UniFirst Corp

NYSE:UNF

Earnings Call Transcript 2018-Q4

[Operator]

Ladies and gentlemen, thank you for standing by. Welcome to the UniFirst Corporation Fourth Quarter Earnings Conference Call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. [Operator Instructions]

I would now like to turn the conference over to Steven Sintros, UniFirst's President and Chief Executive Officer. Please go ahead.

[Steven S. Sintros, President and CEO]

Thank you and good morning. I'm Steven Sintros, UniFirst's President and Chief Executive Officer. Joining me today is Shane O'Connor, Senior Vice President and Chief Financial Officer. I'd like to welcome you to UniFirst Corporation's conference call to review our fourth quarter and full year financial results for fiscal year 2018 and to discuss our expectations going forward.

This call will be on a listen-only mode until I complete my prepared remarks, but first, a brief disclaimer. This conference call may contain forward-looking statements that reflect the Company's current views with respect to future events and financial performance. These forward-looking statements are subject to certain risks and uncertainties.

The words, anticipate, optimistic, believe, estimate, expect, intend, and similar expressions that indicate future events and trends identify forward-looking statements. Actual future results may differ materially from those anticipated depending on a variety of risk factors. I refer you to our discussion of these risk factors in our most recent 10-Q and 10-K filings with the Securities and Exchange Commission.

I'm happy to report that UniFirst's fourth quarter produced strong results for both our Company and our shareholders. Overall, revenues for the quarter reached an all-time high, coming in at $434.1 million, up 7.6% from last year's fourth quarter.

On the profit side, fiscal 2018 and 2017's fourth quarters were affected by one-time items that we reconciled out of our results to provide more meaningful comparisons for investors. As a result of the U.S. tax reform, in the fourth quarter of 2018 we approved a one-time bonus to our valued employee team partners. Our executive team felt it was important to share this benefit with our employees because of the integral role they play in our ongoing success. The total charge in the fourth quarter related to this one-time bonus was $7.2 million, with the cash outlay coming in September. As a reminder, our fourth quarter of 2017 was impacted by a $55.8 million impairment charge related to the Company's CRM systems project.

Excluding these two non-recurring items, operating income increased 7% when comparing the fourth quarter of 2018 to the same quarter a year ago. Shane will go through the details of this shortly as there were many benefits and headwinds that blended together to impact our final results.

For the full year, revenues were also a new UniFirst record at $1.696 billion, up 6.6% from fiscal 2017. And excluding non-recurring items, operating income was up 10.5%. Our fourth quarter and full-year earnings per share comparisons were positively impacted by the recent U.S. tax reform and our buyback of 1.178 million shares of Class B and common stock in the third quarter of 2018.

Overall, we're pleased with the results of fiscal 2018, a year in which our Core Laundry Operations led the way with a record in new account sales. In addition, the Company benefited from the timing of customer price adjustments and increases in merchandise recovery charges.

Our Specialty Garments segment, which delivers specialized nuclear decontamination and cleanroom products and business services, as well as our First Aid and Safety segment contributed positively by providing oversized contributions to our top and bottom lines for the full year.

To give credit where credit is due, I would like to sincerely thank our thousands of employee team partners throughout North America, Central America, and Europe, for their continued commitments to our customers and to our Company and for all their hard work to help produce positive financial results for UniFirst in 2018. Going forward we'll continually be focusing on innovative ways to improve our existing and to introduce new Company-wide processes and systems to help ensure the delivery of consistent service excellence that exceeds our customers' expectations.

We'll continue counting on our professional field and national account sales teams to effectively communicate the UniFirst difference to the markets that we serve and to continue with their record-setting selling trends for fiscal 2018 and to drive our organic growth. And we'll continue investing in our Company's most important asset, our people, with evolving and expanded training programs, improved tools and infrastructure to assist them in performing their jobs, all while providing career advancement opportunities.

