Cintas Corporation

Good day. Welcome to the Cintas quarterly earnings results conference call. Today's call is being recorded. At this time, I'd like to turn the conference over to Mr. Mike Hampton, Executive Vice President and Chief Financial Officer. Please go ahead, sir.

Good evening, and thank you for joining us tonight. With me is Paul Adler, Cintas Vice President and Treasurer. We will discuss our second quarter results for fiscal 2020. After our commentary, we will be happy to answer questions. The Private Securities Litigation Reform Act of 1995 provides a safe harbor from civil litigation for forward-looking statements. This conference call contains forward-looking statements that reflect the company's current views as to future events and financial performance. These forward-looking statements are subject to risks and uncertainties, which could cause actual results to differ materially from those we may discuss. I refer you to the discussion on these points contained in our most recent filings with the SEC. Revenue for the second quarter of fiscal 2020 was a record $1.84 billion, an increase of 7.3% over last year's second quarter. The organic growth rate, which adjusts for the impacts of acquisitions and foreign currency exchange rate fluctuations, was also 7.3%. In the second quarter of fiscal 2020, the organic growth rate for the uniform rental and facility services operating segment was 5.8%, and the organic growth rate for the First Aid and Safety Services operating segment was 10.6%. Gross margin for the second quarter of fiscal 20 of $852.4 million increased 10%. Gross margin as a percent of revenue was 46.2% for the second quarter of fiscal 20, compared to 45.1% in the second quarter of fiscal 19, Uniform rental and facility services operating segment gross margin as a percentage of revenue improved 130 basis points from last year's second quarter to 46.6%. And the first aid and safety services operating segment gross margin improved 40 basis points to 48.4%. Operating income for the second quarter of fiscal 20 of $334.5 million increased 21.3%. Operating margin was 18.1% in the second quarter of fiscal 20, compared to 16% in fiscal 19. Operating income in the second quarter of fiscal 19 was impacted by integration expenses related to the G&K acquisition of $7.8 million, or 50 basis points. Net income from continuing operations for the second quarter of fiscal 20 was $246.4 million, and reported earnings per diluted share were $2.27. Excluding the one-time gain on the sale of a cost method investment and the G&K acquisition integration expenses, both in fiscal 19, EPS increased 29%. As our chairman and CEO, Scott Farmer, was quoted in today's earnings press release, we are pleased with our second quarter and year-to-date performance. We thank our employee partners for continuing to execute well and take great care of our customers. In addition to the strong financial performance, we continue to generate strong cash flow and commit to effectively deploying cash to increase shareholder value. On December 6th, we paid an annual dividend of $2.55 per share, an increase of 24.4% over last year's annual dividends. We've increased the dividend for 36 consecutive years. In the past 10 years, the annual dividend per share increased at a compound annual growth rate of 18.2%. Before turning the call over to Paul for more details, I'll provide an update of our fiscal 20 expectations. We have increased our expectations of financial performance. We expect revenue to be in the range of $7.29 billion to $7.33 billion. We expect EPS to be in the range of $8.65 to $8.75. Note the following regarding the guidance. The growth rate at the revenue guidance range is 5.8% to 6.4%. However, our fiscal 20 contains one less workday than our fiscal 19. Adjusting for this one-day difference on a constant workday basis, the revenue growth rate range at guidance is 6.2% to 6.8%. One less workday also has a negative impact on EPS, reducing it about six cents, which is a 90 basis point drag on the EPS growth rate. Adjusting for this, the EPS growth rate range is 14.7% to 16%. Guidance assumes an effective tax rate for fiscal 20 of 19.2% compared to a rate of 19.7% for fiscal 19. Keep in mind that the tax rate can move up or down from period to period based on discrete events, including the amount of stock compensation expense. It assumes a share count for computing EPS of 109 million shares. This consists of diluted weighted average shares outstanding plus participating securities in the form of restricted stock. The guidance does not assume any future share buybacks or any additional G&K integration expenses. I will now turn the call over to Paul.

