Terminix Global Holdings Inc (TMX) 2005 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the ServiceMaster Company's second quarter 2005 earnings conference call. [OPERATOR INSTRUCTIONS] I would like to turn the conference over to Bruce Byots, Vice President, Investor Relations, ServiceMaster Company. Please go ahead, sir.

Good morning and thank you for joining us. On the call this morning is John Ward, our Chairman and CEO and Ernie Mrozek, the Company's President and Chief Financial Officer, Also joining us is Deb O'Connor, our controller and Eric Zarnico (ph), our treasurer.

Before I turn the call over to John, I'd like to remind you that our quarterly earnings report discusses our business outlook and contains forward-looking statements. These particular forward-looking statements and all other statements that be made on the 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 risk factors that could cause results to differ. Additionally, during the call we may be using certain non-GAAP measures as defined by the SEC and Reg G. Please refer to our website, stm .com, for the required reconciliation for the most directly comparable GAAP financial measure.

Lastly, I would like to remind you that we will be having our investor conference this year in New York City on Tuesday, September 13. This half-day event will be held at the Socantel Hotel, which is on 44th Street, and will start at 8:00 a.m.

I would like to turn the call over to John Ward.

Thank you, Bruce, and good morning and welcome to the call. We are very pleased with our performance during the quarter, delivering top-line revenue growth in every one of our business segments. And this was an important quarter for us. If you remember, we were confident about the year, but because of some factors beyond our control, our first quarter results gave some of you concern. This is an important quarter for both sales and production. We're quite pleased and we feel we did well on birth -- both counts.

Ernie will take you through each segment, but here are a few headlines. TruGreen LawnCare had solid revenue growth, while continued to diversify its sell -- sales approach. We also had nice gains in pricing realized during the quarter, and feel very comfortable about the year. TruGreen LandCare saw modest growth, while improving its internal processes. We're pro -- focusing on being more systemic in its operations and more attuned to the commercial customer, by focusing on sales hires, sales training and, most importantly, client retention rates.

This year is shaping up to be very symmetrical. What do I mean by that? Our performance in the second half will mirror very similarly to what we've had in the first half, as far as revenue growth and our ability to put additional earnings to our bottom line. So, we continue to expect revenue growth to be in the mid to high single-digit range for the year, right in-line with our mid to long-term strategic focus. And that earnings per share will grow faster than revenue and likely to be in the low double-digits for this year

Terminix saw growth in termite completions and profits, while taking actions to simplify our branches by consolidating sales centers, thereby simplifying the focus in the branches, allowing our branch managers to more and more focus on keeping the customers they have and making sure the production they have gets done. American Home Shield showed continued strength, particularly in direc -- direct-to-consumer sales and renewals, and ARS and AMS saw solid revenues and profit growth. And, as you know, as we continue to conduct our portfolio review, seeing these businesses perform in normal weather conditions has been an important part of our understanding of their future participation of our Company. And I will pl -- say that I was both pleased with Mark Burel and Ed Dunn's performance during the quarter. I was pleased with Mark Burel and Ed Dunn's performance during the quarter.

This year is shaping up to be very symmetrical. What do I mean by that? Our performance in the second half will mirror very similarly to what we've had in the first half, as far as revenue growth and our ability to put additional earnings to our bottom line. So, we continue to expect revenue growth to be in the mid to high single-digit range for the year, right in-line with our mid to long-term strategic focus. And that earnings per share will grow faster than revenue and likely to be in the low double-digits for this year.

Market conditions continue to be slightly favorable. What do I mean by that? Low inflation, good consumer confidence and unemployment rates that we can find an available work force. Factor costs, however, continue to hurt us, particularly fuel and health care. But as we've said over the last two years and we continue to reiterate here, that the actions we control are far more important than external factors. More and more we talk about the actions we're taking, not about the actions that we're victims from. And we will continue to perform, as we transform this industry.

Our message is simple, direct and consistent, and it is not changing. Even as we deliver these results, we continue to reinvest back in our businesses. That is a strong strategic shift from many years ago. We know there are additional growth opportunities, for activity-improvement opportunities in the businesses we're serving today. And as our business unir -- unit leaders use that capital wisely and take the expense dollars back into their business, and keep customers and putting more back into our work force, the technology and making their ability to serve customers better, we will continue to -- to do that as priority number one in our Company. We believe that this is the best way to ensure our performance, not just for quarters but for years to come.

Over the last several weeks, we've been looked at our 2006 preliminary plans, what we call our growth meetings. What is next for the businesses we're in? And it's encouraging and exciting to see our leaders identify many ways to strengthen our business model, to both excel the customers and generate returns for our shareholders. Things we'll challenge ourselves on include routing and scheduling, targeted new offerings, offering different levels of service to meet customers needs, how they want it, when they want it, new sales models, geographic expansion to adjacent under-penetrated markets, reaching more households to bring new users into our space, and an unrelenting focus on improving retention across our businesses. And resolving concerns of our current customers, so they know we stand behind their work and we get the advantage of them referring us to new users and their neighbors, in referral marketing that is becoming increasingly important in all of our services.

