Terminix Global Holdings Inc (TMX) 2017 Q3 法說會逐字稿

Ladies and gentlemen, welcome to ServiceMaster's Third Quarter 2017 Earnings Call. Today's call is being recorded and broadcast on the internet. Beginning today's call is Brian Turcotte, ServiceMaster's Vice President of Investor Relations and Treasurer, and he will introduce the other speakers on the call. At this time, we'll begin today's call. Please go ahead, Mr. Turcotte.

Thank you, Chris. Good morning, and thank you for joining our Third Quarter 2017 Earnings Conference Call. Before I review the agenda and introduce the other speakers, I'd like to remind you that throughout today's call, management may make forward-looking statements to assist you in understanding the company's strategies and operating performance.

As stated on Slide 2, all forward-looking statements are subject to the forward-looking statement legend contained in our public filings with the Securities and Exchange Commission. These forward-looking statements are not guarantees of performance and are subject to the risk factors contained in our public filings that may cause actual results to vary materially from those contemplated in the forward-looking statements. Information discussed on today's call speaks only as of today, October 31, 2017. The company undertakes no obligation to update any information discussed on today's call.

This morning, ServiceMaster issued a press release filed with the SEC on Form 8-K, highlighting our third quarter 2017 financial results, and we have posted a related presentation, both of which can be found on the Investor Relations section of our website.

We will reference certain non-GAAP financial measures throughout today's call, and we have included definitions of these terms in our press release, which is available on our website at www.servicemaster.com. We have also included a reconciliation of these non-GAAP financial measures to the most comparable GAAP financial measures in our press release and presentation in order to better assist you in understanding our financial performance. All references on the call to EBITDA today are to adjusted EBITDA as defined in our press release.

Joining me on today's call are ServiceMaster's Chief Executive Officer, Nik Varty; and Chief Financial Officer, Tony DiLucente. For those of you that haven't had a chance to download the investor presentation from our website, I'll walk through the agenda items shown on Slide 3.

Nik will lead off with some opening remarks regarding his key activities and observations during his first 100 days as CEO at ServiceMaster, and then provide an update on the Terminix business transformation and the company's strategic growth priorities. Tony will follow and summarize our consolidated third quarter financial results, review the individual business unit results, provide more details in regard to our financial statements and then speak to the updated full year outlook. We'll then open up the call to your questions.

I'll now turn the call over to Nik. Nik?

Thanks, Brian. Good morning, and thank you all for joining us today for our third quarter 2017 earnings call. During the quarter, we saw good revenue and EBITDA growth across American Home Shield and Franchise Services Group, and also at Terminix, when normalized for Hurricane Irma and Harvey and excluding Alterra customer attrition. Tony will provide details on the financial results later.

We also launched a disciplined approach toward improving performance at Terminix, building on some of the investments we described earlier in the year. We're making good progress on the spinoff of American Home Shield and have embarked on developing and establishing a strategy to set up 2 highly successful listed companies.

I'll start with Slide 4. Having now spent 100 days with the company, I'm very confident that there is a significant opportunity to unlock value at ServiceMaster by sharpening our focus on our results and operational excellence. ServiceMaster has powerful and well-recognized brands that reach into more than 5 million homes annually nationwide. First and foremost, we see tremendous potential at Terminix to improve performance and drive long-term profitable growth through our strategic transformation plan. Terminix operates in markets with strong future growth potential and has significant opportunity to leverage its core strengths to grow rapidly in the commercial business space, with the right level of focus, leadership and implementation of key growth strategies.

American Home Shield, or AHS, continues to be a strong and consistent performer, delivering high single-digit organic growth annually for the past 5 years. We're continuing to drive profitable growth at AHS in this vastly underpenetrated market and see significant potential in adjacent markets through the use of our industry-leading contractor network. We will continue to drive shareholder value to our plan to spinoff AHS, which is on schedule for the third quarter of 2018. We're building a strong leadership team that can capitalize on the high growth potential of this business and deliver sustainable long-term value for our shareholders.

As one of the nation's largest franchises of home and commercial services through our highly profitable Franchise Services Group, we're continuing to expand that business by growing our national accounts and broadening our service capabilities into new areas. We have increased our customer level revenue in that business to $2.5 billion annually, and we see significant further growth potential as we account for only a small fraction of the very large and fragmented home and commercial services market. Over the past 100 days, I've had the opportunity to meet with hundreds of our employees across all the 3 businesses and corporate support center. And I have been impressed by their professionalism and commitment to improving the customer experience. I visited Terminix and American Home Shield call centers in Dallas and LaGrange, Georgia, met with employees and I've listened to numerous customer calls. At Terminix branches in Massachusetts, California and Ohio, I had the opportunity to learn from our tech and outside sales professionals and our branch and service managers and also accompany route technicians on service calls. I had an excellent experience meeting with our largest franchisee of Terminix in South Carolina as well.

I also traveled to Houston, a few days after Hurricane Harvey devastated South Texas, to thank our employees and franchisees for their incredible dedication to getting people back in their homes and back to their jobs. We mobilized more than 1,000 people to help out with the recovery efforts, and I'm very proud of how our people rallied around our customers, both personally and professionally, to support them during this critical time of their need. This response demonstrates how well prepared we are at all times to help our customers when they face disaster-related events. And although I didn't have an opportunity to travel to Florida or the Caribbean, following Hurricanes Irma and Maria, I also want to recognize our employees and franchisees in those areas. In all of the locations affected by these storms, I could not be more proud of our teams. Although I have been in the CEO role a very short time -- relatively short time, I have also had an opportunity to meet with sell-side analysts that follow ServiceMaster and many of our valued shareholders and debtholders. I value your opinions and the opportunity to demonstrate our commitment to driving long-term value for our owners.