Thank you, Mike. Please note that our fiscal 20 contains one less workday than in fiscal 19. One less day will negatively impact fiscal 20 total revenue growth by 40 basis points. To illustrate the magnitude of the headwind using fiscal 19's annual revenue, one less workday equates to about $27 million. One less workday also has a negative impact on operating margin and EPS. Fiscal 20 operating income margin will be reduced by about 12.5 basis points in comparison to fiscal 19 due to one less day of revenue. The negative impact on the margin occurs because certain expenses like amortization of uniforms and entrance mats are spent on a monthly basis as opposed to on a daily basis, and we will have one less day of revenue to cover the expenses. As Mike stated, one less workday is a headwind of about 90 basis points on EPS growth and about a six cent drag on total EPS in comparison to fiscal 19. Each quarter of fiscal 20 contains 65 workdays. In comparison to fiscal 19, our upcoming Q3 of fiscal 20 will have one additional day and our Q4 will have one less day. Please keep the quarterly day differences in mind when modeling our fiscal 20 results. We have two reportable operating segments, uniform rental and facility services, and first aid and safety services. The remainder of our business is included in all other. All other consists of fire protection services and our uniform direct sale business. First aid and safety services and all other are combined and presented at other services on the income statement. The uniform rental and facility services operating segment includes the rental and servicing of uniforms, mats, and towels, and the provision of restroom supplies and other facility products and services. The segment also includes the sale of items from our catalogs to our customers en route. Uniform rental and facility services revenue was $1.47 billion, an increase of 5.7%. excluding the impact of acquisitions and foreign currency exchange rate changes, the organic growth rate was 5.8%. Our uniform rental and facility services segment gross margin was 46.6% for the second quarter compared to 45.3% in last year's second quarter, an improvement of 130 basis points. Operating income margin was a record 19.5% for the second quarter, and it was 19% year-to-date. Profit margins have strengthened for many reasons, including strong revenue growth and realization of cost synergies from the acquisition of G&K. Our first aid and safety services operating segment includes revenue from the sale and servicing of first aid products, safety products, and training. The segment's revenue for the second quarter was $169.7 million. The organic growth rate for the segment was 10.6%. The first aid segment gross margin was 48.4% in the second quarter compared to 48.0% in last year's second quarter, an increase of 40 basis points. First aid segment gross margins continue to increase with strong revenue growth. Our fire protection services and uniform direct sale businesses are reported in the all other categories. Our fire business continues to grow each year at a strong pace. Uniform direct sale business growth rates are generally low single digits and are subject to volatility, such as when we install a multi-million dollar account. Uniform direct sale, however, is a key business for us, and its customers are often significant opportunities to cross-sell and provide products and services from our other business units. All other revenue was $204.1 million, an increase of 17.2%. The organic growth rate was 16.5%. The fire business organic growth rate was 9.6%. Uniform direct sale business had an exceptionally strong quarter, posting an organic growth rate of 25%. Growth was driven in large part due to the rollout of Carhartt-branded garments to a Fortune 100 customer. All other gross margin was 41.8% for the second quarter of this fiscal year compared to 41.2% last year. Selling and administrative expenses as a percentage of revenue were 28.1% in the second quarter of fiscal 20 and 28.6% in the second quarter of fiscal 19. Improvement was realized in many areas, including lower G&A labor expense as a percent of revenue. Last quarter, We mentioned that medical expense as a percent of revenue spiked. It came back in line in the second quarter as we expected. Our effective tax rate on continuing operations for the second quarter of fiscal 20 was 20.1%. Stock-based compensation positively impacted the tax rate. As Mike stated earlier, the tax rate can move from period to period based on discrete events, including the amount of stock compensation expense. Our cash and equivalence balances of November 30th was $226.5 million. Year to date, operating cash flow increased about 66% from last year because of strong earnings growth and improvements in working capital, particularly accounts receivable, inventories, uniforms, and other rental items and service and accounts payable. Capital expenditures in the second quarter was $61.4 million. Our capex by operating segments was as follows, $48.6 million in uniform rental and facility services, $10.8 million in first aid and safety, and $2 million in all other. We expect fiscal 20 capex to be in the range of $265 million to $290 million. As of November 30th, total debt was $2,738.4 million. $2,538.6 million was fixed interest rate debt, and $199.8 million was variable rate debt in the form of a term loan. At November 30th, our leverage was 1.8 times debt to EBITDA.

That concludes our prepared remarks. We are happy to answer your questions.

If you'd like to ask a question, please type the web prefix star 1 on your cell phone keypad. If you're using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, press star 1 to pose a question. We'll pause for just a moment to allow everyone an opportunity to signal for questions. Please go ahead. Well, I think our first question from Tony Kaplan at Morgan Stanley. Please go ahead.