There is no doubt our market can support the growth. Our services are in demand, households are under-penetrated, and the competition is fractured, and we are taking more and more advantage of this every quarter. We challenge ourselves to move even faster, to take full advantage of these opportunities, as our confidence, capabilities and commitment continue to narrow and focus on those things that make a significant difference. We created many of the service models that are used today, and if we created those models, there's no one better to change them and to make them more attuned to the customers, as we go forward. We didn't come to leaders in our industry overnight, it took decades of hard work, hard to replicate, and we are now convinced that we can take these models to new and improved levels. We will improve and innovate, and do things that our regional and local competitors can't even think about doing.

That's how we are transforming the industry today and will continue in the years ahead. Now, we turn it over to Ernie, who'll review the quarter in further detail. Ernie?

Thanks, John, and hello again, everybody. I'm delighted to share with you some of the details regarding our performance. Overall, we're encouraged by our results, which reflected a combination of accelerated revenue growth, strong management of what we will call controllable costs, improved operating income margins, and double-digit growth in earnings per share. Our second quarter revenue growth of 8% was solid and it was well-balanced. Virtually all of that growth was organic, and every one of our eight major business units had increases over the prior year.

Operating income grew at a faster rate of 12%, with overall margins increasing from 11.9% last year to 12.3% in 2005, and that reflected increased profitability in our termite business, which was achieved in spite of a relatively weak termite swarm season, and improved results in our heating and cooling operations. In addition, we're beginning to realize very meaningful benefits from our efforts to improve safety-related costs, and we've talked about those efforts with you in prior calls. Earnings per share increased 13% for the quarter and 11% for the first half, consistent with our previously stated expectations of delivering sustainable low doub -- double-digit growth over the long term.

While quarter-to-quarter variations have been and will occasionally continue to be impacted by seasonality and the timing of our investments back into the business, aggregate earnings per share growth over the past eight quarters have been in line with this objective. Second quarter and first half results have been affected by two significant costs that are going in opposite directions. Enterprise-wide we continues to be negatively impacted by significant increases in fuel costs. Although we hedge approximately two-thirds of our estimated annual usage, even net of the benefit of the hedges, fuel costs increased almost $4 million in the quarter and expected to continue to present a stiff challenge in the second half. We are piloting routing and scheduling software and GPS technologies, which among other benefits, would help reduce future drive time and fuel consumption, somewhat.

On the positive side, we're getting very favorable results from our safety efforts, and costs, which include workers' compensation, auto and general liability claims, those costs totaled almost $120 million annually and, prior to our efforts, had been regularly increasing at double-digit rates. In the first half of this year, we achieved a reduction in overall vehicle collision rates, and a very sharp decline in lost employee work days. In addition, the cost of claims incurred in 2004 and prior years continue to trend favorably, in comparison to the estimates that were prepared by our independent actuaries and that used to establish our related balance sheet reserves. When you put it all together, safety and insurance costs, including the effects of the favorable prior-year claims trending, were down approximately $5 million during the quarter, and we are targeting continued progress in the future.

Turning to our cash-flows, the decrease in cash generated from operations was entirely attributable to the $132 million in tax payments that we made earlier in the year and that were associated with the favorable agreement with the IRS that we have discussed on previous calls. If you back that item out, first half cash-flow totaled $129 million and was up 11% over prior year, very much in line with earnings growth. As a reminder, that those payments that I just mentioned reperso -- represent only one part of a four-part IRS agreement, which also included tax savings of $25 million that were realized at the end of last year, a reduction in our required estimated tax payments in the second half of this year of $45 million, and a deferred tax annuity totaling $57 million that we will realize over the next seven years. Stepping back and getting the big picture, the big picture is that cash-flows have consistently and significantly exceeded net income at ServiceMaster, and we expect them to continue to do so in 2005, even after considering the effects of this non-recurring tax item.

Our annual operating cash-flows have averaged 200% of reported net income over the past five years, and they support our attractive dividends and share repurchase policies. Our dividend currently yields almost 3.75% and has increased every year for 34 consecutive years. Share repurchases were temporarily curtailed during the second quarter, as our cash was used to fund peak seasonal operating needs, as well as the IRS payment. Repurchases will resume in the second half and are expected to be much closer to 2004 levels for the year, as a whole.

Our balance sheet remains very strong, and continues to improve, even after reflecting the unusual tax payment. If you look at the last 12 months, over that period of time long-term debt has declined to just under 800 million, cash and short and long-term marketable securities have increased to almost $375 million, and our debt-to-equity ratio has improved significantly to approximately 0.75 to one. Approximately $40 million of the cash and securities balances that I just mentioned are deemed available for general corporate purposes. Taken together, we have significant financial strength and flexibility and remain committed to retaining our investment-grade status.

