Terminix Global Holdings Inc (TMX) 2005 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to The ServiceMaster Company fourth quarter 2005 earnings conference call. [OPERATOR INSTRUCTIONS]

And I would now like to turn the conference over to Bruce Byots, Vice President Investor Relations. Please go ahead.

Good morning and thank you for joining us. On the call this morning is Jon Ward, our Chairman and CEO, and Ernie Mrozek, the Company's President and Chief Financial Officer. Also joining us is Deb O'Connor, the Company's Controller, and Eric Zarnikow, our Treasurer.

Before I turn the call over to Jon, I'd like to remind you that today's earnings report discusses our business outlook and contains forward-looking statements. These particular forward-looking statements and all other statements that will 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 the risk factors that could cause results to differ. Additionally, in the press release and during the call, we are using certain non-GAAP measures, as defined by the SEC and Reg G. Please refer to the exhibit in our press release and our website -- or our website, at svm.com, for the required reconciliation to the most-directly comparable GAAP financial measures.

Now I'd like to turn the call over to Jon Ward.

Thanks, Bruce, and as you saw this morning, we reported a year with full year revenue and earnings per share that was in line with our expectations, $0.65 that adjusted to $0.61 after consideration for businesses to be held for sale. It was also a year where we grew top-line revenue in every one of our business segments. We were very proud that two of our core businesses, Terminix and TruGreen ChemLawn, each surpassed $1 billion in sales for the first time, joining ServiceMaster Clean with over $1 billion of revenue at the customer level. We have said that outstanding companies deliver outstanding results regardless of factors beyond their control, and that's what we believe we did in 2005. We overcame strong factor costs led by a rise of fuel, along with the cost of petrochemicals, which are an important part of our materials. There was a continued shrinkage in the telemarketing channel that was more than offset by expanded neighborhood selling efforts and direct mail efforts within TruGreen Lawn Care. And we made good progress in pricing through 2005.

We were a little disappointed with the flattening in retention rates in both Terminix and TruGreen, but we're attacking this issue with renewed focus in 2006 with our efforts around problem resolution. And we also know that our aggressive pricing strategies do affect on-the-margin retention rates. As you know, almost all the businesses we're in today were acquired in the late '80s or the early '90s. Mostly, we've had remarkable success at building national brands that dominate and do a very good job in their markets. We have the experience of running and building businesses that can create long-term value for our shareholders. Last year, at our investor conference, we talked about the litmus test of what it takes to be a strong ServiceMaster Company. Let me go over them again with you.

First, a predictable revenue stream, either recurring services with a customer or a sustainable sales pipeline that comes back time-and-time again. We need to be doing things that competitors can't do. We need to brand that experience with consistent service and more and more attention to what the consumer wants in that service call. Our third thing we focus on in our litmus test is working towards and keeping the number one position, and having a national expanding footprint. Or, we want to make sure we're in businesses that we can control our own destiny, where we believe that things we're working on are more important than the external factors beyond our control. And as we looked at our portfolio, we made decisions that were consistent with that litmus test. We concluded that ARS and AMS, although solid businesses with much potential, would be more valuable in someone else's portfolio. So last fall we began exploring strategic options through one-on-one conversations with interested parties. But in doing that, it became clear that we were better off moving the process to a more public scenario, getting more interested parties to be able to look at the properties that were on the market and engage our leadership teams in conversation.

We also saw, at the same time, an opportunity to expand our strong disaster restoration business, and that led to the acquisition of InStar earlier this year. Combining the capability of InStar with the ServiceMaster Clean is clearly a game-changing move in the disaster restoration business. We have recently received news that we will not be required to prepare a Hart-Scott-Rodino filing in connection with the acquisition of InStar. We now expect to close this acquisition on February 28th. Last week we also announced Project Accelerate, designed to substantially complete our move to becoming one Company. There are targeted savings in the area of $50 to $75 million on a gross basis. But more importantly, we're finding ways to pull services and competencies together, dollars that will be freed up to invest in new sales to offset factor costs and drop additional dollars to the bottom line.

We've now achieved two consecutive years of revenue and earnings growth on target that gives us confidence and momentum as we head into 2006. And as we deliver our business plan this year, we're going to concentrate on winning big by delivering an outstanding service experience for our customer. The successful integration of InStar, the divestitures of ARS and AMS -- and I want to say that the leadership teams, the field teams, all the way down to technicians have done a great job of being part of our team in the portfolio, and we know that their future is bright and we'll continue to work with them during this transition.

