Terminix Global Holdings Inc (TMX) 2003 Q3 法說會逐字稿

Ladies and gentlemen thank you for standing by. Welcome to the ServiceMaster Company third quarter 2003 earnings conference call. During the presentation all participants will be in a listen-only mode. Afterwards we will conduct a question and answer session. At that time if you have a question please press the one followed by the four on your telephone. As a reminder this conference is being recorded Wednesday, November 5, 2003. I would now like to turn the conference over to Mr. Bruce Byots, Vice President-Investor Relations for ServiceMaster. Please go ahead, sir.

Thank you, good morning and thank for joining us. On the call this morning Jonathan Ward, our Chairman and CEO; and Steve Preston the company's Chief Financial Officer. Also joining us is Deb O'Connor, our controller and Eric Zerniko, our treasurer. The third quarter earnings report discusses our business outlook and contains forward-looking statements. These particular forward-looking statements and all other statements that may be made on this call, excluding historical facts, are subject to a number of risks and uncertainties and actual results may differ materially.

Please refer to our press release and SEC filings for more information on the risk factors that could cause additional results to differ. Additionally, during this call we are using certain non-GAAP measures as defined by the SEC in regulation G. You will find on our website at www.svm.com, the required reconciliation to the most directly comparable GAAP financial measure. I would now like to introduce Jonathan Ward who will discuss the third quarter performance and his views on the company's outlook.

Thanks, Bruce, first I want to take a look back on the first nine months of the year and remind you where we've come from. If you remember the year began, it was very tough and disappointing our first quarter was down from the prior year; and it kind of had us recognize we had a lot of work to do this year. It was a time when both economy and our ability to attract new customers was challenged by external factors beyond our internal controls. We went into the second quarter with a commitment to catch up, we did a lot of work in TruGreen and other businesses to make sure that we got productions done, didn't fall behind; the good news there is we got that done but there was a significant incremental increase in labor to make sure we did get caught up.

I think the third quarter is an indication of the progress that we have made. We have been tough on cost control. We have been working to get retention rates moving forward in a tough economy. And we have focused significantly on execution to make sure that this year did not yet away from us. So I look back on the third quarter both from an earnings perspective, revenue growth and feel as though it is indication of progress we are making; consistent with what we talked about with a lot of you folks in our investor meeting in September and sets the direction as we go towards '04. Cash flow in the quarter was up, back to kind of our historical trend line up $8 million to $108 million for the quarter.

I want to remind you that as we talk about things today those of you that were not at our investor conference call it is still on our website at www.svm.com and would encourage you to spend time looking that the because it gives you a pretty good perspective on where we are taking our company. Since that time we also presented that strategy to our board at a recent board meeting, and I think the comments we heard from investors were very consistent with what we heard from our board. It's a sound strategy, it makes sense- go execute and get it done. But it is really our strategy that is clear and sound it's taking customer insight and turning it into action.

It is a cultural change for us, it's moving from an operationally based where historically we thought ourselves as a holding company. We're moving much more to start to think about from the customer back to our company and make sure we are taking advantage of scale and integration across many areas of our company. It's also a strategy that is close to home, but it won't get done with the business as usual approach; so as we work with our business leaders, as we work to bring in new expertise in the company, it's marrying that strength we have had historically around financial accountability, around operational effectiveness and adding new competencies to it. Today our actions are building towards that strategy and we think the quarter showed that.

First, we're working on delivery and experience that customers want. You've heard us talk about research, new proprietary research that allowed us to understand in each one of our businesses what customers want. It's had us develop strong brand positions across all our companies. And we're aligning that brand position with the consumer demand. Our challenge is make sure that each and every one of our technicians, teammates, associates executes that every day. This is how we catch the attention of consumers and customers, it generates more leads, we can break those leads into sales, we improve retention rates. It's also imperative in here that we go back and talk to our consumers and our customers on a regular basis. Understand where trends are going and also understand how we're meeting their needs today. We are reaching more customers and we're taking actions to make sure that we attract customers through organic growth.

We do not believe that our markets are mature, we believe there are opportunities for market share gain; both through better marketing, better brand positioning, acquisitions, geographic expansion, and new channels. We believe the third quarter started to show that, we believe as we go into '04 with a reasonable economy we will reinforce that. The same time we talk about the customers, we're also optimizing the branch and how the experience is delivered. We took some short term actions in the second quarter when we saw that the first quarter wasn't very good.

When took incentive pay out for leadership, we put tight controls in our non-customer facing activity, we've been careful about the size of staff, careful about how many technicians we've had in place; and recognized in the short term, until we got the revenue engine going again, we had to take some actions to ensure that our performance did not deteriorate. At the same time we're using Six Sigma in technology to think about how we transform the game in the mid to long term in our branches. So this whole idea of the Six Sigma competencies that we brought in to think about process, to think about process mapping and to think about how we change operations in our branches; coupled with new technology from both our business unit and corporate technology team is allowing us to think much differently about how we connect the technician and the customer together in the months and years ahead. At the same time, we are doing a lot to simplify our back office consolidation.

You've heard us talk about mission in Terminix, that rollout will be completed early next year. We're moving a lot of other activities such as cash posting away from branches to central lock boxes. Once again allowing our branches to focus on what they need to do best, serve customers and interact with their employees. We also believe that the economic trends are starting to look better and I think this bodes well as we go into our main selling season early next year, assuming the consumer confidence stays where it is. The University of Michigan originally announced that the October consumer confidence was at 89.6, a significant increase. Personal incomes were up in September, three tenths of one percent after a similar gain in August. So the trends look better.

