Serve Robotics Inc.
Q2 2018 Earnings Call Transcript

Published: 31 Jul 2018

[Operator:]

Ladies and gentlemen, welcome to ServiceMaster's Second Quarter 2018 Earnings Call. Today's call is being recorded and broadcast on the Internet. Beginning today's call is Jesse Jenkins, ServiceMaster's Senior Director of Treasury and Investor Relations, and he will introduce the other speakers on the call. At this time, we’ll begin today's call. Please go ahead, Mr. Jenkins.

[Jesse Jenkins:]

Thank you, Tia. Good morning and thank you for joining our second quarter 2018 earnings conference call. Before I review the agenda and introduce the other speakers, I'd like to remind you that throughout today's call, management may make forward-looking statements to assist you in understanding the company’s strategies and operating performance. As stated on slide 2, all forward-looking statements are subject to the forward-looking statement legends contained in our public filings with the Securities and Exchange Commission. These forward-looking statements are not guarantees of performance and are subject to the risk factors contained in our public filings that may cause actual results to vary materially from those contemplated in the forward-looking statements. Information discussed on today’s call speaks only as of today, July 31, 2018. The company undertakes no obligation to update any information discussed on today’s call. This morning, ServiceMaster issued a press release filed with the SEC on Form 8-K, highlighting our second quarter 2018 financial results. The press release and the related presentation can be found on the Investor Relations section of our website. We will reference certain non-GAAP financial measures throughout today's call, and we have included definitions of these terms in our press release, which is available on our website at www.servicemaster.com. We've also included reconciliations of these non-GAAP financial measures to the most comparable GAAP financial measures in our press release and the appendix of this presentation in order to better assist you in understanding our financial performance. All references on the call to EBITDA are to adjusted EBITDA as defined in our press release. Joining me on today's call are ServiceMaster's Chief Executive Officer, Nik Varty; and Chief Financial Officer Tony DiLucente. For those following along with the presentation available on our website, I’ll walk through the agenda items shown on Slide 3. Nik will lead off by providing second quarter 2018 highlights. We will then provide an update on the American Home Shield separation and progress on the Terminix business transformation. Tony will follow and summarize our consolidated second quarter 2018 financial results, review the individual business unit results, provide more details in regard to our financial statements and then speak to the updated full-year 2018 outlook. We will then open the line to allow questions. I'll now turn the call over to ServiceMaster's CEO, Nik Varty for opening comments. Nik?

[Nik Varty:]