And lastly, we need to successfully execute the implementation of Project Accelerate. Our best opportunity to continue to build shareholder value is to have fewer priorities, but to pursue them with greater intensity. Going forward, our Company book, comprised of leading services brands that collectively have strong cash flow, higher revenue potential, greater operating margins, and greater return on invested capital. We are changing the nature of our Company, which will also change the nature of our returns. We believe that our improved portfolio, combined with solid execution of our business strategies, will enable us to deliver mid to high-single digit revenue growth and low double-digit earnings growth in 2006. From a base of continuing operations of $0.61, our target for the year will be $0.69. Based on those actions we are taking this year, our target is to achieve high single-digit revenue growth and earnings per share growth in the mid-teens, starting in 2007. That is an inflection point from where we have been the last couple of years. And as we bring those type of returns, we'll also make sure that our cash from operations continues to grow and greatly exceeds our net income.

With that I'll turn it over to Ernie Mrozek for some more detail on the year and the quarter.

Well, thanks, Jon, and hello again, everybody. 2005 was a very encouraging year, especially considering the significant challenges we overcame. Those included record high fuel prices, steadily rising interest rates, unusually harsh weather, and continued expansion in telemarketing restrictions. And we overcame those challenges by focusing on what we can control; like safety, like customer satisfaction, and like sales force and geographic expansion. In the end, we delivered on our revenue and earnings targets for the year, and ended 2005 with an excellent fourth quarter. Our results, combined with the actions we announced two weeks ago, give us a higher level of confidence that the solid profit growth being generated by our Company can be sustained and, in fact, increased over the foreseeable future.

Now, as a result of the planned sales of ARS and AMS, the financial statements that we released this morning look a little different, since these two businesses are now segregated and reported as businesses held pending sale. We've included a table in the release that summarizes certain key financial results on a preadjusted basis, which is consistent with how we ran the business throughout the year. We hope that supplemental information is helpful to you in making comparisons to our previously-reported results, as well as our forward-looking statements. Those preadjusted results show that total earnings per share for the year increased 10%, from $0.59 to $0.65 per share, consistent with the consensus estimate, and that was on a 7% increase in revenues. Operating income was up 8%.

If we focus on continuing operations only, results were also solid, with comparable earnings per share up 9% to $0.61. Revenues grew 6%. In the fourth quarter, profits from continuing operations grew at a faster pace, with net income and earnings per share both increasing at mid-teen rates. Most of our revenue growth was organic, and every one of our businesses achieved increases over the prior year.

Now, we've been keeping you updated on trends -- both positive and negative -- in some of our key factor costs. With respect to fuel, our large fleet continues to be negatively impacted by significant increases in oil prices, and those have also adversely impacted fertilizer costs at TruGreen ChemLawn. Although we hedge approximately two-thirds of our estimated annual consumption, even net of the hedges, fuel costs for our continuing operations increased approximately $13 million in 2005, and that would round to about $0.025 per share from that factor alone. Prices remain very high, and we currently expect that our continuing operations will absorb approximately $0.02 per share of incremental costs in 2006. As we've discussed in the past, GPS and routing and scheduling technologies that we've been implementing will help reduce drive time and fuel consumption.

Healthcare costs continue to experience strong inflationary pressures, and that's expected to continue. We'll also be making an additional investment in our benefits in this area of approximately $0.01 per share in 2006, and as part of our efforts to further enhance our existing position as an employer of choice. On the positive side, we continue to experience very favorable results from our efforts to reduce safety costs. In 2005, we achieved a 4% reduction in vehicle collisions and a double-digit decline in lost employee workday cases. Total costs from continuing operations, including the income statement effects of favorable trending of prior-year claims, were down almost $10 million for the year. The great news, we're still well short of our long-term safety targets, and we anticipate continued progress in the future. We've set a goal of $12 to $15 million of additional savings from continuing operations over the next two to three years.

Now let's turn to our cash flows. After adjusting for nonrecurring items, our cash from operations increased and, again, very significantly exceeded reported net income. In 2005, reported cash from operations was $243 million, which included net tax payments of about $86 million that were associated with a favorable agreement with the IRS that we've discussed throughout the past year. So our on-going cash flow base was about $329 million or roughly 80% higher than our reported net income. Last year, 2004, reported cash flow of $370 million reflected two nonrecurring items that we previously disclosed; a net-tax timing benefit of $25 million, and a non-sustainable reduction in incentive comp payments of approximately $20 million. So as adjusted, comparable cash from operations for 2004 was around $325 million, almost double the reported net income for that year.

So there's a trend here, and if we look at the past five years, cash from operations on average has almost doubled reported net income. That's an extraordinary relationship, and it's due to a combination of reliable fundamentals about our businesses that aren't going to go away soon. Specifically, we have low fixed asset requirements, many of our customers pay in advance, most receivables turn quickly, and inventory requirements are very modest, totally less than 10% of current assets. Most importantly, we continue to realize significant and recurring annual cash tax savings that are included in our cash flows, but not allowed to be recognized in our income statement. These benefits relate to the conversion back-to-corporate form that we experienced several years ago, and those incremental tax benefits are expected to average roughly $57 million annually for another seven years. That's an additional $0.19 per share on a pro forma or cash EPS basis. And to put that in perspective, that amount represents almost one-third of our reported EPS from continuing operations. So reported EPS would be one-third higher if adjusted for this item, so obviously that factor's very critical to any meaningful valuation of our shares.