Tony and I have conducted monthly operating reviews and deep dives for all 3 of our businesses as well as functional reviews over the past 3 months. This process has allowed me to better understand both the opportunities and challenges facing our business and also provides me with a forum to appraise our talent toward the organization. I can tell you that I have been very impressed with the people throughout our businesses and have identified areas where we can further enhance our teams to drive improved performance.

As I mentioned on the second quarter earnings call, the decision to separate the AHS business from ServiceMaster is the right and necessary step at this point in time. The planned spinoff is expected to better position both AHS and ServiceMaster for the future as more highly focused companies that are able to pursue their distinct strategies and growth opportunities. It will allow Terminix to fully focus on its transformation activities while allowing AHS to pursue its high-growth opportunities.

I was pleased to announce on October 2 that we have hired Dion Persson to head the spin management office and manage the overall strategy for the company. Dion will be responsible for developing and executing a well-structured process for spinning of AHS and will be responsible for identifying and advancing all business development activities for the company. This includes directing and evaluating new marketplace opportunities, such as strategic partnerships, mergers and acquisitions that support ServiceMaster's strategic growth and development plans, with the goal of positioning 2 successful publicly traded companies in 2018 post-spin. Prior to joining ServiceMaster, Dion served as Vice President of Strategy and Analytics for Ingersoll Rand, and also served as Senior Vice President and General Counsel and Head of Human Resources at Johns Manville as well as Senior Vice President of their largest business, the Engineering Products Group. He previously worked for the law firm of Skadden, Arps as well. We are extremely pleased to have him on our team.

We are committed to keeping you informed as the spin process moves forward. We recently named Matt Stephenson as President, Terminix Residential. Terminix Residential will become a separate P&L, with full accountability for driving improvements in the residential business and delivering results. This new business unit focus will enable us to better understand our residential customers and their needs to accelerate growth and introduce new products and services. In this new role, Matt will reportedly directly to me and have full P&L responsibility for Terminix Residential business, and we'll be focused on driving growth and profitability in the $5 billion residential pest control and termite market. We believe that having a dedicated focus on the residential market will allow us to leverage our understanding of the homeowner's specific pests and termite control needs into unique offerings to attract and retain customers and accelerate growth.

Prior to joining ServiceMaster, Matt served as President and General Manager at Meritor WABCO, where he significantly improved performance in many areas, including sales, operations and marketing, and repositioned the business for greater profitability, growth and long-term success. Prior to WABCO, Matt held a variety of executive sales, marketing and operations roles at Bridgestone Americas and Daimler Trucks North America. We are excited to have Matt joining our Terminix team.

Before I turn the call over to Tony to review our third quarter results and full year 2017 outlook, I'd like to update you on our Terminix business transformation. Please turn to Slide 5. At Terminix, we are taking a disciplined approach to executing a series of systematic transformational activities to significantly upgrade the customer experience, improve our customer retention rates and profitably grow our market share. We are building a strong leadership team, with significant experience in delivering results and driving profitable growth to lead the tremendous individuals we have throughout the business. At the same time, we are creating an organizational structure that enhances personal accountability and supports a high-performance culture. We are empowering our route technicians to deliver an exceptional customer experience by giving them the tools they need to improve customer engagement while providing them with timely customer feedback. We're beginning to see results from our past technological investments in improving pre and post-service customer engagement and our ability to receive direct customer feedback. We will develop a strong commercial business to better able to focus on and serve commercial customers, which represents a significant opportunity for us.

We will implement a disciplined, Lean Six Sigma approach to enhance efficiency, to significantly improve customer levels, strengthen our investment discipline and drive profitable growth. We are enhancing our ability to consistently deliver on our commitments by increasing our transparency, improving operational cadence and measurement systems and strengthening business processes with a goal of creating long-term sustainable value. We recognize change will not happen overnight and that it will take time for us to demonstrate the benefit of steps we're taking to drive improved performance. But I'm confident we are headed in the right direction to deliver consistently strong revenue and earnings growth.

Turning to Slide 6. I'll share some of our strategic growth priorities for each of our businesses. At Terminix, we will continue to execute on the business transformation I just reviewed. Our initiatives are designed to achieve world-class customer service, to improve customer satisfaction and increase customer retention levels. And we will seek to expand our commercial pest control and termite business. Today, our commercial revenue represents about 20% of our total Terminix revenue, and I'm confident that we can grow that profitably. At AHS, we will also seek to increase market penetration by providing world-class service to our valued customers. As we've mentioned on the past few earnings calls, we have increased call center investment to improve response time as well as upgrading contractor capacity and quality. We also plan to extend product offerings and expand into adjacent markets. I don't want to provide too much detail today about our plans for competitive reasons, but we will be updating you in the future.

And at the Franchise Services Group, or FSG, we will continue to leverage relationships with the insurance companies that currently provide us with disaster restoration leads as well as form new relationships to grow that business. The ServiceMaster Clean business will work to both increase share with existing national accounts as well as add new accounts to drive higher revenue growth. FSG is also exploring opportunities to expand their current reach beyond its core area to drive growth.

I'm very excited about our growth opportunities across all of our businesses and plan to share our progress as we move forward. I'll now turn the call over to Tony.

Thanks, Nik, and good morning, everyone. Turning to our consolidated results as shown on Slide 7. ServiceMaster produced solid revenue and EBITDA growth in the third quarter. Total company revenue grew $39 million or 5% compared to the prior year. Our results were primarily driven by organic growth at American Home Shield, where we continue to see strong demand for our products in both the real estate and direct-to-consumer channels, coupled with the favorable impact of our acquisition of Landmark Home Warranty last year.

Terminix delivered 1% organic revenue growth versus prior year, excluding the impact of temporary branch closures related to the hurricane and expected Alterra customer attrition, and we continue to believe that we're on a clear path to improve customer retention and organic growth. The Franchise Services Group grew organically by 7%, excluding the impact of the converted Merry Maids branches to franchisees and the master distributor acquisition in January.

