信達思 (CTAS) 2017 Q2 法說會逐字稿

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 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 FY17.

After our commentary, we'll 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 a year-over-year, and a sequential increase of 290 and 30 basis points, respectively, due to the realization of synergies from the acquisition of ZEE Medical in FY16.

Operating income for the second quarter of FY17 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 are updating our annual guidance.

We expect FY17 revenue to be in the range of $5.180 billion to $5.225 billion, and FY17 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 Employee Share-Based Payment Accounting, and the impact of one less workday in FY17, compared to FY16.

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 quoted in today's press release, we are pleased with our second quarter results.

They 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're 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 US and Canada, and other customary closing conditions.

The merger was approved by G&K shareholders in November.

We continue to work toward attaining 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 FY17 contains one less workday than in FY16.

It is the third quarter of FY17 that has one less day than the prior year quarter.

We estimate that this will negatively impact FY17 total revenue growth by about 40 to 50 basis points, and operating margin by approximately 10 to 15 basis points in comparison to FY16.

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.

The 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 routes.

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 continued to see the impact 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 a 110 basis point impact in the previous quarter.

Our uniform rental and facility 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 this 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 month 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 relied only upon SSRs to grow the business.

The added sales reps will help us grow the acquired customer base by penetrating with our broad range of products and services.

As a result of this investment, 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 onboard and goodwill 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.

The 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 facility 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 margins 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 a 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 Workday, and sales resources to grow recently acquired customers in our first aid and safety segments.

Regarding the increase in medical expenses, note that we are self-insured, and we had a handful of atypical, very expensive claims in the quarter.

I mentioned that SG&A was impacted by our investment 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 are 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 FY17 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 temporarily higher as of the end of our 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 have 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 FY16, we entered into an interest rate lock agreement with a notional value of $550 million for a forecasted debt issuance.

In anticipation of debt issuance for the closing of the G&K acquisition, and to protect Cintas from rising interest rates, we recently 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 FY17 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 balance as of August 31.

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 repayment 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 FY17 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 Shred-it.

Proceeds were about $26 million and recorded in the investing section of the cash flow statements.

That concludes our prepared remarks.

We are happy to answer your questions.

(Operator Instructions)

We do have our first question from Manav Patnaik with Barclays Capital.

Yes, good evening, gentlemen.

Thank you for the call.

First question is just around the acceleration in the uniform rental business.

Maybe just a little bit more color, like was it broad-based?

Was it a couple of -- was it selling more mats, towels, or anything?

And then, how sustainable do you think that is?

Well, we -- so our organic growth rate from the first quarter to the 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 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 see some change.

But we feel very good about our execution.

And that's where we've been -- that's where our results have been for a number of quarters, except for that one vertical.

Okay.

And I think Paul said that you think oil and gas is at the bottom, 75 basis point 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, Manav, it's Paul.

We estimate that that headwind that went from 110 to 75 will continue to step down in Q3 and Q4, such that for the full year, the headwind would probably be in the 75 to 85 basis point range for the full year.

Okay.

Got it.

And then, just on first aid and safety, your comments on improving growth rates for the remainder of the fiscal year, again, just some color on from 3.3[%] how do we step it up?

I know you talked about monthly was better.

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 a 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 over time.

And we certainly expect to make progress on that in the back half of the year.

Okay.

All right.

Great.

Thanks a lot, guys.

Our next question comes from Toni Kaplan with Morgan Stanley.

Hi, good afternoon.

Hi, Toni.

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 and the national branding campaign and medical expenses as being 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 double-digit SG&A expense growth for the rest of 2017 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 move out of the pilot and into the full implementation.

The spend that we have talked about tonight, $20 million to $25 million, as 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 have a coordinated effort to move forward in the right way with both of those projects.

If you 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 about 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.

That's great.

And can you talk about you 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?

Well, certainly, we've seen a lot of positive sentiment, and at this point in time, it's just sentiment.

And so, we've got a 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 US-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're 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 improvement.

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.

Perfect.

Thanks for the answers, and happy holidays.

Thank you.

Our next question comes from Nate Brochmann with William Blair.

Good evening, gentlemen.

Hello, Nate.

So wanted to ask a couple things.

One, I'm obviously over the last five years, you've really changed the direction of the Company, in terms of developing new end markets and new services and whatnot.

Could you talk a little about how the culture has evolved along with that, in terms of supporting those new entrepreneurial efforts?

And also too, just looking forward, what do you think the next milestones are over the next three to five years post the integration of 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, prior to the last cycle, we were building the footprint still.

We were adding sales reps, and we were getting a lot of growth in that manner.

And as we fully built 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.

And 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's no doubt we've changed from a company 10 and 15 years ago, where we're building a footprint to a company that's really looking for more and unique ways of serving businesses.

So as we move forward then, we've got some exciting things 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've got, is a great infrastructure to provide services to 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 then, just one little bit of -- a quick clarification on the last question.