Turning now to the segments, our LawnCare team continues to successfully expand new sales channels, and that's helped us offset continued sharp declines from tele-marketing. During the first half, sales from our direct-mail efforts increased 10%, while sales from our neighborhood programs more than tripled. Implementation of best practices and other program improvements have enabled us to achieve a solid increase in the average productivity of our neighborhood sales reps, which is somewhat unusual at a time when such a substantial expansion of the scope of our efforts was simultaneously occurring.

With respect to overall pricing, a more strategic and a more disciplined approach, which included reduced discounting and new sales and selectively targeted increases to our existing base have resulted in 2% overall improvement in price, up from just under 1% last year. Our customer retention rate was down modestly for 40 basis points, as continued improvements in the United States were offset by declines in Canada. And those declines, we believe, are attributable to unique circumstances in that market. Remember that overall retention rates have increased 400 basis points since 2001, and we are both targeting and anticipate meaningful additional improvement in the future. To capture that opportunity we've taken comprehensive steps to improve customer communication, as well as our problem resolution procedures. The change in sales mix that I mentioned earlier is also expected to contribute to improved retention. As we discussed last time, first quarter revenues were adversely impacted by late snows. We recaptured approximately one-half for the delayed production, or about $4.5 million in the second quarter, with most of the balance now scheduled for the third.

Finally on the cost side, there are two tiny changes, which had a nearly offsetting impact on overall second quarter results. Our co -- a correction, a minor correction in our method of allocating certain sales and marketing costs among interim periods, had a favorable impact. And that was offset by a higher portion of our expected full-year bonus costs being recognized in the second quarter. Turning to our commercial landscaping operations, a total revenues increased modestly in both the second quarter and the first half, maintenance revenues were up slightly overall, as gains from a higher level of new sales were offset by a modest decline in customer retention. And AMS's revenues increased 3% in both the quarter and in the first half. Retention is an area of that's getting increasing focus, but it also represents a very significant achievable -- and achievable opportunity for us with current rates at least ten full percentage points below our long-term expectations. It's a top operational priority, with intensified focus on improving customer communications and service level consistency.

Second quarter profit results were adversely impacted by the timing of certain expenses between the first and second quarters in 2004, that's last year. But they were improved in the first half of 2005, taken as a whole. So, ironing out the timing differences, profits were up. We continue to anticipate strong improvement in the second half and the full year, and that's going to be driven by key initiatives, including the efforts we've made to enhance our capabilities, training and methods of our sales team, reducing workers compensation and safety claims, and improving the scheduling and management of labor costs.

Overall, Terminix had a solid quarter. Revenues were up 8% and operating income increased 18%, despite sharp increases in fuel and factor cost. This was driven by particularly strong results on the termite side of the business. Sales of renewable term -- termite units increased 9% during the quarter, despite the weak swarm, and benefited from our planned investments to increase market penetration that we talked about during the first quarter call. Those efforts included branch splits and the expansion of our sales force in under-penetrated territories. In terms of mix, we continue to experience a modest shift toward lower price liquid treatments, which increased as a percentage of second quarter totals from 58% to 63%. In March, we introduced a new day option for our customers, which utilizes an active ingredient from day one and is providing very meaningful cost and marketing advantages over our prior offering. Labor productivity gains were also realized in our liquid option as a result of a new application techniques, which are referred to in the industry as perimeter treatments, to meaningful economic gains.

But, as disclosed in this morning's release, the second quarter profit growth was also favorably impacted by timing differences in the pattern of revenue recognition under the new fading option. Specifically, since a larger percentage of our total estimated costs in the first year of the fade contract are now incurred at the time of installation, we are required to recognize a proportionately larger percentage of our total first year revenues and profits at that time. This resulted in the accelerated recognition of approximately $5 million in operating income that would otherwise have been recognized over subsequent quarters. However, it's important to remember in evaluating growth rates that's last year we also had a non-recurring item. It was a $6 million favorable adjustment to damage -- termite damage plans. So these two timing differences, if you will, virtually offset each other during the quarter.

On the pest side of the business, solid revenue growth reflected a modest increase in unit sales and to the affect of acquisitions. And that was partially offset by the decline depicted in customer retention. But we believe that those past retention comparisons have been adversely impacted by the relative timing of cancellations that occurred last year, and we are working to ensure that they are not indicative of the start of a new track. Termite retention declined very modestly, less than 1%, on the 88% retention rate we're currently achieving in that category. However, we're taking it seriously. We're responding to it with the help of our six sigma teams by fine-tuning our approach to price increases and taking steps to improve problem resolution.

At American Home Shield, overall value trends remained very strong, with earned revenues up 8% and new contracts written up 9%. Up by channel, customer renewals, which is our largest source of revenues, experienced solid double-digit growth and that reflects both a larger renewable base and improvement in our retention rates, primarily as a result of reduced losses from mortgage refinancings. Our consumer sales experienced strong double-digit growth once again, resulting from a the successful expansion of our targeted direct-mail programs. Our real-estate sales decrease modestly in the quarter, as a result of increased competition in certain higher-usage stakes.