Adjusted EBITDA for the third quarter increased $8 million or 4% compared to the prior year. The increase in EBITDA was primarily the result of the conversion of higher revenue driven by organic growth, acquisitions and lower claims costs at AHS. The ongoing business transformation initiatives and hurricanes drove margin compression at Terminix versus prior year. I'll cover the third quarter performance at Terminix in more detail in a moment.

Our adjusted net income for the third quarter was $99 million, an $18 million increase versus prior year and adjusted diluted earnings per share of $0.73 was up $0.14 versus prior year. This 22% increase in adjusted net income was primarily driven by higher adjusted EBITDA and a lower provision for income taxes related to stock option exercises.

Turning to Slide 8 and the third quarter performance of Terminix. Revenue was relatively flat at $395 million. The increase in core termite control, termite renewals, wildlife exclusion, mosquitoes and insulation was offset by the decline in core pest control due to the temporary closure of 53 Terminix branches, primarily in Texas and Florida, due to Hurricanes Harvey and Irma and expected customer attrition associated with Alterra.

Adjusted EBITDA for the third quarter declined by $10 million from $92 million in 2016 to $82 million in 2017. If you view the waterfall chart on the bottom of Slide 7 and starting on the left side, you'll see that higher revenue conversion was about $1 million favorable in the third quarter, including the unfavorable impact of Alterra customer attrition. The impact from the 53 temporary branch closures related to the hurricanes in the third quarter and favorably impacted EBITDA by $3 million. There should be no significant carryover impact on the fourth quarter.

Moving to the right, we incurred about $1 million in additional production labor costs, primarily from having more supervisors. Also, as I mentioned last quarter, we found that to meet our customer service expectations at the outset of this effort that we need to allow for more time for service business. However, we do anticipate optimizing the process going forward, which should reduce the labor costs. The $3 million increase in termite damage claims reflect increased warranty claims and reserve requirements in the third quarter of 2017. Large claims increased in the third quarter compared to our historical norms, primarily on the Gulf Coast. We are continuously evaluating how we estimate future claims. But as of now, we are expecting a $1 million unfavorable EBITDA impact from termite damage claims in the fourth quarter versus prior year. The $2 million increase in our insurance programs was principally driven by an increase in the number of company-owned sales vehicles versus prior year. As we discussed earlier in the year, we decided to lease company vehicles for our field service -- field sales personnel. We estimate that the vehicle insurance will be $1 million higher year-over-year in the fourth quarter.

And finally, the $2 million increase in sales and marketing costs was driven by higher commissions as new pest sales in the third quarter were higher than the same period in 2016. Please note that we're planning to spend about $4 million more in both sales and marketing in the fourth quarter versus the same period in the prior year to drive organic growth. In summary, regarding the additional costs, we're investing in growth, and we're committed to finding efficiencies that will improve margins. However, we believe that the full year 2017 EBITDA margins will be between 200 to 300 basis points lower than prior year, due to the ongoing business transformation initiatives and the third quarter hurricanes impact.

Turning to Slide 9. And the Terminix revenue drivers for the third quarter. Terminix organic revenue growth versus prior year was 1%, excluding temporary branch closures, impact from Hurricanes Harvey and Irma. If we also include the impact of Alterra customer attrition on the third quarter, Terminix revenue growth would have been 2%. Starting on the left side of the chart, revenue from termite completions, which includes new termite sales and other services, was $72 million, which is an increase of $3 million or 5% over prior year. Termite renewal revenue increased $1 million or 1% to $72 million.

During the third quarter, about 70% of this $72 million in termite completions and other services revenue was derived from the sale of core terminate completions, meaning a first-time termite service. Core revenue increased about 3% year-over-year, continuing the trend established in the fourth quarter to 2015 of year-over-year increases in the number of core termite completions. The remainder of the $72 million of termite completions and other services revenue comes from services, such as exclusion and insulation, and this revenue stream increased by about 9% year-over-year. Termite renewal revenue increased by 1% compared to the prior year, driven by price and an initiative to upgrade our bait monitoring stations for a small subset of our customers.

Pest control revenue of $228 million in the third quarter decreased by $6 million or 3% versus the prior year. As previously mentioned, organic pest control revenue growth was significantly impacted by an expected $5 million organic revenue decline associated with the Alterra customer attrition. The unfavorable revenue impact from the 53 temporary branch closures related to Hurricanes Harvey and Irma was about $4 million in third quarter.

As we previously discussed, we have significantly invested in improving service levels and driving new growth in Terminix. Although we have much more to do, we have seen significant improvement in customer engagement and service as evidenced by the higher net promoter scores and have realized significant growth in new sales during 2017. We are increasingly confident that we have taken the right steps on our continuing journey to transform service quality, improve retention and growth and position the business for long-term sustainable growth. For 2017, we expect organic revenue growth at Terminix, excluding the impact of hurricanes, to come in at 1% for the full year.

Let's turn to Slide 10 and discuss American Home Shield's third quarter performance. AHS had another strong quarter, with continued solid top line and bottom line growth versus prior year. Revenue increased from $309 million to $346 million or 12%, with organic growth contributing about 2/3 of that growth and acquisitions driving the remainder. The organic revenue growth was mostly driven by an increase in customer count, which accounted for 7% of AHS' 8% organic growth. Higher prices accounted for 1% of the organic growth in AHS. The Landmark acquisition contributed about $12 million or 4% of growth. Revenue growth continued to be solid in both of our key channels to market.

Year-over-year, organic growth in the direct-to-consumer channel was 7% and 9% in the real estate channel. We remain focused on sustaining our strong growth rates through optimizing our advertising, promotion and direct mail campaigns to drive new sales units as well as improving service quality to improve retention rates. Third quarter gross margin was up 230 basis points versus prior year at approximately 51%. EBITDA increased year-over-year by $17 million or 21% and with margin up 210 basis points to 27.8%.

