Earnings Call Transcript - CTAS Q2 2020

Operator, 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, Executive Vice President and CFO

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 was $334.5 million, an increase of 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 is 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 $0.06, which is a 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 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'll now turn the call over to 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 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 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 last year's 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 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%. The 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

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

Toni Kaplan, Analyst

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, Executive Vice President and CFO

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

Toni Kaplan, Analyst

Yes.

Mike Hansen, Executive Vice President and CFO

Let's discuss the quarter. We had a very good quarter with all our businesses experiencing growth, especially our direct sales sector, which performed particularly well. In terms of the macro environment, we didn't see much change during the quarter. At the start, we mentioned some softness in the energy sector, and we did observe that over the quarter, including the bankruptcy of a significant customer in that area. Generally speaking, the industrial sector remains a bit unpredictable. Despite this, there hasn't been substantial change lately. We're optimistic about the progress regarding USMCA and trade with China, and we await the outcomes. There seems to be a steady direction from the Fed concerning interest rates. As we conclude the second quarter, there are some positive signs, but we must remain cautious as we enter an election year and consider the prevailing uncertainties in the market, particularly regarding whether small businesses and others will keep investing. Regarding our guidance, the first half of the year was strong, largely due to our partners' efforts, and the overall performance aligns with our expectations. We achieved approximately 7% growth, with organic growth also exceeding 7% in the first half. Some favorable conditions contributed to this, including rental benefits that have had a year-over-year impact as we recovered from last year's lows following the G&K acquisition. We expect to see pricing stabilize back into the range we've experienced in recent years. Our direct sales business had an excellent first half, but for the second half, we anticipate it may level off or decline, which will have roughly a 75-basis point impact on growth when comparing the two halves. As we look at the second half, we recognize that not all of the first half's successes may carry over. However, our same workday growth is projected between 6.2 and 6.8, and the year is largely unfolding as we anticipated. If we achieve these figures, it will be a very positive year for us.

Toni Kaplan, Analyst

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, Executive Vice President and CFO

Yes, we have authorization for about 1.2 billion. As we mentioned, we approach this opportunistically. It’s important to note that in the first week of December, we made a $268 million payment for our dividend and also have some debt interest payments due. We will be utilizing commercial paper in December, but we will consider the buyback opportunities as the year progresses. To specifically answer your question, we have not altered our approach to capital allocation.

Operator, Operator

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

Hamzah Mazari, Analyst

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, Executive Vice President and CFO

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, and 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, Analyst

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, Executive Vice President and CFO

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 kinds 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, Operator

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

Manav Patnaik, Analyst

Can you explain the reasoning behind the lower CapEx assumption and provide some context regarding your main investment priorities over the next two to three years?

Mike Hansen, Executive Vice President and CFO

We are primarily focusing our capital expenditures on growth opportunities, such as expanding our routes and increasing capacity. We are actively adding new routes, which involves purchasing trucks, an essential part of our strategy. In terms of laundry capacity, we have some promising projects underway that we believe will be beneficial in certain instances. We are noticing some advantages because of these efforts. I mentioned G&K auto source, which serves as a support for some of our facilities, and we are in the process of implementing similar initiatives. We are also exploring improvements in our washing operations. Furthermore, we still have some additional capacity from the G&K acquisition. The combination of these factors has led to efficiency gains, especially in our production environment, and we are beginning to see positive impacts on our gross margin.

Manav Patnaik, Analyst

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, Executive Vice President and CFO

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, 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, Operator

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

Andrew Steinerman, Analyst

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, Executive Vice President and CFO

From an inventory conversion perspective, we are currently in the process of transitioning. This occurs at varying times for different customers. For instance, if a customer has ten items in legacy G&K inventory, as they experience turnover and replace open positions with new hires, we will transition them into current legacy G&K garments. There will come a point when we deplete these garments, which can vary by style or size and is dependent on the specific customer. Once we start running out of G&K legacy garments, we will replace them with Cintas garments, ideally all at once to maintain a consistent look. However, this decision is made on a customer-by-customer basis, influenced by their specific styles. Therefore, it’s difficult to provide an overall percentage since this is happening nationwide. We are still working through the G&K legacy inventory. When customers switch to Cintas inventory, pricing discussions also occur on a case-by-case basis. Some might see no change, while others might have an option to upgrade to a higher-end garment, like Carhartt. In such instances, there may be times we adjust the pricing as needed. Thus, both the timing of the conversion and the pricing structure are determined individually for each customer.

Andrew Steinerman, Analyst

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, Executive Vice President and CFO

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 is 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.

Operator, Operator

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

Gary Bisbee, Analyst

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, Executive Vice President and CFO

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 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.

Gary Bisbee, Analyst

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, Executive Vice President and CFO

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-selling 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, Analyst

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 flowed through. But what's like a long-term target or opportunity there?

Mike Hansen, Executive Vice President and CFO

We continue to believe in the potential for growth, specifically aiming for increments of 20% to 30%. Our rental division is approaching the lower end of that range. As we achieve success with penetration opportunities and target larger customers in certain sectors, we see further possibilities for growth. Looking ahead, we expect increments to remain within that 20% to 30% range. If we can leverage the various strategies we've discussed, such as improved penetration and more efficient service delivery, we believe we can reach increments in the mid-20 range. It's an exciting opportunity that we are eager to pursue.