Thanks Jesse. Thank you all for joining us today and your interest in our company. I will start with our highlights on the quarter on Slide 4. We were pleased by the strong revenue growth across our businesses in the second quarter. Our transformation efforts at Terminix are on track and beginning to drive improved NPS scores, revenue growth and profitability. While the expansion of our presence in the commercial disaster restoration business and the strengthening of the commercial cleaning business drove improved results at the Franchise Services Group or FSG. We reported an 8% year-over-year revenue increase to $874 million in the quarter with organic growth in all our segments highlighted by 9% growth in American Home Shield or AHS and 14% in the franchise services group. This topline growth continued to the bottom line with adjusted net income of $108 million up $15 million year-over-year and adjusted EPS of $0.11 per share to $0.79 per share or 16% higher over the same quarter last year. Free cash flow generation continues to be a trend of the company, as we generated $119 million in the second quarter, which is 110% of adjusted net income. We are continuing to focus on acquisitions that add strategic value to our business. We delivered $25 million of growth to Copesan and four additional pest control companies we acquired in the second quarter. The acquisition of Cooper Pest Control will significantly enhance our expertise and capabilities to deliver bedbug solutions, and we can leverage these across our entire customer base. We are making meaningful strides in other areas of the Terminix transformation with a focus on enhancing our service delivery to drive customer satisfaction to new levels. We are also driving empowerment towards the organization with keen focus on providing our technicians and local branch management at Terminix with the ability to service customers in the flexible manner that they demand. We continue to drive strong growth at AHS and are taking decisive actions to address the previously announced claims cost issue, which Tony will describe in detail in a few minutes. Turning to Slide 5, you can see that we remain on track for a late Q3 spin of American Home Shield. We have received our private letter ruling from the IRS that qualifies the transaction as tax free. Our work streams continue to progress as expected under many initiatives, including building on the management team. In that regard, I was very pleased to recently announce our own Brian Turcotte as the CFO of American Home Shield. We will certainly miss Brian on the Investor Relations and Treasury front but are excited for his opportunity to leave the finance function at a strong business. I would also like to announce the promotion of Jesse Jenkins to Senior Director of Treasury and Investor Relations and thank him for jumping right into his new responsibility by hosting this call today. As has been work streams build momentum and now that we have closed the date of the spin, we can provide guidance related to ongoing costs to stand up AHS as a public company and the standard cost impact for ServiceMaster from spinning off AHS. Hereinafter, we will report these ongoing cost impacts as the synergies. In total for both companies, there will be approximately $9 million in these synergies for the remainder of 2018 and close to $20 million on an annualized go forward basis. As a reminder, these increased operating costs are primarily related to the duplication of certain corporate functions such as finance, legal, IT and human resources. We are targeting our mid to late September equity roadshow and an Investor Day on the morning of September 12 in New York based around the Form-10 public filing that we are finalizing in the coming days. This will be an opportunity to meet the new management team and participate in a deep dive on the standalone operations of American Home Shield. There remains work to be done but we are confident that we will be able to complete the spin by late in the third quarter. As you turn to slide 6 you will see a slide we have shared with you several quarters now updating our progress on the Terminix transformation. As we have mentioned in previous quarters, the true differentiator is talent. And we are building a strong leadership team across the businesses. Both Matt Stevenson and Kelly Kambs are putting the stamp on the residential and commercial side of the Terminix business. As they continue to staff other teams with a combination of strong internal and external power. Dion Persson has been instrumental in helping our business leaders in building our exciting business strategies for all our brands driving a renewed focus on strategic acquisitions and ensuring we deliver on our commitment of a timely spin-off of American Home Shield. And when Tony touches on Terminix performance in a few slides, you will again see improvements driven by Chief Transformation Officer, Pratid Dastidar, as he continues his work driving waste out of the system. Adding Rex Tibbens to lead AHS gives us incredible horsepower to effectively execute our exciting strategies for American Home Shield. I’m exciting to the team we have assembled, and the tone we are setting on becoming a strong process-oriented company depending on empowering our people, raising customer satisfaction and driving a digital and physical transformation. The Terminix business is reinforcing accountability by utilizing seven key metrics identified as vital towards success. We stack rank our branches based on scores and safety, employee engagement, household count, Net Promoter Scores or NPS, new renewable units, revenue, and branch level EBITDA. In addition to allowing us to provide real-time halt to our underperforming branches and hold them accountable, we are also able to identify high-performing branches and learn from their successes. These best practices are utilized in our transformation office to create repeatable and scalable processes which are shared across the business. Because these vital metrics were developed in conjunction with our branch managers, if you empower to continue to deliver results, this is just one way we empower our technicians and branch management who deliver exceptional customer service. The changes we made to improve compensation plans for our technicians continue to pay dividends as evidenced by NPS scores up again year-over-year this quarter 5% in pest and 9% in termite. Rewarding the right behavior is beneficial to not only the technicians but also our customers, and ultimately the company through improvements and sustainable organic growth. We are maintaining high level of guiderails and holding technicians accountable, while at the same time removing complexity and difficulty from their daily activities and rewarding them for their successes. Empowerment at all levels of the company is vitally important as we allow individuals to take the appropriate actions to delight our customers on a daily basis. We remain focused on rebuilding a strong commercial pest control business. The second quarter represents the first quarter of fully incorporating Copesan into our commercial business. We continue to absorb as much knowledge about how to best serve our commercial customers from our Copesan partners. Their history of strong retention and unique go-to-market strategy for national accounts presents a huge growth opportunity that we are in the early phases of implementing. Sharpening our expertise in the long longer-term sales process necessary to line complex commercial customers will allow us to continue to grow this business. I will have some additional details on commercial business development on the next slide. We are also driving this elimination and process improvement throughout the company led by our transformation office. Again, this quarter, we were able to show year-over-year productivity gain in both bad debt expense and sourcing savings on materials. As we drive Lean Six Sigma philosophies down through the organization and ingrain it in our day-to-day processes, we will continue to capitalize on efficiencies. This productivity allows us to reinvest in critical aspects of the business designed to help us grow. A Lean Six Sigma approach is something that will be part of our continuous improvement mindset indefinitely. The Terminix transformation continues to take a disciplined approach to executing on a number of initiatives designed to significantly upgrade the customer experience and drive organic growth in this business. Organic growth of 0.5% is in line with our expectations. Despite a challenging year-over-year comparison and we stand by our guidance of 1% to 2% growth for the whole year, I am confident that we are on the right path at Terminix to lead us to sustainable profitable growth for years to come. Turning to Slide 7, we are starting to see tangible progress from our focus on building our commercial capabilities. With Copesan now fully incorporated, we have begun the integration of our own national accounts into Copesan business model. The company's nationwide footprint, combined with a world-class service capabilities of Copesan make our combined company a meaningful player in the growing national accounts space. The best-in-class service capabilities of Copesan allowed us to grow that business at rates faster than the industry in the second quarter. We will leverage those capabilities and systematically incorporate them across all of our company-owned locations. Eventually, we will be able to match the incredibly high customer retention rates that Copesan enjoys as we learn from them how to satisfy these profitable and sustainable customer relationships. During our acquisition due diligence, we laid out a systematic plan to integrate our internal national accounts to that of Copesa. We are wishing our teams to execute that plan as quickly as possible without impacting customer relationships and are making significant progress to that end. Over the coming quarters, we will work to drive synergies identified in our commercial acquisitions that will allow us to improve upon margins as well. Kelly Kambs is adding strong leadership capabilities within the business. Kelly is specially focused on transforming the commercial sales team, developing the right salespeople to focus on the longer lead time and more demanding commercial customers is a beginning step towards strengthening customer retention. Kelly and our team are also working on improving service delivery by leveraging Copesan’s quality assurance process, developing metrics that more effectively monitor and drive performance and improving the digital platform utilized by commercial service technicians. I am very excited about our growth opportunities across all of our businesses and look forward to sharing our successes as we move forward. I’ll now turn the call over to Tony who will cover second quarter 2018 results. Tony?