We were asked last week how the divestitures of ARS and AMS would impact this so-called annuity. The answer is not much at all, with 2006 savings in the year of divestiture increasing and the future annual annuity decreasing slightly -- by slightly I mean roughly $4 million a year -- but with the aggregate total savings virtually unchanged. The strength of our cash flow supports our attractive dividend and share repurchase programs and, as you probably know, our dividend currently yields roughly 3.5%, and that dividend has now increased every year for 35 consecutive years. Share repurchases, which were curtailed during the fourth quarter due to a blackout that we imposed as we pursued the recently announced strategic initiatives, totaled approximately $52 million for the year. We expect repurchases for 2006 to be in the $80 to $100 million range. Our balance sheet is strong and it continues to improve. Total debt is now under $660 million, and that's a nine-year low. Cash and total marketable securities were almost $370 million, with approximately $20 million of that deemed available for general corporate purposes. Overall, we have significant financial strength, good flexibility, and remain committed to retaining our investment grade status.

Turning now to the segments, 2005 was a significant year for Danny Sutton and his lawn-care team, which for the first time in its history exceeded $1 billion in revenues. That lofty, market-leading level was up 4.5% over 2004, and that growth was achieved in spite of continued declines in telemarketing sales, as well as below-average weather throughout most of the country. Summer drought conditions dominated several of our key regions, adversely impacting both production and customer retention. We were encouraged by the team's continued success in expanding new sales channels to help offset continued declines in telemarketing. In 2005, sales from our direct mail efforts increased over 14%, and sales from our neighborhood sales programs more than tripled to almost 300,000 new customers. This successful expansion of new channels, combined with a 2% improvement in price and growth in supplemental services, led to the 4.5% revenue growth that I mentioned earlier. I'd like to remind everyone that, as we continue to develop these new sales channels, the timing of customer sales will be more heavily concentrated in the second quarter versus the first quarter, when telemarketing was historically more heavily concentrated.

In the short-term, weather can periodically impact our business, but we strongly believe that our own actions over the medium and long term have a much greater impact on our business. Although our total customer retention declined by 100 basis points in 2005, that reflected a sharp drop in the Canadian operations and a very modest decrease in the much larger U.S. business. The circumstances in Canada were unique, and included the effects of combining five acquired brands into one at the beginning of the year, as well as tightened application regulations. Although the decrease in 2005 was disappointing, retention rates have increased 350 basis points over the past four years, taken as a whole, and as Jon mentioned, we anticipate meaningful improvement in 2006 and thereafter. To capture that opportunity, we've taken comprehensive steps to improve customer communication, as well as problem resolution procedures, expand our quality assurance processes, and provide focused incentives at all levels of the business.

Turning to income, comparable operating income, after adjusting for the two non-recurring items that are disclosed in the release, increased about $2 million during the year, with an 8% increase in the fourth quarter. The fourth quarter was affected by both increased revenues and favorable timing of certain expenses vis-a-vis earlier quarters, and those positive factors were partially offset by higher fuel and fertilizer costs.

Turning now to our commercial landscaping business, TruGreen LandCare ended the year strong, as fourth quarter revenue growth of 7% benefited from an increased level of enhancement revenues, some of which was hurricane related. For the year, our base contract maintenance revenues increased 2%, despite a modest decline in customer retention. Enhancements, which account for about one-third of our revenues, grew 6%, and were favorably impacted by more consistent focus throughout the country, as well as the hurricanes. Increasing customer retention is a top priority for Rick Ascolese’s team because it represents a significant and achievable opportunity. Current retention rates are at least 10 percentage points below our long-term expectations. Future gains will be driven by improved procedures related to customer communications, landscape inspections, and problem resolution, combined with more selective targeting of sales prospects.

Operating results in LandCare improved by almost $9 million, and approximately $7.5 million, excluding the effects of nonrecurring 2004 items. These improvements were led by better labor management techniques, including more timely reductions in the seasonal work force during the fourth quarter, and reductions in safety related costs. As with all of our direct businesses, profit gains were partially offset by much higher fuel costs.