By the way, we are not expecting a lot of lift as we go into '04, from the economy, but we do believe the head wind has subsided. It'll help us with retention rates in the short-term; and, we think, have us in a much better position unless things were to unwind themselves as we go into our main sales season for both Terminix and TruGreen during the first and second quarter of '04. Recognizing that there will be factor cost challenges now and in '04, we think we're dealing with them. Healthcare challenges are faced by every business in America. We've done a lot to mitigate these. We've switched suppliers, we've expanded plan choices, and we have also talked a lot with our employees about their need to be smart with their dollars because we do have a co-pay element in our plans that say it is not just all on ServiceMaster's dime, each and every one of us need to be prudent on how we invest our dollars. Workmans comp and insurance costs continue to add to our position, but we also have taken steps in '03 into '04 to work on this.

We have significantly expanded our safety programs in each and every one of our businesses, and are now tracking very aggressively workmans comp claims, loss time accidents, auto accidents; and we believe as we work '04 into '05 we will start to see the benefits of this. Just one example here, in our AMS, one of our smaller businesses added safety expertise about a year and a half ago. Their claims have been reduced from $1.7 million to about $.5 million over an 18 month period. So it does take some upfront investment in staffing, we've got to make sure we put the right people in the field; but as we do that, we know the benefits will be there for our business. One of the things we've done as we look forward to next year, we've talked about an alignment with our board; that if the performance isn't there, incentive is isn't there.

So as you look into our proxies next year you'll see that there wasn't much and won't be much of bonus payment for the leadership of this company. We think this year has been mediocre. We believe in pay for performance. It will create a little bit of a growover as we go into 2004. Variable pay both from 401(k) and bonuses will be ramped up in '04, as we believe the business performance will improve. Steve Preston will talk a lot about our impairment charge that we announced today but I want to let you know a little bit of the background here.

This is part of a regular review, as a lot of you know, most of you know; accounting rules and regulations changed in this about a year and a half ago. It requires companies on a regular basis, be very aggressive, be very systematic in how they look at the value of the businesses. It had us as we were putting our strategy positions together during the third quarter for both our board and investor day, look at TruGreen LandCare, ARS, and AMS; and quite honestly they haven't met their expectations. I want to let you know though that the impairment charge we took today is aligned with the business performance we presented in our investor presentation. So the investor presentation we did in September is aligned with the impairment charges we have taken here. There is no change going forward in our outlook for these businesses; and we believe that AMS, ARS, and LandCare all have positions of opportunity within our company.

We are in the process of making each one of these better performing businesses, and we have talked to you; the business leaders know if we can't make them better performers, they won't be part of our company in the long-term. We're also staying close to the management and execution of these businesses. We had two, once again, great quarters from American Home Shield and ServiceMaster Clean. These business have been performing very well throughout the year and they've been steady performers. We're also pleased in quarter that we saw TruGreen LawnCare, with Dave Slott focusing on the business; and Albert Cantu in Terminix, have solid quarters. Both of them did much better than they did in prior years and we are confident that we are making progress in both of these areas. In TruGreen LawnCare we're impressed with momentum and customer counts and retention. Interesting flip here and this is where both internal and external reasons for cancellation are important for us to track.

Over the first nine months of this year we have seen a 14% drop in cancellations due to lack of quality results. One of our biggest cancellations were people not pleased with the results they had. One of our brand positions going to '04 is the concept of visible results. How do we make sure our homeowners see very clearly and very quickly when they become a customer that we can make a difference in their lawn. Over the same period of nine months we've seen a 15% increase in cancellation due to financial reasons. These may include I lost my job, I can't afford it; along with other reasons of the economy is tough I've just got to cut back. So despite our overall retention rate being basically flat and now starting to bump up a little bit for the year. You can see the reasons that we think we control visible results.

Big dropoff in why people cancel, things we don't control, external economy; we've seen them tick up. It bodes well when the economy comes back. We have accomplished this through a lot of replication. A lot of hard work. Getting 200 some branches to work on the same best practices, it takes solid local execution; and we believe that as we continue to work under Kate Oliver's attention that we'll make continued progress in retention rates in the years ahead. We will end the year with 4.5% more customers than we began the year. We've had a solid year of acquisitions. They've been brought into the company, we've done a better job of thinking about how to attract customers; and we think that going into '04 to think that we'll have 4.5% more customers than we started '03, bodes well for this business next year. We are not being ignorant, or ignoring do-not-call list. Once again, two years ago we got 6% of our customers from non-telemarketing activities.

This year it was 23% and we're looking for a similar jump, I think, to the mid-30s in '04. We talked about how we're working with do-not-call list. Our plan is in place, getting more and more detail and substance behind it, to which we presented at our investor conference. We're confident that we will continue to grow customer counts next year beginning with the 4% increase we start the year. I want to reiterate, we are not moving off our stance that we will honor the do-not-call list regardless of how confusing things get in courts. It's the right thing to do, it's consistent with our values, and consumers have told us they don't want to be called.

As we reduce our dependency on telemarketing, there will be a change in how and when we attract customers. Typically telemarketing is a preseason activity that is particularly heavy in January and February. So when we talk to you about customer counts, the move to non-telemarketing will move the attraction of new customers from a preseason telemarketing activity, to an in-season direct mail, local affiliation, new channels. So January-February activity now becomes a March, April and May. We want to make sure we track with you, as we give you customer counts we would anticipate a slight dip in customer counts during the first quarter next year as part of our marketing mix change. Telling you about doesn't have us making excuses for it next year. It has us understanding and making sure that we're executing to the plan we have in place. Our peak attraction of new customers next year will bridge the first quarter. It'll be in March peaking in April.