[Tony DiLucente:]

Thanks, Nik, and good morning, everyone. Before I begin, I would like to take this opportunity to personally congratulate Brian Turcotte on his new appointment as CFO of the American Home Shield business. He has been a valued member of my finance team, and I know he will do a tremendous job in his new role. I would also like to recognize Jesse Jenkins on his well-deserved promotion and look forward to working with him in his new role. Turning to Slide 8, total company revenue grew $67 million or 8% compared to the prior year. Our results were driven by continued strong organic revenue growth of 9% at AHS, predominantly driven by unit growth and price realization and 14% at FSG driven by continued janitorial national accounts growth and higher disaster restoration royalty fee. Terminix revenue is up over 6% mostly due to the acquisition growth for Copesan. Adjusted EBITDA for the quarter is now $2 million or 1% compared to the prior year. As we previously released, the decrease was driven primarily by the $22 million increase in year-over-year claims cost at American Home Shield. The claims cost increase was predominantly driven by an increase in appliance replacements versus repairs that we will discuss in more detail in a moment. Higher claims costs were offset by higher revenue conversion in all of our segments and Terminix business productivity. Our adjusted net income for the second quarter was $108 million, a $50 million increase versus prior year. Adjusted diluted earnings per share of $0.79 was up 60% versus prior year. The increase on the bottom line was primarily driven by a lower effective income tax rate as we continue to realize the benefits of the Tax Cuts and Jobs Act of 2017. Turning to Slide 9, I will detail the second quarter performance of Terminix. Revenue increased over 6% to $456 million driven by a $25 million in acquisition growth predominantly from the Copesan acquisition. Organic growth was 1.5%, driven by a modest increase in new termite completions, as well as increases in attic insulation, wildlife exclusion and other revenue which was offset by a decline in termite renewals. It should be noted that the second quarter 2017 was the beneficiary of an initiative to upgrade our monitoring stations for a subset of our customers. If we normalize prior year for the impact of this benefit, Terminix organic growth would have been approximately 1%. Adjusted EBITDA for the second quarter increased 4% or $4 million to $109 million. If you review the waterfall chart on the bottom of slide nine, it’s starting on the left side. You'll see that higher revenues converted to a $7 billion improvement. Business productivity improvements added $5 million of EBITDA and those improvements included a $3 million of chemicals and materials savings, $2 million of reduction in bad debt expense driven by enhanced credit policies and collections efforts. So, these productivity gains allow us to reinvest in critical aspects of the business with a relentless focus on continuing to improve our organic growth rates. Selling and administrative costs from our acquisitions increased $5 million in the quarter predominantly driven by Copesan. We had a $6 million timing benefit this quarter from the adoption of an accounting rule change on January 1, 2018 that impacts the timing on the recognition of certain sales costs. Full-year impact from this accounting change will be negligible. We also invested $5 million in targeted sales and marketing to increase new sales and drive organic growth. We expect this investment to continue at a similar level in coming quarters. Material items within the other bucket includes a $2 million increase in incentive compensation and a $1 million increase in fuel expense although we were able to avoid significant costs by effectively hedging the majority of our fuel spend so far this year. The $4 million growth and adjusted EBITDA for the quarter was highlighted by process improvements that drive business productivity gains, a key element of our ongoing Terminix transformation. Turning to Slide 10 in Terminix revenue by channel for the second quarter starting on the left side of the chart, revenue from termite completions which includes new termite sales and related services with $96 million up 3% versus prior years. During the quarter, approximately 60% of this $96 million in termite completion and other services revenue was derived from the sale of four termite completions, meaning a first-time termite service. Core termite revenue increased 1% year over year. The remaining 40% of termite completion and other services revenue comes from services such as attic installation, wildlife exclusion and other onetime services. This revenue stream increased by 7% year over year. Termite renewal revenue decreased by $3 million or 3% compared to the prior year. As I previously noted, a significant portion of the Q2 year-over-year decline in renewals was the result of a base station conversion done for a subset of our customers in Q2 2017. Pest control revenue of $254 million was up 11% versus prior year driven by acquisition revenue from Copesan. As previously mentioned, this growth is primarily within commercial demonstrating our continued focus on building a strong commercial business. Also, within pest revenue, we received positive feedback on our new Quick Guard Mosquito Service with mosquito revenue up 14% organically over prior year. As previously mentioned, Terminix organic growth of 0.5% was in line with our expectation despite a challenging year-over-year comparison. We remain confident that transformation is gaining traction and reiterate our full-year organic revenue guidance of 1% to 2%. Let's turn to Slide 11 and discuss AHS’ second quarter performance. It was a quarter a strong top line growth with revenue up $29 million or 9%, that’s all organic growth. The revenue growth was largely driven by new and renewal unit sales growth, which accounted for more than 7% of AHS’s 9% growth with improved price realization accounting for the remaining 2% of growth. Revenue growth continued to be strong in both of our key channels of market with direct to consumer or DTC in real estate both up 9% year-over-year. This was driven largely by initiatives that led to improvements in both customer service and contractor quality. Second quarter gross margin decreased by 510 basis points versus prior year due to the $22 million increase in contract claims costs principally driven by a higher mix of appliance replacements versus repairs which is an industry-wide trend driven by parts availability. To remain well positioned for this trend, we're working closely with our partners to ensure consistent supply continuity. Adjusted EBITDA decreased $10 million or 12% to $73 million versus prior year with margins down 480 basis points. To understand the drivers of EBITDA during the quarter, please turn your attention to the waterfall chart on the bottom line of slide 11. Starting on the left side, organic revenue conversion growth was $19 million in the quarter with $14 million related to volume and $5 million related to price. Moving to the right, you see the $22 million increase in contract claims costs principally driven by higher mix of appliance replacements versus repairs I just mentioned. I'll cover the increase in claims costs in more detail in a moment. The $3 million increase in sales and marketing costs was driven by targeted spending to drive sales growth. The $2 million dollar increase in customer service cost was an incremental investment in customer care center cost deliver a new level of customer service. And finally, other includes incremental ongoing costs related to the spin-off of AHS of $1 million which primarily is related to the separation of information technology systems historically shared by our business units. Moving on to Slide 12, I want to address the claims cost issue that we disclosed in our prerelease on July 17. Claims costs have significantly escalated in appliances primarily due to industry wide parts availability trends that are increasing appliance replacement rates. I want to walk you through the impact in more detail and more importantly address the decisive steps we're already taking to strengthen AHS going forward. The table on Slide 12 outlines the causes of changes for both the second quarter year-over-year impact in the current full-year 2018 outlook versus the previous outlook provided in May. Starting with the second quarter impact, the $22 million increase in contract claims costs includes an adjustment of $12 million related to prior periods. This adjustment recorded in the second quarter represents the change in estimates as a result of adverse development of contract claims cost originally estimated and recorded in the previous quarters based on historical claims experienced and actuarial estimates. Reserves