Turning to Terminix, they delivered another strong performance, with a 10% increase in full-year operating income on a revenue growth of 6%. 2005 was also a milestone year for the Terminix team, lead by Katrina Helmkamp, as they also exceeded $1 billion in revenues for the first time, and all of that was accomplished despite a very weak annual termite swarm throughout most of the country. Sales of renewable termite units experienced solid growth, reflecting benefits derived from the investments that we made to increase market penetration. Those included 25 branch splits and the expansion of our sales force in under-penetrated territories. In terms of mix, we experienced an additional shift from bait to lower-priced liquid treatments. Those liquid treatments increased as a percentage of full year totals from 55% to just under 70%. A relatively modest additional shift is expected in 2006. Our team was encouraged by their ability to maintain pricing of both liquid and bait services, despite the introduction of a new, lower-cost liquid perimeter treatment technique in 2005. Our renewal revenues had solid growth and that reflected the impact of improved pricing. In pest control, solid revenue growth reflected the effects of acquisitions and was partially offset by a modest decline in customer retention.

On the income side, we've previously discussed two positive developments, which had a very meaningful impact on our performance. In March, we introduced a new bait option, which utilizes an active termiticide from day one, and provides meaningful labor and material cost advantages over our prior offering. Labor efficiencies are also being realized in our liquid option as a result of the new perimeter treatment technique. These efficiencies, along with solid revenue growth, enabled operating income to grow 10%, despite higher factor costs and the effects of the adjustments to prior year damage claim reserves that have been disclosed in the release.

At American Home Shield, our home warranty business completed another year of solid top-line growth, and that occurred despite a meaningful and continuing slow down in the pace of home resales, industry wide. Home Shield's revenues reached the $0.5 billion mark in 2005 for the first time. Under Scott Cromie’s leadership, the Home Shield team has been one of ServiceMaster's fastest growing businesses over the past several years. And 2005 reflected a continuation of that trend, with revenues up 8%, all from internal sources. That reflected a solid increase in customer renewals, which is our largest source of revenues, and that renewal improvement reflected both a larger base of renewal customers, as well as solid improvement in the customer retention rate. And that improved rate reflects a favorable mix of renewing customers, as well as a reduced level of nonrenewals, due to lower mortgage refinancings. Real estate sales showed some improvement in the second half of the year, but did continue to be adversely impacted by the weak market conditions I mentioned a moment ago. Our fastest growing channel, consumer sales, again experienced strong double-digit growth as a result of expanded and more successful targeted direct mail programs.

Looking at the profit side for the year as a whole, American Home Shield experienced a 1% decline in profits that was primarily attributable to higher claim costs associated with much hotter weather than the unusually-mild conditions that prevailed throughout most of the country in 2004. Profit comparisons were also impacted by planned investments to increase market penetration and further improve customer retention, both of which should enhance long-term growth.

In the other operations segment, Mike Isakson and the ServiceMaster Clean team once again achieved double-digit growth in disaster restoration revenues, with improving momentum in commercial cleaning, as well. Our existing disaster restoration business achieved customer level revenues exceeding $500 million, reflecting a five-year compound growth rate of over 15%. Joy Flora and her Merry Maids team continued to achieve strong internal growth in both its branch and franchised operations. The overall change in operating results in the segment reflected higher profitability from Clean and Merry Maids, as well as the effects of favorable actuarially-determined adjustments to prior year insurance reserves. And those were partially offset by increases in other headquarters costs and investments. Please note that totals for this segment have been adjusted from prior presentations to absorb certain headquarters support and insurance allocations that were previously reflected as expenses within the ARS and AMS segment. That adjustment was required under accounting rules for presentation of continuing and discontinued operations, and the amount of the adjustments are shown in the exhibit to the press release.

As we look forward to 2006, this segment will also reflect the results of the InStar acquisition. InStar has been growing and is expected to continue to grow at much faster rates than the businesses now pending sale. It also earned significantly higher margins, double-digit margins. We expect InStar to be accretive in the $0.01 range during the 10 months following acquisition, and that's after interest and amortization costs.

Jon mentioned Project Accelerate, and as we stated in our February 2nd call, we ultimately believe we can achieve gross savings in the $50 to $70 million range, and net saving of $25 to $35 million, after reinvestments and factor costs increases. Those savings should begin to be realized in 2006, and reach end state on an annualized runrate basis in 2007. Excluding the effects of one-time reverence and implementation costs, the amounts of which we'll be determining over the next six weeks, as we finalize our more detailed plans and timetables, and which we will be sharing with you in our first quarter call -- excluding those items, we would estimate 2006 savings from Project Accelerate in the $0.02 per share range, helping us to offset rising factor costs and contribute to continued strong bottom-line growth.

Stock options. The full implementation of the new rules here will result in roughly $0.01 per share of incremental expense in 2006. Relatively speaking, that's a smaller hit than many other companies are taking, because we began expensing options on a prospective basis beginning in 2003. So, taking all factors into consideration, and as Jon stated in the press release, we expect to deliver mid to high-single digit revenue growth and low double-digit earnings per share growth in 2006, from a base of earnings from continuing operations of $0.61. As always, our off-season first quarter will be a period of investment for us, and those investments, mostly in sales and marketing initiatives, will primarily benefit subsequent quarters.