Let me turn to Terminix. This business has started to show resiliency. We talked about earlier this year that we had a poor swarm season in and our termite counts are actually down a little bit for the year. Earlier this year it was hit by the economy and the weather. We believe this business got back on track during the third quarter and the bottom line is showing growth for the nine month period. Terminix leads which we talked about earlier had been down 15% to 20% in some months and some quarters, are now trending back to prior year levels and we believe that this is an indication of the economy coming back . We have a lot of things going on in Terminix. One of the things that they are building their brand position on is choice and segmentation of the customer.

We've talked about this before, particularly around the termite offering and liquid and bait. I want to talk a few minutes to walk you through how this transaction works. We'll be entering the new year with a significantly enhanced segmented offer for consumer. We believe it will improve the number of leads we close, and also have us at custom tailor the service more to the customer's liking. Choice translates into pricing power, choice translates into less discounting, and choice presents us as a company that is more aligned with what consumers want. Choice is aligned with this business is one of platforms we have gone through.

Liquid and bait customers have equivalent lifetime value, but the revenue and earnings cycles are a little bit different. Liquid customers have less first year profitability and more in subsequent years. It takes less for ongoing service of a liquid customer than it does a bait. The number of times you have to check the baiting station and how expensive that is makes bait customers more profitable in the first year, but less profitable in subsequent years. Overall the overall profitability of the two customers is about the same. So as we enter 2004 and see it move from 85% bait to 15% liquid and end the year we believe at about 40% bait and 60% liquid; you will see a change and we will keep working with you to understand in first year profitability.

Having said that this is a good news story for ServiceMaster and we believe it lead to better pricing in bait. It will lead to more customers converting to use ServiceMaster and Terminix because we have choice but it does mean a little bit of the a mix change. Terminix is also a good example of how we are going after productivity gains through investment in technology. We talked about it for a couple of years now, we will be completing the rollout of a back office management system in Terminix called Mission. That will be completed early next year. It is the backbone that will enable future technology, particularly of productivity and handhelds in the field to be connected to the system.

So we build the back office system that puts all our branches operating on the same system, and then connect it to the field operations over the next 18 months. And move forward. We believe that this, combined with other productivity opportunities, opens a new and smarter ways for us to think about interacting with our customers. Ultimately we have to deliver on our promise of productivity gains in this business; and that foundation will be through technology and systems investments. We are also taking action to bring the troubled businesses back into line and to health. TruGreen LandCare- the biggest news there is we announced a new leader in this business a month and a half ago and I'd say Bob Fates is well under way to changing both the business model, attracting some new talent; we have hired one person from our major national competitor, and we believe that we are confident an emerging business model in '04 will lead us to much better results. We divested a utility line clearing business that had basically seen a model change.

We will reverse the revenue declines. We are confident we will see improved performance from our branches in '04, and fully expect earnings growth out of this business over the next 18 months. ARS we made this a better business. We scaled it back, two of the last three quarters we've seen positive earnings improvement. We know what we have to improve in this business, the management team is focused on improving that, and we are very confident that we will know a lot more about the long-term viability of this business as it relates to ServiceMaster over the next 18 months. I can tell you one thing, through the very open and frank conversations with leadership in this business, we are out to prove it, and many many times in ServiceMaster history; it has taken a significant number of years to get a vertical to work.

We have made verticals work whether it is ServiceMaster Clean, Terminix, TruGreen, where many many others have failed and we are out to prove, once again, that AMS is a new vertical for this business. AMS we recognize is a cyclical business. The construction market got saturated during, what I would say the technology bubble, a lot of our work was finishing out office spaces related to telecommunication and other industry that had great growth in the late 90s, early 2000. We believe that the two year down cycle has ended; our backlog is up, although the production schedules are moving a little bit slower than normal in this area, we believe the business is rebounding and will be positioned to make more money as we go into 2004.

A quick comment on the fourth quarter, consistent with our press release we're looking at our current performance in market conditions and believe we will be in the 8-9 cents range for earnings. As we also said, we will give you guidance for '04 with the full year results in February of 2004. Just a final comment, you know, our businesses that we believe have turned the corner. We have talked to you a lot on these prior calls about significant investments we have made. We believe most of those investments are behind us. These are things like customer research, customer satisfaction, procurement organizations, safety organizations, Six Sigma. A lot of these upfront costs are behind us, as we look to '04, we see minimal increase in their run rate it's about harvesting those investments. We believe we made the right choice about our portfolio, we've made investments to build our capabilities, we're getting much more detailed insight into our customers and our markets that we can act on, we've been tough in controlling costs this year as we didn't see that momentum and the economy didn't work with us.

And we are taking this insight and turning it into actions in '04; and are confident we will start to reap the results in both revenue growth and earnings growth as we go into '04 and beyond. With that I would like to turn it over to Steve Preston and then we'll be ready for some questions.

One of the encouraging aspects of 2003 has been the fact that the company's momentum has built throughout the year. We started out with a difficult first quarter as winter weather lingered, delaying the lawncare business and dampening the termite activity. Last quarter we saw TruGreen make up much of that loss in Q1 production, while in American Home Shield the franchise businesses continue to show strength. This quarter the strength in the business is broadening. TruGreen ChemLawn showed further improvement with customer counts continuing to improve further, now up 4% relative to last year.