are established based on estimates of the ultimate cost to settled claims. Home service plans take about three months to settle on average, and substantially, all claims are settled within six months of occurrence. The amount of time required to settle a claim can vary based on a number of factors including whether a replacement is ultimately required. In addition to the $12 million of higher claims cost from prior periods, the impact of higher appliance replacements in the second quarter increased claims cost by $4 million. The increase in contract claims cost in the second quarter also includes normal inflationary pressure on the underlying cost of repairs totaling $3 million and a higher number of work orders driven by significantly warmer summer temperatures in 2018, which increased claims cost by $3 million. If we now look at the causes of change from the previous full-year outlook, the $21 million increase in contract claims cost include an adjustment of $6 million related to prior periods. In addition to the $6 million of higher claims cost from the periods prior, the impact of higher appliance replacements in 2018 are projected to increase claims cost by $12 million or $3 million per quarter. The remaining increase in contract claims cost in 2018 include a higher number of work orders driven by significantly warmer summer temperatures, which could increase claims cost by $3 million. It's important to note that we're taking decisive actions to address the fact that appliance replacement rates have accelerated above historic levels. We are focusing on our efforts in four areas. Number one, people. We're putting in place strong leadership throughout the organization to drive greater accountability. Number two, pricing. We are increasing pricing to properly reflect the rise in replacement rates of appliances and implementing processes to more dynamically-priced home service contracts. Third, process and visibility. We are improving our operations and analytics to identify changing trends earlier, including daily visibility, the information that will allow us to understand changing market trends much faster. And fourth, cost containment. This effort includes renegotiating appliance contractor agreements. We believe that our actions will have a mitigating impact on the current industry-wide trend. We are confident that these changes will make the business much stronger over the long term and we expect to return to historical margin levels over time. Let's move to Slide 13 where I will cover SFG’s second quarter performance. Revenue increased $11 million year-over-year or 21%. The increase was driven organically by $4 million of higher domestic janitorial national accounts revenue, $3 million of higher royalty fees driven by increases in disaster restoration including increases in commercial and fire disaster restorations. Revenue also increased by $4 million related to the adoption of a new accounting rule regarding revenue recognition that took effect on January 1. We now report franchisee contributions to the national advertising fund as revenue rather than as a reduction in advertising expense. This accounting change has no impact on EBITDA and is simply a reclassification of how we record franchisee contributions to the national advertising fund. We now expect a full-year revenue impact from this accounting rule change to be approximately $40 million with no impact to EBITDA. Second quarter adjusted EBITDA was up $2 million or 9% versus prior year. Despite the growth in EBITDA dollars, the EBITDA margins decreased 420 basis points versus prior year to 37.4% due to the increase in the national accounts revenue and the previously mentioned revenue recognition accounting change. As you may recall, ServiceMaster recognizes revenue directly on services provided to the national account customers and subcontract the work to franchisees. Therefore, as we grow our national accounts revenue, it has a negative impact on margins but does add incremental EBITDA. To understand the drivers of EBITDA during the quarter, please turn your attention to the waterfall chart on the bottom of slide 13. Starting on the left side, revenue conversion growth was $3 million due primarily to higher disaster restoration royalty fees and we had a $1 million increase in G&A from a number of small items. At FSG where we are expanding our reach to include commercial disaster work, and saw positive momentum in this area in the quarter. And then our drive to increase EBITDA dollars in the segment, we have also increased new sales at janitorial national accounts leading to positive momentum that will continue in this area over the remainder of the year. Turning to the second quarter consolidated P&L on slide 14, a little over half of the year-over-year revenue increase of 8% or $67 million was organic with the Copesan acquisition driving most of the remaining revenue growth. Second quarter gross profit was down $15 million in the quarter driven by the $22 million year-over-year impact from AHS claims offset by business productivity gains at Terminix and higher revenue conversion at all of our businesses. The year-over-year SG&A increase of $19 million primarily reflects a net $6 million of increased sales and marketing costs which include the $4 million increase from the previously discussed FSG national advertising fund accounting change, $5 million of target investments to drive sales growth at Terminix offset by $6 million of benefit related to the previously discussed accounting rule change that impacted the timing of recognition of certain sales cost at Terminix. There was also a $5 million of higher acquisition SG&A predominantly from Copesan, and about $2 million of higher call center cost that AHS aimed at improving customer service. As a result, SG&A as a percent of revenue increased by 20 basis points to 25.7%. Net income of $96 million for the second quarter was up $11 million versus prior year. Adjusted net income for the second quarter was $108 million, up $15 million from the same period in 2017 due to a lower effective tax rate from the enactment of tax reform. With respect to cash flow, as shown on slide 15, year-to-date free cash flow is $238 million, up 6% year over year and 68% of year-to-date adjusted EBITDA. The company paid $16 million in cash taxes in the second quarter, $24 million less than prior year due to tax reform. The $8 million increase in year-over-year property additions is related predominantly to onetime AHS spin purchases in our recent global service center relocation. We did not repurchase any shares of ServiceMaster stock in the second quarter of 2018, and we currently have $155 million remaining from the original $300 million share buyback program. The full-year 2018 updated outlook is shown on Slide 16. I realize this page is very detailed, but as we are approaching the spin, we felt it was important to detail the individual companies on a stand-alone basis as well as on a WholeCo basis, which reports the current company with regard to spin. For the sake of time, I will take you through only the WholeCo guidance in the far right-hand column. As a reminder, the WholeCo 2018 outlook assumes ASH remains part of ServiceMaster for the full year and excludes the impact of any future acquisitions. The changes from the outlook we've provided on the Q1 earnings call on 2018 are as follows. We now anticipate full-year 2018 revenue to range from $3.15 billion to $3.160 billion or an increase of between 7% and 9% compared to 2017. This midpoint change of just over $40 billion is related to higher than anticipated disaster royalties in FSG, as well as the impact of acquisitions in Terminix. We also now anticipate full-year 2018 adjusted EBITDA to range from $680 million to $700 million or flat to an increase of 3% compared to 2017. As detailed earlier, this change of approximately $13 million is predominantly related to an increase in AHS claims costs largely derived from the higher replacement rate on appliances offset by $8 million of improved margins in Terminix due to business productivity gains from our Terminix transformation. In addition, we are now including our projected 2018 dis-synergy costs of approximately $5 million at SpinCo and $4 million at RemainCo. Turning to Slide 17, we have included some additional guidance details to assist you with modeling. I'll highlight a few of those items. There has been no change to our organic revenue growth targets for the year and we remain on pace for 1% to 2% growth in Terminix. mid-single digits that have FSG in high single-digits than American Home Shield. And due to the previously mentioned AHS replacement rate issue, we now expect gross margins at AHS between 46% and 47% resulting in an EBITDA margin of approximately 20%. I'll now turn the call back over to Jesse to lead us through a question-and-answer session. Jesse?