Thanks very much, and good afternoon. You had a pretty solid beat in the question. did a pretty solid beat in the quarter, but only a modest 2% raise for the full year. Could you just talk about your expectations around maybe the broader macro and anything else that might be one time in the quarter or might reverse as we go through the year? Just wondering why not a bigger raise thing.

And so you're speaking of revenue right now, correct? Yeah. Yeah.

And so from a – let's talk about the quarter. We had a very good quarter. All of our businesses grew, and in particular our direct sale business had a really nice quarter. Tony, you had asked a little bit about the macro first. And, you know, I would say not a lot of change during the quarter. We did say at the beginning of the quarter that energy, we were starting to see a little bit of softness in the energy area. We did see a little bit of that during the quarter. In fact, we had one fairly good-sized customer in this space go bankrupt. But, you know, I would say the other thing is industrials are a bit choppy, generally speaking. Having said that, Not a lot of change during the quarter. We are encouraged, as we kind of think forward, we are encouraged that it looks like we've made some progress in the USMCA and the China trade. We're encouraged by the movement there, and we look forward to getting those results. Seems like we've seen a little bit of a steady direction out of the Fed on interest rates, and so... As we leave the second quarter, I would say there are some encouraging signs, but we're entering the election year. There still is a lot going on in terms of the noise in the marketplace and whether or not small businesses and other businesses will continue to invest. And so we still look a little bit with caution as we think about the second half of the year. As it relates to the guidance, look, we had a very good first half of the year. Our partners did a great job. And the year is playing out generally as we expected. We had growth of roughly 7%, organic growth of over 7% for the first half of the year. But we also had some things that went our way. I talked a little bit about this in the first quarter where rental payments Probably got a little bit of year-over-year benefit in the first quarter, and that certainly helped as we kind of were finding the bottom last year in our rental business as we lapped the G&K acquisition. So we got a little bit of benefit in the first half there. We talked about pricing being incrementally positive in the fourth quarter and the first quarter. Maybe not quite as incrementally positive in the second quarter. but certainly some benefit in the first half of the year. I would expect that we'll fall back into kind of the pricing range we've been in the last few years. When you think about the direct sale business, we talked about that. We've referred to that a few times. Had a great year in the first half. In the second half, our expectation is, as this business can be lumpy, that we'll be flat to down in that. And so just that alone is about 75 basis points of growth impact when you compare the first half to the second half. I talked a little bit about the outlook on the macro. And so, you know, as we think about the second half, we're thinking about the macro. We're thinking about, you know, there are some things that really went well in the first half, may not get all of that benefit in the second half, having said all of that. Look, our same workday growth is 6.2 to 6.8, and the year is shaping up pretty much the way we expected it to. And if we can hit those kind of numbers, that's a really nice year for us.

That's great. And I just wanted to ask about buybacks. We really pulled back pretty dramatically this quarter. I just wanted to get some color around how we should be thinking about, any sort of change to capital deployment philosophy or just why it's very minimal five-axis quarter? Thanks.

Yeah, we do have – we've got the authorization of about $1.2 billion. And we look at that, as we've talked about, we look at that opportunistically. One thing to keep in mind is we – in the first week of December, we made a $268 million payment related to our dividend. And we also had some debt interest payments. So, you know, we're back in the CP in the month of December. But we'll look at the buyback opportunistically as we move through the rest of the year. And specifically to your question, we have not made any changes to the way we think about capital allocation.

Thank you. All right, we're going to take the next question from Hamza Mazzari at Jefferies.

Please go ahead.

Good afternoon. Thank you. My first question is just on the SAP rollout, sort of just any update there. Specifically, you know, where do we see benefits once that's rolled out in April or May next year? Is that going to be an organic growth through cross-selling, or do we see sort of SG&A come off? Any color as to benefits of that? on that rollout?

Hamza, we're about 85% of the way through our SAP journey at this point in time, so we've made some good progress in the quarter, and we're still on track to complete the project by the end of the fiscal year. As far as benefits are concerned, I think the benefits from SAP are going to be kind of throughout the P&L. We've talked about some of them already that that can be achieved by locations individually, better technology in the hands of the people providing the services, better information at their disposal, the ability for our accounting and finance people and operations people to look at data from the very back of the house all the way to invoicing and pricing with the customer. But then there are other benefits that, you know, we believe will be benefiting the top line later on and more perhaps impactfully when the entire network is in the system. But, you know, certainly we believe that putting the uniform rental business and our first aid business in the same operating system, you know, will foster more collaboration, more cross-selling, which will help, you know, the top line. And just better, as I mentioned earlier, use of data. looking at our big, large national accounts from city to city to city to do analyses and make sure that we're getting all the entitled revenue that we should for the agreements, make sure the pricing is appropriate for the contract. So lots of opportunities, but not able to quantify anything at this point in time. As I said, we'll complete that rollout this fiscal year and have more color next fiscal year for you.