As we look ahead to fiscal 2019, we're excited about the opportunities that lie ahead. However, as we discussed in our earnings call last quarter, we continue to expect that the ongoing low unemployment economy will result in related headwinds, including staffing and recruiting challenges as well as related salary and wage pressures. We also expect to face cost implications associated with rising merchandise and energy costs.

These headwinds were building in the fourth quarter but their impact was tempered by the strong revenue growth, including the timing of customer price adjustments and quarter over quarter improvement in healthcare claims as well as workers' compensation and other payroll related costs.

We expect these challenges to take a larger toll on our operating margin in fiscal year 2019, as will investments that we continue to make in our people, our technologies, and our overall infrastructure, in pursuit of our ultimate objective of being universally recognized as the top service provider in our industry. We believe these investments will ultimately aid in new customer acquisition and customer retention, resulting in long-term value and returns to our shareholders.

And with that, I'd like to turn the call over to Shane, who will provide additional details on our quarterly results of fiscal 2018 and our outlook for fiscal 2019.

[Shane O'Connor, SVP and CFO]

Thanks Steve. Revenues in the fourth quarter of 2018 were $434.1 million, up 7.6% from $403.6 million a year ago. And full-year revenues were $1.696 billion, up 6.6% from $1.591 billion in fiscal 2017. Operating income for the quarter was $41.4 million, compared to an operating loss of $10.4 million in the fourth [indiscernible]. [Indiscernible] should be reconciled out to provide a more meaningful comparison of our financial performance.

Operating income in the current quarter was reduced by a one-time bonus to our employees of approximately $7.2 million, to share in the benefits received from the recent U.S. tax reform. This bonus was approved in the fourth quarter of 2018 and was recorded to selling and administrative expenses. In addition, in the prior year period, operating income included a $55.8 million impairment charge related to our CRM systems project. Excluding the effect of the one-time bonus to our employees and the impairment charge, adjusted operating income in the current quarter was $48.6 million, an increase of 7% when compared to the adjusted operating income in the prior year period of $45.4 million.

Net income for the quarter was $35 million, or $1.81 per diluted share, compared to a net loss of $49 million or negative $0.24 per diluted share in 2017. Net income for the full year was $163.9 million or $8.21 per diluted share, compared to $70.2 million or $3.44 per diluted share in the prior year. Excluding the effect of the one-time bonus and the impairment charge we previously discussed, our adjusted net income for the fourth quarter of 2018 would have been $39.9 million or $2.06 per diluted share, compared to $29.2 million or $1.44 per diluted share in the fourth quarter of fiscal 2017.

Our adjusted net income comparison in the quarter benefited from a lower tax rate in 2018 of 20.2% compared to 39.3% in the prior year period, primarily due to the positive impact of the recent U.S. tax reform as well as other discrete adjustments mostly related to tax credits Company recognized in the quarter. In addition, our adjusted diluted earnings per share further benefited from the previously announced $146 million repurchase of Class B and common stock in March of 2018.

Our Core Laundry Operations, which make up 90% of our total business, reported revenues for the quarter at $391.8 million, up 7.4% from last year's fourth quarter. Organic revenue growth, which adjusts for the estimated effect of acquisitions as well as fluctuations in the Canadian dollar, was 6.6%. During the quarter, we continued to benefit from the strong new account sales in fiscal 2018 as well as the timing of certain positive price adjustments and the collection of merchandise recovery charges.

Excluding the effect of the one-time bonus and the $55.8 million impairment charge, Core Laundry adjusted operating income increased to $46.3 million, up from $41.9 million in prior year, or 10.6%. Adjusted operating margin for this segment increased to 11.8% in the quarter compared to the adjusted operating margin in prior year of 11.5%.

During the quarter, we primarily benefited from lower healthcare and workers' compensation expense compared to the prior year. As a reminder, in the second half of 2017, we experienced abnormally high healthcare and workers' compensation claims and were concerned that there might be a similar trend in the second half of 2018. However, our claims experience was significantly better than both the prior-year period as well as our expectations coming into the quarter.