Operating profits were relatively flat, but were also ahead of our internal budget expectations. Profit growth was impacted by hotter weather conditions than the unusually mild conditions that prevailed throughout most of the country last year, and that led to a higher rate of service claims. As we talked before, planned investments to increase market penetration and further improve customer retention also had an impact. These claim and investment factors are also expected to impact third quarter growth comparisons at American Home Shield.

Our ARS and AMS segments achieved a 13% increase in revenues and a very sharp improvement in operating profit. At ARS, strong growth and replacement sales was accentuated by an improved mix of higher priced and more energy-efficient units. A residential new construction sales were also sharply higher. Combined, these more than offset continued declines in core plumbing and HVAC service costs. At AMS, our installation and retrofit pro -- retrofit project revenues and our related backlogs were both up significantly, as the commercial construction sector continues to slowly but steadily recover from a cyclical downturn. Profit growth for the segment benefited from increased revenues, as well as profit improvement efforts at our underperforming locations. On the cross side, increased fuel and variable compensation costs were offset by reduced sales and marketing expenses.

Finally, in our other operation segment, ServiceMaster Clean again achieved double-digit growth, in our disaster restoration services, as well as modestly improved momentum in commercial cleaning. Merry Maids continued to achieve very strong internal growth in both its branch and franchised operations. In both the second quarter and the first half, improved segment profitability included the effects of favorable, actuarially determined adjustments to prior year insurance reserves and higher profits from Clean and Merry Maids, offset by planned increases in other costs and investments.

Overall we're encouraged by our results and now we turn it over to you and welcome your questions. Thank you.

[ OPERATOR INSTRUCTIONS ] The first question comes from the line of Sam Darkatsh with Raymond James. Please go ahead.

Good morning, John. Good morning, Ernie.

Morning.

A couple quick questions, if I could. My notes, I don't know but hopefully this is correct, we're suggesting that we were looking for about 25% SG&A of 10% of sales in this quarter and we came in considerably better than that in terms of leverage. Was there a -- a -- a timing or a push of certain discretionary costs into Q3 from Q2, or was this simply a matter of -- of better cost control?

I think it's a ma -- matter of controls and mix. If anything, we probably accelerated investments into the quarter. But, no I -- I think it's mostly a function of the factors I just mentioned, control and mix of costs.

The marketing spin sequentially from Q1, what was -- was, in fact, similar as you -- you thought it might be the last quarter?

Certainly within line with our expectations, Sam.

Okay. Second question, La -- LandCare retention rate's down. You -- you talked about a little bit, bu -- but help us understand wha -- what specifically led to the -- the modest decline and -- and why -- why you're so op -- optimistic that the second half will reverse that trend, since it's a critical an ele -- initiative going forward?

Well, I -- first of all, let me take the second half first. I don't think your heard Ernie say we're optimistic the second half will improve. What we said is we are demanding and challenge this business unit over the mid to long-term to improve by ten percentage points. Quite honestly, we just -- Ernie and I were just with the LandCare team in Las Vegas. When we talk down, we're talking down 1%, it's as much a rounding error, but flat, slightly down, is totally unacceptable. It is the biggest thing we've got to get right in this business. And I think it's a combination of this leadership team, which is focused on commonality of operational purpose, which is making significant improvement in this business over the last year. now turning its attention, which it has, to its sales process from recruitment of sales people to the training of salespeople to the in-house sales people and our operational people work together on retention.

And it is job number one, it is a focus region-by-region on the top 25 accounts, who sees them, how often do we see them, how do our lawn quality audits go forward. You know, clearly when you talk to the business, they would say they've been turning out customers that are not aligned with where they're taking their business. And I say to Rick Askalese (ph), who's been part of that business a year, Rick, that's great to here. I say to Bob Fates, who's part of the business, Bob, that is great to hear. But Rick, for you and Bob, I heard it from the team before you for three years before that.

So, it's a matter of job number one, this team has proven itself to get a business stabilized and it's proved its operational performance, and just by focusing on the issue, by having all hands on deck, I'm confident that we've kind of said, you know, gee, maybe I'll take five years to get a 10% retention improvement. I have said guys, I'm tired of it, I'm done with it, you're going to get it done in three years. And we're going to have a team in place that is both operationally driven and a team in place from the sales side that gets the message around retention and gets it done. So a little bit is me becoming patient, a little bit of Ernie becoming less tolerant ,and a team that fully owns it t and spent three days at a mid -- mid-year meeting with this being job number one for the business unit.

Okay, complete answer. Thank you. Two more quick questions, if I might. And I guess, while we're on the topic of gauging your -- your tolerance levels, let's talk about ARS AMS. The performance, was -- was obviously considerably better this quarter. The core business is still soft, at least in ARS, and -- and you didn't quantify how much sales and marketing expenses were down, but that -- that's a discretionary cost and that also could -- could ma -- make results look a little bit -- optically look better than what they might be, internally. Wha -- what's the -- what's the feeling there in terms of have we turned a corner or it's still kind of a wait and see short leash kind of thing? And -- and what was the -- what was the quantification of the reduced sales and marketing expenses in the quarter?