It's very helpful. And just a follow-up question, I'll turn it over. When you think about M&A outside of, you know, core uniform rental and the businesses you're in, what are some of the metrics you're looking at? I know you want to touch more businesses. I assume it's route-based. Does it have to be accretive to growth, accretive to margin? I know you guys did credit a long time ago and, you know, that business got sold. We did CNK that was part of the core. Just any color as to metrics you can share, how you think about larger M&A outside the core? Thank you.

Sure. First of all, we look for B2B. We love the recurring revenue nature of our kinds of businesses. Route-based is preferred, but it's not absolutely necessary. The key is what kind of service can we add to provide some level of value to the customer. So that's the real key. You know, we would want it to be an opportunity that can add value to many of our customers, not just a small subset. And we would want it to have margin potential. So you asked, does it need to be growth accretive and margin accretive? We certainly would love it to be, but there really aren't that many out there. We're looking hard for them. But those are the kind of things that we will look for, recurring revenue streams. Can it benefit our current customers? is it a large opportunity for us or is it very narrow? What's the service component?

Very helpful. Thanks a lot, Mike. Okay.

I'll take the next question from Manal Submit at Brokerage. Please go ahead.

Thank you. Good evening, guys. My first question is just can you just walk us through why the lower CapEx assumption and then maybe just for some context when you look at the over the next two to three years, I guess, where are your greatest investment needs?

Yeah, we, you know, generally we are making our capex in terms of our growth opportunities like new routes and adding capacity. I would say we continue to add the routes. So, in other words, buying trucks, And that is certainly important for us. But as it relates to laundry capacity, for example, we've got some really interesting projects that are going on that we think can help us out in certain cases. And so we're seeing a little bit of a benefit because of that. I've talked a little bit about a G&K auto sort that – It's kind of a quasi-auto sort that helps us in certain facilities. And we're moving on rolling out some of those kind of things. We're looking at things like efficiency in the wash alley. And then we certainly still have a little bit of the capacity that we have gotten from the G&K acquisition. So the combination of all of those things has created efficiency opportunities for us, particularly in the production environment. And you're seeing a little bit of that benefit in our gross margin.

Right. And then just, you know, in terms of GNK and maybe tied to the SAP implementation, are there systems, I guess, on SAP as well? And, you know, is it, Still too hard for you guys to quantify any revenue synergies that you might be getting from that deal?

Well, keep in mind, we converted all G&K locations to either the Syntox SAP system or the legacy Syntox system so that we could fully get off of that system. And that was completed, gosh, probably – over a year ago. And so we still have some of those that need to get from the Cintas legacy system to SAP. And so we inserted those locations as it made sense into the SAP rollout. And so we're almost there. Paul said we're 85% of the way there in total in terms of the conversion, and we make good progress. So we have a pretty good handle in terms of viewing the G&K legacy locations in much the same way that we're viewing the CENTOS locations. And so we see some benefits. I would call them anecdotal. We need to get all the way on SAP before we really start taking advantage of the power of that information, though.

All right. Thank you, Dave.

I'll take our next question from Andrew Steinerman at JPMorgan. Please go ahead.

Hey, Mike. You mentioned that you just treat GNK legacy locations like Cintas locations. I want to know about the inventory. You know, how much of the uniforms today are still the GNK uniforms, and when you convert over and introduce Cintas uniforms, which are presumably better, uniforms to G&K legacy customers? How have they responded? And you know, have there been a price adjustment since they're getting better uniforms?

