Cintas Corp

NASDAQ:CTAS

Earnings Call Transcript 2020-Q2

[Operator]

Good day. And welcome to the Cintas Quarterly Earnings Results Conference Call. Today's call is being recorded.

And at this time, I would like to turn the conference over to Mr. Mike Hansen, Executive Vice President and Chief Financial Officer. Please go ahead, sir.

[Mike Hansen]

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 '20, 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 who's 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% for 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 $0.06, which is 90 basis points 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 counts 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'll now turn the call over Paul.

[Paul Adler, Vice President and Treasurer]

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 headwinds, 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 expensed 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 $0.06 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 as 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 on ramp. Uniform Rental and Facility Services revenue was $1.47 billion, an increase for 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 profit synergies from the acquisition of G&K.

Our First Aid and Safety Services operating segments 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 14.4% in the second quarter compared to 14% in masters second quarter, an increase of 40 basis points. First Aid segment gross margins continued to increase with strong revenue growth.

Our Fire Protection Services and Uniform Direct Sale businesses are reported in 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 multimillion 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 service 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 Sales business saw 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 percentage 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 equivalents balance as 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 in service and accounts payable. Capital expenditures in the second quarter were $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 a 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.

[Operator]

[Operator Instructions] We will take our first question from Toni Kaplan at Morgan Stanley. Please go ahead.

[Toni Kaplan, Morgan Stanley]

You had 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? Thanks.

[Mike Hansen]

And Toni, you are speaking of revenue right now. Correct?

[Toni Kaplan, Morgan Stanley]

Yes.

[Mike Hansen]

And so, from a -- let's talk about the quarter. We had a very good quarter. The -- all of our businesses grew, and in particular our direct sale business had a really nice quarter. Toni, you'd asked a little bit about the macro first. And 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 the space go bankrupt. But 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 forward, we are encouraged that we've -- it looks like we've made some progress in the USMCA and China trade and we're encouraged by the movement there and we look forward to getting those results.

It seems like we 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 there's still 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 business 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 have some things that went our way. I talked a little bit about this in the first quarter where rental 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've lapped the G&K acquisition. So again, 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 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 referred of 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 as we think about the second half, we're thinking about the macro. We're thinking about -- 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, it's -- our same work day 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.

[Toni Kaplan, Morgan Stanley]

And just wanted to ask about buybacks, you really pulled back pretty dramatically this quarter. 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 buybacks this quarter?

[Mike Hansen]

Yes, we do have -- we've got the authorization of about 1.2 billion. And we look at that, as we talked about, we look at that opportunistically. One thing to keep in mind is we, in the first week of December, we made $268 million payment related to our dividend, and we also have some debt interest payments. So we're back into CP in the month of December, but we will 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.

[Operator]

We will now take the next question from Hamzah Mazari at Jefferies. Please go ahead.

[Hamzah Mazari, Jefferies]

My first question is just on the SAP rollout sort of just any update there. Specifically, where do you 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 rollout?

[Mike Hansen]

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 to that that we believe will be benefiting the top-line later on and more perhaps impactfully when the entire network is in the system.

But certainly, we believe that putting the Uniform Rental business and our First Aid business in the same operating system will foster more collaboration, more cross-selling, which will help the top-line. And just better, as I mentioned earlier, use the 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.

[Hamzah Mazari, Jefferies]

And just a follow-up question and I'll turn it over. When you think about M&A outside of 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 our base. Does it have to be accretive to growth, accretive to margin? I know you guys just did shred it a long time ago and that business got sold. We did G&K that was part of the core. Just any color as to metrics you can share, how you think of our larger M&A outside the core? Thank you.

[Mike Hansen]

First of all, we work 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. 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.

[Operator]

We'll now take our next question from Manav Patnaik at Barclays. Please go ahead.