The reduction was not material or I would have quantified it. I think it was in the $1 million range. Certainly, though, one of several costs that -- and I mentioned others that increased, so that was not a material factor. With respect, and we're said this before, this is a business that's been doing a awful lot of things right, starting first and foremost with having ex -- very high customer satisfaction scores. It's suc -- it has achieved some success in finding new sales channels and methods, i.e., our partnership with a large retailer, our efforts to improve sewer line repairs and commercial plumbing. All of those things are showing very tangible progress. However, it's -- it's also not deniable that we have continued to see our core service calls show flatness or slight declines for an extended period here. Part of that's attributable to more reliable products. So, those are the different tensions that we're dealing with, but this is a business that's been doing an awful lot of things right, just had difficulty putting points on the scoreboard. So, you know, it was encouraging to see the second quarter come through the way -- the way it has, but we've still got a lot of work to do.

Last question, ho -- whether it impacts negatively AMS and, to a certain extent, it helps, you know, ARS and AMS, is that a -- how sh -- should we look at that as, basically, a net wash when that happens or is it a net negative because of AMS's higher relative profitability levels?

We all take our microclimates we live in and extrapolated it across the expe -- across the entire country. The reality is whether weather's hot or there's a drought here, does not matter to our Company in the mid to long-term. It's the things we control, what we do every day with our customer service calls. Yes, a few more air conditioners may break, so -- so I'm just telling you, say this time and time again, this is not weather dependent Company and the things we control from our customer satisfaction, our sales techniques, our efficiency in the branch, are far more important than any weather can -- can attribute. You know, we had a lot of pessi -- pessimism about us after our first quarter, and we said okay, we didn't get a couple LawnCare trucks out in March. It doesn't fundamentally change any investment pieces about this Company, okay? We said it. We're going to continue say it. We control where we're taking our Company, the actions we take every day. Every company I've ever seen has some external factor that can affect it, but the thing that's important about our Company is we control our destiny and that's what we're working on.

Thank you very much, gentlemen.

You bet, appreciate it.

The next question comes from the line of Matt Litfin from William Blair and Company. Please go ahead, sir.

Yes, hello. Good morning. Question on the real estate channel within A -- AHS. Existing home sales have been at all-time highs, so from whom have you been seeing the competition that you mentioned and are you -- are you losing any market shares in key markets?

Yes, I would have to say, Matt, based on the flattishness of our Home Shield efforts, particularly in California, we're losing to the normal cast of characters out there a little bit. Once again, if I had -- you guys are doing a pretty good job on picking on a few points. despite just terrific performance across our Company that I'm unhappy with. I am unhappy with the flatness in the sales channel, American Home Shield. We put some efforts in place late last year. We think we've taken the right steps, but they're not coming through the level we'd like them to. We will continue to reexamine them, but we've done a lot about putting more sales people out there, giving our salespeople more tools and customer support.

We believe these are the things that we -- excuse me, we know these are the things that came through in both our conversations with re -- real-estate brokers and our end customers, so we'll continue work on those. It's going to take a little patience, but I'm not overly happy that we've got flat sales, despite the number of sales units being up. And I would say this, that I don't find the business units sitting there trying to rationalize it away, they're working hard on it also. Scott Cromie, Dave Crawford (ph) and team continue to look for ways of making sure we don't lose market share in California and gain it back. We are having some good success in the new markets we enter with the real estate channel. We are fully dedicated to expanding our real estate channel, as we also grow our direct consumer channel and American Home Shield.

I think it's also important to remember, for some of you that have been following us for a long time, we have substantially reduced our reliance in that business on the real estate sector, and, you know, our renewals alone are over 50% of our annual revenue totals now. And, with the consumer channel growing as rapidly as it has, real estate's about one-third of the total. So, we had really good, solid res -- double-digit growth in the -- the other two channels and, as John said, we're making the investments to get --- to get real estate back on track.

Okay. Thanks. I've got another one. Definitely not trying to pick on the negatives, so did I forgot to say congratulations on the quarter?

(inaudible) my job, so help me find them and we'll talk about them.

Right. Well, speaking of that, LandCare USA or LandCare, can you help us out with the -- the operating margin there in the second quarter? Wher -- generally, where are we at there, and what level of improvement did you say that you're expecting in the second half and, maybe, talk a little bit more about why?

Matt, I'll handle a little bit of it. We would -- we would anticipate revenue not growing at 5% in the second half, but close to it in LandCare. And year-on-year improvement in this business, we are -- we know that this business is going to improve our -- their EBITDA contribution to the Company by plus or minus over $10 million. And I think, for a Company that has brought in new leadership team, worked hard at investment and sales force, redeployed division managers across the country, they're having one terrific year.

So, as I think about it, the seeds have been set, the -- the team is in place and this team is executing in a way that is first improving their operational efficiency and now they've got to work on this retention issue and refine the sales process. But, year-on-year improvement -- and once again, it's not a business that I -- I get overly nervous about quarter-to-quarter, because there's always little things from Q1 to Q2 to Q3 to Q4 that can occur. But the trend line here on both revenue generation and their ability to convert that to improve profitability has been very, very solid this year with some things we talked about earlier in this call, particulate retention, that they've got to get better at.