From an inventory conversion standpoint, we are, we're in the midst of that. And those those happen at such different times, Andrew. So for example, if we have a customer that's got 10 wares, for example, in legacy G&K inventory, we may be in a style where as they turn, in other words, as they have turnover and they replace their open positions with new hires, and we put them into legacy G&K garments, there's going to be a point in time at which we run out of those garments, whether it's the style or the size. And that happens at very different intervals depending on the kind of garment that they have. And so it is a customer-by-customer approach. When they start to run out of – when we start to run out of G&K Legacy garments, we will start to put them into Cintas garments. And generally that can be all at once because we don't want them to have different looks. But as I said, that is a customer-by-customer. decision point based on the styles. So it's really hard to give you a full percentage because it's happening all over the country. We are not finished with that. We are still working our way through G&K legacy inventory. When they get on to Cintas inventory, as you know, pricing becomes a customer by customer conversation as well. And there may be some where there is no change at all, and we've put them in something that's, let's say, a workwear type of a garment. There may be others where we give them an opportunity to upgrade into a Carhartt garment, for example. And in that case, there may be times where we will increase the pricing or adjust the pricing as it's necessary. So it is a customer-by-customer decision on when to convert, And then it's also a customer-by-customer decision on what does that pricing and what does that contract look like.

And do you think the customer recognizes that the Cintas uniform, on average, is a better uniform than the legacy uniforms they had?

You know, I can give you anecdotally the answer is yes. You know, we – we need to be doing a pretty good job of showing why they're moving into a Cintas garment and what are the features and functions of that new garment. It may be that it's softer. It may be that it fits a little bit better. It may be that the fabric breathes a little bit better. And generally, when we explain those kinds of features to the customer, they get it and they understand. And it doesn't take very long for them to be in those garments to recognize that there's a quality difference.

Okay. Thank you.

I'll take our next question from Gary Bisbee. Thank you, America. Please go ahead.

Hey, guys. Good evening and happy holidays. I guess the first question from me just you know, the uniform rental revenue slowed somewhat, obviously, at a much tougher comp. But anything other than that, I guess you mentioned one, a little weaker energy. Anything other than that you'd call out in the sequential deceleration of the organic controversy revenue growth?

Yeah, I don't think it's anything of real significance, but I would point to the three things I mentioned earlier. A little bit of the absence of that lapping a little bit of a choppiness in the energy and maybe industrials generally. And pricing maybe wasn't quite as incrementally positive as we'd seen in the previous two quarters. I think those things kind of capture what we saw in the quarter. Still a good quarter for us, but I think those things capture it.

Okay. And then, you know, you've been asked for a few years about cross-sell potential both within G&K and just more broadly against your different businesses. And, you know, I realize you don't have the data and haven't provided real granular color, but can you give us any sense, like, as your salespeople for the main businesses go out, you know, how often are they targeting people that are customers of your other businesses? How important is cross-sell in terms of how you're trying to compensate the different types of salespeople. Is it really something you've focused a lot on to date, or should we think that the data that SAP will provide is really going to be the key to unlocking that more broadly?

We do spend a lot of time with that today, Gary. You know, our SSRs are looking for opportunities. We have our, we call them market development reps who are, who are looking at some of our more complex customers and looking for upsell and penetration opportunities there. And we've become a bit better at the cross-sell between rental and first aid and fire. I think we still have some ways to go there to take advantage of all of that opportunity. But we're starting to spend more time than in the past. So it has been important to us, and I think we've been doing a pretty good job of that over the last few years, including in the last probably 18 months with G&K legacy customers. But having said that, SAP will unlock some additional potential. That is going to be something that should prove to be a nice opportunity for us.

Great, and then just one more, and this isn't so much next quarter or anything like that, but as we think out over the next few years in sort of a normalized economy, how are you thinking about incremental operating margins these days? What's the potential? They've been obviously terrific the last few years, particularly as the G&K savings have flown through, but what's like a long-term target or opportunity there?

Yeah, we still like the, you know, we talk a lot about incrementals of 20% to 30%. We're getting pretty darn close to the bottom of that with our rental division. But, you know, as we continue to get success with penetration opportunities, to get success in some of the verticals that can be even bigger types of customers with a service opportunity that's more efficient, we think there are still opportunities. And that incremental, you know, as we move forward, we think that incremental certainly is in the 20 to 30. And, you know, if we can capitalize on some of those different things that we've talked about, the penetration, the sales into these customers with maybe more efficient service aspects, the capacity efficiencies, we think we can get that incremental forward. into that mid-20s type of a neighborhood.

So it's a nice opportunity that we look forward to.

Great. That's all I got. Thanks.

I'll take the next question from Andrew Whitman at RW Beard. Please go ahead.