To understand the drivers of EBITDA growth, please turn your attention to the waterfall chart on the bottom of Slide 10. Starting on the left side, the largest contributor to the increase in EBITDA was $14 million of flow-through from organic revenue growth, with $11 million of it related to volume and $3 million related to price. Lower claims cost provided an additional $3 million of EBITDA benefit in the quarter, as favorable claim incidence rates more than offset inflation. The acquisition of Landmark contributed about $4 million in the third quarter. On a year-to-date basis, the acquisitions of OneGuard and Landmark has contributed $12 million of incremental EBITDA, and we expect a nominal impact in the fourth quarter as we will have lapped most of the Landmark impact. A $4 million increase in sales and marketing costs reflect both the shift in a $2 million advertising campaign from the second to the third quarter as well as an additional spend of $2 million. Note that we plan to increase our marketing spend by about $3 million in the fourth quarter as compared to the prior year to drive more units as we enter 2018.

And finally, the $2 million increase in call center service costs was driven by higher labor costs, resulting from both an overall increase in call center staffing levels to improve response times and staffing levels that were too low in the third quarter of 2016. Call center costs should be approximately $1 million higher in the fourth quarter versus prior year. As we mentioned on recent earnings calls, the AHS team continues to upgrade their contractor base, both with respect to total capacity as well as quality. We manage over 15,000 contractors and believe that this provides us with the necessary scale, competitive advantages and capacity to grow going forward. In total, our contractor base, excluding acquisitions, as of the end of September 2017, was 12% higher than it was as of the end of September 2016 and our preferred contractor count improved by 7% during this time frame as well.

Moving on to Slide 11, let's now cover Franchise Services Group's third quarter performance. Revenue increased $4 million year-over-year or 7%. The increase was driven by $3 million of higher domestic janitorial national account revenue, $2 million of higher royalty fees, primarily domestic disaster restoration fees and a $1 million increase in product sales, offset in part by lapping the favorable impact of the Canadian fire restoration fees of $2 million in 2016. Excluding the conversion of the Merry Maids branches to franchises and the master distributor acquisition, organic revenue was also 7% higher year-over-year.

Adjusted EBITDA for the second quarter was $22 million, which is $1 million or 4% higher than the previous year. This improvement in EBITDA was driven primarily by higher revenue conversion, the favorable impact of converting the Merry Maids branches to franchises and lower sales and marketing costs. The Franchise Services Group experienced 130 basis points of EBITDA margin compression in the third quarter versus the same period in prior year due to a revenue mix shift from high-margin royalty fees to lower margin janitorial national accounts. Janitorial national accounts has a lower EBITDA margin because we recognize all of the customer level revenue in the margin calculation since we own the relationship with the customer. Conversely, we only use royalty fees as earned revenue in the margin calculation for our other brands. Despite lower margin, we certainly like the increased EBITDA that the janitorial national accounts contribute.

In the first 9 months of 2017, FSG's EBITDA has grown 12% over the same period in 2016, thanks in large part to high fee revenue arising from disaster restoration efforts. Although we cannot predict the royalty fees that we could receive from hurricane cleanup efforts over the next few months, we do expect lower year-over-year EBITDA in the fourth quarter, due to the low revenue conversion, timing of marketing expenses and nonrecurring G&A benefits in 2016.

Turning to the consolidated P&L on Slide 12, and looking at ServiceMaster in its entirety. The year-over-year revenue increase of 5% or $39 million, includes $25 million or 5 percentage points of net organic growth. The remaining $14 million of revenue increase comprises $2 million due to acquisitions within Terminix and $12 million from the acquisition in AHS. Gross margins are slightly higher versus prior year. The increase in AHS margins driven by lower claims costs more than offset lower margins at Terminix and the Franchise Services Group. The year-over-year SG&A increase of $14 million primarily reflects $5 million of costs from acquisitions at AHS, $2 million of higher call center service costs at AHS, $4 million of AHS and $2 million of increased Terminix sales and marketing costs and $3 million of higher depreciation expense, primarily related to vehicles and the investment in technology to upgrade the mobile digital platform at Terminix. As a result, SG&A, as a percentage of revenue, increased by 50 basis points to 25%. Net income of $80 million for the third quarter is up $11 million. Adjusted net income for the second quarter is $99 million, which is up $18 million from the same period in 2016.

Moving on to Slide 13, let me cover the bridge from adjusted EBITDA to adjusted net income. As previously noted, adjusted EBITDA for the third quarter was $200 million, $8 million higher than the same period in 2016, while adjusted net income was $99 million, $18 million higher than the prior year. The $18 million or 22% year-over-year increase in adjusted net income was driven by $8 million of higher EBITDA as well as $10 million of benefit from a lower effective tax rate in the third quarter of 2017 versus the same period in 2016. In the third quarter of 2017, the effective tax rate was only 29.6% versus 39.8% in the same period 1 year ago. This lower rate was driven by excess tax benefits for share-based awards. Lower stock-based compensation and interest expense were offset by higher depreciation expense in the third quarter 2017 versus the same period in 2016. The higher depreciation expense was driven by prior year investment in technology as well as acquiring company vehicles for our Terminix outside sales professionals.

With respect to cash flow, as shown on Slide 14. Free cash flow was $67 million in the third quarter, which was $110 million higher than the same period in 2016. In the third quarter of 2016, we made payments of $88 million related to the U.S. Virgin Islands fumigation matter. This payment was partially offset by reduced tax payments in the third quarter of last year related to the fumigation matter, which is the primary driver of the change in our tax accounts year-over-year. Increases in net income of $10 million and a decreased seasonal working capital outflow of $15 million were the other large contributors to the cash flow improvement in the quarter.