Let me sneak in one more, if I might, on Terminix. Very strong quarter here, what would Katrina say about the -- the level of the swarm this past spring and how -- how that has affected things here in the second quarter in your outlook?

It's not Katrina. It would be all the major operators in the -- in the industry, so the industry would say it was below normal swarm. We tend to hear scales of one to ten. This would be 3.5, four, as it relates to, quote, unquote, what not only Katrina but all our major competitors would be saying about the termite activity this spring.

Also very consistent with the feedback we get from our fran -- remaining franchisees.

Very helpful. Thanks and congratulations.

Next question comes from the line of Kevin Monroe, Thomas Weisel. Go ahead.

Good morning.

Good morning.

Kevin, how are you?

Good. Could you guys quantify the -- of the decline in the AHS operating margins and what was -- how much was from increased claims and how much was from your increased investment?

I think about two-thirds was attributable to higher claims level and one-third was due to the incremental investments. So those are rough numbers, but I think they're pretty close. Just a reminder that that still leaves that business with very, very solid operating income margins, not even considering the -- the additional income we earn on the investment portfolio, which is, of course, recorded below the operating income line.

Right, another question. On -- overall I'm looking, you guys have been expanding your sales effort and making investments in various businesses. Where do you think you stand in terms of, you know, expanding the sales challenge in TruGreen and making investments there, making investments in AHS? I mean, are we still in the early innings or are we approaching, kind of, the end of these efforts?

Let me first talk to LawnCare. You know, we are basically -- for two years have treaded water in the total aggregate number of new customers we've gotten. Now, I think that's a terrific accomplishment in a period of time, Kevin, where we've had a unbelievable shift in channel. This team is now focused. Vic's been the head of market there for two years and we were sitting down with him at lunch about a year ago saying John, if four or five years from now, all I'm doing is generating the same number of new customers that my predecessor has, you haven't hired a very good marketing director.

So the challenge for them is okay, we've got it stabilized, we basically have neighborhoods selling rolled out, what else is out there? How are we approaching it? What we do in the retail channel? There -- my judgment there's significant more to do in our inquiry sales, there's significantly more selling additional services to our current customers. We've seen some terrific progress in pricing, which is also part of your revenue generation and pricing, by the way, does affect, somewhat, your ability to get new customers. So this team is focused on the issues. I don't believe that you're going to see organic 7% or 8% customer counts in this business, but we're not going to be satisfied with organic flat wi -- customer counts in the years ahead.

So that would be number one. Home Shield, as we get into direct-to-consumer, I think we're, to use your analogy, the top of the third inning. I think there is more to do. I think we've got to understand, more aggressively, lifetime value, how much more we can be mailing. Matter of fact, over the next month or so, led by Mitch Jingle, there'll be a lot of conversations about are we making all of the, quote, unquote, aggressive decisions we can around neighborhoods selling, around inquiry? Where else can we take our branches and do geo expansions? So we believe that each one of these have potency of, you know, none of them in and of themselves being a home run, but each and every one of them can add a percent or two of growth. And with price and other things we're doing, you know it's why we believe that this, you know, mid to high single-digit revenue growth is sustainable for a period time going ahead.

Thank you.

[ OPERATOR INSTRUCTIONS ] The next question comes from the line of Chris Gutek, Morgan Stanley. Please go ahead.

Thanks, good morning.

Morning, Chris. How are you?

Good, thanks. John, I wanted to start with a big picture question on the macro outlook. It seems certainly relative to the spring when we talk about the soft patch, that the macro environment seems to be improving. I guess the emerging consensus expectation is that will continue in the back half of the year. That should have positive implications for improving consumer confidence and, therefore, potentially a potential upside to the growth rates for both top and bottom lines for ServiceMaster. I'm curious, when you talk about comparable growth in the second half versus the first half, are you being conservative? Are you not necessarily placing much of a macro improvement set? Or is there something else you're seeing from a consumer confidence perspective that makes you a little bit cautious?

Yes, I -- Chris, I -- you know, I've seen these little wavering in consumer confidence. You know, I think we're slicing the onion a little too thin when we try and say is the consumer confidence going to go up six points or ten point or four points. I think we're operating, when I'm out talking to our employees, when I'm out talking to customers on the phone, I don't see a -- you know, a -- you know, the roller coaster up or down that, you know, a lot of the economists have been talking about. I think we're in a relatively benign environment. I think that benign environment will continue. It's not too hot and it's not too cold, either from consumer confidence or economic factors, and I believe that environment will continue in the quarters ahead. And that's why we believe we've got a lot of symmetry to our revenue growth and our profitability in the next two quarter is coming forth.

Okay. And, John, you touched on the performance or the portfolio review. Can you elaborate there on what your current thinking is?