In fact, operating at TruGreen ChemLawn was at it's highest level of any quarter in three years. Terminix is turning around a difficult year, as lead flow is returning back to normal; and revenue in all service lines grew. In American Home Shield and our franchise businesses continued continued to produce strong results as they have so reliably done for a long time. We even saw earnings growth at American Residential Services, as operating income increased about $2 million. To put those businesses together that added about 3 cents a share to the EPS in the quarter. However, lower earnings at LandCare and AMS offset this growth by about 2 cents a share, relative to last year; and as we discussed in the past, investments enterprise initiatives also increased.

As a result, we do feel like we are going into a fourth quarter with the tail wind picking up behind us that could support us going into next year. That momentum is important as we grow through cost pressures on the other side. We continue to see pressure from insurance costs, by the end of the year they will have grown about 3 cents a share and we expect them to grow another 3 cents a share going into 2004. In addition we expect to cut variable compensation significantly this year which will need funding next year. So these are costs that we will have to outgrow. We have renewed and increasing focus on the safety side in the organization to address some of these cost challenges we're adding field resources, we've improved tracking, and we've invested in employee communications programs to address the issue.

We've already seen strong improvement at AMS, which kicked off a heightened safety initiative in 2002, somewhat ahead of the other business units. I would like to turn my attention now to the impairment charge before reviewing the financial results more broadly. As many of you know, under FAS 142 we do have an obligation to review our intangible asset valuations at least annually, or whenever we thing that circumstances warrant a review. That process involves not only convincing ourselves that the value of our intangible assets is valid, it also requires that a third party valuation expert and the company's independent auditors concur. Coming into the year we believe that the significant decline in 2002 was an anomaly, and that if we had a good summer season and could support a clear trend toward ongoing improvement there would be a validation of the intangible value on our books.

However, between the sale of Trees, Inc., which reduced the LandCare revenue base by approximately $80 million, a decision to close certain operations at ARS, and a weak summer season in these businesses; it became clear that we were not only not going to meet the level of projections which would support intangible assets, but that we really should take a look at accelerating our review of intangibles. So we determined that we had sufficient information, additional information in Q3 to make that impairment determination. As you can appreciate, the longer a downturn continues, the more difficult it is to substantiate the expectation of a dramatic turnaround. I'm sure that for many of you the fact that we're taking an impairment charge is not a complete surprise.

We'd discussed the possibility of a review to assess the goodwill in our second quarter 10-Q filing. We also stated at our investor day that these businesses may not be worth what we paid for them. Additionally numerous other companies in the HVAC industry have already taken large charges. Nonetheless the charge does have a significant affect on our financial statements. Operating income will reduced $481 million in both the quarter and the full year, while net income for both periods will be reduced by $383 million or $1.30 a share. Intangibles on our balance sheet will also be reduced $481 million, and equity by $383 million. The charge eliminates all of the $189 million in intangibles on the books at LandCare.

While we have faith in the new president at LandCare, Bob Fates and he is building a team around him, the business is expected to lose money this year and suffer it's second year of earnings declines. The charge also eliminates all of the $68 million in goodwill at American Mechanical Services. While this business has generally operated admirably in spite of the difficult environment, it is heavily dependent on new construction and it is a cyclical business. Intangibles at American Residential Services will be reduced by $224 million, but it will retain about $57 million in goodwill on it's books. This business has continued to be profitable throughout its difficulties, and we would expect it to generate operating income this year even after $1to $3 million in costs relating to the shutdown of the under performing branches and service lines.

We're also seeing signs that a number of our initiatives in this business are taking hold. Before moving on let me talk for a second about the implications of the impairment charge to the enterprise over all. First of all this charge is entirely non-cash. It is solely relates to our obligation to revalue intangibles under FAS 142. It does not affect the company's compliance with any of our financial covenants in our lending arrangements, our covenants are not affected by unusual non-cash charges. And finally, as John mentioned earlier, and most importantly; we believe these businesses will turn around as we shared with you at the September investor day.

Let's now turn to the consolidated results for the quarter and then I'll get into the segments. Revenue in the quarter of $1,018,000,000 was up 3% compared with the prior year. TruGreen ChemLawn, Terminix, and American Home Shield were the primary contributors to that growth, offset in part by the lower revenue in the ARS-AMS segment. Reported operating income for the quarter was negative $355 million or $126 million before the impairment charge. That compared with $123 million last year. And that was based on the factors we just reviewed. Below the operating income line net interest expense for the quarter decreased $2 million primarily reflecting lower interest rates and higher investment income.

As we have discussed previously our tax rate before impairment has returned to a more normalized rate of 39%, that compares with 38% in our tax provision for the third quarter of last year. Last year's rate was lower because of an NOL we were able to utilize. I need to take a second to address the number of shares outstanding that you see on our income statement. As you know, when we calculate diluted earnings per share, we generally include in the denominator both outstanding shares; as well as, share equivalents such as options on a converted basis. However, in the case of a loss we are required to exclude share equivalents from the denominator because it results in a more dilutive earnings per share calculation..