Thank you, and now I'd like to turn it back to the operator in order to open it up for your questions.

Thank, you. [OPERATOR INSTRUCTIONS]

The first question will be from the line of John Tate with Raymond James. Please proceed.

Good morning, everybody.

Good morning.

My first question has to do with LandCare. I was wondering if you could help us with how much of the incremental EBIT on a year-over-year basis came from the hurricane-related enhancement services?

Almost none, John. Maybe $1, $1.5, $2 million, but de minimus in the whole scheme of things.

Okay, so you're -- the EBIT margin for LandCare in the fourth quarter was about 7% versus 2% in the prior year. Would the -- the real EBIT margin, you're saying, would be closer that to that 7%?

Yes. Remember also on the growth part of the question that the prior year also included some hurricane-related enhancement revenues, so I think the incremental impact of hurricanes would be at the lower end of Jon's range.

Okay.

So probably $1 million.

Okay.

Okay?

And is the seasonality of LandCare similar to LawnCare? Do you see -- from an earning -- from an operating-profit standpoint and revenue standpoint?

The seasonality, John, is more heavily concentrated in the fourth quarter, given the way we recognize revenues on our base contract maintenance situations, which we essentially straight line and we have lower production costs in the fourth quarter to match against those revenues. In addition, the team has been focusing very diligently on improving labor management techniques, which will impact the full year, but particularly impacted the fourth quarter this year as we were much more timely in reducing our labor force for seasonal layoffs.

Okay. And my last question on LandCare is having to do with the first three quarters. Was LandCare profitable in each of the first -- or, I guess, unprofitable in each of the first three quarters or was it split differently?

I don't have the exact split. I think there's marginally unprofitable in a couple of the quarters, and a slight profitability in the first quarter. But we can get back to you on that, John. I don't have that detail in front of me right now.

Okay. Thank you very much, gentlemen.

Your next question is from the line of Chris Gutek with Morgan Stanley. Please proceed.

Thanks. Good morning, guys.

Good morning, Chris.

Couple of quick questions starting with the ChemLawn business, the volume growth rate for the full year was pretty low and, I guess, on an organic basis, was probably more or less negligible. And certainly there are moving parts there on the marketing side, as you move away from telemarketing, but ramp-up some of the there efforts. Could you give us a little bit more of an update on the outlook there? Are you -- are you confident that, as you shift away from telemarketing, that you'll actually be able to get some net growth in customers this year? And looking out over the next couple of years, what is a reasonable volume growth expectation for that business?

Chris, your point is a good one. As I sit here and think about the long-term prospects, we would target this to be like a 5% grower. I think that'll come with some customer counts, some pricing, and some incremental services to our existing base. We're doing a little different packaging of how we sell our services this year. We continue to see great traction in both neighborhood sellings and we're kind of reorganizing how we're approaching direct mail. So I'd say, one more year of -- you know, basically flat customer counts where we're doing a better job on pricing and increase in the amount of services. I think we will be up maybe 1.5 or 2% this year, but this is a -- you know, in our portfolio, which we think we've done a good job of both rationalizing and looking forward, Chris, this is a 5% grower. We think about reaching mid-teens as far as EPS. We want revenue growth in the 5% range here. We think we can convert it in TruGreen LawnCare better than 5%. So, we get 5% revenue growth, that's what we're looking for out of this business in the mid to long term.

Right. And then one more, if I could. On the American Home Shield business, 8% revenue business in the full year, decelerating to 5% in the fourth quarter. Obviously, the real estate markets are softening and you touched on some of the marketing efforts you had there as well. But, is that deceleration a sign of things to come, and do you think we could see a sharp further slow down this year? Or is that being too cautious on the dependence on the real estate market?

Well, when Ernie and I sit down and look at our outlook for 2006, when we talk with our team, we talk about the integration of InStar, we talk about Project Accelerate and now you've hit the two, Chris. Making sure we keep the revenue growing in American Home Shield. There has been a tail-off in the real estate channel, but it has us more focused on consumer. And the other one you talked about was TruGreen LawnCare. So, those are the operational risks we have going into the year. We think we've got them well thought-out. We think we've got our -- our real estate sales organization focused on growing. But we typically see, Chris, is when resales start to fall off, the first sign of it is, you know, we see less contracts; then all of a sudden, a higher percent of those homes for sale put our warranty contracts on it as a way to make the home more enticing. We think we're going through that transition right now. But it will be one of the two areas that we keep close eyes on for the next couple of quarters inside of our Company.

Great. Thanks, Jon.

Your next question is from the line of Jim Barrett with C.L. King & Associates. Please proceed.

Jon, I may have missed it, but could you amplify on your mid-teens EPS growth target for 2007. What will be the key drivers, what are the key assumptions and what implicit economic assumptions are you making for 2007?