[Jesse Jenkins:]

Thanks Tony. As a reminder during the question-and-answer session, we encourage you to ask any questions that you may have but please note that guidance is limited to the outlook we provided in our press release and webcast presentation. Additionally, since the queue is long this morning, please limit yourself to one follow-up questions, so that we can get to everyone in the allotted time. Tia, let’s open up the line for questions.

[Operator:]

[Operator Instructions] And our first question comes from the line of Judah Sokel with JPMorgan. Please proceed with your question.

[Judah Sokel:]

I just wanted to ask a quick question, a housekeeping, could you tell us the NPS scores or the retention rates how those trended in the quarter? You've been kind enough to provide those in the last couple of quarters and it’s really key for assessing how that turnaround is going at Terminix.

[Nik Varty:]

We don't give out the absolute numbers. As you know, we get to a trend on how we perform. And as you - as I mentioned earlier, our test NPS scores are up 5% and termite NPS scores are up 9%, which is an encouraging sign given the amount of work we have to do to turn around performance issues and all that we've faced in the past. And what I've seen are extremely encouraging trends in terms of behavior, in terms of the motivation. And if look at that, we did register 0.5% organic growth this quarter which is very much in line with our expectations. As we focus on the quality of revenue, we are trying to generate a reasonably challenging quarter last year which had a conversion to bait stations which has a onetime effect. Barring that, we would've been closer to 1% growth rate. So, I think, all in all, on the residential side, we've seen some significant improvements on the pest side. We're starting to see some improvements on the termite side because our first focus was passed. And I'm pretty encouraged with what I'm seeing and see for the rest of the year. On the commercial side, as you know, we started that work fairly late in the game. Our first focus was residential when Kelly coming on board about four, five months ago. And we're starting to see some improvement given our efforts with Copesan. But that's going to take a little while to turn compared to the residential side as well.

[Judah Sokel:]

And just from my follow-up question, I was hoping to dig a little bit more into the issue in AHS of parts availability. I'm just trying to understand a little bit what is going on to drive that dynamic. Did anything change in terms of the vendors, perhaps, mergers or anything changing your relationships with those vendors, have input costs for those parts gone up and there? And this is simply a case of the vendors putting it through to you guys. Maybe you could just discuss a little bit about what's driving that dynamic. Thank you.