So, as a result, on the face of the income statement our shares outstanding are lower by 20 million for the quarter and 19 million for the nine months; that reflects both the absence of share equivalents, as well as, the share repurchases we've done over the last year. If you calculate the EPS before the impairment, which is positive, shares outstanding are only 8 million lower which reflects only the share repurchases we have done over the last year. When you put it all together net income from continuing operations was negative $317 million. Or $67 million before the impairment, which compared with $66 million in the prior year. While earnings per share in the quarter were a negative $1.08 or 22 cents before the impairment compared, with 21 cents in the prior year.

If you take the first half into account and look at the nine month period, revenue increased 2% to $2.8 billion, while operating income of negative $205 million, or $276 million before the impairment; compared with $294 million last year. That decline was largely based on the factors we discussed in LandCare, AMS and other operations segment; as well as, the difficult first quarter we had in TruGreen Chemlawn. Net interest expense was reduced by $28 million for the nine months reflecting the reduction of long-term debt, as well as, the payment of a $15 million premium in 2002 too repurchase public bonds. The tax rate before the impairment for the nine months was 39.2%, almost 3% higher than the prior year.

Shares outstanding reduced by almost 7 million. Once against that is before the impairment charge. Getting to the bottom line, net income from continuing operations was negative $245 million. That compared with $138 million before the impairment for the first nine months and about the same level last year. While earnings per share negative 83 cents compared with 46 cents a share before the impairment; that was one cent higher than we reported last year. Turning now to cash flows, we had a solid quarter in cash flows; we generated about $108 million in cash from operations. That was $8 million more than we had in the same quarter last year.

Taking into account the $58 million in cash we generated in the first half, cash from operations for the nine months totalled $166 million; that compared with $243 million last year. Most of the differential compared with last year for the nine month period occurred in the first quarter. And that was based on the number of timing differences which we discussed with you in both of our last two conference calls, so I won't get into that in detail. However, overall the cash flow pattern we have seen this year is much more indicative of a normalized pattern so we expect to have 2004 look a little bit more like 2003 in terms of the cash flow.

Supporting the strong cash flow in the quarter, we saw days sales outstanding improve in 7 out of 8 business units and we also saw solid working capital management throughout the businesses. Let me make a couple of comments about our cash usage for the nine month period. Net Cap Ex was approximately $30 million, that was some what below last year; which reflected certainly leased assets coming under the balance sheet. Share repurchases completed in the nine months total 57 million. We anticipate using available cash to purchase approximately 15-20 million additionally before the end of the year. The share repurchase policy will remain consistent with the stated objective and our committment to remain investment grade.

Dividend payments totalled $94 million for the nine months, that reflected a 10.5 cent a share quarterly dividend level throughout the year. In October we paid our fourth quarter dividend and we announced a declaration of our first quarter of 2004 dividend, both at the same quarterly rate. As a result total dividends per share in 2003 were 42 cents. That is a 2.4% increase over last year and it marks our 33rd consecutive year of annual growth in dividends. And finally cash payments for acquisitions totalled $24 million, those were primarily focused at TruGreen ChemLawn.

Looking at the balance sheet, total debt at the end of the second quarter was $825 million down slightIy from the year end level of $835 million. In cash and marketable securities at the end of the quarter was $261 million. I would note about $154 million of that amount is at American Home Shield to support regulatory requirements, we do expect that our overall cash balance will continue to build throughout the end of the year; as we receive very strong seasonally high cash flow levels in the fourth quarter.

Looking now at the segments, in the TruGreen segment the utility line clearing operations which we sold in the third quarter have been reclassified as discontinued operations so they are not in this continuing operations number. We have filed an 8-K with the historical summary by quarter of the restated results for 2001, 2002, and 2003 to assist you in your understanding of the historical trends without Trees, Inc. in the numbers. On this restated basis, revenue in TruGreen increased by 6% while operating income excluding the charge was down as compared to the prior year. LawnCare revenues increased 7% with full program lawn customer counts up over 4%, supported by tuck and acquisitions stronger sales and higher production.

This year we have more than doubled our sales through non-telemarketing channels, which now are making up about 20% of our new sales volume. Telemarketing does continue to be a very cost effective channel relative to other channels, so we have seen an increase in our sales and marketing costs as a result of this shift. Even so we saw an increase in operating income at the lawn care business in the quarter resulting from the higher revenues. As we look to the rest of the year we expect fourth quarter growth in both revenue and operating income at TruGreen Chemlawn; based on the higher customer counts a strong production calendar, as well as deeper penetration in southern markets, where we enjoy a longer production season.

In the landscaping unit, revenue increased 1%, but lower operating margins offset the earnings growth we had in the lawn care business, and led to lower growth in the segment overall. Several factors affecting margins including high insurance and labor costs affected the results. As a result, operating income for the segment was negative $117 million before the impairment charge, however, operating income was $72 million and that was down about 4% relative to last year. Capital employed in the segment declined 13% as a result of the LandCare impairment charge. In Terminix, third quarter revenues increased 5% supported by higher revenue from new termite contracts, renewals as well as pest control. This growth reflected higher unit pricing, as well as, an increase in mix of the higher priced bait services within the renewal mix.

Customer counts in pest control were also up 2% that has shown improvement over last quarter; while termite customer counts, however, were down 2% and that is in line with where we were last quarter. And that was based on somewhat lower sales and retention. Operating income was $32 million compared to $25 million in the prior year. As a result of the strong operating income in the quarter, Terminix is now showing bottom line growth for the full nine months even following the difficult first half. Capital employed into this segment was about 1% below last year. Revenue in American Home Shield for the third quarter increased 9% that was based on strong growth and renewals throughout the year. Sales of new contracts in the quarter were up double digit digits in all three of the primary channels: real estate, direct to consumer, and existing customer renewals.