Well, we're not expecting anything different from the economy, so we kind of say that's a non-recessionary -- kind of a, you know, 3% type of GDP we have had, Jim. It's not -- we've had very, very high home resale over the last couple of years. I don't think they're going to sustain, but I think they'll stay easily above five million units. I can remember, you know, three or four years ago, we thought 5 to 5.5 million units was a good real estate market, so we think that'll be maintained. But what we're seeing really here, Jim, is the investment pieces that we've made, the portfolio where we're bringing in a higher margin business in InStar. We have proven in disaster restoration; we can grow it at a minimum of 15%.

Our team in ServiceMaster Clean has done a great job with their owners over the last five years doing that, so we sit -- we just sit here with a better portfolio. We're being tough on cost. One of the things you've got to remember is we're -- in the divestitures of ARS and AMS, there are thousands of employees who'll be working for a different company here over the next couple of quarters. InStar brings a total of 400 employees with it. So one of the things we got -- we're able to do here is look at our streamlining of our ability of support services per employee, as we look at InStar in and AMS and ARS out. So, Project Accelerate, InStar, and what we think is continued trajectory we've given you out of our businesses over the next couple of years ends up to a healthier portfolio, a higher growth portfolio, a higher earnings portfolio, and a higher margin portfolio.

And I take on it a related point, would you envision accelerating your share repurchase if -- in front of that kind of business plan?

Well, I think what we're going to do is look at between now and, you know, probably mid-year, both our dividend and our share repurchase. And we've been committed to two things; returning capital efficiently to our shareholders -- once again I think we've been disciplined in our litmus test about businesses that aren't performing where we think we need them to -- and also disciplined about type of acquisitions we're looking at. We'll take that all under consideration and I would suspect mid-year -- once again, we're not just going sit on our cash. We get paid to either put it back in the business or give it back to the shareholders, in both a combination of dividends and share repurchase.

Okay. Thank you very much.

The next question will be from the line of Scott Hill with Brown Brothers Harriman. Please proceed.

Hey, Jon, how are you.

Good morning.

Jon, a little more on American Home Shield, if you would. I -- there's obviously a deceleration on the top line and the negative move in the operating income line was pretty significant in the fourth quarter. But actually, I guess, even more concerning is if you look at those things against the capital employed and the growth in that business gives you -- at least me -- cause for concern in terms of the returns that you expect there. So, maybe you could talk more about the capital in that business, and help us explain and understand a little better?

Sure. I'm going to take the first half, then turn it over to Ernie and maybe talk about the portfolio and some other things in there. First of all, remember, 2005 was a year where we saw our incident rate on slow service calls go up significant due to very, very hot weather in the summer, so our margin impact -- by the way, we kind of think that gives us -- it'd be hard to imagine that weather be repleted, so we think it -- repeated in '06, we think it gives us a leg-up going into '06 on likely scenario of weather. And, obviously, we're already seeing a pretty warm winter, so we're not getting as many service calls in the first five or six weeks of the year. Remember, this is a very, very high margin business -- excuse me, I want to say high margin -- a high return business today. We have margins in -- you know, in the low teens, 11, 12%. We get a higher return on capital.

So, as I've been talking to this Company and this business, I've been less concerned about the return on capital than whether or not they can grow. They are clearly way above their cost of capital. So, when I have a business way above the cost of capital, I always think about two ways to improve their EVA. One to further improve their cost of capital, or second, to get a lot more revenue growth. Our primary focus in Home Shield is being strategic but aggressive in how we think about customer acquisition. Part of return on capital is also the investment portfolio we have there, and I'm going to turn it over to Ernie for a comment or two.

Yes, there's a couple of things. When you look at capital employed in American Home Shield, that includes significant cash and marketable securities balances. In fact, most of it. And the income that we derive from those balances is not included in our operating income. It's concluded as non-operating items, so you got a little bit of an apples-and-orange basis. As we look at the business and our board looks at the business, American Home Shield has an excellent return on capital. That's not at all the issue. Operating income margins have been at the 14% kind of range. Yes, this year they were down, but we knew going into the year we had a double whammy. 2004 was unusually mild. We went from pretty harsh conditions, but we have no concern about the sustainability of strong operating income margins over the near-to-long term. So really, we've got down to the one factor, which we have described, which is the slowing real estate resale sale channel. The other two channels are doing quite well.

So you don't expect continued growth rate in capital employed anywhere near this 25% level going in future time periods?

No, no. And again, whatever that growth rate is it's mostly coming in cash and marketable securities.

Obviously, my tongue and cheek. I hope I do, because it means the only way we're going to grow the invested capital would be that my revenue is growing 25% and the state insurance companies make me set aside the money. So basically, the capital set aside for insurance claims and warranty claims is a state-regulated issue, and it will basically grow consistent with the amount of revenue we generate in business. So if we're going to grow 12%, you're going to see the amount of money we have in our investment portfolio set aside 12%. And we can walk you through off-line how that flows through our income statement, but it actually makes the business significantly healthier than it does in our income statement.

