind of complicated when you have some of these things that we talked about in SG&A. When you have a different mix percent of the Direct Sales business than you had in previous quarters versus the Rental business and the Direct Sales business tends to have a little less margin, so you have to be a little cautious. I think suffice it to say that we certainly are impacted negatively on a margin standpoint when we have fewer workdays because, as Mike mentioned, with material costs, depreciation, amortization all being done on a monthly basis, that can have a 50, 60 basis point differential just on the margins. And then you get other things that are being factored in there. <Q - Andrew J. Wittmann>: Okay. I guess that makes sense but it sounds like if you were to do it, the only segment that you'd even have a chance would be the core Rental segment. And I guess if I do that math, I see kind of a 20 basis point gross margin hit and a 30 basis point Rental hit, which it's not up but it's not there's clearly a very big impact from the extra day. <A - William Clifton Gale>: Yeah, but I think I wouldn't make too much out of a 20, 30 basis point change. I mean your mix of new business, the mix of the types of the business, those type of variations are going to happen quarter to quarter.
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<Q - Andrew J. Wittmann>: Yes. Okay. That's good. And just in terms of the routes, you kind of talked about this a little bit but you've split some routes. Is the business supportive of continuation of that or is it now have you done the splitting of the routes and now it's just making those happen? Or should we see the route splitting as maybe an ongoing headwind to near-term leverage with long-term benefits? <A - William Clifton Gale>: I think, let's keep in mind, I think the splitting of routes is a good long-term strategic move to enable us to serve more customers. And we will continue to I think be very successful in selling new business and therefore we need to stay ahead of the game and having the routes available to handle the new business so that we can properly take care of our customers. So I see it going on. What I hope will happen is obviously, we'll see some improvement in the attitude of businesses to hire additional people at existing stops and increase the amount of revenue without increasing the number of stops in all our routes. But with a very large sales force that is very productive, and we think we have some competitive advantages with product and with service systems, we'll continue to see robust new business and when you have new business you'll have to have the route capacity to handle it. <Q - Andrew J. Wittmann>: Is there any one of your segments that's getting a disproportionate amount of new routes still? <A - William Clifton Gale>: The Rental I'd say any of our route-based businesses are all adding routes. <Q - Andrew J. Wittmann>: Okay, great. And then just final question, Mike, document constant currency ex-paper, what was that for the quarter? <A - J. Michael Hansen>: We had a nice improvement in the quarter to 7.1%. <Q - Andrew J. Wittmann>: Great. Thank you very much.
Operator
We'll go next to James Samford with Citigroup. Please go ahead. <Q - James Samford>: Thanks. Just wanted to touch on a few things, fuel prices and natural gas have been on the rise here, you're still seeing some leverage on the energy cost side. Just wondering if you could comment on whether how we should think about Q4 in terms of energy cost with the current levels of commodity prices? And how does adding new routes impact the energy cost line just in general? <A - William Clifton Gale>: Right now, our energy costs as a percent of revenue were relatively consistent with what we saw in the second quarter, were a little over 3% of revenue. And the natural gas prices, yeah, have shown a little bit of uptick but not significant enough that I would think there'd be a big change. Quite honestly, James, it's the price of the gas and diesel, the more dramatic change in those prices have a bigger impact on our energy costs overall because that's the biggest percentage of our energy costs by far. As to the route capacity, the more trucks you have on the road, the more gas you're going to use. So you certainly will see an increase in utilization of gasoline and diesel because you have more trucks and therefore we'll have that cost going on. We won't get the leverage necessary on the revenue line that we would if we were not adding route capacity and were just seeing revenue increases at existing accounts. <Q - James Samford>: That's fair enough. That's what I was trying to get at. But from a capacity perspective, where do you stand right now in terms of total wearers versus prior peak and maybe comment on what the mix of Rental wearing versus other products is at this point? <A - J. Michael Hansen>: Well, we still have fewer wearers today than at the peak. I won't get into the details any more than that but because of that, we still have capacity generally speaking, and more than we did in 2008. Now, capacity is certainly a local issue and there are some spots that have grown faster than others in the last couple of years. And we may have some capacity needs from a plant standpoint in the next few years. But generally speaking, we have
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some pretty good capacity and when I talked about fewer wearers today, our revenue is higher than it has ever been and that's because we've replaced those the revenue from those lost wearers with other things like cleaning chemical solutions and hygiene products that don't require a lot of capacity. So to answer your question, plant capacity is still pretty good. <Q - James Samford>: I guess one quick question on the Affordable Care Act. I know you've talked about some impact on your business. Any sort of update on where you're thinking the impact in 2014 might be and what kind of offsets you have or levers you have to the change to absorb some of that cost? <A - William Clifton Gale>: Well I think everyone is aware that it's getting a lot more press. There was an article on the Journal about a week ago that talked about the $63 charge that everyone is going to have to pay for every covered individual and their dependents. So, the rules are just getting announced and written. There certainly is going to be an increase. So what is our strategy? Well, our strategy has got to be to provide our employees with a decent medical program but because of the significant increases in costs, they're going to have to share in some of that through higher weekly cost of their share of the cost, maybe higher co-pays. We're offering some high deductible plans and inducing employees to get into those that we think that would help us control our cost. And we continue to work with our various suppliers in trying to get the best deal possible in terms of the amount we have to pay for prescription drugs, for medical coverage, et cetera. There is just no doubt that there's going to be some increase in overall cost both to the employee and to companies and we'll do our best to keep that cost to a minimum. But there's still a lot to be resolved yet in terms of what the government is going to be forcing companies to do and we're just watching it and then we'll try to react accordingly. <Q - James Samford>: Great. Thank you.