We saw more home listings in our markets, better overall retention, in spite of cancellations from the mortgage refinancings which we discussed with you in the past; as well as more marketing active in the direct channels. Operating income increased 10%, that reflected a 20 basis points margin improvement; and we continued to see the number of claims per contract decline although not quite to the same degree in the first half. We also continued to manage the our contractor costs tightly and that's critical to maintaining strong margins in this business. In fact, next year if we do see a return to more normalized weather conditions, we would expect some margin pressure in the American Home Shield business.

Capital employed in American Home Shield increased 31% and that can be attributed to the growth in regulatory capital. Combined revenues in the American Residential Services and American Mechanical Services segment declined 6%, somewhat lower than the decline we saw last quarter. Reported operating income from the segment was negative $284 million, that reflected obviously the impairment charge; before that charge operating income in the quarter was $7.3 million and that was $418,000 below last year. The ARS portion of the business however reported earnings growth exceeding $2 million. Margins at ARS improved 170 basis points, before the impairment. That was due to pricing initiatives, cost controls, as well as closures of underperforming branches. We are also beginning to see good traction in the number of initiatives to increase revenue in that business, such as sales through the retail channel, focused efforts on sewer repair, and HVAC replacement.

Lower earnings at AMS however offset the ARS growth. Even though both bidding activity and back log levels are growing, we see we are seeing jobs with lower margins and longer duration. Capital employed in the segment decreased by 77% as a result of the impairment charge as well as lower working capital. Finally, revenue in the other operations segment increased by 6%. The combined ServiceMaster Clean and Merry Maids franchise operations reported an increase in earned revenue of 11% in the quarter. In the third quarter of 2002 the segment recorded a $6 million licensing fee, that related to our former Terminix UK operations; and that offset some of the growth we saw in the franchise businesses. Operating loss for quarter in the other ops segment was $7 million compared with a $4 million loss last year.

Continuing growth in the profits of our franchise operations were likewise offset by this $6 million licensing fee that we got last year that was not in the number this year. Capital employed in the other operations segment declined by $16 million and that reflected the wind down of discontinued operations. So in closing, we feel like we've made some very good progress throughout most of our businesses. We think that's giving us a very solid platform going into next year. And at this point we would welcome your questions.

Thank you, ladies and gentlemen, if you would like to register for a question, please press the one followed by the four on your telephone. You will hear a three-tone prompt to acknowledge your request. If your question has been answered and you'd like to withdraw your registration press the one followed by the three. If you are using a speaker phone please lift your handset before entering your request. One moment please for the first question. The first question comes from the line of Matt Litfin of William Blair & Company. Please go ahead with your question.

Hi, good morning.

Good morning, Matt.

Question on the ARS branch closures, could you maybe talk about the number of branches, how many are left now, and then maybe discuss what kind of revenue contributions you actually removed here, and what benefit to operating income we'll see going forward, and looking more on the dollar figures basis than you know margin percentages if possible?

If you want to start maybe I'll complement you. We may not have all those pieces with us here today but I think we can probably answer about three quarters of them.

It was about five branches and then there were other branches where we actually closed service lines within the branches; so for example if we had a large HVAC shop with a small plumbing component that was really sub scale we closed that as well. Most of them were not significant -- weren't losing a lot of money, but we just did not see the ability to get them to the point where they had either sufficient scale or the right market presence to make them into what they needed to be in those markets.

Okay.

And Matt if you have more detailed information I think we can have you follow up with Bruce and we will make that available to others who want it, too.

That's fine. No problem. I just have one other question and it is on - I'm trying to understand the financial effects on Terminix of the expected shift back to a liquid treatment next year. How much lower is the price point on that than the bait in year one, and can you give us the expected difference in year one on the margin earned on the new termite customer.

I'll handle the first one and won't use actual numbers because I want o be a little competitive, you know, quiet here; but basically there's about a 60% or 70% difference in first year customer pricing bait versus liquid. What is more important, though, as we think about it here, though, Matt is; if you only have one offering what we have tended to do is basically. Steve's handing me a not saying he thinks it is only 40% and I'm doing the math in my head here. Yeah, okay.

Maybe I'll say it is about a 50% difference but more important there, Matt, is that what we've had when you only have one offering is that you will take that; instead of losing the customer the sales person will take one product line and use that entire-use that product over a very wide pricing spectrum so there is a lot of discounting going on. The basic premise is the customer's still profitable at this lower price point over the long term. With choice what we've said to the sales person is there's an expected range below which you won't receive commissions on bait. If the consumer wants another alternative, we now have a liquid alternative that we believe if the long term will be as effective, not have a big spike up in damage claims; but we can now go to the consumer and say if you are interested in these characteristics of bait which tend to be less invasive, less chemicals put down, higher ongoing service responsibility, this is the product you want.

If you want something that is equally affective, more invasive of your exterior, we have a liquid option for you; and there is always, by the way, certain types of construction that it can either take a bait or a liquid that we may have had to walk away from if we didn't have a good liquid treatment. So I think a little bit less about you know the price point as a opposed to taking away discounting. To your question of margins I don't think we have first year contribution here on margins, but because of the lower price point and it actually is fairly significant to install a liquid treatment that it does have lower first year margins and I'll work with Bruce and Steve to figure out whether we are willing to share what the margin difference are in first year; but after the first year the number of trips we make back to visit a bait station, as required by our use of the baiting systems we use, is fairly high.