[Nik Varty:]

You did notice this is a trend, and we look at it. This is across the industry, so it's not just American Home Shield, but we've seen across the whole industry that appliance placement rates are going up and parts availability being a major issue. Now, we're working being one of the largest players, and we are working very systematically with a lot of our vendors to improve that situation and curtail that. So, this is not – the costs haven't gone up per se. The issue is just the availability of parts.

[Operator:]

Our next question comes from the line of Ian Zaffino with Oppenheimer. Please proceed with your question.

[Ian Zaffino:]

Just a quick question on the AHS side. What sort of the market's tolerance for maybe price increases there, or maybe you could give us an idea of what you've done historically when situations like this have happened in the past. How long does it take you to recoup any of the lost margin, et cetera? Thanks.

[Nik Varty:]

In this market, typically, we have been able to raise prices anywhere from 1% to 2% and also being able - very successfully with that because we match with the industry trends. And typically, we are much better able to anticipate these and get the pricing in place. We've seen typically – we've been able to counter inflation. As you've seen, we’ve generated steady margins or consistent margins over the past few years. We have seen replacement rates actually jump about 200% - 200 basis points compared to last year, which is a much larger uptick than you've seen in the past, which is closer to the 100% increase. And there are several different reasons why that is happening, as I mentioned earlier. So, it’s an ability. I think one other thing we’re doing, Ian is we have improved our systems and our capabilities or visibility to anticipate some of these changes in a better way. For example, we are putting in not only visibility but people who will be looking at this on a daily basis. So, we see the trend uptick and we can react much quicker than we did in this instance. The other thing we're looking at is an upgrade in our system to do dynamic pricing. What I mean by dynamic pricing is rather than having across the board consistent pricing we're looking at now via zip code and what the price elasticity is and there are certain customers who were able to bear more pricing or we know that these - the profiles in certain areas is much more severe in terms of cost and the customers are actually willing to pay that kind of pricing to go in. The question is improving our capability to match that going into the business while we take these accounts rather than react to it like we're doing at this stage.

[Operator:]

Our next question comes from the line of Andrew Wittmann with Baird. Please proceed with your question.

[Andrew Wittmann:]

I wanted to dig into the AHS claims costs and its impact on guidance. Not so much on 2018 but as you - first of all, thank you for the detail on slide 12. When we look at this the line that draws the most attention to me is the higher appliance replacement rates in 2008 which is a $12 million variance from your prior look. So, I guess I just want to confirm that’s basically a three-quarter adjustment of $12 million or an average about $4 million per quarter implying potential $16 million annual headwind. Tony, is that the right way to think about how the replacement issues are affecting the business net of any remedial actions that you're taking?

[Tony DiLucente:]

Yes. I think it's more like $3 million a quarter on an ongoing basis rather than $4 million. I would use that $12 million a year or $3 million a quarter.

[Andrew Wittmann:]

And how do we think about the replacement thing? It seems like this is going to have been an issue that's going to carry on. You've got the mitigating factors. When do you think that your actions could take effect? And how do you consider the weather that's happened this year? Is it unusually hot versus averages, or how should we factor in the weather impact as we think out into next year?

[Nik Varty:]

There's a couple of questions there, Andy. If you look at summer, this particular May was, in the last 124 years that weather has been measured, was the hottest May in history almost by an average of 5 degrees across most states, which is a significant increase. So, this is an anomaly. Weather has always been up or down, but over time, you see that kind of even out as we see. It was a hot May, but we're going to see some normalization in some months. And we don't normally try to play and predict weather. So, we typically in our estimates predict the normalized impact as we keep calculating. But May was a huge anomaly for this year across all practically every state in the U.S. On the other questions on replacement rates, there's a couple things we’re doing. Number one important thing to me always is about people. And by putting in not only Rex at a C-suite but a very capable team under him, we believe that there's a team that is much more capable combined with the visibility we’re putting in the systems and early warning system that this team is able to take accountability and rapid actions to match that. This whole concept of dynamic pricing which is fairly new and being installed in place will also allow us to anticipate the nature of business by zip code. As I mentioned, knowing specific elasticities of different markets that we’re able to price these based on anticipated trends rather than reactionary trends. So, why we are deeply disappointed with what happened here especially from the timing, not the replacement rates because that's a trend, the key is how quickly can you anticipate and react to these trends. What I'm really interested about is, how well Rex and the team reacted to this situation and how rapidly they have put some action plans in place already starting to raise prices. Over two-thirds of the business is already sort of in the bank, it's hard to cycle that through in less than a year. But going forward, I think this is - what's really good about this is I can - I have a strong conviction that this situation won't happen or it’s highly unlikely to happen again or creep up on us because we have good people, good prophecies, good systems, good visibility, matching pricing. So we're putting all the ingredients in place to run this incredibly strong business going forward.

[Andrew Wittmann:]

If I can, I wanted to dig into the impact of your contractor network as well, specifically, your usage of preferred contractors. Anybody who's read the pros press or owns a house knows that it's hard to find these specialty contractors today. Are you guys having to go out of network or use less preferred contractors? And how much of a factor is that into the AHS cost headwinds that we've seen so far this year, if at all?