Great. Can you guy also talk about the capital intensity of InStar? You've said it's a high-margin business. How about capital?

It will -- if the business is growing, it will -- it will consume capital in relationship to working capital as it grows. So, what we tend to do here, as you grow the business, working capital is needed. You tend to have receivables that today are put off a little bit longer than we'd like them to be. But going forward, we would think that capital -- we hope that -- we think that we can grow this business. After we get it lined up with ServiceMaster Clean, our target is going to grow this thing 15 to 20%. So, we'll be using some capital as it does it, but it's basically working capital. There is also the -- you know, I'd say probable or possible acquisition of small organizations around the country to help fill out their fulfillment network, so that could consume some acquisition capital, but not in a significant manner. I would say, you know, under $100 million over the next 18 to 24 months here.

And just one clarification. Jon did say working capital consumption. Overall cash flows would still be expected to be positive from this business, even in periods of strong growth, okay? So it's positive cash flow, but doesn't have -- in the periods of growth, it won't have the relationship to net income that I talked about earlier, but most businesses don't. So it will be positive cash flow generating, even in periods of rapid growth, but with some consumption of working capital as receivables increase.

And then, lastly, can you guys talk a little more about the specific mechanics? The difference between effective and cash tax rates and this $0.19 a share positive impact in terms of cash looking out for the next seven years? This, obviously, can't be factored into most valuation parameters. Maybe it's not well understood.

Right. Would agree. Would agree. And --

Those that own our stock understand it very well, is what I say.

The $0.19 -- again, this relates to -- we were able to step up the tax basis of our assets when we converted back to corporate form. To make a very technical story, hopefully, simple, we were able to step up the basis to the aggregate basis that our shareholders held in their limited partnership shares. Okay? There was no corresponding step up in book goodwill. But the -- we are not allowed to reflect the benefit of that economic event in our income statement. It does obviously impact our cash flows. And again, the difference is roughly $0.19 a share today. And as I said in my remarks, that might drop down to $0.175 or $0.18 post ARS/AMS divestiture. But we really don't lose anything. We just get that difference a little earlier. We get it in the -- all in the year of divestiture, rather than spread out over the next seven years. So it's a complex matter. I hope that gives you a flavor for where it came from and what it is, and it's very significant.

I’d put it maybe another way to get a handle on it. On a reported net income PE, we basically trade at a market average. On a cash PE, reported cash PE, we trade at a significant discount from any metric that you would use out there for a peer group. But I think that's the -- one of the strong investment pieces that we've been talking about. It continues to get stronger as we go forward and we're going to continue to talk about it.

Thank you.

[OPERATOR INSTRUCTIONS] The next question is from the line of Matt Litfin with William Blair and Company. Please proceed.

Hi, good morning. You mentioned in your prepared comments some aggressive pricing strategies in 2005. I wondered, can you quantify that and talk about where those price increases were realized by segment -- not by segment, but which segments mostly?

Well, we -- Home Shield has always had a very good disciplined pricing strategy. Year-over-year they look at what's covered under their incidents and what adjusted service calls. They've got a big transition coming up this year, with the requirement that air conditioning units be a higher efficiency, what we call a 13 SEER. So, we've got some what we think is some very, very intelligent pricing on 13 SEER in American Home Shield, as we go into 2006.

Terminix. Terminix has done a lot of work, Matt, on pricing renewals. My back of the envelope says that we've been pretty aggressive; maybe getting close to mid-single digit pricing increases on, particularly, termite renewals. We have started to see -- I'm not going to use the price -- but some resistance as we raised those prices above a certain level. We think it did hurt our retention rate a little bit. You saw it drop 1%. We'll be backing off on that a little bit, but also raising the bottom. The whole concept here is bring up the bottom of the bucket but also, at the same time, be understanding what can be done as to aggressive renewal rates.

In TruGreen LawnCare, there's been a bouncing back and forth. First, for a couple of years, there wasn't very much done on pricing. In 2004, we started looking at how we raised prices with customers who were coming in. 2005 we did a fair amount of work of testing to understand what type of renewal strategy we could have. We tested a mid-year price increase. We tested a few other things, and we think those warnings will allow us to continue to build the health of that business, but be more consistent and strategic in how we think about pricing. So a whole bunch of tests. And TruGreen has been focused both on renewals and new customers. In Terminix it's been focused, basically, on renewal rates of both pest and termite. And in American Home Shield, it's been a consistent strategy over the last five to 10 years, and this year we've got to take into account 13 SEER.