We make a significant number of additional visits to bait customers versus a liquid to make sure that the barrier has not been broken and and that the liquid treatment is still effective. All we're doing is trading first year margins versus subsequent year margins. The only other issue that comes through our income statement in the short-term is in the baiting systems, we have a deferred revenue component that as you have a mix change from bait to liquid; right now we're actually seeing some of this deferred revenue come through our income statement which has profitability associated with it. Over the next couple of quarters as we see the move from bait to liquid.

Hopefully that gives you the information you want. We have looked at this very carefully. We believe the consumer wants choice, the big news for us is we'll close more leads and have more customers; and in the long-term there isn't a significant change in profitability of the two customers.

The only other thing I'd add to that is historically liquid treatments have had a little bit of a bad rep, because they have not been nearly as efficacious; and that was one of the reasons the leadership at Terminix decided to lead the way in moving over to bait. The new liquid treatment that are rolling out are much more efficacious, so we think that they will have a similar level of work on the termites; so we are not as concerned about some of the issues we had under prior liquid treatments.

Thanks for detail.

Matt, I just grabbed the calculator here. The number it is 35-40% in the pricing difference.

The next question comes from the line of Chris Gutek from Morgan Stanley. Please go ahead with your question.

Thanks. Good morning, guys. In the context of this goodwill impairment charge in the quarter, John, a question for you. I'm wondering if you're still of the view that these are good businesses, number one. Number two, recognizing that both LandCare and AMS are targeting business customers, as opposed to the other core business targeting home owning consumers as the customers; are you still convinced that both LandCare and AMS are a good fit for the company?

First of all I'll answer the second part of that first and if you look at our kind of vision mission statement we put equal weighting to business and home owners, so absolutely I believe that there is a significant component. In TruGreen, excuse me, in Terminix today 30% of our customers are kind of the commercial mix; so we believe there is equal footing in our company. ServiceMaster Clean has a large janitorial business, and I've said it a few times, I think over the next 5-7 years- we get LandCare squared away that I believe our commercial could grow quicker than residential. We focused on and talked a little more about the residential side because it's where we needed to do more of the consumer research. So yes I think there is a -- I like the balance of residential and commercial as we go forward. Talking back to the businesses once again a couple things.

AMS we know is a cyclical business, we get great returns in an up economy and we do relatively well in a soft construction economy; and that is what we are seeing right now. I think Ed Dunn and his team have proven they know how to make a lot of money in an up cycle, they know how to protect the bottom line in a down cycle. LandCare, we've brought in a new leadership team. I'll reiterate what we said at the investor conference in New York, we know there is a successful national model out there. We're not copying that, we're going to do it in our own way; and it we believe, we are highly confident, that over the next 18-24 months we will see LandCare be a significant contributor to both revenue and earnings growth in this company.

I think just our ability to break these businesses apart, bring in more focused leadership, replicate that model; the leader we brought is very much a detail guy. The significant variance there, Chris, is that we have- Steve talked about how in ARS the locations we've looked to shut down lose a little bit of money and other locations making some money. In LandCare we have dramatic differences between good performing regions and branches, and poor performing branches and regions. That's the issue we got to get out there. So not only do we have a good national competitor, we know we have a footprint out there about 30% of our branches that perform equally well to a national competitor and our challenge here is to replicate that.

ARS we have talked about it, you've seen a lot of our competitors say uncle, get out of it and we know what we have to do in the heating and cooling side. It focuses on add-on replacement units and making sure that works. Plumbing was a good business for a significant period of years, we have seen a falloff; we think there is a slight decrease of demand long-term as we get into more plastic. But we also know here that the sweet spot is making sure we have great service, a brand position that's very unique, making a difference already, Chris, and then the leads we are getting and how the business is reacting to it. Two hour window, on time guaranteed. By the way, probably moving to a one hour window sometime in the future.

Along with making sure we get more than our fair share of what we call sewer repair type of jobs that we are doing some unique things to make sure we create demands. We talked about it with you, we've talked about it with the ARS leadership and management team. We believe that we will know a lot more about the long-term viability of this vertical over the next 18 months.

If we were sitting here ten years ago you would have been asking questions- why would you ever want to be in a home warranty business and what is American Home Shield about, no one is doing well in the business; and a number of years later it's our fastest growing, highest return business and we created a national template in a business where no one else has succeeded and that is both a history and compelling nature of how we think ServiceMaster thinks about itself as we go forward.

And on the commercial businesses, Chris, I would also highlight that in pest control and in lawn care the commercial customer bases is important to the businesses and also a real focal point for targeted growth.

Great thanks.

Thank you. As a reminder, ladies and gentlemen, to register for a question it is the one followed by the four on your telephone. The next question comes from the line of Jim Barrett from C L King & Associates. Please go ahead with your question.

Good morning, everyone.

Good morning, Jim.

Good morning, Jim.

John, could you talk about just LandCare. You didn't mention you were changing the business model, is it too early to elaborate on that?

I think it is a little early and we know what have to change it. What Bob Fates has done is spend a lot of time out in the field with all regions. He's ascertaining which ones he believes are working well, where he has to make leadership changes, and also putting together, what I'd call, his team that says John these guys have it figured out. I think what you'll see is three or four of those guys emerge. That they'll put together here is the way we're gonna run the business. We're not discussing any longer, we have a model of what TruGreen LawnCare is going to look like, we'll take a little bit from our best performing regions, come up with a common way, we're taking a choice out of how to run in the LandCare region. There will be daily reports, there will be followup on customer retention, how much revenue we're supposed to sell today and how we're supposed to produce, what was the percent of labor, what is going on with your enhancements and pound pound pound daily execution across the country. So we believe that within our own model we know what the right way to run the business. It is making sure that it gets systemically put together and then followed up and replicated across the country in every location day in and day out.