For the 9 months ended September 30, 2017, free cash flow was $293 million in the year-to-date period, which was $123 million higher than the same period in 2016. In the year-to-date period of 2016, we made payments of $90 million related to the USVI fumigation matter. We also had favorable timing of tax payments of $21 million and a decreased seasonal working capital outflow of $4 million as compared to the prior period. In the third quarter, we used $14 million for the purchase and cancellation of a portion of our 7.25% 2038 bonds. We did not repurchase any shares of the ServiceMaster stock in the third quarter 2017. We currently have $155 million remaining from the original $300 million share buyback program.

Finally, moving to Slide 15. I'll cover our full year outlook for 2017. Full year 2017 revenue expectations remain in a range from $2.9 billion to $2.92 billion or an increase of 6% compared to 2016, primarily at AHS. We are revising our full year 2017 adjusted EBITDA expectations to a range from $670 to $675 million, or from flat to an increase of 1% compared to 2016, reflecting the impact of hurricanes on third quarter results and ongoing business transformation initiatives at Terminix.

As I explained last quarter, as we stay steadfast in rebuilding the core of our growth platforms at Terminix, we are investing in additional leadership, technology, resources and service capabilities to ultimately drive higher levels of organic growth at Terminix. Additionally, we have increased our spending on Terminix marketing to drive lead generation and increased our staffing of sales technicians to help spur new organic sales. Although these investments have a short-term impact on margin, we remain confident that they will generate strong organic growth. We also believe that the implementation of new operating processes and systems will lead to cost efficiencies that will allow us to clawback against margin erosion. Finally, in AHS, we expect to see more modest year-over-year adjusted EBITDA growth in the fourth quarter as we have phased more of our 2017 marketing spend towards the latter part of the year to drive momentum going into 2018. Additionally, we expect claims costs to be higher in the fourth quarter as the third quarter benefited from an unusually cold summer. Please note that our 2017 outlook excludes the impact of any potential acquisitions during the year.

With that, I'll now turn the call back to Brian, so we can move into the Q&A portion of the call.

Thanks, Tony. As a reminder, during the question-and-answer session, we encourage you to ask any questions you may have, but please note that guidance is limited to the outlook we provided in our press release and webcast presentation. (Operator Instructions) Chris, let's open up the line for questions, please.

(Operator Instructions) Our first question comes from the line of Sam Eisner with Goldman Sachs.

So on the -- I think your implied guidance for the fourth quarter for EBITDA is about $129 million, net $15 million down year-on-year. I think you highlighted about $10 million of that walk in the higher call center costs, the marketing, the sales and marketing to Terminix. I think there's a net kind of $5 million that's yet to be identified. Can you maybe give us additional color on what else is in there in terms of kind of year-over-year impact in that fourth quarter?

Well, I think we covered most of it. We talked about the year-over-year marketing increases in the American Home Shield business, also higher marketing expenses in Terminix. We also are not going to assume that we're going to have favorable weather-related impacts to our claims costs in the fourth quarter. I mean, that's just a prudent way that we have to really stay focused on a normal weather pattern. And we did benefit to some extent, in the third quarter from a unusually cold summer. So perhaps, the claims costs, in particular, are probably most of the gap that you're picking up on.

And then just maybe a second question here. You highlighted, Nik, in your kind of opening statement an opportunity to get into the commercial market. I think that was something that you highlighted with the sell side during our meeting. I'm curious if you can expand on that further and how is that strategy being fully kind of made at this point?

Yes. Well, that's an interesting question because if you look at the strength of our business and the significant footprint we have across the country, we are in a great position to focus on some sweet spots in the commercial space. And right now, we're in the final stages of developing and implementing our strategy. We recently parted ways with our current commercial business leader, and we're close to finalizing announcement of a leader for the commercial business. So I have a great level of confidence in our ability to show some rapid increases as we go forward, but with the right strategy, with the right focus and the right leadership, we can definitely put a lot more focus than we have as a company in the past. And I see certain specific verticals that will tend much more easier for us to get into or -- when I say easier, nothing's easy, but we have to drive the level of service and customer expectations, and that's -- it's a different focus than the residential, but by creating a dedicated focus, bringing in a leader with strong capabilities in growing national accounts, we're confident that we can leverage this space that we have not really focused on over the past few years. And I'll definitely keep you guys updated throughout as -- and as we have been -- since I've started here on how we progress on that strategy.

Our next question comes from the line of Anj Singh from Crédit Suisse.

Just wanted to revisit the EBITDA revision walk. Perhaps asked another way, could you parse out your estimate of the hurricane impact to EBITDA versus the increased investments into Terminix as we look at the $7.5 million change from your prior midpoint to the current midpoint?

So the hurricane was $3 million of the change. So that -- I think that is really what you were asking. Anything else regarding that you want me elaborate on? I think that's...

I guess, the way I was looking at, is if the hurricane impact at Q3, it seems like was more than offset by the better contribution from AHS. What is the incremental or stepped-up spend that's happening at Terminix? Is there increased investment at Terminix beyond what you were anticipating at Q2?

So we are increasing our spend in marketing year-over-year in Terminix, marketing expenses and sales expenses. So that's a big part of the increase as well. And I want to also -- if you're looking ahead to the fourth quarter, we're not going to forecast the same type of incident rates we saw in the American Home Shield with respect to claims cost. So that has some impact on the revision of guidance, too. And then, finally, if you look at American Home Shield, remember that I had mentioned that we rephased some marketing expenses from the second quarter into the third quarter, while we also have more marketing on a quarterly basis in the fourth quarter as well. So we really rephased our marketing spending more backend loaded in the third and fourth quarter than we have in previous years.

Okay. Okay, got it. And then a follow-up. If we look at your Terminix revenue adjusted for the hurricane impact, it seems like it still would have decelerated a little bit from the 2Q levels. Could you talk about what is driving the moderation in the performance and outlook adjusted for the hurricanes? Is the performance just weaker? Or the transformation efforts just taking a little bit longer? Just any color there.