We continue to be impacted by wage pressures, primarily within our production and service and delivery position, which resulted in higher payroll costs in the quarter as a percentage of revenues. In addition, increasing merchandise amortization, energy costs, and depreciation expense, provided additional margin pressure during the quarter. Energy costs increased to 4.3% of revenues in the fourth quarter of 2018, up from 4.1% a year ago.

Revenues in the quarter for our Specialty Garments segment, which delivers specialized nuclear decontamination and cleanroom products and services, increased to $29 million, from $24 million in the prior-year period, or 20.7%. This top line performance was again driven by strong contributions from its Canadian and European customers as well as its cleanroom division. Specialty Garments' operating income in the fourth quarter of 2018 decreased to $1.2 million from $1.6 million in last year's fourth quarter, primarily due to higher production costs as a percentage of revenues.

For the full fiscal year, Specialty Garments set a new segment record for both revenues and operating income, with revenues totaling $118.5 million and operating income of $14.1 million. As a reminder, this segment's results can vary significantly from year to year due to the timing of reactor outages and projects.

For the fourth quarter of 2018, our First Aid segment reported revenues and operating income of $13.3 million and $1 million respectively, compared to $14.7 million and $1.9 million for the same period in fiscal 2017. The decrease in both revenues and operating income during the quarter was primarily the result of lower direct sale activity in the segment's wholesale distribution business compared to prior year.

UniFirst continues to maintain a solid balance sheet and financial position. At the end of the fourth quarter of 2018, cash and cash equivalents and short-term investments totaled $270.5 million, down from $349.8 million at the end of fiscal 2017. This decrease is primarily due to the $146 million share repurchase we previously discussed as well as $42.7 million spent on the acquisition of businesses.

Capital expenditures in fiscal 2018 totaled $112.7 million, as we continue to invest in capital projects that will help us meet our long-term strategic objectives, including new facility additions, expansions, updates, and automation systems. In 2019, we expect CapEx to be elevated and approximate $130 million due to a higher level of plant replacement and expansion projects that we have decided to move forward with to improve our capacity, capabilities, and efficiencies within the related market.

Over the last number of quarters, we have indicated that we have been evaluating our options moving forward related to our CRM systems project. In the fourth quarter of 2018, we finalized a partnership with a third-party to license the solution that will meet the requirements of our business and customers. We have kicked off a multi-year project to further develop, implement, and subsequently deploy this application, and in fiscal 2018 capitalized $1.9 million related to the project.

Our preliminary estimates are that we will capitalize between $30 million and $35 million related to this project, with $5 million to $10 million coming in fiscal 2019. These costs include license fees, consulting fees, capitalized internal labor costs, handheld devices, and hardware costs to support the deployment of this system.

I'd now like to take this opportunity to provide our outlook for our fiscal 2019, which will include one extra week of operations compared to fiscal 2018 into the timing of our fiscal calendar. We anticipate our full-year revenues for fiscal 2019 to be between $1.765 billion and $1.785 billion, and we expect full-year diluted earnings per share to come in between $6.65 and $7.05.

I will remind you that net income and earnings per share comparisons in fiscal 2019 will be significantly influenced by the one-time impact of tax reform in fiscal 2018, with next year's effective tax rate assumed to be 26% compared to 12.5% in fiscal 2018. Although 2019's effective tax rate is expected to be 26%, this rate will fluctuate from quarter to quarter based on discrete events, including the impact of stock compensation benefits.

The top line guidance assumes an organic growth rate, excluding the impact of the extra week in fiscal 2019, of between 2.5% and 3.5% for our Core Laundry Operations, and an operating margin at the midpoint of the range of approximately 9.7%. The decline in margin is primarily due to unfavorable comparisons from payroll and payroll-related costs, merchandise amortization, energy, and depreciation expense, as a percentage of revenues.