Operator
We'll go next to Andrew Steinerman with JPMorgan. Please go ahead. <Q - Andrew C. Steinerman>: Hi, gentlemen. I want to ask about the Rental gross margin line, which is down 120 basis points. I know you explained the reason. If it was not for the one less day, how close to even would Rental gross margin be in the third quarter? And is there a shot that Rental gross margin will be up in the fourth quarter given your comments about add-stop and even days? <A - J. Michael Hansen>: Well, if you would adjust for the workday in the third quarter, as Bill mentioned, we would see the Rental gross margins likely go up about 50 basis points because of that one day, one less workday. It was about a 50 basis point impact. Last year's fourth quarter gross margin in Rental was 43.3% and do I think we can get to that? You know, it depends a bit again on how our revenue comes back. If we continue to see a movement, a positive trend in add-stops like we saw the end of this quarter, then certainly we can see a very good gross margin in the fourth quarter. If however that doesn't play out and we turn to a negative trend or a flattened trend, then because of the increase in routes, we may have a little bit more difficulty matching that gross margin from last fourth quarter, last year's fourth quarter. <Q - Andrew C. Steinerman>: Good. That's very helpful and promising. And if you could go to the acceleration of Rental revenue growth in the third quarter, which pieces to revenue growth accelerated year-over-year in Rental? <A - William Clifton Gale>: It really came through both the uniform wearer as well as the facility services. It was kind of consistent. We've seen some very nice growth continuing albeit from a relatively low base in the chemical dispensing and the tile and carpet cleaning. But I was encouraged with seeing kind of an across-the-board improvement with pretty much the core business, the dust business, the rental garment business. We've expanded into some different segments like healthcare with some microfiber mops and wipes and scrub rental and I think that has been somewhat of a benefit for us also.
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Again, it was not consistent through the whole quarter. As I mentioned earlier, we had a tough December but we began to see a little life in mid-January and then it kind of picked up as we moved through the end of February. So, I am I'd like to say I'm very optimistic for the fourth quarter but I can't because I just don't know what's going to happen but at least the trend was more positive as we exited the third quarter. <Q - Andrew C. Steinerman>: Bill, often you describe that same thing in terms of new business/lost business. So if you take the third quarter as a whole, did new business accelerate the lost business ebb? <A - William Clifton Gale>: Lost business ebbed a bit. New business again was very strong especially in the second half of the third quarter. <Q - Andrew C. Steinerman>: Perfect. Thanks for the color.
Operator
We'll go next to Scott Schneeberger with Oppenheimer. Please go ahead. <Q - Daniel Hultberg>: Hi, guys. This is Daniel Hultberg filling in for Scott. Can you take us a little deeper on the strategy employed to drive some cost leverage in the business please? Thank you. <A - William Clifton Gale>: Well the strategy has been always to get as much capacity and revenue on our routes and route as we mentioned earlier route density is a key to that. Utilization in our plants is certainly something that we're always looking for and then the SG&A leverage. So our strategy has been to always add routes as needed to handle additional stops and then do whatever we can to increase revenue at those stops. <Q - Daniel Hultberg>: Okay. Thank you.