But talking about the encouraging sentiment, 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 that nuance?

Or are you hearing that out of your customers as well, in terms 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 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 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 it's felt in the last few quarters, with the exception of that -- 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.

Appreciate it.

Sure.

Our next question comes from Andrew Steinerman with JPMorgan.

Hi, there.

You presented the way you have your FY17 EPS guide a little bit differently in the second quarter press release than 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 accounting benefit and before G&K costs?

And just to make sure, did you say, lower it by $0.03?

EPS, yes.

I think you lowered the range by $0.03.

Yes, I -- that's not the way I see it, Andrew.

Go ahead.

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 $4.55 to $4.63, 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.

Yes, yes.

That gets us to a $4.50 to $4.58, compared to tonight's range, or today's range of $4.51 to $4.59.

So I would see it as -- it's really about the same, but a $0.01 higher.

Okay.

Thank you very much.

Our next question comes from Hamzah Mazari with Macquarie Capital.

Good afternoon.

Thank you.

Mike, just wondering, on your net financing costs, you spoke about locking in financing and interest rate, certain interest rates.

Could you give us a sense of how we should think about pro forma [net] financing costs, 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 in 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 new administration, if there's higher tariffs on overseas sourcing, does that impact you guys at all, or is that not material?

And any color, that would be great?

Thank you.

Well, it -- 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, 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 will -- we'll work to see how can we manage that labor input as best we can.

And so, I guess, what I'm telling you is, it's a large part of our cost structure, but 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 it 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 time frame, 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.

Great.

Thank you.

Next question comes from Andy Wittman 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 $0.01 raise.

If you go a step further, 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 those -- if you just assume SAP and healthcare, then you're still back to the flat, to maybe a $0.01 pickup?

Would you agree with that, Mike?

Yes, I would say, it's right around there, Andy.

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 it's 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 Toni a little bit ago, we will continue to see some elevated SG&A because we're going to make sure we're ready for that -- for both of those projects.

And all of that's incorporated into that guidance.

Yes.

You brought up the two big programs that you're running.

It sounds like -- you didn't say it this way, but it 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 million to $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?

Yes, I would say that it's getting a little bit combined with -- those two projects are getting fairly connected.

While we're not ready to say that that $40 million to $45 million 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.

Maybe one way to look at it from just a system spend is to say, we had originally looked at that SAP integration for ourselves, as being the second half of FY17, and then all of FY18.

And I think Paul and I have said over the last couple calls, as we insert G&K into that, it's likely going to go into FY19, and we still believe that.

And so, there's probably going to be the same effort in FY18, but just a little bit more effort in FY19.

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 pulls in that -- in the synergy effort with G&K is that system conversion.

And so we're going to be continuing to work on it.

I'm not ready to change it from the $40 million to $45 million.

But I think it will go into 2019, just because we've got more locations.

Does that answer your question?

Yes, I think that does.

It gives a character of how you're thinking about it.

Thank you for that.

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 add/stop 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 less or more competitive today.

That would be helpful to give us some context as some of the drivers into that acceleration into organic growth.

Yes, Andy.

It's Paul.

The add/stops, 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 add/stops 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 add/stops.

And then in terms of pricing, no change.

Still very competitive, but nothing significant to speak of.

Okay.

Thank you very much.

Next we have George Tong with Piper Jaffray.

Hi.

Thanks for taking my questions.

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's 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 million] to [$20 million] in the back half of the year, little bit more of it's 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 primarily in the first quarter.

And so you're 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 the routine.

Got 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 higher rate in future quarters?

The atypical 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 these high dollar claims, we generally don't need to necessarily include that in our IB&R going forward.

Got it.

Thank you.

Next we have Joe Box with KeyBanc.

Hello, guys.

Hi, Joe.

So obviously there was a lot of commentary around why the organic growth rate in uniform stepped up sequentially.

But I was actually hoping that maybe you could deconstruct where the 6.5% organic growth was actually coming from.

Maybe just give us some 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, the 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 a period of lower diesel costs.

Have you guys given any consideration to maybe pushing through a surcharge mechanism to your customers, or maybe doing some hedging on that front?

We don't.

That's not -- that diesel or gas surcharge is not something that we do.

And Joe, we're buying gas every day 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.

Okay.

Okay.

Thank you.

Our next question is from Scott Schneeberger with Oppenheimer.

Thanks.

Good afternoon.

Could you guys address the branding campaign?

Maybe I'm watching less TV, but I haven't seen as much of 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.

(laughter) But no, the rebranding campaign is going very well.

We're still not far enough along that we have enough of a full body of work to be able to analyze and come back to you with a return on our investment.

But anecdotally, what we're hearing from our partners, the customers, it's all very positive.

In FY16, 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 FY17.

As I said in the prepared remarks, we'll 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, that you answered a prior question saying that the spend is done, the initial change.

And now, you have a -- curious to see how much of that is variable, might we see that pick up, or will it be commensurate with production?