[Manav Patnaik, Barclays]

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

[Mike Hansen]

We -- generally, we are making our CapEx in terms of our growth opportunities, like new routes and then -- 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 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 G&K auto source that that's kind of a quasi auto source 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.

[Manav Patnaik, Barclays]

And then just in terms of G&K and maybe tied to the SAP implementation. Are there systems I guess on SAP as well? And is it still too hard for you guys to quantify any revenue synergies that you might be getting from that deal?

[Mike Hansen]

Well, keep in mind we converted all G&K locations to either the Cintas SAP system or the legacy Cintas 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 made good progress.

So we have a pretty good handle on in terms of viewing the G&K legacy locations in much the same way that we're viewing the Cintas location. And so we see some benefits, so 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.

[Operator]

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

[Andrew Steinerman]

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

[Mike Hansen]

From an inventory conversion standpoint, we are in the midst of that. And those happened at different such times, Andrew. So for example, if we have a customer that's got 10 wears, for example, in legacy G&K inventory, we maybe 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 current 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 style. 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 we -- there is no change at all and we put them in something that's, let's say, at a work wear 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 its 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.

[Andrew Steinerman]

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

[Mike Hansen]

I can give you anecdotally, the answer is yes. 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 little bit better, it maybe that is -- that the fabric breath is 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.

[Operator]

We'll now take the next question from Gary Bisbee at Bank of America. Please go ahead.

[Gary Bisbee, Bank of America]

I guess the first question from me, just the Uniform Rental revenue slowed somewhat, obviously, at a much tougher comp, but anything other than that. I guess you mentioned a little weaker energy, anything other than that you would call out as sequential deceleration in the organic constant currency revenue growth?

[Mike Hansen]

Yes, 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 the choppiness in the energy and maybe industrials, generally; and pricing maybe wasn't quite as incrementally positive as we've seen in 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.

[Gary Bisbee, Bank of America]

And then you have been asked for a few years about cross-sell potential, both with G&K and just more broadly against your different businesses. And I realized 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 business go out, how often are they targeting people that are customers through your other businesses? How important is cross-sell in terms of how you are trying to compensate the different types of sales people? Is it really something you 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?

[Mike Hansen]

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 looking at that some of our more complex customers and looking for upsell and penetration opportunities there. And we've become a bit better at 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 are 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 at that over the last two 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.

[Gary Bisbee, Bank of America]

And then just one more, the initiative have been next quarter or anything like that, but as we think out of 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 have been obviously terrific the last two years, particularly as the G&K savings have flown through. But what's like a long-term target or opportunity there?

[Mike Hansen]

We still like -- 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 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, as we move forward, we think that incremental certainly is in the 20% to 30%. And 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 into that mid-20 type of a neighborhood. So it's a nice opportunity that looks -- that we look forward to.

[Operator]

We'll now take our next question from Andrew Wittmann at RW Baird. Please go ahead.

[Andrew Wittmann, RW Baird]

Yes, I was looking at the two year growth rate stack in your Rental segment. It looks like the comps prove out at 12.4 over the last two years, both for the first quarter and the second quarter. But kind of brings me to the question you've talked about in the past, which is your sales force productivity. You mentioned the kind of the headwind for the deceleration in 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 for those new customers?

[Mike Hansen]

Yes, when we think about total, 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.

[Andrew Wittmann, RW Baird]

And then I guess I wanted to maybe, Paul, if you can just help us a little bit on some of the elements of 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 can call in the cost structure? I think, labor has been something that people have flagged, maybe that would be something you've addressed. You mentioned health care that is back to normal. But just anything else you can help us understand the moving pieces inside the margins, I think could be helpful?

[Paul Adler, Vice President and Treasurer]

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

[Mike Hansen]

Yes. 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 sales people are productive and they're selling good profitable business, and that's been good. And we are -- we've done a nice job of capturing the G&K synergies.