Yeah, great. Thanks for taking my questions here. Yeah, I was looking at the two-year growth rate stack in your rental segment, it looks like. The counts prove out. It's 12.4 over the last two years, both for the first quarter and the second quarter. But it kind of brings me to the question you've talked about in the past, which is your sales force productivity. You mentioned kind of the headwinds for the deceleration and the growth rate, but I was just wondering how the sales force is performing for you. I think it was not that many quarters ago you said even the G&K people that you kept on were producing at record levels. Can you just give us an update, Mike, about what you're seeing out of them in terms of the ability to add gross new customers?

Yeah, when we think about total, you know, look, we have one sales team. And so that sales team continues to perform well. And they're doing a nice job of adding customers and selling into existing customers. Their productivity levels, are still, this quarter was a little bit higher than last year in this quarter. So, we're still making some really nice improvements. So, we are still very pleased with the sales rep productivity.

Okay, that's helpful.

And then, I guess I wanted to, maybe Paul, if you could just help us a little bit on some of the items in the cost structure. I think typically you've given energy as a percentage of your rental segment revenue. How much of a benefit was that? And just any other details that you could call out in the cost structure? I think labor has been something that people have flagged. Maybe that would be something you'd address. You mentioned health care, and then it's back to normal. But just anything else you can help us understand the moving pieces inside the margins I think would be helpful.

Yeah, Andy, energy was a 20 basis point benefit year over year, flat sequentially. So, you know, I think that's – You know, if oil continues in the price per barrel in the second half where it is in the first half, it'll be a little bit of a tailwind for us in the cost structure in the second half. Labor, you know, I would say overall in check. We talked about, gosh, it was probably a year ago now, about, you know, certain areas of our workforce, particularly in the production area. We were having some labor inflation, and we made some changes. So we believe that that view is behind us, and we won't have to make any further adjustments there. But otherwise, you know, inflation is, you know, normal, I would say. It's something that we've been able to, you know, to deal with. You know, it's certainly tight, but it hasn't prevented us from, you know, running the business and serving our customers.

Yeah, and Andy, when you think about our gross margins, for example, we've seen some really nice year-over-year improvement in this first half of the year, and certainly the growth levels have been good, and that helps. So we're getting really nice leverage. Our salespeople are productive, and they're selling good, profitable business, and that's been good. And, you know, we've done a nice job of capturing the gene case synergies, but what we're also seeing a little bit of, as we've talked about over the last few years, there's a lot of inefficiency in running the facilities when you're going through a lot of conversion of genes. incorporating GNK volumes into CentOS legacy plants and closing those plants and rebarcoding inventory. And there's a lot of work that goes on there. And really what we've seen in the first half of the year is we've captured those GNK synergies just as we've wanted them to. And we've seen some real nice efficiency gains because There aren't quite as many of those projects going on. Those are a little bit more in the past. And so, the timing for us has been kind of fortunate and good from the standpoint of when we were seeing a little bit of pressure in our production labor, for example, we were also making some synergies and capturing some synergies there too. And we've been able to get more efficient in this first half of the year. And I think that's a little bit of what you're seeing.

Great. Thanks. I'll leave it there, guys.

Great. We'll now take the next question from Scott Sheenberger at Oppenheimer. Please go ahead.

Good evening, guys. It's Daniel, I'm for Scott. You discussed efficiencies earlier. Could you provide a little bit more perspective on some type of efficiencies you pursue on a go-forward basis besides the route optimization and a little bit of color on automation of processes and use of advanced technology, how that is applied and where you could go there. Thank you.

Sure. We're always looking for them. And so when we think about efficiencies going forward, I talked a little bit about capacity. How can we continue to get more efficient in terms of using our wash alleys? Some of that is automation. I'm sorry, technology. And some of that is Six Sigma-like process improvement. There are opportunities there. we still have a lot of route optimization to go. That is both a little bit of technology, but just it's customer touching, and so we're being cautious in that regard. We've talked about getting through the SAP conversion, and as we are able to then – pull off of the legacy CentOS system a bit. That's going to create some efficiency just because we won't have duplicate systems. But also then using that technology for things like sales or productivity gains and cross-selling and penetration opportunities. So we do have a number of those different efficiency opportunities as well as then just typically the Six Sigma processes that we're always working on, and how can we get better? And as the business changes, can we get more efficient in the way we move products through our plants and provide services? We're looking at all of those different things, but we think we've got some nice opportunities ahead.

Got it. That's helpful. Thank you. Switching gears a little bit, cotton prices have been down in the first half of this fiscal year on an earlier basis. Could you please discuss how that is impacting earnings? I mean, I know historically you've smoothed that out through amortization, but how is that really impacting earnings presently? Thank you.