And moving on to TruGreen is seems like you are seeing a nice rebound in customer counts. Could you split that up between how much is organic versus both on acquisitions.

A little bit of both. One, if you remember as you came into the season we saw a falloff in retention rates we think it was economy driven. They've started to come back now. Probably about 75% of our customer count growth this year would be from tuck in acquisitions. So if you say we're kind of flat on new customer sales, I would agree with that; I think that is a great accomplishment in the economy we dealt with and the economy where it was hard to get new customers and customers found it easy to cancel and by the way our best go to market strategy was being pulled away from us long before the do-not-call list in October. We operated this year with 37 different states having do-not-call registrations that we had to comply with on a local basis.

And Terminix, if I wrote it down correctly, the baiting mix is moving from 85% at the beginning of this year to 40% next year?

We believe it will end the year at 40% bait in 2004. Let me tell you a little bit we have pretty good indications here. We had I think two regions that we moved aggressively toward this dual offering starting in the second quarter of this year. So we are now 12, 16, 18, 20 weeks into seeing the impact on lead flow, conversion rate and pricing; so we are no going into next year with this being a wing and a prayer. We're going into it with Albert having done a good job of getting out there and saying let's get some data, understand what it does to mix, understand it what it does to worker productivity, understand what it does to lead close, and understand how choice given to a consumer becomes part of the brand proposition.

Well, it would seem if those numbers are approximately correct, at least near term, Terminix it would seem would see a pretty significant profit decline next year is that sort of globally-

I think what mitigates that and offsets it almost to 100%, I'm looking at Deb O'Conner, my controller, is that with the price realization a higher price in liquid and a higher price in bait mitigates that risk; along with some of this pull forward of deferred revenue from the bait customers that we have sold in the last 12 months and Deb is giving me a correct answer that one.

Thank you very much.

The one thing Deb would say is there is some dependency of whether we return to a normal swarm season next year or not.

The next question is a follow up from the line of Chris Gutek from Morgan Stanley. Please go ahead with your question.

Thanks, Steve. You did quantify the EPS impact next year from higher insurance costs. Would it be possible to also quantify the EPS impact from higher incentive compensation?

Chris, that is going to be entirely dependent upon performance levels and setting those standards as we finish the budgeting season. So if the company absolutely knocks the cover off the ball next year we could see another, you know, $25 or $30 million going out on the incentive side. If it doesn't it will get scaled back based on variable targets, so those numbers get paid out as we perform; and at this point it is a little early to tell.

Fair enough and then with the American Home Shield business you talked about the weather that was unfavorable for some of the other businesses actually helps American Home Shield, because there were fewer repairs. In that context, the profitability of that business might come under a little bit of pressure going forward. Is that still the expectation, in fact we did see the margins in the current quarter quite a bit below what we were looking for. Is that what is happening a return to more normal weather patterns?

A little bit of that, although as earlier in the year you have a little bit of lag of how many claims you actually had. So there was a little lift in prior years from catching up on reduced service calls. A couple other things that impact the business. We are aggressively growing customer counts in this business. I could give you guys some more profitability in this business if we decided not to go out and get new customers, so part of the margin deterioration is how much we are going after. And part of our plan next year is to significantly expand into new markets with sales reps that take awhile to become profitable for the company. Where we are working on a lot of direct consumer and third party adds. At this point a lot of those are, at best, break even first year; if not a loss. So we've made some investments for the long-term health of this business. We know it is the right thing to do, so a little of the margin pressure comes from that side. As we go into next year, I'll give Scott and his team a lot of credit, not only are we seeing a little bit of a weather favorability; and the big variable there is likely more air conditioning repairs that can be somewhat more costly than other repairs. But Scott and his team have done a lot about increasing the basic service call from $35 to $50, excluding certain types of repairs that has also put a long-term downward trend in the number of service calls per contract we have; so a little bit of weather risk but not significant.

Great, thanks a lot.

The next question comes from the line of Tom Kerr from RBC Investments. Please fed with your question.

My question has been answered, thanks.

Thank you. We now have a followup question again from Matt Litfin from William Blair & Company. Please go ahead.

Yes, I had a question on the operating loss in the other operations segment. It has been pretty volatile lately I guess the question is can we expect the better trends that we saw here in the third quarter to continue going forward?

Yeah, I think next quarter you will see a more favorable trend there as well, Matt. So as John mentioned we don't see a lot of growth over the current level of investment in the company and we will also benefit in the fourth quarter from cost cutting initiatives that will flow to the other operations line.

Excellent, thanks.

Thank you. As a reminder, ladies and gentlemen, to register for a question, it is the one followed by the four on your telephone. We have no further questions at this time I will turn the conference back to you, sir.

Okay. We appreciate your time today. Steve, Bruce, and I and the rest of management available over the next couple of days if you have questions or comments. Once again we are pleased with the progress we showed in '03. We think it bodes well for the underlying strength and we look forward to bringing that home to you in '04 and beyond,. Thanks for your time today and we will talk to you soon, bye bye.

Ladies and gentlemen, this concludes the conference call for today and we thank you for your participation and ask that you please disconnect your line.