Operator
We'll go next to Shlomo Rosenbaum with Stifel Nicolaus. <Q - Shlomo H. Rosenbaum>: Hi. Thank you for taking the questions. Bill, is there anything that is different about the add-stop change at the end of the quarter? We've had a number of head fakes with add-stops. It's clearly the biggest lever of potential for your business. Is there any sense that you have at this point in time you might be feeling the real thing as opposed to the head fakes we've got a couple times the last few years? <A - William Clifton Gale>: No. I can't I couldn't tell you that convincingly. <Q - Shlomo H. Rosenbaum>: Come on, come on. <A - William Clifton Gale>: I wish I could but I can't. I agree. <Q - Shlomo H. Rosenbaum>: And how long I guess when you talk about the end of the quarter, I guess how long did you see it for? In other words, you guys manage your business I assume on kind of more of a weekly basis. So, how what part of the quarter did you see that in? <A - William Clifton Gale>: The last two to three weeks. <Q - Shlomo H. Rosenbaum>: And did that continue going into this quarter? <A - William Clifton Gale>: You know, we looked we really don't have anything yet. This is pretty early in March. So I would say I don't have anything that I could really look at and tell you whether it did because it's just difficult that we're so early in the month. <Q - Shlomo H. Rosenbaum>: And then, the trends of the business have been improving and I'm trying to bridge that with the EPS guidance kind of being narrowed down to the lower half. What are you expecting to change in the fourth
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quarter? <A - William Clifton Gale>: Well, a couple things. One is of course the paper price. As Mike alluded to, we've now reduced our expectation on paper price in the fourth quarter from what we assumed back in December when we gave you that updated guidance and that probably cost us in that quarter alone $0.015 or so. We are also a little bit concerned that maybe we will not have a repeat performance of the medical, the lower medical expenses we saw last year and therefore, based on what we saw in the third quarter, we've up we've ticked that up a little bit. We continue to expect there to be more impact the material cost impact. Although, we've seen that trend come down a little bit, we still think that will be higher than last year's fourth quarter. I think the tax rate's a tad bit higher. So, I'd say those are the major factors. But with all that said, we're still looking at the fourth quarter, our guidance still indicates a fairly nice improvement in operating income in the fourth quarter over last year even looking at the low end of the guidance. So, I feel pretty good that it's going to be a decent quarter assuming that the revenue comes in. <Q - Shlomo H. Rosenbaum>: So, just to quantify some of that, is it fair to say that the tax rate in total is $0.015 per quarter. So like $0.03, is the difference not the tax rate. I'm sorry. The paper pricing? <A - William Clifton Gale>: The paper price was yeah, based on what we thought it was going to be in December, it's like $0.015, yes. <Q - Shlomo H. Rosenbaum>: So is it $0.015 per quarter or $0.015...? <A - William Clifton Gale>: Per quarter. Per quarter. <Q - Shlomo H. Rosenbaum>: So $0.03 out of the $0.04. <A - William Clifton Gale>: Right. $0.025 to $0.03. Shlomo. <Q - Shlomo H. Rosenbaum>: Okay. And then tax rate is kind of a fraction of $0.01? <A - William Clifton Gale>: Yeah. Okay. You're getting into the minutia. I... <Q - Shlomo H. Rosenbaum>: All right. [indiscernible] (45:01) the bulk of it it sounds like it's the paper pricing is what it sounds like. <A - William Clifton Gale>: The bulk of it, I would say, is the paper prices and a little less a little more concern on some of these expenses like medical benefits, liability claims, that sort of thing that which is because we saw a little uptick in the third quarter. <Q - Shlomo H. Rosenbaum>: Okay. That's fair. Thank you.
Operator
We'll go next to Gary Bisbee with Barclays Capital. Please go ahead. <Q - Gary E. Bisbee>: Yeah, hi guys. Good afternoon. <A - William Clifton Gale>: Hi, Gary. <A - J. Michael Hansen>: Hi, Gary. <Q - Gary E. Bisbee>: Can you you were kind enough to give us the impact of the one less workday on the Rentals gross margin, can you give us a sense either the actual numbers or directionally the other two issues how much they contributed to new customer impact and the route investments? <A - J. Michael Hansen>: Gary, we haven't gotten into those to that level of detail and we'd prefer not to.