Not really any impact in the first half of this year. We are, as you mentioned, it takes a while for that cotton price to ripple through into our P&L. We have to sew the garments. We have to bring the garments into our distribution center. We then ship them from our distribution centers out to our rental locations. And at that point, they start an 18-month amortization process. So it takes a while. And then even when it does get through, we're generally smoothing that out, as you said, because we've got – if we see a spike for a few months – You might have one-eighteenths worth of that in one month. You could have two or three-eighteenths worth of that. It's got to be sustained movement in that before it really starts to hit us. And keep in mind, cotton isn't a – it's not one of the more significant pieces of our cost structure. So if you think about our cost structure, our cost of rentals is – you can think of it in three buckets. One is material costs. One is production, so the running of our laundry facilities, and the third is our service costs, so the routing. The cotton piece is then part of that material cost, but that material cost includes also the labor content to sew the garments, the freight on the garments, the trim on the garments, et cetera. And so it really takes some sustained large movement in cotton before it really starts to impact us.

Yeah, that's a helpful caller. Thank you very much.

I'll take the next question from George Tong at Goldman Sachs. Please go ahead.

Hi. Thanks. Good afternoon. Your revenue outlook is certainly improved from where it was a quarter ago. You discussed the macro factors that are impacting this, but can you elaborate on some internal initiatives where you're seeing traction that improves your revenue expectations for the full year?

Well, they are things generally, George, that we've been working on for a while, and that is we are looking to continuously focus on some of the verticals that have been really powerful for us. So, for example, the healthcare vertical, the education, government, hospitality, those places where the sales are a little bit more complex, the purchasing decisions might be a little bit more complex. And we've made some really good progress in those areas. And we still are in the early innings and think there are great opportunities as we move ahead. And so those are areas that are really important to us. The penetration, I mentioned that we have been working more on the penetration opportunities. I think we can get better and more opportunities ahead for that area as well. And the penetration is both better coordination between our businesses but also taking advantage of our newer products and making sure we're getting things like ChefWorks in front of all of the right decision makers. And so it's really continuing to move forward with what we believe to be our unique products that create opportunity in the marketplace. We are doing the same kinds of things. in our first aid and safety business where we are looking for those penetration opportunities, product adjacencies are great, and continue to look for larger national-type customers as well in both first aid and our fire businesses. So we're doing all of those things. We've made some really nice progress, and, you know, we think we've got a really nice year ahead of us as we move into the second half.

Got it. That's helpful. Your gross margins expanded about 110 basis points year over year in the quarter. Can you discuss how much pricing contributed to this margin expansion and how sustainable pricing increases are at the current pace?

You know, pricing certainly has an impact. I mentioned that it wasn't quite as incrementally positive in this quarter as it had been in the previous two quarters. And so I would say that the The pricing is somewhat in line with what we've seen over the last couple of years absent the last couple of quarters. You know, generally, we've been able to – when we can show value and when we can have the right conversations with our customers, generally, we've been able to get some pricing, and I don't see that necessarily changing. But as it relates to then the margin opportunity and the margin improvement, it's really more about the growth creates leverage. It creates efficiencies in our plants. When we grow in our rental business in particular where we don't use capacity, like our restroom and hygiene products, we effectively get some really nice leverage and get more efficient with the capacity. And in addition to that, we've pulled out a little bit of inefficiency in the business. So more of the gross margin improvement relates to the revenue of the business, the leveraging, and the efficiency that we're able to gain.

Very helpful. Thank you.

And I'll take the next question from Kevin McVeigh at Credit Suisse. Please go ahead.

Great, thanks. Hey, just to follow up on the guidance a little bit, I know last year there was some severe weather in the third quarter. It was kind of unexpected. Do you have any kind of thoughts on or any allowance for that in the Q3 guide, obviously, which would be incorporated into the full year? How are you thinking about just the weather impact as we work our way through the back half of the year?