Anj, if you look at adjusting for hurricanes, we were flat to slightly above flat, and then we have already talked about the attrition this year. We've seen after the penalty clause expiration of the Alterra customers, so if you adjust for that, our normalized revenue in Terminix is growing about 2% year-over-year in the quarter and 1% organic. So we still -- and this is why we've launched this systematic transformation approach to rebuild the core of our growth platforms. And we are going to remain steadfast on building our ability to grow in this business because I see, tremendous potential in how we approach that. Now, we are at the same time, going to have adopting a Six Sigma Lean approach to identify any duplication of efforts or waste in the system, so this cannot only help us avoiding unnecessary costs and providing a disciplined investment, but it will also simplify our business model significantly, which gives us an ability to unlock capacity to deliver on the growth opportunities that we were consistently able to raise the new sales or new accounts that we generated in our pest business. We just have to make it simple and raise our customer engagement or customer experience level to best in class to continue to retain at a higher level.

Our next question comes from the line of Toni Kaplan from Morgan Stanley.

Could you share any statistics that you're tracking on employee turnover within the Terminix business just since you've sort of implemented new metrics and strategy? And I know it's still early, but just any sort of trends that you're seeing improve and maybe what sort of your goals are that we can measure you against in the future? Any sort of metrics we can sort of point to going forward?

Yes. We -- in these last few months that I've been here and I have visited several of our branches and touched base with plenty of our techs, our outside sales professionals, our branch managers and even went on right along to just see how they're running their show, how they interact with customers and how can we better help them. We definitely can do a significantly better job, and we are working on it to because I truly believe in exemplary treatment of our employees is definitely going to lead to exemplary treatment of our customers and improve their loyalty. From a retention basis, on our tax, we see on an average, the industry rate of retention is about 70%. We're performing well above that, probably also compared to our competition, even slightly above what competition retention rates are. So we definitely can continue to improve that. Also continue to improve retention rates of our call centers, so we are taking a very strong focus on how we are -- in this company, how do we make our organization more customer-centric and put our tax upfront as the top of the pyramid of our organization to ensure that we're giving them the right of tools and the right flexibility to serve our customers better. So while I'm not worried right now about our retention rates, what we've demonstrated this year, my goal is to help the company take it to significantly higher levels from where it is, because retention of employees does lead to have a direct correlation to how we retain our customers.

Okay, and that's great. And then just one on the hurricanes. So your closest competitor mentioned a possible reacceleration post the 3Q hurricanes. But it sounds like you're expecting that there won't be an impact in the fourth quarter. Could you actually see a benefit as branches come back online? And see some benefits from maybe the increased pests? And are you being conservative when you say no impact or how should we be thinking about it?

Well, first of all, I must give a lot of high marks to the Terminix branches for how rapidly they were able to bring back business, all the branches back up, how they were able to redeploy some of the resources to help in areas that were not as badly affected. And I also applaud the company's efforts to keep our employees as whole as possible, and we continue to provide them financial support in these difficult times that even they face in their business areas. There's going to be probably some hangover. I don't think that much of an effect carrying over into Q4. But from a positive side, we are driving a dedicated focus to assess the level of pest increase and how we can approach that. So that is still under quantification and how we can bring back capacity back up and build that into our capacity models to serve these additional opportunities as we go forward. With any hurricane or any such event, we're definitely, there's a longer-term trend. I don't want to predict exactly what it will be in the Q4 versus next year, but we definitely -- it's going to be a positive in these areas, supporting the increased activity of pests. But we're systematically evaluating at this stage, but also not just evaluating but building capability to support these kind of activities that we can actually fulfill the demand that rises from this.

Our next question comes from the line of Andy Wittmann with Baird.

I guess, I just wanted to ask for maybe a little bit more update on your -- on the spin process. Certainly, you guys made some progress on this one, and wanted to get maybe the 2 key questions of maybe what you can to help us with on the capital structures of each company? And/or the SG&A load that you might be angling in on here as you progress down this path?

Well, let me address the first part of your question, Andy. As you know, it's -- we announced the spin a few months ago, and since then, we've made significant progress, a, bringing in highly capable leader like Dion Persson. It's hard to find somebody with -- who practically checked all the boxes you need for this kind of a complex job, and we're really happy to have Dion over. He's going to provide, definitely, a significant improvement in the process. He's -- we're on track to deliver as promised. We have engaged several external partners that are absolutely necessary to deliver on the spin commitments flawlessly. But in the background, we're working very hard on building 2 highly successful or capable leadership teams, to list successful publicly traded companies. The major work right now on -- and the fundamental reason why we even chose to spin is to allow both these businesses to focus on their distinct strategies. So we're working on what these businesses will be going forward. I mentioned earlier in my remarks about AHS, having a clear strategy towards growing in adjacent spaces beyond where they are. It's a little too premature for me to share in exact details, but we will definitely be doing that going forward. And also Terminix, with a clear razor-sharp steadfast focus on rebuilding the core of our growth platforms, having the Six Sigma Lean approach to ensure that we very disciplinedly pay for what we're investing in as we go forward, but the core is, the real approach of the spin, as I said, is it's on track. We've got the work streams going full steam on it. We're ensuring that the resources dedicated to the spin are not impacting the way we drive our business, both at Terminix, AHS and also at FSG for that matter. The second part of the question, I'll ask Tony to take on the capital structure question and the G&A question.

Sure. More specifically, on the timing of the spin, we're still on track to complete the spin in the third quarter of 2018. We do expect to file an initial confidential Form 10 in the first quarter. This filing has to be confidential and nonpublic because the 2017 audited financial statements won't be completed by that time. We're required to do 3 years of audited financials. And so it will become public at some later date. As far as, Andy, your questions on the capital structure, obviously, we've already spent a lot of time looking at that. And we have more time to spend going forward. We do have a general plan and structure, but we haven't made any final decisions on exactly how much leverage we're going to put on each company. I will say this. Our wonderful cash flow in both of the businesses gives us some flexibility, but we want to take our time and do this the right way, and we're working to it systematically with our advisers and our teams appropriately. I think that was the majority of the question. Did I miss anything?