Payroll and payroll-related costs are expected to increase primarily due to the wage pressures that we continue to experience. We have had to raise wage levels in many markets due to the impact of minimum wage increases as well is general competition for and the availability of labor in this low unemployment environment. Ensuring that we are able to attract and retain quality team partners is core to our ability to provide strong service to our customers. Based on the current energy prices, we are modeling an overall increase in energy costs in 2019 to 4.5% of revenues, compared to 4.3% in 2018.

In the latter part of 2018 and into 2019, we have continued to see increases in the amount of merchandise we are placing into service to support our customers' rental programs. This is partially due to stronger new account sales in fiscal 2018 as well as a higher level of replacement adds compared to a year ago. These increases have and will continue to result in increased merchandise amortization costs in 2019. Lastly, depreciation expense will be higher due to the increased amount of capital investments that we have made over the last few years.

Our Specialty Garments segment revenues are forecast to decline between 2% and 4%, coming off a historically strong year. In addition, the segment's operating income is forecast to be backwards between 10% to 15%. The anticipated decline in both revenues and operating income is due to the timing and relative profitability of its planned outages and project work. Our First Aid segment's revenues and operating income are expected to be ahead of fiscal 2018 by approximately 2% to 3%.

In 2019, we also expect to be impacted by a number of items, all within selling and administrative expenses, that are largely offsetting. However, we thought it warranted calling them out. Our guidance includes the impact of our adoption of Accounting Standards Update 2014-09, Revenue from Contracts with Customers. We expect this adoption will have no impact on the timing of our revenue recognition. However, our selling and administrative expenses will benefit from the capitalization of sales commission payments and the subsequent amortization of those commissions over the expected service period of the associated customer relationship. This is a non-cash impact and we expect the net benefit will approximate $2.5 million in fiscal 2019.

As I previously discussed, we have kicked off a new CRM systems project and will be capitalizing certain internal labor costs related to its implementation. We anticipate that $2 million to $3 million of payroll costs that we incurred in 2018 will be capitalized in the upcoming year.

These benefits will be largely offset by increased expenses related to the timing of certain selling promotional events as well as the impact of a recent change in our vacation policy that we anticipate will result in additional expense due to its impact on our employees' vacation usage in 2019 compared to the prior year.

Based on these projections, we expect that we will generate free cash flows in fiscal 2019 of approximately $65 million to $70 million. This cash flow combined with our existing available cash continues to position us to make additional investments in our business, pursue acquisition targets aggressively, as well as explore additional capital allocation strategy.

This concludes our prepared remarks and we would now be happy to answer any questions that you might have.

[Operator]

[Operator Instructions] The first question comes from the line of Andrew Steinerman with J.P. Morgan. Please go ahead.

[Andrew Steinerman, J.P. Morgan]

My question is to kind of look back on margins to look forward past 2019. For a long time your operating margins were close to 14%, which were on the high end of the industry, and then they've been coming down most recently and into next year. My question is, do you have a medium-term goal for your margins and do you sense that perhaps some of your margin successes in the past are kind of becoming a headwind now, particularly around merchandise amortization?

[Steven S. Sintros, President and CEO]

Andrew, this is Steve. So, I think as far as the 14% and you talked about merchandise amortization, I don't think that's the biggest differentiator between then and now. I think we talked a lot over those couple of years, the benefits from some of the energy markets we were realizing as partially being the reason that the margins had ticked up so much.

Looking ahead, and you say kind of a mid-term target, I mean we really would like to push those margins up toward 11%-plus and we think we can get there. But as I alluded to in my comments, we're going through a period right now where we are making a lot of investments in the business to position ourselves for the future, whether it'd be with technology investments in our facilities in a number of areas that we feel are important for the long-term. And that combined with I think some of these near term challenges with the salary pressures and so on are intersecting to create what we're guiding for next year.

We'll continue to be looking at opportunities. A lot of the investments that we are making, we do expect to lead to efficiencies, although some of them are sort of multi-year projects similar to this technology initiative we're going through. So, hopefully that answers your question.

[Andrew Steinerman, J.P. Morgan]

It does. Can I just put one more question on merchandise? You mentioned a higher level of merchandise replacement going on right now. I was wondering if there might also be a benefit on your side in terms of merchandise recoveries being charged to customers and what's the timing there?

[Steven S. Sintros, President and CEO]

That's a good question. I mean at times when your merchandise infusions are higher, there is some offsetting recovery. We did have a strong recovery year and quarter. I think we're a little cautious that that may provide some difficult comparisons going into next year, but that is an area when you ask about how do we continue to deal with rising merchandise and rising cost in general, and looking to our customer to make sure we're being fairly paid for those services, and that merchandise is a big part of that. So, we will continue to do that.

[Andrew Steinerman, J.P. Morgan]

Appreciate it. Thank you.

[Operator]

Thank you. Our next question comes from the line of John Healy with Northcoast Research. Please go ahead.

[John Healy, Northcoast Research]

Steve, I was hoping you could talk just a little bit about the trend seen throughout the quarter, maybe what you're seeing to start this quarter, just in terms of the revenue momentum if there was any sort of improving or decelerating cadence as the last few months have taken place?

[Steven S. Sintros, President and CEO]

I think as we alluded to from – I'll break it down in a couple of different pieces – on the new sales side, we've had a very strong year. We sold more new business by over 10% than we did a year ago. So, I think the environment continues to be strong. Our team internally continues to execute on that side.

I wouldn't say there has been any major change in trend over, say, the last several months in terms of the environment. From an economic perspective, we talk about adds reductions being an indicator. We have not seen any major improvements or declines in that area.

I know a question we get asked often is that oil sector and what we're seeing. So, to kind of answer that one, West Texas continues to be strong, but that's really the only area that we're seeing decent size upticks in business. Other than that, I think our customers are fairly healthy. I think they are dealing with a lot of the same employment and staffing related issues as we are and they continue to work through it.

Our retention has been stable during the year, but as I've alluded to before, in my mind not good enough and I think that's an area of opportunity and a lot of the investments we're making are designed around improving that area of our growth drivers to improve the organic growth.

[John Healy, Northcoast Research]

Great. And then just one question about capital allocation, seems like a lot of the internal investments you're making either into technology or the facilities, is there a thought to maybe not pursuing M&A as aggressively until you get some of this stuff behind you, and if there is any sort of kind of updated thoughts on maybe any ways to return cash to shareholders in any unique ways?

[Steven S. Sintros, President and CEO]

As it relates to the M&A, I would say there is not a thought to be less aggressive. Particularly on the smaller tuck-ins, one to two-plant operations, we're still out there aggressively looking for opportunities. As you well know, most of those opportunities arise out of family businesses going through their lifecycle and we continue to keep those relationships close to take advantage of opportunities as they arise. So, particularly for the small or mid-sized deals, we'll continue to be aggressive and try to bring those into the fold.

In terms of other capital allocation, we'll continue to evaluate depending on our level of cash flow, the level of those acquisitions that have come along. When you look at this year, obviously we did some share buybacks. We spent about $40 million on acquisitions. We raised the dividend a little bit. And those are the things we'll continue to balance as we move forward and looking at what opportunities are out there, whether it's buying our own stock or looking at acquisitions. So, it is part of the continued evaluations and that will continue.

As Shane alluded to, our CapEx will be up some this year and probably some elevated next year as well as we go through, and probably have made somewhat of a conscious decision to do a few more projects that are out there to get some of our infrastructure where we'd like it to be to put ourselves in a good position to grow.

[Operator]

The next question comes from the line of Justin Hauke with Baird Capital. Please go ahead.

[Justin Hauke, R.W. Baird]

So, I guess I'm going to ask a little bit more on the 2019 margins, just hopefully help us understand a little bit more, because what you're saying with the 9.7 at the midpoint, I mean maybe you have to go back till like 2006-2007 that the margin at that level, and given the overall strength, just it's hard to reconcile why the decremental margin would be that significant even recognizing the labor expense headwinds and some of the other items that you talked about? So, maybe the first thing would be, as a total percentage of your cost structure, how much is labor and labor-related and what are you assuming that increase is in 2019's guidance, just so we can understand the labor component a little bit better?