And you're obviously only giving guidance for the fiscal year-end.

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 2017, 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'll -- we made a larger than typical investment in the first quarter.

Those partners are now starting to become productive.

But we will -- we'll 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.

But yes, to your question, not only do we see, or we expect some improvement 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.

Mike, sounds good.

Thanks.

Our next question comes from John Healy with Northcoast Research.

Thank you.

I wanted to ask just a little bit more explanation on the ZEE Medical business and some of the deceleration in the first aid and safety organic growth.

Can you help us understand what was going on with the sales force?

And is it now simply that Cintas salespeople were trying to go and retain the business, and weren't focused on growing it and selling it?

Because we've seen the organic growth rate come down for about three or four quarters in that business.

I'm just trying to understand the mechanics of what happened in the field.

Sure.

So we -- let's go back to -- we made that deal in August of 2015.

And the first thing that we needed to do was get that business onto our systems.

When we are operating on their system, it's hard for us to go and hire a sales rep and put them onto their system, and -- 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 product.

This, in ZEE's case, they didn't have salespeople.

They let -- they had their drivers, their service sales reps, or as we call them SSRs.

They had their SSRs 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 onto our system.

That, as we've talked about, took us really through the entire FY16 year.

And so as we are doing that conversion onto our system, then we have to make sure that we train those SSRs 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 routes, 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 salespeople start to drive revenue.

And so in this case, in the case of ZEE, we didn't invest in salespeople 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 are ready to really begin aggressively selling, and we should see that organic growth improve.

Okay.

No, that's helpful.

And Mike, just along the same lines, when you think about the G&K acquisition, obviously, they have sale people and what we call SSRs as well.

Is it reasonable to think that you might see organic growth in the laundry business, macro condition is 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 a 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's 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 salespeople, how to sell Cintas product, how to sell using our policies, our procedures and our tools.

And so there's 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 ZEE for a second, our gross margin dollars are up 56% over pre-acquisition dollars.

And so while there is some pressure on the top line, we are really creating synergy opportunities and really creating cash flow because of the synergies we're able to create.

Great.

Thank you.

And just one final question.

When you look at the acquisition of G&K, I know you guys have put out the $140 million -- the $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 merchandise.

Is there a way to think about how much of the synergies would be leaked away because of that?

I'm not quite sure I understand the question and I --

I would just say, John, that I think we're still very comfortable with the $130 million to $140 million.

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 million to $140 million.

So nothing related to your question that causes us pause at this point in time.

Right, but is that $130 million to $140 million before or after any purchase accounting associated with the merchandise 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?

Well, 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)

But would it reflect that impact?

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.

Okay.

Thanks.

And next up we have Gary Bisbee with RBC Capital Markets.

Hello, guys, just a couple of quick ones.

I know it's getting late here.

What is the cost of the swaps or the interest rate activity you did between now and actually getting the financing to close the deal?

Should we think that interest expense changes because of these things you're doing now to prepare for taking on that debt, or is that not going to be [material]?

Yes, generally there's not a cost, and there's 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.

Okay.

Great.

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, you've 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 the mix of timing within the year, the third quarter is that, on a year-over-year basis, the branding spend likely to be more?

Is that something that will be a drag on margin?

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's still more in that Q3 than in the Q4 of FY17.

Yes, okay.

Fair enough.

And just the last one on that, the energy comps, can you give us a sense how much you think that changes from this quarter you just reported, in terms of energy costs, fuel cost?

I think if you do 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 asking about the fuel costs.

I think you said --

Oh, sorry.

(multiple speakers)

[Where] gasoline and diesel prices were, that the low was the third quarter a year ago, so --

Yes, I -- (multiple speakers)

Yes.

(multiple speakers)

Is that [materially] different sequentially, February versus the November you just reported?

Yes, I don't have the data with me by quarter, but I can tell you this.

Because we've already given you what our Q1 energy was about 1.9% of revenue, Q2 was 2%.

We think we'll end 2017 in like the 2% to 2.2% range.

So we're expecting prices at the pump to rise.

That compares to about 2% for FY16

Yes, 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.

Okay.

All right.

Great.

That's very, very helpful.

That's all I've got.

Merry Christmas.

Happy holidays.

Thank you.

Same to you.

And our final question comes from Dan Dolev with Instinet.

Hey, guys.

Hi, Dan.

Thanks for taking my question.

So 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 broke a little bit of a trend.

You were running at [63]%, maybe like in [56%] range.

What should we expect looking at third quarter and fourth quarter in terms of gross margin incremental, in rental?

I would say this, Dan.

Last -- for FY16, 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 margin 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 thing 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.

Is that pressure versus the second quarter or pressure versus the -- ?

Pressure versus what we saw in the second half of last year, or relative to this 60%-ish.

Got it.

What about the other incremental, they were 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 call it out specifically yet.

Got it.

Thanks so much.

Happy holidays.

Thank you.

You too.

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.

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.