SG&A burden was the other portion of that, sorry.

Yes. Nothing, Andy, that we can really elaborate now. Again, we're going through a very methodical process. I mean, the first step is to define how you want to operate post spin for both, let's call it, ServiceMaster and American Home Shield. And then after you define an operating model, then you build a cost model, and then at that point, we'll have, what I would call, an estimate that we could share when all that is done, which is later on in the process. So we'll continue to keep you advised as we progress on this journey. But that's just a little bit too soon to really report that information.

I think -- want to add onto that, Andy. Obviously, the clear strategy in both these will -- is helping us develop a structure to support it. The systems and cadence to drive it, and the right people to deliver it. So we're very systematically working through that process. And as you know, we're going to be -- as the process goes by, we'll be sharing additional information about the commitment that we made.

Great. And then, I guess, Nik, I wanted to kind of follow-up on the Terminix segment and the investments that you're making. Clearly, you highlighted a number of those here in this call, including sales and marketing. But as you look at other investments in the P&L, you've talked a lot about people, systems, processes. How much more investment needs to come out? Or where are you in that journey? Is most of it now kind of in place, excluding maybe, a couple of key hires here? I guess, I'm just trying to get a sense of about what the '18 outlook for Terminix margins could be without giving guidance, just kind of thinking about where you are in a sequential basis with your P&L investment?

Yes. As I've shared with you earlier, the first part of my journey was to get a full assessment on where the gaps in the business are, what do we need to do to drive it. And that has given me a tremendous amount of confidence that there is no reason why we can't build -- rebuild the core of this business back to growing at or above market levels. So there's 2 things. One is significantly elevating the customer experience, which will allow us to retain or improve our customer retention significantly. And the second is a product strategy that clearly allows us to differentiate ourselves as a leader, going forward. So yes, there are definitely investments in not just marketing, but also in the right organization structure, creating a focus around commercial. But I believe these are necessary investments. Now on the other hand, it's not just about how much we invest and how much we spend, but how we do it. And we are launching a very, very disciplined Six Sigma Lean approach, because for me -- and this is again, my past experiences, like coming from Allied Signal, that's one of the companies, has been where we find look really structured way. We first of all, lean out the process and eliminate a lot of the steps in the way that actually make the business model much more simpler, our ability to engage with customers much easier, our ability to give flexibility and the opportunity for techs much more easier. And that definitely helps in unlocking a lot of the clogged capacity to serve even the existing tech to just give a better, much better service level to our customers. And so we have a lot of work to do on the efficiency improvements and stuff, so it's a balanced equation between how much we're investing and how we will clawback. But I want to make sure that we're not doing things just to deliver the next quarter or quarter after that, what really stays steadfast in our goal to rebuild this business, to get it back to market plus or above market growth level that we deserve to be. And I'm very confident that with this focus, having the key leaders on top. Now as an organization, I believe there's a tremendous amount of talent in this business. And if you look at the continuous growth that we've been able to demonstrate at American Home Shield over the last 5 years, high single digit, we've grown significantly in FSG, that just underscores the ability of -- at ServiceMaster to know how to grow businesses profitably. So I'm pretty confident with the right focus and leadership. And it's a little too premature for me to comment on 2018. Of course, we will be giving a lot more color to this in our fourth quarter report and when we close our fourth quarter in February, definitely we'll outline the guidance for 2018 and give a lot more color on this initiative as we learn more and we even progress further.

Our next question comes from the line of Judah Sokel with JPMorgan.

I was hoping to ask a little bit about the commercial vertical within Terminix. Clearly, that's a strategy of yours, Nik, that you want to expand Terminix's exposure to. So maybe you could talk a little bit about how that business has been trending for ServiceMaster until now? What the opportunities are that you feel exist in the commercial vertical? And what are some of the challenges, especially compared to residential?

Well, if you look at our commercial business, which is about 20% of our total Terminix revenue till date, the trend in that business has been relatively flat to modest growth in the past few years. And that comes with just clearly not making it one of the focus priorities and investing in the right way or approaching the customer -- right levels of customers. Our strength in that business has been quite significant in the small, medium scale businesses, and we are currently developing a national account strategy, which we believe in certain verticals and certain specific markets we're highly capable of delivering strong differentiation to capture those. My belief with the core strategy that we are putting in place, bringing in a leader, we -- as I mentioned earlier, we recently parted ways with the commercial business leader who was in place for a few years. Bringing in really a highly talented individual whose ability to grow a national account, serve national account, create a business structure systems so that can support that will significantly upgrade our ability. I -- this is a faster-growing space in the market. And I truly believe that for some of the very specific markets, we have great opportunities that will probably pay off indefinitely with that right level of focus and leadership.

Understood. Maybe just a quick second question on AHS. This is, and once again, third quarter saw the real estate channel growing at a really nice pace in addition to the DTC channel. I think investor perception was that over the years, AHS transformed that business by moving more into the DTC channel, away from the real estate channel, because there was more of a growth opportunity. But we're seeing pretty fast growth at both. So maybe you can touch on what the opportunity is in real estate? Do you think that the real estate channel can continue to be a high single-digit organic grower? Where does the opportunity lie ahead for AHS?