Yeah, good question. Last year in the third quarter, we talked a little bit about the weather and the holidays. You know, it's hard to predict the weather. And so we are, I would say we're not trying to build in any particular weather pattern. As it relates to the holidays, one of the things we talked about last year was Christmas and New Year's falling on a Tuesday, which was the first time in a number of years And, you know, that has an impact. This year the holidays both fall on a Wednesday. And the last time they fell on a Wednesday I think was like our fiscal 14 years. So it's been a bit of a time period since we've had a Wednesday. And so if you think about our weekly flow, You can think of it as a bit of a bell curve. Mondays and Fridays I would call maybe our lower days. And as you go from Monday to Tuesday, the volume starts to build because customers are just more easy to see, et cetera. Wednesday tends to be one of our heavier days. And then you start to come back down as you go through the rest of the week. With the holidays both being on a Wednesday this year, we aren't considering that we will have any year-over-year benefit because of the comments we made last year during the holidays. We're kind of thinking that, look, we're going to still have that holiday disruption a little bit. I don't think it necessarily will be a drag on growth, but it certainly isn't going to help us with an easier come.

It's super helpful. And then just, you know, the margins, again, really nice.

And if I have it right, it looks like kind of the other category at least outpaced our estimates. And I know that can be kind of uniform sales for your lower margin. Is there anything else in there that's helped boost the gross margins overall despite the mix?

You know, we are continuing to make improvements in the fire business. We really like that business, and it has performed very well in the second quarter and in the first half. And as we gain, as we get bigger and we gain scale and that revenue growth allows us to leverage our infrastructure a bit better, it creates more dense routes, and that creates some margin opportunity. We've got a long way to go, but certainly have seen some nice performance in the fire business, and certainly the heavy volume in our direct sale business was a bit of a help too.

Super. Thank you.

I'm going to take the next question from Seth Weber at RBC Capital Markets. Please go ahead.

Hey, guys. Good afternoon. Most of the questions asked and answered, but I wanted to see if we could dig into your – you've made the pricing comments a few times now, just a little bit less robust than maybe what we saw in the first quarter. Is there anything you'd call out? Is it a mix issue? Are the comps just getting harder, or is there something going on from the competitive front that you would highlight? Thanks.

I think it's a bunch of different things, Seth. I think there is a little bit of mix going on. You know, we've had some good performance in a few quarters in a row now. And, you know, that kind of outperformance isn't sustainable in the long term. And You know, I don't think it's anything that we are concerned about, but just something a little bit of a – maybe a notch below where we had seen in the last couple quarters, made up of a, you know, a number of different things.

Okay. And then just on working capital has been, you know, frankly, better than what we would have thought given the growth trajectory. I mean – Do you think that working capital can continue to be just a little bit better than normal? Normally, I think you'd expect to see a little bit more usage here. Is there something you'd call out that's really helping that, or can we expect that to continue? Thanks.

Well, look, from a working capital standpoint, we certainly have been in a period of disruption over the last couple of years. as it relates to our accounts receivable, converting to systems as it relates to our inventory and shutting down DCs, opening new DCs, converting a lot of volume. And, you know, we're starting to get some of those inefficiencies and disruptions behind us. And so, for example, in accounts receivable, We've seen a nice improvement year over year, and that's part because we've gotten a little bit of that disruption behind us. There still is some system conversion to go, but we think we're getting a little bit better and better and more efficient at it. You know, if you think about the – I'll swerve to cash flow for a second. When you think about our operating cash flow, It was pretty strong this quarter and really for the first six months of the year. And our conversion of net income to operating cash flow has been over 100%. I would expect that that's going to continue for the second half of the year. Free cash flow was really strong, and I think that's going to be strong for the rest of the year. And so I think more than anything, Steph, it's getting a little bit of this disruption of two system conversions, a new business conversion, a little bit of that stuff behind us. But as we've talked in the past, when we're growing, we're generally going to use some working capital. In other words, we're going to see AR continue to increase. We're going to see, generally speaking, inventory and in-service inventories grow over time. Inventory is a little bit different now. from the standpoint of we do have opportunities there where some of those opportunities will create more inventory. For example, if we believe we can have enough volume to bring new products into our distribution center, that may create new inventory. However, as we get more efficient and you get the G and K conversion behind us, that's going to create some problems. forecasting and supply chain opportunities. So there's going to be some ups and downs in that inventory line item. But generally, the performance has been good. We've gotten a little bit of that disruption behind us, but we're generally going to be a user of the working capital. Right.

Okay. Super helpful. Thank you, guys. Have a good night. Thanks.

It appears there are no further questions at this time. I'd like to turn conference back to the speakers. Please go ahead.

Well, thanks very much for joining us tonight. We will issue our third quarter financial results in March, and we look forward to speaking with you again at that time, and we wish you all happy holidays.