Well, I think I stated earlier that, you know, we continue to always -- by the way, you know, any company or maybe I won't say any company but any company I'm associated with is going to continue to look, on an ongoing basis, what businesses they're in, what businesses we should enter, what businesses we should exit, should we be for sale or sho -- we should be buying? So, an ongoing examination of our portfolio, how it aligns with where trends are, where our capabilities are, is part of running our Company. So, I don't want to over-react or any -- under-react,but we clearly also said, Chris, that we would be, you know, giving our investors furth -- further visibility to this during the third quarter.

We're still in the third quarter and we are -- continue to work. As I said, what I like is, with ARS and AMS, we've seen them operate now in what I'll say a normal pattern and activity. We've got to determine and we've set down with ARS and say, based on you'er performing now, and I won't give you the fill in the blank, but to get above the cost of capital the return that we'd like to see at, you've got a gap of 'X.' And their challenge is to come back and fill in that gap of how they're going to, you know, make that gap up with the number being 'X' over a reasonable period of time. And that's the plans we're working with them, and you can expect in September, if not before, to see a confidence of how we're either going to close that gap or challenge them as to, you know, their part of our portfolio. But, it all starts with current performance, and both Ed Dunn and Mark Burel have put up some solid numbers here, as you can see.

And finally for Ernie. Looking at the TruGreen LawnCare business. Comment on what the year-over-year impact is in terms of the increased marketing costs and/or customer acquisition costs, as the Company moves away from telemarketing?

Yes, it -- things have improved rather than eroding one respect, and that is as we gain more familiarity and experience with the neighborhood sales program, we have seen about a 15% improvement in the productivity per rep. So that's helped narrow the difference between telemarketing and neighborhood sales. There -- there's about a 20% to 25% gap in -- in expense costs per sale, neighborhood exceeding telemarketing by about 20% to 25%. But we would expect that that gap will narrow further, as we gain more experience and use more heavy sales team that's not virtually all green as we start the year.

Chris, one other comment I would put in there is that we contin -- we'vetalked about inquiry sales here in American Home Shield a little bit, and also Terminix. In TruGreen, significant retention rate difference in inquiry. So as we sit down with Dennis Sutton and his team, the value of an inquiry sale, which is above and more expensive than telemarketing, is significantly offset by their ability to retain longer. And as we think about retention rates in TruGreen, we are absolutely convinced it's got to be focused on that first-year customer that comes to us through telemarketing and neighborhood selling, where we're being more proactive and going out and talk to that customer.

So, it is where the focus is with Kate Oliver, Vic and Dennis Sutton and entire team. First your retention rates, when two people cancel, why do they cancel? Are they really signing up for a full-year program or just wanting an application or two? This is where the effort is and we'll be communicating more during the second half of the year, which we think is very, very positive information about the difference between first year renewal rates and subsequent renewal rates in TruGreen, and what literally happens from the time a customer sh -- you know, signs up with us in March of a given year and how that relationship builds with them over a 12 or 13 month period. And I think that, as I've said a couple times on these phone calls before, we are very hard on ourselves how we measure retention rates.

And true, we measure in a more negative way than the other businesses within our Company, and I will likely commit that by beginning of the year '06, we'll measure TruGreen retention rate the same way we do in the other businesses. And it improves the retention rate in this business by about five percentage points. And we'll walk people through the during the second half of the year, and I think it shows both the robustness and healthiness of the business, as we continue to work on getting that first time trier to become a dedicated user of our LawnCare service.

Great. Thanks.

The next question comes from the line of Mike Hamilton of RBC Dean. Please go ahead, sir.

Morning. Nice job on that top line.

Thank you.

First, if you could just provide a little color on what you're seeing with TruGreen Canada and, kind of, any implications you are drawing out of it?

Yes, Mike, we -- if we go all the way back to the acquisition we made last year, I remember being on this phone call and saying we bought a distressed property at one-third the average revenue price that we buy most (inaudible) and we recognized there going to be significant changes in the operating model in Canada early in 2005, and we -- it's why we were able to buy the -- buy the revenue at such a distressed price. Those changes did occur. They went to a more regl -- regulated environment, with the integrated pest management and what could be put on lawns. It's why the property was for sale. Quite honestly, if you go back, one of the pro forma and the number of customers we would anticipate of having had at this time compared to original plan, the business and the acquisition is working as we would have anticid or -- anticipated or very close to it.

So when you see the down retention rate in TruGreen, I think, Ernie, this is correct, the domestically we are about 40-points --

That's correct.

still making progress domestically and all the reduction was off of the Canadian base. But that was anticipated in the acquisition model and part of our business plan and acquisition price that we bought a year ago.

So, once again, sometimes you've got to peel the onion a little bit back and say what's actually going on. And as I said, I'm pleased with a 40 basis points improvement in TruGreen but, once again, I want to be get more than 40 basis points in a given year. And, as you know, as a lot of times when you work on a plan, you work on progress, you make 400 basis points improvement over three and one-half years, I think we're at a point now, Mike, where we have to pause domestically and say okay, we really hammered that one pretty good. Let's go back and totally rethink customer retention again, start all over, strip away what we've worked on, it's all been good stuff, but what's the next way to approach retention in TruGreen to take it up another four or five basis points over the next three to four years?