I think, as I mentioned earlier, it's, number one, what I really like about the AHS business is it's an incredible platform, with the one key solid differentiator, where we have about 15,000 of the country's best contractors, who we are able to level load their jobs and utilize them as partners across the country to deliver increasingly better service to our customers. So both in the DTC channel and real estate channel, I see quite a lot of potential to continue to add volume. What I like about this again also as it's a vastly underpenetrated market. I mean, if you look at our market share today, which is north of 50%, considering the market size to be close to or slightly above 4 million homes. Between single-family homes and rental properties and apartments, there's close to 100 million homes in America. That just tells you that there is -- and the services are being performed. The key is how do we drive our business model beyond the current way we do business or way we go-to-market. So we are redefining that strategy and putting a significantly higher focus. So on the current warranty base or risk-based model, we see increased DTC, not only in penetration in the market, but also significant opportunity in the type of services we can enhance to. Same thing in the real estate model, we see higher penetration. I'm not sure if you caught one of our announcements recently, where we launched an effort in the real estate market, which we see significantly helping retention going forward, where we improve the engagement. We launched a re-keying service. So when a new homeowner enters his home, we have a service now that will provide as part of the whole package, changing all the locks and keys on their home. That provides that initial touch point, which in many cases in a real estate deal, if somebody inherits that from the seller, and we don't serve that customer for over a year because they had no problem, there's a perception on part of the owner whether are they getting real value for that and should they be paying for it. This initial contact just starts them off in the right way to understand the value of the contract. So we're working on additional such ideas and opportunities that can help improve this market penetration as well, and we still see significant space on DTC, but also, on a non-risk-based model, which, as I mentioned earlier, as we will share as time goes by as we consolidate our strategies and launch these new efforts.

Our next question comes from the line of Gary Bisbee with RBC Capital Markets.

Nik, the first question for you, Nik. You've talked a lot about the disciplined approach you want to put in place, the Lean Six Sigma opportunity, just more accountability throughout the Terminix organization. And I guess, who really needs to drive that? And who is impacted by these changes? Is this largely a corporate? Or is there a lot of work that needs to be done at the branch level? And as part of that, how much disruption does changing the cultural approach to these processes likely have on the business? And over what time period would it be reasonable to begin to see the benefits of these efforts? I assume there's a sort of long period of time where you put in all the changes before it really begins to benefit the business. Any color on that would be helpful.

The key to succeeding on such a journey is to have a clear structured approach that not only we can articulate to our shareowners and you guys and the analysts side, but it's our ability to articulate that right down the line to our techs. So the key focus right now is how do we unclog some of the things we've done in the past that didn't serve us that well, but focusing on investments and the right thing where we enable the tech. I mean, this business is a fairly simple business. It's all about the customer experience that the tech leaves with the customer. That enhances retention significantly, which -- so we've demonstrated our ability to grow on new sales. The key is we have to work hard to improve that retention rate, to get the next revenue growth moving significantly higher. So it will take time. But for me to drive a cultural change, the first thing is to have a clear strategy that gets a buy in, which we are fairly close to articulating across the board in the company, in the next coming weeks. Driving that is the organization structure, as I mentioned, clearly, we're driving focused approach on residential and commercial. The residential leaders already in place. I mean, managed to get that done within 2 months, which is pretty good, and we've got a real solid proven leader, who has demonstrated in the past driving significant growth, working across hundreds of company-owned franchises and branches at Bridgestone, and also being able to demonstrate major turnarounds within a relatively short period of time. So for me, this is a journey where we need to get back to the growth levels that we want. But also, ultimately, I think, Gary, the key focus for me is staying steadfast, with an approach to drive at market or above market growth going forward, not only with the customer levels, but with a fully revamped product strategy that we're about to launch.

Okay, great. And then just a follow-up. There have been some efforts began last year to consolidate certain things, like marketing and some of the digital efforts from Terminix into the AHS business effectively, which was centralized. I know you're reversing all of that, but how much of that was done? And how much either spend or disruption is there in pulling the Terminix marketing efforts and advertising efforts out from that central group? Is that already done? Or is that something that's going on now?

Let me tell you probably, the one -- the best return investment we've got is really taking our ability of our employees to significantly improve the interface with the customer by upgrading the technology, so giving iPhones and iPads to every employee who has the tools in their hand when they approach a customer. So that improves the pre-engagement ability. That improves the full service engagement. It notifies our customers on our dispatching app, where the customer sees more like an Uber-like format, where the tech is approaching their home, improve our on-time delivery with the customer versus previously, doing the service, hanging the yellow tag and leaving, we have significantly enriched that. So that took quite a lot of money. We reinvested in providing much better vehicles to both our techs and our outside sales professionals. That carries a lot of brand value with Terminix trucks driving around. It improves a lot of recall. It improves the morale of the people in how they approach the customers as well. So there's a lot of great things that were done. And I'm not being critical about the marketing efforts or not, but I think with our current strategy, we are improving significantly our ability to segment those markets, where we can see the biggest bang for our buck and refocusing our marketing investments in those areas, in those treatments, like certain specific type of pests in that area, just to get a maximum return on investment on how we approach these markets. So it's a matter of -- it's not like taking something and just completely turning it around, but driving a systematic turnaround of what a world-class business should look like. Ultimately, it's all about service. The real differentiator is the experience we leave with our customer and why they want to stay with us for the rest of their life. We just want to keep that lifetime cycle value completely increased. That helps prevent costs of acquisition in the future as well, which will definitely help us.

There are no questions on the phone lines at this time. Mr. Varty, I'll turn the conference back to you.

Thank you. I want to close by affirming my earlier comments that we are focused on consistently delivering on our commitments and to improve operations and drive profitable growth. And while change will not happen overnight, I am very confident we're taking the right steps to create long-term value for our shareholders. I thank you all for joining our call today, and we look forward to reporting on our continued progress in the future. Thank you.

Thanks, Nik. Thank you, again, for participating in today's conference call and webcast. As a reminder, a replay of the webcast will be available on our website at www.servicemaster.com in about 1 hour from now. We look forward to speaking with you again on our fourth quarter and full year 2017 earnings call at a date to be announced in February of 2018. Chris, please end the call, and Happy Halloween, everybody.

Thank you. Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines.