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G&K Services, Inc. Solid Beat Driven by Margin Gains; Internal Operations Showing Improvement

G&K reported adjusted EPS growth of 38%, to $0.62, which was well above the Street consensus of $0.54 and our $0.53 estimate. The beat was driven by margin improvement from both lower costs and productivity gains, as well as a $0.02 from a lower‐than‐forecast tax rate. The operating environment appears to have slowed a bit during the quarter as the key add/stop metric turned slightly negative, which we believe reflects political uncertainty and the cloudy economic outlook. While we believe the election can help stabilize the operating environment, we do not see a near‐term catalyst to drive additional earnings upside. Over the longer term, our outlook continues to be more positive as the company should be able to leverage its improved cost structure when wearer additions eventually rebound.

Growth remains steady despite the sluggish environment. Total revenue increased 6%, to $222 million, driven by solid growth in the core rental segment (up 6% organically) and 21% growth in direct sales. Growth in core rental came from increased sales to existing customers and some benefits from slightly better pricing. New rental account sales slowed somewhat sequentially, and management noted that the key add/stop metric turned slightly negative. In our view, any decline in wearers probably reflects heightened uncertainty for business owners leading up to the election and is likely just another bump in the road on what we believe will continue to be a slow recovery in the job market, yet nonetheless is a the key variable to monitor.

Gross margin improves from lower energy costs and diminishing impact from higher merchandise amortization. Gross margin improved 60 basis points, to 31.2%, driven by lower energy costs (60 basis points), which declined because of lower energy prices and the company’s efficiency improvements. Merchandise amortization continues to be a headwind (150 basis points), but its impact is diminishing (230 basis points last quarter) as higher fabric prices, which peaked in early 2011, work their way through the company’s inventory. We expect core rental gross margin to stabilize over the next few quarters as this impact abates.

Operating margin expansion driven by productivity gains. Operating margin increased 140 basis points, to 8.7%, as the company drove better productivity in production and delivery within the rental business. In particular, G&K is benefiting from the rollout of its new plant productivity system (a process that started more than a year ago) and should see some additional gains as the system is installed in remaining plants.

Guidance. Management increased 2013 EPS guidance to the range of $2.25 to $2.45 (previously $2.20 and $2.40), which brackets the current Street consensus estimate of $2.36. The company continues to expect revenue to fall in the range of $890 million to $910 million. Management noted that its guidance does not assume any lift from the economy or employment.

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