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<Q - Gary E. Bisbee>: Okay. That's not very helpful but I'll move on to the next one. How about some color on the how the new business has trended over the last 12 months to 18 months? And in particular what I'm getting at is when will some of this amortization start to roll off? Has this picked up a lot like in the quarter so that that expense is going to be there for a while? Or is this the combination of new business having improved over the last year and so as you rolling off quarters, it wasn't as strong in adding in several where you've had good growth that sort of the impact? I'm trying to think how long is this headwind is really the question. <A - William Clifton Gale>: Well, I guess I would answer that question by saying if we were to stop selling new business, it wouldn't become a headwind but the fact is we still have an awful big sales force and they're continuing to be very productive so we're always going to have new business. And as a result of that, you're always going to have that kind of injection of products. So, I'm not sure you're going to see a significant drop in the material costs because the amortization drops. <Q - Gary E. Bisbee>: I guess what I'm getting at... <A - J. Michael Hansen>: As I mentioned, Gary As I mentioned, Gary, though the rate of increase year-over-year in our third quarter was less than our second quarter. And so, we started to see a bit of that start to happen. In other words, the headwind was a little bit less in the third quarter than in the second quarter. And if we get a little bit of help with net add-stops in the fourth quarter, we might get a little bit of we might get a little bit more help in the fourth quarter. We did see some of that was cotton from the second quarter to the third quarter. But again, this saw a little bit of an improvement in the rate of increase and I would say rather than all of a sudden a headwind going away, it's probably going to be something that goes away very slowly over time. <Q - Gary E. Bisbee>: Okay. <A - J. Michael Hansen>: Unless we see a real change in net add-stops. <Q - Gary E. Bisbee>: Okay. All right. Fair enough. Can you give us any color on where the improvement in add-stops came from? Was it more the wearers or more potentially bad weather leading to more jackets which I've heard you reference in the past? Or anything like that to help us understand exactly where it improved? Thanks. <A - William Clifton Gale>: It was more wearers and more facility services product adds. <Q - Gary E. Bisbee>: And then just one last question from me. I know I've asked you this a lot over the last couple years but at what threshold do you think about breaking out the hygiene and facility services business into its own segment? I think with the fourth quarter of last year when you gave us a mix, it looks like it's getting close to that 10% threshold at which companies start to do that. Is that something you might do the next fiscal year? And why not? <A - William Clifton Gale>: No. Because we cannot properly split out the costs since they are housed in the same facility and often on the same routes. So there is it would be a beset with a tremendous amount of allocations in order to split out the cost side and as a result of that, we are not going to do that in the near term. <Q - Gary E. Bisbee>: I thought the Sanis business, when you acquired that many years ago had its own route and a lot more of that was going off on different trucks. Is that not the case? <A - William Clifton Gale>: It's a mix. There's a lot of trucks that are mixed trucks. There are trucks that are exclusively facility services. But it's not clear cut. <Q - Gary E. Bisbee>: Okay. Thanks for all the color.
Operator
And our final question comes from Jason Rogers with Great Lakes Review. Please go ahead.
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<Q - Jason Rogers>: Thanks for taking the question. I just wanted to get an update on your business internationally as well as growth opportunities there currently? Thanks. <A - William Clifton Gale>: Well, our business internationally right now is I think we've said about 40 a little over $40 million of revenue in Document Management in Europe. And not doing very well. They have experienced some difficulties in growing the business over there and in fact they shrunk a little bit from the third quarter last year. Profitability has improved somewhat and we've been spending resources trying to improve the profitability. But we have we've had some issues with that and I think they are really caused more by the macro issues of Europe in total than by anything else. As far as other international business, we do sell uniforms to many of our U.S. based customers, our North America based customers throughout the world. We are seeing a pickup in that, more interest in having to service them, but again it's a relatively minor piece of our overall business. Our focus continues to be in North America 95%, 98% of our business between 95% and 90% of our business is North American and that's really what our ongoing focus is going to be.
Operator
That does conclude our question-and-answer session. At this time I'd like to turn the conference back over to your presenters for any closing comments.
William Clifton Gale

Thank you again for joining us. Mike and I appreciate everybody's interest and we will look forward to speaking with you on our fourth quarter earnings release sometime in mid-to-late July. And we'll look forward to talking to you then. Goodnight.
Operator
This does conclude today's conference. We thank you for your participation. This transcript may not be 100 percent accurate and may contain misspellings and other inaccuracies. This transcript is provided "as is", without express or implied warranties of any kind. Bloomberg retains all rights to this transcript and provides it solely for your personal, non-commercial use. Bloomberg, its suppliers and third-party agents shall have no liability for errors in this transcript or for lost profits, losses, or direct, indirect, incidental, consequential, special or punitive damages in connection with the furnishing, performance or use of such transcript. Neither the information nor any opinion expressed in this transcript constitutes a solicitation of the purchase or sale of securities or commodities. Any opinion expressed in the transcript does not necessarily reflect the views of Bloomberg LP. COPYRIGHT 2013, BLOOMBERG LP. All rights reserved. Any reproduction, redistribution or retransmission is expressly prohibited.
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Q3 2013 Earnings Call Company Participants

MANAGEMENT DISCUSSION SECTION

William Clifton Gale

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