Thanks. I would assume along that line in Canada you're seeing a healthy improvement in operating margin. as you roll through the changeover?

Well, I -- we saw it -- we -- when we tuck things in, it occurs day one. This is a -- an organization that very quickly integrates our ability to put our business together with the acquisition up there last year, literally occurred probably basically within 30 or 60 days. So the value that was up there last year, quite honestly, as you take the customers away, you will have a deleveraging of margins this year, as you lose a little bit of route density. So, you know, the tuck-in ability, the ability to take out the overhead, all occurred second, third quarter last year, with very little residual left over for this year.

Yes, I understand what you're saying. Could we shift over to ARS, AHS and just educate me in a little bit. When I look at the dynamics of -- of what you are talking about going on, intuitively to me, the replacement, new construction business is going to carry the most cyclicality, while the -- the core plumbing and HVAC should be the most stable through a cycle. The dynamics going on, all things being equal, probably mean a little bit more cyclicality if these trends continue.

Well, I think there's one other twist in there, and Ernie wants to jump in here too. It's what we're having our folks focus on, you know, so you can have this recurring service call. The -- the real value in the business, particularly in the air-conditioning, is what we call add-on replace, when that air conditioning unit breaks down. So, we have done more to focus and do more direct mail, more outgone -- outgoing on marketing, putting into partnerships that have us focusing on that add-on replacement. So, if you think about our techs, theyre more geared toward that type of service and replacement call than the just go out and clean my filters.

So, I hope -- I like to see bias toward -- toward that on replacement, because we see our marketing programs to focus and position ourselves as the Company you call for add-on replacements are paying off. The same thing true in plumbing. Ernie mentioned earlier faucets don't break as readily as they used to, PVC pipe last a lot -- last a lot longer. It's why we have moved towards, you know, sewer repairs, commercial work, because it is a more dependable source and more recurring revenue in a more frequent incident basis that occurs, compared to the average household -- residential households in America today. Ernie, did you to add something?

Yes, just to make sure we -- we had clarity, when we talk about replacement sales within ARS, we were talking about a phenomenon that's not terribly cyclical, perhaps more dependent on intense temperatures, but not terribly cyclical. And just to put it in perspective, that particular sliver of the business in revenue dollars is actually more significant than the service call part. So the replacement side of ARS is one factor. Clearly in your comments were right as it pertains to retrofit and commercial installation projects, which are more common in AMS, which are the dominant business in AMS, so just for that clarification.

Intuitively, along that line, it seems like the -- the replacement that you're talking about is going to carry less margin. Is that why we -- I would have expected more leverage off of the sales growth. Is it because of the margin on the replacement side?

The plus margin because of the heavy material costs of the --

No, that makes sense.

unit that you're installing. Much more profit dollars, but lower margins, yes.

No, that was a very clear answer. Thanks for the help.

Next question is a follow-up question from Matt Litfin from William Blair and Company. Please go ahead, sir.

Yes, I wondered if you could just update us on your most recent thinking for tuck-in acquisitions for this year? In what areas would you want to do them and maybe your latest thoughts on how much you think you might want to spend this year?

Let me take the first part. First of all -- maybe I'll take both parts, Matt. We don't have a -- we don't have a limit on the budget. When we find good tuck-in acquisitions in TruGreen LawnCare, Terminix, if American Home Shield's have a competitor available, we'd be ready to write a fair price, reasonable check right now. So, there is no -- no budget budget limit on it. We have, quite honestly in the last couple months here, asked particularly LawnCare and Terminix to be more aggressive, not in pricing but just making out and making sure that our -- that our people in the market place know we're interested, how we're interested, how the pricing might work or not -- may not work, so we've got what I would call, quote, unquote, an open to spend.

I have yet to come -- have to say someone and say we just don't have the money to do that. So, if the economics makes sense, the geography makes sense and the -- you know, the way it'll be tucked in makes sense, I don't foresee a -- you know, Ernie and I saying no. Having said that, I think we have seen, you know, Katrina Helmkamp as she gets settled in, working with Albert Cantu and Tom Bracket spending a lot of time the last quarter or two talking to folks. Dennis Sutton and I were talking about things this morning, so there's a good level of activity, Matt. I don't see a big inflection point. I wish there were one. But I'm not going to force one when there's not there. And we will continue to work hard on our tuck-in acquisition activity. Ernie, anything you want to add on that or --

No, I think that's well said.

Okay.

Thanks.

Mr. Byots, there are no further questions at this time. Please continue with your presentation or closing remarks.

Okay, thank you very much. Appreciate all your questions and any follow-ups, please don't hesitate to give me a call.

And we will see you in New York in September. Thank you.

Thank you all.

Ladies and gentlemen\t, this does concludes the conference call for today. We thank you for your participation and ask that you please disconnect your lines. Thank you and have a good day.