[Steven S. Sintros, President and CEO]

Sure. I mean I guess the best way we can tell you is that we expect about a 0.7 to 0.8 on the margin headwind related to labor, and that is broken up in a few areas. I think probably about 0.5 point is related to more of our service and delivery labor, maybe a little bit more than 0.5 or 0.6 point, and that is directly or at least a lot of it is related to the wage pressures that we're seeing, whether it'd be minimum wage increases or just the trickle-up effect of minimum wage increases across our employee base.

Some of the other delta probably fall on labor, probably falls in the category of what I'm been talking about, investments that we'll continue to make in our infrastructure trying to improve a number of different areas just to improve our overall capabilities and improve efficiency in a number of areas. So we're making investments in training and development of our people, efficiency projects on maintenance, and some other areas we're investing in that we think will have a return over time, hopefully later in the year, into the following years, but that makes up some of the difference.

So, when you look at the 1.5 or so percent decline that we're projecting, that's the labor piece. And then the remaining, you have a couple of tens on merchandise, a couple of tens on depreciation, a couple of tens on energy, and that's sort of taking us to where we go. We will continue to try to work with our customers and our operations to offset as much of that as we can, but that's what our outlook looks like right now.

[Justin Hauke, R.W. Baird]

Okay, that's helpful in terms of just the moving pieces of it. So, 70 to 80 basis points, so 50 basis points is the direct wage increases. I guess on a percentage basis, I mean how much are wages increasing across the organization? I mean, what are you assuming, is that a 5% increase, is that a 10% increase? I'm not exactly 100% sure how much of the total cost structure is labor.

[Steven S. Sintros, President and CEO]

That number, and I don't have it in front of me, but about 40% of our expenses are labor. It's probably not exactly the right number, but it's in the ballpark.

[Justin Hauke, R.W. Baird]

Great, okay. And that's direct and indirect I guess?

[Steven S. Sintros, President and CEO]

Correct.

[Justin Hauke, R.W. Baird]

Okay. So, shifting years, on the CRM system, I guess it sounds like you went with another third party, you had a third-party before and you were kind of thinking about maybe doing some self-development instead. What is it about this new system or the choice that you made that's different than the last one and why it makes sense, if you could just give a little more on that because that seems like there was a pretty big milestone to make a decision?

[Steven S. Sintros, President and CEO]

The biggest decision, to clarify, is that our previous project was a much more significant custom project, building a lot of the application from ground-up. The new project is working with the partners, develop some technology that's very on point for the industry itself, and working to partner with them to enhance the technology as the base of the system. So, it's a little bit more of a ready-made product, proven product, that we're going to work with them to enhance. So, from that perspective, we view it as much lower risk, and we're excited and happy about the new path that we've landed on.

[Justin Hauke, R.W. Baird]

And when is the at least initial goal for when that system would be live with the [indiscernible] project?

[Steven S. Sintros, President and CEO]

At this point, we're not putting out that timeline. What I'd say is, for fiscal 2019 we will not be actively deploying the system, but we will keep investors updated as we move along. I think for obvious reasons, based on what we went through the last time, we want a little bit more runway before landing on when those go-live dates would be.

[Justin Hauke, R.W. Baird]

Okay. Okay, that's it for me for now. Thank you, guys.

[Operator]

[Operator Instructions] It appears that there are no further questions on the phone lines at this time.

[Steven S. Sintros, President and CEO]

Okay, I'd like to thank everyone for joining us today to review our fourth quarter and year-end financial results. We look forward to speaking with you again in January when we expect to be reporting our first quarter results for fiscal 2019. Thank you and have a great day.

[Operator]

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. Thank you and have a good day.