Okay. And the other area I wanted to ask about was TruGreen ChemLawn. How does the early selling season look? And where are you modeling the percentage of your customers in that business segment from telemarketing in 2006 versus your '05 experience?

Yes. Matt, as Ernie mentioned, we're getting more and more customers later. This is, typically, our telemarketing season. We predicted a growth. The growth of the 'do not call list' has gone from the mid-70 million names to in excess of 100 million names. So, where right now, we would have -- typically, you know, five years ago we'd have a pretty good understanding of where the business is. We're now just starting our neighborhood selling and direct mail campaign, so too early to tell. Clearly, less than half our sales this year will come from telemarketing. Ernie, I don't remember the exact percentage, but I'm going to say somewhere around 40%, but that's a little bit of a swag.

About 45.

45%, Matt. So, this is a Company that three years ago, 95% of its customer came from telemarketing. Chris Gutek's comment earlier that our new customer generation has been basically flat during the last couple of years is correct, but a huge channel shift -- and as I said, this could have been a torpedo in our boiler room -- we've been flat lined during the transition. We're proud of flat lining, but we're not accepting that. We think this is the last year of the transition, and then it's an acceleration to our direct mail and neighborhood selling in '07 and beyond.

Okay. Thank you.

The next question is a follow-up from the line of Chris Gutek with Morgan Stanley. Please proceed.

Thanks. Jon, a couple of follow-ups. On the last conference call, there was a lot of talk about consumer confidence and the risk, given high energy prices. And certainly it looks as if consumer confidence, generally, has held up reasonably well. But you guys do have a unique perspective, given your businesses. So I was hoping you could give us an update on your view of consumer sentiment and any slight negative impact in Q4, and what you're thinking if you put your economist hat on for 2006?

Well, since Greenspan retired, I'll take his hat. We're feeling -- Chris, you're right. I was little concerned in November. We saw consumer confidence, a lot of other things had us concerned. I'm not as concerned as I was at that point, although, once again, I don't get as early a read as I used to with our move away from telemarketing. But I don't see anything out there there that has us concerned, with the exception that you and I talked about a few minutes ago, Chris, that the housing -- the housing resales are down a little bit. And that does effect how the consumer feels about reinvestments into their homes, et cetera, but that's the only thing we're seeing out there right now that has us at all concerned. Housing prices flattening out may effect a little bit of consumer wealth, but we don't believe that's going to affect our services. They're less -- they're every day becoming less and less discretionary, and part of the household budget. So, we're feeling okay to very -- pretty good about the outlook for the consumer confidence and the consumer spending during our important sales season here over the next eight to 10 weeks.

Okay, great. A quick one for Ernie. The interest income in the quarter was a little bit low versus the trend. Was that just lower gains from American Home Shield portfolio, and if so, what was the reason for that?

Chris that's exactly right. It's just timing on the gains on the portfolio during the course of the year.

Okay.

That's the single biggest difference.

Okay. Jon, I think you said you don't want to comment on the ARS divestiture, but I think I'll ask the question anyway. Anything that you do care to say about where you are?

Just that we -- we appreciate the hard effort of our folks who are still working at ARS/AMS, and I'd be surprised to have anything real soon, Chris. It think it’ll take a couple of months to play itself out.

Okay. And then, finally, the implied '06 EPS guidance is, I guess, a little bit below us in the Street. Obviously, part of that is factoring in the ARS divestiture and lost earnings there. But, there's also these investments you guys have been talking about. I'm wondering if those really are the factors or if there's any conservatism or how you feel about the guidance? Does it -- do you feel any conservatism in there?

Once again, we feel we've given -- if you do the math on it, $0.61 to $0.69 is a 13% EPS growth. So, if anything, it's more aggressive and it's getting towards that mid-teens we're committing to in '07. So we think if anything, Chris, it's the opposite. It's hard to bridge everybody through it, but in follow up calls, you know, you got stock options in there, you got some timing differences in that we're -- you know, ARS and AMS, we don't -- the proceeds in, assuming -- you know, we're kind of assuming a midyear sale, so we've got some timing differences of between proceeds out for InStar and money in for ARS/AMS. So we feel good about 13% EPS growth for the year and we'll be proud to deliver that, and we think it's a continuation of what we started in 2003.

Alright. Thanks, Jon.

You get 10 months on InStar instead of 12, and accelerate will take time to ramp-up, so we've taken all of that into consideration.

Understood. Thanks.

Mr. Byots, there are no further questions at this time. We'll now turn the call back to you. Please proceed with your presentation or closing remarks.

Okay. Thank you everybody for your call. The press release, the conference call's all on our website, so please feel free to refer to that, and please feel free to give me a call with any questions after this. Thank you very much.

Thank you. Good day.

Ladies and gentlemen, that does conclude the conference call for today. We thank you very much for your participation and ask that you please disconnect your lines. Have a nice day.