[Tony DiLucente:]

Yes, Andy. I’ll take that one. That is not an issue this time. We’re still running roughly 80% of our cost through preferred contractors. So, that was not the issue as we strictly repair – replace versus repair this time around. So, we're doing a good job of maintaining our contractor network, our preferred percentage all in line with our expectations and goals.

[Operator:]

Our next question comes from the line of Tim Mulrooney with William Blair. Please proceed with your question.

[Tim Mulrooney:]

Just piggybacking on Andy's question with the weather related issues that AHS, in your preliminary results statement you said that the revised outlook for 2018 included an annualized $12 million from ongoing contract claim costs and $18 million from increased number of claims due to weather. I didn't hear you guys mentioned this $18 million figure in your press release today or in your comments today. Is this still a relevant number?

[Jesse Jenkins:]

Yes. This is Jesse. That $18 million is not an accurate number. We shouldn’t use the new guidance that we had provided based on weather. So, only $3 million of that actually impacts the guidance going forward the rest of the year.

[Tony DiLucente:]

And that's the $3 million that we saw in the second quarter because mostly the unusually hot May.

[Tim Mulrooney:]

So, if I'm thinking about 2019 would it be fair to just assume a normalized rate I would add back that $3 million to get a base number and then and then add back 30% incremental operating margins on your organic growth rate? Is that a good way to think about AHS margins moving forward?

[Tony DiLucente:]

I think so – I mean the way I look at it is the ongoing impact of the replacement versus repair issue is $3 million a quarter or roughly $12 million, whether it's going to – we think over time EBITDA some years will be hotter than normal, some years will be colder than normal or less weather impact than normal. So I look at it as $12 million of higher cost in our operating base going forward because of this issue we're facing with appliance parts.

[Nik Varty:]

But we would have in tandem pricing that is reflecting that increase, so we can take care of that and help our margins going forward.

[Tony DiLucente:]

It’s high that we’ll offset that with actions, pricing and supply chain actions.

[Nik Varty:]

And that will allow us to get back to the historical margin levels.

[Tony DiLucente:]

Yes.

[Tim Mulrooney:]

Okay.

[Nik Varty:]

So, whether we don’t normally - we will never predict whether, so we usually take the history and use that as a normalized pattern of what will happen next year.

[Tim Mulrooney:]

That's more simple way of looking at it. Thank you. That's very clear now. And then shifting gears to Terminix, your pest control revenue growth of 11% was quite a bit stronger than what we've seen recently. Were there any onetime items to think about here or are we really starting to see the impact from the turnaround effort?

[Nik Varty:]

Apart from the residential improvements that we’ve seen, the bulk of it really came from actually the acquisition of Copesan and some of the smaller acquisitions we made, but mainly Copesan. One of the reasons you see a guidance bump is not only that new acquisitions, but our retention rates at Copesan were way higher than what we had anticipated because we've been able to pretty much retain all customers with the with the combination. And as I mentioned in my remarks earlier, Copesan actually grew at higher than market or 6.5% year-over-year organic growth. We don't count that in organic today because Copesan is an acquisition. So, that shows up in our inorganic growth, but Copesan registered a very sizable growth this quarter for us.

[Tim Mulrooney:]

Got it. Thank you.

[Nik Varty:]

This is a great sign for us. It’s a real – again, a reaffirmation that we did the right thing, and the execution of the integration is – the team has done a great job.

[Tony DiLucente:]

Just to add to that, Copesan will add significant capabilities all throughout our commercial business, so we're very in line in that acquisition.

[Operator:]

Our next question comes from the line of Michael Hoffman with Stifel. Please proceed with your question.

[Michael Hoffman:]

Thank you very much for taking the question. You answered this earlier. I just didn't hear it very well. Sorry. I apologize for asking it again. How did you frame the retention in the quarter by residential versus commercial – pest control? Sorry.

[Nik Varty:]

We have started breaking out residential versus commercial. But what I said is we've seen an overall NPS for improvement of 5% on pest and about 9% on termite, which is the strongest correlation of future organic growth for us. Now, what I mentioned between residential and commercial is we started the efforts on residential of bringing in a new leader, completely resetting the team and focusing very hard on our transformation effect as one of the first pillars outright during the company almost a year-to-date ago. And so, we’ve seen much improvement in that because we've been more into that game. On the commercial side, we brought in a leader in Kelly four or five months ago. He's been building our team. We had acquired Copesan and a couple of others. So, we’re very strongly focused in that business where we were number 4 with $300 million today, number 3 with about $375 plus million. We are making progress but it will take us some more time to get to the same level of improvement we're already seeing in residential and we'll continue to see. So, I would say that I'm pretty encouraged with the progress we've made on the residential side on the pest, and on the commercial side I’m seeing good signs, the number 1 is putting in the people, learning from the Copesan practices, combining our national account teams with each other. So there are some good things going on which will bode well towards the end of the year or going into next year.

[Michael Hoffman:]

Well, to sort of stretch that further than underlying residential growth of the markets 1% to 2%, you're not growing in line with that, that means your retention is still hampering that. When do you see getting back in line with the underlying market growth?