But what we're also seeing a little bit of is, as we've talked about over the last few years, there is a lot of inefficiency in running the facilities when you're going through a lot of conversion of incorporating G&K volumes into Cintas 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 G&K synergies just as we wanted them to. And we've seen some real nice efficiency gains, because there are quite as many of those projects going on, those are a little bit more in the past.

And so our -- we've -- 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.

[Operator]

And we'll now take next question from Scott Schneeberger at Oppenheimer. Please go ahead.

[Daniel Hultberg, Oppenheimer]

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

[Mike Hansen]

Sure. We are always looking for them. And so when we think about efficiencies going forward, I've talked a little bit about capacity. How can we continue to get more efficient in terms of using our Wash Alley, some of that is automation, I'm sorry, technology and some of that is a 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 its 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 Cintas system a bit. That's going to create some efficiency just that because we won't have duplicate systems, but also then using that technology for things like sales rep productivity gains and cross-selling and penetration opportunities, so that 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 product and 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.

[Daniel Hultberg, Oppenheimer]

Switching gears a little bit, cotton price has been down in the first half of this fiscal year on a year-over-year basis. Could you please discuss half of that is impacting earnings. I mean I know historically you've smooth that out through amortization, but how is that really impacting your earnings presently? Thank you.

[Mike Hansen]

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, if we have to sell 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 months 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 118 fourth of that in one month, you may could have two or 318th fourth 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 cost, one is production, part of this 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 serve garments, the freight on the garments, the trim on the garments, etc. And so it really takes some sustained large movement in cotton before it really starts to impact us.

[Operator]

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

[George Tong, Goldman Sachs]

Your revenue outlook has 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?

[Mike Hansen]

Well, there they are -- things generally George that, 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 that penetration is both better coordination between our businesses, but also taking advantage of our newer products and making sure we're getting things like check works 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 we think we've got a really nice year ahead of us as we move into the second half.

[George Tong, Goldman Sachs]

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?

[Mike Hansen]

Pricing, certainly has an impact, I mentioned that it wasn't quite incrementally positive in this quarter as it had been in the previous two quarters. And so I would say the pricing is somewhat in line with what we've seen over the last couple of years, absent the last couple of quarters. 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 I would -- 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 efficiencies that we're able to gain.

[Operator]

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

[Kevin McVeigh, Credit Suisse]

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

[Mike Hansen]

Last year in the third quarter, we talked a little bit about the weather and the holidays. 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 that has an impact. This year, the holidays both fall on a Wednesday, and the last time they fell on a Wednesday, I think it was like our fiscal '14 year. 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 of volume you can think of it as a bit of a bell curve Monday -- Mondays and Friday's I would call are our, maybe our lower days and our as you go from Monday to Tuesday that when the volume starts to build because customers are just more, they're more easy to see etc. 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 -- by the holidays, both being on a Wednesday, this year we are 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's certainly, it isn't going to help us with an easier comp.

[Kevin McVeigh, Credit Suisse]

And then just the margins again really nice and if I have it right, it looks like kind of the other category at least outpaced our estimates that can be kind of uniform sales which are lower margin. Is there anything else in there that's helping boost the gross margins overall despite the mix?

[Mike Hansen]

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 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.

[Operator]

We will take our next question from Seth Weber at RBC Capital Markets. Please go ahead.

[Seth Weber, RBC Capital Markets]

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 or the comps just getting harder or is there something going on from a competitive front that you would highlight? Thanks.

[Mike Hansen]

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

[Seth Weber, RBC Capital Markets]

And then just on working capital has been 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 expect to see a little bit more usage here. Has there something you'd call out that's really helping that or can we expect that to continue? Thanks.

[Mike Hansen]

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 two systems as it relates to our inventory and shutting down DCs, opening new DCs, converting a lot of volume. And 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. If you think about the sort of 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 Seth, 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 are 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 from a 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&K conversion behind us, that's going to create some 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.

[Operator]

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

[Mike Hansen]

Well, thanks very much 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.