Operator, Operator

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

Andrew Wittmann, Analyst

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, Executive Vice President and CFO

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, Analyst

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

Energy provided a 20 basis points benefit year-over-year and remained flat sequentially. If oil prices in the second half align with those in the first half, it will likely benefit our cost structure. Regarding labor, we previously discussed inflation in certain areas of our workforce, especially in production, but we believe that issue is resolved and no further adjustments will be necessary. Overall, inflation is manageable for us. While it's certainly tight, it hasn't hindered our ability to operate the business and serve our customers.

Mike Hansen, Executive Vice President and CFO

Yes. When considering our gross margins, we have seen significant year-over-year improvement in the first half of the year. The growth levels have been strong, which contributes positively. Our sales team is performing well and managing profitable business effectively. We have successfully captured the G&K synergies, although we have noticed some inefficiency in operating the facilities during the conversion of G&K volumes into our legacy plants. This includes closing plants and re-barcoding inventory, which involves considerable effort. In the first half of the year, we achieved the synergies we anticipated and experienced notable efficiency gains, as there are fewer ongoing projects related to this conversion. The timing has worked in our favor since, while facing some pressure in production labor, we have also been able to capture synergies and improve efficiency during this period.

Operator, Operator

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

Daniel Hultberg, Analyst

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 on a go-forward basis besides the route optimization and a little bit color on automation of processes and how advanced technology is applied and where you could go there with? Thank you.

Mike Hansen, Executive Vice President and CFO

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, Analyst

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 how 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, Executive Vice President and CFO

There hasn't really been any impact in the first half of this year. As you mentioned, it takes time for the cotton price changes to affect our profit and loss. We first have to sell the garments and bring them into our distribution center. From there, we ship them to our rental locations, which triggers an amortization process that lasts 18 months. So, it doesn’t immediately affect us. Even when it does begin to influence us, we generally smooth those impacts. If there's a price spike for a few months, it may not translate evenly— we might see one significant month followed by smaller impacts in others. It takes a substantial and sustained change in cotton prices before we really start to feel the effects. It's also important to note that cotton is not a major part of our cost structure. When we look at our costs, they fall into three categories: material costs, production costs related to operating our laundry facilities, and service costs involved in distribution. The cotton cost is a part of the material expenses, which also includes labor for garment service, freight, and trim. Therefore, we need a consistent and significant rise in cotton prices for it to have a tangible impact on us.

Operator, Operator

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

George Tong, Analyst

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, Executive Vice President and CFO

We have been concentrating on key areas that have proven beneficial for us, such as healthcare, education, government, and hospitality. These sectors often involve more complex sales and purchasing decisions, and we have made significant progress there. We believe we are still in the early stages and see great potential for growth as we move forward. We are also focusing on enhancing our penetration opportunities, which involves better collaboration across our businesses and maximizing our newer products to ensure they reach the right decision-makers. In our First Aid and Safety business, we are similarly searching for penetration opportunities and looking to engage larger national customers in both First Aid and Fire sectors. We have made good strides and are optimistic about the upcoming year as we enter the second half.

George Tong, Analyst

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, Executive Vice President and CFO

Pricing has certainly had an impact. I noted that it wasn't as incrementally positive this quarter as it had been in the previous two quarters. Overall, pricing is somewhat consistent with what we've experienced over the past couple of years, excluding the last few quarters. Generally, when we demonstrate value and engage in the right conversations with our customers, we’ve been able to implement some pricing changes, and I don’t expect that to change. Regarding margin opportunities and improvements, it's largely about growth creating leverage and efficiencies in our plants. This is particularly evident in our rental business, where we don’t utilize capacity as much for our restroom and hygiene products, allowing us to achieve greater efficiency. Additionally, we’ve eliminated some inefficiencies within the business, so a significant portion of the gross margin improvement is tied to the revenue growth, leveraging, and efficiencies we are able to achieve.

Operator, Operator

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

Kevin McVeigh, Analyst

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 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, Executive Vice President and CFO

Last year in the third quarter, we discussed the weather and the holidays. It's difficult to anticipate weather patterns, so we aren't planning around any specific weather. Regarding the holidays, we previously mentioned that Christmas and New Year's fell on a Tuesday, which was unusual and had an impact. This year, both holidays are on a Wednesday, the last time being in our fiscal '14 year, so it's been a while since they fell on a Wednesday. In terms of our weekly volume flow, it's like a bell curve; Mondays and Fridays are our quieter days, while volume increases from Monday to Tuesday as customers become more active. Wednesday is usually one of our busiest days, and then volume starts to decline toward the end of the week. With both holidays on a Wednesday this year, we expect some year-over-year challenges, similar to what we mentioned last year about the holiday disruptions. We don't believe it will hinder growth significantly, but it won't make our comparisons any easier.

Kevin McVeigh, Analyst

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, Executive Vice President and CFO

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, Operator

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

Seth Weber, Analyst

Most of the questions have been answered, but I wanted to explore your pricing comments, which seem to be less robust than what we saw in the first quarter. Is there anything specific you would point out? Is it a mix issue, are the comparisons just getting tougher, or is there something happening on the competitive side that you could highlight? Thank you.

Mike Hansen, Executive Vice President and CFO

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, Analyst

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, Executive Vice President and CFO

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, 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, Executive Vice President and CFO

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.