[Nik Varty:]

As I've mentioned, when we took over this we are doing a lot of improvements in terms of what we've done is moved away from a complete centralized model to a smart central and much of a more decentralized given the business back into the branches. So, resetting the metrics from 40 to 45 fluctuating metrics or seven key metrics which I reiterated in my script today, changing the pace structure of our technicians which is bearing dividends already So, a lot of these things take a while. Any recurring business, a significant portion of that is in our - already in our numbers and we've still seen struggles on retention but we're starting to see some noticeable improvements and we will continue to see that as we go forward in the next quarter. And on the presidential side and we're still improving in the commercial. And as I've mentioned before, we have guided the whole year to be 1% to 2% given the knowledge of the underlying issues we have and the fix we have because what we want to come to, Michael, eventually is a business that can sustainably grow without impacts on one-timers and all is really on a sustainable basis that we are able to deliver at or above market growth going forward and that takes the hard work we have to do which we continue to see a lot of progress on.

[Michael Hoffman:]

And then one housekeeping question, when can we expect to see the Form 10, so we can be prepared from a standpoint of depth of data we're going to get from that?

[Nik Varty:]

In the next couple days - coming days.

[Operator:]

And our next question comes from the line of Toni Kaplan with Morgan Stanley. Please proceed with your question.

[Toni Kaplan:]

The amount of dis-synergies that you're projecting in 2019 is a fair amount lower than what we were previously thinking. And so, just trying to understand, are there any other costs that could be potentially incurred annually that might be higher than if you were keeping the companies together? Just trying to understand if there are some factors that could drive the dis-synergies higher. Thanks.

[Nik Varty:]

We think we're okay with that. I think our estimates are pretty strong. We've been working really hard to ensure we're minimizing those going in, but making sure we're not cutting any corners. We are making sure we’re at help setting two independent companies for success. So I think the $9 million forecast we’re giving for the year, we're standing by it and we believe that should be fine for this year. The annualized impact, as I mentioned, next year for the full year would be around $20 million. And that includes not only duplication of functions like finance, HR, IT, legal and others that necessary for two public companies but also some of the stranded costs that remain at ServiceMaster which we have to continue to that.

[Tony DiLucente:]

And I will add to that, our goal over time is to drive productivity to offset as much of these as we can. So, that will keep testing that as we go through in the future.

[Toni Kaplan:]

And in terms of the inorganic contribution in the Terminix business from Copesan and the other acquisitions, would you be able to provide a split for us of how much was Copesan? Just trying to understand if there's, like, basically the seasonality by quarter for Copesan. And you mentioned the 6% growth in that business. How does that compare to what it was growing at before you acquired it? And I guess how fast are the other acquired businesses growing? Thanks.

[Tony DiLucente:]

Well, the global growth that we delivered to our acquisitions including organic growth over there with the growth last year was $25 million for the quarter. Now, it's hard for you to estimate what the other four were because there were quite different parts during the year. And we've given some of the upgraded guidance for the rest of the year. We're not getting into the details of exactly which acquisitions delivering how much, I mean…

[Nik Varty:]

In Q2, Copesan is the vast majority of the increase. And so – and then I will say on the growth in the second quarter, Copesan grew –we had a very strong growth rate of over 6.5%. Again, just to reiterate, we're not counting that as organic even though it's occurring after the acquisition per year. We'll count that as inorganic. So, Copesan did have a good quarter, and we're really excited about Copesan going forward

[Toni Kaplan:]

And is there a seasonality in that business like a higher amount in fourth quarter than another quarter or something like that?

[Nik Varty:]

I think in all of our businesses there's always some element of seasonality in the second and third quarter being higher than the first and fourth quarter being lower. So, that always has to be taken into account for any of our past differences.

[Operator:]

And our final question comes from the line of Jamie Clement with Buckingham Research. Please proceed with your question.

[James Clement:]

Nik, did you say pro forma for Copesan and commercial pest control is about 375 on an annual run rate basis. Is that right?

[Nik Varty:]

Yes. Annualized.

[James Clement:]

And now that you’re on the business for a couple of months, as you look to share best practices and those kinds of things, obviously, great growth from them. What do you think you all can learn from the folks of Copesan to help build your commercial business over time?

[Nik Varty:]

Well, number one is the consistency in the delivery of their service and how closely they are aligned to every single customer whether they understand the needs. All those needs are baked into the tech practices. And they have an incredibly strong quality assurance system which is something we can strongly benefit from. And as I’ve mentioned earlier, we are in the process of combining our national accounts, so even if we acquire Copesan, Copesan is our brand. We're very proud of it and we're combining our Terminix commercial national accounts into Copesan directly. And we’ve appointed a leader from Copesan to drive those accounts for us. So, we will soon start seeing some of those benefits in our systems as well. Now, our Chief Transformation Officer is very deeply tied with them and we're working extremely closely not only to use some of their best practices, like I said, customer - deep understanding of customers' specific requirements, baking them into our protocols, almost like a pack having a clean recipe book on what exactly you do. There's independent quality assurance built into that system, good communications with the customer. So, all those will benefit, not only the national accounts at Terminix going forward, but also other commercial customer accounts that we have. And we are learning these best practices not only from the Copesan from a front-end perspective, but also the partners who help deliver the service today. We're partnering very strongly with them and it's been incredibly open and fruitful relationship for us.

[Jesse Jenkins:]

Thank you, all, again for your participation in today's conference call and webcast. As a reminder, a replay of the call will be available on our website in about 1 hour from now. We look forward to speaking with you on the third quarter earnings call currently scheduled for October 30. Thank you.

[Operator:]

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.